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Internal Revenue Service Treating Non-U.S. Mutual Funds as PFICs

The Internal Revenue Service has been informing tax advisors and their clients participating in the Voluntary Disclosure Program that ran from March 23 through October 15, 2009 that investments those clients made in non-U.S. mutual funds and certain other types of entities may be subject to U.S. income taxation as investments in passive foreign investment corporations (“PFICs”). A PFIC is any corporation organized under the laws of a non-U.S. jurisdiction which satisfies either an income test or an asset test.  The income test is satisfied if 75% or more of the foreign corporation’s gross income is passive income.  The asset test is satisfied if 50% or more of the foreign corporation’s assets produce or are held to produce passive income.  Code Section 1297(a). Characterization of a corporation’s income as “passive” is governed by the foreign personal holding company provisions of Code Section 954(c).  Generally, income earned from dividends, interest, royalties, rents, annuities, capital gains from sale or exchange of property which produces such income, foreign currency gains, and other items described in Code Section 954(c) will be characterized as passive income.  Active business income and income received from certain “related persons,” as well as certain other transactions are excepted from the definition of foreign personal holding company income.

The fact that the non-U.S. mutual fund is organized as a trust will not prevent its characterization as a PFIC. In Private Letter Ruling 200752029, the Internal Revenue Service determined that “an unincorporated, open-ended, limited-purpose trust” established under the laws of a non-U.S. jurisdiction, which was ”created for investment purposes” and qualified as “a mutual fund trust” under the laws of the jurisdiction in which it was organized would be regarded as a foreign corporation.  Similarly, U.S. Treasury Regulations provide that “an ‘investment’ trust will not be classified as a trust if there is a power under the trust agreement to vary the investment of the certificate holders.” Treas. Reg. Section 301.7701-4(c)(1)   “A power to vary the investment of the certificate holders exists if there is managerial power under the trust instrument that enables the trust to take advantage of market variations to improve the investment of the investors.” PLR 200752029 citing  Commissioner v. North American Bond Trust, 122 F2d 545 (2nd Cir. 1941), cert. denied, 314 U.S. 701 (1942).

Characterization of a non-U.S. mutual fund as a PFIC subjects the fund’s investors who are citizens or residents of the United States (“U.S. persons”) to one of three alternative methods to determine the amount of income the taxpayer will recognize as a result of investment in the fund.  For most investors, the most favorable method of taxation will be to treat the PFIC as a “qualified electing fund” (“QEF”).  The QEF election allows the taxpayer to distinguish between capital gain and ordinary income of the PFIC (in contrast to the “excess distributions” method described below).  However, in order for the QEF election to be effective, the PFIC must provide the taxpayer with a “PFIC Annual Information Statement” setting forth sufficient information to enable the taxpayer to accurately determine the taxpayer’s pro rata share of the PFIC’s ordinary income and capital gain for the taxable year. In addition, the PFIC must either have obtained the permission of the Internal Revenue Service to be treated as a PFIC or provide a statement that the PFIC will permit its investors to inspect and copy sufficient information to confirm the PFIC’s ordinary earnings and net capital gains as determined in accordance with U.S. income tax principles.

If it is not possible to make a QEF election, U.S. persons holding interests in PFICs may elect to annually treat the investment on a “mark-to-market” basis under Code Section 1296.In order to make the mark-to-market election, the units the investor owns in the PFIC must be “marketable stock.”  Code Section 1296(a). Generally, the term “marketable stock” is defined by the Code to mean stock regularly traded on a national securities exchange or stock in a foreign corporation comparable to a regulated investment company which is redeemable at net asset value. The mark-to-market election allows the taxpayer to include in gross income the difference between the taxpayer’s basis for the investment in the PFIC over the investment’s fair market value at the end of the taxable year (the “mark-to-market gain”).  Treas. Reg. Section 1.1296-1(c)(1).  Mark-to-market gain, as well as any gain on sale or disposition of the investment in the PFIC is treated as ordinary income.  Treas. Reg. Section 1.1296-1(c)(2).

The QEF and mark-to-market elections are made on form 8621. When these elections are not made on a timely basis, the taxpayer will be taxed under the excess distributions method described in Code Section 1291(a). The excess distributions method applies to any distribution in  excess of 125% of the average distributions received by the investor over the immediately preceding three-year period. Code Section 1291(b)(3). Generally, the excess distribution is deemed to have been earned ratably over the period of the taxpayer’s investment in the PFIC. The tax that would have been paid in prior years (computed at the highest rate) bears interest at the underpayment rate determined under Code Section 6621. As a result, the investor pays tax in the year the excess distribution is received on the amount of the excess distribution increased by the accrued interest.

The current instructions to Form 8621 limit the filing requirement to years in which the taxpayer (1) receives direct or indirect distributions from the PFIC, (2) recognizes gain on disposition of the taxpayer’s interest in the PFIC, or (3) makes a QEF or mark-to-market election. However, Section 521 of the Hiring Incentives to Restore Employment Act of 2010 amends Code Section 1298 to require any US person who owns an interest in a PFIC to “file an annual report containing such information as the Secretary may require.”  Code Section 1298(f).  The instructions to Form 8621 have not been amended to reflect this change in the statute which was effective March 18, 2010.  The Internal Revenue Service has released guidance which confirms that PFIC investors who were not required to file Form 8621 before enactment of Code Section 1298(f) will not be required to file the Form for tax years beginning before the date of enactment solely as a result of the change in law.  See Notice 2010-34, 2010-17 IRB 612 (April 6, 2010).