Taxation of Passive Foreign Investment Company

An interesting aspect of foreign investing is the difference in the treatment of foreign investment companies, mutual funds and unit investment trusts as compared to US based mutual funds.

US vs. Foreign

In the US, generally, a mutual fund is treated in a manner similar to a partnership with respect to the income and the gains of the fund.  The income is passed through to the shareholders in proportion to their holdings and reported to the IRS on a form 1099 by the mutual fund.  A copy of the report is also sent to the shareholder to use to prepare his tax return.

Foreign investment companies or mutual funds are not subject to this kind of reporting and disclosure, nor do they want to be.  In the US, the burden is on the shareholder to determine their share of the income of the investment company.  The tax code refers to any kind of corporate mutual fund or investment company outside the US as a passive foreign investment company (PFIC).

US tax laws were set up to deter US persons from investing in mutual funds outside the US, or using a foreign corporation as an investment fund, where the income or gains of the foreign funds are not subject to current taxation, as are the gains and other income of most domestic mutual funds.  For example, if 11 (or more) US persons own equal shares in a foreign corporation, it will not meet the definition of a controlled foreign corporation  and none of the shareholders would be subject to current tax on the income of the foreign corporation, but if that same corporation is also a PFIC, the shareholders will be subject to severe tax treatment on any distributions from the PFIC unless

  • the PFIC elects to be subject to the SEC and the IRS reporting requirements or unless
  • the shareholder elects to pay tax on the undistributed current income of the PFIC (which requires the co-operation of the PFIC) or unless
  • the PFIC is listed on a national securities exchange and the shareholder elects to pay tax on any increase in the market value of the shares from one year to the next.

As a general rule, a US person would be in far better position to invest directly in the stock of foreign corporations that are not PFICs or to invest in a US mutual fund that invests in foreign stocks or foreign mutual funds. In some cases, a US person may be able to utilize a foreign variable annuity or variable life insurance contract to invest in foreign mutual funds, but the tax treatment will be based on the rules for investments in annuities or life insurance rather than for investments in the underlying stocks or mutual funds.

Tax code sections 1291 through 1297 provide the rules for US persons who invest in (PFIC).   According to the tax code, a PFIC is defined as “ … any foreign corporation if 75 percent or more of its gross income is passive income or if 50 percent or more of its assets are assets that produce or are held to produce passive income”.

There are exceptions for bona fide banks, insurance companies and foreign corporations engaged in the securities business – meaning the active marketing of securities.

A PFIC that had elected to be a “foreign investment company”, before December 31, 1962,  is subject to some older rules, which require that;

  1. the company be registered under the US Investment Company Act of 1940, or
  2. it must be engaged primarily in the business of investing or trading in securities and
  3. 50% or more of the total combined voting power of all classes of stock are held directly or indirectly by U.S. persons.

If the foreign investment company elects to distribute at least 90% of its ordinary income, and the shareholders report net capital gains whether or not distributed, the shareholders are not taxed at ordinary income tax rates on their respective share of the earnings and profits of the foreign investment company when their shares are sold or redeemed.  Basically, this will produce the same tax result as owning shares in a US mutual fund.

For companies that had not made such an election before 1963, if a foreign investment company is registered with the SEC, or if it is more than 50% owned by US persons, any gain realized by the shareholders will be treated as ordinary income unless the corporation elects to be taxed in a manner similar to US mutual funds.

If the PFIC isn’t qualified to be an electing foreign investment company or does not choose to do so, the US shareholder may elect to have the PFIC treated as a “pass through entity” – known as a “qualified electing fund” or QEF. If this election is made by the US shareholder, the shareholder must report as income his or her pro rata share of the earnings and capital gains of the QEF for the taxable year. The investor making this election may also elect to delay payment of the tax on the shareholder’s portion of the undistributed earnings of the QEF, but that deferral will be subject to an interest charge. This election is only allowed if the PFIC complies with the IRS information disclosure requirements which will enable the IRS to determine the PFICs ordinary earnings and capital gains.

If the US beneficiaries of a trust investing in a PFIC expect and agree to be taxed on the trust’s income – even though they do not expect to receive any current distributions from the trust, there should be no disadvantage to electing QEF status for every PFIC in which the trust has invested, and indeed there are enormous disadvantages from failing to do so.  If the PFIC is not a QEF for every year in which it is a PFIC, then the conversion from capital gain to ordinary income and the interest charge rules continue to apply to the extent of the company’s earnings while it was a non-QEF.  In other words, only a so-called “pedigreed” QEF which has been a QEF in every year in which it was a PFIC is excused from the interest charge and character conversion rules.  For this reason, a foreign trust agreement should provide that the trustee may not acquire any equity interest in a foreign company that qualifies as a corporation for U.S. tax purposes (unless that company is engaged in the active conduct of a trade or business) without providing notice to any US beneficiaries and their accountants so that the appropriate election to be a QEF can be made in a timely manner.  Furthermore, the trust agreement should provide that this notification requirement must be made applicable to any investment adviser engaged by the trustee to manage any trust assets.

If a PFIC does not agree to be subject to the jurisdiction of the SEC and does not provide the IRS with the annual information the IRS requires for a QEF election, then the shareholders of the PFIC are subject to;

  1. ordinary income tax on  any current distributions from the PFIC,
  2. distributions and dispositions of fund shares deemed to be from prior years earnings of the PFIC are taxed at the highest rate for ordinary income in each prior year and
  3. an interest charge on the deferred distribution.

Distributions in the first year of a PFIC are treated as ordinary income. Future distributions are also treated as ordinary income to the extent that the distributions are no more than 125% of the average distributions for the previous three (or fewer) years.  Thus, planned distributions can be used to minimize the tax on distributions of accumulated income.

Dispositions of PFIC shares by gift, at death or by other means (such as some redemptions) are treated like distributions but are not eligible for the ordinary income tax treatment described above.

The Taxpayer’s Relief Act of 1997 introduced some changes that are intended to eliminate some conflicting and overlapping provisions of the rules applicable to a controlled foreign corporation (CFC) that is also a PFIC.  Basically, a foreign corporation that would otherwise be a PFIC will not also be subject to the pass-through rules for a CFC for the 10% or greater US Shareholders of the CFC. This change is applicable for tax years after 1997. However, where a PFIC is not a QEF (qualified electing fund), any stock held by a US person who owns 10% or more of the stock is either (1) subject to a current tax and an interest charge on the deferred distributions, or (2) is subject to the rules for a PFIC. In addition, if a CFC shareholder ceases to be a 10% shareholder but remains as a shareholder, the shareholder will immediately be subject to the PFIC rules.

Another “simplification rule” in the 1997 law permits US owners of a stock in a PFIC that is traded on a national securities exchange to make a “mark-to-market” election (IRC section 1256) based on the market value of the PFIC shares at the end of each year. However, any gains recognized by the shareholder will be treated as ordinary income and any losses are limited to gains previously recognized. In addition, the IRS has introduced proposed regulations that will make it very difficult for many foreign mutual funds to qualify for the “mark-to-market” election.

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Wash Sale explained

In the previous post about cost basis reporting, the mention of a wash sale came up as being exempted.

So what is a wash sale?

I looked it up and here is what I found;

Wash Sales rule.  If you buy replacement stock shortly after the sale — or shortly before the sale — you can’t deduct your loss.

Why might this rule be in place?  Look at this example below…

When the value of your stock goes down you know you have lost money.  US tax law does not allow that loss until you sell the stock.  The problem is, you may have a conflict. You want to deduct the loss, but you also want to keep the stock because you think it’s going to bounce back.  You might think that you can sell the stock to take the loss and buy it right back to keep it in your portfolio, but that is where the wash sale rule comes in.  This rule is in place for 30 days. 

So you have a wash sale if you sell stock at a loss, and buy substantially identical securities within 30 days before or after the sale.

Example: On March 31 you sell 100 shares of BCE at a loss. On April 11 you buy 100 shares of BCE. The sale on March 31 is a wash sale.

The wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale and the 30 days after the sale.  If you want to claim your loss as a deduction, you need to avoid purchasing the same stock during the wash sale period. For a sale on March 31, the wash sale period includes all of March and April.

Wash sale rules also apply if you enter into a contract or option to acquire stock.  Or, if within that wash sale period, you sell a put option on the same stock that is “deep in the money”.  You also have a wash sale if you sell options at a loss too.

The wash sale rule actually has three consequences:

  • You are not allowed to claim the loss on your sale.
  • Your disallowed loss is added to the basis of the replacement stock.
  • Your holding period for the replacement stock includes the holding period of the stock you sold.

The basis adjustment is important: it preserves the benefit of the disallowed loss. You’ll receive that benefit on a future sale of the replacement stock.

Example: Some time ago you bought 80 shares of BCE at $50. The stock has declined to $30, and you sell it to take the loss deduction. But then you see some good news on BCE and buy it back for $32, less than 31 days after the sale.

You can’t deduct your loss of $20 per share. But you add $20 per share to the basis of your replacement shares. Those shares have a basis of $52 per share: the $32 you paid, plus the $20 wash sale adjustment. In other words, you’re treated as if you bought the shares for $52. If you end up selling them for $55, you’ll only report $3 per share of gain. And if you sell them for $32 (the same price you paid to buy them), you’ll report a loss of $20 per share.

Because of this basis adjustment, a wash sale usually isn’t a disaster. In most cases, it simply means you’ll get the same tax benefit at a later time. If you receive the benefit later in the same year, the wash sale may have no effect at all on your taxes.

The wash sale rule can also have truly painful consequences.

  • If you don’t sell the replacement stock in the same year, your loss will be postponed, possibly to a year when the deduction is of far less value.
  • If you die before selling the replacement stock, neither you nor your heirs will benefit from the basis adjustment.
  • You can also lose the benefit of the deduction permanently if you sell stock and arrange to have a related person — or your IRA — buy replacement stock.
  • A wash sale involving shares of stock acquired through an incentive stock option can be a planning disaster.

 

Some additional information on wash sales:

  • You don’t have a wash sale unless you acquire (or enter into a contract or option to acquire) subsequently identical securities.
  • You don’t have a wash sale, even though you bought identical shares within the previous 30 days, if the shares you bought aren’t replacement shares
  • There are mechanical rules to handle the situation where you don’t buy exactly the same number of shares you sold, or where you bought and sold multiple lots of shares.
  • If a person who’s related to you — or an entity related to you, such as your IRA — buys replacement property, your loss may be disallowed under a different rule: you may be treated as if you made an indirect sale to a related person.
  • You don’t actually have to purchase stock within the wash sale period to have a wash sale. It’s enough if you merely enter into a contract or option to acquire replacement stock.

The wash sale rule only applies to losses. You can’t wipe out a gain from a sale by buying the same stock back within 30 days.

Plan around the wash sale:

While no technique is entirely safe and risk-free, here are some ideas to consider.

  • Most obviously, you can sell the stock and wait 31 days before buying it again. The risk here is that the stock may rise in price before you can repurchase it.
  • If you’re truly convinced the stock is at rock bottom, you might consider buying the replacement stock 31 days before the sale. If the stock happens to go up during that period your gain is doubled, and if it stays even you can sell the older stock and claim your loss deduction. But if you’re wrong about the stock, a further decline in value could be painful.
  • If your stock has a strong tendency to move in tandem with some other stock, you may be able to reduce your risk of missing a big gain by purchasing stock in a different company as “replacement” stock. This is not a wash sale because the stocks are not substantially identical. Thirty-one days later you can switch back to your original stock if that is your wish. But there’s no guarantee that any two stocks will move in the same direction, or with the same magnitude.