On January 24, 2022, the Internal Revenue Service issued proposed rules that would affect some of the polls available to US taxpayers regarding their indirect interests in passive foreign investment companies (PFICs).
According to the proposed rules, to the extent that an interest in PFIC is owned by a domestic partnership, US partners will be deemed to be shareholders of PFIC rather than a domestic partnership. Thus, any Qualified Selecting Fund (QEF) or Mark to Market (MTM) elections in respect of PFIC will be conducted at the US partner level. This is in contrast to existing rules, which treat the domestic partnership as a US shareholder for the purpose of conducting such PFIC elections. The proposed rules apply equally to US shareholders of S corporations (S corps) who have an interest in PFIC.
PFIC elections conducted by a domestic partnership or S Corp under the current rules with respect to any taxable years of PFIC shall be respected and shall apply to all relevant US partners and S Corp. shareholders as on that date.
What is PFIC?
A non-U.S. corporation will generally be treated as a PFIC if most of its assets constitute passive assets (for example, shares, cash, certain intellectual property) or a significant portion of its income originates from passive sources. (for example, dividends, interest, capital gains, royalties).
US shareholders of PFIC are subject to a punitive US tax regime that applies regardless of ownership percentage. Specifically, U.S. shareholders will generally be subject to ordinary income tax rates (that is, no lower capital gains tax rate) and a substantial interest charge on any distributions from PFIC or disposition of PFIC shares. Under certain circumstances, U.S. shareholders may incur a total tax liability in excess of their gross return from PFIC investments.
These punitive PFIC rules may be relieved if a US shareholder makes a timely QEF or MTM election regarding PFIC investments. In the case of a QEF election, the US shareholder will be taxed on the undistributed PFIC income as it is earned on a current basis. QEF elections must be made in the taxable year when the PFIC investment is first acquired by a U.S. shareholder or the non-U.S. corporation becomes the first PFIC.
In the case of an MTM election, the US shareholder shall recognize any unrealized gain in PFIC shares as ordinary income on an annual basis (ie by effectively marking the investment in the market each year). Only PFICs which are marketable securities are eligible for MTM election.