QEF Election Eases Punitive Tax PFIC Regime

QEF Election Eases Punitive Tax PFIC Regime

QEF Election (Qualified Electing Fund)

QEF Election (Qualified Electing Fund) Eases Punitive Tax Regime:  The purpose of making a QEF (Qualified Electing Fund) election is to try and ease the punitive nature of owning a PFIC (Passive Foreign Investment Company). When it comes to international tax and the IRS, one of the worst parts about US Tax Law is how the United States taxes certain type of passive investments. This is especially true when the foreign investment qualifies as PFIC or a “Passive Foreign Investment Company.” Unlike many international tax and reporting requirements such as FDII and GILTI — which are intended for business income taxes — PFIC tax rules disproportionately impact US Person Individuals. With PFIC, many unsuspecting individual taxpayers who may have invested in foreign mutual funds and other equity funds abroad (even before coming to the US) get stuck having to reconcile a highly complicated offshore compliance equation.  When it comes to PFIC, it gets more complicated due to the tax monstrosity referred to as the “Excess Distributions (ED).” Oftentimes the tax on Excess Distributions can result in a 40% to 75% tax liability for passive income that would have otherwise been taxed at a 15 or 20% tax rate (LTCG and QD). In order to combat this tax result, a US taxpayer may be able to make a QEF Election. But, this is not always feasible — and comes with its own share of headaches. Let’s look at the basics of the QEF Election:

QEF (Qualified Electing Fund) – What is it?

In order to avoid the inevitable excess distribution calculation when it comes to a Passive Foreign Investment Company, a Taxpayer may be able to make a Qualified Electing Fund election in order to limit or avoid those tax consequences. The qualified electing fund election is made under Internal Revenue Code Section 1295 — which would then change the tax effect of having a PFIC (usually for the better).There are certain requirements in terms of making the election and when it is made at a later day, it may involve two parts which is to both rid the investment of the excess distribution taint up until the point the QEF election is made — and then the actual election. 

Excess Distributions and NO QEF Election

When a Taxpayer does not make a QEF Election, their excess distributions get taxed at whatever the highest tax rate is for the compliance period — including interest (aside from the current year, in which it is taxed at the Taxpayer’s progressive tax rate). Especially when the Taxpayer redeems a Mutual Fund, oftentimes the entire gain is considered Excessive Distribution. This may result in a very high and unfair tax consequence.

Making a QEF Election

With a QEF election, instead of getting taxed at the Highest Tax Rate, the Taxpayer instead receives Long-Term Capital Gain treatment similar to a domestic mutual fund – although there are no qualified dividends — so depending on the type of investment and income generated, the tax benefit can range extensively.

QEF Election & Prior Year Taint vs Current Year

When a Taxpayer makes a QEF election in a prior year, it first requires a cleansing of the Excess Distribution Taint. This means that for the prior years before the election is made, Taxpayer must cleanse the investment and pay the excess distribution before the QEF election takes effect. Conversely, if the election is made in the first year of the QEF, this result can be avoided.

Form 8621 Instructions for QEF Election

The Form 8621 Instructions can be helpful to Taxpayers — and provides the following:

To Make the Election

      • Generally, a shareholder must make the election to be treated as a QEF by the due date, including extensions, for filing the shareholder’s income tax return for the first tax year to which the election will apply (the “election due date”). See Retroactive election below for exceptions.

      • The foreign corporation will be treated as a QEF with respect to the shareholder for the tax year in which the election is made and for each subsequent tax year of the foreign corporation ending with or within a tax year of the shareholder for which the election is effective.

Retroactive Election

A shareholder may make a QEF election for a tax year after the election due date (a retroactive election) only if:

      • The shareholder has preserved its right to make a retroactive election under the protective statement regime (described below), or

      • The shareholder obtains the permission of the IRS to make a retroactive election under the consent regime (described below).

Protective Statement Regime

      • Under the protective statement regime, a shareholder may preserve the ability to make a retroactive election if the shareholder:

        • 1. Reasonably believed, as of the due date for making the QEF election, that the foreign corporation was not a PFIC for its tax year that ended during that year (retroactive election year);

        • 2. Filed a Protective Statement (see below) with respect to the foreign corporation, applicable to the retroactive election year, in which the shareholder describes the basis for its reasonable belief;

        • 3. Extended, in the Protective Statement, the periods of limitations on the assessment of taxes under the PFIC rules for all tax years to which the protective statement applies; and

        • 4. Complied with the other terms and conditions of the protective statements.

      • The Protective Statement must be attached to the shareholder’s tax return for the shareholder’s first tax year to which the statement will apply.

      • For required content of the statement and other information, see Regulations section 1.1295-3(c).

Consent Regime

      • Under the consent regime, a shareholder that has not satisfied the requirements of the protective regime may request that the IRS permit a retroactive election.

      • The consent regime applies only if:

        • 1. The shareholder reasonably relied on tax advice of a competent and qualified tax professional;

        • 2. The interest of the U.S. Government will not be prejudiced if the consent is granted;

        • 3. The shareholder requests consent before the PFIC status issue is raised on audit; and

        • 4. The shareholder satisfies the procedural requirements under Regulations section 1.1295-3(f)(4). For more information on making a retroactive election, see Regulations section 1.1295-3.

Special Rules

      • For rules relating to the invalidation, termination, or revocation of a section 1295 election, see Regulations section 1295-1(i).

      • Also, see Regulations section 1.1295-1(c)(2) for rules relating to the years to which a section 1295 election applies.

      • How To Make the Election For the tax year in which the section 1295 election is made, the shareholder must do the following.

        • 1. Check box A in Part II of Form 8621.

        • 2. Complete the applicable lines of Part III. Include the information provided in the PFIC Annual Information Statement, Annual Intermediary Statement, or a combined statement (see below) received from the PFIC.

        • 3. Attach Form 8621 to a timely filed tax return (or, if applicable, partnership or exempt organization return). For each subsequent tax year in which the election applies and the corporation is treated as a QEF, the shareholder must:

          • 1. Complete the applicable lines of Part III, and

          • 2. Attach Form 8621 to a timely filed tax return (or, if applicable, a partnership or exempt organization return).

Tax Consequences for Shareholders of a QEF Election

      • A shareholder of a QEF must annually include in gross income as ordinary income its pro rata share of the ordinary earnings of the QEF and as long-term capital gain its pro rata share of the net capital gain of the QEF.

      • The shareholder may elect to extend the time for payment of tax on its share of the undistributed earnings of the QEF (Election B) until the QEF election is terminated.

      • If the QEF election is not made with respect to the first year of the shareholder’s holding period in the PFIC, the shareholder may be able to make a deemed sale election (Election D) or deemed dividend election (Election E) (if eligible).

      • If the shareholder properly makes a deemed sale election or deemed dividend election in connection with its QEF election, then the PFIC will become a pedigreed QEF (as defined in Regulations section 1.1291-9(j)(2)(ii)) with respect to the shareholder.

      • Note. A shareholder that receives a distribution from an unpedigreed QEF (defined in Regulations section 1.1291-9(j)(2)(iii)) is also subject to the rules applicable to a shareholder of a section 1291 fund (see below).

      • Basis Adjustments

        • A shareholder’s basis in the stock of a QEF, or in any property through which the shareholder is treated as owning stock of a QEF, is increased by the earnings included in gross income and decreased by a distribution from the QEF to the extent of previously taxed amounts.

Letter Ruling 201220006 (the “Ruling”)

There was a Letter Ruling back in 2012 which effectively lays out the QEF election:

      • Code section 1295(a) provides that a PFIC will be treated as a QEF with respect to a shareholder if

        • (1) an election by the shareholder under Code section 1295(b) applies to the PFIC for the taxable year; and

        • (2) the PFIC complies with the requirements prescribed by the Secretary for purposes of determining the ordinary earnings and net capital gains of the company.

      • Under Code section 1295(b)(2), a QEF election may be made for a taxable year at any time on or before the due date (determined with regard to extensions) for filing the return for the taxable year.

      • To the extent provided in regulations, the election may be made after the due date if the shareholder failed to make an election by the due date because the shareholder reasonably believed the company was not a PFIC.

      • Under Treas. Reg. §1.1295-3(f), a shareholder may request the consent of the Commissioner to make a retroactive QEF election for a taxable year if:

        • 1. the shareholder reasonably relied on a qualified tax professional, within the meaning of Treas. Reg. §1.1295-3(f)(2);

        • 2. granting consent will not prejudice the interests of the United States government, as provided in Treas. Reg. §1.1295-3(f)(3);

        • 3. the request is made before a representative of the Internal Revenue Service raises upon audit the PFIC status of the company for any taxable year of the shareholder; and

        • 4. the shareholder satisfies the procedural requirements of Treas. Reg. §1.1295- 3(f)(4).

      • The procedural requirements include filing a request for consent to make a retroactive election with, and submitting a user fee to, the Office of the Associate Chief Counsel (International). Treas. Reg. §1.1295-3(f)(4)(i).

      • Additionally, affidavits signed under penalties of perjury must be submitted that describe: PLR-120120-11 4

        • 1. the events that led to the failure to make a QEF election by the election due date;

        • 2. the discovery of the failure;

        • 3. the engagement and responsibilities of the qualified tax professional; and

        • 4. the extent to which the shareholder relied on the professional.

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