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Passive Foreign Investment Company Tax & Mark-to-Market (MTM) election
A PFIC is a passive foreign investment company. One of the most common types of PFIC is ownership of a foreign mutual fund.
Our office has worked with clients from dozens of countries. However, Indian mutual funds are especially problematic because Indian dividend/capital gain treatment rules are very different, and Indian mutual funds must be linked to bank accounts, which often results in frequent distributions.
How does an individual report to the IRS under the PFIC regime?
In general, an owner of a PFIC must file a four-page Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund). There are some exceptions, exclusions, and limitations, but generally, unless you are below the threshold value you have to report the form each year. The form should be attached to the shareholder’s US income tax return and may need to be filed even if the shareholder is not required to file a US income tax return or other return for the tax year. Even worse, the failure to file such a report leaves the return year open for review or audit forever until the report is filed.
Form 8621 is very complex and not included in most tax software programs. The IRS also does not provide simple instructions when preparing the form or how to calculate any PFIC tax.
There are certain “elections” a taxpayer can make to try to limit tax. One election is the Mark-to-Market (MTM) election. These elections are not easy to make, and if the filer does not make the election in the initial year, they will generally lose the opportunity.
The Mark to Market election under §1296 is an optional method of PFIC taxation. Generally, any unrealized gain in the PFIC during the tax year is included in the shareholder’s income as ordinary income. When the PFIC is sold gains are ordinary income.
When a Mark to Market election is made the taxpayer is required to “purge” any prior gain in the PFIC by doing a deemed disposition under §1291 rules and paying any §1291 tax and interest prior to the election taking effect. This means that the entire investment is treated as if it were sold for fair market value (FMV) on Dec 31 (the last day of the taxpayer’s tax year). All shares that have a gain will be taxed as excess distributions meaning that the gain allocated to the current tax year will be included on the tax return as ordinary income and any gain allocated to years before the current one will be taxed at the highest tax rate for that year and an additional interest charge will be added. Any shares that have dropped in value due to either the performance of the investment or fluctuation in the currency exchange rates will be disregarded- no losses are allowed in a §1291 “purge”. Losses can only be recognized when they are realized.
Only PFICs that are marketable securities are eligible to make a Mark to Market election. Mark to Market elections can only be made on a timely filed tax return. Once made it remains in effect for all subsequent years and Form 8621 is required annually.
Unfortunately, it has become increasingly easy and possible for U.S. persons to unknowingly become shareholders of PFICs, the results of which are unexpected income taxation and an annual requirement to file Form 8621. Without guidance from their tax advisors, those U.S. persons may not be aware of elections that mitigate the unexpected tax consequences of PFIC ownership. Good advice is crucial for helping taxpayers recognize when an investment has to be classified as a PFIC, understand the tax consequences of that investment, and make timely elections to mitigate the tax effects of PFIC ownership.
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