Many a US taxpayer who holds shares in a Canco may be subject to the onerous US passive foreign investment company (PFIC) tax regime. Although the PFIC rules are designed to eliminate the benefit of a US tax deferral on passive income earned by a corporation, active corporations such as startup businesses or certain sales or service companies may inadvertently fall into the PFIC category. The consequences may devastate a US investor, and the remedies are limited.
A corporation is a PFIC if (1) at least 75 percent of its gross income is passive income, or (2) at least 50 percent of its assets (generally an FMV test) produce or are held for the production of passive income. Thus, a Canco that is primarily engaged in passive activities such as investing in marketable securities may be treated as a PFIC.
In general, the US PFIC shareholder is subject to a special tax on receipt of a so-called excess distribution, which is a PFIC distribution to the extent that the total amount received in the year exceeds 125 percent of the actual average distributions to the shareholder in the preceding three years. An excess distribution also includes any gain on the sale of PFIC stock. The excess distribution is allocated pro rata over the taxpayer’s entire holding period and is taxed at the highest ordinary income tax rate in effect for each year that the corporation was a PFIC; an interest charge applies to amounts allocated to the prior years. An investor must file IRS form 8621 (“Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund”) with his US tax return to report an excess distribution. Thus, a US shareholder with a PFIC interest may face extremely harsh tax consequences. Moreover, the investor generally cannot claim foreign tax credits for Canadian or other foreign taxes imposed on the PFIC.
Sometimes it is possible to mitigate the harsh tax consequences of owning a PFIC interest. One option is to make a qualified electing fund (QEF) election for the PFIC shares held. If a timely QEF election is made, a shareholder includes in gross income each year his pro rata share of the PFIC’s ordinary income and net capital gain. The QEF election must be made on form 8621 by the due date for filing the US investor’s tax return for the first year that the corporation becomes a PFIC. If a timely election is not made, the excess distribution rules apply even if a QEF election is made later; this outcome is often referred to as “the PFIC taint.” However, a US investor is often unaware that the company was a PFIC in the first year that it became a PFIC. If an investor discovers that the company is a PFIC when it is too late to make a timely election, he may make a retroactive QEF election if his failure to file a timely election arose because he reasonably believed that the company was not a PFIC. Retroactive relief may be available under the protective regime or the consent regime.
Under the protective regime, the investor must have reasonably believed as of the election due date that the foreign corporation was not a PFIC, and he must file a protective statement that describes the basis for that belief. The protective regime assumes that the investor was aware of the PFIC rules and their potential application to his shares. However, the rules are very complex, and an investor and his tax adviser may not have been aware of them, especially if they operate to capture a Canco that is engaged in an active business. Thus, the protective QEF election is not always a practical option.
Under the consent regime, a US investor who was not aware of the PFIC rules and has not filed a protective statement may request the IRS commissioner’s consent to make a retroactive election by submitting a private letter ruling request to the IRS. Consent is generally granted if the investor reasonably relied on a qualified tax professional who failed to identify the corporation as a PFIC or failed to advise the shareholder of the consequences of making or not making a QEF election. Consent is not granted if the shareholder knew or reasonably should have known that (1) the foreign corporation was a PFIC and that a QEF election could have been made, (2) the qualified tax professional was not competent to render tax advice with respect to the shares’ ownership, or (3) the qualified tax professional did not have access to all of the relevant facts.
The IRS routinely issues private letter rulings that grant retroactive QEF elections in situations where the investor was not aware of the PFIC rules and his adviser failed to advise him of the possibility of making a QEF election. One requirement under the consent regime is that the taxpayer must have reasonably relied on a qualified tax professional. In my experience with preparing and processing these ruling requests, the IRS is generally unwilling to modify the requirement that the investor reasonably have relied on a qualified tax professional for the years in question. Thus, for example, an investor may not qualify for relief if he prepared his own returns.
A US citizen residing in Canada who has an investment in a Canco should be aware of the PFIC rules. In particular, a US citizen residing in Canada who invests in Canadian mutual funds should be aware of these rules: most foreign mutual funds are usually treated as PFICs. Furthermore, in light of the recent focus on offshore tax compliance, the IRS may be paying closer attention to any US taxpayer who lives abroad and has a PFIC interest.