Taxpayers and other tax professionals have been calling us asking, "What is this PFIC I have just heard about? Do I have one? Do I have more than one? Do I now owe hundreds of thousands of dollars to the IRS?”
Just what are PFICs?
PFICs are Passive Foreign Investment Companies (Pronounced "pee-FIK"). They either have half of their assets in foreign passive income producing assets (Asset Test), or get a majority of their income from foreign passive sources (Income Test). In fact, they really probably aren't your companies. Nonetheless, the accounting work required is insanely difficult and time-consuming, and the tax treatment sort of stinks too.
What they really are (or 99% of the time) are Foreign Mutual Funds (this is also the rule IRS agents trained on).
What is the reason for this onerous PFIC tax treatment for Foreign Mutual Funds? I can't say what the cleaned-up "official" reason is, but I can tell you what the real reason is: Protectionism. PFIC language was snuck into Section 1291 of the Tax Reform Act of 1986 as a protectionist measure for the US-based mutual fund industry.
Entrenched Wall Street interests hated the fact that offshore mutual funds had a strategic advantage over domestic funds, with lower costs and higher returns, as foreign funds do not have to jump through the (editorial content warning) expensive, asinine hoops of the Securities and Exchange Commission (SEC). So instead of getting rid of the SEC (and all those federal jobs), Congress decided to intentionally make Foreign Mutual Funds less attractive by requiring expensive, mind-boggling PFIC accounting. So everyone wins, except you.
How complicated and onerous is it? The accounting is so complicated that IRS agents and technical advisers who have to audit PFIC accounting hate PFICs more than anyone else. Their supervisors have no concept of just how time-consuming it can be and fail to budget enough time. And computations prepared by even bright accountants and CPAs are routinely incorrect.
How are PFIC gains (and losses) calculated within the OVDP?
Outside an IRS Offshore Voluntary Disclosure Program (OVDP) you have three ways in which you can treat your PFIC income:
- You can calculate gains and losses pursuant to IRC section 1291 (the oldest, most onerous version).
- Second, you can elect “Qualified Election Funds” treatment.
- Third, you can elect to make a Mark-to-Market election (using the market value at the end of the year).
However, when you are in an IRS OVDP, the "QEF" treatment is removed. Your remaining choices of PFIC treatment alternatives depend on whether you enter full OVDP, OVDP opt-out, or Streamlined Domestic or Foreign OVDP.
- First, if you are in the full OVDP program (where you will amend up to 8 years of returns), you must do Mark-to-Market Calculations for each year you had the PFIC during your disclosure period (the 8 years you will already be amending). If you opt-out, while you may elect MTM in the future, you cannot go back in time to make the elections post hoc so you are stuck with the onerous Section 1291 methodology (there is a possibility you could "sneak by" with a MTM, or actually no PFIC accounting at all — but Revenue Agents are getting a bit hipper to the PFIC crucible). Why? Our guess is the OVDP rules are structured this way to squeeze more people into Streamlined OVDP (less work for the IRS) or compel them to pay the 27.5% (and now 50% in some cases) offshore penalty (less work for the IRS).
- Second, if you are in the Streamlined program (where you amend 3 years of returns), you are stuck with the more onerous Section 1291 method. As we tell our clients in the streamlined OVDP, the amount of years that need to be amended decreases, but the complexity of each return greatly increases.
- No IRS voluntary disclosure program uses a QEF treatment, but again this is an election you can make in the future.
How is PFIC Mark-to-Market calculated in Standard OVDP?
Below, we will explain in more detail the full OVDP and Mark-to-Market election avenue (We will not be explaining the less common Section 1291 and QEF in the article, well because, I think we would run out of internet).
Mark-to-market (MTM) treatment taxes you on the increase in value of your PFIC from year-to-year, regardless if you sold any of it. It attempts to capture your unrealized gain. For practical purposes, MTM calculations mean that you take the value of your PFICs on the last day of the year (December 31), pretend that you sold them, then use the end year value of the account from last year as your basis (aka the purchase price), and then calculate the gain or loss. An example will help.
Good news! In the above example, the Mutual Fund (MF) increased in value in Y1 and Y2. So how do we calculate the MTM gains for OVDP?
For Y1, since we bought the MF earlier in the year, our basis to calculate the MTM gain at the end of Y1 is our happened-in-reality original purchase, $15. The end year value in Y1 is $20, making our MTM gain $5, which is the amount the IRS will tax in Y1.
What about Y2? Well we know the Y2 end year value was $30. Our basis for Y2 is now the Y1 end year value, $20. The MF increased in value, from $20 to $30, making the MTM gain $10, which the IRS will tax in Y2.
Now we have to ask, what to do with those MTM gains? Where do they get reported? Well, for OVDP, those increases, of $5 and $10, will not go directly on to a tax return. The taxpayer must do an additional calculation. Under OVDP FAQ 10 the taxpayer takes 20% of the MTM gain as a tax, and put that amount on the second page of your Form 1040. Now our example looks like this:
Looks like Y1 will have $1 added to the “Other Taxes” section on the Form 1040, and $2 will be added in Y2. Under the OVDP, no other number from the PFIC calculations goes on the Form 1040.
But what if there is a loss instead of gain? You essentially do the same calculations, but with some differences, which I will get to further down. Let’s look at an example.
Just like in the example above, we have an increase from the time of purchase to the end of Y1. We bought $20; the end value of Y1 was $30, which is an increase of $10, which gives $2 PFIC Tax.
But Y2 has a decrease. The basis for Y2 (the end year value of Y1) is $30; the end value is $15, resulting in a loss of $15. Even with a loss, you calculate 20% of the change in value (the decrease). This gives what is, effectively, a “credit” of $3. You put that on your Form 1040’s “Other Credits” line. So now you put $3 of credit on your return, right?
Get ready for two words that go great together, in that IRS & PFIC sort-of-way: Unreversed Inclusions
Not so fast – there is one thing we have to consider, and it is the most technical part about MTM PFIC calculations for the OVDP — Unreversed inclusions. An unreversed inclusion is the amount of your allowable loss in the current year you can apply the 20% to. For practical purposes, the unreversed inclusion is gain from prior years. In our example above, loss in Y2 was -$15, and the gain from Y1 is $10. That means the amount of allowable loss in Y2 is $10, and it that allowable $10 of loss that we apply the 20% to. Oh, and that extra -$5 loss gets lost to the aether, never to be used (tough luck, says the IRS). Now our chart looks like this:
PFICs: As simple as we can make it
Again, we promised you an article on PFIC calculations as simple as we could make them. We hope we delivered that, but we would understand if you disagree: Any "simplified" guide that ends with the words "unreversed inclusions," well…that just can't be right, can it?
Again, if you really wanted to understand PFICs properly, you only need that one word: Protectionism. The terrible accounting demands causes by this almost covert, yet despicable protectionism by the domestic US mutual fund industry make me wonder why foreign countries have not filed a complaint with the World Trade Organization against the US for these insane PFIC rules — you need one heck of a higher return on your Foreign Mutual Funds in order to overcome the associated accounting costs of PFICs.
And that would be a great way to get back at the US for FATCA, no?
Special Thanks to Attorney Robert V. Hanson for his help is this article and also for doing so much of our PFIC accounting AND being such a great sport about it. If you need assistance understanding the reporting reqirements for your PFICs, contact us. We can help.