- Article Category
- US Tax Filings
Updated Posted
The Stealth Exit Tax, PFIC-Style
Phil Hodgen
Attorney, Principal
Share
New weekly PFIC email list
Yesterday, we soft-launched our new email list, PFICs Only. Every Thursday at 6 am Pacific time we will be publishing an email on a PFIC topic. Sign up here.PFIC conference call today, noon pacific time
Something fun is coming up in six hours. You are not too late. You can participate.Section 1291 fund distributions
Today (May 8, 2015) at noon Pacific time, our regular International Tax Lunch call will cover a PFIC topic.The topic is "Dealing with Distributions From a Section 1291 Fund".Debra Rudd, CPA is the presenter. (She is also the primary author of the PFICs Only newsletter.)How to participate
We use old style tech for our International Tax Lunches -- dial-in conference calls.To listen in, sign up for the International Tax Lunch mailing list. You will get an email with the program materials and the dial-in details (phone number and magic super-secret code).Even if you can't attend this month's session, you should sign up for our monthly calls. Second Friday of the month, noon Pacific time.The stealth exit tax, PFIC-style
To celebrate this mind-boggling extravaganza of PFIC-ery, this week's Friday edition contains a little PFIC pixie dust from me, too. Plus an extremely jaundiced look at the authoritative power of Proposed Regulations.I call this the Stealth Exit Tax.Everyone knows about the regular exit tax. Section 877A. If you give up your U.S. citizenship or long-held green card, you may well have to pay a tax for the privilege of extracting yourself from the U.S. tax system.At least with the regular exit tax you can tell if it applies to you. You have to give up your passport or green card, and you have to be rich enough (or delinquent enough in your tax filings and payments) to be hammered by the exit tax.Not so with this PFIC-related exit tax. This is a roulette wheel:- It applies to anyone who goes from resident to nonresident status.
- It applies regardless of your wealth.
- It may or may not apply and may or may not be a problem because . . . the rules were proposed in 1992 and while the IRS says you don't have to follow them, IRS tells its employees they should use the rules against you.
Who is at risk
L-1 visa holder
You're a normal person living outside the United States, working for a random multinational corporation. You have the normal stocks, bonds, and mutual funds sitting in an investment account in your home country, just like everyone else.One day your boss says, "How would you like to work in our headquarters in the USA?" You say "Cool!" and before you can turn around twice you have an L-1 visa in your hand and you are living and working happily in the United States. You just leave your savings and your investments intact in your home country. Why sell everything and close your account? That would be dumb.You stay for two years in the United States, filing tax returns as a U.S. resident (as you should). One day your boss says, "How would you like to work in our headquarters in your home country again?" and you say "Cool!" and before you know it you have packed your bags and you are home again, your time in the United States just a cloud of dust in the rear view mirror.H-1B worker
You're a normal H-1B worker, in the United States working for some MegaCorp for a couple of years. You have mutual funds in an investment account at home. They just sit there for two years while you work in the United States.While you are working in the United States, you file U.S. income tax returns as a resident because, after all, you are a resident.Your visa expires and you return to your home country, and your resident status in the United States converts to nonresident status.Nonresident married to a U.S. person, and you never set foot in the USA
You are a normal human, except for your choice of spouse: you married a U.S. citizen or green card holder. :-)You are living outside the United States with your spouse, and based on bad information you make an election under Section 6013(g) of the Internal Revenue Code to be treated as a U.S. resident for income tax purposes. You happily file U.S. income tax returns with your spouse for many years.One day you wake up and realize that this was a dreadful mistake and you want to take your head out of the lion's mouth. (Nice kitty!) You revoke the Section 6013(g) election, and revert to your nice, safe status as not a U.S. taxpayer.Common elements
Key facts hidden in my little moments of literature:- You never had a green card and you never had U.S. citizenship.
- You only stayed for a few years and then you left the United States. Or maybe you never touched U.S. soil.
- You owned foreign (from the U.S. perspective) mutual funds. Critically, this means you own stock in Passive Foreign Investment Corporations. PFICs.
If "disposition", then tax
The problem comes from the PFIC law.If you have a "disposition" of PFIC stock, you have to pay a lot of tax. Technical jargon alert: you have an "excess distribution" from a "Section 1291 fund". (This is Debra's topic today at noon. Just saying. You should dial in and listen.)Quoting from the Holy Writ, Title 26, Section 1291(a)(2):If the taxpayer disposes of stock in a passive foreign investment company, then the rules of paragraph (1) shall apply to any gain recognized on such disposition in the same manner as if such gain were an excess distribution.
Resident to nonresident = disposition
You, our L-1 or H-1B friend, owned foreign mutual funds (PFIC shares) before you came to the USA to live. You kept the mutual funds the whole time you were living in the United States. You still owned those same mutual fund shares when you left the United States and returned to your home country.The IRS says you dispose of your PFIC shares when you leave the United States and change from a resident taxpayer in the United States to a nonresident taxpayer of the United States.Just by leaving the United States, you have a tax to pay. Sounds like an exit tax, right?The rule comes from Proposed Regulations published in 1992:If a shareholder of a section 1291 fund becomes a nonresident alien for U.S. tax purposes, the shareholder will be treated as having disposed of the shareholder's stock in the section 1291 fund for purposes of section 1291 on the last day that the shareholder is a U.S. person. Termination of an election under section 6013(g) is treated as a change of residence (within the meaning of this paragraph (b)(2)) of the spouse who was a resident solely by reason of the section 6013(g) election.See Prop. Regs. §1.1291-3(b)(2).Important: this rule ("you are treated as having a disposition of a PFIC when you change from resident to nonresident") is from Proposed Regulations. It is not in the Internal Revenue Code.
The power (?) of Proposed Regulations
The big question is obvious. These are Proposed Regulations. They are not in effect yet. And they have been proposed -- but not finalized -- for 23 years.So you, a normal person going from nonresident of the United States to resident and back again. Do you take these Proposed Regulations seriously? Or not?Judges say . . . Proposed Regulations ain't worth spit
Courts generally say that Proposed Regulations are no better than an argument in a legal brief:- "[P]roposed regulations are entitled to no deference until final." In re AppleTree Markets, Inc., 19 F.3d 969, 973 (5th Cir. 1994).
- "Proposed Regulations are suggestions made for comment; they modify nothing." LeCroy Research Sys. Corp. v. Commissioner, 751 F.2d 123, 127 (2d Cir. 1984).
- "Indeed, whatever may be said about "temporary" regulations that have not gained permanent status after 13 years (see n. 9), any notion of ascribing weight to anything that has remained in the "Proposed Regulation" limbo for a like period is totally unpersuasive." Tedori v. United States, 211 F.3d 488, 492, n. 13 (9th. Cir. 2000). Emphasis added.
IRS says . . . taxpayers need not follow Proposed Regulations
The Internal Revenue Manual admits that taxpayers do not need to follow the rules laid out in Proposed Regulations.Proposed Regulations provide guidance concerning Treasury's interpretation of a Code section. * * * Taxpayers may rely on a Proposed Regulation, although they are not required to do so. Examiners, however, should follow Proposed Regulations, unless the Proposed Regulation is in conflict with an existing final or temporary regulation.See I.R.M. 4.10.7.2.3.3 (01-01-06). Emphasis added.
IRS says . . . examiners should use Proposed Regulations
But what is that alarming sentence from the Internal Revenue Manual? Just after the IRS says that taxpayers need not follow Proposed Regulations, the Internal Revenue Manual says:Examiners, however, should follow Proposed Regulations, unless the Proposed Regulation is in conflict with an existing final or temporary regulation.See I.R.M. 4.10.7.2.3.3 (01-01-06). Emphasis added.In the next section of the Internal Revenue Manual, the position is softened a bit:
When no temporary or final regulations have been issued, examiners may use a Proposed Regulation to support a position. Indicate that the Proposed Regulation is the best interpretation of the Code section available.I.R.M. 4.10.7.2.3.4 (01-01-2006). Emphasis added.Examiners "should" follow Proposed Regulations. Examiners "may" use a Proposed Regulation to support a position.Let me translate this into English. Here is what the IRS just told you:
"Proposed Regulations have no legal power. We know that. You, taxpayer, don't have to follow them. But we will enforce them if we feel like it."Or, a bit more succinctly, the IRS is saying:
"Proceed at your peril, peasant. Know your place."
AICPA comment from 1992
It is a known problem.When the Proposed Regulations were published in 1992, the AICPA chimed in with comments and suggestions. Here is what they said about the problem discussed in this week's Friday Edition:CHANGE OF U.S. RESIDENCE OR CITIZENSHIP. Under the Proposed Regulations, if a shareholder of section 1291 fund becomes a nonresident alien, that shareholder is treated as having disposed of its stock in such a section 1291 fund on the last day the shareholder is a U.S. person. Further, where a nonresident alien individual and that individual's spouse have made an election under section 6013(g) to treat the nonresident alien as a resident of the U.S., termination of that election is treated as a change of residence of the electing spouse who was resident solely by reason of the election.We believe this rule is too broad in that it operates to impose tax on the full appreciation of shares in a section 1291 fund, much of which may have occurred prior to commencement of a resident alien taxpayer's U.S. residency.The Proposed Regulation also causes taxable income when there has not yet been a realization event with respect to the shares. This result is beyond the intended scope of the PFIC rules and beyond the specific regulatory authority of section 1291(f) and section 1297(b)(5).We believe U.S. tax should not be imposed on unrealized appreciation that occurred prior to U.S. residency. The Proposed Regulations should be amended to exclude gain attributable to pre-residency appreciation from the excess distribution regime. Additionally, the shareholder's holding period for purposes of section 1291 should begin on the day the U.S. person first became a U.S. citizen or resident, to prevent an interest charge being imposed on years during which the shareholder was not a U.S. citizen or resident.Alternatively, the regulations, when finalized, should clearly provide Prop. Reg. section 1.1291-3(b)(2) does not apply to section 1291 fund stock acquired during a pre-residency period prior to the effective date of the final regulations.Tax Notes International, 92 TNI 60-17 (October 29, 1992).