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November 2, 2017 - Haoshen Zhong

Distributions from a PFIC under a QEF Election

This is a question we received through an email:

I own stock of a PFIC. I made a qualified electing fund election for the PFIC stock. The QEF received a distribution of qualified dividends during the year. Later, I sold the QEF for a loss. Can I use the loss to offset income from the QEF?

In this post, I will introduce how QEF works and why the loss from the sale of the stock cannot be used to offset the passthrough of income from the QEF.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. It applies to a foreign corporation if it satisfies either:

  • An income test: 75% or more of its gross income is passive income, or
  • An asset test: 50% or more of its gross assets produce passive income or are held for the production of passive income.

There are 3 ways income from a PFIC is taxed to a US person:

  • Default rules
  • Under a qualified electing fund (QEF) election
  • Under a mark-to-market (MTM) election

In this post, we assume that the US person has made a QEF election for the PFIC stock he owns.

QEF election sort of results in passthrough of income

When a US person makes a QEF election with respect to a stock in a PFIC, every year he must take into account his share of the QEF’s ordinary earnings for the year as ordinary income and his share of the QEF’s net capital gain for the year as long-term capital gain. IRC §1293(a).

The QEF provides a PFIC Annual Information Statement to the shareholder, which tells the shareholder his share of the QEF’s ordinary earnings and net capital gain. Reg. §1.1295-1(g).

There is no passthrough of losses. There is no passthrough of foreign tax credit, except for 10% corporate shareholders. IRC §1293(f). This is why it is not quite a full passthrough of income.

The qualified dividend is part of net capital gain

The QEF rules do not define what net capital gain means. The rest of the Code offers 2 different definitions of net capital gain:

  • Section 1222(11) defines net capital gain as net long-term capital gain minus net short-term capital loss (minimum of 0). IRC §1222(11).
  • Section 1(h) defines net capital gain as net capital gain defined by section 1222(11) plus qualified dividend income. IRC §1(h)(11).

Under QEF rules, we may determine net capital gain by “calculat[ing] and report[ing] the amount of each category of long-term capital gain provided in section 1(h) that was recognized by the PFIC…” Reg. §1.1293-1(a)(2)(i)(A). This implies that we use net capital gain as defined by section 1(h), which includes qualified dividends.

The qualified dividends that the QEF received is passed to the shareholder as net capital gain.

Limited to $1,500 of deduction of capital loss

The QEF regulations give us 3 ways of passing the QEF’s net capital gain to its shareholder, which the QEF chooses when it issues the PFIC Annual Information Statement to the shareholders. Reg. 1.1293-1(a)(2)(i).

  • Calculate each category of long-term capital gain provided in section 1(h);
  • Calculate the total net capital gain and state that the amount is subject to the highest capital gain rate of tax to the shareholder; or
  • Calculate the E&P for the year and report the entire amount as ordinary earnings.

Under the first method, the QEF would pass qualified dividend income to the shareholder. Normally, a person is limited to a deduction of $1,500 of capital loss against qualified dividend income. Having the qualified dividend income pass through the QEF does not change the result.

The second method is ambiguous, but I suspect the QEF simply passes a net capital gain that is to be directly added to the total amount subject to the highest capital gain rate (28%). This amount is simply added to line 18 of schedule D of Form 1040.

Under the third method, the shareholder receives a passthrough of ordinary income. He is limited to a deduction of $1,500 of capital loss against ordinary income.

In all cases, the loss from the sale of the QEF stock provides a deduction of up to $1,500.

PFIC and CFCs