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October 5, 2017 - Haoshen Zhong

Foreign Tax Credit on Sale of a PFIC

This is a question that sometimes comes in an email:

I am a US citizen living abroad. I sold a PFIC. I paid foreign tax on the gain. Can I use the foreign tax as a foreign tax credit?

We do not have a definitive answer to this question, because there is very little guidance from the IRS on this matter. This post discusses the positions you can take and our preferred approach.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for gain, there are special rules that apply. There are 3 possible ways to tax income from a PFIC:

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

In this post, I assume the PFIC is taxed using the default rules.

How is the gain taxed?

This is a very abbreviated summary of the default rules as applied to gains.

  • The entire gain is treated as “excess distribution” from a PFIC. IRC §1291(a)(2).
  • The excess distribution is allocated on a per day basis to the seller’s entire holding period. IRC §1291(a)(1)(A).
  • Excess distribution allocated to the current year is included as ordinary income. IRC §1291(a)(1)(B).
  • Excess distribution allocated to prior years is taxed at maximum ordinary income tax rates in effect for the year to which the excess distribution is allocated. IRC §1291(c)(2).
  • The tax on prior year excess distribution is subject to an interest charge as if the taxpayer owed the amount in the prior years. IRC §1291(c)(3).

How is foreign tax credit applied on a distribution?

To understand the problem with taking a foreign tax credit for foreign tax on gains from a PFIC, it is useful to first understand how foreign tax credit works when the PFIC makes a distribution.

There is a special rule for foreign tax credits “with respect to any distribution in respect of stock”. IRC §1291(g). A distribution from a PFIC may include both an “excess distribution” portion and a “non-excess distribution” portion. For the sake of simplicity, let us assume the entire distribution is excess distribution.

  • Separate the foreign tax paid on distribution from each PFIC. Prop. Treas. Reg. §1.1291-5(a). This means you cannot cross credit the foreign tax paid on one PFIC against the US tax on a different PFIC.
  • You allocate the foreign tax on a per day basis to the entire holding period. IRC §1291(g)(1)(B).
  • Tax allocated to the current year is available as a foreign tax credit normally. IRC §1291(g)(1)(C)(i).
  • Tax allocated to prior years can be used to reduce the US tax on the same year on the same PFIC only. IRC §1291(g)(1)(C)(ii).

On a high level, the rules more or less mirror how tax is calculated on the excess distribution. The basic idea is that foreign tax credit should be available on a per PFIC and per year basis.

How is foreign tax credit applied to a gain?

When a taxpayer sells a PFIC, the Code and regulation address only a special case: When a controlled foreign corporation is involved.

I will look at the general case only: What happens when the PFIC is not a controlled foreign corporation? Because there is no specific guidance, there are several possible theories.

No foreign tax credit is provided

Under this theory, section 1291(g) is the sole basis for providing a foreign tax credit. Because it does not provide for a foreign tax credit for any foreign taxes paid on the gain from the sale of a PFIC, none is allowed.

Foreign tax credit is made available on the same terms as a distribution

Under this theory, gain from selling a PFIC is treated as an excess distribution, so foreign tax credit should be granted as if the gain were a distribution.

Under this theory, foreign tax credit is available only when it is possible to allocate the foreign tax to a specific PFIC. In many cases, the taxpayer pays a general, annual personal income tax on the sale of a PFIC. The tax cannot be allocated to the gain from any specific PFIC.

Foreign tax credit is available normally under §901

Under this theory, there is nothing in the PFIC rules that says section 1291(g) is the only basis for claiming a foreign tax credit, so we turn to the general rules for foreign tax credit under section 901. And because the taxpayer properly paid foreign taxes on the gain, he is entitled to use the foreign tax as a credit.

We tend to use option 2

We tend to forgo the foreign tax credit when it is not possible to allocate the foreign tax to a specific PFIC. This is not because we think it is absolutely the correct interpretation of the ambiguous statute. It is because many of clients are planning to expatriate or filing late. In these situations, the client and our preference is to avoid aggressive tax positions that can lead to adverse changes in an audit.

 

PFIC and CFCs