Hello again from Debra Rudd.

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Today’s topic: How to make a QEF election once a fund has been a PFIC

Imagine that you own a Canadian mutual fund. You have owned it for five years. There have been no dividends from the fund and you have not sold any of your shares. It is slowly growing in value. You have never made any elections with respect to the fund, so the default rules of I.R.C. § 1291 are in force.

For 2014, you are given a QEF investor statement for the first time. You search the internet and read a little about what this piece of paper is and why you are receiving it. D’oh! A QEF election, it turns out, would have been really helpful to make back when you purchased the fund.

Today I am going to talk about how to properly convert your PFIC to a Qualified Electing Fund if you have owned the PFIC for years before making the QEF election. You could have missed making the QEF election because you did not:

  • know it was a PFIC,
  • know you owned it (I have seen it happen),
  • receive a QEF investor statement in the past so you could not have made the election, or
  • for whatever other reason, you just simply didn’t make the election.

The election you make in any of those situations and the process for making it is the same. You must make the QEF election on Form 8621 which is submitted with a timely filed return. And you must also make another election on Form 8621, called a purging election, if you don’t want to face some pretty ugly consequences.

First, some basics about QEFs

A QEF, or Qualified Electing Fund, is a PFIC for which you have made a special election.

The tax treatment of a QEF is better than the other two ways of taxing PFICs:

  • the excess distribution rules of I.R.C. § 1291, or
  • the mark to market (MTM) rules of I.R.C. § 1296.

QEFs are taxed much like partnerships, meaning that income retains its character (capital gains are taxed as capital gains, for instance) and is passed through to the shareholder for current inclusion in income.

This is much better than the MTM and excess distribution regimes. Here is a very brief refresher on how those rules work:

  • The MTM regime taxes unrealized gains at ordinary income tax rates (with strict limitations on losses). You are taxed on increases in value, whether you sell the mutual fund shares or not.
  • The excess distribution regime forces you to allocate gains and certain portions of dividends over your entire holding period, pay tax at the maximum rates for each year, and apply a daily compounded interest charge that runs through the current year’s tax return due date. You pay tax at a higher income tax rate than your actual income tax rate for your other income, and pay interest on top of the tax.

Clearly you would prefer to make a QEF election if you could, because you will pay less tax.

What makes it a QEF?

You have a QEF when both of the following two things are true:

  • You make an election that applies to the taxable year in question, and
  • The company or fund provides you with a QEF investor statement and otherwise complies with IRS requirements for QEFs. I.R.C. § 1295(a).

Only when both of those things happen do you have a QEF.

You are probably thinking, “Great! I received a QEF investor statement from the Canadian fund I have owned for five years. I should be able to go back and amend my prior tax returns to make the QEF election for those years and all my troubles are over.”

Unfortunately, that is not how it works for two reasons:

  • You have to receive a QEF investor statement for each year for which the election is in effect (because it tells you what income needs to be included on that year’s tax return), and
  • You cannot make a late QEF election unless a very specific set of circumstances apply to you.

No late QEF elections, generally

In general, you cannot make late QEF elections. If you have owned a PFIC for five years, you could not now make a QEF election that is effective as of the beginning of your holding period, even if you get the fund to give you a QEF investor statement for each of the years that has passed. Only if you “reasonably believed that the company was not a passive foreign investment company” for those prior years and the Regulations otherwise allow for it would you be able to make a late QEF election. I.R.C. § 1295(b)(2).

For most people this is not possible. You would need to demonstrate that you knew what a PFIC was and that you had a reasonable basis for believing that your investment was not a PFIC. That type of situation generally only arises because of valuation errors or similar on a company’s financial statements, where you understand the law and make a good faith effort to apply it — but in doing so, somehow arrive at the wrong conclusion. Ignorance of the law, such as not knowing what a PFIC is, does not allow you to make a late election.

In our example, you knew the Canadian mutual fund was a PFIC. You just did not receive the requisite QEF statements to be able to make the election. You did not have any basis for believing that the fund was not a PFIC. As a result, no late QEF election for you, even if you could convince the fund manager to give you QEF investor statements for all the years you owned the fund prior to 2014.

But you can make an election for the current year

It is, however, possible to make a QEF election in the current year, because you received the QEF investor statement for that year and (I will assume) you have properly extended the due date of your tax return to October 15, 2015. But you will also want to terminate the excess distribution rules for that PFIC or some ugly consequences will occur.

“What ugly consequences?” you are probably wondering.

Once an entity is subject to the excess distribution rules under I.R.C. § 1291 for any portion of the investor’s holding period (or to put it a little more directly, once it is a PFIC according to the income test or the asset test of I.R.C. § 1297(a)), it continues to be taxed according to the excess distribution rules for that investor even if it no longer meets the definition of a PFIC. I.R.C. § 1298(b)(1). This is known as the “once a PFIC, always a PFIC” rule.

Your Canadian fund is subject to the excess distribution rules because you have owned it for years and you have never made any elections. The excess distribution rules are the default treatment for a fund when no elections have been made. Under the “once a PFIC, always a PFIC” rule, your fund is stuck with that treatment — until you do something that will end it.

Making a QEF election triggers the QEF treatment. But making the QEF election does not end the application of the excess distribution rules, because of the “once a PFIC, always a PFIC” rule. To terminate the excess distribution regime, you must make a purging election. If you make the QEF election but do not make a purging election, you have a PFIC that is subject to both the QEF rules and the excess distribution rules.

That is pure madness. You will want to make simultaneous QEF and purging elections so that you stop the mutual fund from being taxed using the excess distribution treatment and start using the QEF tax rules — with no overlap.

Making only the QEF election means both rules apply simultaneously to the same income. Overlap in the excess distribution and QEF periods means two different methods of calculating and paying tax on the same income. And because the excess distribution rules are so punitive in nature, it is not just double taxation, but what I like to think of as “multiple taxation”. Overlap is bad.

How the purging election works

There is more than one type of purging election. I will only look at the one that applies to you and your Canadian mutual fund in today’s example — the Deemed Sale Election.

This election treats your PFIC as sold under the excess distribution rules as of the beginning of the tax year — in our example, January 1, 2014. I.R.C. § 1291(d)(2)(A).

Remember that, because no elections have been made, your Canadian mutual fund is taxed under the excess distribution rules of I.R.C. § 1291. Gains on the sale of I.R.C. § 1291 funds are treated as if they are excess distributions. Excess distributions are allocated over the entire holding period of the fund, then you pay tax at the maximum rates for each year and apply a daily compounded interest charge that runs through the current year’s tax return due date.

The tax results under the Deemed Sale Election are not ideal. But they serve the purpose of terminating the excess distribution treatment so that you can operate under the QEF rules from 2014 on. Once you make the Deemed Sale Election, it is as if you have sold your PFIC under the excess distribution rules and, assuming you also make the QEF election, re-purchased it under the QEF rules, with the accompanying step-up in basis. Regs. § 1.1291-10(f)(1).

The mechanics of the elections on Form 8621

Now, hopefully, you understand what elections you must make to cleanly exit the excess distribution regime and simultaneously begin the QEF period. That is the hard part. The (relatively) easy part is making the elections on your 2014 Form 8621.

Elections are made in Part II of Form 8621. You, as the owner of a Canadian mutual fund who is making the QEF election for the first time, will be checking two boxes in Part II:

  • Election To Treat the PFIC as a QEF, and
  • Deemed Sale Election

The first box, Election To Treat the PFIC as a QEF, activates QEF status for the fund as of the first day of the tax year. In our example, that is January 1, 2014. The second box you will be checking, Deemed Sale Election, triggers a pretend sale of the PFIC and terminates the application of the excess distribution rules to the fund as of January 1, 2014.

This is the result you want to achieve. As of the beginning of the tax year, you no longer have a I.R.C. § 1291 fund, and now have a QEF.

No overlap. No “multiple taxation”.

You are not finished yet. For the QEF election, you must complete lines 6a through 7c of Part III of Form 8621. This is where you tell the IRS what kind of income and how much of each kind of income is attributed to you under the QEF rules for the 2014 tax year.

For the deemed sale election, you must complete line(s) 15f (through 16f, if applicable) of Part V of Form 8621. This is where you pretend that you sold the PFIC as of January 1, 2014 and apply the excess distribution regime to your gains.

I am not going to further discuss how to fill out the applicable sections of Form 8621 when you make these two elections in today’s newsletter. That would turn this email into a lengthy book. 🙂

A brief recap

While it is generally not possible to make a late or retroactive QEF election, you can make a current year QEF election to trigger the QEF treatment from the current year forward.

If you do, be sure to make a purging election at the same time so that you terminate the excess distribution regime with respect to that fund while simultaneously activating the QEF treatment. Otherwise, you are in the disastrous position of paying two different types of tax on the same asset.

Making the purging election requires a pretend sale of the fund under the excess distribution regime. While the tax results of the pretend sale are not ideal, the QEF-purging election scheme may be a good idea if you have not held the fund very long at the time you are making the election and you expect to hold the fund for a long time, because the preferential QEF taxation rules will ultimately create a lower tax bill for you.

Thanks

As always, thank you for reading, and please feel free to reach out to me should you have any questions. I always love to talk about PFICs.

And a quick obligatory disclaimer: This email is not tax advice to you. PFICs are incredibly complex. I have no doubt failed to talk about some important aspect of this process. Hire a professional if you need help.

See you next week.

Debra