Hello from Debra Rudd.

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How to make the MTM election after owning a PFIC for years

Two weeks ago in this newsletter, I wrote about how to make a QEF election when you have owned a PFIC for years and never made any elections. Emails subsequently began to trickle in with questions about whether you can make the Mark to Market (MTM) election in the same scenario, and if so, how you do it. (Thank you for the questions, by the way. Please keep sending them. You help make this newsletter a better resource when you do.)

The good news is that you can indeed make the MTM election after owning a PFIC for years and not making any elections. The bad news is:

  • You cannot make the MTM election retroactively, and
  • To make the MTM election, you must first pretend-sell your PFIC under the punitive excess distribution rules.

For those of you who read the newsletter from two weeks ago and think this sounds vaguely familiar, you are correct. When you have owned a PFIC for years and never made any elections, the processes for making the QEF and MTM elections are similar (but not identical).

The scenario

We will use the following example:

Assume you purchased a Canadian mutual fund 5 years ago. The fund has never provided you with a PFIC Annual Information Statement. You have never made any elections with respect to the fund. You just learned about the MTM election and how it would produce a better tax result than the default rules you currently operate under. You have properly extended the due date of your 2014 tax return to October 15, 2015.

You study up on the subject and confirm that your mutual fund does, in fact, qualify as a marketable security under IRC § 1296(e), so you will be able to make the MTM election. How do you do this? Can you make the MTM election for the 2014 tax return?

In today’s newsletter, I will talk about how you make the Mark to Market election for your 2014 income tax return. Specifically, I will talk about:

  • How you cannot make the MTM election retroactively (it can generally only be made in the current year), and
  • How you must use the IRC § 1291 rules (not the MTM rules) for your 2014 tax returns, and pretend-sell the fund as of December 31, 2014.

MTM? Whassat?

First, a bit of background. There are three different tax treatments for PFICs:

  • The excess distribution rules under IRC § 1291 force you to allocate gains and certain portions of distributions over the entire holding period of your PFIC, apply maximum tax rates for each year before the current year, and add a daily compounded interest charge to the tax. This is the default regime when no elections are made.
  • The MTM rules under IRC § 1296 call for recognition of gain as ordinary income on the unrealized year-to-year appreciation of your PFIC, with strict limitations on losses. The MTM rules only apply if you make the MTM election, which you are only permitted to do if your PFIC is a marketable security under IRC § 1296(e) and your MTM election is timely.
  • The QEF rules under IRC § 1295 treat your PFIC similarly to a partnership: income retains its character (meaning capital gains are taxed at capital gain tax rates) and is passed through to the shareholder for inclusion in current year income. The QEF rules only apply if you make the QEF election, which you are only permitted to do if you receive a PFIC Annual Information Statement from the PFIC and your QEF election is timely.

The QEF election results in the lowest tax, and the excess distribution rules result in the highest tax. The MTM election usually results in a tax lower than the excess distribution rules but higher than the QEF rules — in other words, somewhere in the middle.

You would clearly prefer to make the QEF election if you could, but you cannot make that election if you do not receive the PFIC Annual Information Statement. Many PFIC investors are not fortunate enough to receive that statement; however, if your PFIC qualifies as a marketable security under IRC § 1296(e), you can make the MTM election.

No late or retroactive MTM elections

In general, the MTM election must be made on a timely filed return, according to Regs. §1.1296-1(h)(1)(i):

A United States person that owns marketable stock in a PFIC, or is treated as owning marketable stock under paragraph (e) of this section, on the last day of the taxable year of such person, and that wants to make a section 1296 election, must make a section 1296 election for such taxable year on or before the due date (including extensions) of the United States person’s income tax return for that year. The section 1296 election must be made on the Form 8621, “Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund”, included with the original tax return of the United States person for that year, or on an amended return, provided that the amended return is filed on or before the election due date.

The Regulations also specifically address retroactive elections in Regs. §1.1296-1(h)(1)(iii):

A late section 1296 election may be permitted only in accordance with Section 301.9100 of this chapter.

“Wait!” you may be thinking. “That says I can make a late MTM election under the 9100 rules. I’ll do that!”

As with most things in tax, it’s not as easy as it may at first seem. To qualify for late election relief, you must show that you “acted reasonably and in good faith, and the granting of the relief will not prejudice the interests of the Government”. Regs. § 301.9100-3(a).

To show that you acted reasonably and in good faith, you must show that you understood the election requirements and somehow your exercise of due diligence led you astray, or that you relied on some bad advice from the IRS or a tax professional, or that some event beyond your control prevented you from making the election. Regs. § 301.9100-3(b)(1). Most people will fail on all of those criteria, since the most common reason for not making a timely MTM election is not knowing about it. Not knowing about it will not qualify you for late election relief.

Furthermore, the late election relief will not be granted if it prejudices the interests of the Government. If the election results in a lower tax liability, it is considered to have prejudiced the interests of the Government. Regs. § 301.9100-3(b)(2). Typically, the MTM election will result in a lower tax liability than the default treatment, so you will not be allowed the late election, even if you somehow qualify under the “reasonably and in good faith” criteria.

If you have held a fund for years and never made any elections, it is nearly impossible for you to be able to make the MTM election retroactively.

But you can make a MTM election for the current year

It is, however, possible to make a MTM election for 2014, because your PFIC qualifies as a marketable security under IRC § 1296(e) and you have properly extended the due date of your tax return to October 15, 2015. But for the first year that you make the election, the tax results may be a little painful.

“Painful how?” you may be wondering.

For QEF funds, you must check a box on Form 8621 indicating you are pretend-selling the fund and recognizing gains so that you can proceed under the QEF rules only in future years. This is known as making a purging election, which terminates the excess distribution rules for the fund. Making the QEF election alone does not terminate the excess distribution rules — you need to make the purging election to do that.

When you want to make the MTM election for the first time after owning the fund for years and never making an election, there is no applicable purging election. But do not think that means you are free from the excess distribution rules. You are not.

Excess distribution rules apply in first year of the MTM election

Regs. § 1.1296-1(i)(2) describes how this works:

For the first taxable year of a United States person (other than a regulated investment company) for which a section 1296 election is in effect with respect to the stock of a PFIC, such United States person shall, in lieu of the rules of paragraphs (c) and (d) of this section–

(i) Apply the rules of section 1291 to any distributions with respect to, or disposition of, section 1296 stock;

(ii) Apply section 1291 to the amount of the excess, if any, of the fair market value of such section 1296 stock on the last day of the United States person’s taxable year over its adjusted basis, as if such amount were gain recognized from the disposition of stock on the last day of the taxpayer’s taxable year; and

(iii) Increase its adjusted basis in the section 1296 stock by the amount of excess, if any, subject to section 1291 under paragraph (i)(2)(ii) of this section.

In the first year of your MTM election, which for you will be 2014, you must treat any dispositions or distributions that took place during 2014 according to the excess distribution rules, and you must also treat the excess of the year-end fair market value over your basis in the fund as an excess distribution. As a small consolation for your pain, you get to increase your basis by the amount the year-end fair market value exceeded adjusted basis.

Notice that the Mark to Market gain in the first year is taxed entirely under the excess distribution rules. The basis adjustment described in Regs. § 1.1296-1(i)(2)(iii) gives you your new adjusted basis for the beginning of the following year, but everything taking place in 2014 — any actual sales or distributions plus the pretend sale at the end of the year — is fully within the IRC § 1291 rules. (And that is the painful tax result I mentioned a few paragraphs ago.)

MTM rules do not apply in first year of MTM election

Note the language used in the Regulations: “For the first taxable year . . .for which a section 1296 election is in effect . . .in lieu of the rules of paragraphs (c) and (d) of this section . . .” the excess distribution rules apply. Regs. § 1.1296-1(i)(2) (emphasis is mine).

Paragraphs (c) and (d) of Regs. § 1.1296-1 detail how the MTM rules work.

For 2014, instead of following the rules for MTM funds, you follow the IRC § 1291 rules.

This is a weird result. You made the MTM election for 2014, but you do not get to apply the MTM rules until the second year of the election, which will be 2015.

I suspect the rules about the timing of the election were written that way because it is possible to make the MTM election in one year without knowing the fair market value of the fund as of the end of the previous tax year (or beginning of current year), in situations where the MTM election was not made previously because the fund was not a marketable security under IRC § 1296(e).

In practice, this seems to function much like the deemed sale election that you must make to purge a QEF of its PFIC status (except for the timing of the IRC § 1291 income recognition being at the beginning of the year for QEFs and at the end of the year for MTM funds). But an MTM fund does not need to be purged; it remains a PFIC when the election is in effect, and the MTM rules simply trump the excess distribution rules whenever the MTM election is in effect. It is not possible for an MTM fund to be taxed under both the MTM rules and the excess distribution rules at the same time, the way a QEF fund can be taxed under both the QEF rules and the excess distribution rules when a purging election is not made.

How to fill out Form 8621

Enough theory. It is time for paperwork. How do you make a MTM election for the first time on a fund you have owned for a while?

Elections are made in Part II of Form 8621. You, as the owner of a Canadian mutual fund who is making the MTM election for the first time, will be checking one box in Part II: Election to Mark-to-Market PFIC Stock.

Checking that box activates the MTM election for the fund. But the MTM treatment does not apply just yet. For 2014, any actual sales or distributions and the excess of fair market value at the end of the year over your adjusted basis are subject to the excess distribution rules.

You do not compute gains or losses under the MTM rules for 2014 because the excess distribution rules are used in place of the MTM rules for the first year of the MTM election.

You fill out Part V of the form showing your distributions and gains and the tax and interest calculations thereon. You do not, paradoxically, fill out Part IV of the form, which the form instructs you to do when you make the election.

A brief recap

If you have held a foreign mutual fund for years and never made an election, it is generally not possible to make a late or retroactive MTM election. However, you can make a current year MTM election.

If you make the MTM election, you will pretend you sold your PFIC under the excess distribution rules on the last day of the tax year in which you made the MTM election for the first time. In addition, any actual gains or distributions during the year are also subject to the excess distribution rules. For the tax year following the year in which you made the MTM election for the first time, the Mark to Market rules will operate in the way you expect.

Thanks and stuff

Thanks for reading.

The content contained herein is not designed to be advice to you. Let’s face it – this stuff is complicated and I probably messed something up. Hire someone to help you rather than relying on a free newsletter I stayed up way too late on a school night to write.

Keep sending your questions, and I’ll see you next week.

Debra