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June 1, 2017 - Haoshen Zhong

Mark-to-Market Election for PFICs You Own Through a Fund

PFICs held in a fund

This is a situation we see fairly often:

I have a foreign retirement account. I realized that I am taxed on the income from the account as if it is a normal account. The account owns a single fund offered through the account custodian, which invests in several publicly traded funds. Can I make a mark-to-market election for the underlying publicly traded funds?

For today’s post, we will assume that in fact, the US person is taxed as if the retirement account is just a normal investment account. That is not always the case for foreign retirement accounts.

We will discuss when the US person can, and whether they should, use a mark-to-market election for the underlying funds to reduce the tax burden from passive foreign investment companies (PFICs).

What is the mark-to-market election?

The mark-to-market (MTM) election is a special election you can elect for passive foreign investment companies (PFICs).

Under MTM rules, you are deemed to have sold your MTM shares at the end of each year. IRC §1296(a). You recognize gain as ordinary income. IRC §1296(c)(1)(A). You can use loss, but the amount of your loss you can use is limited. IRC §1296(a)(2).

This sounds rather terrible, but it is actually often better than the default rules for taxing PFICs, so if a US person owns a PFIC, making the MTM election is often desirable.

What is a PFIC, and why does the US person have this problem?

A PFIC is a foreign corporation that either (a) derives 75% or more of its income from passive income, such as dividends, interest, gains from selling property that give rise to dividends and interest, and the like; or (b) has assets that are 50% or more passive. IRC §1297(a).

Foreign funds derive almost all passive income, and they own almost all passive assets. Usually, the only question is whether they are foreign corporations. Most of the time, publicly traded funds have a legal structure that is classified as a corporation under US tax law, even if they are not organized as a company under foreign law.

Let’s assume that the underlying publicly traded funds are PFICs.

Requirements for the MTM election

The MTM election is available for “marketable stock”. IRC §1296(a).

The first requirement for being marketable is that it must be regularly traded on a qualified exchange. Reg §1.1296-2(a)(1).

Regularly traded means more than de minimis (negligible) volume of trade in on at least 15 days during each calendar quarter. Reg. §1.1296-2(b)(1). When a financial firm registers a fund on an exchange for public trading, usually the fund is regularly traded on the exchange.

Qualified exchanges includes any SEC regulated exchange, but it also includes any foreign exchange that (Reg. §1.1296-2(c)(1)):

  • Is regulated by a government entity;
  • Has volume, listing, financial disclosure, oversight, and other requirements that prevent fraud and manipulation and promote an open, fair, and orderly market that protects investors; and
  • The laws of the country are actually enforced.

As far as I know, the IRS has never published a list of exchanges that satisfy these criteria or explained what they mean. We generally assume that large, reputable exchanges exchanges qualify. But there are some uncertainty as to what open, fair, and orderly means. For example, the Shanghai exchange has A shares (which are only available to Chinese nationals and companies) and B shares (which are open to foreigners). Is the Shanghai exchange open and fair, despite the nationality restriction? It is not clear from the IRS guidelines.

For this post, I assume that the underlying publicly traded funds are regularly traded on a qualified exchange.

The intermediate fund creates problems

Recall that the retirement account does not hold the publicly traded funds directly. The retirement account holds a fund that the account custodian offers, and the fund in turn invests in the publicly traded funds.

The intermediate fund may not be eligible for MTM election

In many situations, the intermediate fund is not publicly traded–it is only available to those who hold retirement accounts with the account custodian. Thus, it is not uncommon to see an intermediate fund that is not marketable and thus not eligible for the MTM election.

The intermediate fund may prevent MTM elections for the underlying funds

Normally, when you own a PFIC, and that PFIC owns other PFICs, you must look through the intermediate PFIC to the underlying PFICs, as if you owned them directly. IRC §1298(a)(2)(B).

Unfortunately, MTM uses a different set of lookthrough rules. You look through a foreign partnership, foreign trust, or foreign estate. IRC §1296(g)(1). You cannot look through a foreign corporation. 67 FR 49637. Thus, if the intermediate fund is a PFIC, then you cannot make the MTM election for the underlying funds.

Do not make a MTM election for the intermediate fund, even if you can

Let us assume that the intermediate fund is marketable, so you can make the MTM election. The result of making the MTM election is that the intermediate fund will be subject to MTM, so you are taxed on any increase in value of the intermediate fund during the year.

But you still cannot make MTM elections for the underlying funds, because you own them indirectly through a foreign corporation. This means the underlying funds are taxed under the default rules for PFICs.

Furthermore, under the default lookthrough rules, you must look through the intermediate fund to the underlying funds. Thus, you are taxed on income from the underlying funds directly under the default rules for PFICs.

This results in double taxation. First, you pay tax on the income from the underlying funds using the default rules for PFICs, because you must look through to them. Second, you pay tax on the increase in value of the intermediate fund, because income or growth from the underlying funds tends to increase the value of the intermediate fund.

Unfortunately, this means even if the intermediate fund is marketable, you do not want to make a MTM election for the intermediate fund.

You can get out of this problem if the intermediate fund is a partnership

Under the MTM rules, if you own a PFIC through a foreign partnership, then you can make the MTM election for the underlying PFIC. Thus, if the intermediate fund is a partnership, then you can make the MTM election for the underlying funds.

It is not impossible for the intermediate fund to be a partnership: If the intermediate fund creates personal liability for the investors, then it would be a partnership under US tax law. Reg. §301.7701-3(b)(2)(i)(A). Figuring out whether the intermediate fund is classified as a partnership means looking at local law governing liabilities to creditors, then determining if the investors in the intermediate fund have personal liability for the debts of the fund.

Summary

When you own publicly traded funds that are classified as PFICs, it is often possible to elect the mark-to-market (MTM) treatment for the funds to reduce US tax burden. But when you own an intermediate fund that, in turn, invests in other funds, there are issues.

You often cannot make the MTM election for the underlying funds, because you can make the MTM election only for PFICs you own indirectly through partnerships, estates, and trusts. And the intermediate fund often is not eligible for MTM, because it is not marketable. Even if the intermediate fund is marketable, it is a bad idea to make the MTM election for it, because it results in double taxation under lookthrough rules.

PFIC and CFCs