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December 14, 2017 - Haoshen Zhong

QEF Election for a Fiscal Year Company in the Year of Immigration

This is a war story:

I have owned shares of a foreign company that rents out a warehouse for years. It operates on a fiscal year ending 31 March, 2017. I immigrated to the US on 1 February, 2017. I believe it is a PFIC. I would like to make a QEF election. When do I make this election, and is there anything else I need to do?

In this post, I will explain why the shareholder would make a QEF election with his 2017 tax return, why he does not need to do a deemed sale election, and how the passthrough of income works for 2017.

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.

The warehouse rental company is likely a PFIC, because it collects rent (and probably does not actively manage the warehouses). IRC §§1297(b), 954(c)(1)(A). 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 general (though not always), the the QEF election gives the best tax results, so if it is possible to make the election, it is desirable to make it. There are some requirements for making the QEF election, which I omit from this post for brevity. Debra has written about the requirements for the election here.

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 provision for passthrough of losses. There is no no passthrough of foreign tax credit, except for 10% corporate shareholders. IRC §1293(f). This is why it is only sort of a passthrough of income.

Make the QEF election with the 2017 return

A shareholder makes the QEF election on or before the due date for the income tax return for the first taxable year to which the election will apply. Reg. §1.1295-1(e)(1). The first year for which the shareholder is a US person is 2017, so he needs to make the election on or before the due date of his 2017 income tax return.

He makes this election by completing Form 8621, checking the box for the QEF election, and attaching it to his income tax return for 2017. Reg. §1.1295-1(f)(1).

There is no need for a deemed sale election to purge PFIC taint

You may have heard about a “once a PFIC, always a PFIC” rule, which forces you to make a purging election once you have treated the shares as shares of a PFIC.

The basic idea is this: If you do not make any election for a PFIC, then you use the default rules under section 1291. Congress did not want taxpayers to get out of the default PFIC rules by making the (usually) more favorable QEF election, so they require the taxpayer to make a purging election to end the treatment under default rules. The process works (in brief) like this:

If you then make a QEF election, then it becomes an unpedigreed QEF, because within your holding period, there were years when it was a PFIC but not a QEF. Reg. §1.1291-9(j)(2)(iii). You must continue to use the default rules for unpedigreed QEFs in addition to the QEF rules. Reg. §1.1291-1(b)(2)(v); Prop. Reg. §1.1291-2. You can end the use of the default rules by making a purging election. Reg. §§1.1291-9, -10.

Debra has written about how to make the purging election here.

Fortunately, there is no need to make a deemed sale election in our situation. This is because when you are a nonresident alien, you do not treat your shares as shares of a PFIC, even if the foreign corporation satisfies the tests for PFICs. Reg. §1.1291-9(j)(1).

This means 2017 was your first year in which you owned shares in a PFIC. If you make a QEF election in 2017, then for all years when the foreign corporation was a PFIC during your holding period, it was also a QEF.

In this situation, the QEF is a pedigreed QEF, and the default rules do not apply. You do not need to make a purging election.

In short, make the QEF election on the tax return due with the first year of residency, and you are good.

 

PFIC and CFCs