Greetings from Haoshen Zhong.
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This week’s newsletter came by way of a CPA I will call GW.
if a dividend from a PFIC is not paid to the holder of the PFIC, but is reinvested in the fund, does this constitute a ‘distribution’ for the purposes of the excess distribution section 1291 rules under the Code?
I haven’t been able to find anything to confirm whether the doctrine of constructive receipt applies, or whether Section 1291 applies only to distributions actually paid out to the shareholder of a fund which is, for U.S. tax purposes, classed as a PFIC.
As GW noted, the question of whether the taxpayer has “constructively” received the dividend, even though he did not receive any cash, is the problem we are trying to solve.
Certain types of foreign corporations (as defined under US tax law) are classified as passive foreign investment companies (PFICs). IRC §1297(a). Shareholders of these PFICs must use special rules related to the PFICs.
There are 3 ways the shareholder of a PFIC can be taxed:
Both the MTM rules and the QEF rules require the shareholder to make an election. IRC §§1293-1296. Under these rules, the shareholder is taxed on “income” from the PFIC, even when there is no distribution or sale. We will assume that neither of these elections apply, so we are using the default rules.
When the shareholder of a PFIC receives a “distribution in respect of stock” from a PFIC, he must apply a set of complicated rule to calculate the tax on the distribution. IRC §1291(a), (c). I will not go into detail about what these rules are, except to note that they do not address reinvested dividends specifically.
Generally, a taxpayer reports income on either a cash receipts method or an accrual method. IRC §446(c).
By default, a taxpayer includes income in the year in which he received the income (cash receipts method). But if he keeps books that records income when he earns it, then he may include income when he earns it (accrual method). IRC §451(a).
Let us assume that the shareholder in GW’s question is an individual. An individual who runs a sole proprietorship might keep books for that sole proprietorship on an accrual method, but he almost certainly does not keep books of his personal life on an accrual basis. Therefore, we can be reasonably safe in assuming that the individual uses the cash method: He reports income when he receives the income.
But even if the shareholder uses the cash method, he can “constructively receive” income before he actually receives income:
Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. Reg. §1.451-2(a).
This more or less says, “If you can take the income for yourself at any time, then you must include the income even if you had not actually received it in hand”. In our case, the PFIC declared a dividend for the shareholder, but it did not actually distribute the dividend. Rather, it reinvested the dividend.
Is this sufficiently credited to his account, set apart for him, or otherwise made available to him to have been constructively received?
I am not aware of any material that directly addresses the question of reinvested dividends in the PFIC context, so we will have to do some extrapolation by analogy.
The IRS has described a few examples of constructive receipts in the context of dividends in general (Reg. §1.451-2(b)):
Generally, the amount of dividends or interest credited on savings banks deposits or to shareholders of organizations such as building and loan associations or cooperative banks is income to the depositors or shareholders for the taxable year when credited…
However, if any such portion of such dividends is not subject to withdrawal at the time credited, such portion is not constructively received and does not constitute income to the depositor or shareholder until the taxable year in which the portion may be withdrawn…
Accrued interest on unwithdrawn insurance policy dividends is gross income to the taxpayer for the first taxable year during which such interest may be withdrawn by him…
In the absence of guidance specific to PFICs, we should assume that the normal rules of constructive receipt apply. In general, it is safe to apply the rules of constructive receipt, because the rules permit the IRS to collect taxes sooner–and the IRS likes to collect taxes now rather than later.
I do not know how the PFIC that GW’s client owns is organized, but from most organizing documents I have seen, the investors in the PFIC are limited in when they can withdraw their investments in the PFIC. I have seen unit trusts that do not permit withdrawal until the investment period of 5 years is over, even though the unit trust issues annual financial statements that declare dividends and reinvest them. I have also seen mutual funds that permit dividend withdrawals annually.
The withdrawal window for dividends is when the PFIC first makes distribution for US income tax purposes. And there is no general rule for when that withdrawal window is: The PFIC’s organizing documents contain the rules for when withdrawals are permitted, and the withdrawal window determines when income must be included.
The normal constructive receipt rules for when a taxpayer receives a distribution apply to PFIC distributions.
Each PFIC has rules about when an investor can withdraw dividends. This withdrawal window may or may not be annual, and it may or may not occur every time dividends are reinvested into the PFIC. You will need to check the PFIC’s rules for when that withdrawal window occurs.
That withdrawal window is when the taxpayer receives a distribution for PFIC purposes.
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