The IRS issued definitions and reporting requirements for shareholders of passive foreign investment companies (PFICs) effective December 31, 2013 for US tax returns for 2013 and onwards. The regulations provide guidance for determining a PFIC’s ownership and the annual filing requirements for shareholders of PFICs and controlled foreign corporations (CFCs). Potentially severe penalties apply for failure to comply with reporting requirements, and thus US citizens and residents should assess the rules’ application to them.

A non-US corporation is a PFIC if (1) at least 75 percent of its gross income is passive income, or (2) at least 50 percent of its assets (generally an FMV test) produce or are held for the production of passive income. Thus, a Canadian mutual fund and other Cancos may be treated as PFICs. A PFIC shareholder who is a US citizen or is otherwise subject to tax as a US resident (a US PFIC shareholder) must comply with the PFIC regime tax and information reporting requirements.

The PFIC tax regime includes three alternative tax systems for PFIC shareholders: (1) the excess distribution rules; (2) the qualified electing fund (QEF) rules; and (3) the mark-to-market (MTM) rules. (1) Under the excess distribution rules, a US PFIC shareholder is generally taxable on receipt of an excess distribution: the total amount received in the year exceeds 125 percent of the actual average distribution to the shareholder in the preceding three years. An excess distribution includes a gain on the sale of PFIC stock. An excess distribution is taxed at the highest ordinary income tax rates for individuals, and interest is based on the allocation of the excess distribution to prior years. (2) The QEF rules may mitigate the harsh consequences of the PFIC regime if a US PFIC shareholder timely elects to include in gross income each year his pro rata share of the PFIC’s ordinary income and capital gain. (3) A US PFIC shareholder may be able to elect to include MTM amounts in income and avoid the excess distribution rules.

Another tax and reporting regime applies to a CFC’s US shareholders. A CFC is a foreign corporation whose US shareholders own more than 50 percent of the total combined voting power or more than 50 percent of the total value of the forco’s stock on any day in its tax year. For this purpose, a US shareholder is a US person who owns—directly, indirectly, or by attribution—at least 10 percent of the forco’s total combined voting power.

A US shareholder may be subject to both the PFIC and the CFC regimes. For periods starting after December 31, 1997, the CFC rules generally take precedence over the PFIC rules.

Proposed 1992 regulations, which provided significant PFIC definitions and reporting requirements, were not adopted. After 1992, Congress enacted additional PFIC legislation, and the IRS issued notices to provide interim guidance. The new regulations adopt some of the 1992 proposed regulations, and revisions reflect changes in the law.

Definitions. The new regulations define PFIC terms such as “shareholder” and “indirect shareholder.” A shareholder is any US person that owns PFIC stock directly or indirectly; an indirect shareholder is any US person that owns PFIC stock indirectly. The regulations attribute ownership of PFIC stock held in a corporation, a partnership, an S corporation, an estate, and a trust. If a domestic or foreign partnership, estate, or trust or an S corporation directly or indirectly owns stock, each partner, shareholder, or beneficiary is considered to own the stock proportionately.

If a person owns stock of a forco that is a PFIC and is also a CFC, notwithstanding the coordination rule, the forco is treated as a PFIC to determine whether the shareholder owns an interest in any PFIC stock held by the forco.

The regulations provide special rules for non-grantor and grantor trusts. If a foreign or domestic grantor trust directly or indirectly owns PFIC stock, a person treated as the owner of any part of the trust is also considered to own that part’s interest in the stock. If a foreign or domestic estate or non-grantor trust directly or indirectly owns PFIC stock, generally each beneficiary is considered to own a proportionate amount of the stock. Under the regulations, until further guidance is issued, a beneficiary of an estate or a non-grantor trust that holds PFIC stock subject to the excess distribution regime should use a reasonable method to determine its ownership interest in the PFIC stock; Treasury is soliciting comments on how to determine the beneficiary’s proportionate ownership in the PFIC stock.

Treasury’s explanation of the regulations in the preamble says that they do not provide guidance on the excess distribution regime’s application if an estate or non-grantor trust—or a beneficiary of that trust—receives, or is treatedas receiving, an excess distribution (including a gain treated as an excess distribution). The preamble states that the excess distribution regime must be applied in a reasonable manner to preserve or trigger the tax and interest charge rules. Until further guidance is issued, the estate, trust, or beneficiary must take excess distributions into account in a reasonable manner that is consistent with the general operating rules applicable to estates, trusts, beneficiaries, and decedents.

General filing requirements. A US person that is a PFIC shareholder must generally file an annual report that contains information required by the Treasury on form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund” (Code section 1298(f )). The temporary regulations generally require that form 8621 be filed annually by the US person that is at the lowest tier in a chain of ownership and is a direct or indirect PFIC shareholder. For example, if a US citizen is a partner in a US partnership that owns PFIC shares, the partnership must file an annual report because it is the US person at the lowest tier in the chain of ownership. A US PFIC shareholder that owns PFIC stock through another US person must also file an annual report in certain circumstances—for example, if the US person receives income subject to tax under the excess distribution regime. Duplicative reporting for PFIC stock is generally eliminated for shareholders subject to the QEF or MTM rules.

A US person that is treated as the owner of a domestic and foreign grantor trust that owns PFIC stock generally must file an annual form 8621. The filing requirement may not apply to a US person that is treated as the owner of any part of a foreign grantor trust that is a foreign pension fund operated principally to provide pension or retirement benefits: under a US tax treaty, the income earned by the pension fund must be taxed in the US person’s hands, but only if and to the extent that the income is paid to or for that person’s benefit. A US person that is a beneficiary of a foreign estate or non-grantor trust and that has made a QEF or an MTM election with respect to PFIC stock held by the trust or estate must generally file an annual report only if the estate or trust (and any other US person in the chain of ownership) fails to file an annual report.

Reporting threshold. If the aggregate value of a US shareholder’s PFIC stock is US$25,000 (US$50,000 for joint filers) or less, and if no MTM or QEF election has been made, the shareholder need not file an annual form 8621. If the stock is owned indirectly, the threshold is reduced to US$5,000.

Special filing requirements. IRS notices had suspended certain form 8621 filing requirements until the regulations were issued, but indicated that when they were issued, a US PFIC shareholder must file for those earlier years under suspension. The new regulations say that suspended years’ filings are no longer required, but the regulations do not affect filing requirements for previous years’ filings of form 8938, “Statement of Specified Financial Foreign Assets.”

A US PFIC shareholder may need to file form 8621 under more than one PFIC filing provision. An individual who is exempt from filing under the new regulations may still need to file information under another provision. An individual who must report a PFIC as a specified foreign financial asset need not report the PFIC if he or she reports it on a timely filed form 8621 and his or her form 8938 indicates that the filing requirement was complied with on a form 8621.

A direct or indirect US PFIC shareholder should determine how all PFIC reporting rules apply in its particular situation. The new regulations are only part of the reporting guidance; this article does not address all aspects of the new rules.