IRS Announces New Settlement Method for PFIC Investments
November 23, 2010
U.S. taxpayers entering a Voluntary Compliance Disclosure (VCD) program of the Internal Revenue Service (IRS) with respect to previously undisclosed or incorrectly disclosed foreign income or assets may be able to discharge potential back taxes, interest and penalties at a somewhat reduced rate.
In the course of participating in such a program, a taxpayer may disclose – or learn during disclosure – that investments have been held in one or more Passive Foreign Investment Companies (PFICs). A PFIC generally is a foreign corporation of which at least 75% of gross income is from passive sources such as dividends, interest, royalties, or capital gains or at least 50% of assets produce such income. U.S. persons owning shares of such a corporation – no matter how small their percentage interest – are subject to ordinary income taxation at the highest individual tax rate and deemed interest charges (at the IRS statutory deficiency rate) on their distributions or disposition proceeds from such holdings, unless they timely file certain elections to be taxed on a current basis on accumulated income of the corporation.
One important question for VCD resolution of past U.S. tax liabilities in connection with an investment in a PFIC is how to determine and tax the previously untaxed accumulated income associated with the holding.
Basic Effect of the New Method
In a webcast of the American Law Institute-American Bar Association, John C. McDougal, Office of Chief Counsel of the IRS’s Small Business/Self Employed Division, said that investments in foreign mutual funds, which are PFIC investments, "have turned up in a large number of voluntary disclosures that we're processing…." However, calculations under the statutory PFIC regime require the taxpayer to locate historical information on the basis and holding period of investments, which may not be readily available.
The alternative that is now available allows VCD participants to follow a mark-to-market approach for all of their PFIC investments. (For investments that were held before 2003 – the first year covered by the special VCD program – taxpayers should try to determine historical basis from actual records, but when records are not available, the IRS plans to be reasonable in working with taxpayers to find an alternative method of reconstructing probable basis.)
Mr. McDougal further explained, "We're going to limit mark-to-market losses to previously reported gains on the particular investment. This means you don't net losses against income as you do with capital gains; each investment is looked at on its own. The loss on a particular investment is only allowable…to the extent that there was previously included income with respect to that investment."
In addition, for 2003-2008, the tax rate that will be applied to PFIC gains or losses and the interest rate that will be charged are both generally favorable to taxpayers. According to Mr. McDougal, "Rather than figure out what rate applies in each case, we're going to apply a standard 20% tax rate on all PFIC gains and losses during the six-year voluntary disclosure period” – i.e., the initial gain on the prior holding period that is rolled into 2003 income, and on each year’s mark-to-market gain.
Observation: For years after 2008, apparently the mark-to-market treatment will remain in effect, but tax rates will revert to the normal rates required in the PFIC statute.
For tax calculated on the historic income of the PFIC investment, there is a one-time interest charge of 7% from the date of acquisition through December 31, 2003.
This interest charge essentially eliminates the statutory requirement of the look-back interest calculation that is required in allocating gain to all periods in which the U.S. person held the PFIC investment. For subsequent period adjustments covering 2003-2008 for which the 20% tax rate is applied to gain or loss, there will continue to be an underpayment interest charge from the due date of the tax return of the year involved to the date the tax is paid.
How to Proceed
Taxpayers who make timely, complete, and truthful disclosures through the general VCD program are still eligible for a letter from the IRS’s Criminal Investigation Division stating that the division does not recommend prosecution.
However, since participation in the VCD program must be sought before the taxpayer is under IRS audit or investigation, professional practitioners may seek preliminary clearance checks to ensure that their clients are not under investigation before filing a disclosure.
VCD information document requests recently issued by the IRS apparently have been the same for all taxpayers. However, there is no external appeals process in the VCD program, so it is important that the taxpayer, legal counsel and other appropriate professionals work effectively with the IRS revenue agent handling the matter.
Observation: EisnerAmper LLP has developed an internal program to assist in calculating PFIC taxes for clients.