It is not mandatory to file this form unless there is a distribution of income from a passive foreign investment company (PFICs) in which a U.S. person is a shareholder or a disposition of the shares of a PFIC by gift, death and most types of otherwise tax free exchanges or redemtptions. However, taxpayers or preparers will not find a statement to this effect anywhere in the instructions to the form or in the applicable IRS regulations.
The form must be filed to compute the tax due on any "excess distributions" from or dispositions of a PFIC. Generally, an "excess distribution" is a distribution (after the first year) that exceeds 125% of the average distribution in the previous three years. All dispositions appear to be treated as excess distributions and are treated the same as distributions in excess of 125% of the average distributions.
In most cases, a U.S. person that has a direct or an indirect ownership interest in a PFIC is required to file this form if there are excess distributions or if the taxpayer wants to elect a current method of taxation. Indirect ownership would include a partner in any partnership that owns any shares of any PFIC and a beneficiary of any trust or estate that owns any shares of any PFIC.
This form should not be used by those who have investments in a foreign partnership where the partnership does not own any shares of any PFIC. A partnership is not a PFIC even if all of its income is from passive investments. The same is true with respect to any trust or estate that does not own any shares of any PFIC. A PFIC is a corporation (by definition) and in most cases, a trust or partnership would not be a PFIC. (There may be some instances where the IRS would argue that a foreign trust or foreign partnership had the characteristics of a corporation.)
A special rule applies to U.S. shareholders of a controlled foreign corporation that would satisfy the definition of a PFIC. U.S. shareholders of a controlled foreign corporation (CFC) that is a foreign personal holding company (or otherwise meets the tests of a PFIC) should not file a Form 8621 so long as they are subject to tax on the investment income of the CFC. However, if the CFC owns shares of a PFIC, it could be required (or elect) to file this form and the income of the PFIC would then pass through the CFC to the U.S. shareholders.
Having to file this form to pay tax on the current income of a PFIC can be avoided when the sole U.S. owner of a foreign corporation has elected to have the foreign corporation taxed as a disregarded entity and where the foreign corporation has not invested in a PFIC.
This form should not be filed by beneficiaries of a foreign trust unless the foreign trust has invested in a PFIC. However, where a foreign trust has the characteristics of a corporation, the trust could be deemed to be a PFIC by the IRS. The IRC, the IRS Regulations and the IRS instructions to the Form 8621 all explicitly refer to the PFIC as a corporation. We do not believe that it is the obligation of a taxpayer to presume that a trust should be treated as a corporation.
Form 8621 is just two pages long, but the instructions consist of seven pages of very confusing information. The confusion is caused by the fact that the form is basically an election to pay taxes currently on the shareholder's pro-rata share of the income of the PFIC. There are two methods of electing to pay current taxes on the income of a PFIC and a default method of taxation if no election is made.
The default method involves a complicated allocation of an "excess distribution" (as defined above) to the prior tax years in which the taxpayer was a shareholder. For each of those years, the income tax is computed on the basis of the highest tax bracket for that year even though the taxpayer may have been in a much lower marginal tax bracket. For all years back to 1993 the top rate was 39.6% and for tax years from 1992 back to 1986, the top rate was 33%. Prior to 1987, the PFIC rules did not exist and excess distributions to such years would be treated as ordinary income for those years. After computing the tax, there is an interest charge (compounded daily) on the tax for each of those years. However, the applicable law provides that the total tax and interest will not exceed the amount of the distribution.
This punitive form of taxation can be avoided by electing to pay the tax on the current income of the PFIC in one of two general ways.
One method is with a "mark-to-market" system based on the list price of publicly listed foreign mutual funds. As a practical matter, the IRS regulations regarding the mark-to-market method are extremely stringent and only a few foreign mutual funds would qualify.
The other method is called the "Qualified Electing Fund" (QEF) and requires extensive information from the PFIC. In order to use the QEF election, the U.S. shareholders must own enough of the stock to force the fund managers to provide the required information for the shareholders to compute their share of the income of the PFIC each year.
The form should be filed with the tax return of the U.S. taxpayer for each separate PFIC in which the taxpayer is a shareholder.
It should be filed with the IRS center to which the taxpayer sends his or her return or the Philadelphia address above. If the taxpayer is not required to file an income tax return, then copies of the form 8621 should be sent to the Internal Revenue Service Center, POB 21086, Philadelphia, PA 19114.
The IRS estimate of the time required to prepare this form is about seven hours, exclusive of the time required to learn about the form and the time required for record keeping throughout the year. The actual time will depend on the election made by the taxpayer. Reporting income using the mark-to-market method doesn't take very long. Reporting income using the QEF election might take seven hours (or more) depending on how the information is provided by the PFIC. If the PFIC makes cash distributions that do not exceed 125% of the average distributions in the three previous years, it may only take a few minutes to prepare the form. Where the form is used to compute the tax on an excess distribution, it could take much longer than seven hours to prepare the form.
Where there are no distributions to the shareholders, there are no explicit penalties for a failure to file the form. Generally, it is to the advantage of a U.S. taxpayer to file this form and to make an election to pay taxes on the current income of the PFIC. If an election is not made to pay taxes on the current income of the PFIC, then any future distributions may be subject to the punitive tax on excess distributions. In addition, the QEF election may permit the taxpayer to retain the benefits of the lower tax rate on long term capital gains realized by the PFIC.
Form 8621 is an election that may be filed by the shareholders of a foreign corporation that is a "passive foreign investment company" or PFIC. A foreign corporation is a PFIC if 75% or more of the corporation's gross income for it's tax year is passive income as defined in tax code section 1297(b), or if at least 50% of the average value of the corporations' assets for its tax year is attributable to assets used in the production of passive income or held for the production of passive income. The form must be prepared for each PFIC in which the taxpayer is an investor and wants to elect a current method of taxation on the shareholder's portion of the income of the PFIC. The extent of the percentage of ownership in the PFIC by the U.S. person is not a factor in filing this form.
If a foreign trust invests in any foreign mutual funds (PFICs), such funds are deemed to be passive foreign investment companies under U.S. tax law and the U.S. grantor may want to file a Form 8621 for each such fund, each year.
In addition to the cost of preparing the forms, the grantor may lose the benefit of any long term capital gains tax rates on the sale of the foreign mutual funds and effectively loses the benefit of any tax deferral that would otherwise be available.
The instructions to Form 8621 state that passive income is defined in tax code section 1296(b) but that appears to be a typo because the definition of the term is included in 1297(b). That section defines passive investment income by reference to the definition of foreign personal holding company income (as defined in section 954(c)) with certain exceptions. Tax code section 954(c) defines foreign personal holding company income as including interest, dividends, rents, royalties and annuities, gains (but not losses) from the sale of assets that produce interest, dividends, rents, royalties and annuities, gains from certain commodity transactions, foreign currency gains and income that is equivalent to interest or dividends. However, there are some exceptions where this kind of income is earned in an active trade or business, dealer income and certain income from related "persons".
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