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Christopher Phelps
Christopher Phelps, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 2710
Experience:  CPA, CFP, PFS, Tax Practitioner 21 Years, Member AICPA/CSCPA Tax/Financial Planning Committee Member
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Tax ramifications of owning a PFIC

Customer Question

I purchased a stock in 2004 that according to their 20-f is a PFIC. The name of the company is Crucell(Nasdaq CRXl, on AMS is listed as CRCL.AS) and is based in the Netherlands. I own this stock both in my 401K and in a standard brokerage account. I filed for an extension for my federal taxes for the year purchased(2004). What are the ramifications of having this stock in my 401k, for my brokerage account, and if you could answer two more possibilities, how about someone who holds it in their IRA or ROTH IRA. I hope this is enough information.
Submitted: 11 years ago.
Category: Tax
Expert:  Christopher Phelps replied 11 years ago.

With respect to the shares of a PFIC that you hold in your tax-deferred accounts, there is no special impact because of the company's status as a PFIC.  As with any other foreign stock or U.S. exchange traded ADS shares, foreign taxes withheld on shares held in a tax-deferred account are not eligible to be claimed for the foreign taxes paid credit.


However, with respect to the shares you hold in taxable accounts, there are significant ramifications.  Generally, if you hold shares in a foreign company that is classified as a PFIC in any year, and you do not make an IRC Sec. 1296 mark-to-market election, then the dividends you receive will be taxed as ordinary income (i.e. not eligible to be treated as qualified dividends subject to a 15% tax rate cap) and any gains realized on the sale of the shares will also be treated as ordinary income.  Further, any losses realized on the sale of the shares will not be deductible.  Further, the amount of the income tax incurred on the dividends and gains on sale, will be increased by an interest charge to compensate for an assumed tax deferral associated with PFIC's, calculated as if the excess distributions (i.e. the dividends and gains) had been earned ratably over the period the U.S. holder held its ordinary shares or ADSs. Classification as a PFIC may also have other adverse tax consequences, including the denial of a step-up in the basis of ordinary shares and ADSs at death.


You can avoid most of the unfavorable rules described above by electing under IRC Sec. 1296 to mark your ADS's to market. For any year in which you own a company that is a PFIC and if you make a mark-to-market election, you will include as ordinary income the excess of the fair market value of the ADS's at year-end over your cost basis in those ADSs. In addition, any gain recognized upon an actual sale of ordinary shares or ADSs would be taxed as ordinary income in the year of sale.   For any year in which your cost basis exceeds the fair market value of the ADS's, you may deduct the loss to the extent you previously recognized ordinary income under this IRC Sec. 1296 election.  Each year in which you recognize ordinary income as a result of the mark-to-market rules, you will increase your cost basis by alike amount.  Each year you recognize a loss as a result of the mark-to-market rules, you will decrease your basis by a like amount.  As a result of making the election, any dividends you receive will generally be considered to be qualified dividends subject to a max tax rate of 15% unless otherwise specified by the Company.  Also, any foreign taxes withheld will be eligible for the foreign taxes paid credit.  Further, for any year in which the Company is no longer a PFIC and in which you sell the ADS shares, any gain or loss will be eligible for capital gain or loss treatment.


You make an IRC Sec. 1296 election by checking the box on line F of Part I of form 8621, (Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund) and reports the gain or loss on Part III of the form.  See www.irs.gov for the form.  You may make the election for 2004 up to the due date (including extentions) for filing your return (i.e. so your not late, good job filing for the extension).  Once you make this election it is irrevocable unless the Company's ADS shares become unmarketable or the IRS allows you to teerminate the election.  Thus, even if the Company ceases to to be a PFIC, you will still be required to mark-to-market.  The IRS will likely agree to terminate your Sec. 1296 election once the Company determines it will likely no longer be a PFIC.


The reason these rules are in place is as a result of a lot of abuse by offshore investors.  I suggest you dump this stock unless you really like them and are willing to put up with the hassel.  I reviewed th 20-F and it appears to me that the Sec. 1296 is your best bet.  The Company does not appear to be forthcoming with the information required to make a "QEF" election under Sec. 1295 (not that  its much of an improvement) and you can not force them to provide you the info.  

 
Christopher Phelps, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 2710
Experience: CPA, CFP, PFS, Tax Practitioner 21 Years, Member AICPA/CSCPA Tax/Financial Planning Committee Member
Christopher Phelps and other Tax Specialists are ready to help you
Customer: replied 11 years ago.
Follow up questions.
If the company goes from PFIC status to "regular" status at some point in the future, will the taxes due still be mark to market? For example, if it changes status in 2006, when can the sale of the stock be considered long term gains, and will it be at the purchase price, or the price adjusted mark to market at the end of 2005(as filed for my 2005 return)

(my commentary, just state whether this comment is correct)Basically, any profit on this stock is going to be short term capital gain(taxed as ordinary income)not matter how long the stock is held,no matter what I do, and unless precautions are taken, then losses may not be deductible, and interest and penalties due on "income" may be substantial.

Just so I understand, bought the shares at $8/share in August 2004. They were $13/share at end of 2004. I will in essense pay taxes on $5/share($13-$8)for 2004, despite not selling the shares. This happens each year I own the stock(with losses being adjusted down). Are the losses subject to the $3000 max deduction for capital gains? Stock is now $20, if it is $20 at the end of this year then I will pay the difference between $20(end of 2005 price) and $13(end of 2004 price) or $7/share, again regardless of whether or not I have sold the shares.

Apparently the company WILL provide the information needed to do a QEF(sec 1295), what are the benfits of this as compared to filing sec 1296.
Customer: replied 11 years ago.
Can I ask a follow up question for the same person? If so how? It seems it would be easier for him to answer my question then sending it to somebody else?
Expert:  Christopher Phelps replied 11 years ago.

Once the Company assumes "regular" status you still must mark-to-market every year the election is in effect.  However, if you sell the stock AFTER the Company attains "regular" status, any gain, calculated as the selling proceeds less your cost basis (i.e. the value of the postion on the last mark-to-market date), will be treated as long-term capital gain if you held the position for more then one year.  In your example, if the Company is regular in 2006 and you sell your position, any gain over the 12/31/05 value will be treated as long-term if you held the position for more then one year.


With respect to your second to last paragraph, your measurement of the gains/losses on a year-to-year basis is correct.  However, any gains realized are reported as ordinary income on line 21 of the 1040.  You also report mark-to-market losses on this same line as well.


QEF.  By making the election to apply the QEF rules, you will essentially be treated for tax purposes like an S Corporation shareholder.  That means you will be subject to tax on your pro-rata share of the earnings and profits of the Company.  The Company will provide you with a breakdown between ordinary income and net capital gains.  Income you recognize on your tax return will increase your cost basis and any distributions you receive will generally reduce your cost basis (i.e. the distributions/dividends themselves will not be taxable).  There may be certain "adjustments" to how much income you recognize on an annual basis but the Company will provide you with the details.  The QEF election is made on form 8621 and is generally inlieu of the mark-to-market election.  Any foreign taxes withheld from distributions are eligible for the foreign tax credit and the normal capital gain/loss rules apply to any sale transactions.  


Under the QEF rules, you may make an election (on an annual basis) to defer being taxed on your QEF income to the extent the income has not been distributed to you.  This computation is rather complex and the IRS will charge you interest on the taxes you defer.


Generally, the QEF election is not that different from the mark-to-market election over the entire holding period of your ownership of the PFIC.  The primary difference relates to the timing of the recognition of income under the two sets of rules.  In the mark-to-market the stock markets' take on your position will drive your income recognition, while under the QEF regime the Company's accounting policies will be the primary driver.


I do not favor one or the other except that the QEF approach is a little more complex. 


 


    

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