In a recent case before the U.S. Court of Federal Claims, two married taxpayers appeared pro se in challenging the assessment of passive foreign investment company (PFIC) income taxes. David C. Shnier et ux. v. United States; No. 1:18-cv-01257
In the 1960s, Taxpayer’s father and four uncles created family trusts to share ownership of their jointly owned Canadian floorcovering company.
The Canadian company later became six holding companies. Five belonged to each of the uncles. One holding company, Enshnierco, belonged to the Taxpayer. Another holding company, Metropolitan Equities Limited, owned buildings that were owned by the floorcovering company.
Taxpayer immigrated to the U.S. from Canada in the mid-1990s and became a naturalized citizen.
The floorcovering company was sold in 2007. Taxpayer’s father invested Enshnierco’s proceeds from the sale in passive investments, including real estate.
Beginning in 2007 and continuing for several years, Taxpayer received distributions from the Canadian holding companies.
Taxpayers timely filed their tax returns but did not report the distributions on their U.S. federal tax returns.
Then in 2013, Taxpayers filed amended 2007, 2010, and 2011 tax returns while participating in the IRS’s now-defunct Offshore Voluntary Disclosure Program.
Taxpayer’s amended returns included the distributions from Metropolitan Equities Limited as income from a passive foreign investment corporation.
Taxpayers then opted out of the OVDP program. The IRS assessed PFIC taxes against plaintiffs, leading to payments of additional taxes, interest, and I.R.C. § 6662 penalties for 2007, 2010, and 2011.
Taxpayers’ representative sent a letter (informal refund claim) in response to the tax and penalty notices. The IRS refunded the § 6662 penalties but rejected the tax assessment protest. Taxpayers then filed a complaint in U.S. Court of Federal Claims and represented themselves.
The PFIC taxing regime
The purpose of PFIC rules are to discourage the income tax deferral of certain types of foreign income. In addition to holding companies as in this case, PFICs can also include foreign mutual funds, certain money market accounts, and exchange traded funds.
What is a PFIC?
Sections 1291 through 1297 of the tax code provide the rules for passive foreign investment companies.
Under Section 1297, a PFIC is any foreign corporation in which:
(1) 75 percent or more of the gross income of such corporation for the taxable year is passive income, or
(2) The average percentage of assets (as determined in accordance with subsection (e)) held by such corporation during the taxable years which produce passive income or which are held for the production of passive income is at least 50 percent.
Passive income test: A foreign corporation meets the passive income test if at least 75% of its gross income for the year includes dividends, interest, royalties, rents, and annuities, among other things.
Passive asset test: A foreign corporation meets the passive asset test if at least 50% of its assets produce passive income or are held for the production of passive income.
Determining whether a company meets the passive income or asset test will require looking through the company balance sheet and income statement. Generally a foreign mutual fund is a PFIC. Foreign stock may or may not be a PFIC.
De minimis exception: A PFIC shareholder is not required to complete the annual reporting requirement under IRC 1298(f) if the shareholder has not received any distribution or recognized gain and the aggregate value of all PFIC stock is less than $25,000 ($50,000 if married filing jointly).
Foreign pension funds: For any portion of a foreign pension fund that is considered a grantor trust, the taxpayer may be subject to the PFIC annual reporting requirements. The exception is if the tax treaty contains a provision that allows the deferral of foreign pension fund income until distribution.
Taxation of PFICs
A shareholder of a PFIC is required to annually report their interest in and any distribution from the PFIC. This requirement is satisfied by reporting the PFIC on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
A PFIC distribution consists of two parts — an excess distribution and a non-excess distribution portion. Non-excess distribution is taxed under the same rules as other U.S. sourced income.
An excess distribution is the portion of the current distribution that exceeds 125% of the average of the preceding three years.
The excess distribution is then allocated ratably over each day of the shareholder’s holding period. Then these distributions are taxed at the highest graduated rate in effect for each previous tax year along with interest.
Taxpayers agreed that Enshnierco and Metrolopitan Equities Limited are PFICs under IRC 1297 and are therefore subject to the PFIC taxing regime under the actual statute.
However, they argued that the court should read the text of the statute in its proper context and find their companies to not be PFICs and thus not subject to PFIC taxation.
Taxpayers argue that (1) the text, when read in context, supports their position; and (2) the court should look beyond the text to legislative intent.
According to Taxpayers, the context demonstrates “the PFIC regime was created to discourage American investors to hold passive investments through foreign corporations that would allow them certain advantages,” so the statute includes a willfulness requirement, which plaintiffs fall outside of.
Taxpayers argue the PFIC regime is “punitive” because it “was intended to dissuade US investors from investing offshore” but “it is an aberration of justice to apply the punitive PFIC regime” to them because their PFIC status was non-willful.
When a statute is unambiguous, courts “should prefer the plain meaning since that approach respects the words of Congress.” Here the statute is clear. There is no ambiguity in the statute or as to whether the Canadian companies are PFICs, and the Taxpayers even agreed to that point. So there is no need for the court to look beyond the statute to legislative history. The court grants the government’s motion for summary judgment.