The “G” election, provided for under U.S. Treas. Reg. Section 1.1411-10(g), impacts U.S. direct and indirect individual shareholders of controlled foreign corporations (“CFCs”) and passive foreign investment companies (“PFICs”). A U.S. individual shareholder of a CFC or PFIC with a qualified electing fund (“QEF”) election is required to report and pay U.S. federal tax on certain undistributed income from the CFC or PFIC/QEF. This undistributed income is generally treated as a deemed dividend inclusion, which is subject to both regular U.S. federal individual income tax and the net investment income tax.
The G election allows the U.S. individual shareholder of a CFC or PFIC/QEF to report and pay U.S. tax on undistributed income from a CFC or PFIC/QEF in the same year for both regular tax and net investment income tax purposes. Without the election, the shareholder does not recognize CFC or PFIC income for net investment income tax until the year when an actual cash distribution is made. While the opportunity for deferral may seem favorable, the recordkeeping necessary to keep track of the information to substantiate the deferral and later recognition is not practical for many taxpayers and their tax preparers.
U.S. individuals typically may own indirect interests in CFCs and PFICs through investment fund partnerships, which are pass-through entities. For the tax year ending 12/31/2013, many investment funds have reported footnote disclosures in the investor’s annual Schedule K-1 which advise the individual investor to make the G election on their respective Form 1040 individual income tax return. The disclosures typically advise the U.S. investor that the CFC or PFIC/QEF income is already included in the Schedule K-1 amounts and that the fund did not make the G election. A pass-through entity has the option to make the G election for the year 2013 if the fund obtains consent from all of its direct investors. The fund also has the option to make the G election for years after 12/31/2013.
The technical area of PFIC tax compliance already has very impractical reporting consequences for U.S. taxpayers. The G election is another consideration in specialized U.S. foreign reporting that should not be overlooked.
Please consult your Aronson LLC tax advisor or Alison Dougherty of Aronson’s international tax practice at 301.231.6290 for more information.
Hedge funds are investment partnerships that issue a Schedule K-1 to investors which are partners in the partnership. The Schedule K-1 reports the partner’s distributive share of the taxable income, gain, loss, deduction and credit from the partnership. The Schedule K-1 is filed with the hedge fund’s U.S. federal partnership tax return. Hedge funds issue Schedule K-1s with detailed footnotes which include disclosures regarding additional reporting that may be required by the partners on their respective U.S. federal tax returns. Hedge fund Schedule K-1s typically include certain foreign reporting disclosures regarding the fund’s investments in foreign corporations including Passive Foreign Investment Companies (PFIC) and foreign partnerships.
Some of the U.S. foreign reporting disclosures that typically appear in hedge fund Schedule K-1s including the following.
Please consult Aronson LLC tax advisor, Alison N. Dougherty at 301.231.6290 for more information.
Based on the general rule of deferral, a U.S. shareholder of a foreign corporation defers U.S. federal taxation on earnings of the foreign corporation until a dividend distribution is actually repatriated to the U.S. shareholder. There are some important exceptions to this general rule under the anti-deferral tax regime that applies to controlled foreign corporations. A controlled foreign corporation (CFC) is a foreign corporation of which more than 50% of the vote or value is owned by U.S. shareholders who each own at least 10% of the voting stock of the foreign corporation. A U.S. shareholder of a CFC is required to pay U.S. federal tax on deemed distributions of undistributed income from the foreign corporation, even though an actual cash dividend is not received. The U.S. shareholder is considered to have a deemed dividend inclusion subject to U.S. federal tax if the foreign corporation has Subpart F income or if the foreign corporation has earnings invested in U.S. property.
There are several categories of Subpart F income. One main category of Subpart F income is foreign base company income, which includes several subcategories of income: foreign personal holding company income, foreign base company sales income, foreign base company services income and foreign base company oil related income.
There are de minimis and full inclusion rules for Subpart F income. Based on the de minimis rule, the CFC is not considered to have Subpart F income for the year if the total of its gross Subpart F income is less than the lesser of 5% of all gross income or $1 million. Based on the full inclusion rule, the CFC is required to treat 100% of its gross income for the year as Subpart F income if the Subpart F income is greater than 70% of the total gross income.
A CFC is considered to have earnings invested in U.S. property if it has trade or service receivables owed to the CFC by a U.S. person or if the CFC guarantees the obligation of a U.S. person or stock of the CFC is pledged as collateral for the obligation of a U.S. person. A CFC also is considered to have earnings invested in U.S. property based on investments in stock of U.S. corporations, obligations of U.S. persons or rights to utilize intangible property in the United States.
The new 3.8% net investment income tax applies to U.S. individual, trust and estate taxpayers for tax years beginning after December 31, 2012. For U.S. individual taxpayers, the tax is 3.8% of the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount. The threshold amount is $250,000 for joint filers, $125,000 for married filing separately and $200,000 for other U.S. taxpayers. For purposes of the tax, investment income includes:
Net investment income is calculated to include the types of income referenced above, decreased by expenses allocable to such income. Modified adjusted gross income is AGI plus foreign earned income excluded under the foreign earned income exclusion.
The calculation of net investment income for the 3.8% tax includes income attributable to investments in foreign corporations. Net investment income takes into account dividends and gains from stock of a controlled foreign corporation (CFC) or passive foreign investment company (PFIC). A CFC is a foreign corporation of which more than 50% of the vote or value is owned by U.S. shareholders who each own at least 10% of the voting stock. A PFIC is a foreign company of which 75% or more of the gross income for the year is passive income or 50% or more of the average assets for the year produce passive income. Proposed Treasury Regulations Section 1.1411-10 provides rules that apply to an individual, estate or trust that is a U.S. shareholder of a CFC or that is a U.S. person who owns directly or indirectly an interest in a PFIC. The proposed rules also apply to an individual, estate or trust that owns an interest in a U.S. partnership or an S corporation that is a U.S. shareholder of a CFC or which has made a Qualified Electing Fund election for a PFIC.
The proposed regulations provide a rule that requires the U.S. taxpayer to include distributed income from a CFC or PFIC in net investment income for the 3.8% tax if such distribution was previously taxed as a deemed distribution of undistributed income. An anti-deferral rule generally requires U.S. shareholders of a CFC or PFIC to pay U.S. federal tax on certain undistributed income of the foreign corporation. When the earnings that were previously taxed are then distributed later, the U.S. taxpayer is allowed to exclude the distribution from taxable income. The U.S. taxpayer is not required to pay U.S. federal tax again on the actual distribution of the earnings that were taxed previously as undistributed income.
The U.S. taxpayer is allowed to make an election under the proposed regulations to include the undistributed income from the CFC or PFIC in net investment income for the 3.8% tax in the year in which the U.S. taxpayer pays U.S. federal tax on the undistributed income. The election enables the U.S. taxpayer to treat the undistributed income from the CFC or PFIC consistently as taxable income for both regular U.S. federal tax and the 3.8% net investment income tax. Unless an election is made to achieve consistency, the U.S. taxpayer is required to pay the 3.8% net investment income tax on the actual distribution from the CFC or PFIC of the previously-taxed undistributed income that is excluded from regular U.S. federal taxable income.
The proposed regulations also provide other technical rules for basis adjustments and the inclusion of gains from the sale of CFC and PFIC interests.
In a case recently decided by the Fifth Circuit U.S. Court of Appeals, permanent U.S. residents were subject to U.S. federal individual income taxation at ordinary income tax rates on undistributed income of a controlled foreign corporation. In Rodriguez vs. Commissioner, the U.S. taxpayers were a husband and wife who owned a Mexican corporation. Although not fully explained in the case opinion, the Mexican corporation had earnings invested in U.S. property. This caused the U.S. shareholders to be subject to U.S. taxation on undistributed earnings of the foreign corporation. The U.S. shareholders took the position on their U.S. federal tax return that the undistributed income from the foreign corporation should be subject to U.S. federal taxation at the lower 15% qualified dividend tax rate. The Fifth Circuit affirmed the decision of the U.S. Tax Court and it held that the income was neither an actual nor a deemed dividend.
Such undistributed income is known as a “Section 951 inclusion,” based on the applicable provision of the U.S. Internal Revenue Code. Section 951 is what is known as an “anti-deferral” provision. This means that a U.S. shareholder of a controlled foreign corporation (‘CFC”) is limited in being able to defer U.S. federal taxation on income of the CFC until a dividend distribution is actually repatriated. A foreign corporation is a controlled foreign corporation if more than 50% of the vote or value is owned by U.S. shareholders who each own at least 10% of the voting stock. The U.S. anti-deferral regime causes a U.S. shareholder who owns at least 10% of a CFC to be subject to U.S. taxation on certain undistributed income of the CFC, even though the earnings are not actually distributed in the form of a dividend distribution.
With the proper U.S. international tax planning, the advantage of deferral can be preserved so that a U.S. shareholder of a CFC is not subject to current U.S. federal taxation on undistributed income of a CFC.