On December 8, 2005, the IRS issued final (TD 9231), temporary (TD 9232), and proposed (REG-133446-03) regulations providing guidance for taxpayers that continue to be subject to the passive foreign investment company (PFIC) excess distribution regime of Code section 1291 because the foreign corporation in which they own stock used to be a PFIC under section 1297(a) or (e). The regs provide elections to purge the PFIC taint and are effective for tax years beginning after December 8, 2005; taxpayers may elect to apply the final regs to a prior taxable year if the limitation period for assessment has not expired. The text of the temporary regs also serves as the text of the proposed regs.

Final regs purge taint of former PFIC. A foreign corporation is a PFIC if it satisfies an income test (at least 75 percent of the taxable year's gross income is passive income, such as dividends and interest) or an asset test (of its assets held during the year, at least 50 percent--which, depending on the circumstances, is based on FMV or adjusted basis--produce passive income).

A US person who has not made a QEF election is not taxed currently on a PFIC's income but is taxed on certain excess distributions received, including (1) gains on the sale or deemed disposition of PFIC stock, and (2) actual PFIC distributions received in the tax year exceeding 125 percent of the average actual distributions received in the preceding three years. An excess distribution is allocated rateably to each day in the US person's holding period. Amounts allocated to the current year and any pre-PFIC holding period are taxed currently as ordinary income; other amounts allocated to the PFIC period are subject to tax at the highest ordinary income tax rate, plus an interest charge to reflect the tax deferral. A timely QEF election avoids the excess distribution regime, and the US person is taxed currently on the PFIC income.

The new final regs allow specific relief elections for certain US persons who have not made QEF elections but continue to be subject to the PFIC excess distribution regime even though the foreign corporation no longer satisfies the PFIC income and asset tests. With minor changes, the final rules adopt temporary regs that were issued in 1988, were amended in 1998, and expired on January 2, 2001.

If at any time during a shareholder's holding period, a foreign corporation was a PFIC (but not a QEF), the stock retains its character as PFIC stock, even if the corporation ceases to be a PFIC under the income and asset tests, unless the shareholder elects to purge the PFIC taint under rules similar to the QEF rules (Code section 1298(b)(1)). After so electing, the taxpayer shareholder is treated as having sold its stock in the foreign corporation on the termination date, the last day of the corporation's last tax year during which it was a PFIC. After the election, the stock is not PFIC stock.

The final regs describe the time and manner of the deemed-sale election. Under the prior temporary regs, the shareholder could elect by filing an amended return for the tax year that included the termination date; the final regs allow an election without the filing of an amended return if an election can be filed by the due date of the shareholder's original return for that tax year. The election is made on form 8621 ("Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund") and is filed with the shareholder's return for the election year. If the election year is closed, the PFIC taint cannot be purged under the final regs, but the new temporary regulations may provide relief via a late purging election, with the IRS's consent.

Temporary regs purge taint of Code section 1297(e) PFIC. The new temporary regs allow a shareholder of a foreign corporation to make a deemed-sale (or deemed-dividend) election when Code section 1297(e) applies. Under that rule, a foreign corporation generally is not a PFIC vis-à-vis a shareholder if it is a CFC and, during the post-1997 holding period, the shareholder owned at least 10 percent of the corporation (a Code section 1297(e) PFIC). Under the temporary regs, such shareholders and shareholders of former PFICs may, with the IRS's consent, make late deemed-sale purging elections, which in some respects differ from QEF elections. The gain on a QEF-election deemed sale is taxed as an excess distribution received by the shareholder on the qualification date, defined as the first day of the PFIC's first taxable year as a QEF. Under the temporary regs, the deemed excess distribution is received on the CFC qualification date, which is the first day the PFIC becomes a CFC. The term "post-1986 earnings and profits" under the QEF regs means certain undistributed earnings and profits as of the day before the qualification date. The temporary regs define the term in relation to the day before the CFC qualification date, which, unlike the QEF qualification date, may be other than the first day of the taxable year.

The deemed-sale election must be made by filing form 8621 in the shareholder's original return for the tax year that includes the CFC qualification date, or in an amended return for that year that is filed within three years of the original due date. The gain is reported as an excess distribution, and tax and interest must be paid with the return.

The temporary regs address the "once a PFIC, always a PFIC" taint by providing that shareholders of a former Code section 1297(e) PFIC--and a former PFIC for which the election year is closed--may make a late deemed-sale election to purify the stock with the IRS's consent in certain circumstances. The taxpayer must enter into a closing agreement to eliminate any prejudice to the US government's interests as a consequence of the taxpayer's inability to file an amended return and must also complete and file form 8621-A ("Return by a Shareholder Making Certain Late Elections to End Treatment as a Passive Reprinted with permission, Canadian Tax Highlights, Foreign Investment Company"), released by the IRS in December 2005.

It is not unusual for a Canadian corporation to inadvertently become a PFIC with respect to US shareholders by, for example, selling significant assets or raising capital through a public or private offering in a taxable year. Once the corporation becomes a PFIC, it remains a PFIC until the taint is purged by a QEF or deemed-sale election. These new regulations may provide some relief to US investors by allowing late elections. The excess distribution regime is extraordinarily harsh, and a purging election should always be considered for US investors in PFICs or former PFICs that failed to make a QEF election.