Reproduced with the permission of the Canadian Tax Foundation from, Marla Waiss, "Retroactive QEF Elections" (2003) vol. 12, no. 4 Canadian Tax Highlights.

Canadian Tax Highlights
April, 2004

by Marla Waiss

Recent IRS rulings provide further guidance on retroactive qualified electing fund (QEF) elections for stock in passive foreign investment companies (PFICs).

Many US residents and citizens who hold shares in Canadian corporations are affected by the PFIC regime, which was designed to eliminate the benefit of deferred US tax on income earned through foreign corporations deemed to be engaged primarily in passive activities. A corporation is a PFIC if either (1) at least 75 percent of the corporation's gross income is passive income or (2) at least 50 percent of its assets (an FMV test in most cases) produce or are held for the production of passive income. Before the PFIC regime's enactment, a US shareholder could defer tax on undistributed profits of such a corporation that was not a CFC or an FPHC until he sold the shares; at that time, the gain on the sale was normally a capital gain, even though some or all of the shares' appreciation was attributable to the company's undistributed income.

In general, a PFIC's US shareholder is subject to a special tax on receipt of an "excess distribution," including a gain on a sale of the stock and the distributions from the PFIC to the extent that the total received in the year exceeds 125 percent of the actual average distributions to him in the preceding three years. The "excess distribution" is treated as if realized pro rata over the taxpayer's entire holding period and taxed as ordinary income (not capital gain) at the highest rate in effect for each year; an interest charge applies to the tax on the gain allocated to prior years in which the corporation was a PFIC. The tax liability generated is so harsh and punitive that the "excess distribution" stigma should be avoided if at all possible. The QEF election offers one solution.

An investor who makes a QEF election includes in gross income each year his pro rata share of the PFIC's ordinary income and net capital gain for the year. The election must be made by the due date for filing the investor's tax return for the first year that the corporation becomes a PFIC. A subsequent election cannot prevent the "excess distribution" regime's application; the stock bears "PFIC taint" and is subject to the excess distribution rules upon sale. However, a retroactive election may be available to an investor who learns that a company was a PFIC in a prior year if the failure to file a timely election arose because the investor reasonably believed that the company was not a PFIC. A retroactive election may be made under the protective regime or the consent regime.

Under the protective regime, the investor must have reasonably believed as of the election due date that the foreign corporation was not a PFIC, and he must file a protective statement that describes the basis for the belief and that extends the statute of limitations for the assessment of taxes under the PFIC rules. Certain qualified shareholders who own less than 2 percent of the votes and value of each class of the PFIC's shares need not satisfy the "reasonable belief" requirement or file a protective statement and may make a retroactive election for any open tax year in their holding period.

Under the consent regime, a US investor who was not aware of the PFIC rules and failed to file a protective statement may request the IRS commissioner's consent to make a retroactive election. Consent is granted if the investor reasonably relied on a qualified tax professional who failed to identify the corporation as a PFIC or failed to advise the shareholder of the consequences of making or not making a QEF election; consent is not granted if the shareholder knew or reasonably should have known that (1) the foreign corporation was a PFIC and that a QEF election could have been made, (2) the tax professional was not competent to render tax advice with respect to the ownership of shares of a foreign corporation, or (3) the tax professional did not have access to all the relevant facts. No reasonable reliance exists if the shareholder chose not to elect after the tax professional informed him that the foreign corporation was a PFIC and that a QEF election was available. Nor is consent granted if it would prejudice the interests of the US government; the IRS generally considers such prejudice to exist if the QEF election would result in an aggregate lower liability for tax and interest charges in the affected tax years.

In a series of recent private letter rulings, the IRS granted retroactive QEF elections in situations where the accountants or attorneys who rendered tax return advice to taxpayers failed to advise them of the possibility of making QEF elections. Another recent IRS ruling denied a partnership's request for permission to make a retroactive QEF election: the IRS said that the partnership did not reasonably rely on the accountant's advice because it knew or reasonably should have known that the accountant involved did not have access to all relevant facts and information.