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Net Investment Income Tax

Section 1.1411-10

Controlled Foreign Corporations

(CFC) and Passive Foreign

Investment Companies (PFIC)

Kenneth J. Vacovec, Esq. February, 2014

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• Surtax on individuals at a rate of 3.8% on

the lesser of:

– NII for the tax year, or

– Excess of Modified Adjusted Gross Income

(MAGI) over the threshold amount

– Threshold Amount:

• Joint Return $250,000

• Married Separate $125,000

• Single or Head of Household $200,000

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MAGI – Start with Adjusted Gross

Income

• Increased by Section 911(a)(1) exclusion

less deductions or exclusions disallowed

under Section 911(d)(6).

• Rules in Reg. Section 1.1411-10(e)(1)

which apply to US shareholder of a QEF

or US person that directly or indirectly

owns an interest in a CFC.

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• Category (i) Income: – Interest, dividends, annuities, royalties and rents

unless excluded by the trade or business exception; and

• Category (ii) Income: – Other gross income derived from a trade or business

as: • A passive activity – Section 469, or

• Trading in financial instruments or commodities; and

• Category (iii) Income: – Net gain on the disposition of property except to the

extent excluded by the Paragraph (d)(3)(ii)(A) exception attributable to property held in a trade or business not described in Reg. Sec. 1.1411.5, over

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• Deductions allowed by Subtitle A properly allocable to income or gain as provided in Reg. Section 1.1411-4(f).

• Property allocable deductions (Paragraph (f)).

– Deductions described in Sections 162, 163, 164 and 165.

– Limitations under Section 67 (2% floor on miscellaneous itemized deductions) and Section 68 (overall limitation on itemized deductions) apply.

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NII surtax is imposed by Chapter

2A of the code

• No credit is allowed from a Chapter 1 provision against Chapter 2A surtax.

• A deduction is allowed under Chapter 2A for taxes described in Section 164(a)(3).

• No credit is allowed for foreign taxes elected to be a credit under Section 901(a)-Reg. Sec. 1.1411-4(F)(3)(i)(c).

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Calculation of NII Dividends

• Dividends (Election under Paragraph (g) is not in effect).

Distributions of earnings and profits that is not a dividend for Chapter 1 (Section 959(a) or Section 1293(c)) is a dividend for purposes of NII., in years beginning after December 31, 2012.

• Dividends (Election under Paragraph (g) is in effect). Amounts included in income as a dividend for Chapter 1 purposes (Section 951(a) or 1293(a) is a dividend for purposes of NII.

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Calculation of NII – Net Gain

• Net gain on the disposition of property: – Gains treated as excess distribution (Section

1291(a)(2)) are treated as NII.

– Inclusions and deductions on (Section 1296) mark to market election are treated as NII.

– Dispositions of stock of CFC and QEF where election under Paragraph (g) is not in effect using basis calculation of Paragraph (d).

– Disposition of domestic partnerships or S corporations that own directly or indirectly CFC’s or QEF’s – income where election under Paragraph (g) is not in effect using basis calculation or Paragraph (d).

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Application of Section 1248 where

election under Paragraph (g) is not

in effect:

• Basis is determined under Paragraph (d), and

• 1248(a) applies without the earnings and profits

exclusions of Section 1248(d)(1) section 951

inclusion and (d)(6) – section 1293 inclusion.

• Except the exclusion apply to:

– Amounts included in gross income under Section

951(a) or Section 1293(a) in a tax year beginning

before December 31, 2012 that have not been

distributed.

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Conforming Basis Adjustments

• Stock of a CFC or QEF where election

under Paragraph (g) is NOT in effect

– Basis increase under 961(a) and 1293(d) for

tax years after December 31, 2012 are not

taken into account; and

– Basis decrease under 961(b) and 1293(d)

treated as dividends for NII purposes are not

taken into account for NII purposes.

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Stock of CFC or QEF held directly or

indirectly by domestic partnership or S

corporation when election under

Paragraph (g) is NOT in effect.

• Rules similar to rules applicable to

individuals shall apply.

• If stock of a CFC or QEF is disposed, the

Section 1411 recalculated basis will be

used to determine the gain or loss.

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Rules where an election under Paragraph

(g) IS in effect, the pro rata share of gain

or loss for NII purposes is the same as for

Chapter 1 taxes.

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Special rules for partners of

domestic partnerships that own

directly or indirectly CFC’s or QEF’s • Election under Paragraph (g) is not in effect.

• Stock is held through foreign entities.

• Section 705(a)(1) basis increase for Section 951(a) and 1291(a) are not taken into account for NII purposes.

• Applies to tax years after December 31, 2012.

• Basis adjusted only for NII distributions.

• This rule applies to all tax consequences related to tax basis.

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Specific rules for S corporation

stockholders that own directly or

indirectly CFC’s or QEF’s.

• Election under Paragraph (g) is not in effect.

• Stock is held through foreign entities.

• Section 1367(a)(1)(A) basis increases for Section 951(a) or Section 1293(a) are not taken into account for NII purposes.

• Applicable to tax years after December 31, 2012.

• Basis adjusted only for NII distributions.

• This rule applies to all tax consequences related to tax basis.

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Conforming adjustments to MAGI

for Individuals:

• Increased by NII income from

– Distributions of previously taxed E and P.

– Excess distributions that constitute dividends.

– Net gains treated as excess distributions.

– Amounts distributed by an estate or trust.

– That are not otherwise included in income for

Chapter 1 purposes;

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Increased or decreased by the

difference between: • The gain or loss attributable to the disposition of

stock of CFC’s or QEF’s owned directly or through a domestic partnership or S corporation, and the amount of gain or loss calculated on the disposition under Chapter 1;

• Decreased by an amount included in gross income for Chapter 1 purposes under Section 951(a) or Section 1293(a) where no election under Paragraph (g) is in the effect, and

• Increased or decreased by the difference in investment interest expense calculated and deducted under NII rules and the amount calculated for Chapter 1.

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Election with respect to CFC’s and

QEF’s – Paragraph (g) Election:

• Amounts included in gross income under

Section 951(a), Section 1293(a)(1)(A), and

Section 1293(a)(1)(B),

• In tax years beginning in year the election

is made,

• Are treated as NII.

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Years to which the election applies:

• Applies to the taxable years for which the

election is made,

• All subsequent tax years,

• All subsequently acquired or reacquired

interests in the CFC or QEF for which the

election is made, and

• The election is irrevocable.

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Who may make the election?

• An individual, estate, trust, domestic partnership,

S corporation, or common trust fund,

• With respect to each CFC or QEF,

• That it holds directly,

• That it holds indirectly through a foreign entity,

• The owner of an entity can make the election for

CFC’s or QEF’s indirectly owned if the direct

owner does not make the election.

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Time and manner of making the

elections

• In the first tax year after December 31,

2013,

• Gross income for Chapter 1 purposes is

included under Section 951(a) or 1293(a),

and

• Is subject to NII tax as if the election were

made.

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For certain domestic pass through

entities

• In the first tax year after December 31,

2013,

• Gross income for Chapter 1 purposes is

included under Section 951(a) or 1293(a)

and

• A direct or indirect owner is subject to NII

tax as if the election were made.

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Tax years that begin before

January 1, 2014:

• An individual can make the election.

• Domestic pass through entities provided

all partners or shareholders consent to the

election.

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Dividend – special rule for 2013 tax

year. (A look back rule for 2013) • Election under Paragraph (g) is NOT in effect,

• Distribution is not treated as a dividend for Chapter 1 purposes,

• Is a dividend for NII purposes. – Distribution of earnings and profits is attributable to

amount included in gross income under Section 951(a) or Section 1293(a) for tax year beginning after December 31, 2012 and before January 1, 2014,

– The paragraph (g) election is made for a tax year beginning after December 31, 2013; and

– The election for years prior to January 1, 2014 is made.

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Time for making the election:

• In the manner prescribed in:

– Forms

– Instructions, or

– Other guidance, on

– Original or amended tax returns.

• If on an amended return only applies to the years open.

• No extension to make the election shall be granted.

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Passive Foreign Investment

Company Temporary

Regulations Issued December

2013 for Persons not

Currently Required to Report

Kenneth J. Vacovec, Esq. February, 2014

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• PEDIGREED QEF – a PFIC which has

been a QEF for all taxable years as a

PFIC.

• SECTION 1291 FUND – a PFIC that is not

a pedigreed QEF or a Section 1298

Election is not in effect.

• SHAREHOLDER – a United States person

that owns directly or indirectly stock of a

PFIC.

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• INDIRECT OWNERSHIP THROUGH A CORPORATION – a person owns directly or indirectly 50% or more of the stock value of a foreign corporation which is not a PFIC owns a proportionate share of stock owned by that foreign corporation.

• INDIRECT OWNERSHIP THROUGH A PFIC – a person owns a proportionate amount of stock owned by the PFIC.

• OWNERSHIP THROUGH A PARTNERSHIP, S CORPORATION, ESTATE OR NONGRANTOR TRUST – all partners own stock owned by the partnership proportionately.

• OWNED BY A GRANTOR TRUST - grantor owns the stock held by that trust.

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Section 1298(f) reporting requirements for

U.S. persons as shareholders of PFIC’s.

“file Form 8621”

• General rule – U.S. shareholder must file

if:

– A direct owner of PFIC stock.

– An indirect owner of PFIC stock through one

or more entities.

– The grantor of a grantor trust that owns PFIC

stock.

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An indirect owner must file if:

1. Receives an excess distribution – Section

1291(b).

2. Recognizes gain treated as an excess

distribution – Section 1291(a)(2).

3. Includes a QEF inclusion in income –

Section 1293(a).

4. Includes a mark to market inclusion in

income – Section 1296(a).

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5. Is required to report the status of a section

1294 election.

6. Exception to 3. and 4. to an indirect

shareholder if the entity files Form 8621 and,

if owned through a partnership or S

corporation, that entity has made a QEF

election.

7. No filing requirement if the PFIC is owned

through:

• a liquidating trust in bankruptcy or

• a widely held fixed investment trust.

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8. No filing if owned through a foreign pension

fund.

9. No filing if owned through a foreign estate or

trust if no excess distribution received.

10. No filing if shareholder is a tax exempt

entity.

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General rule – a shareholder of a

PFIC is not required to file if on the

last day of the tax year

• the value of all PFIC stock owned directly or indirectly is $25,000 or less, or

• the Section 1291 fund is owned indirectly through another PFIC has a value of $5,000, or less,

• the shareholder has not received an excess distribution during the tax year, and

• the shareholder has not made a QEF election in respect to that PFIC.

• on a joint tax return the limit is $50,000 or less.

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Time and manner of filing:

• attach Form 8621 to the federal income

tax return for the year to which the

obligation relates.

• file a separate Form 8621 for each PFIC.

• joint return can file one Form 8621 for

each PFIC owned jointly or individually.

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A Domestic Entity that is a “Specified

Domestic Entity” pursuant to Prop. Reg.

§1.6038D-6 is required to report specified

foreign financial assets in which it holds

an interest. Form 8938 as with

Individuals as soon as the regulation is

finalized.

Applies to:

1. Domestic Corporations.

2. Domestic Partnerships.

3. Trusts described in

§7701(a)(30)(E).

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For a Corporation or a Partnership

to be a Specified Domestic Entity

1. Must have an interest in a specified foreign financial asset.

2. Must be closely held by a Specified Individual (§1.6038D IT(a)(2).

3. Must meet either of two of the following conditions:

a. at least 50% of gross income or 50% of assets at anytime during the tax year, produce or held to produce passive income.

b. at least 10% of gross income or 10% of assets at any time during the tax year produce or held to produce passive income, and the entity is formed or availed of by a specified individual with the principal purpose of avoiding the reporting obligations of 6038D.