The Mark-to-Market Election for PFIC Explained (MTM)
Contents
The Mark-to-Market Election (MTM) for PFIC
When a US person invests in foreign passive investments, sometimes the investment will be considered a Passive Foreign Investment Company. For taxpayers who are not involved in foreign businesses, this usually equates to owning units of a foreign mutual fund. When a person does not make an election, they may become subject to very unfair tax treatment by the Internal Revenue Service — which is referred to as excess distributions. With excess distributions, what would otherwise usually be a 15-to-20% tax rate can more than double if not triple depending on how long they have held the investment; the size of the investment, and how much interest accrued during that time. To avoid this outcome, some taxpayers prefer to make an election. There are two main types of elections that taxpayers can make regarding their PFIC. One is a Qualified Electing Fund (QEF) and the other is a mark-to-market election. While the qualified electing fund typically results in a better tax outcome — it is not always available based on the amount of information the taxpayer must provide from the Foreign Financial Institution. Let’s take a look at the Mark-to-mark election.
26 USC 1296 Mark-to-Market Election
General rule
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In the case of marketable stock in a passive foreign investment company which is owned (or treated under subsection (g) as owned) by a United States person at the close of any taxable year of such person, at the election of such person—
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(1) If the fair market value of such stock as of the close of such taxable year exceeds its adjusted basis, such United States person shall include in gross income for such taxable year an amount equal to the amount of such excess.
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(2) If the adjusted basis of such stock exceeds the fair market value of such stock as of the close of such taxable year, such United States person shall be allowed a deduction for such taxable year equal to the lesser of—
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(A) the amount of such excess, or (B)the unreversed inclusions with respect to such stock.
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(b) Basis adjustments
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(1) In general The adjusted basis of stock in a passive foreign investment company—
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(A) shall be increased by the amount included in the gross income of the United States person under subsection (a)(1) with respect to such stock, and
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(B) shall be decreased by the amount allowed as a deduction to the United States person under subsection (a)(2) with respect to such stock.
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What does this Mean?
It means that each year in which a person made a mark-to-market election for their PFIC, instead of waiting for an excess distribution down the line in order to have taxable income, they have to include as income any amount that exceeds the basis – as ordinary income. Losses are limited to prior gains.
What is Marketable Stock? 26 USC 1296(e)
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(e)Marketable stock For purposes of this section—
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(1) In general The term “marketable stock” means—
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(A) any stock which is regularly traded on—
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(i) a national securities exchange which is registered with the Securities and Exchange Commission or the national market system established pursuant to section 11A of the Securities and Exchange Act of 1934, or
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(ii) any exchange or other market which the Secretary determines has rules adequate to carry out the purposes of this part,
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(B )to the extent provided in regulations, stock in any foreign corporation which is comparable to a regulated investment company and which offers for sale or has outstanding any stock of which it is the issuer and which is redeemable at its net asset value, and (C)to the extent provided in regulations, any option on stock described in subparagraph (A) or (B).
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What does this Mean?
This essentially means that in order for the stock to be marketable, it must be the type of stock that is regularly traded on a foreign country’s national securities exchange.
PFIC MTM Instructions Explained
As provided by the IRS:
Mark-to-Market Election
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A U.S. shareholder of a PFIC may elect to mark to market the PFIC stock under section 1296 if the stock is “marketable stock.” See the instructions for Election C, later, for information on making this election. Marketable stock.
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Marketable stock is:
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PFIC stock that is regularly traded (as defined in Regulations section 1.1296-2(b)) on:
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A national securities exchange that is registered with the Securities and Exchange Commission (SEC), The national market system established under section 11A of the Securities Exchange Act of 1934, or A foreign securities exchange that is regulated or supervised by a governmental authority of the country in which the market is located and has the characteristics described in Regulations section 1.1296-2(c)(1)(ii).
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Stock in certain PFICs described in Regulations section 1.1296-2(d).
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For additional information, including special rules for regulated investment companies (RICs) that own PFIC stock, see Regulations section 1.1296-1 and 1.1296-2.
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Tax Consequences
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After a PFIC shareholder elects to mark the stock to market under section 1296, the shareholder either:
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Includes in income each year an amount equal to the excess, if any, of the fair market value of the PFIC stock as of the close of the tax year over the shareholder’s adjusted basis in such stock; or
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Is allowed a deduction equal to the lesser of:
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The excess, if any, of the adjusted basis of the PFIC stock over its fair market value as of the close of the tax year; or
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The excess, if any, of the amount of mark-to-market gain included in the gross income of the PFIC shareholder for prior tax years over the amount allowed such PFIC shareholder as a deduction for a loss with respect to such stock for prior tax years.
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See the instructions for Part II, Election C, and Part IV, later, for more information, including special rules that may apply in the year that a mark-to-market election is made. Basis adjustment.
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If the stock is held directly, the shareholder’s adjusted basis in the PFIC stock is increased by the amount included in income and decreased by any deductions allowed. If the stock is owned indirectly through foreign entities, see Regulations section 1.1296-1(d)(2).
Examples as Provided by the IRS:
Example 1. Treatment of gain as ordinary income.
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A, a United States individual, purchases stock in FX, a foreign corporation that is not a PFIC, in 1990 for $1,000. On January 1, 2005, when the fair market value of the FX stock is $1,100, FX becomes a PFIC. A makes a timely section 1296 election for taxable year 2005. On December 31, 2005, the fair market value of the FX stock is $1,200. For taxable year 2005, A includes $200 of mark to market gain (the excess of the fair market value of FX stock ($1,200) over A’s adjusted basis ($1,000)) in gross income as ordinary income and pursuant to paragraph (d)(1) of this section increases his basis in the FX stock by that amount.
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Example 2. Treatment of gain as capital gain
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The facts are the same as in Example 1. For taxable year 2006, FX does not satisfy either the asset test or the income test of section 1297(a). A does not revoke the section 1296 election it made with respect to the FX stock. On December 1, 2006, A sells the FX stock when the fair market value of the stock is $1,500. For taxable year 2006, A includes $300 of gain (the excess of the fair market value of FX stock ($1,500) over A’s adjusted basis ($1,200)) in gross income as long-term capital gain because at the time of sale of the FX stock by A, FX did not qualify as a PFIC, and, therefore, the FX stock was not section 1296 stock at the time of the disposition. Further, A’s holding period for non-PFIC purposes was more than one year.
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Example 3. Treatment of losses as ordinary where they do not exceed unreversed inclusions
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The facts are the same as in Example 1. On December 1, 2006, A sells the stock in FX for $1,100. At that time, A’s unreversed inclusions (the amount A included in income as mark to market gain) with respect to the stock in FX are $200. Accordingly, for taxable year 2006, A recognizes a loss on the sale of the FX stock of $100, (the fair market value of the FX stock ($1,100) minus A’s adjusted basis ($1,200) in the stock) that is treated as an ordinary loss because the loss does not exceed the unreversed inclusions attributable to the stock of FX.
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Example 4. Treatment of losses as long-term capital losses
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The facts are the same as in Example 3, except that FX does not satisfy either the asset test or the income test of section 1297(a) for taxable year 2006. For taxable year 2006, A’s $100 loss from the sale of the FX stock is treated as long-term capital loss because at the time of the sale of the FX stock by A FX did not qualify as a PFIC, and, therefore, the FX stock was not section 1296 stock at the time of the disposition. Further, A’s holding period in the FX stock for non-PFIC purposes was more than one year.
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