You do not want to open this can of worms. Cost basis accounting for passive foreign investment company (PFIC) stock is way beyond the capabilities of most individual taxpayers.
Unfortunately, some investors find themselves in the predicament of having to deal with the PFIC rules because they bought stock in a PFIC without realizing the ramifications. A prime example is Genesis Lease Ltd ADS (NYSE:GLS), which merged in 2010 with AerCap Holdings NV ADS (NUSE:AER.) Also, with the recent popularity of gold and silver bullion, PFIC ownership can sneak up on you if you buy precious metal stocks such as Sprott Physical Gold and Silver Trusts or Central Goldtrust.
What is a PFIC? Basically it is a foreign corporation which gets 75% or more of its gross income from passive income sources (such as rents, dividends, or interest) rather than trade or business sales revenue. It can also be a PFIC if at least 50% of its assets produce passive income.
For PFIC stock, there are three ways to compute the cost basis for tax purposes: 1. Qualified Electing Fund (QEF) election; 2. Mark-to-market election; or 3. No election made at all.
In all of these cases, the dividends are not eligible for the special 15% reduced tax rate for qualifying dividends.
Uncle Sam created the PFIC rules in 1986 to close the loophole that some taxpayers were using. By creating a foreign corporation to hold their passive investments and never taking out any taxable dividend income, they could defer income indefinitely, like an IRA only without contribution limits or required minimum distributions. On top of that, when the foreign corporation was sold, all the deferred income increased the corporate assets and sale price and could be taken as a capital gain rather than ordinary income. What a deal that was!
However, following the law of unintended consequences, the PFIC rules now catch in their net many of the aircraft and ship leasing and precious metal stocks, serving as hurdles to the raising of capital for these industries.
How do you know if you own PFIC stock? The company will tell you. Letters will be mailed to shareholders with the information needed to file Form 8621. It will also be posted on the company's website under the investor relations tab as tax information.
Some examples of PFIC stock are:
Aircastle Ltd (NYSE:AYR) Babcock & Brown (NYSE:FLY) Bradmer Pharmaceuticals Inc (OTC:BRPHF) Genesis Lease Limited (NYSE:GLS) Sprott Physical Gold Trust (NYSE Arca:PHYS) Top Ships Inc (Nasdaq:TOPS) Western Copper (NYSE:WRN)
ASA Limited (NYSE:ASA) Banro Corp (NYSE:BAA) Central Goldtrust (NYSE:GTU) Primus (NYSE:PRS) Sprott Physical Silver Trust (NYSE Arca:PSLV) Vista Gold Corp (NYSE:VGZ) Western Lithium (OTC:WLCDF)
QEF Election Made: If you own a PFIC, you can elect to treat it as a Qualified Electing Fund (QEF) by filing IRS Form 8621 with your individual income tax return in the year of purchase. You would also file Form 8621 every year you own the stock to report basis adjustments. This approach is highly recommended compared to the alternative.
If a valid QEF election has been made, the cost basis for the stock is computed as: 1. Original purchase cost, including fees and commissions; 2. Plus pro-rata share of ordinary earnings (but not loss) of the company for the number of days owned; 3. Plus pro-rata share of capital gains (but not loss) of the company for the number of days owned; 4. Less distributions of cash and property received from the company; 5. Equals ending cost basis.
Mark-to-Market Election: A US person who owns shares of a publicly-traded PFIC which trades regularly on a U.S. or foreign securities exchange can elect to "mark-to-market" at the close of each tax year that the PFIC is owned. First the adjusted cost basis is increased for reported taxable income and decreased for distributions received. Then the investor includes (or deducts) taxable income for the difference between (1) the fair market value per share on December 31 and (2) the adjusted cost basis per share of the PFIC stock.
No QEF Election: If no valid QEF election is in place, the cost basis for the stock is the original purchase cost, including fees and commissions. The investor is only taxed on dividends when they are received. However, the taxpayer must calculate if there are any "excess distributions" in each taxable year which are defined as distributions greater than 125% of the average annual distributions for the last three tax years, or the period since purchase, if shorter. Excess distribution amounts are then allocated to each tax year based on days held. Amounts allocated to prior tax years are then taxed at the marginal rate in effect for that prior tax year and interest charges are owed for the deemed tax deferral benefit. Furthermore, when the PFIC shares are sold, any capital gain is also subject to the excess distribution rules. (Didn't I tell you the QEF election was highly recommended?)
Inherited PFIC Stock: Another difference from normal rules is that inherited PFIC stock for which no QEF election was made (or was not made in the year of purchase or was made later without electing to recognize gain) will NOT receive the stepup in basis to fair market value on the date of death. Instead, it will receive a carryover basis equal to the shareholder's cost basis before his or her death.
What if you missed making the QEF election? An investor who missed making the QEF election in the year of purchase can make the election in a subsequent tax year by treating the PFIC as being sold on the first day of the current tax year at fair market value and reporting the gain on sale under the excess distribution rules described above. Thereafter, the QEF rules will apply.
PFIC Stock Held Inside IRAs and 401k Plans Investors who hold PFIC stock inside their IRA plans or 401k accounts do not need to make QEF elections, since the cost basis of the individual securities held inside the plan is not relevant. The taxpayer will be taxed at ordinary income tax rates on any distribution of cash or property taken from the plan, without regard to what the cost basis was of any individual asset.
However, there is a good reason to steer clear of PFIC investments in IRA plans. The dividends will be subject to tax withholding by the foreign country, and no foreign tax credit will be able to be claimed because it is inside your IRA. Thus, you may pay tax twice on the same income.
A useful summary of the PFIC tax rules can be found by clicking on the icon to the right. It is sourced from the website of ASA Limited.
For the specific case of the Genesis Lease Ltd/AerCap merger, Genesis Lease Ltd is a PFIC. AerCap was not a PFIC for 2009 (according to the tax opinion in the prospectus), but its status for 2010 will not be known until the year is over.
The cost basis accounting will be as follows (assuming appraisal rights are not exercised), according to the prospectus:
1. If a valid QEF election was made for Genesis, the cost basis and holding period of Genesis carries over to the AerCap shares.
2. If a valid QEF election was not made for Genesis, the cost basis will depend on whether AerCap is determined to be a PFIC for 2010, the year of the merger: A. If AerCap is a PFIC, the cost basis and holding period of Genesis carries over to the AerCap shares. B. If AerCap is not a PFIC in 2010, (1) the investor will recognize a gain (but not a loss) for the difference between fair market value of the AerCap shares received less their adjusted cost basis in Genesis shares; (2) the gain is subject to the "excess distribution" rules and interest charges for the deemed tax deferral benefit described above; and (3) the holding period for AerCap shares starts the day of the merger.
The calculators on this website will be updated after 12/31/2010 to reflect the appropriate cost basis treatment for the 2010 merger once the status of AerCap is known.