INSIGHT: Retrospective ‘PFIC’ Gains Are Not Included in Gross Income

The U.S. Tax Court recently decided—for the first time—that retrospective gains from passive foreign investment company (PFIC) stock isn’t included in gross income for the current year.

The Internal Revenue Service issued to two taxpayers a notice of deficiency determining deficiencies in their 2006, 2007, and 2008 income tax. The taxpayers contended that assessment of the deficiencies was “time barred” under tax code Section 6501(a).

In general, Section 6501(a) provides a three-year period of limitations for the IRS to assess an income tax liability. The three-year period generally begins to run after the return is filed. The parties agree that this three-year limitations period had expired as of the date the instant notice of deficiency was issued.

Section 6501(e)(1)(A)(i) provides an exception. If the taxpayer omits from gross income an amount properly includible therein and the omission exceeds 25 percent of the amount of gross income reported in the return, then the period of limitations is extended to six years. The IRS contended this exception applied. The parties disagreed, however, as to whether the six-year limitations period applied.

Spreading PFIC Gains

Gross income for purposes of Section 6501(e)(1)(A)(i) generally means “gross income” as defined in Section 61(a), which generally includes “gains derived from dealings in property.” (Gross income does not include losses resulting from dealings in property.) See Section 61(a)(3).

Gain from the sale of PFIC stock is taxed according to special rules. Gain from the sale of PFIC stock is taxed under Section 1291 unless the taxpayer elected to treat the PFIC as a “qualified electing fund” (QEF) or elected to “mark to market.” The taxpayers made neither such election.

Section 1291(a) provides that gain on the disposition of PFIC stock is allocated ratably to each day in the taxpayer’s holding period for the stock. The statute provides that gain allocated to the current year is included ingross income as ordinary income. “Section 1291 expressly provides that ‘only’ current-year PFIC gains are included in gross income,” the court said, citing Section 1291(a)(1)(B). “By contrast, non-current-year PFIC gains are not included in gross income for the current year. Instead, Section 1291(a)(1)(C) provides that ‘the tax imposed for the current year shall be increased by the deferred tax amount’“ the court said.

Section 1291(c) provides that the deferred tax amount is calculated by (1) allocating the non-current-year PFIC gains to years in the taxpayer’s holding period (ratably by day), (2) multiplying the amount allocated to each particular year by the highest ordinary income tax rate in effect for that year, (3) computing an interest charge on that multiplicative product, and (4) taking the sum of all products and interest charges for all years. This sum, the deferred tax amount, is then added to the taxpayer’s income tax for the current year.

In short, under the express terms of Section 1291(a)(1)(B), only current-year PFIC gains are included in gross income for the current year. Under Section 1291, non-current-year PFIC gains are not included in gross income for any year. Thus, current-year PFIC gains are counted in the Section 6501(e)(1)(A)(i) gross income amount; and non-current-year PFIC gains are not counted in gross income for purposes of Section 6501(e)(1)(A)(i), the court said.

The IRS contended that any non-current-year PFIC gain is, in fact, gross income and that Section 1291 merely “provides for the calculation of the tax and interest owed on that portion of gross income from the sale of the PFIC stock.“ The court did not agree. Section 1291, it noted, is the more specific provision and ”governs the more general terms of Section 61.“ There is, the court remarked, ”no apparent reason to deviate from the text of Section 1291 which provides that only current-year PFIC gain is included in…gross income for the current year, or to ignore the specific method employed in Section 1291 for taxing non-current-year PFIC gains, which does not include those gains in gross income for any year“ (emphasis added).

Policy Counterargument

The IRS argued that the legislative history of Section 1291 “shows that the PFIC provisions were enacted so that taxpayers investing in foreign investment companies would be treated similarly to taxpayers investing in domestic investment companies and, for this reason, Section 6501(e)(1)(A)(i) should be interpreted so as to treat gains from sales of PFIC stocks in a way that is similar to the way Section 6501 treats gains from sales of ’RIC’ [i.e., regulated investment company], stock.” The court was unmoved by this line of reasoning.

The court noted that “upon close inspection of Section 1291 and its legislative history,…it is not immediately apparent that the PFIC provisions were enacted so that taxpayers investing in PFICs would be treated similarly to taxpayers investing in domestic investment companies in every respect.” For example, the entire amount of gain on the sale of PFIC stock is taxed, under Section 1291, as ordinary income or at the highest ordinary rates, whereas RICs may make capital gain dividends (Section 852(b)(3)) and sales of RIC stock are generally treated as sales of capital assets. See Section 852(b)(4).

Accordingly, the court concluded that the IRS’s policy concerns provided no basis for a different interpretation of Sections 1291 and 6501(e)(1)(A)(i). If, as the IRS suggested, “there are competing policy considerations as to how the statute of limitations should apply in this context, it is the role of the legislature, rather than of this Court, to evaluate and address such policy considerations.”

In the instant case, for 2006 only, the amount of unreported gross income exceeded 25 percent of the gross income reported on the taxpayers’ original tax return. Accordingly, Section 6501 does not bar assessment of the deficiency for that taxable year, but does bar such assessment for the other years in issue, 2007 and 2008. In those years, the omitted gross income (including only the current-year PFIC gains) fell well below the amount of gross income reported by the taxpayers on their original return.

Finally, the taxpayers contended that their gains from sales of PFIC stock may be offset by their losses therefrom. That is, the taxpayers contended that Section 1291 applies to net gains from all sales of PFIC stocks during the taxable year.

The IRS contended that losses on sales of PFIC stocks are properly treated as either long-term or short-term capital losses and that such capital losses can be used only to offset capital gains of the taxpayer. The court agreed with the IRS—Section 1291, it noted, “does not provide for the netting of gains and losses on dispositions of PFIC stock.” Section 1291, by its express terms, applies to “any disposition upon which gain is recognized. Section 1291 does not address, and therefore does not apply to, dispositions on which losses are recognized.” The taxpayers, therefore, were not entitled to offset gains from sales of PFIC stocks with losses from sales of PFIC stocks. The case was Toso v. Commissioner, 151 T.C. No. 4 (9/4/18).