QEF vs mark-to-market: PFIC elections and the section 1291 tax

Which PFIC election can my fund take on Form 8621: QEF, mark-to-market or neither?

Your fund's paperwork decides the menu. A QEF election (Election A on Form 8621) is possible only if the fund gives you a PFIC Annual Information Statement, or an intermediary passes one on. A mark-to-market election (Election C) is possible only if your shares are marketable stock. With neither, the fund is taxed under the default section 1291 rules (IRS: Form 8621 instructions).

The choice is rarely simple. Each election covers one fund, applies to every later year, and generally ends only with IRS consent. A QEF election is due with the return for the first year it applies, by its extended due date, on the original return or an amended one filed by then (26 CFR 1.1295-1(e)). An election made after your first year with the fund leaves the earlier years under section 1291 unless you pay to clear them. A fund that owns other funds can leave lower layers outside your election. If you are unsure whether the fund is a PFIC at all, start with foreign funds on a US return; whether Form 8621 is due is covered in Form 8621 filing and missed years.

Gather before deciding:

• Every purchase, reinvested dividend, payout and sale, with dates and amounts, fund by fund
• The fund's annual information statements, if it issues them
• The exchange listing and trading history, or the fund's net-asset-value terms
• Year-end values and the date you became a US person
• Past Forms 8621 and returns showing any election already made

What makes a fund marketable stock for the mark-to-market election?

Shares are marketable stock if they are regularly traded on a qualified exchange, or if the fund meets a strict test for funds redeemable at net asset value (the value of its holdings per share) (26 U.S.C. 1296(e); 26 CFR 1.1296-2).

A qualified exchange is a US national securities exchange registered with the SEC, the US national market system, or a foreign exchange regulated by its government that enforces listing, disclosure and anti-fraud rules and promotes active trading. Each tier of a foreign exchange counts as a separate exchange.

Regularly traded means the shares trade, in more than tiny quantities, on at least 15 days in each calendar quarter. A lighter test applies in the year of a public offering. Trades made to meet the test do not count.

A foreign fund that is not listed but redeems at net asset value qualifies only if, for the class you hold, it meets every condition below for the year; the shareholder, access, price and debt conditions must hold at all times in the calendar year (26 CFR 1.1296-2(d)):

• More than 100 unrelated shareholders
• Open to the public at net asset value, with no minimum initial investment above $10,000
• Prices published at least weekly in a widely available medium the fund does not control
• Independently audited financial statements, made public at least yearly
• Regulated as an investment company by a foreign government
• No senior securities and no more than minimal debt
• At least 90% passive gross income and at least 90% passive assets on average

A fund that misses one condition, or acts to manipulate its net asset value, is not marketable stock under this test for that year.

QEF vs mark-to-market vs section 1291: how does the tax compare?

QEF taxes the fund's earnings as they are made, mark-to-market taxes the change in value each year, and section 1291 waits for a payout or sale and then adds tax and interest for the earlier years (26 U.S.C. 1291; 26 U.S.C. 1296; IRS: Form 8621 instructions).

Under section 1291, each slice of a payout or gain assigned to an earlier PFIC year is taxed at the highest individual rate in effect for that year, whatever your bracket was; the Form 8621 instructions list that rate for each past year. Interest then runs from that year's return due date to the current year's return due date, both without extensions, at the IRS underpayment rates in effect over that time, not today's rate (26 U.S.C. 1291(c); IRS: Form 8621 instructions, lines 16c and 16f).

A QEF shareholder can also elect (Election B) to put off paying tax on undistributed earnings, but interest is charged on the deferred tax and it becomes due when the election ends (IRS: Form 8621 instructions, Election B).

How is the PFIC excess distribution calculated with many lots or reinvested dividends?

Section 1291 works block by block: shares with the same holding period form one block, and each block gets its own Part V on Form 8621. Each purchase, and each reinvested dividend that buys shares, starts a new block with its own history (IRS: Form 8621 instructions, Part V; 26 U.S.C. 1291(b)).

For each block:

1. Find the excess part of the year's payouts. It is the amount above 125% of the average payouts on that block in the three preceding years, or in your shorter holding period before this year. Annualize payouts if you did not hold the block all year. An earlier excess distribution counts in the average only to the extent it was taxed as ordinary income: the slices for its own year and for years before the fund was a PFIC.
2. Apply the first-year rule. Nothing paid in the year a block's holding period begins is an excess distribution; it follows the normal dividend rules. If that first year had no payout, the comparison average for the next year is zero, so that year's whole payout is excess.
3. Treat sale gain as excess. The whole gain on selling the block is an excess distribution, even in the first year. Transferring the shares or pledging them as loan collateral also counts as a sale.
4. Spread the excess evenly over every day you held the block, ending on the payout or sale date.
5. Tax each slice. Slices for the current year and for years before the fund was a PFIC are ordinary income. Slices for earlier PFIC years get the top-rate tax and interest described above, reduced by any foreign tax allocated to that year.

The part of a payout that is not excess follows the normal dividend rules. Do the calculation in one currency, as the foreign fund reporting guide explains; foreign tax on payouts is covered in foreign income on a US return.

What happens in the first year of a late mark-to-market election?

If the fund was a PFIC and not a QEF in any earlier year you held it, the first mark-to-market year is taxed under section 1291, not as plain ordinary income. The year's payouts go through section 1291, and the gain from basis to year-end value is treated as a sale on the last day of the year (26 U.S.C. 1296(j); 26 CFR 1.1296-1(i)).

The deemed gain in that first year is spread over your whole holding period, with top-rate tax and interest on the earlier PFIC years. Your basis then rises by the gain, and the gain counts as an earlier inclusion, so a later drop in value can be deducted against it (26 CFR 1.1296-1(a)(3)). From the next year on, ordinary mark-to-market rules apply and section 1291 no longer reaches the old years (26 U.S.C. 1291(d)(1)). A drop in value in that first year gives no deduction.

A mark-to-market election is due with a timely return, including extensions, for the year it starts. A late one is possible only through the general IRS relief procedure for late elections (26 CFR 1.1296-1(h)(1)). For funds you owned before becoming a US resident, the starting value differs and whether years before you were a US person count is unsettled; see PFIC rules when moving to the US.

Can a purging election clear the old years before a QEF election?

Generally yes, at a cost, if you start a QEF election after your first PFIC year with the fund. Without a purging election, the fund is an unpedigreed QEF: you pay QEF tax each year, and payouts and sales still go through section 1291 for the old years (IRS: Form 8621 instructions, Elections D and E).

After either election, your basis rises by the amount taxed, your PFIC holding period restarts on the qualification date, and the fund becomes a pedigreed QEF. Later sales then follow ordinary stock rules (26 CFR 1.1291-10; 26 CFR 1.1291-9).

Make either election with the original return for the year that includes the qualification date, by its extended due date, or on an amended return filed within three years of that return's due date, including extensions. If the fund's tax year is not the calendar year, the qualification date usually falls in your earlier tax year, and the election must then go on an amended return for that year. Choosing it after the due date without extensions adds interest on the late tax (26 CFR 1.1291-10(c) and (d)). The trade-off is paying the tax and interest on built-in gain now, against carrying the section 1291 charge until you sell. Mark-to-market has no purging election; instead its first-year rule runs the built-in gain through section 1291 once.

Can I make a late QEF election for earlier years?

A late QEF election is possible only through a protective statement or IRS consent; ordinary late-election relief does not apply to it (26 CFR 1.1295-3(a)).

• Protective statement. You must have reasonably believed, by the election due date, that the company was not a PFIC, and filed a protective statement then that extends the IRS time limit for the PFIC taxes. It cannot be set up after the fact. A holder of less than 2% of each class's vote and value may not need the statement if the company said in a public filing that it believed it was not a PFIC, unless the holder knew or had reason to know that was wrong. That relief does not reach a company whose main activity is holding a diversified portfolio, because the holder is treated as knowing it is a PFIC (26 CFR 1.1295-3(e)).
• IRS consent. You file a ruling request, with a user fee and sworn affidavits, with the IRS Office of the Associate Chief Counsel (International). The IRS grants it only if you reasonably relied on a qualified tax professional who failed to identify the PFIC or explain the election, the government is not prejudiced, and you ask before an IRS examiner raises the fund's PFIC status. If the professional told you the fund was a PFIC and about the election and you chose not to make it, the regulation treats you as not having relied on them.

Prejudice means the late election would leave you with lower total tax and interest than a timely election would have; the IRS may still consent if you sign a closing agreement to pay the difference (26 CFR 1.1295-3(f)). A late election is due by the extended due date of your return for the year you found out, or should have found out, that the fund was a PFIC; under the consent route, the year consent is granted. It goes on amended returns, with Form 8621, for the retroactive year (or the earliest open year) and every later year affected, and you pay all tax and interest those years now owe. A purging election (deemed sale, or deemed dividend if the fund is a controlled foreign corporation) can be made at the same time or within two years after that amended return is filed (26 CFR 1.1295-3(g)).

Can I revoke or switch a PFIC election, and what ends mark-to-market on its own?

Revoking either election needs IRS consent, but a QEF election ends automatically when you elect mark-to-market, and a mark-to-market election ends automatically when the shares stop being marketable (26 CFR 1.1295-1(i); 26 CFR 1.1296-1(h)(3)).

Ending a QEF election, by revocation or by switching to mark-to-market, also ends any Election B deferral: the deferred tax and interest are due by the due date, without extensions, of the return for the last QEF year (26 CFR 1.1295-1(i)(4)). A fund that stops being a PFIC is covered by 26 U.S.C. 1298(b)(1) and the Form 8621 instructions, Elections F and H.

Each election covers one fund and all your shares in it, including shares bought later. Selling every share does not end a QEF election; shares bought back are still covered (26 CFR 1.1295-1(c)(2)).

Does an election on a fund of funds cover the funds inside it?

No. A QEF election applies only to the fund you name, so each PFIC inside it needs its own QEF election and statement; a fund may give one combined statement for all of them (26 CFR 1.1295-1(d) and (g)).

Mark-to-market reaches shares you own through a foreign partnership, trust or estate, but not funds owned by a fund that is a corporation (26 U.S.C. 1296(g); 26 CFR 1.1296-1(e)). Those lower-tier funds generally stay under section 1291 for you as an indirect holder, so their payouts and sales can create a charge even while the top fund is marked to market. The regulations do not settle every overlap between the two layers; work it out fund by fund. A separate Form 8621 is filed for each PFIC in a chain when one is required.

Where do PFIC income, tax and interest go on Form 1040?

Each regime reaches the return through a different line. The Form 8621 instructions give these locations for individuals; line numbers can move between years, so check them against the current form (IRS: Form 8621 instructions, Parts III to V).

Example

Illustrative amounts in US dollars. Each fund is a PFIC throughout, and the holder is a US person throughout.

Mark-to-market from the start

An exchange-listed fund is bought for $20,000 at the start of year 1, with a mark-to-market election from year 1.

• Year 1: worth $24,000. $4,000 ordinary income; basis $24,000.
• Year 2: worth $22,000. A $2,000 ordinary deduction, allowed because it is within the $4,000 already included; basis $22,000.
• Year 3: worth $30,000. $8,000 ordinary income; basis $30,000.

With no election and a sale for $30,000 at the end of year 3, the whole $10,000 gain is an excess distribution, about $3,333 per year. The year 3 slice is ordinary income; the year 1 and 2 slices are taxed at each year's top rate plus interest.

Late mark-to-market

A fund is held for four years with no election, then marked to market from year 5. Basis is $35,000, and the value at the end of year 5 is $50,000.

• Year 5: the $15,000 gain is treated as a sale on the last day and spread over the five years held. The year 5 slice, about $3,000, is ordinary income; the four earlier slices get top-rate tax and interest. Basis rises to $50,000.
• Year 6: the value falls to $45,000. A $5,000 ordinary deduction is allowed, because the $15,000 taxed in year 5 counts as an earlier inclusion.

Deemed sale with a new QEF

A fund starts issuing an annual information statement; its tax year matches the holder's. The holder elects QEF and a deemed sale on time. Basis is $30,000, and the value on the qualification date is $42,000.

• The $12,000 gain is taxed as an excess distribution with that year's return, spread over the days held up to the qualification date, with top-rate tax and interest on the earlier PFIC years.
• Basis becomes $42,000, and the PFIC holding period restarts.
• From then on, the holder includes the fund's yearly ordinary earnings and net capital gain, paid out or not, and a later sale is an ordinary stock sale.

Different for you?

• You are not sure the fund is a PFIC: see foreign mutual funds, ETFs and wealth products on a US return.
• You need to know whether Form 8621 is due, or you missed years: see Form 8621 filing and missed years.
• You owned the fund before becoming a US resident: see PFIC rules when moving to the US.
• The fund sits in a TFSA or FHSA: see TFSA and FHSA for US citizens.
• The fund sits inside a foreign pension: see foreign pension reporting.
• Foreign tax was withheld from payouts: see foreign income on a US return.
• You want a late QEF election, a purging election, a revocation, or have a fund of funds or many lots: these need the full holding history and a cost comparison; see cross-border tax help.