Net Investment Income Tax Applies to U.S. Shareholders of CFCs and PFICs
November 15, 2013
The new 3.8% net investment income tax applies to U.S. individual, trust and estate taxpayers for tax years beginning after December 31, 2012. For U.S. individual taxpayers, the tax is 3.8% of the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount. The threshold amount is $250,000 for joint filers, $125,000 for married filing separately and $200,000 for other U.S. taxpayers. For purposes of the tax, investment income includes:
- Capital gains
- Rental income
- Non-qualified annuities
- Income from businesses, including trading of financial instruments and commodities and businesses that are passive with respect to the taxpayer
Net investment income is calculated to include the types of income referenced above, decreased by expenses allocable to such income. Modified adjusted gross income is AGI plus foreign earned income excluded under the foreign earned income exclusion.
The calculation of net investment income for the 3.8% tax includes income attributable to investments in foreign corporations. Net investment income takes into account dividends and gains from stock of a controlled foreign corporation (CFC) or passive foreign investment company (PFIC). A CFC is a foreign corporation of which more than 50% of the vote or value is owned by U.S. shareholders who each own at least 10% of the voting stock. A PFIC is a foreign company of which 75% or more of the gross income for the year is passive income or 50% or more of the average assets for the year produce passive income. Proposed Treasury Regulations Section 1.1411-10 provides rules that apply to an individual, estate or trust that is a U.S. shareholder of a CFC or that is a U.S. person who owns directly or indirectly an interest in a PFIC. The proposed rules also apply to an individual, estate or trust that owns an interest in a U.S. partnership or an S corporation that is a U.S. shareholder of a CFC or which has made a Qualified Electing Fund election for a PFIC.
The proposed regulations provide a rule that requires the U.S. taxpayer to include distributed income from a CFC or PFIC in net investment income for the 3.8% tax if such distribution was previously taxed as a deemed distribution of undistributed income. An anti-deferral rule generally requires U.S. shareholders of a CFC or PFIC to pay U.S. federal tax on certain undistributed income of the foreign corporation. When the earnings that were previously taxed are then distributed later, the U.S. taxpayer is allowed to exclude the distribution from taxable income. The U.S. taxpayer is not required to pay U.S. federal tax again on the actual distribution of the earnings that were taxed previously as undistributed income.
The U.S. taxpayer is allowed to make an election under the proposed regulations to include the undistributed income from the CFC or PFIC in net investment income for the 3.8% tax in the year in which the U.S. taxpayer pays U.S. federal tax on the undistributed income. The election enables the U.S. taxpayer to treat the undistributed income from the CFC or PFIC consistently as taxable income for both regular U.S. federal tax and the 3.8% net investment income tax. Unless an election is made to achieve consistency, the U.S. taxpayer is required to pay the 3.8% net investment income tax on the actual distribution from the CFC or PFIC of the previously-taxed undistributed income that is excluded from regular U.S. federal taxable income.
The proposed regulations also provide other technical rules for basis adjustments and the inclusion of gains from the sale of CFC and PFIC interests.
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