Late Qualified Electing Fund (QEF) Elections – what it means to you
25 January 2023 | Applicable law: US | 3 minutes
The Passive Foreign Investment Company ("PFIC") rules have long cast a shadow over US-European private wealth planning. In certain instances, a US investor who makes certain technical foot-faults in the early stages of PFIC investments can be severely penalized when that investor ultimately realizes cash from that position. In some welcome news, President Biden's administration has released plans in recent months to ease some of the worst excesses of these unforgiving rules.
A PFIC very generally means a non-US corporation that holds primarily passive assets, which for this purpose includes portfolio positions in underlying investment securities. In the European investment market, mutual funds, exchange-traded funds ("ETFs"), and hedge fund structures will more often than not fall within the definition of a PFIC. At a very high level, the PFIC rules provide that a US citizen, green card holder, or presence-based US federal tax resident (collectively, a "US Person") who invests in these types of vehicles is subject to punitive US federal income tax treatment—the "excess distribution" tax regime—when he or she receives a distribution from such a fund or disposes of his or her share in the fund. Under the excess distribution regime, a US Person who sells PFIC shares at a gain or receives a distribution from a PFIC will suffer an effective rate of US federal tax that begins at ordinary income rates and increases on a compounding basis the longer the person has held his or her investment in the PFIC. In theory, if a US Person holds his or her fund position for a long enough period, then his effective rate of US federal income tax can approach 100% of the gross value of the distribution or gain, as applicable. Moreover, excess distribution income cannot be offset by capital losses realized on other PFIC or non-PFIC positions. The US foreign tax credit rules are also more complex, and generally less favorable, as applied to PFIC excess distribution income and gain.
If a US Person investor has taken appropriate US federal tax advice at the inception of his or her investment, he or she can often avoid the worst excesses of the PFIC regime by making a so-called "Qualified Electing Fund" ("QEF") election (or in certain very limited situations beyond the scope of this article, a "Mark-to-Market" election for the first taxable year in which he or she owns the relevant PFIC position. A QEF election must generally be made on a timely-filed US federal tax return for the relevant year. The effect of a QEF election is to treat the investor as being subject to US federal income tax on a flow-through basis each year as to his or her pro rata share of the applicable PFIC's net capital gain and ordinary earnings for that year. In order to make a QEF election, the PFIC issuer must agree to pass up the necessary US federal tax reporting information to the investor on a yearly basis. In our experience, while many European fund issuers will agree to accommodate QEF elections for US Person investors, this cannot be taken for granted and this issue must be discussed at the outset of a potential subscription or purchase transaction.
If a PFIC investor does not make a "timely" QEF election in respect of his position, that position will build up latent high-tax excess distribution liability. While an investor can in theory make a QEF election on a future US federal tax return, at a later juncture during his or her holding period, the election will generally only have any effect on a going forward basis, and any gain or income which is attributable to the investor's pre-QEF holding period will still be subject to the unfavorable excess distribution rules on an ultimate disposal or on a cash distribution. A PFIC position with respect to which an investor has made a mid-holding-period QEF election is known as an "unpedigreed QEF." An investor is generally permitted to "purge" the latent excess distribution liability attaching to an unpedigreed QEF via a so-called "purging election," but this election can come at a considerable tax cost and is usually much worse than having simply made a timely QEF election from the beginning.
Under current law, a US Person may make a "late" QEF election—i..e a QEF election with retroactive effect—only in extremely limited circumstances—specifically: (i) when the investor held a reasonable belief that the position was not a PFIC; or (ii) when the investor relied on the advice of a qualified US tax professional and concluded, on the basis of that advice, that the position was not a PFIC. Both of these exceptions are subject to onerous procedural requirements and are facially irrelevant as applied to the kinds of investment funds described above (which tend to fall squarely within the definition of a PFIC, with no reasonable argument to the contrary).
The QEF timely filing rules therefore represent a significant trap for the unwary. They effectively mean that a US Person who is ignorant of the PFIC rules, who receives bad advice, or who is simply unaware of the specific positions in his portfolio may be stuck forever with a punitive excess distribution liability simply because he missed a somewhat arbitrary deadline for electing QEF treatment.
President Biden's administration has taken some encouraging strides toward fixing this problem. Specifically, the Treasury Department's explanation of the Biden Administration's 2023 budget proposals (the "Explanation") promises to expand access to retroactive QEF elections. According to the Explanation, the Treasury Department would enact regulations allowing a US Person to make a retroactive QEF election, even on a tax return for a "closed" year beyond the statute of limitations, so long as that retroactive election does not materially prejudice the Internal Revenue Service. We are encouraged by this development and urge the administration to take the necessary steps to alleviate the draconian impact of the QEF timely-filing rules.