Proposed regulations issued by the IRS over 20 years ago are a source of confusion for some individuals with investments in passive foreign investment companies (“PFICs”). A PFIC is defined as any foreign corporation if 75 percent or more of its gross income for the taxable year consists of passive income, or 50 percent or more of its assets consists of assets that produce, or are held for the production of, passive income. The quintessential PFIC is a foreign mutual fund.
If no election is otherwise made, Code §1291 provides default rules for the taxation of a PFIC. Under the default rules, PFICs are known as “section 1291 funds.” Proposed Regulation §1.1291-3(a) states:
Any direct or indirect disposition of stock of a section 1291 fund within the meaning of paragraphs (b), (c), (d), and (e) of this section is taxable to the extent provided in section 1291, this section, and section 1.1291-6. For dispositions of stock of a section 1291 fund that qualify for nonrecognition treatment, see section 1.1291-6. Gain is determined on a share-by- share basis and is taxed as an excess distribution as provided in section 1.1291-2(e)(2). Unless otherwise provided under another provision of the Code, a loss realized on a disposition of stock of a section 1291 fund is not recognized. (Emphasis added)
Some individuals believe that the bolded text prevents a loss from being recognized upon the disposition of stock of a section 1291 fund. Fortunately, the loss is recognized under another provision of the Code, namely Code §1001. The stock of the section 1291 fund is treated as any other stock for purposes of loss recognition when disposed. The preamble to the Proposed Regulation cited above supports this treatment, stating:
The general rules applicable to losses recognized on a disposition of stock apply to losses realized and recognized on the disposition of stock of a section 1291 fund.
It is also important to remember that proposed regulations are not binding on taxpayers. KTA-Tator, Inc. v. Comm’r., 108 T.C. 100 (1997).
Note that if a qualified electing fund (“QEF”) or mark-to-market (“MTM”) election has been made with respect to the PFIC, other special loss rules may apply.