Question: If a qualified electing fund (“QEF”) election is made for a passive foreign investment company (“PFIC”), and if the PFIC receives qualified dividend income (“QDI”), can the QEF report the QDI to its U.S. shareholders as net capital gain?
Answer: Unfortunately, no. A QEF cannot report QDI that it receives as net capital gain.
If a U.S. shareholder elects to treat a PFIC as a QEF, the U.S. shareholder is taxed currently on its share of the QEF’s earnings. Code §1293. QEF elections may be made only if the PFIC provides sufficient data to its shareholders so that the PFIC’s ordinary earnings and net capital gain can be determined each year. Code §1295(a)(2) and Treas. Reg. §1.1295-1(g)(1).
Code §1293(a) provides:
(1) In general. Every United States person who owns * * * stock of a qualified electing fund * * * shall include in gross income—
(A) as ordinary income, such shareholder’s pro rata share of the ordinary earnings of such fund for such year, and
(B) as long-term capital gain, such shareholder’s pro rata share of the net capital gain of such fund for such year.
Thus, the two categories of gross income described in the statute include: ordinary earnings and net capital gain. Code §1293 does not define the term net capital gain, but Code §1222 does. Code §1222 provides in part:
For purposes of this subtitle * * *(11) * * * The term “net capital gain” means the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for such year.
Both Code §§1222 and 1293 are within Subtitle A of Title 26 of the Internal Revenue Code. Thus, the definition in Code §1222(11) would apply for purposes of Code §1293.
Net capital gain, if any, is long-term capital gain, less long-term capital loss, less net short-term capital loss. Dividends are not included in the definition of net capital gain under Code §1222. Consequently, QDI would not be included in the term “net capital gain” under Code §1293.
Net Capital Gain As Defined in the Regulations
Treas. Reg. §1.1293-1(a)(2) provides:
Net capital gain defined -
(i) In general. This paragraph (a)(2) defines the term net capital gain for purposes of sections 1293 and 1295 * * *. The QEF * * * in determining its net capital gain for a taxable year, may either -
(A) Calculate and report the amount of each category of long-term capital gain provided in section 1(h) that was recognized by the PFIC in the taxable year;
(B) Calculate and report the amount of net capital gain recognized by the PFIC in the taxable year, stating that that amount is subject to the highest capital gain rate of tax applicable to the shareholder; or
(C) Calculate its earnings and profits for the taxable year and report the entire amount as ordinary earnings.
(ii) Effective date. Paragraph (a)(2)(i) of this section is applicable to sales by QEFs during their taxable years ending on or after May 7, 1997.
This regulation was published in 1998 as a temporary regulation (T.D. 8750), and then in 2000 as a final regulation (T.D. 8870). The preambles to both of these Treasury Decisions stated:
[T]he Taxpayer Relief Act of 1997 (1997 TRA) amended section 1 to provide categories of long-term capital gain and the maximum rates of tax to which the categories are subject. In certain cases, this amendment affects the calculation of net capital gain for purposes of section 1293.
At the time the regulations were published, there was no such thing as QDI. The concept of QDI was introduced in 2003 with the enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (“JGTRRA”). Thus, the drafters of the regulations did not consider the concept of QDI.
Under the regulation, there are three options to determine net capital gain. The first option requires the calculation and reporting of “each category of long-term capital gain provided in section 1(h) * * *.” The categories of long-term capital gain include: unrecaptured section 1250 gain, 28-percent rate gain, and other long-term capital gain. QDI is not long-term capital gain and therefore does not fit into any of these categories.
The second option requires the calculation and reporting of “net capital gain” and stating that that amount is subject to the highest capital gain rate of tax. As described above, the definition of net capital gain under Code §1293 does not include QDI. Thus, the amount reported as net capital gain would not include QDI.
The third option requires the calculation and reporting of earnings and profits entirely as ordinary earnings, without any breakout of net capital gain. Under this option, none of the inclusion is reported as net capital gain, and so none of the QDI would be reported as net capital gain.
Net Capital Gain As Defined in Code §1(h)
JGTRRA amended Code §1(h) by adding at the end new paragraph 11, which is titled “Dividends Taxed As Net Capital Gain.” Code §1(h)(11)(A) now reads:
For purposes of this subsection, the term “net capital gain” means net capital gain (determined without regard to this paragraph) increased by qualified dividend income.
Thus, “net capital gain” in Code §1(h) means net capital gain (as defined in Code §1222(11)) plus QDI. This definition is solely for purposes of subsection (h) of Code §1. It does not apply for purposes of Code §1293.
One might argue that the first option in Treas. Reg. §1.1293-1(a)(2) looks to Code §1(h) to define net capital gain, and Code §1(h) now defines net capital gain to include QDI. The argument would be that the definition of net capital gain in Code §1293 should therefore include QDI.
However, this argument is flawed. First, the regulation was published prior to the introduction of the term QDI. Second, the regulation is only applicable to “sales by QEFs” and not dividends received by QEFs. Treas. Reg. §1.1293-1(a)(2)(ii). Lastly, the regulation provides that certain categories of “long-term capital gain” can be reported as “net capital gain.” Nowhere does the regulation, or any other authority, suggest that QDI is considered long-term capital gain. As previously described, the categories of long-term capital gain in Code §1(h) include: unrecaptured section 1250 gain, 28-percent rate gain, and other long-term capital gain. QDI does not fit into any of these categories.
Code §1293 requires that each U.S. shareholder of a QEF include in gross income their pro rata share of ordinary earnings and net capital gain. The term “net capital gain” is defined in Code §1222(11), and this definition does not include QDI. Therefore, QDI received by a QEF would be considered ordinary earnings and not net capital gain.