IRC 1293 and Qualified Electing Fund (QEF) Tax Rules

Internal Revenue Code (IRC) Section 1293 is a provision of U.S. tax law that details how American investors are taxed on their share of income from certain foreign investment funds. This rule specifically applies to investments in what are known as Passive Foreign Investment Companies, or PFICs. The tax treatment under this section only comes into play when the investor makes a valid Qualified Electing Fund (QEF) election for their PFIC stock. This election fundamentally changes how the investment is taxed, moving away from more punitive default rules. The purpose of the QEF regime is to tax a U.S. shareholder on their portion of the fund’s earnings annually, regardless of cash distributions, creating a tax outcome more aligned with owning shares in a domestic mutual fund.

Understanding the Qualified Electing Fund Election

A foreign corporation is considered a Passive Foreign Investment Company (PFIC) if it meets either an income test or an asset test. The income test is met if 75% or more of the corporation’s gross income for the year is passive, such as interest, dividends, and capital gains. The asset test is met if at least 50% of the average value of the corporation’s assets produce or are held to produce passive income. Many foreign mutual funds and exchange-traded funds (ETFs) fall into this category.

When a U.S. person invests in a PFIC, they are subject to a special set of tax rules. By default, the investment is taxed under the “excess distribution” regime of IRC Section 1291. This method can result in high tax rates and an interest charge on gains and certain distributions.

The other alternative is the Qualified Electing Fund (QEF) election. Making a QEF election means the U.S. shareholder chooses to be taxed currently on their share of the fund’s earnings each year. For the election to be valid, the foreign fund must comply with IRS requirements to track and report its ordinary earnings and net capital gains to its shareholders.

Conceptually, the QEF election treats the U.S. investor similarly to a partner in a partnership. The shareholder agrees to pay tax on their portion of the fund’s income annually, which allows for more favorable tax treatment upon the eventual sale of the shares.

Tax Treatment of QEF Inclusions

Under the QEF rules, a shareholder who has made an election must include their pro-rata share of the fund’s income on their personal tax return each year. This income is divided into two distinct categories: ordinary earnings and net capital gain. The character of this income flows through to the shareholder, meaning the portion identified as ordinary earnings by the fund is taxed as ordinary income, and the portion identified as net capital gain is taxed as long-term capital gain. This preserves the potential for preferential long-term capital gains rates.

A shareholder is required to report and pay tax on their share of the QEF’s earnings for the year, even if the fund does not distribute any cash. This can create a situation where the investor owes tax without having received any money from the investment to pay it.

To prevent double taxation, the shareholder’s tax basis in their QEF stock is increased by the amount of ordinary earnings and net capital gains they include in their income. This upward adjustment ensures that when the shares are eventually sold, the previously taxed income is not taxed a second time.

Conversely, when the fund makes an actual cash distribution, that distribution is generally treated as a tax-free return of capital, up to the amount of earnings that have already been taxed. Such distributions require the shareholder to decrease their basis in the QEF stock by the amount of the distribution.

Information Needed to Comply with QEF Rules

To properly follow the QEF tax rules, a shareholder must obtain specific information from the foreign fund itself, documented in a PFIC Annual Information Statement. Without this statement, a shareholder cannot use the QEF tax treatment for that year, as they would lack the necessary data to calculate their income inclusion accurately. The responsibility for providing this statement rests with the PFIC.

The PFIC Annual Information Statement must provide the shareholder’s specific pro-rata share of the fund’s ordinary earnings and net capital gain for the fund’s taxable year. Alternatively, the statement can provide sufficient information to allow the shareholder to calculate these amounts themselves.

This statement is provided by the fund on an annual basis for each year the QEF election is in effect. If the PFIC stock is held through a financial intermediary, the shareholder might receive an Annual Intermediary Statement instead, which serves the same purpose.

Making the QEF Election and Annual Reporting

Once a shareholder has received the PFIC Annual Information Statement, the next step is to make the formal election and report the annual income to the IRS. Both of these actions are accomplished using Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” A separate Form 8621 must be filed for each PFIC investment and attached to the shareholder’s annual income tax return.

The initial QEF election is made in Part II of Form 8621. A shareholder makes the election for the first year it applies by checking the appropriate box and attaching the form to a timely filed tax return. This is a one-time election for that specific investment, but the annual reporting requirements continue for as long as the stock is held.

With the election in place, the shareholder must then complete Part III of Form 8621 each year. This is where the data from the PFIC Annual Information Statement is used to enter the pro-rata share of the QEF’s ordinary earnings and net capital gain for the year on the designated lines. These amounts are then carried from Form 8621 to the appropriate lines on the shareholder’s main tax return.

Electing to Defer Tax Payment

A special provision connected to the QEF regime, found in IRC Section 1294, allows a shareholder to defer the payment of tax on certain QEF income. This election is available for the portion of the shareholder’s tax liability that is attributable to QEF income inclusions for which no cash distribution has been received. It addresses the “phantom income” problem by allowing the shareholder to postpone paying the tax until they actually receive the money from the fund.

The election only defers the payment of the tax; it does not defer the income inclusion itself. The shareholder must still report their full pro-rata share of QEF earnings on their tax return for the year.

A consequence of making this election is that the IRS charges interest on the deferred tax amount. This interest charge, governed by IRC Section 6601, compensates the government for the delay in receiving the tax revenue.

The election to defer payment is made on Form 8621. The deferral generally terminates, and the deferred tax and accrued interest become due, when the fund makes a distribution of the previously taxed earnings or when the shareholder disposes of their QEF stock.