Excess Distribution (Section 1291 PFIC Regime)

Detailed Explanation

The excess distribution regime of IRC Section 1291 is the default tax treatment of a Passive Foreign Investment Company when no QEF or mark-to-market election is in place. An "excess distribution" is the portion of total distributions received during the year that exceeds 125% of the average distributions over the three preceding years; in the first year of ownership no distribution can be excess. On a sale or other disposition, the entire gain is automatically treated as an excess distribution. The excess distribution is then allocated ratably to each day in the shareholder's holding period. The amount allocated to the current year and to any pre-PFIC years is taxed as ordinary income at the shareholder's normal rate this year. The amount allocated to each prior PFIC year is taxed at the highest ordinary income rate in effect for that year (37% for recent years) regardless of the taxpayer's actual bracket, and an interest charge is added to that deferred tax. The interest is computed at the Section 6621 underpayment rate (the federal short-term rate plus three percentage points, recently 7% to 8%), compounded daily from the original due date of each prior-year return. There are no long-term capital gains rates and no qualified dividend treatment, and over a long holding period the combined tax and interest can approach or exceed the entire gain.