Careful attention must be paid when you are working with taxpayer’s who also file U.S. state tax returns. You will have to determine how two independent yet interrelated tax codes will work together when you are dealing with passive foreign investment company income. Issues will include the timing of when gain or loss is recognized, the character of the income inclusions or deductions, capital loss carry forwards and differences in adjusted cost base.
Not all states include PFIC income in the same year as the federal, nor do they always characterize the income the same way. Very often the income that you are including on federal Form 8621 is phantom income, and states vary widely in how they see the taxation of non-realized investment income.
California for example comes right out and says the Franchise Tax Board does not recognize IRC §1291-1298. For California purposes a foreign corporation is treated as a regular corporation. Income will not be recognized, nor taxes imposed, until a distribution is received or a disposition has occurred. Ohio, on the other hand, works on the same timing as the IRS for income inclusion will recognize income in the same year the IRS does. California’s treatment will create a different cost basis for federal and state tax purposes and potentially a mismatch of capital loss carryforwards.
Also consider under §1291 that some of the income does not show up on Form 1040 as part of taxable income yet it is treated as if it has because an extra tax on this income is on page 2 of the 1040. What do you have to do if the state begins their computation of taxable income with the federal AGI? Will this create an understatement of income? You may have to add all or part of the excess distributions subject to the highest rate of taxation into state income before you calculate the tax. Wisconsin provides clear instructions that excess distributions from PFIC investments not included in federal income are an addition to income on Form 1 line 4 Code 05. Others are just silent on the matter and it is up to you to figure out.
The main issues with PFIC taxation at the state level are:
- determining when state adjustments are required to accurately reflect state income;
- how to recognize when state and federal basis may be different due to timing of income inclusions; and
- lack of guidance by many state tax codes.
For more insight information, read the following article by Mary Beth Lougen (COO of Expat Tax Tools, Inc):
The Nightmare of PFICs at the State Level – Answers to FAQs