§1291(a) Gains Allocated to Prior Years Are Not Included in Determining Applicability of Six-Year Statute

In the case of Toso, et al v. Commissioner, 115 TC No. 4, the Tax Court considered issues related to passive foreign investment company (PFIC) gains.  Specifically, the Court looked at how gains taxed under the rules of IRC §1291(a) will be counted for purposes of determining if there is a substantial omission from gross income under IRC §6501(e)(1)(A)(i) that would allow for a six-year statute of limitations.

IRC §6501(e)(1)(A) provides:

(e) Substantial omission of items

Except as otherwise provided in subsection (c)—

(1) Income taxes

In the case of any tax imposed by subtitle A—

(A) General rule

If the taxpayer omits from gross income an amount properly includible therein and—

(i) such amount is in excess of 25 percent of the amount of gross income stated in the return, or

(ii) such amount—

(I) is attributable to one or more assets with respect to which information is required to be reported under section 6038D (or would be so required if such section were applied without regard to the dollar threshold specified in subsection (a) thereof and without regard to any exceptions provided pursuant to subsection (h)(1) thereof), and

(II) is in excess of $5,000,

the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time within 6 years after the return was filed.

Gains on the sale of passive foreign investment corporation stock is taxed under special rules found at IRC §1291(a) that provides:

(a) Treatment of distributions and stock dispositions

(1) Distributions

If a United States person receives an excess distribution in respect of stock in a passive foreign investment company, then—

(A) the amount of the excess distribution shall be allocated ratably to each day in the taxpayer’s holding period for the stock,

(B) with respect to such excess distribution, the taxpayer’s gross income for the current year shall include (as ordinary income) only the amounts allocated under subparagraph (A) to—

(i) the current year, or

(ii) any period in the taxpayer’s holding period before the 1st day of the 1st taxable year of the company which begins after December 31, 1986, and for which it was a passive foreign investment company, and

(C) the tax imposed by this chapter for the current year shall be increased by the deferred tax amount (determined under subsection (c)).

The gain is allocated over the entire holding period of the stock, with that allocated to the current year taxed as an ordinary income and is included in ordinary income.  All remaining gain is taxed under the special deferred gain rules found at IRC §1291(c).

The IRS argued that all gain (both that from the current year and that from prior years) is included in determining the applicability of the six-year statute. The taxpayer argued that, by the explicit terms of IRC §1291(a)(1)(B)(i), only the current year portion is included in gross income under IRC §61 and, therefore, the gain taxed under IRC §1291(c) does not impact the applicability of the six-year statute.

The Tax Court agreed with the taxpayer that the plain language of the provisions in question require excluding the gains outside the current year from the calculation of omitted income in determining if the six-year statute of IRC §6501(e)(1)(A)(i) applies.  The opinion states:

Because current-year PFIC gains are included in gross income under section 1291, they are counted in the section 6501(e)(1)(A)(i) gross income amount. Similarly, because non-current-year PFIC gains are not included in gross income under section 1291 for any year, non-current-year PFIC gains are not counted in gross income for purposes of section 6501(e)(1)(A)(i).

The IRS argued for a contrary result.  The Tax Court described the IRS’s position as follows:

On brief respondent argues for a different result, contending that any noncurrent-year PFIC gain is gross income and that section 1291 merely “provides for the calculation of the tax and interest owed on that portion of gross income from the sale of the PFIC stock [i.e., non-current-year PFIC gain].” Consequently, respondent contends, we should add all non-current-year PFIC gains to the section 6501(e)(1)(A)(i) gross income calculation because such gains would have been included in “gross income” if section 1291 were not in the Code.

The Tax Court rejected that view, pointing out that pretending that §1291(a) is not in the Code is not an option given the plain language of the provisions involved.

But section 1291 is in the Code, and, as the more specific provision, it governs the more general terms of section 61. See D.B. v. Cardall, 826 F.3d 721, 735 (4th Cir. 2016) (“As a rule of statutory construction, * * * the specific terms of a statutory scheme govern the general ones * * * particularly * * * where ‘Congress has enacted a comprehensive scheme and has deliberately targeted specific problems with specific solutions’[.]” (quoting RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 566 U.S. 639, 645 (2012))). There is no apparent reason to deviate from the text of section 1291, which provides that only current-year PFIC gain is included in the taxpayer’s gross income for the current year, or to ignore the specific method employed in section 1291 for taxing non-current-year PFIC gains, which does not include those gains in gross income for any year. Accordingly, we decline to adopt a reading of sections 1291 and 6501 that would define “gross income” differently for purposes of the statute of limitations than it would for calculating the tax on sales of PFIC stocks.

The IRS countered that this result runs counter to the purpose of §6501(e)(1).  The agency argued that IRC §1291 was added to the law in order to prevent taxpayers from favoring investments in foreign corporations over those in domestic mutual funds.  Thus, since income from mutual funds and the sales of the funds are included in the calculation of gross income for purposes of §6501(e)(1).

But the Tax Court pointed out that, in fact, the provisions of §1291 do not result in treating a PFIC as if it were a domestic mutual fund.  While Congress may have discussed the impact on domestic mutual funds, the actual treatment is not the same.  As the Court concludes:

For these reasons, we conclude that respondent’s policy concerns provide no basis for a different interpretation of sections 1291 and 6501(e)(1)(A)(i). If, as respondent suggests, there are competing policy considerations as to how the statute of limitations should apply in this context, it is the role of the legislature, rather than of this Court, to evaluate and address any such policy considerations.