Internal Revenue Code Section 1246 is a repealed provision that once converted gains on foreign investment company stock into ordinary income for U.S. shareholders. Congress eliminated it through the American Jobs Creation Act of 2004, and the job it used to do now belongs to the Passive Foreign Investment Company (PFIC) rules in Sections 1291 through 1298.1Congress.gov. American Jobs Creation Act of 2004 If you are looking at tax code Section 1246 today, you are almost certainly working with an old return, an old treatise, or trying to trace how the current offshore-fund rules came to be.
What Section 1246 Did While It Was in Force
Section 1246 aimed at a specific problem: U.S. investors parking money in offshore funds, letting the earnings accumulate untaxed, and then selling out at long-term capital gains rates. The statute stopped that by recharacterizing the favorable-rate gain as ordinary income up to a defined ceiling.
Under Section 1246(a), when a U.S. shareholder sold stock in a qualifying foreign investment company held more than one year, the gain was treated as ordinary income up to the shareholder’s “ratable share” of the company’s accumulated earnings and profits for taxable years beginning after December 31, 1962.2Office of the Law Revision Counsel. 26 U.S.C. 1246 – Gain on Foreign Investment Company Stock Any gain beyond that ratable share kept its capital character. So if a foreign fund accumulated $100,000 in earnings during your holding period and your stake entitled you to $10,000 of those earnings, $10,000 of your sale gain was ordinary income and the rest stayed capital.
The rule only reached stock held more than a year. Short-term gains were already taxed at ordinary rates under general capital gains rules, so Section 1246 had nothing to add there.
Which Foreign Corporations Were Covered
Section 1246(b) defined a “foreign investment company” as a foreign corporation that met either of two tests for any taxable year beginning after December 31, 1962:
- It was registered under the Investment Company Act of 1940 as a management company or unit investment trust; or
- It was primarily in the business of investing, reinvesting, or trading in securities or commodities, and at least 50 percent of its total voting power or total stock value was held by U.S. persons.2Office of the Law Revision Counsel. 26 U.S.C. 1246 – Gain on Foreign Investment Company Stock
The 50 percent threshold counted shares held by U.S. citizens, residents, domestic partnerships, and domestic corporations, including indirect ownership under attribution rules. A foreign fund with mostly non-U.S. shareholders sat outside the definition entirely. Section 1246 was aimed squarely at offshore vehicles that Americans controlled or dominated.
When Section 1246 Was Repealed
The American Jobs Creation Act of 2004 repealed Section 1246 along with the related foreign personal holding company rules.1Congress.gov. American Jobs Creation Act of 2004 By that point, Congress had already built a broader anti-deferral system through the PFIC rules enacted in 1986. Two overlapping regimes were no longer worth maintaining, and repeal consolidated enforcement into the PFIC provisions that remain in force.
The PFIC Rules That Replaced It
The current framework lives in Sections 1291 through 1298. It is meaningfully broader than Section 1246. A foreign corporation is a PFIC if it meets either of two tests:
- Income test: 75 percent or more of its gross income for the year is passive income (dividends, interest, rents, royalties, and similar items).
- Asset test: At least 50 percent of its assets produce or are held to produce passive income.3Office of the Law Revision Counsel. 26 U.S.C. 1297 – Passive Foreign Investment Company
There is no U.S. ownership threshold. A foreign fund with no American shareholders can still be a PFIC. Classification turns on what the company earns and owns, not who holds the stock, which sweeps in many more foreign corporations than Section 1246 ever did.
One trap catches taxpayers years later: once a foreign corporation qualifies as a PFIC during your holding period, it stays a PFIC as to you even if it later fails both tests. This “once a PFIC, always a PFIC” rule under Section 1298(b)(1) can only be removed through specific elections or purging transactions.
Default Treatment Under Section 1291
If you hold PFIC stock and have made no election, you fall under the default excess distribution regime in Section 1291. When you sell PFIC stock at a gain or receive an excess distribution, the amount is spread ratably across every day you held the stock. The portion allocated to the current year and any pre-PFIC years is taxed at your ordinary rates. The portions allocated to prior PFIC years are taxed at the highest marginal rate in effect for each of those years, plus an interest charge running from each prior year’s return due date to the present.4Office of the Law Revision Counsel. 26 U.S.C. 1291 – Interest on Tax Deferral
An excess distribution is any distribution exceeding 125 percent of the average distributions received over the prior three years. A gain on sale of PFIC shares is treated the same way. The combination of top-bracket taxation and compounding interest is punitive by design, and it is meant to push investors toward one of the two elections below.
The QEF Election
A Qualified Electing Fund election under Section 1295 requires you to include your pro rata share of the PFIC’s ordinary earnings and net capital gain in your income each year, whether or not the fund distributes anything.5Office of the Law Revision Counsel. 26 U.S.C. 1295 – Qualified Electing Fund Ordinary earnings are taxed at ordinary rates; net capital gain keeps long-term capital gain treatment. Later distributions and sale proceeds are not taxed again to the extent you already reported them.
The election depends on cooperation from the fund. You need an annual information statement breaking out the fund’s ordinary earnings and net capital gain, and many foreign funds refuse to produce one. Without that data the election is not workable. You make it by filing Form 8621 with your return, and it applies to all future years unless the IRS consents to revocation.6Internal Revenue Service. Instructions for Form 8621
The Mark-to-Market Election
A Section 1296 mark-to-market election is available only for PFIC stock that trades on a national securities exchange registered with the SEC or a comparable foreign exchange.7Office of the Law Revision Counsel. 26 U.S.C. 1296 – Election of Mark to Market for Marketable Stock You report the annual increase in fair market value as ordinary income even without a sale. If the value drops, you can deduct the decrease as an ordinary loss, but only up to the cumulative gains you previously reported under the election. Actual sale gains are also ordinary, not capital.
That is less favorable than QEF treatment for the capital gain portion, but it has a practical edge: you do not need any information from the foreign fund. If the shares have a readily available market price, you can make the election on your own.
Form 8621
Any U.S. person who owns PFIC stock, directly or indirectly, generally files Form 8621 with their federal income tax return for each PFIC held.6Internal Revenue Service. Instructions for Form 8621 Three funds mean three forms. A limited de minimis exception is available for small holdings with no excess distributions and no dispositions during the year, but any sale or excess distribution during the year removes the exception regardless of the dollar value involved. Failing to file the form can keep the statute of limitations open indefinitely on the entire return for that year, not just the PFIC items.
Why Section 1246 Still Shows Up
Section 1246 has been off the books for more than two decades, but it still appears in tax research for a few reasons. Older treatises, CPA exam materials, and historical IRS publications reference it. Pre-2005 returns being audited or amended can bring it back into play. And the underlying concept of turning capital gain into ordinary income to discourage offshore deferral started with Section 1246 and its neighbors before Congress folded the idea into the broader PFIC framework that governs foreign fund investments today.