How does California tax PFIC income when it does not conform to the federal PFIC rules?

Two regimes for the same distribution

The federal PFIC regime exists to police deferral. A United States shareholder in a passive foreign investment company that has made no qualified electing fund or mark to market election is subject to the excess distribution rules of IRC Section 1291: the portion of a distribution above 125 percent of the trailing three year average is an excess distribution, allocated ratably over the holding period. The portion of an excess distribution allocated to the current year (and to any years before the company was a PFIC) is included in gross income as ordinary income; the portions allocated to prior PFIC years never enter taxable income at all, and instead generate a deferred tax amount, tax at the highest rate for each year plus interest, added to the federal tax (IRC section 1291(a)(1), (c)). None of it depends on the company's earnings and profits.

California has never incorporated these provisions, and the mechanism is an express carve-out rather than an omission, a distinction that matters to anyone tracing the reasoning from the conformity statutes. Revenue and Taxation Code section 24990 conforms to Subchapter P of the Internal Revenue Code as a whole, providing that Subchapter P, relating to capital gains and losses, shall apply, except as otherwise provided. The PFIC regime is Part VI of that same Subchapter, so it would ride into California law with the rest of Subchapter P but for the exception: Revenue and Taxation Code section 24995 provides that Part VI of Subchapter P, relating to treatment of certain passive foreign investment companies, shall not be applicable. A reader who stops at section 24990 reaches the opposite answer, which is why the carve-out belongs in the citation. The Franchise Tax Board states the same conclusion plainly in its Water's Edge Manual, which devotes an entire chapter to the state treatment of PFICs and instructs that income reported federally under the PFIC regime enters the California return only as a state adjustment. The nonconformity is structural rather than date-based, which matters after SB 711 (Stats. 2025, ch. 231) moved California's general conformity date from January 1, 2015 to January 1, 2025: the update refreshed the vintage of the provisions California already incorporates, but it did not newly incorporate the PFIC regime, so the answer here did not change with the date. For California purposes, the foreign fund is a foreign corporation like any other. No election is available or required, and none of the federal machinery, the throwback, the rate override, or the interest charge, has a California counterpart.

What California does instead

With the PFIC overlay gone, the analysis reverts to first principles. A shareholder recognizes no California income from merely holding the shares while the fund accumulates earnings; deferral, which the federal regime exists to punish, is the California answer. Income arrives on two occasions only.

The first is a distribution. California applies the general dividend rules: a distribution is a dividend to the extent of the payor's current earnings and profits and then its accumulated earnings and profits on a last in, first out basis, with both computed under California law rather than taken from the federal PFIC computation. Distributions in excess of earnings and profits are a return of capital that reduces stock basis, and distributions beyond basis are capital gain. The earnings and profits computation is the working heart of this analysis, because a foreign fund's E&P on a California basis is rarely a number anyone has, and the classification of the entire distribution turns on it.

The second is a disposition. Gain or loss on the sale of the shares is recognized under the ordinary rules, measured against California basis. Because California never taxed the phantom inclusions of a federal QEF or mark to market election, it also never granted the basis increases that accompany them, so the California basis in PFIC shares held under a federal election will typically be lower than the federal basis, and the California gain correspondingly larger. Federally, gain on disposing of stock in a PFIC with no election in place is itself treated as an excess distribution (IRC section 1291(a)(2)); California treats it as capital gain under the general rules. The same nonconformity applies for personal income tax purposes (Revenue and Taxation Code section 18181), so an individual holding PFIC shares runs the same two ledger problem on a California return.

The practical consequence: an amended return problem

The divergence surfaces most often on returns that carried the federal treatment into the California computation by default. Because the federal starting point contains only the current-year slice of an excess distribution, the California computation usually has to add back the thrown-back portion to the extent the distribution is a dividend out of California-basis earnings and profits, and subtract any current-year slice that California treats as return of capital. Left alone, the federal figure flows into the state return, and the California result can be materially different in either direction. A distribution that was mostly excess distribution federally may be mostly return of capital for California if the fund's California-basis earnings and profits are thin, which shrinks California income. In the other direction, a distribution of amounts previously included under a federal qualified electing fund election, which is nontaxable federally, may be a fully taxable dividend for California, which never taxed the inclusions. Neither answer can be assumed; both must be computed.

For a water's edge filer, one more California door is worth checking before the dividend is booked at full inclusion. California allows a 75 percent deduction for qualifying dividends received from a corporation in which the water's edge group owns, directly or indirectly, more than 50 percent of the total combined voting power, provided the payor's average United States property, payroll, and sales factors are less than 20 percent, since RTC 24411 conditions the deduction on both tests together. A minority position in a foreign fund, held below that line, takes no benefit from it, but fund interests are not always minority interests, and the difference between a fully included dividend and one that is 75 percent deductible is worth the ownership check. The PFIC shares themselves also stay outside the water's edge combined group in the ordinary case, since the fund's own income does not enter the group's apportionable base merely because a member holds its stock. A majority-owned fund that is a unitary controlled foreign corporation is the exception, since part of its income can enter the water's edge report through the Subpart F inclusion rule (Rev. and Tax. Code section 25110(a)(2)(A)(ii)).

Practice notes

The California PFIC analysis is an earnings and profits analysis. First, when a federal return reports an excess distribution, the federal figure should not ride into the California return: recompute the distribution's character under the general dividend rules, which requires the fund's earnings and profits on a California basis, current and accumulated, and document the LIFO ordering. Second, track two bases: shares held under a federal QEF or mark to market election carry federal basis adjustments California does not recognize, so a schedule reconciling federal and California basis, kept current from acquisition, is what prevents a disposition-year scramble. Third, on any sizable foreign fund position, confirm the ownership percentage against the water's edge qualifying dividend threshold before finalizing the inclusion. Fourth, when the E&P computation is unobtainable, document the efforts made and the assumptions used, because the classification adopted without it is an estimate, and an examiner will treat it as one. G&G State Tax Group provides California analysis of foreign fund and PFIC investments alongside its state and local tax practice.