One area where complexities of U.S. taxation is clearly demonstrated is the Passive Foreign Investment Company (“PFIC”) rules. These PFIC rules generally apply to U.S. investors in a foreign corporation where U.S. ownership is 50% or less. A PFIC is any foreign corporation if –
- 75 percent or more of the gross income of such corporation for the taxable year is passive, OR
- The average percent of assets held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent (quarterly average over the course of the tax year).
Said differently –you have a PFIC if 75% or more of the foreign corporation’s income is passive OR at least 50% of its assets are passive.
If a foreign corporation meets the “income test” or “asset test”, then it will be a PFIC. Unfortunately, the PFIC provisions provide that once a foreign corporation meets either the asset test or income test, it will always be treated as a PFIC to the U.S. shareholder regardless if it does not meet either test in future years –known colloquially as the “once a PFIC, always a PFIC” rule.
The details of how a PFIC is taxed are not addressed in this article. In short, absent any election, a distribution from a PFIC is generally taxed at the highest applicable ordinary rate and subject to an interest charge (to the extent the underlying earnings of the PFIC have been deferred from U.S. tax). The focus of this article is to provide practical tips on how to avoid PFIC status entirely – i.e., avoid having to worry about how a PFIC is taxed by never having the foreign corporation in question become a PFIC in the first place.
The PFIC rules were introduced in the Tax Reform Act of 1986 as a result of Congress believing that lack of specific tax rules would effectively operate to provide U.S. investors incentives to make investments outside the U.S. rather than inside the U.S. (by virtue of avoiding current taxation through the investment in a foreign corporation rather than investing domestically).
Practical PFIC Issues:
The following are a few examples of types of businesses or phases in a business that can inadvertently get caught by the PFIC definition creating adverse U.S. tax consequences to its U.S. shareholder(s). For ease, we have used “ForCo” to represent the foreign corporation used throughout these examples.
- Cash Heavy Businesses (e.g., Service Company)
Facts: ForCo is an advertising agency, which generates its revenue from providing services to clients. It typically collects on its accounts receivable within 30 days from the date of issuing its invoices. It leases office space in a coworking office space and its only “hard assets” are laptops and other handheld devices for its employees.
Issue: Cash/working capital is always treated as passive for PFIC testing purposes regardless if such cash was derived or deployed in ForCo’s active operations. Lacking “hard assets” and being “cash heavy” can create a potential trap of being treated as a PFIC.
Potential Solution: The asset test is the average quarterly balance. Accounts receivable will be characterized as a non-passive asset provided that the character of the income that generated the receivable is non-passive. Given ForCo’s service revenue should be non-passive, it may be advantageous to delay collections of accounts receivable around PFIC asset testing days to maintain a higher level of non-passive assets. Further, ForCo may have some “off the books”, self-created intangible assets (goodwill, customer lists, contracts, etc.). Such intangible assets are generally non-passive assets to the extent such intangibles are used in a non-passive income producing activity. It may be beneficial for ForCo to undertake periodic valuations and use the FMV method to test for PFIC status. Detailed review and analysis should be undertaken with respect to valuation methods and the use of FMV.
- Start-Up Businesses
Facts: ForCo is a start-up technology company located in Country A that is developing a mobile device application. Its founders and initial investors contribute cash to ForCo on December 1st of year one. Due to unforeseen circumstances, the development of the technology and thus deployment of capital is delayed over a period of time in excess of 12 months.
Issue: Although there is a narrow exception for not being a PFIC in ForCo’s first year of existence, this exception only applies if ForCo is not a PFIC in either of the next two subsequent years. For purposes of this rule, ForCo’s short year of December 1st – December 31st counts as its first year. Thus, ForCo must deploy the capital converting it to non-passive assets in its 2nd year to avoid PFIC status.
Potential Solution: This issue can be difficult but depending on forecasted cash flow, it may be advantageous to wait until January to form ForCo (or, if available, create a tax year-end that allows for the longest period for the first year). Monitoring the PFIC status of the start-up ForCo in years 2 and 3 is imperative to make sure capital is deployed appropriately keeping in mind the asset testing dates.
- Manufacturing Companies with Losses
Facts: ForCo manufactures widgets in Country A. For the year, ForCo generates $100 of sales, $120 of cost of goods sold and $25 of interest income from an interest bearing account.
Issue: ForCo’s gross income, as defined for U.S. tax purposes, should be $5. As a result of this, 100% of ForCo’s income should be passive and thus meet the PFIC income test.
Potential Solution: The IRS has issued guidance providing that the gross income test does not apply where a foreign corporation has no gross income determined pursuant to U.S. tax principles.
- Capital Injections to Businesses
Facts: ForCo has never been a PFIC. However, in year 5 of its operations, it has a successful capital-raising resulting in its receiving a significant amount of cash. ForCo plans to acquire foreign target assets with the cash injection. However, there is a delay in the closing of the transaction and the purchase does not occur until the next tax year.
Issue: Similar to the cash heavy example above, although ForCo’s intent is to purchase foreign target assets that presumably generate non-passive income, the cash sitting on its balance sheet will be treated as a passive asset.
Potential Solution: Although it may not be practical, having the investors hold their commitment until right before the close of the deal or when the immediate need to deploy the cash is necessary (or within the quarter so that the cash comes on and off the books between PFIC asset testing dates). Alternatively, use the capital to repay down other liabilities (e.g. line of credit) and then later draw on that line of credit at the time of the close when the cash is needed for the target foreign assets.
- Real Estate Rental Companies
Facts: ForCo owns real estate located in Country A. It leases the real estate to an unrelated party, uses a management company to manage and operate the property and has no other material income.
Issues: Rental income by default is treated as passive unless the “active rents” test is met.
Potential Solution: In order to treat the rental income as non-passive, ForCo must lease the real property through its own officers or staff of employees who regularly perform active and substantial management and operational functions. Thus, this exception generally requires ForCo to bring “in house” all functions rather than outsourcing to independent contractors and/or management companies. Detailed analysis should be undertaken to determine what constitutes active and substantial management and operational functions in order to meet this “active rents” test.
This article is intended to provide an overview of some areas which we have seen in practice inadvertently catch foreign corporations into PFIC status. This is not an exhaustive list nor did we address the details of the PFIC rules, and how they may apply to a U.S. investor in a foreign corporation.
The two key takeaways from this are (i) never assume that a foreign corporation “can’t be a PFIC” because of X or Y –a multitude of factors can easily make it conceivable and (ii) always remember the rule, “Once a PFIC, always a PFIC” – so taking the necessary measures to avoid this status where possible is imperative in proactive U.S. tax planning.
Depending on the specific facts, a foreign corporation may be treated as a controlled foreign corporation (“CFC”) and/or PFIC. However, this article is not addressing how the ownership test works for CFCs as well as how the CFC and PFIC provisions interact.
Joint Committee on Taxation HR 3838, 99th Congress, Public Law 99-514, Page 1023. Congress went on to add: “Congress further believed that the nationality of the owners of controlling interests of a corporation which invests in passive assets should not determine the U.S. tax treatment of its U.S. owners. In Congress’ view, the absence of U.S. control did not necessitate preferential U.S. tax treatment to U.S. personas who invest in passive assets through a foreign corporation. Moreover, Congress recognized that U.S. persons who invested in passive assets through a foreign corporation obtained a substantial tax advantage vis-à-vis U.S. investors in domestic investment companies because they not only were able to avoid current taxation but also were able to convert income that would be ordinary income if received directly or receive from a domestic investment company into capital gain income.
IRS Notice 88-22, 1988-1 C.B. 489.
IRS PLR 9447016. Note that a PLR is not binding authority from the IRS but in practice is often used a general guidance in which the IRS may interpret the relevant provisions.
Although not binding in any subsequent case, the IRS stated in PLR 9447016 that “gross income” of a manufacturing business means total sales less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources.