When a U.S. expat invests in a business overseas, one of the key questions that should be addressed is whether the company structure is subject to the U.S anti-deferral regimes. One such regime is the passive foreign investment company (“PFIC”) regime, which triggers heightened reporting requirements and can have severely adverse tax consequences if not dealt with properly in the early stages of the investment.
Under Section 1291 of the Internal Revenue Code, every United States person who owns any percentage of stock in a PFIC, directly or in some cases indirectly, is required to pay, as additional U.S. federal income tax, an amount computed as an interest charge on the deemed deferred tax liability attributable to any distributions made, or any gain recognized, on such stock. Any gain on the disposition of such stock will be treated as ordinary income.
Importantly, a foreign corporation that is controlled by U.S. persons, and thereby has the status of a controlled foreign corporation (“CFC”), is not treated as a PFIC with respect to the CFC’s 10% U.S. shareholders. Rather, such shareholders are subject to separate anti-deferral rules and reporting requirements under the CFC regime.
Therefore, typically, a situation that involves partial ownership is when PFIC classification has greater relevance.
Definition of a PFIC
A PFIC is defined in Section 1297 as any foreign corporation if, for the taxable year: (1) 75 percent or more of its gross income is “passive” income (the “PFIC income test”); or (2) the average percentage 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 (the “PFIC asset test”).
Once a foreign corporation qualifies as a PFIC at any time during a United States person’s holding period of stock in such foreign corporation, any subsequent distribution by the PFIC to, or disposition of the PFIC stock, by the United States person will be subject to the excess distribution rules of IRC Section 1291, regardless of whether the foreign corporation is a PFIC in the year of the distribution or disposition. Thus, the PFIC “taint” remains with the U.S. person even if the distribution or disposition occurs in a later year when the foreign corporation ceases to be a PFIC.
The adverse effects of PFIC classification can be ameliorated if the United States person elects qualified electing fund status under Section 1295 of the Code (the “QEF regime”) or makes a mark-to-market election under Section 1296 (the “MTM regime,” which is applicable only to publicly-traded PFIC stock) for the first taxable year of the foreign corporation in which the United States person held the stock or was deemed to hold the stock and in which the foreign corporation was a PFIC.
The QEF Election and Retroactive Protection
The QEF regime is elective on the part of the U.S. shareholder. If the election is made, and the PFIC agrees to supply annually certain information to the U.S. shareholder, the shareholder’s interest may be treated as an investment in a QEF. Where a QEF election is in effect, the U.S. shareholder, rather than being subject to the onerous default rules of Section 1291, is treated as receiving an annual distribution of his or her pro rata share of the PFIC’s ordinary earnings and net capital gain. A QEF election may be made for any taxable year of the U.S. shareholder at any time on or before the due date (including extensions) for filing the shareholder’s tax return for the taxable year for which the election is made.
Section 1295(b)(2) of the Code contemplates that a U.S. shareholder may make a late QEF election where he or she reasonably believed that the foreign corporation was not a PFIC. Such late election is designed to be effective retroactively, since a QEF election may be made for any year, but would result only in so-called “unpedigreed QEF” status if made after the first PFIC year. The regulations provide, in relevant part, for a retroactive election under the so-called protective regime.
As a general rule, to make a retroactive election under the protective regime, a shareholder must have possessed a reasonable belief, as of the time the election was originally due, that the corporation was not a PFIC. The shareholder must describe the basis for this belief in a protective statement pursuant to which the shareholder must agree to extend the statute of limitations for PFIC-related taxes for all years to which the protective statement applies. Whether a shareholder had contemporaneous reasonable belief is determined by facts and circumstances, including the relative size of the shareholder’s interest in the foreign corporation. Further, reasonable belief must be based upon a good faith effort to apply the relevant law. Ignorance of the law is not a factor to excuse the shareholder.
In general, a shareholder is deemed to have reasonably relied on a qualified tax professional only if the shareholder reasonably relied on a qualified tax professional (including a tax professional employed by the shareholder) who failed to identify the foreign corporation as a PFIC or failed to advise the shareholder of the consequences of making, or failing to make, the Section 1295 election.
The protective statement must be attached to the shareholder’s federal income tax return for the shareholder’s first taxable year to which the statement will apply. The shareholder must file its return and the copy of the protective statement by the due date (including extensions) for the return.
The PFIC Income Test
Under the PFIC income test, a PFIC is defined as any foreign corporation if, for the taxable year, 75 percent or more of its “gross income” is “passive income.” The PFIC income test is determined by taking into account all gross income of the relevant foreign corporation for its taxable year. The PFIC rules do not provide a definition of gross income.
In this regard, the IRS has issued a private letter ruling (PLR 9447016), which references the principles of Section 61 of the Code in defining gross income for purposes of PFIC testing. Section 61 provides that gross income includes “all income from whatever source derived.” This includes gross income from business, interest, rent, royalties and dividends. In a manufacturing or merchandising business, “gross income” means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. Expenses that are deductible but that are not included in the cost of goods sold, such as salaries, interest, taxes, and depreciation are not taken into account in measuring gross income, but only in determining net income.
In PLR 9447016, the IRS gave a ruling with respect to a foreign corporation that had a loss from active business operations that exceeded the sum of its passive and non-passive income. The IRS ruled that the foreign corporation was not a PFIC under the gross income test, because it had zero gross income for the taxable year. The ruling implies that a foreign corporation engaged in an active business would be treated as a PFIC under the gross income test if it had a net operating loss from its business operations but also had passive income from investments that exceeded that loss. In that case, it would have gross income, and 100% of its gross income would be passive.
The PFIC Asset Test
Under the PFIC asset test, a PFIC is defined as any foreign corporation if, for the taxable year, the average percentage 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. Passive assets are assets that produce passive income for purposes of the PFIC income test, or are held for the production of such income. The asset test is applied on a gross basis; no liabilities are taken into account, even if secured by assets or otherwise directly traceable to particular assets.
The U.S. Treasury and IRS published final and proposed regulations in January of 2021 addressing the operation of the asset test (See See T.D. 9936, 86 Fed. Reg. 4516 (Jan. 15, 2021). Before the regulations were published, Notice 88-22, 1988-1 C.B. 489, had been the primary source of guidance with respect to the asset test. In general, the rules in the 2021 regulations are similar to the rules provided by Notice 88-22, with some notable exceptions.
Similar to Notice 88-22, the 2021 final regulations provide that a foreign corporation being tested for PFIC status calculates the average percentage of its passive assets by determining the average of the fair market values of the passive assets and the total assets held) by the tested foreign corporation on the last day of each measuring period of the tested foreign corporation’s taxable year. In general, each quarter of the tested foreign corporation’s taxable year is a “measuring period,” and the last day of each quarter is a “measuring date.” The average of the fair market values of the tested foreign corporation’s passive assets or total assets for the taxable year is equal to the sum of the values of the passive assets or total assets, as applicable, on each measuring date of the foreign corporation’s taxable year, divided by the number of measuring dates in the taxable year. In the case of foreign corporations with quarters as measuring periods, the divisor is four.
Generally, under Notice 88-22, intangibles that produce identifiable items of income, such as patents and licenses, are characterized in terms of the type of income produced. According to the Notice, goodwill and going concern value must be associated with a specific income-producing activity and characterized as passive or non-passive on the basis of the income derived from that activity.
Notice 88-22 states that the inclusion of intangible assets in testing for PFIC status is “subject to further consideration in prospectively applied regulations.” This indicates that the IRS has some questions regarding how intangible assets are to be taken into account for purposes of the PFIC tests. Many, if not most, active foreign corporations rely on the valuation of goodwill to avoid being classified as PFICs under the asset test. Absent valuing the goodwill of an active business, in many cases, the corporation would default to PFIC status due to the absence of significant fixed assets. Goodwill is usually valued based on a multiple of cash flow; earnings before interest, taxes, depreciation, and amortization (EBITDA); or a similar measure in the same way a buyer would value a target.
The preamble to the 2021 proposed regulations states that the government believes that the approach provided in Notice 88-22 for determining the character of goodwill under the asset test is reasonable, although it acknowledges that not always economically accurate. While the preamble agreed in general with commentators’ argument that goodwill is inherently a business asset, it goes on somewhat circularly to state that goodwill should not always be treated entirely as a non-passive asset, adverting to the government’s position that active financing income (and hence the assets that produce that income) can be treated as passive. The preamble requests comments on alternative approaches to addressing the treatment of goodwill for purposes of the asset test.
Notice 88-22 generally provides that working capital of a business, including cash, is treated as a passive asset due to the working capital producing passive income (i.e., interest income). Critics of this rule have suggested this rule unfairly classifies working capital as a passive asset because active businesses use working capital in the conduct of an active business. The U.S. Treasury and IRS have acknowledged that active operating companies must have cash or cash equivalents on hand to pay operating expenses. However, in the preamble to the 2021 proposed regulations, the U.S. Treasury and IRS stated that they are also aware that some active businesses hold substantially more cash or cash equivalents than the present need requires and for extended periods of time.
The 2021 proposed regulations provide that for purposes of the asset test, an amount of currency denominated in functional currency held in a non-interest bearing financial account that is held for the present needs of an active trade or business and is no greater than the amount necessary to cover operating expenses incurred in the ordinary course of the trade or business of the tested foreign corporation (for example, accounts payable for ordinary operating expenses) and reasonably expected to be paid within 90 days is not treated as a passive asset. For this purpose, cash equivalents are not treated as currency, and amounts held for purposes other than to meet the ordinary course operating expenses of the trade or business, including for the purpose of providing for: (1) future diversification into a new trade or business; (2) expansion of trade or business activities; (3) future plant replacement; or (4) future business contingencies, are treated as passive assets.
The U.S. Treasury and IRS requested comments on this proposed rule as well as other aspects of the PFIC provisions, so it remains to be seen how these rules will look when finalized.