PFIC and CFCs Archives - HodgenLaw PC

Greetings from Haoshen Zhong. You are receiving this email because you are subscribed to our PFICs Only newsletter, delivered to your inbox every other Thursday at 6:00 am Pacific time. To stop receiving these emails, scroll to the bottom and click “unsubscribe”. To browse our other newsletters, go to hodgen.com/newsletters.

Do we have a foreign corporation?

This week’s newsletter is part 1 of a 2 part series inspired by the following question from a reader I will call Q:

I have shares in a UK investment club. It invests in UK breweries. I think it is a PFIC. How do I determine if it is one??

Two steps to answer this question

This is the definition of a PFIC under section 1297(a):

For purposes of this part, except as otherwise provided in this subpart, the term “passive foreign investment company” means any foreign corporation if–

(1) 75 percent or more of the gross income of such corporation for the taxable year is passive income, or

(2) the average percentage of assets (as determined in accordance with subsection (e)) 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. IRC §1297(a)

Section 1297(a) prominently lists 2 items. Item (1) is the income test. Item (2) is the asset test. Meeting either of these 2 tests will make a foreign corporation a PFIC. But there is a necessary requirement that is not separately listed in the Code: The arrangement in question must be a foreign corporation under US tax law. If the arrangement is domestic, or if it is not a corporation, then it’s not a PFIC no matter what its income and assets are.

To determine whether we have a PFIC we really ask 2 questions in sequence:

Is it a foreign corporation? Today’s newsletter will cover this question.
Does it meet either the income test or the asset test? The next newsletter will cover this question.

Find out what kind of entity it is under the laws of the foreign jurisdiction

Many of the tax rules we are dealing with will depend on what the entity is and how it operates under the laws of the foreign jurisdiction in which it was formed. The first step when encountering an entity is to find out what it is exactly in the foreign jurisdiction.

In our case, Q did not say what the entity was when she asked us the question. We asked her in a follow-up email and found the answer: Q’s investment club was organized as a private limited company under UK law.

Foreign: Organized outside the US

Whether a corporation is foreign or domestic is entirely straightforward: A corporation is a type of business entity. Reg. §301.7701-2. A business entity is domestic if it it is organized within the US, under a US law, or under a state law. Otherwise it is foreign. Reg. §301.7701-5(a).

Q’s investment club is a UK private limited company. If it is a corporation (or any other types of business entity), then it would be foreign. The more interesting question is: Is it a corporation?

Corporation: Apply a series of rules in sequence

US tax law has its own definition of what a corporation means. Reg. §§301.7701-1. The entity’s classification under foreign law can be helpful, but it’s not determinative of its US tax law classification.

A corporation is a type of business entity. Reg. §§301.7701-2, -3. So first, Q must check whether the investment club is a business entity. The Treasury Regulations define a business entity as follows:

[A] business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under § 301.7701-3) that is not properly classified as a trust under § 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code. Reg. §301.7701-2(a).

To determine whether we have a business entity, we first see whether it is a trust or falls under a special classification.

The investment club does not fall under a special classification

There are a number of special classifications for entities. These are generally based on the activities of the entity. The activities that potentially apply are regulated investment companies and real estate investment trusts.

A regulated investment company must be a domestic corporation, and it must be registered with the SEC. IRC §851(a). If the UK investment club is a corporation, then it is almost certainly foreign. It is unlikely that the investment club is registered with the SEC. So it is not a RIC.

A real estate investment trust must invest in real estate. We know Q’s investment club invests in breweries, so it is not a REIT.

The investment club is not a trust

Some times UK investment vehicles are organized as unit trusts, which are treated as trusts under UK law. Fortunately, we know Q’s investment club was organized as a private limited company, not a unit trust. We do not need to parse the trust rules.

We now know Q’s investment club is a business entity.

The investment club is eligible to elect its US tax classification

A business entity that is not automatically classified as a corporation (per se corporations) is an eligible entity that can elect its US tax classification. Reg. §301.7701-3(a).

The types of per se corporations include various US and state entities, an insurance company, and a laundry list of foreign entities. Reg. §301.7701-3(b)(1), (3)-(8).

Q’s investment club was not organized under US or state laws, and it doesn’t belong to the US or a state. It cannot be a corporation under those classifications.

Q’s investment club is not an insurance company.

If we look in the list of foreign entities, the only per se corporation for UK is a public limited company. Q’s investment club is a private limited company, so it is not a per se corporation.

This means Q’s investment club is an eligible entity. It can elect its tax classification.

Default classification without election: corporation

An eligible entity that does not elect its US tax classification receives a default classification. Reg. §301.7701-3(b). It is unlikely that Q’s investment club made an election with the IRS, so we look at the default classification.

A foreign entity with multiple owners is a partnership if one or more members does not have limited liability (in other words, one or more members have personal liability). It is a corporation if all members have limited liability. Reg. §§301.7701-3(b)(2)(i), -2(b)(2).

The UK authorizes several types of companies (Companies Act 2006, §3):

An unlimited company
A company limited by guarantee
A company limited by shares

We know Q’s investment club is a limited company, so it cannot be an unlimited company.

Q told us that she has shares in the investment club, so it is probably a company limited by shares. There is some risk that Q is using the term “shares” loosely. It is best to ask her whether the investment club is a company limited by shares or limited by guarantee.

For this newsletter, I will assume it was a company limited by shares, because Q referred to shares, and companies limited by guarantee are rare.

In a company limited by shares, the members’ liabilities are “limited to the amount, if any, unpaid on the shares held by them”. Companies Act 2006, §3(2).

The members of a company limited by shares do not have personal liability merely by reason of being members of the company. Their liability is limited to the value of the shares (the sum of paid and unpaid for shares). The members of a company limited by shares have limited liability.

If Q’s investment club is a company limited by shares, then all members have limited liability. The investment club would be a corporation, as you would expect.

Applying the income and asset tests

We know Q’s investment club is foreign, because it is organized in the UK under UK law.

We are reasonably confident Q’s investment club is a corporation, regardless of whether it is limited by guarantee or limited by shares.

Q has shares in a foreign corporation. It is potentially a PFIC. We have to apply the income and asset test rules to check whether it is in fact a PFIC. Stay tuned for how to apply the income and asset tests.

Thank you

Thank you for tuning in to our PFIC newsletter. Please send us any PFIC questions you have by clicking “reply” to this message.

Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Greetings from Haoshen Zhong.

You are receiving this email because you are subscribed to our PFICs Only newsletter, delivered to your inbox every other Thursday at 6:00 am Pacific time. To stop receiving these emails, scroll to the bottom and click “unsubscribe”. To browse our other newsletters, go to hodgen.com/newsletters.

Do we have a foreign corporation?

This week’s newsletter is part 2 of a 2 part series inspired by the following question from a reader I will call Q:

I have shares in a UK investment club. It invests in UK breweries. I think it is a PFIC. How do I determine if it is one??

Two steps to answer this question

When you see a question like the one Q has, the analysis takes 2 steps:

Is this arrangement a foreign corporation under US tax law? If it is not a foreign corporation, then it cannot be a PFIC.
Does the foreign corporation meet either the income test or the asset test for PFICs? If it meets either 1 of the 2 tests, then it is a PFIC.

In the previous newsletter, we determined that Q’s investment club is a foreign corporation. Today, we ask whether it meets either the income test or the asset test.

Income test and asset test defined:

This is the definition of a PFIC under section 1297(a):

For purposes of this part, except as otherwise provided in this subpart, the term “passive foreign investment company” means any foreign corporation if–

(1) 75 percent or more of the gross income of such corporation for the taxable year is passive income, or

(2) the average percentage of assets (as determined in accordance with subsection (e)) 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. IRC §1297(a)

Item (1) is the income test. Item (2) is the asset test. To find out if Q’s investment club is a PFIC, we have to check whether it meets either of the tests.

At this point, it is useful to ask the client for the financial statements and the activities of the company. Q provided financial statements and explained that the largest investment by percentage the club made was a 9% stake in a particular brewery.

Passive income

Both the income test and the asset test include the term “passive income”. Passive income means:

any income which is of a kind which would be foreign personal holding company income as defined in section 954(c). IRC §1297(b)(1).

Foreign personal holding company income includes a laundry list:

Dividends, interest, royalties, rents, and annuities
Gains from the sale of property that gives rise to dividends, interest, etc
Gains from the sale of an interest in a trust, partnership, or REMIC
Gains from sales of property that gives rise to no income
Commodity and foreign currency transaction gains
Income in lieu of dividends, interest, royalties, rents, and annuities

Income test

The financial statements Q gave us show that the “revenue account” for the club had 2 types of inflows: member contributions and dividends and interest received.

It seems that the investment club’s income consists entirely of passive income, so the club would be a PFIC under the income test. We just need to be careful about exceptions.

An exception is made for dividends, interest, rent, or royalty received from a related person, as long as the dividend is not from passive income. IRC §1297(b)(2)(C). But “related person” means a person that shares a more than 50% ownership relationship with the foreign corporation. IRC §954(c)(3). The highest percentage of shares the investment club owned was 9%, so there is no related person exception.

If a foreign corporation owns 25% or more of the stock of another corporation, the parent looks through to the income of the subsidiary. IRC §1297(c)(2). The investment club held no more than 9% of any of its investment targets. The lookthrough rule does not apply.

At this point, we can stop: Q’s investment club satisfies the income test, and it needs to satisfy only 1 of the 2 tests to be a PFIC.

For completeness’ sake, let us also look at the asset test.

Asset test

Q’s investment club has only cash and stocks.

Notice 88-22 tells us that cash (and working capital that can be easily converted to cash) is a passive asset, regardless of the purpose for which it is held. Notice 88-22; 1988-1 C.B. 489.

Stocks produce dividends, which is a type of passive income. And the income test tells us that these stocks do not fit into any exceptions that would classify dividends as non-passive.

Q’s investment club also satisfies the asset test. Q’s investment club is a PFIC under the asset test as well.

Getting out of the PFIC treatment

Q’s income from a PFIC such as the investment club is subject to punitive rules by default. The effective tax rate can be well in excess of the highest ordinary income tax rate, and returns of investment can be taxed as if it were income. Debra Rudd covered the default rules in this post: Distributions, Excess Distributions, and Total Excess Distributions.

QEF election

To avoid the default rules, the PFIC rules permit a shareholder of a PFIC to make a qualified electing fund (QEF) election. IRC §1295(b)(1). A QEF election require the PFIC to issue a PFIC Annual Information Statement, which states the shareholder’s share of the PFIC’s income under US income tax rules. Reg. §1.1295-1(f).

Given the expense of issuing the statements, it is unlikely that Q would be able to convince the investment club to issue the statements for her to make a QEF election.

MTM election

The PFIC rules also allow PFIC income to be taxed under mark to market (MTM) rules instead of the default rules. IRC §1296. But the MTM rules are limited to publicly traded entities. IRC §1296(e).

Q’s investment club is a private limited company. She is not eligible to use the MTM election for the investment club.

Partnership election

The last option to avoid the default rules is not in the PFIC rules: As an eligible entity with more than 1 owner, the investment club can elect to be treated as a partnership using Form 8832. Reg. §301.7701-3(a).

Making this election results in a deemed liquidation. Reg. §301.7701-3(g)(1)(ii). Any unrealized gains built into the investment club shares are taxed under default rules. Afterwards, the investment club is no longer a PFIC, because it is no longer a corporation.

To make this election, either all members of the investment club must sign the election, or an officer of the club who is authorized (under UK law) to make the election must sign the election–presumably with the approval of the members. Reg. §301.7701-3(c)(2)(i).

Making the election to be treated as a partnership means the members are responsible for their distributive shares of the investment club’s income. For US members, the partnership taxation rules are likely better than the default PFIC rules, so they should not have any problems consenting. For non-US members, they do not have any US income to recognize, as long as the club makes no investment in the US.

But there are practical problems aside from having to recognize income:

Will the investment club want to voluntarily interact with the IRS? Most businesses do not like interacting with a foreign tax authority when it is not necessary.

Will the investment club run into problems in the UK? Before FATCA, as long as the investment club had no investments in the US, there was no problem. But making the election changes the investment club’s FATCA classification from a corporation to a partnership. Will the UK financial institutions give the investment club trouble?

Q will have to work these issues out with the club.

Summary

Q’s investment club meets both the income test and the asset test for PFICs. Meeting either test makes the investment club a PFIC.

Q probably cannot make a QEF election to avoid the punitive default taxation rules for PFICs, nor can Q make a mark-to-market election. But Q might be able to convince the club to elect to be treated as a partnership. This is something Q would have to work out with the investment club.

Thank you

Thank you for tuning in to our PFIC newsletter. Please send us any PFIC questions you have by clicking “reply” to this message.

Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Hello from Debra Rudd.

You are receiving this email because you are signed up for our PFICs Only newsletter, delivered to your electronic mailbox every other Thursday at 6:00 am Pacific time. To stop receiving these emails, scroll to the bottom and click “unsubscribe”. To see what other newsletters we offer, go to hodgen.com/newsletters.

How do losses affect MTM basis and gain recognition?

This week’s question comes from reader G (lightly edited):

I bought mutual funds in 2015. I plan to make a mark-to-market election. At the end of 2015 they were down. As an example on one there was a loss of $800 (it wasn’t sold) and I stated the FMV on Dec 31 as $14,500, down from $15,300 adjusted basis. 2 questions:

At the end of 2016 what do I show as my basis in the fund? $15,300 (its purchase price) or $14,500 (its fair market value at end of 2015)?

In the future if it increases, and say at the end of 2016 the FMV will be $15,500, what is my gain? Is it $1,000 ($15,500 – $14,500) or $200 ($15,500 – $15,300)?

To answer these questions, I will first need to take a look at how loss recognition works for mark-to-market (MTM) PFICs. Then I will talk about how loss recognition affects the basis of a MTM PFIC.

What is a PFIC?

A passive foreign investment company is a foreign corporation that meets either the income test or the asset test of IRC §1297(a):

If 75% or more of its income is passive, or if 50% or more of its assets are passive, it is a PFIC.

Foreign mutual funds and other similar investments often end up being PFICs. This is because they are often configured in such a way that they will be foreign corporations under US tax law (even if they are not organized as corporations under foreign law), and because usually all of their income is passive.

If it is classified as a foreign corporation under US tax law, and it meets the income test or asset test, it is a PFIC.

G is assuming that his mutual funds are PFICs, and he is probably correct.

How are PFICs taxed?

There are three ways that PFICs are taxed:

Under the default treatment, distributions and dispositions are taxed under the extremely punitive excess distribution rules: Returns of capital can be swept in as taxable receipts. Taxable receipts are subject to a mix of ordinary and maximum tax rates. And there are daily compounded interest charges on top of that.
Under the MTM election, annual increases in value are taxed as ordinary gains.
Under the QEF election, income is passed through to the shareholder as either capital gain or ordinary income.

If you have a PFIC, you will want to make either the MTM or QEF election if you can, because the default treatment means very high taxes to pay.

MTM election generally

The MTM election can only be made for what the Code calls “marketable stock”. There are some specific requirements for what qualifies as marketable stock, but basically it is stock that is traded on an exchange. I will assume that G’s PFICs are marketable stock and qualify for the MTM election.

When you make the MTM election, you must pretend to sell the stock at the end of every year for its fair market value and pay tax on any gain that arises in the pretend sale. The gain is taxed as ordinary income.

Losses and “unreversed inclusions”

For each MTM PFIC, you must keep a record of a running balance that the Code refers to as “unreversed inclusions”. The unreversed inclusions for any PFIC can never be less than zero.

Each time you report a gain from the annual pretend sale of your PFIC under the MTM rules, the unreversed inclusions for that PFIC are increased by the amount of the gain you report.

If you claim a loss on that PFIC from the annual pretend sale of your PFIC, you decrease unreversed inclusions for that PFIC by the amount of the loss you claim on your tax return. But because the unreversed inclusions can never be less than zero, you cannot claim losses in excess of the unreversed inclusions available. You also cannot use unreversed inclusions from a different PFIC.

To put it a different way, you can deduct losses on the annual pretend sale of your PFIC only up to the total amount of prior gains you reported for that PFIC (decreased by losses you were able to claim for that PFIC).

Losses you take on PFICs subject to the MTM rules are ordinary losses. You deduct the MTM losses against ordinary income.

Example: Losses in excess of unreversed inclusions

What happens if you do the pretend sale and you have a loss that exceeds your unreversed inclusions? This is best answered with an example.

Let’s say that you have a MTM loss of $2,000, but you only have $1,000 in unreversed inclusions. You are only permitted to show a $1,000 loss on your tax return, the amount of your unreversed inclusions. You adjust your basis in the PFIC down by $1,000. You also adjust your unreversed inclusions down by $1,000 so that they are now $0, and there are no further MTM losses you can take.

If, in a subsequent year, there is another $500 gain, you would pay tax on that gain and unreversed inclusions would once again increase by $500. A loss in a later year would be deductible up to the $500 unreversed inclusions amount.

G’s example

This brings us to G’s example. He describes a situation where he purchases a PFIC for $15,300 in 2015. The value of the PFIC is $14,500 at the end of 2015. This is a decrease of $800.

G must pretend he is selling the PFIC at the end of 2015. Under the normal tax rules, the sale of this stock would create a capital loss of $800.

Under the MTM rules, you have to first ask “do I have any unreversed inclusions that I can use?”. Only if you have unreversed inclusions can you take the loss.

In G’s example, there are no unreversed inclusions, because he has never previously had a MTM gain for this PFIC.

G does not get to recognize the loss for 2015.

This brings us to G’s first question.

Question 1

G’s first question is what his basis in the PFIC is at the end of 2016. Assuming he has made no sales or purchases during calendar year 2016, he will be looking at year end 2015 to determine his basis for year end 2016.

As a general principle, gain or loss recognition and basis move together. In other words, if you pay tax on a gain associated with an asset, you would expect that your basis in that asset will be increased by the amount of the gain you report. If you deduct a loss associated with an asset, you would expect that your basis in that asset will be decreased by the amount of the loss you report.

Because he could not deduct his loss at the end of 2015, his basis in the PFIC did not decrease.

G’s basis in the PFIC at the end of 2016 is still $15,300, his original purchase price.

Question 2

G’s gain at the end of 2016 is $15,500 (fair market value) – $15,300 (basis) = $200.

Why not recognize the entire $1,000 increase from fair market value at the end of 2015 to fair market value at the end of 2016? Because his basis never adjusted down with the decrease in value that took place in 2015, because the loss was not claimed.

G’s basis going into 2017 is his original cost basis of $15,300 plus the 2016 gain recognized of $200, or $15,500.

Losses upon sale with no unreversed inclusions

Suppose that on December 31, 2015, instead of doing a pretend sale under the MTM rules, G actually sells his PFIC. He would receive $14,500, its fair market value on the date of the sale.

His adjusted basis, or purchase price, is $15,300. He has a loss of $800.

Under the unreversed inclusion rules for pretend MTM sales, G would not get to recognize the loss.

But for losses that arise from real sales, you get a small break: you can deduct the loss under the rules that would normally apply to such assets in the absence of the PFIC rules if there are no unreversed inclusions. In other words, G would get a capital loss.

This is the difference between real and imaginary sales under the MTM rules when you have a loss: unreversed inclusions principles apply for the imaginary annual MTM sales; (mostly) normal tax principles apply for the real sales.

G would get to recognize a short term capital loss of $800 for 2015 if he were to sell the PFIC at the end of the year.

Losses upon sale with unreversed inclusions available

If you do have unreversed inclusions available when you sell your PFIC stock at a loss, you get to claim some or all of the loss against ordinary income, depending on how much unreversed inclusions you have available.

Just for fun, suppose that G has held the MTM fund for a several years and has total unreversed inclusions of $100. He sells it for a loss of $250.

G can claim an ordinary loss of $100, the amount of his unreversed inclusions in the PFIC. He can claim a long term capital loss of $150, the amount of loss upon sale in excess of unreversed inclusions.

Summary

The MTM rules require a pretend sale of your PFIC at the end of every year. The taxation of MTM funds can essentially be reduced to five bullet points:

MTM gains are taxed at ordinary tax rates.
MTM losses (up to available unreversed inclusions) are deducted against ordinary income. MTM losses in excess of unreversed inclusions are not deducted.
Basis adjusts up for gains you pay tax on and down for losses you deduct.
Gains upon sale of a MTM fund are taxed at ordinary tax rates.
Losses upon sale of a MTM fund are deducted against ordinary income (up to available unreversed inclusions) and any loss in excess of unreversed inclusions is taxed as a capital loss.

Send your PFIC questions now

There are tax deadlines approaching, and we all have questions we need answered: those little bothersome queries you just don’t know the answers to that wake you from a dead sleep at 4 am.

Send me your PFIC-related questions and I may feature your question in a newsletter and provide a detailed response. Just hit “reply” to this email and your response will be sent directly to me.

Thank you

Thank you for reading. You may not rely on this publication as advice. Hire a professional if you need help.

Debra

Greetings from Haoshen Zhong.

Do I report PFICs held in my life insurance policy?

This week’s newsletter topic came by way of a reader I will refer to as Morgan:

In France, the Assurance Vie (life insurance) acts as a tax deferred savings account and is the preferred investment for French residents. The tax practitioners here in France do not have a clear understanding as to whether their US citizen, French resident clients need to report their life insurance investments as PFICs.

I will assume that France has a set of laws governing life insurance that define what life insurance means under French law, and that the taxpayer’s life insurance satisfies the French definition.

Morgan’s question requires us to answer 2 separate questions:

Is the life insurance itself a PFIC?
Does the taxpayer look through the life insurance to report the underlying investments?

PFIC definition

Internal Revenue Code section 1297(a) defines a passive foreign investment company (PFIC) as “any foreign corporation if [it meets an income test or an asset test]”. IRC §1297(a).

To own a PFIC, a taxpayer must first own shares in a foreign corporation. If what the taxpayer owns is not shares of a foreign corporation, then he does not own a PFIC.

But the fact that the policy is life insurance under foreign law is not the end of the story. Treasury Regulation tells us:

The Internal Revenue Code prescribes the classification of various organizations for federal tax purposes. Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal law and does not depend on whether the organization is recognized as an entity under local law. Reg. §301.7701-1(a)(1).

In short, we need to check what the policy is under US tax law. If it is a corporation under US tax law, then it could be a PFIC.

The foreign life insurance is life insurance under US tax law

Code section 7702(a) gives the tax law definition of a life insurance. The definition looks scary, and it is scary if you are not an insurance actuary. You can ignore that definition, because Code section 7702(g)(3) tells us the following:

If any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance contract under subsection (a), such contract shall, notwithstanding such failure, be treated as an insurance contract for purposes of this title. IRC §7702(g)(3).

This tells us that as long as the policy is life insurance under foreign or State law, it is life insurance under US tax law. In fact, the only consequence of failing the definition of life insurance is that the taxpayer may need to pay tax on income from the policy each year. IRC §7702(g)(1).

We assumed Morgan’s policy is life insurance under French law. Hence, we can conclude that the policy is life insurance under US tax law.

The life insurance is not a PFIC

A corporation is a type of business entity, and a business entity is an entity that is “not otherwise subject to special treatment”. Reg. §301.7701-2(a).

A life insurance policy is probably not an entity under US tax law. But even if it is an entity, it would not be a business entity. Code section 7702 lays out what life insurance means and provides special treatment for life insurance. Thus, life insurance is “otherwise subject to special treatment” and therefore not a business entity.

The policy is not a business entity–and therefore not a foreign corporation. The policy itself cannot be a PFIC.

No lookthrough to underlying PFICs

The Internal Revenue Code contains attribution rules. These rules generally say that even if a taxpayer is not the owner of an asset under local law, US tax law would still treat the taxpayer as the owner of the asset. Under attribution rules, it is possible for a taxpayer to be the owner of a PFIC under US tax law.

No attribution from life insurance under PFIC-specific attribution rules

Section 1298(a) gives us attribution rules specifically for PFICs. These include attribution through corporations, partnerships, estates, trusts, and options. IRC §1298(a). These do not include life insurance, and the implementing Regulations do not mention life insurance. See Reg. §1.1298-1T. The PFIC attribution rules do not directly require attribution through life insurance.

The life insurance should not be treated as a securities account

One argument for attribution is that these policies should be treated as securities accounts. These policies differ from securities accounts in 3 ways:

They do not give the investor direct access to the underlying investments.
They are specifically classified as life insurance under US tax law.
They transform income from investments into ordinary income, even if the underlying investments would have returned long-term capital gains or qualified dividends.

These differences suggest that these policies should be treated differently than accounts. The taxpayer should not look through to the underlying investments merely because securities account holders look through the accounts.

No importation of constructive ownership rules

Another argument argument is that PFIC rules import constructive ownership under section 318. These are generic attribution rules for corporations that the Code and the Regulations generously import into other rules related to corporations.

Section 318, by its own terms, applies to “this subchapter”, meaning sections 301 to 391 of the Internal Revenue Code. PFIC rules are in sections 1291 to 1298. By section 318’s own terms, its constructive ownership rules do not apply to PFICs.

Neither Congress nor the IRS is shy about directly referencing constructive ownership or section 318 when it wishes to import constructive ownership rules. See e.g. IRC §958(b); Reg. §§1.6038-2(c), 1.6046-1(i). By contrast, none of the PFIC rules reference constructive ownership or section 318. IRC §1298(a); Reg. §1.1298-1T. Our conclusion is that the PFIC attribution rules do not import the section 318 ownership rules. The IRS more or less said as much:

When Congress intends constructive ownership rules to apply, it will expressly so state. TAM 200733024.

We can be reasonably confident that the taxpayer does not have to look through his life insurance to any underlying PFICs.

No need to report PFICs held in life insurance

The policy itself is not a PFIC, because it is not a foreign corporation.

The taxpayer does not need to look through the policy, because there is no attribution through life insurance under PFIC attribution rules.

The taxpayer whose life insurance invests in PFICs is safe from PFIC reporting and tax rules, provided that the policy is life insurance under foreign law.

Update: Is the foreign life insurance really the foreign equivalent of US life insurance?

I have received some feedback on how assurance vie works, specifically that it is not analogous to the US life insurance.

This is directed to what life insurance means in the US outside the context of tax. And insurance requires “risk shifting” and “risk distribution”. These concepts are explained most in depth in relation to captive insurance rather than life insurance (see Rev. Rul. 2002-89, 90, 91). Life insurance simply means that the insurance insures the risk of death.

The feedback indicates that assurance vie does not insure the risk of death at all: Its payout is tied strictly to the performance of its investment.

Which means the assurance vie would not be a life insurance under US tax law. But it is important to note that the reason it fails is because it does not insure the risk of death. The fact that it has investment features is not determinative.

Thank you

Thank you for tuning in to our PFIC newsletter. Please send us any PFIC questions you have by clicking “reply” to this message.

Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Hi from Debra Rudd.

PFIC distributions and Net Investment Income Tax

Today I’m going to talk about a question I’ve received from a few different people. This particular version of the question comes from reader X:

Does the Net Investment Income Tax apply to the entire distribution I receive from my PFIC? Since some of the distribution is not included in income, I have heard many people say that a portion of the distribution should not be subject to the Net Investment Income Tax. Do you know how this works?

X’s question can be answered by addressing the following three separate questions:

What is the Net Investment Income Tax?
How are PFIC distributions taxed, and what does X mean when he says a portion of the PFIC distribution is not included in income?
How does the IRS apply the Net Investment Income Tax to PFIC distributions?

What is the Net Investment Income Tax?

The Net Investment Income Tax, or NIIT, became effective in January 2013 as part of the Affordable Care Act. It applies to taxpayers with Modified Adjusted Gross Income high enough to trigger the requirement (and there are different thresholds for different filer types). For our purposes, let’s ignore the term “Modified Adjusted Gross Income” and just assume that the NIIT does in fact apply to X.

NIIT is a 3.8% tax that is applied to your net investment income in addition to any other income tax that applies.

“Net investment income” means income items like interest, dividends, capital gains, rental and royalty income (and etc.), minus certain deductions.

The IRS has a web page that describes how this works in a little more detail.

The question X wants to answer is: How does the NIIT get applied to PFIC distributions?

How PFIC distributions are taxed

First, let us examine what X means when he says that a portion of the PFIC distribution is not included in income, which requires a basic understanding of how PFIC distributions are taxed.

I will assume that X has not made any PFIC elections, so he is operating under the default excess distribution rules of IRC §1291.

When you receive a distribution from a PFIC, and your PFIC is taxed under the default rules, the very first thing you do is ignore the usual rule under IRC §301 that says that your distribution is either a dividend, a return of capital, or a capital gain (or some combination of those)

Instead, you must figure out: What portion of the distribution is an “excess distribution” under IRC §1291?

The amount you calculate to be the excess distribution is subject to a particularly harsh set of rules with very high tax rates and interest charges; the remainder of the distribution follows the normal rules of section 301.

Excess distributions: what are they?

I am not going to go into detail about how to calculate excess distributions in this post. If you would like to read about that, visit a previous post that dealt with that topic in detail.

For our purposes, just assume that of the total distribution X received, some portion of it is excess distribution and some portion of it is non-excess distribution.

The non-excess portion of the distribution is subject to the normal section 301 rule: it is either dividend, return of capital, or capital gain. The excess portion of the distribution is taxed in a special way.

Excess distributions: how are they taxed?

Once you have computed your excess distribution, you have to allocate the excess distribution over each day of your holding period, ending with the date of the distribution.

You then assign each day to one of the following periods, and add up the amount of excess distribution allocated to each period. The amounts allocated to each period are taxed as follows:

Pre-PFIC period: ordinary tax rates.
Prior years PFIC period: maximum individual tax rate for each year in the period plus a daily compounded interest charge.
Current year: ordinary tax rates.

The important piece of information to take away from this is that your excess distribution is allocated to different time periods, and the amounts allocated to those different time periods are taxed in different ways.

Excess distributions: amounts “not included in income”

The excess distribution allocated to the prior years’ PFIC period is subject to a special tax and interest calculation.

That special calculation involves dividing the amount allocated to the prior years’ PFIC period up by tax year, applying maximum individual tax rates to the amount allocated to each year, and applying an interest charge to the tax computed for each year.

Because X is computing the tax and interest directly on the prior years’ PFIC period, those changes do not get included in his income on his tax return. Instead, it is added directly into the tax X pays on page 2 of his Form 1040.

The amount allocated to the current year, however, is included in income, and X pays tax on it at his marginal rate.

X’s question was whether the NIIT applies to the amount allocated to the prior years’ PFIC period, because that amount is not included in income.

This is not an unreasonable question. After all, section 1411 (the Code section that imposes NIIT) specifically defines net investment income to be the sum of certain types of gross income and net gain.

NIIT on PFIC distributions

The Treasury Regulations say something different, however.

For purposes of computing NIIT, ignore all of the computations just discussed for the PFIC distribution. You still do those computations, and the PFIC is still taxed the way I described above, but that doesn’t matter for NIIT.

Instead, the NIIT is applied to amounts that constitute dividends under IRC §316. Regs. §§1.1411-4(a)(1)(i) and 1.1411-10(c)(1)(ii).

IRC §316 says that a distribution is a dividend if it is paid out of current or accumulated E&P.

X simply has to look at the total distribution he received for the year and determine whether any or all of the distribution was paid from current or accumulated E&P. If the answer is “yes”, that amount is a dividend for NIIT purposes and must be included in the NIIT calculation.

If any portion of the dividend for NIIT purposes is not included in income and therefore does not auto-populate on Form 8960 (where NIIT is calculated) in the software he is using, X should use line 6 of Form 8960 to make an adjustment so that NIIT will be computed correctly.

The NIIT regulations do not make any special provisions for the portion of an excess distribution that is not included in income, which tells us that Congress did not intend for us to be able to exclude a portion of the distribution from NIIT based on the theory that its tax was computed outside the normal tax rules.

Indeed, the Form 8960 Instructions indicate that if there is an amount that was not included in your taxable income from a PFIC but should be subject to NIIT, then you are responsible for making the manual adjustment so that NIIT does include the correct amount.

Recap: NIIT for PFIC distributions

When determining whether NIIT applies to your PFIC distribution, ignore all the PFIC computations you are required to do for Form 8621. You still do those computations, and you still file Form 8621 and pay the tax and interest, but that does not determine the NIIT you pay.

Simply look at whether the entire distribution or any portion of it constitutes a distribution from current or accumulated E&P and would be taxed as a dividend if not for the PFIC rules; if so, that amount is subject to NIIT.

Thank you

As always, thank you for reading. You absolutely should not rely on this as advice; make sure to hire a professional if you need help.

Debra

Hi from Debra Rudd.

PFIC deemed sale gains and Net Investment Income Tax

I received the following question from reader S after writing about the Net Investment Income Tax in the context of PFIC distributions:

Along the same lines, if you were doing a deemed sale to remove the PFIC taint, would the gain from the sale still be subject to the NIIT? It’s not an actual sale as nothing was sold, but the taxpayer does get an uplift in basis for the deemed sale. I’m thinking it would be, but would appreciate your opinion.

I think S is right about this.

In today’s newsletter, I will first talk about what the Net Investment Income Tax is. Next, I will take a look at what the regulations say about how to apply the NIIT to PFIC gains, and lastly, I will try to answer S’s question about NIIT in the context of gains that arise from a deemed sale.

What is the Net Investment Income Tax?

The Net Investment Income Tax, or NIIT, became effective in January 2013 as part of the Affordable Care Act. It applies to taxpayers with Modified Adjusted Gross Income high enough to trigger the requirement (and there are different thresholds for different filer types). For our purposes, let us ignore the term “Modified Adjusted Gross Income” and just assume that the NIIT does in fact apply in the scenario S is describing.

NIIT is a 3.8% tax that is applied to your net investment income in addition to any other income tax that applies.

“Net investment income” means income items like interest, dividends, capital gains, rental and royalty income (and etc.), minus certain deductions.

The IRS has a web page that describes how this works in a little more detail.

How to apply NIIT to PFIC gains

The Treasury wrote a rule for how to apply NIIT to gains from PFICs:

Gains treated as excess distributions under section 1291(a)(2) are included in determining net gain attributable to the disposition of property for purposes of section 1411(c)(1)(A)(iii) and § 1.1411-4(a)(1)(iii). Regs. §1.1411-10(c)(2)(i).

When you have a gain on the disposition of a PFIC, the entire gain is treated as an excess distribution according to section 1291(a)(2), which means the entire gain is included in your net gain from disposition of property for NIIT purposes.

It works the same way for gains on pretend sales

That is easy enough for a real sale where you exchange PFIC stock for money. What about gains from pretend sales?

There are at least a couple different situations in which a taxpayer will have to recognize gain from the pretend sale of a PFIC. One is the situation S mentioned, where you make a deemed sale as a purging election to remove the PFIC treatment. There are others, too.

In all deemed sale situations, you are pretending that you sold the PFIC and reporting the gain (if any) on the sale, but you receive no sale proceeds and you retain ownership of the PFIC stock.

For NIIT purposes, a gain from a deemed sale would work the same way that a gain from a real sale would. Look at the language of Regs. §1.1411-10(c)(2)(i): “Gains treated as excess distributions” are subject to NIIT.

Both gains from real sales and gains from deemed sales are treated as excess distributions. The regulations do not make any exception to the rule for deemed sales. We should infer that the gain from a deemed sale is subject to NIIT in the same way that a gain from a real sale is subject to NIIT.

You get the basis adjustment, after all

When you make a deemed sale of a PFIC to purge the PFIC status, you get to adjust your basis in the PFIC up by the amount of the gain you report.

Pretend you buy a PFIC for $10, make a deemed sale when it is worth $20, and then later sell it for $40. When you sell it for $40 you are reporting a $20 gain.

Applying NIIT to the gain from the deemed sale is consistent with getting an increase in basis.

What about losses on a deemed sale?

S did not ask about this, but it is an interesting question, so I will talk about it anyway. :)

The NIIT rule for PFIC gains is relatively simple. The gain from any sale, real or pretend, is subject to NIIT.

Losses from a deemed sale, however, are not always recognizable. For example, when you are making the deemed sale as part of a purging election, no losses are allowed. That means you do not report a loss on your tax return, and your basis in the PFIC stock does not adjust down for the deemed sale loss.

My guess would be that you would not include a PFIC loss in the NIIT computation when you do not get to recognize that loss and you do not get a basis adjustment for that loss.

In a situation where you have a loss on a deemed sale for purposes other than purging elections (for example, if you are a covered expatriate who has to pretend you are selling your worldwide assets), you do get to recognize the loss on the sale. Again, this is just a guess, but I would guess that in those situations you would get to include the loss in your NIIT computation.

Summary

Gains from the sale or deemed sale of a PFIC are always subject to NIIT.

For losses, it is most likely the case that you have to look at the specific rule that governs whether you can recognize the loss or not — if yes, include it in your NIIT computation. If no, do not include it in your NIIT computation.

Thank you

Thank you for reading. I will see you in two weeks with another exciting edition of PFICs Only.

Oh, and… You would be crazy to rely on this as advice. So please, do yourself a favor and hire someone competent before making any life and/or tax decisions.

Debra

Greetings from Haoshen Zhong.

What happens when you set up an IP licensing subsidiary

This week’s newsletter topic comes from a previous client’s question:

I own 40% of a BVI corporation, and a nonresident alien owns the other 60%. The BVI corporation owns an operating corporation in country X that runs a website which makes money from subscriptions for web services. We are thinking of setting up a 2nd subsidiary in the Cayman Islands to hold IPs (software copyright, trademarks, domain name) and license them to the operating subsidiary, so we can generate an expense for the operating subsidiary. Will the IP subsidiary be a PFIC?

Actually, the first questions that come to my mind are not about passive foreign investment companies (PFICs). Rather, I would first ask:

Are the licensing royalties deductible in country X? (anti base erosion rules)
Do the deductions cause the operating subsidiary to lose key treaty benefits? (limitation on benefits clauses)
Is the nonresident alien shareholder going to be subject to adverse tax rules in his home country? (their version of controlled foreign corporation, or CFC, rules)
Are there transfer pricing issues with the royalties?

But for the moment, we are only interested in PFICs, and specifically whether the IP subsidiary is a PFIC. Today, I will only analyze the income test and the asset test for the IP subsidiary.

Let us make the assumption that the operating subsidiary’s income is entirely nonpassive–that seems correct, given that it runs a website that sells subscription for the website’s services, and we will not dig deeper.

Definition of a PFIC

A foreign corporation is classified as a passive foreign investment company (PFIC) if it meets either 1 of 2 tests:

Income test: At least 75% of its income is passive income
Asset test: At least 50% of its assets produce passive income or are held for the production of passive income

If a foreign corporation meets either the income test or the asset test, then it is a PFIC.

Being a foreign corporation is a requirement. The IP subsidiary is a foreign corporation. See Reg. §§301.7701-2, -3, -5. So we need to check the income test and the asset test.

Royalties are usually passive income

We start with the income test, because the asset test requires us first to understand what is passive income and what is nonpassive income.

Passive income is any income which would be foreign personal holding company income (as defined in section 954(c)). IRC §1297(b)(1).

Foreign personal holding company income includes royalties. IRC §954(c)(1)(A).

At first glance, the IP subsidiary’s situation is straightforward: Its income consists of royalties. Royalties are foreign personal holding company income, which means they are passive income. The IP subsidiary’s income consists of passive income. It meets the income test. It is a PFIC. QED.

But there are exceptions that can apply to royalty income. Let us take a look at those.

The active business exception does not apply

There is an active business exception for royalties:

Foreign personal holding income shall not include rents and royalties which are derived in the active conduct of a trade or business and which are received from a person other than a related person… IRC §954(c)(2)(A).

There are 2 requirements:

The rent must be derived from the active conduct of a trade or business; and
The payer must not be a related person.

The IP subsidiary is not engaged in an active business in the ordinary sense, but as it happens, active business in this context includes a category that is not normally thought of as an active business:

Royalties [are] derived in the active conduct of a trade or business if [the royalties are derived from licensing] property that the licensor has developed, created, or produced, or has acquired and added substantial value to, but only so long as the licensor is regularly engaged in the development, creation or production of, or in the acquisition and addition of substantial value to, property of such kind… Reg. §1.954-2(d)(1)(i).

Or putting it in another way, if a company regularly develops IP of a similar kind, either because its normal business requires it to develop IP (for example, a pharmaceutical company) or because it is in the business of developing IP (for example, a software developer), then the royalties from licensing the IP is derived from active business.

Here, the IP subsidiary does not develop the IP, nor does it make derivative works or add value once it has been assigned the IP. It is also not the result of any business function the subsidiary performs, such as marketing. The royalties are not from an active business.

The royalties do not fit the active business exception.

But a related person exception applies

There is also a related person exception to royalties:

Except as provided in regulations, the term “passive income” does not include any income […] which is interest, a dividend, or a rent or royalty, which is received or accrued from a related person (within the meaning of section 954(d)(3)) to the extent such income is properly allocable (under regulations prescribed by the Secretary) to income of such related person which is not passive income. IRC §1297(b)(2)(C).

We assumed that the operating subsidiary’s income consisted entirely of nonpassive income, so the royalties the operating subsidiary paid to the IP subsidiary were not allocable to passive income. It remains to ask whether the operating subsidiary is a related person.

Section 954(d)(3) defines related person as follows:

[A] person is a related person with respect to a [foreign corporation] if

[…]

(B) such person is a corporation, partnership, trust, or estate which is controlled by the same person or persons which control the [foreign corporation].

For purposes of the preceding sentence, control means, with respect to a corporation, the ownership, directly or indirectly, of stock possessing more than 50 percent of the total voting power of all classes of stock entitled to vote or of the total value of stock of such corporation. IRC §954(d)(3).

The same BVI parent owns 100% of the shares of both the operating subsidiary and the IP subsidiary. The parent controls both subsidiaries. Therefore, the operating subsidiary is a related person to the IP subsidiary.

The operating subsidiary is a related person to the IP subsidiary, and the operating subsidiary is not using passive income to pay royalties to the IP subsidiary. The royalties are nonpassive under this related person exception. And as far as I am aware, the IRS has not adopted or even proposed regulations that would remove the royalties from the exception.

The royalties are nonpassive income

Despite being what we would normally think of as a classic example of a holding company whose only income is “passive”, the royalties the IP subsidiary collects are nonpassive in the PFIC context. This is because it collects royalties from a related person–its sister company the operating subsidiary–, and the operating subsidiary has not used passive income to pay the royalties. As a result, the subsidiary is not a PFIC under the income test.

The IP subsidiary probably does not meet the asset test

We turn to the asset test, because satisfying either the income test or the asset test would make the IP subsidiary a PFIC.

The IP subsidiary owns 2 types of assets: cash and IP. Cash is a passive asset. Notice 88-22. For the IP subsidiary to avoid being a PFIC under the asset test, its IP must be nonpassive, and the IP must be more valuable than the cash.

The guidance for whether the IP is a passive asset is not as clear.

Passive assets are assets “which produce passive income or are held for the production of passive income”. IRC §1297(a)(2).

The IPs currently produce nonpassive income–royalties. And the subsidiary was formed to license the IP to the parent, so the subsidiary was assigned the IP so that the IP can produce nonpassive income.

But it is plausible to argue that the IP is held for the production of gains, because it can be sold for a gain later. Gains from the disposition of property that produces royalties are passive income. IRC §954(c)(1)(B)(i). There is no exception for properties that produce nonpassive royalties. See Reg. §1.954-2(e).

Fortunately, the IRS appears to not favor this argument:

Generally, intangible assets that produce identifiable amounts of income, such as patents and licenses, will be characterized on the basis of the income derived from the intangible assets. Notice 88-22.

This treatment is essentially consistent with how IP is valued: Patents and copyrights are valued more or less solely by the income they are expected to generate, whether through implementation in a product or through licenses, so any gain from the sale of a patent or copyright is simply the present value of the remaining–and diminishing–future income. Trademarks are trickier, but we will rely on the IRS’s word and classify the trademarks by the income they generate as well.

The IP subsidiary’s IPs generate nonpassive income–specifically licensing royalties from a related party–, so they are classified as nonpassive assets.

A check the box election may be appropriate

The purpose of the IP subsidiary is to generate a deductible expense for the operating subsidiary in country X. From country X’s point of view, it is likely not relevant whether US tax law says the IP licensor is the parent or the IP subsidiary.

A Cayman limited company can elect its US tax classification. It may be prudent to make a check the box election for the IP subsidiary to make it a disregarded entity. This would make the IP subsidiary something other than a corporation, which in turn means it cannot be a PFIC.

Thank you

Thank you for tuning in to our PFIC newsletter. Please send us any PFIC questions you have by clicking “reply” to this message.

Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Greetings from Haoshen Zhong.

Do I have to annually report PFICs held in a UK pension scheme?

This week’s newsletter topic came by way of a reader I will refer to as Vic:

We see a lot of UK employer funded pension schemes are heavily invested in PFICs – most UK pension schemes fall into this category. Does the US-UK income tax treaty protect the employee from annual filing requirements related to the PFIC investments?

For this newsletter, I assume that the employee is a US citizen who works in the UK, who is a resident of the UK under the US-UK income tax treaty, and who has an approved pension scheme under UK law that his employer funded for work he performed in the UK.

The PFIC annual reporting requirements

In general, if a US person owns a PFIC, he has annual reporting requirements even if he has no income from the PFIC. IRC §1298(f). The IRS has authority to adopt waivers of the reporting requirement. More details on the requirements and the waivers are found in Reg. §1.1298-1T.

Background on pensions: They are also trusts

When looking for rules that apply to pensions, it is also useful to look for rules related to trusts. This is because the US generally considers pensions to be trusts: A settlor (the employer) transfers property to a trustee (the pension manager) for the purpose of protecting it (for retirement) for a beneficiary (the employee) under rules similar to those imposed on trustees. Reg. §301.7701-4(a).

US pension rules are considered similar enough to trustee rules that US pensions and IRAs are trusts. IRC §§401(a), 408(a). The IRS generally takes the same view of foreign pensions, and this is perfectly reasonable for a UK pension: A UK pension scheme is a trust under UK law.

When pension specific rules do not exist in the Code or the Regulations, we also turn to trust rules to supplement them. The rules related to foreign trusts are found in Reg. §1.1298-1T(b)(3)(ii) and (iii).

Section 1.1298-1T(b)(3)(ii) refers to a foreign trust where a US person is treated as the owner. Section 1.1298-1T(b)(3)(iii) refers to a foreign trust where a US beneficiary is treated as the indirect owner of a PFIC owner by reason of PFIC attribution rules only. It is necessary to decide which applies to the UK pension in question.

The employee is not the owner of the pension

When tax law refers to a person as the owner of a trust, it means that the person is taxed as if he owned the assets in the trust. IRC §671. These trusts are known as grantor trusts.

In general, an employee will not be treated as the owner of an employees’ trust if employee contributions are incidental compared to employer contributions. Reg. §1.402(b)-1(b)(6). In Vic’s scenario, the pensions are employer funded, so there is no employee contribution. The employee is not the owner of the pension.

This means we do not use Reg. §1.1298-1T(b)(3)(ii). We use (iii). The result is ironic, because (ii) refers to pensions and treaties specifically, while (iii) does not mention either at all.

No specific mention of treaty interaction

Parsing through section 1.1298-1T(b)(3)(iii) tells us this: If all the following conditions are satisfied, then a US person does not have to file Form 8621 annually to report a PFIC held in a foreign trust:

The US person is an indirect owner of a PFIC
He is an indirect owner only because he is a beneficiary of a foreign trust that directly or indirectly owns the PFIC
No special election has been made for the PFIC
The US person is not treated as having received an excess distribution from the PFIC or as having a gain treated as an excess distribution from the PFIC

If all 4 conditions are met, then the US person does not have to file Form 8621.

It is very likely that the UK pension scheme has received distributions from a PFIC during any given year, has sold at least 1 PFIC for a gain during the year, or both. It is very likely that, without a treaty, the US employee would have excess distribution or gain attributed to him in any given year. This means the UK pension fails condition 4. Reg. §1.1291-1T(b)(8)(iii)(C). The result is that he would have to file Form 8621 annually.

For this newsletter, let us take it as an article of faith that the US-UK income tax treaty protects a US citizen from US taxes on the UK pension’s income until the UK pension is actually distributed. This is not true of every treaty–in fact, almost all US income tax treaties contain a “saving clause” that permits the US to tax a US citizen’s pension’s income, even when the pension has not distributed the income.

The US does not get to tax the income because of the treaty, but it is not clear whether the treaty also protects the employee from having to file information returns. The Regulations do not specifically say.

Our position: No tax means no reporting requirement

We prefer to divine IRS’s intention by reading the purpose of the law.

For this purpose, it is useful to turn back to section 1.1298-1T(b)(3)(ii) and see what the IRS said when an employee is treated as the owner of a foreign pension itself under trust rules (rather than just the owner of PFICs in the pension).

Section 1.1298-1T(b)(3)(ii) says: If all of the following conditions are satisfied, then a US person does not have to file Form 8621 annually to report a PFIC held in a foreign trust:

The US person is treated as the owner of a foreign trust
The foreign trust is a foreign pension fund or primarily exists to provide retirement benefits
Under a treaty, the US cannot tax the pension’s income to the employee until the pension distributes the income to the employee

This does not apply directly to the employee who has an employer funded pension scheme in the UK, because he is not treated as the owner of the pension scheme. But consider this: When a person is treated as the owner of a foreign trust, he is taxed on all income from the foreign trust as if he owned the assets directly. The Regulation says that even when the US citizen is taxed on all trust assets without a treaty, if a treaty protects the US person from US taxes, then he does not need to report the PFIC in the trust annually. It would be bizarre to turn around and say that when a person is not treated as the owner of a foreign trust, then he must report the PFIC held in the trust even when the treaty protects him from US taxes.

Based on this reasoning, we prefer to say that if a treaty protects a US person from being taxed on PFICs held in his pension, he has no annual reporting requirement for PFICs in the pension.

Take this position at your own risk

The alternative way to understand the IRS intention is that section 1.1298-1T(b)(3)(ii) is simply a way to avoid duplicative reporting requirements. When a US person is treated as the owner of a foreign trust, he must either ensure that the trustee files Form 3520-A annually to report the trust’s income or file a substitute Form 3520-A himself.

Form 3520-A contains a section that report’s trust’s income under US income tax rules, which would also report PFIC income. Because the IRS expects Form 3520-A to report the information, it is not useful to also require the taxpayer to report the information on Form 8621 when the US cannot tax the income at all.

We think this interpretation is incorrect, because the IRS requires the same duplicative information reporting if there is no treaty, even when there is no income to report.

This is just how we prefer to interpret the juxtaposition of the 2 rules. The IRS has not made it clear whether our preferred interpretation is correct or incorrect. You will have to make a decision on whether to incur the cost of reporting.

Summary

There is no clear guidance on whether there is annual reporting requirements for PFICs held in a pension, when a US income tax treaty protects the employee from US tax on the pension’s income until the pension is distributed.

So it is not clear whether the US citizen with an employer funded UK pension scheme has annual reporting requirements for the PFICs in the pension.

Our practice is to not file Form 8621 annually.

Thank you

Thank you for tuning in to our PFIC newsletter. Please send us any PFIC questions you have by clicking “reply” to this message.

Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Greetings from Haoshen Zhong.

Do I have to report PFICs held in an employer matching pension?

This week’s newsletter is a question we get frequently:

I have a US citizen client who is living and working in Hong Kong. The employer provides a retirement plan where the employee contributes, and the employer matches some percent of the employee contributions. The retirement plan invests in a foreign mutual fund. If the retirement plan has income from the mutual fund, does the employee have to report the income as income from a PFIC?

There are 2 possible scenarios:

The retirement plan is a nonqualified plan
The retirement plan meets all requirements to be a qualified plan under US tax law, except that it is foreign rather than domestic.

Today’s newsletter will only deal with scenario 1: nonqualified plans. The next newsletter will deal with scenario 2: foreign plans that meet all qualifications to be a qualified plan, except that they are foreign rather than domestic.

Why is the mutual fund a PFIC?

A passive foreign investment company (PFIC) is a foreign corporation where 75% or more of its income is passive income, or 50% or more of its assets are assets that produce passive income. IRC §1297(a). These are known as the income test and the asset test.

Some mutual funds are not organized as corporations, but they are nevertheless classified as foreign corporations. I addressed this in a previous post in the context of unit trusts, but the reasoning is generally true: Mutual funds are organized for investment purposes, so they are business entities. When they are organized outside the US, they are foreign business entities. They are usually organized so that the investors do not have personal liability for the debts of the mutual fund, so they are by default foreign corporations for US tax law.

Passive income includes income such as dividends, interest, rent, royalties, and gains from the sale of property that produce dividends, interests, etc. IRC §§1297(b), 954(c). Mutual funds’ income consists almost entirely of dividends, interest, and gains, and their assets produce these types of income.

Because mutual funds are foreign corporations under US tax law that receive almost all passive income and hold almost all passive assets, they are PFICs.

Retirement plans are subject to trust lookthrough rules

If you look at the Code sections that provide for US based retirement arrangements (§§401, 402, 408, 408A), you will see that the sections refer to qualified retirement plans, 401(k)s, IRAs, etc as trusts. See IRC §§401(a), 402(b), 408(a), 408A.

This is not surprising, when you consider what a trust is under tax law: A grantor (the employer, employee, or both) gives property (cash for retirement funds) to a trustee (the account manager) to protect or conserve (for retirement) for a beneficiary (the employee) under rules applied to fiduciaries (ERISA and analogous foreign pension laws). Reg. §301.7701-4(a).

Because retirement plans are also trusts, we also look at trust rules when deciding whether PFIC lookthrough occurs.

Primer on grantor and nongrantor trusts

When you read rules related to trusts, you will frequently see the terms grantor trust and nongrantor trust.

A grantor trust is a trust where someone (typically the grantor) is taxed on the income of the trust, regardless of whether the trust makes a distribution. The person who is taxed on the income of the trust is referred to as the owner of the trust.

A nongrantor trust is a trust where the trust itself pays tax on undistributed income. If the trust distributes income, then the income is passed to the recipient. A nongrantor trust does not have an owner under income tax rules.

These terms are not defined in the Code or the regulations, but they are spread throughout the Code, the regulations, and tax practice, and are used under these meanings. They appear under the PFIC lookthrough rules.

PFIC lookthrough for nonqualified plans

A retirement plan that does not meet all qualifications of section 401(a) is a nonqualified plan. A nonqualified plan can be a grantor trust or nongrantor trust, depending on whether employee contributions are incidental to employer contributions. Reg. §1.402(b)-1(b)(6).

For PFIC lookthrough purposes, there is actually no difference between a nonqualified plan that is a grantor trust and one that is a nongrantor trust. The employee must look through the plan and report PFIC income, and here is why.

PFIC lookthrough for nonqualified plans that are grantor trusts

For grantor trusts, the regulation tells us clearly that the employee must look through to the underlying PFICs:

If a foreign or domestic trust directly or indirectly owns stock, a person that is treated under sections 671 through 679 as the owner of any portion of the trust that holds an interest in the stock is considered to own the interest in the stock held by that portion of the trust. Reg. §1.1291-1T(b)(8)(iii)(D).

This result is entirely unsurprising: In general, if the retirement plan is a grantor trust, then the employee must report the plan’s income as his own. There is no deferral in general for grantor trusts. You would not expect any deferral for PFICs held in the nonqualified plan that is a grantor trust either.

PFIC lookthrough for nonqualified plans that are nongrantor trusts

For nongrantor trusts, the regulations also tell us that the employee must look through to the underlying PFICs:

If a foreign or domestic estate or nongrantor trust (other than an employees’ trust described in section 401(a) that is exempt from tax under section 501(a)) directly or indirectly owns stock, each beneficiary of the estate or trust is considered to own a proportionate amount of such stock. Reg. §1.1291-1T(b)(8)(iii)(C).

“An employees’ trust described in section 401(a) that is exempt from tax under section 501(a)” is a long-winded way of saying a qualified plan.

What this regulation tells us is that other than for qualified plans, a beneficiary must look through a nongrantor trust. Because we are talking about nonqualified plans, the employee must look through the plan.

The implications of the lookthrough rule in practice

Section 401(a) contains 37 subparagraphs, laying out in detail what Congress thought a plan must satisfy to be a qualified plan. IRC §401(a). These criteria reflect the decisions of the US Congress. They do not reflect some fundamental understanding of what a fair retirement plan must satisfy.

Similar to Congress, the legislatures of most other countries laid out their own list of criteria that retirement plans in their country must satisfy. The result of these competing and complex requirements is that it is essentially impossible for a foreign retirement plan to be a qualified plan by coincidence. Unless a US citizen is working abroad for a multinational corporation, and he is specifically placed in a retirement plan designed for US citizens abroad, his retirement plan is almost certainly a nonqualified plan.

Through a combination of mandatory pension laws, collective bargaining, and industry practice, many US citizens who live and work abroad have foreign retirement plans. Like US retirement plans, the foreign retirement plan managers invest in assets such as mutual funds and government bonds as safe options.

Because these plans are almost certainly nonqualified plans, and the mutual funds are almost certainly PFICs, the US citizen must report income from the mutual funds held in their foreign retirement plans on an ongoing basis.

Summary

If a nonqualified foreign retirement plan invests in a PFIC, look through to the PFIC and tax PFIC income to the employee in the year the plan receives PFIC income.

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Haoshen

Greetings from Haoshen Zhong.

Do I have to report PFICs held in an employer matching pension?

This week’s newsletter is a question we get frequently:

I have a US citizen client who is living and working in Hong Kong. The employer provides a retirement plan where the employee contributes, and the employer matches some percent of the employee contributions. The retirement plan invests in a foreign mutual fund. If the retirement plan has income from the mutual fund, does the employee have to report the income as income from a PFIC?

There are 2 possible scenarios:

The retirement plan is a nonqualified plan
The retirement plan meets all requirements to be a qualified plan under US tax law, except that it is foreign rather than domestic.

Our last post dealt with scenario 1: nonqualified plans. This post deals with scenario 2: foreign plans that meet all qualifications to be a qualified plan, except that it is foreign rather than domestic.

Why is the mutual fund a PFIC?

Because mutual funds are foreign corporations that receive almost all passive income and hold almost all passive assets, they are PFICs.

Retirement plans are subject to trust lookthrough rules

We tend to not think of our retirement plans as trusts, but the classification is not surprising when you consider how a trust is defined under tax law: A grantor (the employer, employee, or both) gives property (cash for retirement funds) to a trustee (the account manager) to protect or conserve (for retirement) for a beneficiary (the employee) under rules applied to fiduciaries (ERISA and analogous foreign pension laws). Reg. §301.7701-4(a).

Because retirement plans are also trusts, we also look at trust rules when deciding whether PFIC lookthrough occurs.

Primer on grantor and nongrantor trusts

When you read rules related to trusts, you will frequently see the terms grantor trust and nongrantor trust.

These terms are not defined in the Code or the regulations, but they are spread throughout the Code, the regulations, and tax practice and are used under these meanings. These terms also appear under PFIC lookthrough rules.

A qualified plan is a nongrantor trust, because the employee is not taxed as the owner of the plan’s income until the income is distributed to the employee.

No PFIC lookthrough for domestic qualified plans

This is the language of the lookthrough rule for nongrantor trusts:

If a foreign or domestic estate or nongrantor trust (other than an employees’ trust described in section 401(a) that is exempt from tax under section 501(a)) directly or indirectly owns stock, each beneficiary of the estate or trust is considered to own a proportionate amount of such stock. Reg. §1.1291-1T(b)(8)(iii)(C).

“An employees’ trust described in section 401(a) that is exempt from tax under section 501(a)” is just a long-winded way of saying a qualified plan.

The regulation does not directly state what happens when you have a qualified plan, but the negative implication is obvious: If a PFIC is in a qualified plan, there is no lookthrough.

So if there is a PFIC inside a domestic qualified plan such as a domestic 401(k), the employee does not have to look through to the PFIC.

The statutory and regulatory language are not clear for foreign plans that meet qualifications

If you look in section 401(a) to find out what “described in section 401(a)” means, you will see the words “a trust created or organized in the United States…”. IRC §401(a). By incorporating 401(a), Regulation section 1.1291-1T(b)(8)(iii)(C) seems to have dealt with domestic qualified plan only. It does not specifically say what happens with a foreign plan that meets all qualifications.

This is what the Internal Revenue Code says about foreign plans that meet all qualifications in general:

For purposes of subsections (a), (b), and (c), [a plan] which would qualify for exemption from tax under section 501(a) except for the fact that it is a trust created or organized outside the United States shall be treated as if it were a trust exempt from tax under section 501(a). IRC §402(d).

A foreign plan that meets all qualifications of a qualified plan is treated as a trust that is exempt from tax under section 501(a) for the narrow purposes of subsections (a), (b), and (c) of section 402. By the Code section’s own terms, there is no benefit for PFIC rules: The PFIC rules are not part of section 402.

The PFIC regulations carve out an exception to lookthrough only for “an employees’ trust described in section 401(a) that is exempt from tax under section 501(a)”. If we read the Code literally, even if a foreign plan meets all qualifications, it is not a “trust described in section 401(a)” generally–only for certain limited purposes.

Read literally, a foreign plan that meets all qualifications is still not a qualified plan, and the employee still must look through to underlying PFICs.

Our take: No lookthrough for foreign plans that meet qualifications

I prefer take the position that the language involved is an example of drafting error, and there is no lookthrough for a foreign plan that meets all qualifications of a qualified plan. Why? A few choice quotes indicating the intent of the retirement plan rules and PFIC rules:

The intent and purpose of section 402(d) is to give those employees […] essentially the same tax treatment as those covered by trusts described in section 401(a) and exempt under section 501(a)… Reg. §1.402(d)-1(a).

The IRS thinks the point of 402(d) is that if a plan meets all qualifications, then the tax results should not depend on where the plan is organized. It would be odd to then interpret PFIC rules to require an employee to look through a foreign plan but not a domestic plan.

Since current taxation generally is required for passive investments in the United States, Congress did not believe that U.S. persons who invest in passive assets should avoid the economic equivalent of current taxation merely because they invest in those assets indirectly through a foreign corporation. JCS-10-87, 1023.

The Joint Committee on Taxation tell us why Congress enacted the PFIC provisions: The US wants to tax either the investment vehicle or the investor on current income. If a US person invests through a foreign corporation, the US cannot tax current income: It can only tax income when it is repatriated to the US person. The PFIC rules eliminate the economic incentive for investing through the foreign corporation.

When you have a retirement plan, the investor is the retirement plan. As long as a retirement plan meets all the qualifications in section 401(a), the US exempts the plan’s income from tax. This is true whether the plan is domestic or foreign. Because the US does not tax the plan’s income at all, there is no incentive for the plan to defer tax by investing in foreign corporations. Therefore, it does not make sense to apply PFIC rules to the plan, regardless of whether it is domestic or foreign.

Based on the legislative intent behind the retirement plan and PFIC rules, I prefer to think that a person who has a foreign plan that meets all qualifications to be a qualified plan does not have to look through the plan to underlying PFICs. In other words, put a domestic qualified plan and a foreign plan that meets all qualifications on the same level, as Congress intended.

An extra warning and disclaimer

This post is based on my interpretation of how the legislative intent between different pieces of tax law interact. The IRS has not provided specific guidance on the subject through regulations, revenue rulings, notices, or even internal memoranda that became public. You should take a careful look at the issue yourself before deciding what to do with the PFICs held inside the foreign retirement plan.

Summary

If a foreign retirement plan meets all qualifications to be a qualified plan–except that it is not organized in the US–the rules are not clear. I prefer to advise clients that there is no PFIC lookthrough.

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Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Greetings from Haoshen Zhong.

Do I have to report PFICs held in an employer matching pension?

This week’s newsletter is a question we get frequently:

I have a US citizen client who is living and working in country X. Country X has an income tax treaty with the US. The employer provides a retirement plan where the employee contributes, and the employer matches some percent of the employee contributions. The retirement plan invests in a foreign mutual fund. If the retirement plan has income from the mutual fund, does the employee have to report the income as income from a PFIC?

Our last 2 posts addressed 2 scenarios where the plan was established in Hong Kong, a jurisdiction that does not have an income tax treaty with the US (the US-China income tax treaty does not apply to Hong Kong, because Hong Kong is not subject to the PRC’s tax law. See US-China income tax treaty, art. 3.1(a)). Today’s post looks at what happens when the retirement plan is established in a treaty country.

Why is the mutual fund a PFIC?

Because mutual funds are foreign corporations that receive almost all passive income and hold almost all passive assets, they are PFICs.

Retirement plans are subject to trust lookthrough rules

If you look at the Code sections that provide for US based retirement arrangements (§§401, 402, 408, 408A), you will see that the sections refer to qualified retirement plans–401(k)s, IRAs, etc–as trusts. See IRC §§401(a), 402(b), 408(a), 408A.

We tend to not think of our retirement plans as trusts but the classification is not surprising when you consider how a trust is defined under tax law: A grantor (the employer, employee, or both) gives property (cash for retirement funds) to a trustee (the account manager) to protect or conserve (for retirement) for a beneficiary (the employee) under rules applied to fiduciaries (ERISA and analogous foreign pension laws). Reg. §301.7701-4(a).

Because retirement plans are also trusts, we also look at trust rules for PFICs when deciding whether PFIC lookthrough occurs.

The trust lookthrough rules under the US internal laws are straightforward: A beneficiary must look through the trust and take into account the trust’s PFIC income, unless the trust is a qualified retirement plan under section 401(a). Reg. §1.1291-1T(b)(8)(iii). I have covered these plans in more detail in previous posts. The short version is that under US internal laws, the employee almost certainly must look through a foreign pension to take into account income from PFICs held in the pension on an annual basis, because it is unlikely that the foreign pension is a qualified plan.

You need to look at each treaty separately

Regulations sections 1.1291-1 and 1.1291-1T provide rules for when to look through a trust (or a retirement plan that is treated as a trust) to the underlying PFICs. These regulations do not mention treaties or conventions at all.

This leaves us with a situation where the Code and the regulations do not provide us with guidance. We have to look at the treaties themselves to determine what the benefits are for PFICs held in retirement plans.

Since we addressed Hong Kong in the last 2 posts, let us move out of the peninsula and into mainland China for one example of how pensions are treated under a treaty. For contrast, we will also look at the treaty with Germany, which has a different tax result.

No treaty benefits under the US-China treaty

If you look at the treaty between the US and China, you will see pension related benefits in Articles 17 and 18. These articles do not address the taxation of the income of a pension at all, so they do not modify how and when the US and China tax the income of a pension to the employee for whom the pension was established.

This result is unsurprising: The US-China treaty was signed in 1984 and modified by protocols in 1986, and the provisions of the treaty were limited to what the countries cared to address at the time.

In 1986, China did not have an individual income tax, so the US did not care to negotiate a provision about when China can tax the income of a pension to the employee-beneficiary.

In 1986, China did not have funded pensions–all Chinese pensions were simply contractual rights to receive pension payments from the former employer; the employer did not set aside a pool of funds to invest and pay the pension payments. Under these types of non-funded pensions, there was no “income of a pension” at all. It should not be surprising that China did not care to negotiate a provision about when the US can tax the income of a pension to the employee-beneficiary.

The US-China income tax treaty confers no benefits for PFICs held inside a retirement plan. The lookthrough rules are the same as if there were no treaty: The employee must look through the pension to take into account income from PFICs held in the pension on an annual basis.

The US-Germany treaty protects the US citizen employee–for the right type of pensions

The US-Germany income tax treaty is rather messy to read. It was originally signed in 1989, but a protocol adopted in 2006 overhauled many of the treaty provisions. It is in the 2006 protocol that pension-related treaty benefits are found.

The US-Germany treaty provides relief to US citizens with employer funded pensions in Germany

You can find the treaty benefit provisions in Article IX of the 2006 protocol, which adds an Article 18A to the treaty. I will use the treaty article number, 18A, in this newsletter.

Specifically, under Article 18A.5(bb) of the treaty, as amended by the protocol, the following criteria must be true for the US to not tax the income of the pension to the US citizen employee-beneficiary annually:

The US citizen was a German tax resident at the time of employment.
The US citizen was employed in Germany when the pension was funded.
The US citizen’s income was taxable in Germany.
The employer was a German tax resident (individual, corporate, or otherwise) or a German permanent establishment.
The US citizen is a beneficiary of a pension established in Germany.

In our scenario, our US citizen is living and working in Germany. I assume he is working for a German resident employer, and that employer established a German pension. He meets the basic requirements for treaty relief.

The pension needs to be the right type of pension

Article 18A.5(d) of the treaty says that the pension benefits do not apply unless “the competent authority of the United States has agreed that the pension plan generally corresponds to a pension established in the United States”.

The Treasury Department’s technical explanation of the protocol tells us what type of German pensions the US has agreed generally correspond to a pension established in the US: “retirement benefit plans under section 1 of the German law on employment related pensions (Betriebsrentengesetz)”. US-Germany income tax treaty 2006 protocol technical explanation, 29.

Section 1 of the Betriebsrentengesetz generally describes a plan that an employer agrees to sponsor. There are probably significantly more details than just that, but let us assume for the purpose of this post that the German employer in question conscientiously followed all the rules and established a proper pension described in section 1 of the Betriebsrentengesetz

Our hypothetical employee’s pension is the right type of pension to qualify for treaty benefits.

The conflict between the PFIC rules and the treaty should resolve in favor of the treaty

The Internal Revenue Code and the regulations require lookthrough of a trust without an exception for treaties. The US-German income tax treaty purports to protect a US citizen from US tax on the income of the pension until the pension is distributed. How do we resolve the conflict between the internal US laws and the treaty?

The rule of thumb is that treaties are given the same weight as Congressional statutes. Usually, they follow a “last-in-time” rule, meaning whichever was last passed controls. See e.g. Whitney vs Robertson, 124 US 190 (1888). Code sections 1291 and 1298 were enacted in 1986. PL 99-514, §1235(a); 100 Stat 2566, 2573. This was well before the 2006 protocol to the US-German income tax treaty. The treaty should control.

Be careful about saving clauses

Almost all US treaties contain a clause that the Treasury Department describes as a “saving clause”. The saving clause generally says that if you are a US citizen, you cannot use the treaty benefits against the US. Usually, the saving clause is found toward the end of Article 1 of the treaty, but it can be hidden elsewhere.

The saving clause is usually followed by a list of exceptions to the saving clause. If a treaty benefit falls under one of these exceptions, then a US citizen may be able to use the benefit against the US. Fortunately, Article 18A.5, which provides relief to a US citizen with a German pension, is one of the exceptions to the saving clause. US-Germany income tax treaty art. 1.5(a). The US citizen employee-beneficiary of the German pension can use the treaty benefit.

In many other treaties, the article providing benefits regarding pension income is subject to the saving clause, so the treaty is not useful for US citizens.

Summary

The PFIC rules in the Code and regulations do not specifically override or defer to income tax treaties. You will need to examine the benefits under each treaty closely to see if the treaty protects the US citizen from having to look through the retirement plan to the underlying PFIC investments.

Thank you

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Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Greetings from Haoshen Zhong.

Do I create a PFIC problem during corporate reorganizations?

This week’s newsletter is a case study of one of our clients. His situation is more or less as follows:

The client is a US citizen. He holds a minority stake in a private equity fund. All other stakeholders are foreigners. The private equity fund created multiple holding companies in the European Union. Each holding company owns all shares in an operating company in the EU and has only a negligible amount of cash to meet maintenance costs. One of the holding companies liquidates its wholly-owned subsidiary for a large gain. Does the large gain cause the holding company to become a PFIC in the year of liquidation?

I will go into more detail about why the large gain is a potential issue for the holding company later in this post, but the short version is this: The gain may be considered passive income. If the holding company has too much passive income in the year of liquidation, it would become a PFIC.

Assumptions

I will make a few assumptions to make this post simpler:

The private equity fund, all holding companies, and all operating subsidiaries are foreign corporations under US tax law.
Each operating subsidiary has mostly nonpassive income and mostly nonpassive assets, so none of the operating subsidiaries is a PFIC.
The private equity fund and all holding companies have only negligible amounts of cash compared to the assets of the operating subsidiary.

Definition of a PFIC

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

Income test: At least 75% of the corporation’s income is passive income.
Assets test: At least 50% of the corporation’s assets are passive assets.

We assumed that each operating subsidiary has mostly nonpassive income and mostly nonpassive assets, so none of the operating subsidiaries is a PFIC. But what about the private equity fund and the holding companies? Dividends certainly seem like passive income, and stocks certainly seem like passive assets.

Lookthrough rule saves the private equity fund and holding companies from being PFICs before the year of liquidation

Generally, dividends are passive income, and stocks are passive assets. IRC §§1297(b)(1), 954(c)(1)(A).

But when a foreign corporation owns (directly or indirectly through a subsidiary) at least 25% of the value of the stock of another corporation (foreign or domestic), a lookthrough rule applies: The foreign corporation will be treated as if it directly received its proportionate share of the income of the subsidiary corporation and as if it directly held its proportionate share of the assets of the subsidiary corporation. IRC §1297(c).

Here, each holding company owns 100% of the shares of 1 operating subsidiary. Using the lookthrough rule, each holding company is treated as if it directly received its proportionate share of the income of its operating subsidiary and as if it directly held its proportionate share of the assets of its operating subsidiary. We assumed that all operating subsidiaries have mostly nonpassive income and mostly nonpassive assets. In turn, this means all holding companies have mostly nonpassive income and mostly nonpassive assets. This means the holding companies are not PFICs.

The private equity fund owns 100% of each holding company. In turn, the private equity fund indirectly owns 100% of each operating subsidiary. Using the lookthrough rule, the private equity fund is treated as if it directly received all income from all operating subsidiaries and owned all assets from all operating subsidiaries. We assumed that all operating subsidiaries have mostly nonpassive income and mostly nonpassive assets. In turn, this means the private equity fund has mostly nonpassive income and mostly nonpasive assets. This means the private equity fund is not a PFIC.

The risk in the year of liquidation

Gain from the sale of assets that produce dividends is passive income. IRC §954(c)(1)(B)(i). This is true even if the dividends themselves are nonpassive income. Reg. §1.954-2(e)(2)(i). In the year of liquidation, it is possible for the holding company whose operating subsidiary is liquidated to have a large influx of passive income that makes it a PFIC.

Use of the lookthrough rule to avoid PFIC status when liquidating a subsidiary

There is no regulation, revenue ruling, or even notice about the IRS’s stance on what happens when a wholly-owned subsidiary is liquidated. But private letter rulings suggest that the IRS liberally uses the 25% lookthrough rule to avoid classifying a holding company as a PFIC merely because it liquidated a subsidiary. PLRs 200604020, 200813036.

A quote from PLR 200813036:

[T]he Service addressed the application of the income and asset tests of Code section 1297(a) to the disposition of look-through stock, ruling that it is considered a disposition of the foreign corporation’s proportionate share of the assets of the look-through subsidiary and of those subsidiaries with respect to which the foreign corporation owns (by value) at least 25 percent. Based on the intent of Congress in crafting the special rule applicable to look-through subsidiaries, the Service continues to believe that this is the correct approach.

The IRS believes that when a holding company liquidates a wholly-owned subsidiary, it is as of the holding company directly sold the assets of the subsidiary, because this is most consistent with the intent behind the lookthrugh rule.

But keep in mind that even if an asset does not produce passive income and is not a passive asset, the gain from the disposition of the asset may still be passive income. IRC §954(c)(1)(B). It will be necessary to look at the character of the gain from a deemed sale of the operating subsidiary’s assets to see if there is a sufficiently high percentage of passive income to make it a PFIC.

The holding company should be liquidated in the same year

Under the lookthrough rule, in the year of liquidation, it is as if the holding company sold the assets of the operating subsidiary directly. Therefore, the holding company will not be a PFIC under the income test.

But after liquidating the subsidiary, it is likely that the holding company will have substantial cash in its assets. This may cause the holding company to become a PFIC under the asset test.

To avoid this result, it is recommended that the holding company be liquidated in the same year as its subsidiary. If liquidation is not feasible, there are 2 alternative options:

Distribute cash to its shareholder (in this case the private equity) as a dividend, so it has little cash remaining; or
Make an election to change its US tax classification from a corporation to a disregarded entity. Reg. 301.7701-3(g)(1)(iii). This option is only available to corporations that are not classified as “per se” corporations, so it is not always possible. Reg. §301.7701-2(b)(8).

It would be a shame if an active business became a PFIC merely because the holding company held too much cash in the year of liquidation, so definitely plan on dealing with the “too much cash” problem.

Summary

When a foreign holding company owns 100% of the shares of a foreign subsidiary, for PFIC purposes, the holding company is treated as if it directly received the subsidiary’s income and directly held the subsidiary’s assets.

If the holding company liquidates the subsidiary, it is as if the holding company directly sold the assets of the subsidiary.

Depending on what the assets of the subsidiary are, it is possible that the gain from the sale will be nonpassive (or will be mostly nonpassive). Even if the holding company liquidates the subsidiary, it will not become a PFIC in the year of liquidation merely because of gains from the liquidation.

Thank you

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Haoshen

Greetings from Haoshen Zhong.

Have I received a distribution if a PFIC reinvests a dividend?

This week’s newsletter came by way of a CPA I will call GW.

if a dividend from a PFIC is not paid to the holder of the PFIC, but is reinvested in the fund, does this constitute a ‘distribution’ for the purposes of the excess distribution section 1291 rules under the Code?

I haven’t been able to find anything to confirm whether the doctrine of constructive receipt applies, or whether Section 1291 applies only to distributions actually paid out to the shareholder of a fund which is, for U.S. tax purposes, classed as a PFIC.

As GW noted, the question of whether the taxpayer has “constructively” received the dividend, even though he did not receive any cash, is the problem we are trying to solve.

Background on PFICs and assumptions

Certain types of foreign corporations (as defined under US tax law) are classified as passive foreign investment companies (PFICs). IRC §1297(a). Shareholders of these PFICs must use special rules related to the PFICs.

There are 3 ways the shareholder of a PFIC can be taxed:

The default rules under section 1291;
The mark-to-market (MTM) rules; and
The qualified electing fund (QEF) rules

Both the MTM rules and the QEF rules require the shareholder to make an election. IRC §§1293-1296. Under these rules, the shareholder is taxed on “income” from the PFIC, even when there is no distribution or sale. We will assume that neither of these elections apply, so we are using the default rules.

Default rules for taxing PFIC distributions

When the shareholder of a PFIC receives a “distribution in respect of stock” from a PFIC, he must apply a set of complicated rule to calculate the tax on the distribution. IRC §1291(a), (c). I will not go into detail about what these rules are, except to note that they do not address reinvested dividends specifically.

Introduction to constructive receipt

Generally, a taxpayer reports income on either a cash receipts method or an accrual method. IRC §446(c).

By default, a taxpayer includes income in the year in which he received the income (cash receipts method). But if he keeps books that records income when he earns it, then he may include income when he earns it (accrual method). IRC §451(a).

Let us assume that the shareholder in GW’s question is an individual. An individual who runs a sole proprietorship might keep books for that sole proprietorship on an accrual method, but he almost certainly does not keep books of his personal life on an accrual basis. Therefore, we can be reasonably safe in assuming that the individual uses the cash method: He reports income when he receives the income.

But even if the shareholder uses the cash method, he can “constructively receive” income before he actually receives income:

Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. Reg. §1.451-2(a).

This more or less says, “If you can take the income for yourself at any time, then you must include the income even if you had not actually received it in hand”. In our case, the PFIC declared a dividend for the shareholder, but it did not actually distribute the dividend. Rather, it reinvested the dividend.

Is this sufficiently credited to his account, set apart for him, or otherwise made available to him to have been constructively received?

There is no getting around examining the PFIC’s organizing documents

I am not aware of any material that directly addresses the question of reinvested dividends in the PFIC context, so we will have to do some extrapolation by analogy.

The IRS has described a few examples of constructive receipts in the context of dividends in general (Reg. §1.451-2(b)):

Generally, the amount of dividends or interest credited on savings banks deposits or to shareholders of organizations such as building and loan associations or cooperative banks is income to the depositors or shareholders for the taxable year when credited…

However, if any such portion of such dividends is not subject to withdrawal at the time credited, such portion is not constructively received and does not constitute income to the depositor or shareholder until the taxable year in which the portion may be withdrawn…

Accrued interest on unwithdrawn insurance policy dividends is gross income to the taxpayer for the first taxable year during which such interest may be withdrawn by him…

In the absence of guidance specific to PFICs, we should assume that the normal rules of constructive receipt apply. In general, it is safe to apply the rules of constructive receipt, because the rules permit the IRS to collect taxes sooner–and the IRS likes to collect taxes now rather than later.

I do not know how the PFIC that GW’s client owns is organized, but from most organizing documents I have seen, the investors in the PFIC are limited in when they can withdraw their investments in the PFIC. I have seen unit trusts that do not permit withdrawal until the investment period of 5 years is over, even though the unit trust issues annual financial statements that declare dividends and reinvest them. I have also seen mutual funds that permit dividend withdrawals annually.

The withdrawal window for dividends is when the PFIC first makes distribution for US income tax purposes. And there is no general rule for when that withdrawal window is: The PFIC’s organizing documents contain the rules for when withdrawals are permitted, and the withdrawal window determines when income must be included.

tl;dr

The normal constructive receipt rules for when a taxpayer receives a distribution apply to PFIC distributions.

Each PFIC has rules about when an investor can withdraw dividends. This withdrawal window may or may not be annual, and it may or may not occur every time dividends are reinvested into the PFIC. You will need to check the PFIC’s rules for when that withdrawal window occurs.

That withdrawal window is when the taxpayer receives a distribution for PFIC purposes.

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Haoshen

Greetings from Haoshen Zhong.

Is my personal service company a PFIC?

This week’s newsletter topic came by way of a CPA I will call SL.

I have a client who is a US citizen and a physician, running a practice through a Canadian corporation. She owns 50% of the shares of the corporation, and her brother owns the other 50%. Her brother is a Canadian citizen and a nonresident alien. The corporation earns all its income from medical services. It owns some chairs, computers, medical implements, etc, but most of its assets are cash. The individual doctors’ goodwill constitute a very small portion of the worth of the corporation. Is this a PFIC?

In this newsletter, we will take a look at how the income and and assets of the medical practice is classified to determine whether the practice is a PFIC, despite obviously being an active business.

Definition of a PFIC

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

Income test: At least 75% of the corporation’s income is passive income.
Asset test: At least 50% of the corporation’s assets are passive assets.

A Canadian corporation is a foreign corporation, because it is not organized in the US, under US laws, or under a US state law. IRC §7701(a)(4). Therefore, if this Canadian corporation meets either the income test or the asset test, then it is a PFIC.

Income test: Watch for personal service income

Almost all income of this Canadian corporation is from medical services, so it would certainly seem that the corporation does not meet the income test. But unfortunately, the way passive income is defined makes it possible that this type of personal service company has passive income.

Passive income is “any income of a kind which would be foreign personal holding company income as defined in section 954(c)”. IRC §1297(b)(1). As it happens, foreign personal holding company income includes the following:

(H) Personal service contracts

(i) Amounts received under a contract under which the corporation is to furnish personal services if–

(I) some person other than the corporation has the right to designate (by name or by description) the individual who is to perform the services, or
(II) the individual who is to perform the services is designated (by name or by description) in the contract, and
(ii) amounts received from the sale or other disposition of such a contract.
This subparagraph shall apply with respect to amounts received for services under a particular contract only if at some time during the taxable year 20 percent or more in value of the outstanding stock of the corporation is owned, directly or indirectly, by or for the individual who has performed, is to perform, or may be designated (by name or description) as the one to perform, such services. IRC §954(c)(1)(H).

This is a very unexpected and unfortunate result of Congress choosing to define passive income by reference to foreign personal holding company income, because the foreign personal holding company income rules exist to prevent deferral of US tax using a foreign corporation, not convert active business income to passive income. Certainly payment for personal services would normally be considered income from an active business.

But Congress chose to define passive income in a way that includes income from personal service contracts. Here, the US doctor and the Canadian doctor both own more than 20% of the shares of the Canadian corporation. Thus, if the service contracts designates a doctor, or the patient has the right to designate the doctor, then the service income would be passive income.

We do not actually know the terms under which this corporation provides services. For many types of medical services, the patient-doctor relationship is a deeply personal one, so the corporation may not be permitted to change the doctor without the patient’s consent. Canadian law may have something to say on this subject, but I do not know what that is.

Without knowing how Canadian law governs contracts for medical services and without knowing how this corporation writes its medical service contracts, it is difficult to say if the income from medical services is passive income. But we should be mindful that it is possible for the income of this practice to be passive income–despite the fact that the medical practice is obviously an active business.

Asset test: Look at the leased equipment

Passive assets are those that produce passive income or are held for the production of passive income. IRC §1297(a)(2).

Cash is a passive asset. Notice 88-22; 1988-1 CB 489. This is not surprising, because cash only produces interest, and interest is a type of passive income. IRC §954(c)(1)(A). We are told that the chairs, computers, medical implements, and goodwill that the corporation owns are worth very little compared to its cash, so it seems that the corporation has more than 50% passive assets.

There is one potential way out of meeting the asset test:

Any tangible personal property with respect to which a foreign corporation is the lessee under a lease with a term of at least 12 months shall be treated as an asset actually held by such corporation. IRC §1297(d)(1).

This rule might provide the practice with a way out of the asset test, because some medical practices lease very expensive equipment.

The amount that the leased asset is worth is “the unamortized portion (as determined under regulations prescribed by the Secretary) of the present value of the payments under the lease for the use of such property”. IRC §1298(d)(2)(A). The discount interest rate is the applicable federal rate that would be in effect for a loan of the same duration as the least term. IRC §1298(d)(2)(B).

What this more or less says is to do the following for a lease of a physical item for which the total lease term is at least 12 months:

Take the payments that have yet to be paid under the lease.
Calculate the present value of the payments by discounting them using the applicable federal rate at the time, as if the lease were a loan.
The present value is the value of the leased asset.

If this corporation leases a significant quantity of expensive medical equipment, then it is possible that the value of the leased equipment would be greater than the cash it has in reserve. There is some potential that this corporation does not in fact meet the asset test.

tl;dr

For a personal service company, look at the company’s contracts. If the contracts designate the employee who will perform services, or if the client can designate the employee, then the personal service income is actually passive income.

Leased equipment contributes to the value of the nonpassive assets. For a corporation that leases a significant quantity of equipment, it can be worth valuing the equipment to see if the corporation can avoid becoming a PFIC under the asset test, even if it holds a lot of cash.

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Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Greetings from Haoshen Zhong.

Shortcuts for determining PFIC status

This week’s newsletter topic is a question we get quite often:

I have a large number of investments in foreign funds and companies. Is there any way to tell whether they are PFICs without checking their income and assets?

In this newsletter, I will talk about the shortcuts we use to determine PFIC status when we encounter a client with a lot of different foreign investments.

Definition of a PFIC

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

Income test: At least 75% of the corporation’s income is passive income.
Asset test: At least 50% of the corporation’s assets are passive assets.

This is a highly mechanical test: If the foreign corporation meets either the income test or the asset test, then it is a PFIC. Technically, there is no shortcut, but in the interest of being reasonably accurate and saving costs for the client, we do employ a number of shortcuts in practice.

Mutual funds and exchange traded funds (ETFs)

Mutual funds and exchange traded funds (ETFs) nearly always meet both the income test and the asset test, so all we check is whether they are foreign corporations. This is defined strictly by whether they are organized in the US. IRC §7701(a)(4).

If the fund has an international securities identification number (ISIN) assigned to it, then it is easy: If the ISIN begins with “US”, then it is a fund that is organized in the US and therefore cannot be a PFIC. If the ISIN does not begin with the US, then it is probably a PFIC–assuming you do not have information to indicate otherwise.

If the fund does not have an ISIN, then we look at the fund’s organizing documents. If the entity is organized under US law, then it is a US entity and cannot be a PFIC. Otherwise, it is a foreign entity and most likely a PFIC.

Check for a PFIC annual information statement

There is a special election that a shareholder in a PFIC can make called a qualifying electing fund (QEF) election. See IRC §§1293-1295.

One of the requirements for making a QEF election is that the shareholder must receive a PFIC annual information statement from the PFIC. Reg. §1.1295-1(g)(1).

Check the investor relations page for the company in question. If it has a PFIC annual information statement from a recent year, then it was a PFIC that year. The client may or may not be able to make a QEF election this year. And even if the client can make the QEF election, it may not be a good idea to do so. Debra has written about the QEF election in a previous post.

Check the SEC disclosures

The SEC disclosure rules require a company that is registered with the SEC to disclose investment risks.

Being classified as a PFIC is considered an investment risk for US persons, because PFICs are subject to extremely punitive tax rules compared to investments in a normal company (especially if the company were in a treaty country). As a result, publicly traded companies in the US disclose the risks of being classified as a PFIC in their SEC filings.

You can check the SEC filing for a company to see if it is a PFIC. Alternatively, the SEC filing may give reasons for why it is not a PFIC. If it does not mention PFICs at all, then the assumption is that it is not a PFIC.

Check the financial statements

This is for companies in which the client has significant investments and for which we can obtain financial statements, but for which we cannot obtain additional details.

An active business–manufacturing, software, service, etc–is very unlikely to meet the income test. But it is possible. For example, suppose you have a manufacturer whose sales revenue is equal to the cost of goods sold. Then the gross income of the manufacturer from sales of inventory is actually 0. Suppose it also has some interest income. Then it will have gross income that is all passive income, making the company satisfy the income test.

For this reason, we check the P&L statement of the company to make sure it is not a PFIC under the income test..

The balance sheet of the financial statement is much less useful for the asset test than the P&L statement is for the income test. This is because the asset test uses fair market value of the company’s assets. An active business has many assets that have nonzero value but do not appear on the balance sheet: patents, copyright, trademarks, trade secrets, goodwill, etc.

For this reason, for an active business, we only check the balance sheet for an enormous disparity between passive assets and nonpassive assets. If the passive assets on the balance sheet exceeds the nonpassive assets by a significant margin, then we assume the company meets the asset test. Otherwise, we assume the nonpassive assets that do not appear on the balance sheet are valuable enough that the company does not meet the asset test.

Real estate companies

This is the most difficult type of company to classify, because real estate can produce either passive or nonpassive income.

If the company merely leases out real estate, then the income is passive. IRC §§1297(b)(1); 954(c)(1)(A). The real estate itself is held for the production of passive income.

If the company actively manages its real estate–for example, by arranging leases, maintaining the building, renovating for new tenants, etc–, then the rent is nonpassive income. IRC §954(c)(2)(A). The real estate itself is held for the production of nonpassive income.

And if a company leases out real estate to a related company, then the rent may or may not be passive income. IRC §1297(b)(2)(C).

A real estate company can very easily have a mix of these businesses: An office building where it arranges for tenants and rearranges offices for the new tenant; a residential complex where it is the management company; and a warehouse where it merely collects rent. The result is a company whose assets and income are not readily classified into passive and nonpassive categories.

We have had the misfortune of trying to classify such a company only once–at least when the client’s holdings were of significant value. We ended up going through the company’s financial statement to find out what subsidiaries it owned, what buildings it owned, whether they were self-managed or tenant managed, etc.

Guess based on what the company does

When all else fails, we make educated guesses: We Google the company in question and see what it does. If it is an active business, then we assume it is not a PFIC. If it looks like an investment entity, then we assume it is a PFIC.

Thank you

Thank you for tuning in to our PFICs Only newsletter. Please send us any PFIC questions you have by clicking “reply” to this message.

Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Greetings from Haoshen Zhong.

Stapled securities

This week’s newsletter topic is a question that came by way of an email:

I frequently see stapled securities, where one part is a share in a corporation that receives nonpassive income and another is a unit in a unit trust that receives passive income. Is this one share in a corporation or two separate shares in two corporations, one of which is a PFIC?

Today’s post begins with a brief description of stapled securities and proceeds to discuss how they are treated under PFIC rules.

What is a stapled security?

This is a type of security arrangement, where two different securities must be bought together. In one common setup, a unit trust holds rental real estate and receives rental income (passive). An affiliated corporation manages the rental property and receives a management fee (nonpassive). The shares in the corporation and the units in the unit trust are then “stapled” together, so that an investor must always buy one share in the corporation and one unit in the unit trust together.

Definition of a PFIC

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

Income test: At least 75% of the corporation’s income is passive income.
Asset test: At least 50% of the corporation’s assets are passive assets.

Let us take it as an article of faith that the unit trust, if it were to be considered a standalone entity, is a foreign corporation, and that the rental income is passive. If you would like more details on why, I have previously written about why a unit trust, standing by itself, is a PFIC.

A few ways to look at this security

As far as I know, the IRS has not published any guidance on how these securities are treated under PFIC rules. We have a few reasonable interpretations:

You have two separate corporations: the corporation and the unit trust.
The stapled security is a single corporation with two classes of shares: The corporation and the unit trust.
The stapled security is a parent corporation. The corporation and the unit trust are subsidiary corporations.
The stapled security is a trust that holds two separate corporations: the corporation and the unit trust.

The stapled securities should be two separate entities

The Internal Revenue Code and the regulations do contain sections dealing with stapled securities: Code section 269B and regulations section 1.269B-1.

The specific language that tells us how to view the stapled entities is as follows:

(a) General rule. Except as otherwise provided by regulations, for purposes of this title–

(1) if a domestic corporation and foreign corporation are stapled entities, the foreign corporation shall be treated as a domestic corporation.

(2) in applying section 1563, stock in a second corporation which constitutes a stapled interest with respect to stock of a first corporation shall be treated as owned by such first corporation, and

(3) in applying subchapter M for purposes of determining whether any stapled entity is a regulated investment company or a real estate investment trust, all entities which are stapled entities with respect to each other shall be treated as 1 entity. IRC §269B(a).

Without going into too much detail, each of these rules exist to prevent a US corporation from using a stapled foreign corporation to avoid certain tax rules. Section 269B(a)(1) exists to prevent stapled foreign corporations from being useful for avoiding controlled foreign corporation (CFC) rules. Section 269B(a)(2) exists to prevent a US corporation from avoiding controlled group rules. Section 269B(a)(3) exists to prevent a US corporation from receiving real estate investment trust (REIT) benefits when it is actually engaged in a business that is not real estate. Specifically how they do so is beyond the scope of this post.

But the fact that these rules exist at all suggest that normally, two stapled entities are considered separate entities. There is no deemed parent corporation, deemed trust, or other deemed arrangement except as provided by statute or regulations.

But watch for regulations that say otherwise in the future

The statutory results of section 269B is limited to 3 specific contexts. They do not apply to PFICs on their own terms.

But section 269B(b) gives the IRS broad power to consolidate stapled entities to prevent taxpayers from avoiding US taxes. Presumably, the IRS can use these rules to force stapled securities to be treated as one entity for PFIC purposes if it considers the stapled entities arrangement to be an abuse of PFIC rules.

So far, the IRS has not published any regulations to this effect under either the staple security rules or the PFIC rules. In their absence, I would prefer to treat the stapled entities as they are under substantive law: Two separate entities. This means the corporation that is engaged in an active business is a normal corporation. The unit trust that receives passive income and holds passive assets is a PFIC.

Thank you

Thank you for tuning in to our PFICs Only newsletter. Please send us any PFIC questions you have by clicking “reply” to this message.

Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Greetings from Haoshen Zhong.

Shortcuts for determining PFIC status

This week’s newsletter topic is a question from email:

I have a client who owns a 10% stake in a European manufacturing company. There are no other US shareholders. I received a profit and loss statement that shows gross receipts from sales, operating expenses that do not distinguish between direct and indirect expenses, and other income. How do I read this to determine if I have a PFIC?

In this newsletter, I will talk about some of the mechanics of applying the income text and how we get around problems in practice.

Why do we care about the income of the company

To discourage passive investments abroad, the US tax law contains a set of punitive rules for passive foreign investment companies.

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

Income test: At least 75% of the corporation’s gross income is passive income.
Asset test: At least 50% of the corporation’s assets are passive assets.

A foreign corporation is classified as a PFIC if it meets either 1 of these 2 tests. An European company is a foreign corporation, so it is important to know how to read the P&L to check if the company meets the income test.

Direct expenses affect gross income; indirect expenses do not

Direct expenses and indirect expenses are accounting concepts.

Direct expenses, that is expenses that vary directly with changes in the volume of goods produced, is part of cost of goods sold. Raw materials, for example, is a direct expense of manufacturing. An increase in expenses also increases cost of goods sold. In accounting, the gross profits from sales is the revenue from sales minus cost of goods sold.

Indirect expenses are expenses that are incurred for the business as a whole. The salary of a CEO, or example, is an indirect expense. Indirect expenses do not change cost of goods sold and therefore do not affect gross profits.

It matters whether an expense is direct or indirect because of the way the income test is defined. Specifically, a foreign corporation meets the income test if:

75 percent or more of the gross income of such corporation for the taxable year is passive income… IRC §1297(a)(1); (emphasis added).

The PFIC rules do not give a definition of gross income, so we use the normal tax law definition of gross income. For a manufacturing concern:

In manufacturing, merchandising, or mining 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. Reg. §1.61-3(a).

The tax law concept of gross income from manufacturing is very much like the accounting concept of gross profits from manufacturing: Cost of goods sold is subtracted to reduce gross income, but indirect expenses are taken into account after gross income is determined. It is important to segregate direct and indirect expenses to know what the gross income to be used in the income test is.

Based on the question in the email, the European company’s P&L does not tell us what the direct expenses and indirect expenses are, so we do not know what gross income is.

You likely need to get additional data from the company accountant

Let us assume a grossly oversimplified P&L. Let us say that the P&L you received from the company says this:

Gross receipts: €600,000
Operational expenses: €700,000
Operating profit (loss): (€100,000)
Income from investments: €10,000
Net profit: (€90,000)

This P&L does not tell you how the operational expenses are divided: What are the direct expenses that go into cost of goods sold and what are the indirect expenses that do not?

This is a relevant question. Suppose we have cost of goods sold of €600,000 and indirect expenses of €100,000. If the expenses were really divided this way, then we have gross income of €0 from manufacturing and €10,000 from investments. This would mean 100% of the income is passive, making the company a PFIC.

But there is no way to tell what were the cost of goods sold and indirect expenses from this P&L. We would need to get more details from the company accountant.

Help from a foreign professional is likely necessary

The foreign country from which you are getting the more detailed financial statement will have its own customs about labeling different revenue and expenses. False friends and specific jargon terms abound in these statements.

It is very common for us to get a financial statement, then have to ask the company accountant many questions along the lines of “what does this label mean”? It is a display of lack of knowledge we find necessary to properly help the client with his tax returns.

Here is our dark secret: When we really need to be sure, we get GAAP conversions, possibly from a Big Four firm. Getting a GAAP conversion from an expert has other potential uses. FOr example, if a US person just acquired a 10% stake in the company, a GAAP financial statement would be necessary to file Form 5471.

What happens if we have a negative gross profit?

Let us assume a grossly oversimplified P&L. Let us say that the P&L you received from the company says this:

Gross receipts: €600,000
Cost of goods sold: €700,000
Gross profit: (€100,000)
Other operating expenses: €100,000
Income from investments: €10,000
Net profit: (€190,000)

As you can see, the cost of goods sold is higher than gross receipts, so we have a negative gross profit. This is how gross income is calculated under tax law:

Nonpassive income: -100,000 (equal to gross profit)
Passive income: 10,000 (equal to income from investments)
Gross income: 0 (cannot be below 0)

The IRS has not published any official guidance on this subject, but it has addressed the situation in a private letter ruling. Specifically, this corporation does not have any gross income, so it cannot be a PFIC under the income test. PLR 9447016.

This outcome makes sense: Congress passed the PFIC rules to discourage US persons from making passive investments abroad. The rules also prevent US persons from getting out of PFIC treatment by changing the corporation’s business before a large distribution or a sale. The rules are not there to ensnare active businesses. It is expected that the IRS would interpret the income test and asset test liberally in favor of classifying active businesses as non-PFICs.

This does leave a gap: Suppose a manufacturing business has gross receipts equal to cost of goods sold, and it has €10,000 of investment income. This manufacturing business has gross income of €10,000, all of which is passive. It would then become a PFIC.

Thank you

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Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

Greetings from Haoshen Zhong.

Superannuation Newsletter

We are launching a new bi-weekly newsletter dedicated to superannuations, starting Wednesday, October 26, 2016. We will be making posts regularly on its dedicated website (coming soon) weekly on Monday, Wednesdays, and Fridays.

Please sign up for the newsletter at hodgen.com/newsletters to learn how to solve superannuation tax problems, and to receive the announcement that the new website has been launched.

Holding companies

This week’s newsletter topic is from an email from a reader I will call John Smith.

I was wondering if a foreign conglomerate corporation, with investments in various manufacturing industries, which trades in a foreign stock exchange, can be considered a PFIC. An example of a U.S. conglomerate corporation would be G.E. and a foreign one would be Toshiba (in Japan).

John is really talking about the holding company of a multinational business. The holding company owns subsidiaries and joint ventures, each of which is engaged in an active business. This post will talk about a number of rules Congress put in place to mitigate the risk that the holding company would be classified as a PFIC–and therefore subject its US shareholders to punitive tax rules.

PFIC defined

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

Income test: At least 75% of the corporation’s gross income is passive income.
Asset test: At least 50% of the corporation’s assets are passive assets.

A foreign corporation is classified as a PFIC if it meets either of these tests. We will assume that the holding company is a foreign corporation, so if it meets either the income test or the asset test, then it will be classified as a PFIC.

The 25% lookthrough rule prevents the holding company from becoming a PFIC in its day to day operations

Under section 1297(c):

If a foreign corporation owns (directly or indirectly) at least 25 percent (by value) of the stock of another corporation, for purposes of determining whether such foreign corporation is a passive foreign investment company, such corporation shall be treated as if it–

(1) held its proportionate share of the assets of such other corporation, and
(2) receive directly its proportionate share of the income of such other corporation.

What this tells us is that if a foreign holding company owns at least 25% of a subsidiary foreign company, look through the subsidiary to the underlying income and assets.

For a multinational business, the holding company usually owns wholly-owned subsidiaries, more than 90% of the shares of a subsidiary (for countries that require at least 2 shareholders for a company), or 50% of the shares of a joint venture. These companies do invest in minority shares in other companies, but it is rare for the holding company to own less than a 25% stake.

This means the holding company looks through its subsidiaries to the underlying income and assets. Take a parent company with the following wholly-owned subsidiaries:

Subsidiary 1
Gross profits from sales: $1,000,000
Interest: $1,000

Inventory: $4,000,000
Manufacturing equipment: $6,000,000
Cash: $2,000,000

Subsidiary 2
Gross profits from services: $500,000
Interest: $1,000

Cash: $6,000,000

Because both subsidiaries are wholly-owned, you look through both subsidiaries and combine the income and assets when you apply the income and asset tests for PFICs. This would give us a parent company that looks like the following:

Parent
Gross profits from sales: $1,000,000
Gross profits from services: $500,000
Interest: $2,000

Inventory: $4,000,000
Manufacturing equipment: $6,000,000
Cash: $8,000,000

The result is as follows:

Nonpassive income: $1,500,000
Passive income: $2,000

Nonpassive assets: $10,000,000
Passive assets: $8,000,000

This parent company is not a PFIC under either the income test or the asset test.

Intercompany dividends do not present a problem

It is not uncommon for a subsidiary to distribute profits to the holding company in the form of a dividend. Normally, dividends are passive income. IRC §§1297(b)(1), 954(c)(1)(A). The question is whether these dividends are still counted if the holding company looks through the subsidiary to the underlying income and assets.

Similarly, the shares of the subsidiary are technically part of the holding company’s assets. Do these shares count as assets for purposes of the asset test?

It seems that to avoid double counting, the dividends and shares should be ignored. For example, any dividend that a 25% subsidiary distributes to its parent is from income, which under the lookthrough rules would have already been counted as income of the parent at some point. Similarly, counting the shares of the subsidiary as a separate asset would seem to double count the subsidiary’s assets.

Congress seems to be under the impression that dividends and shares of a 25% subsidiary should be ignored, which can be seen it described the law on PFICs. See H. Rpt. 100-1104 at 268.

As a result, a holding company will not become a PFIC because of dividends it receives from a 25% subsidiary.

Liquidation of a subsidiary does not immediately create a PFIC risk

Gain from the sale of stocks is passive income, even if the dividends from the stocks would be nonpassive income. IRC §954(c)(1)(B)(i). If a holding company liquidates or sells a subsidiary in which it owns at least 25% of the shares, does that create passive income?

There is no specific regulation or IRS guidance on this subject, but the IRS is aware that the 25% lookthrough rule exists to prevent a holding company from being classified as a PFIC. The result is for PFIC income test purposes, the IRS’s private letter rulings look at the sale, liquidation, or reorganization of a subsidiary as if the parent sold the underlying assets directly. See PLR 200015028; 200813036.

There is a related change of business rule: Under section 1298(b)(3), a foreign corporation that sells a significant portion of its assets is not a PFIC in the year of sale if all of the following are true:

It was not a PFIC before;
It realizes most of its passive income during the year from selling an active business; and
It is not a PFIC for the next 2 years

Combine this rule with the 25% lookthrough rule for the year a subsidiary is sold, liquidated, or reorganized: The parent’s income would be substantially from the sale (or deemed sale) of the underlying business assets of the liquidated subsidiary. As long as the parent was not a PFIC before, and it will not be a PFIC for the next 2 years, it would not be a PFIC in the year of sale, liquidation, or reorganization.

Thank you

Thank you for tuning in to our PFICs Only newsletter. Please send us any PFIC questions you have by clicking “reply” to this message.

Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

PFIC gifts from a NRA

This week’s newsletter topic is from an email from a reader I will call P.

What is the basis and holding period of a PFIC received from a nonresident alien as a gift?

Today’s post is a sequel to a previous post written by Debra Rudd, in which she discussed the basis and holding period of a PFIC received from a nonresident alien as an inheritance. You can read that scenario here.

PFIC defined

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

Income test: At least 75% of the corporation’s gross income is passive income.
Asset test: At least 50% of the corporation’s assets are passive assets.

Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad.

What is basis, and why do we care?

When you sell property (such as shares in a PFIC), you are taxed on the gain from the transaction. IRC §§61, 1001. The gain from the sale is the amount you received from the sale minus your basis in the property. IRC §1001(a), (b).

You want a high basis (if you can get it) because it reduces the amount of income that is subject to tax from a sale.

The recipient takes over the giver’s adjusted basis

There are no special rules for basis of PFICs received as gifts. Just as with a normal gift, the recipient simply takes over the adjusted basis in the hands of the giver. IRC §1015(a).

Under the normal rules for property received as gift, the recipient can receive an increase in basis for gift taxes paid. IRC §1015(d). However, nonresident noncitizens are not subject to gift tax for transfers of intangible assets (such as shares in a PFIC). IRC §2501(a)(2). This increase in basis rule is unlikely to apply.

The recipient’s holding period starts on the same day as the start of the giver’s holding period

Why do we care about the recipient’s holding period?

The calculation of PFIC taxes relies on the holding period of the taxpayer. Suppose the recipient sells a PFIC share. Tax on the gain is calculated as follows (IRC §1291):

The gain is allocated evenly over the recipient’s entire holding period for the PFIC.
The allocated gain is divided into 3 separate intervals: (a) the pre-PFIC period; (b) the current year; and (c) the prior year PFIC period.
Gain allocated to the pre-PFIC period and current year are included in income and taxed at ordinary rates.
Gain allocated to the prior year PFIC period is taxed at maximum rates and subject to interest charge.

It is important to know the holding period because it is used to determine how much gain is taxed at ordinary rates, how much gain is taxed at maximum rates, and how much interest charge is applied.

The recipient’s holding period starts on the same day as the start of the giver’s holding period

With 3 exceptions, the shareholder’s PFIC holding period is determined “under the general rules of the Code and regulations concerning the holding period of stock”. Prop. Treas. Reg. §.1291-1(h)(1).

The first exception relates to a situation where (1) a nonrecognition transfer where the fair market value of the PFIC is below the shareholder’s adjusted basis, and (2) the shareholder making the transfer would have been required to recognize gain under PFIC rules had FMV been above adjusted basis. Prop. Treas. Reg. §1.1291-6(b)(5).

The first exception does not apply, because nonresident aliens do not treat PFIC shares as PFICs. Reg. §1.1291-9(j)(1). The nonresident alien giver is not subject to PFIC gain recognition rules when he gives away the PFIC shares.

The other 2 exceptions are related to purging elections that a PFIC shareholder can use to stop treating shares of a foreign corporation as PFIC shares. Reg. §§1.1291-9, -10. These do not apply, because the nonresident alien giver never treated treated his shares as PFIC shares. You can read more about these purging elections here.

Under general holding period rules, when a recipient receives an asset by gift, his holding period must include the holding period of the giver. Reg. §1.1223-1(b). The recipient’s holding period starts on the same day as the start of the giver’s holding period.

The tax results are not as bad as you think

Suppose the recipient sells the shares in the PFIC. How does the holding period of the nonresident alien giver factor into the calculation? Recall that tax on the gain is calculated as follows (IRC §1291):

The gain is allocated evenly over the recipient’s entire holding period for the PFIC.
The allocated gain is divided into 3 separate intervals: (a) the pre-PFIC period; (b) the current year; and (c) the prior year PFIC period.
Gain allocated to the pre-PFIC period and current year are included in income and taxed at ordinary rates.
Gain allocated to the prior year PFIC period is taxed at maximum rates and subject to interest charge.

The tax results can be quite different, depending on whether the holding period of the nonresident alien is included in the pre-PFIC period (taxed at ordinary income rates) or the prior year PFIC period (taxed at maximum rates and subject to an interest charge). Fortunately, it is included in the pre-PFIC period. The source of this rule is in regulation section 1.1291-9(j)(1):

A corporation will not be treated as a PFIC with respect to a shareholder for those days included in the shareholder’s holding period when the shareholder, or a person whose holding period of the stock is included in the shareholder’s holding period, was not a United States person within the meaning of section 7701(a)(30). Reg. §1.1291-9(j)(1).

The recipient is required to include the nonresident alien giver’s holding period in the recipient’s holding period. For the interval from the start of the holding period to when the recipient actually received the shares, the recipient does not treat the shares as shares in a PFIC. As a result, the interval from the start of the holding period to the date of the gift is part of the pre-PFIC period.

This yields the following tax results:

The gain allocated to the current year is taxed at ordinary income rates.
The gain allocated to the interval between the start of the holding period and the date of the gift is taxed at ordinary income rates.
The rest of the gain is taxed at maximum rates and subject to an interest charge.

If the recipient sells the shares in the PFIC quickly, the results will be not quite as horrific as in the scenario in which a US person held the PFIC shares the entire time. Most of the gain is taxed at ordinary income rates–almost certainly a worse result than if the nonresident alien sold the shares and gave the US person cash but not as bad as when the US person invests in the PFIC directly.

Thank you

Haoshen

This week’s topic is the first of a series of posts that will talk about how various “wrappers” affect the US taxation of PFICs. The particular topic came by way of email:

I established a Canadian RESP for my child. I will move to the US this year and become a US resident. What can I do with the PFICs inside?

This post will talk about how the US sees the RESP and why there are issues other than PFIC rules that should be of concern. For this post, I am skipping the question about what to do with the PFICs inside and focus on the RESP itself: Are there any US tax issues that might make the RESP itself undesirable?

PFIC defined

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

Income test: At least 75% of the corporation’s gross income is passive income.
Asset test: At least 50% of the corporation’s assets are passive assets.

Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad. Our correspondent is quite right to be concerned about the PFICs inside the RESP. But there is a RESP wrapper around the PFICs. Let us address the wrapper first.

Introduction to RESP

RESP stands for Registered Education Savings Plan. In Canada, is a way to defer tax on savings intended for post-secondary education. This is how it works:

A promoter offers a plan to the public.
A subscriber (the person who wants to set up the plan) contributes cash to the plan to be held by the promoter. These are subscriber contributions.
The promoter helps the subscriber apply for government grants to be contributed to the plan.
The plan makes investments that accumulated income.

The RESP is probably a foreign trust

US tax law has a specific definition of trust:

In general, the term “trust” as used in the Internal Revenue Code refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Reg. §301.7701-4(a)

In the case of the RESP, a settlor (the subscriber) transfers title to property (cash) to a trustee (the promoter) for the purpose of conserving it for the beneficiaries (the intended future students, typically the subscriber’s child).

The RESP custodian is charged with preserving the assets (and possibly making a reasonable return through prudent investments). This is a classic trust relationship, and in fact RESPs are usually organized under Canadian trust law. It is almost certain that they are trusts under US tax law as well.

To be a US trust, US courts must be able to exercise primary administrative supervision over the trust, and US persons must control all substantial decisions of the trust. Reg. §301.7701-7(a). Because the RESP is established in Canada and has a Canadian trustee, both of these conditions are false, so it is not a US trust.

The RESP is most likely a foreign trust.

The RESP is probably a grantor trust

A grantor trust is a term of art not defined anywhere in the Code or the regulations. It just means that the trust’s income is taxed to someone other than the trust itself, as if that someone else owned the trust assets directly. Usually, the someone else is the grantor.

The grantor includes anyone who creates a trust or makes a gratuitous transfer to the trust. Reg. §1.671-2(e)(1). For a RESP, this subscriber is the grantor of the RESP to the extent that he funded the RESP. If the RESP contains grants, the Canadian government is probably also a grantor.

The subscriber is taxed as the owner of the portion of the trust attributed to his transfers, because he has the power to revoke the trust. IRC §676(a). The portion of the trust attributed to the grant is more complicated, but I suspect the subscriber is also taxed as the owner, because he can terminate the RESP and vest all income in himself–the Canadian government cannot terminate the RESP or receive income from the RESP. IRC §678(a).

No special tax provisions

If you examine the definition of a trust closely, you see how wide the trust rules reach. For example, in a pension, the employer (settlor) transfers funds to a custodian (the trustee) to invest for retirement (preserve) for the employee (the beneficiary).

US tax law does generally treat pensions as trusts. But the Internal Revenue Code contains special provisions that distinguish between “employees’ trusts”, “compensatory trusts”, and normal trusts. See e.g. IRC §§401, 402, 672(f)(2)(B). These rules can–though not always–prevent the pension from being taxed like a normal trust. For US and Canada, the treaty also provides significant benefits for RRSP beneficiaries.

Similarly, the Code provides benefits for a Health Savings Account, which prevents a HSA from being treated like a normal trust. IRC §223(d).

No such special provision exists for RESPs, either in the Internal Revenue Code or in the US-Canada income tax treaty.

Tax implications

Because the subscriber is the owner of the entire RESP for US tax purposes, and the RESP is a trust, the subscriber is taxed as if he owned the trust assets directly. IRC 671.

If there are PFICs in the RESP, he has to report income from the PFICs and file Form 8621 as if he owned the PFICs directly. Reg. §1.1291-1T(b)(8)(iii)(D).

In addition, he has to file Form 3520 annually to report his ownership of the trust, and he has to ensure the trust files Form 3520-A (or file a substitute Form 3520-A himself) to report information about the trust. IRC §6048(b). If he creates a RESP, makes a transfer to the RESP, or receives a distribution from the RESP, he has to file Form 3520 as well. IRC §6048(a), (c). The penalty for not meeting these requirements is, at a minimum, $10,000 per year.

Thank you

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Haoshen

The post PFIC Wrapper Miniseries #1: Canadian RESP appeared first on HodgenLaw PC – International Tax.

Do we have a foreign corporation?

Two steps to answer this question

Find out what kind of entity it is under the laws of the foreign jurisdiction

Foreign: Organized outside the US

Corporation: Apply a series of rules in sequence

The investment club does not fall under a special classification

The investment club is not a trust

The investment club is eligible to elect its US tax classification

Default classification without election: corporation

Applying the income and asset tests

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Do we have a foreign corporation?

Two steps to answer this question

Income test and asset test defined:

Passive income

Income test

Asset test

Getting out of the PFIC treatment

QEF election

MTM election

Partnership election

Summary

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How do losses affect MTM basis and gain recognition?

What is a PFIC?

How are PFICs taxed?

MTM election generally

Losses and “unreversed inclusions”

Example: Losses in excess of unreversed inclusions

G’s example

Question 1

Question 2

Losses upon sale with no unreversed inclusions

Losses upon sale with unreversed inclusions available

Summary

Send your PFIC questions now

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Do I report PFICs held in my life insurance policy?

PFIC definition

The foreign life insurance is life insurance under US tax law

The life insurance is not a PFIC

No lookthrough to underlying PFICs

No attribution from life insurance under PFIC-specific attribution rules

The life insurance should not be treated as a securities account

No importation of constructive ownership rules

No need to report PFICs held in life insurance

Update: Is the foreign life insurance really the foreign equivalent of US life insurance?

Thank you

PFIC distributions and Net Investment Income Tax

What is the Net Investment Income Tax?

How PFIC distributions are taxed​

Excess distributions: what are they?

Excess distributions: how are they taxed?

Excess distributions: amounts “not included in income”​

NIIT on PFIC distributions​

Recap: NIIT for PFIC distributions​

Thank you

PFIC deemed sale gains and Net Investment Income Tax

What is the Net Investment Income Tax?​

How to apply NIIT to PFIC gains​

It works the same way for gains on pretend sales

You get the basis adjustment, after all

What about losses on a deemed sale?

Summary

Thank you

What happens when you set up an IP licensing subsidiary

Definition of a PFIC

Royalties are usually passive income

The active business exception does not apply

But a related person exception applies

The royalties are nonpassive income

The IP subsidiary probably does not meet the asset test

A check the box election may be appropriate

Thank you

Do I have to annually report PFICs held in a UK pension scheme?

The PFIC annual reporting requirements

Background on pensions: They are also trusts

The employee is not the owner of the pension

No specific mention of treaty interaction

Our position: No tax means no reporting requirement

How PFIC distributions are taxed

Excess distributions: amounts “not included in income”

NIIT on PFIC distributions

Recap: NIIT for PFIC distributions

What is the Net Investment Income Tax?

How to apply NIIT to PFIC gains