This week’s topic is the second of a series of posts that will talk about how various “wrappers” affect the US taxation of PFICs. The last post discussed Canadian RESP.

This post discusses a participating life insurance policy I have seen in China and Southeast Asia. It is called a participating life insurance because the policy contains a cash value that is tied to returns on investments made using the premiums–in this way, the policyholder “participates” in the profits from the investments.

This post discusses the implications of this type of life insurance wrapper around a PFIC.

PFIC defined

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

1. Income test: At least 75% of the corporation’s gross income is passive income.
2. 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. It would be useful if the life insurance wrapper could cut off PFIC tax liability.

How this type of participating life insurance works

This type of life insurance is called a participating life insurance, in that the policy owner participates in the profits of the investments that the insurance company makes. The life insurance contains a death benefit component and an investment component.

The death benefit component functions like a normal life insurance: When the insured person dies, the policy beneficiary receives a death benefit. The death benefit is typically the greater of the cash surrender value of the policy or a sum specified in the policy.

The investment component contains a cash surrender value. If the policy owner surrenders the policy before the insured dies, the policy owner (or a specified beneficiary) receives the cash surrender value. Unlike US policies, these policies only specify a net surrender value. They do not specify the surrender charges.

Most commonly, the policy owner pays high premiums for the first 5 years, during which the cash surrender value is low. At the end of the 5 year period, the cash surrender value becomes slightly less than the total premiums paid. At this time, the policy owner stops paying premiums out of pocket, and future premiums are deducted from the cash surrender value. Each year, earnings from investments that the life insurance company makes is credited to to the cash surrender value of the policy–minus fees and premiums.

Generally, these plans will describe the expected cash surrender values of the policy, depending on the level of initial premium payments and the age of the insured. These are not policy values guarantees. They merely reflect the typical growth of the cash surrender value.

Insurance cuts off PFIC liability

One question that you might ask is, “Is this a life insurance policy under US tax law?” This question is important in the context of PFICs because of lookthrough rules.

Section 1298(a) specifies the conditions under which PFIC ownership can be attributed to a US person, even when the US person does not own the PFIC directly. They can be attributed through corporations, partnerships, estates, trusts, or options. IRC §1298(a)(2), (3), (4). There is no rule for attributing PFICs through an insurance policy.

Similarly, section 1298(a) does not import any attribution rules. For example, section 1298(a) does not contain any reference section 267 (related party rules) or section 318 (constructive ownership of stock), so it does not import those attribution rules.

We can say that section 1298(a) and the underlying regulations form a closed set of attribution rules. Under the special rules applicable to PFICs, there is no attribution through an insurance policy.

Having determined that there is no special rule for PFICs that causes a PFIC to be attributed to a policyholder of an insurance policy, we still need to look at the normal rules of indirect ownership. For example, suppose we have merely a normal stock in this type of life insurance policy; would the policyholder be considered an indirect owner of that normal stock?

For this answer, we turn to the rules that normally apply to life insurance policies.

Is this life insurance policy a life insurance policy under US tax law?

Code section 7702(a) defines a life insurance contract as:

[A]ny contract which is a life insurance contract under the applicable law, but only if such contract [(1) meets the cash value accumulation test or (2) meets the guideline premium requirements and falls within the cash value corridor]. IRC §7702(a).

There are in fact 2 requirements:

1. It must be a life insurance contract under “the applicable law”

and

1. It must satisfy 1 of 2 sets of tests based on actuarial calculations described in section 7702(a).

We only care if the insurance policy is a life insurance policy under applicable law

Before we delve into any actuarial tests, let us see what happens if the policy fails both sets of actuarial tests. In fact, Congress told us what happens:

If at any time any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance under subsection (a), the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during such year. IRC §7702(g)(1)(A).

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).

If the policy fails both tests, these are the consequences:

• The policy is an insurance policy other than life insurance, so it does not benefit from special life insurance provisions (like the death benefits being excluded from income); and
• The policyholder must recognize the growth in the cash value of the policy (presumably attributed to income from the policy) as ordinary income.

Failing both sets of actuarial tests does not convert the policy into an ordinary investment account. In fact, the tax consequences say the exact opposite, because section 7702(g) converts the income of the policy to ordinary income–there is no passthrough of income.

If all we cared about is whether the policyholder must look through the policy to underlying PFICs, then we do not care about the 2 sets of actuarial tests. Once we have determined that the policy is a life insurance contract “under applicable law”, we know that the policyholder does not need to look through the policy (though he can have a number of other problems).

The policy is a life insurance contract under the applicable law

Neither the Code nor the regulations define what “the applicable law” means.

One possibility is that it is a life insurance contract under the foreign law that governs the contract. Let us assume that the policy in question satisfies the definition of a life insurance contract as defined under the foreign law that governs the contract.

Another requirement that can arise is that the foreign law’s definition of life insurance must correspond to the US concept of life insurance–though not necessarily the section 7702 definition. This issue arises mostly in the context of captive insurance companies–an arrangement where a parent company creates a subsidiary for the purpose of insuring the parent company–, where the captive might offer “insurance” that is not insurance under the ordinary understanding of insurance in the US.

The IRS summarized the meaning of insurance under the US understanding in Revenue Ruling 2005-40. An insurance arrangement must contain 2 elements:

1. There must be a shift of risk of financial loss from a fortuitous event from the insured to the insurance company; and
2. The insurance company must distribute its risk of loss by acquiring a sufficiently large pool of insured, so each insured person is not simply paying for the risk directly.

In our scenario, there is a shift of risk of financial loss: Suppose the insured buys the policy at age 30 and dies at age 36, the death benefit is the same as if he died at age 100. The fortuitous event is the death of the insured at an early age, and the risk of loss from an early death has been shifted from the insured to the insurance company.

In our scenario, there is most likely a distribution of risk: The insurance company sells the same type of policy to a large pool of buyers, so the risk of financial loss from an early death is distributed among the large pool of insured: Some might die at an age where the death benefit is more than premiums and earnings, and some might die after premiums and earnings total more than death benefits.

These participating life insurance policies generally correspond to the US idea of life insurance–they just add an investment company. They should be life insurance contracts under “the applicable law”.

No PFIC lookthrough

We know that there is no special PFIC rule that requires the policyholder to look through an insurance policy, and we know that under normal rules, an insurance policy of a type similar to this type of participating life insurance does not require a policyholder to look through to the underlying investments. The policyholder should not need to look through the policy.

Thank you

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

Haoshen

The post PFIC Wrapper Miniseries #2: Participating Life Insurance appeared first on HodgenLaw PC – International Tax.

PFIC wrapped in a continental life insurance

This week’s topic is the third of a series of posts that will talk about how various “wrappers” affect the US taxation of PFICs. The last post discussed participating life insurance I have seen in China and Southeast Asia.

This post discusses a few types of financial products that sound like they are life insurance but may in fact be something else. It is inspired by the French assurance vie and a life assurance product I have seen in the Isle of Man.

This post discusses the implications of this type of life insurance wrapper around a PFIC.

PFIC defined

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

1. Income test: At least 75% of the corporation’s gross income is passive income.
2. 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. It would be useful if the life insurance wrapper could cut off PFIC tax liability.

How this type of policy works

In this type of policy, the policyholder pays a premium. The premium is used to buy investments. In the country of issue, the income from the investment is tax-deferred until the policyholder cashes out the policy.

If the policyholder holds the policy until death, then the cash value of the investments is paid to the policyholder’s heirs–possibly tax-free in the country of issue.

They are probably not insurance

These policies are not like the US concept of insurance at all.

There is a robust cottage industry in the US creating captive insurance companies–where an operating business creates a subsidiary for the purpose of issuing insurance with good terms to the parent. In response, the IRS and the courts have had many opportunities to describe what insurance means in the US context.

The IRS summarized the meaning of insurance under the US understanding in Revenue Ruling 2005-40. An insurance arrangement must contain 2 elements:

1. There must be a shift of risk of financial loss from a fortuitous event from the insured to the insurance company; and
2. The insurance company must distribute its risk of loss by acquiring a sufficiently large pool of insured, so each insured person is not simply paying for the risk directly.

In policies like the assurance vie and the life assurance, there is no risk shifting of any kind: The policyholder is simply entitled to the value of the investment (minus taxes and fees). It is almost certain that these policies are not insurance policies under the US concept.

They are not life insurance under tax law

Code section 7702(a) defines a life insurance contract as:

[A]ny contract which is a life insurance contract under the applicable law, but only if such contract [(1) meets the cash value accumulation test or (2) meets the guideline premium requirements and falls within the cash value corridor]. IRC §7702(a).

To be life insurance, the policy must first be a life insurance contract “under applicable law”, but neither the Code nor the regulations define what “the applicable law” means.

One possibility is that it is a life insurance contract under the foreign law that governs the contract. Let us assume that the policy in question satisfies the definition of a life insurance contract as defined under the foreign law that governs the contract.

But it is unlikely that the US would recognize the policy as life insurance merely because the words used in the country of issue are “life insurance”, words that directly translate to life insurance, or a similar term. Most likely, another requirement is that the foreign law’s definition of life insurance must correspond to the general US concept of life insurance.

We have already seen that this type of life insurance does not correspond to the US concept of insurance at all. They are probably not life insurance under applicable law. Hence, they are not life insurance under tax law.

They are probably just plain investment accounts

What is really happening with these policies is this: You put cash into an account, and that cash is used to buy investments. You can cash out the investments, though the cash-out may be subject to more restrictions than a normal investment account.

There are some provisions in the Code for wrappers for investment accounts that convert the investment into some other type of income, for example variable annuities, pensions, IRAs, and certain life insurance policies that fail the actuarial tests for life insurance. See e.g. IRC §§72, 402(b), 408, 7702(g). But I do not believe any of the exceptions apply to these types of products.

The most likely result is that this policy is a simple securities account under US tax law. The policyholder is the owner of the PFICs held in the policy, and the policyholder is taxed directly.

Thank you

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

Haoshen

The post PFIC Wrapper Miniseries #3: Products That Sound Like Life Insurance appeared first on HodgenLaw PC – International Tax.

Today’s post is a followup to a post I made back in May. The setup is this:

I own 40% of a BVI corporation, and a nonresident alien owns the other 60%. The BVI corporation owns an operating subsidiary in country X. We set up a 2nd subsidiary in the Cayman Islands to hold IPs (software copyright, trademarks, domain name) and license them to the operating subsidiary.

We got into a lawsuit, and we settled it by having our IP licensing subsidiary grant a license to the other party for a modest royalty. Do we need to worry about anything?

In the previous post, we concluded that before the lawsuit, the IP licensing subsidiary was not a PFIC, because under an exception for collecting royalty from related persons, the royalties the IP licensing subsidiary collected from the operating subsidiary was not passive income, and the software was not a passive asset as a result.

In this post, we will examine the effect the lawsuit settlement has on the passive foreign investment company classification of the licensing subsidiary.

PFIC defined

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

1. Income test: At least 75% of the corporation’s gross income is passive income.
2. 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.

To determine if the licensing subsidiary becomes a PFIC as a result of the lawsuit settlement, let us look at whether the royalty income causes it to meet the income test or the asset test.

The related party rule does not exclude the lawsuit royalty

Royalties are normally passive income. IRC §§1297(b), 954(c)(1)(A). But in the previous post, we used a related person exception to exclude the royalties collected from the operating subsidiary from passive income.

Specifically, section 1297(b)(2)(C) tells us that passive income does not include royalty from a related person. The operating subsidiary is a related person for the IP licensing subsidiary because the same parent company owns all shares of both. IRC §954(d)(3). Therefore, the royalty collected from the operating subsidiary was not passive income.

And because the IP produces royalty that is not passive income, it is not a passive asset. Notice 88-22.

The result is that when the IP licensing subsidiary only collected royalties from the operating subsidiary, it was not a PFIC.

The third party to whom a license was granted in the settlement was not a related party, presumably. Therefore, the royalty collected from the lawsuit license does not qualify for the related party rule.

The active business exception does not apply

There is an active business exception for royalties:

Foreign personal holding company 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:

1. The royalty must be derived from the active conduct of a trade or business; and
2. 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).

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 most likely does not develop the IP, nor does it make derivative works or add value once it has been assigned the IP. The royalties are not from an active business.

The royalties do not fit the active business exception to passive income. After the lawsuit, it is clear that the IP licensing subsidiary has passive income.

The IP licensing subsidiary may still have more nonpassive income than passive income

To determine if the licensing subsidiary is a PFIC under the income test, we must compare its passive income to its total income. But we run into a question of what goes into the total income.

Under the related party rule, the royalty collected from the operating company is not passive income. But there remains a question of whether the related party royalty should be included in the income test as nonpassive income. For example, the IRS has said if a parent company liquidates a subsidiary, the gain from the shares is not included in income at all for the income test. See PLRs 200604020, 200813036. This might suggest that related party royalties should be excluded from gross income for the income test.

Fortunately, Congress and the IRS told us why the gain from liquidating a subsidiary is not included in a parent company’s income, and the same reasoning cannot be applied to related party royalties.

For a 25% subsidiary, the parent company is supposed to look through the subsidiary to the underlying income to determine if it has passive income or not. IRC §1297(d). It makes sense to disregard shares in the 25% subsidiary and gains from them–otherwise the gain from the assets of the subsidiary would be double counted during a liquidation: Once as passthrough from the subsidiary’s income and once for the parent company’s own income. See H. Rpt. 100-1104 at 268.

The situation is different for sister companies like the IP licensing subsidiary and the operating subsidiary: There is no rule that requires the IP licensing subsidiary to take into account the income of the operating subsidiary. There is no double counting if we include the related party royalties in the IP licensing subsidiary’s income. So we should not ignore the royalties from the operating subsidiary for the income test. The royalties are included as nonpassive income.

It is still possible for the IP licensing subsidiary to avoid being a PFIC, but you have to compare how much royalties are collected from the operating subsidiary vs from the lawsuit license, and you have to compare the values of the IPs.

Be careful with the asset test

While the assets of the IP licensing subsidiary have not changed, the type of income they produce has. Some (or all) of the IP now produce passive income.

The IRS has said that intangible assets are classified as passive or nonpassive based on the income they produce. Notice 88-22. But it has not said what happens when the same IP produces both types of income. Presumably, you can allocate the total value of the IP based on the proportion of passive and nonpassive income it produces.

For example, if the IP licensing subsidiary collects $8,000,000 of royalties a year from the operating subsidiary for a software and $2,000,000 of royalties a year from the third party from the lawsuit for the same software, then presumably 80% of the software copyright’s value is nonpassive, and 20% of its value is passive.

But be careful when valuing the IPs, because each IP has an expected useful life. For example, if patent 1 produces $20,000,000 of royalties a year, but it is in the 20th year of its life; while patent 2 produces only $15,000,000 of royalties a year, but it is in the 4th year of its life, which is more valuable?

Patent 1 expires next year, so its value is probably only $20,000,000, but patent 2 may produce 16 additional years of income (not necessarily $15,000,000 per year), so patent 2 is likely more valuable than patent 1. This is where you need to be careful in assigning values to the assets.

Maybe it is better to make a check the box election for the IP licensing subsidiary at the start

A Cayman company may elect to its tax classification. Reg. §§301.7701-3(a), -2(b)(8). The IP licensing subsidiary may choose between a disregarded entity or a corporation. Reg. §301.7701-3(a).

If the IP licensing subsidiary chooses to be a disregarded entity, then its income and assets would be treated as those of the parent company to begin with. Under the 25% subsidiary lookthrough rule, the parent company would aggregate the business income and assets (presumably nonpassive) of the operating subsidiary with the royalty income and IP. The chance of having a PFIC is significantly reduced with the election.

The post Running Your IP Licensing Subsidiary appeared first on HodgenLaw PC – International Tax.

Gaps between subpart F income and PFIC classification

Today’s post is about a few gaps between taxation under the subpart F rules for controlled foreign corporations and passive foreign investment company (PFIC) rules. If your business happens to fall into one of these gaps (or can be reconfigured to fall into one of these gaps), it can be useful for deferring US taxes on income.

Complement between subpart F rules and PFIC rules

Congress enacted the subpart F rules, applicable to controlled foreign corporations (CFCs), to prevent US persons from conducting certain kinds of operations through a corporation organized in a tax haven to avoid or defer US taxes. The subpart F rules do so by forcing US persons who own at least 10% of the voting power of CFCs to report its share of the CFC’s profits as income every year, even if there is no distribution from the CFC. IRC §951(a).

But because CFC rules apply only to foreign corporations in which more than 50% of the shares are owned by 10% voting US shareholders, it used to be possible to avoid CFC rules by inviting foreign shareholders or dispersing shares among many US shareholders. To eliminate the financial incentives for deferring tax on certain kind of income by using a corporation in a tax haven that avoids CFC rules, Congress enacted the PFIC rules. See JCS-10-87, 1021.

Type of deferral that PFIC rules are meant to prevent

A PFIC is a foreign corporation that either has “too much” passive income or “too much” assets that generate passive income. IRC §1297(a). Passive income is defined as foreign personal holding company income, which refers to income such as interest, dividends, royalties, and gains from the sale of assets that produce passive income. IRC §§1297(b), 954(c). The definition is fairly intuitive: Interest, dividends, royalties, and gains from the sale of assets that produce passive income are income we associate with passive investments rather than active conduct of businesses.

PFIC rules are meant to catch certain kinds of income that Congress would like to tax as a foreign corporation receives it, but cannot under subpart F rules. This is why passive income is defined by reference to the foreign personal holding company income under subpart F rules, and it is why 10% voting US shareholders in CFCs do not treat shares in the CFCs as PFIC shares, even if the CFC satisfies the PFIC definition. IRC §1297(b), (d).

No anti-deferral for sales and service income held in tax havens under PFIC rules

Subpart F income–the type of income that is subject to annual US taxation in the hands of 10% voting US shareholders–includes several types of income (IRC §954(a)):

• Foreign personal holding company income, which is income such as interest, dividends, royalties, rents, gains from the sale of assets that produce these types of income, and gains from certain assets that are typically investments;
• Foreign base company sales income, which involves using related parties, one of which is incorporated in a tax haven country, to conduct sales and purchases to accumulate income in the tax haven;
• Foreign base company services income, which involves using related parties, one of which is incorporated in a tax haven country, to provide services to accumulate income in the tax haven; and
• Foreign base company oil and gas income.

The PFIC passive income is narrower than the types of income that are subject to subpart F rules: It only includes foreign personal holding company income. Suppose we have a foreign corporation that is not a CFC deriving income from sales, services, or oil and gas extraction. That corporation is free to use a tax haven to defer income with limited PFIC risks, because the sales, services, and oil and gas income are not passive income under the PFIC test.

There is just one catch: Cash and cash equivalents are passive assets, even if they are working capital. Notice 88-22. But if the foreign corporation owns substantial business assets, then it can accumulate significant amounts of profits as cash without risking becoming a PFIC.

As stated previously, passive income under the PFIC rules includes only foreign personal holding company income. But even for foreign personal holding company income, there are slight differences in the CFC definition of foreign personal holding company income and PFIC definition of passive income that create possibilities for deferral.

Liquidating a subsidiary

If a CFC liquidates a wholly-owned subsidiary, the gain is foreign personal holding company income. Reg. §1.954-2(e)(2)(i) The 10% voting US shareholders of the CFC are taxable on the profits from the gain, even if the CFC does not make any distributions.

By contrast, if a foreign corporation liquidates a wholly-owned subsidiary, the gain is probably not passive income because of a change of business exception. The result makes intuitive sense under PFIC rules: Foreign corporations should not fear having to reorganize their business or sell unprofitable businesses for fear of becoming PFICs, but it is odd that the CFC rules do not have a corresponding exception.

Certain related party payments

Suppose you have a Cayman Islands parent company as your business’s holding company. It has a wholly-owned subsidiary in the British Virgin Islands that holds all your business’s IPs. The IP holding subsidiary then licenses those IPs to the Cayman parent company’s wholly-owned operating subsidiaries around the world in exchange for royalties. What results?

Under the PFIC rules, the royalties are collected from a related person. As long as the operating subsidiaries are not using passive income to pay the royalties, the royalties would not be passive income either. IRC §1297(b)(2)(C).

If the Cayman parent company is a CFC, then all its wholly-owned subsidiaries are CFCs. Royalties would normally be foreign personal holding company income under subpart F rules. IRC §954(c)(1)(A). But there is an exception: if a CFC receives royalties from a related person, and the related person is not paying the royalties using subpart F income, then the royalties are not foreign personal holding company income either. IRC §954(c)(6).

The PFIC and CFC rules are consistent in this regard, with one odd difference: Under the CFC rules, the Code provision that excludes the royalties from foreign personal holding income is effective for years 2006 to 2019 only. IRC §954(c)(6)(C). This provision had older sunset dates in prior years, but Congress renewed the provision each time. If Congress does not renew the provision in a future session, then potentially the exclusion will go away under CFC rules, requiring 10% voting US shareholders to recognize income annually.

By contrast, the PFIC exception does not have a sunset date. The IP holding subsidiary will continue to avoid becoming a PFIC under the related party exception rules.

I used royalties as an example, but the same problem applies to dividends, interests, and rent received from a related person: The CFC exception to foreign personal holding company income has a sunset date. The PFIC exception to passive income lacks the sunset date.

Using these differences

In these situations, the differences between CFC rules and PFIC rules favor non-PFICs: The exclusions under PFIC rules are more generous than the ones for CFCs. The idea, then, is to avoid being treated as CFCs.

How you may avoid CFC classification depends on your business.

Suppose you intend to create a holding company in the Cayman Islands, Hong Kong, Ireland, or another low tax jurisdiction, and you intend to take the company public in a few years. There might not be so much engineering required: The company likely will cease to be a CFC once it goes public (too many shareholders). It is then free to reorganize subsidiaries and collect payments from related parties with low (though nonzero) risks under the PFIC rules. You just need to worry about capital gains being converted to dividends under section 1248 should you decide to sell your shares.

Suppose you intend to keep the company private instead, then you may never be rid of the CFC rules by dispersing shareholding. In this situation, it may be useful to seek out a foreign business partner to jointly own the business, so shares in the hands of 10% US voting shareholders do not exceed 50%.

Thank you

Haoshen

The post Gaps Between PFIC and Controlled Foreign Corporation Anti-Deferral Coverage appeared first on HodgenLaw PC – International Tax.

This is a question we got in an email:

My client bought shares in a foreign mutual fund a few years ago. I see from the client’s statements that the average distribution for the last few years has been about the same, but I do not have statements for the entire first year. Can I annualize the first year distribution?

This post will discuss how to annualize the first year distribution to reduce the tax on distributions from a passive foreign investment company.

PFIC defined

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

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

Generally, foreign mutual funds are PFICs, even if they are not organized as corporations in the foreign jurisdiction, because they hold passive assets.

Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad. If a US person invested in a PFIC it is useful to consider if there is any rule that can reduce the tax on the PFIC income.

What does annualizing the first year distribution do?

Annualizing the first year distribution is a rule that can reduce the tax on PFIC distributions, but to understand how this works, we must first understand how PFIC distributions are taxed. Generally, PFICs can be taxed in one of three ways:

1. The default regime
2. The mark-to-market regime
3. the qualified electing fund regime

The annualization rule applies only to the default regime, so we will ignore the MTM and QEF regimes for this post. IRC §1291(b)(3)(C).

Introduction to the default regime

In simplistic terms, this is how the US tax works when you receive a distribution (dividend, return of investment, etc) from a PFIC under the default regime. IRC §1291.

First, you divide the distribution into excess distribution and non-excess distribution. The non-excess distribution is treated like a distribution from a normal corporation. IRC §301(c). The only difference is that a PFIC cannot distribute a qualified dividend. IRC §1(h)(11)(C)(iii).

Second, you divide the excess distribution into three intervals pro-rata by days in the holding period: the pre-PFIC period, the prior year PFIC period, and the current year. The pre-PFIC excess distribution and current year excess distribution are included in gross income as ordinary income. The prior year PFIC excess distribution is not included in gross income. The prior year PFIC excess distribution is taxed at maximum rates and subject to an interest charge.

The prior year PFIC excess distribution is known as the “excess distribution not included in income”, and it is an important concept in understanding how annualizing the first year distribution can reduce PFIC tax.

Finding the non-excess distribution

Non-excess distribution is taxed more favorably than excess distribution, so you want to use available rules that allocates more of a distribution to non-excess distribution.

This is how you find the non-excess distribution:

1. Take the distributions from the PFIC for the past 3 years (or less if the holding period is less than 3 years) and add them to get the total distribution.
2. Subtract the “excess distribution not included in income” for the past 3 years (or less if the holding period is less than 3 years) from the total distribution.
3. Multiply the difference by 1.25.
4. Divide the product by 3 (or the number of prior years if less than 3 years).

If the quotient is less than or equal to the distribution received this year, then the quotient is the non-excess distribution this year. If the quotient is greater than the distribution received this year, then the entire distribution received this year is non-excess distribution.

From this equation, you can see that you would typically expect to have a low excess distribution when the distributions from the past 3 years are high. Further, your second year excess distribution would be made lower if your first year distribution were higher.

How annualizing the first year distribution reduces excess distribution

There is a rule that says even if you do not hold the PFIC shares for the entire year in the first year of your holding period, you may be able to include all distributions the PFIC made in the first year for purposes of calculating non-excess distributions in subsequent years. Prop. Treas. Reg. §1.1291-2(d)(1).

Note that this rule is only for the purpose of calculating non-excess distributions in subsequent years. It does not change the tax liability for the first year.

How annualizing the first year distribution reduces excess distributions

Let us look at a simplistic example to illustrate the concept: You buy a share of a PFIC on July 1 of year 1. The PFIC made a $1,200 distribution on January 1 of year 1. In years 2-5, the PFIC made a $1,200 distribution on December 31 of each year.

This is how non-excess distribution is calculated if you annualize the first year of distributions:

1. In year 1, the entire distribution is non-excess distribution: $0.
2. In year 2, you annualize the distribution from year 1, so you use $1,200 as the first year distribution when you calculate the non-excess distribution for year 2. Multiply by 1.25 and divide by 1 gives you $1,500. The entire $1,200 distribution is non-excess distribution.
3. Similarly, in years 3-5, the entire $1,200 distributions are non-excess distributions.

This is how non-excess distribution is calculated if you do not annualize the first year of distributions:

1. In year 1, the entire distribution is non-excess distribution: $0.
2. In year 2, the non-excess distribution is 0. The excess distribution is 1,200. The amount allocated to current year excess distribution is 800. The prior year excess distribution (“excess distribution not included in income”) is 400.
3. In year 3, the non-excess distribution is (0+1,200-400)(1.25/2)=500. The excess distribution is 700. The amount allocated to current year excess distribution is 280. The prior year excess distribution is 420.
4. In year 4, the non-excess distribution is (0+1,200+1,200-420-400)(1.25/3)=658.33. The excess distribution is 541.67. The current year excess distribution is 154.76. The prior year excess distribution is 386.90.
5. In year 5, the non-excess distribution is (1,200+1,200+1,200-420-400-386.90)(1.25/3)=997.13. The excess distribution is 202.87.

These are the results, side by side:

As you can see, using our assumed numbers, you saved $2,644.54 of excess distribution in the first five years by annualizing the first year of distributions. What is particularly interesting is that even though the first year distribution is not directly used in calculating the excess distribution in year five, annualizing the first year distribution reduced the excess distribution in year five, because annualizing the first year distribution reduced the “excess distribution not included in income” in years two through four.

Depending on the distribution pattern, annualizing the first year distribution can have a ripple effect beyond just the first four years.

What do you need to annualize the first year distribution?

Now we know annualizing the first year distribution can (though may not necessarily) decrease tax liability. The question is what requirements there are to annualize the first year distribution.

The tricky part is that you must know the actual payments made during the first year but before your holding period began.

Let us apply this requirement to our original question:

My client bought shares in a foreign mutual fund a few years ago. I see from the client’s statements that the average distribution for the last few years have been about the same, but I do not have statements for the entire first year. Can I annualize the first year distribution?

You cannot annualize the first year distribution based on the information you have now, because you do not know the actual distributions the mutual fund made in the first year of your client’s holding period (but before the holding period began). You will need to go and find the fund statements for the first year of your client’s holding period.

It is ok if you cannot find all statements. You can annualize distributions based on statements you can find. For example, suppose your client bought the fund shares in the third quarter, and you can find distribution statements for the second, third, and fourth quarters only. You can annualize the second quarter, despite not having information about the first quarter.

Should I annualize?

Annualizing the first year distributions can save taxes by reducing excess distribution for subsequent years. But finding statements so you can annualize first year distributions may be difficult. This is a matter of cost: Is it better to save some taxes, or is it better to save tax preparation fees?

The post Reducing PFIC Tax by Annualizing the First Year Distributions appeared first on HodgenLaw PC – International Tax.

Today’s post is a war story about a pair of US citizen former clients whose PFIC issues we helped clean up. The question, paraphrased, is more or less like this:

We are equal shareholders of a successful Portuguese company (LDA). Our company accrued a lot of profits. We really do not want to let the profits sit idle. Can we safely invest them in exchange traded funds?

This post will discuss how to use a mix of the mark-to-market regime for foreign investment companies (PFICs) and the de minimis exception to foreign base company income for controlled foreign corporation (CFCs) to defer US tax on the profits from the exchange traded funds.

Quick background on PFICs and CFCs

The Portuguese LDA as a controlled foreign corporation (CFC)

LDA is short for sodiedade por quotas de responsabilidade limitada. It is a Portuguese business entity that provides limited liability to all shareholders. It is foreign, because it is organized outside the US. Reg. §301.7701-5. It is a corporation under US tax law, because it limits liabilities for all members. Reg. §301.7701-3(b). It is a controlled foreign corporation (CFC), because two US persons own 100% of the company. IRC §§951(b), 957(a).

Why the ETFs are passive foreign investment companies (PFIC)

Passive foreign investment company (PFIC) refers to a foreign corporation who has at least 75% passive income or at least 50% passive assets. IRC §1297(a). The exchange traded funds (ETFs) are foreign, because they are organized outside the US. They are corporations under US tax law, because their investors have limited liability for the funds’ debts. They are PFICs, because the ETFs receive essentially all passive income and hold essentially all passive assets.

The three ways to tax PFIC income

PFICs can be taxed one of three ways, ordered from worst to best: the default regime, the mark-to-market (MTM) regime, or the qualified electing fund (QEF) regime. The QEF regime requires you to receive a statement from the PFIC. Reg. §1.1295-1(f). We assume the QEF regime is not available in the scenario presented.

Background on MTM rules

The mark-to-market (MTM) regime is an election. It is available for marketable stock. “Marketable stock” refers to stock that is publicly traded on an SEC authorized exchange or an exchange that meets IRS criteria. IRC §1296(e)(1)(A). Let us assume that these ETFs are marketable stock.

Under the MTM regime, the shareholder must pretend that he sold the shares for fair market value at the end of each year. Gains from this deemed sale are ordinary income for the year. The character of loss depends on a value called the unreversed inclusions. There are also some basis adjustments. Reg. §1.1296-1(c). You can read more about the MTM rules in Debra Rudd’s post.

Because we are only addressing the deferral of income in this post, we will ignore the (complicate) loss rules. We just look at the MTM gains at the end of each year.

Quick way to avoid PFIC rules

Note that PFICs must be foreign corporations. An easy way to ensure you are never subject to PFIC rules is to invest the profits in something that is not foreign: buy US investments. You can also invest in something that is not a corporation. For example, the company can buy treasury bonds, corporate bonds, annuities, real estate, etc. Our clients wanted to know about ETFs, so let us assume that we have to look at the PFIC rules.

No lookthrough for MTM stock

Normally, if a person owns 50% or more of the shares of a corporation, then the shareholder is treated as the owner of any PFICs that the corporation owns. IRC §1298(a)(2)(A). Here, each of our clients owns 50% of their company, so under this lookthrough rule, they are treated as the owner of any PFICs that the company owns.

But the lookthrough rule is different for MTM stock. For MTM stock, there is lookthrough for foreign partnerships, foreign trusts, foreign estates, and certain regulated investment companies only. Reg. §1.1296-1(e). Here, our clients own a normal corporation, and the corporation owns the MTM stock. Under MTM rules, our clients do not need to look through their company.

But income can be passed to the shareholders under subpart F rules

Controlled foreign corporations (CFC) receive a special designation because they are subject to anti-deferral rules. These rules related to subpart F income, named after the subpart of the Internal Revenue Code in which the rules are found. Briefly:

US persons who own at least 10% of the voting power of a CFC must take into account their share of the CFC’s subpart F income each year, regardless of whether the CFC makes any distributions. IRC §951(a). Worse, the subpart F income is taxed at ordinary rates rather than the advantageous qualified dividend rates. This creates a substantial problem for companies in treaty countries, as those companies normally distribute qualified dividends. IRC §1(h)(11).

Subpart F income includes a number of types of income, one of which is the foreign personal holding company income. Foreign personal holding company income includes items such as interests, dividends, rent, property gain transactions, commodities income, etc. IRC §954(c). In other words, it includes income that you think of as passive investment income.

For MTM stock held in a PFIC, the MTM gains are foreign personal holding company income. Reg. §1.1296-1(g)(2)(ii)(A). This can create subpart F income that US shareholders must include in their US income every year.

A de minimis exception might solve the problem

There is a de minimis exception for subpart F income. It says that if the total foreign base company income (a term which includes foreign personal holding company income) and gross insurance income for a year is less 5% of the CFC’s gross income and less than $1,000,000, then no income is considered foreign base company income. IRC §954(b)(3)(A).

If it is a private operating company investing some of its profits in ETFs on the side, there is a good chance that the MTM gains are less than 5% of the company’s gross income and less than $1,000,000.

But keep one thing in mind: You are calculating the company’s foreign base company income, not its foreign personal holding company income. Foreign base company income is a super category that includes foreign personal holding company income and a few other types of income that I omitted for brevity. See IRC §954(a).

But assuming all these types of income add up to less than 5% of the CFC’s gross income and less than $1,000,000, there would not be a subpart F problem from the MTM gains.

Spoiler alert: Our client decided to invest in bonds and individual stocks instead of ETFs.

Summary

If you own at least 10% of the voting power of a controlled foreign corporation (CFC), and that CFC invests in exchange traded funds (ETFs), get the CFC to elect MTM regime for the ETFs. The MTM regime avoids PFIC lookthrough rules for you (and the other 10% US shareholders). It is possible that the MTM gains will be taxed to you every year under the separate subpart F rules, but you might be able to use a de minimis exception to save yourself from that.

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

The post Deferring tax on PFIC income using your foreign operating company appeared first on HodgenLaw PC – International Tax.

What happens when a US citizen owns shares of a foreign corporation, and the foreign corporation owns shares in PFICs–for example, foreign mutual funds or money market funds? Does the US citizen need to look through the top level foreign corporation to the PFICs?

When a shareholder looks through a corporation to an underlying PFIC, he must pretend that he owned the underlying PFIC shares directly.

Does the US citizen look through the top level foreign corporation? The answer depends on the percentage of the shares in the top level corporation the US citizen and whether the top level corporation is itself a PFIC.

PFIC defined

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

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

Generally, a foreign mutual fund or money market fund meets both tests, because the fund invests in passive assets–assets that give rise to dividends or interest. IRC §1297(b). Thus, when your company invests in foreign mutual funds or money market funds, it most likely is investing in PFICs.

Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad. Thus, it would be useful if a top level foreign corporation can cut off PFIC taxation rules.

Lookthrough if you own at least 50%

This one is simple: If you own 50% or more of the value of the stock of a top level foreign corporation, then you must look through that parent to any shares that the top level foreign corporation owns. IRC §1298(a)(2)(A).

Look at value of the shares, not voting power

An interesting note about this lookthrough rule is that it is based on the value of the shares only. It does not care about voting power. This leads to a rather interesting setup that small businesses can use to invest in PFICs.

Suppose you and a nonresident alien business partner want to start a business–say a wholesale store. It is an active business, not merely a holding company.

You want to invest excess cash (working capital) into PFICs, such as money market funds.

You can do this without having to look through to the underlying PFICs, provided that you are willing to take a small reduction in your profits. Here is how:

Form a foreign corporation that issues two classes of shares. The first class is entitled to 50% of the voting power but only 49.99% of the profits and assets. You own these shares. The second class is entitled to 50% of the voting power but 50.01% of the profits and assets. Your nonresident alien partner owns these shares.

You now have a situation where you, the US citizen, own less than 50% of the value of the foreign parent. You do not need to look through the top level foreign corporation to its underlying PFICs.

A small side: You own exactly 50% of the voting power of the foreign corporation. If you owned more than 50%, then the foreign corporation would be classified as a controlled foreign company (CFC). CFCs are subject to special rules that you may want to avoid, but that is beyond the scope of this discussion.

The 50% threshold is for active businesses, not investment holding companies

You may be thinking: Can you apply the same rule to your advantage for a company that merely holds investments?

Suppose your foreign corporation is not operating an active business. It holds only cash and PFICs. Your foreign corporation that issues two classes of shares. The first class is entitled to 50% of the voting power but only 49.99% of the profits and assets. You own these shares. The second class is entitled to 50% of the voting power but 50.01% of the profits and assets. Your nonresident alien partner owns these shares.

Do you need to look through this foreign corporation and report the underlying PFICs as if you own them directly?

The answer is yes.

This foreign holding corporation is a PFIC, because it holds only cash and PFICs, which produce passive income. When you own shares in a PFIC, you must look through the PFIC to shares it owns, regardless of the percentage of ownership you have in the PFIC. IRC §1298(a)(2)(B).

You cannot use the 50% rule to get around PFIC lookthrough for a foreign corporation that merely holds investments.

Look through a controlled foreign corporation that is also a PFIC

Suppose you own 20% of a foreign corporation. The foreign corporation has 4 other US citizens, each of whom owns 20% of the shares.

Do you need to look through this foreign holding corporation?

Under the income test and the asset test, the foreign holding corporation is a PFIC, because it owns only cash and PFICs, which produce passive income. The most obvious answer is that you must look through this holding corporation, because it is a PFIC.

But the answer is not so simple, because there is an overlap rule for controlled foreign corporations (CFCs) and PFICs.

The CFC-PFIC overlap rule says if you own 10% or more of the voting power of a CFC, then you do not treat your shares in the CFC as shares in a PFIC (even if the foreign corporation is in fact a PFIC). IRC §1297(d).

You can check if a foreign corporation is a CFC using the following method: IRC §957(a)

1. Take all US persons who own at least 10% of the voting power of the foreign corporation
2. Add the shares of all these 10% US voting shareholders
3. If the sum of the value of their shares is above 50%, or if the sum of their voting power is above 50%, then the foreign corporation is a CFC.

In our hypothetical, there are 5 US persons, each of whom owns 20% of the shares of the foreign corporation. Each US person owns at least 10% of the voting power. The sum of these 10% US voting shareholders equals 100% of the voting power and 100% of the value. Therefore, the foreign holding corporation is a CFC.

Under the CFC-PFIC overlap rule, none of the shareholders treats his shares in the foreign holding corporation as shares in a PFIC.

Unfortunately, the CFC-PFIC overlap rule does not help. When we decide whether to look through a foreign corporation, we ignore the CFC-PFIC overlap rule. IRC §1298(a)(2)(B). Thus, solely for purposes of lookthrough, each shareholder owns shares in a PFIC. Each shareholder must look through to the underlying PFICs in proportion to their shares in the foreign holding corporation.

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

The post Lookthrough Rules When Your Foreign Corporation Owns PFICs appeared first on HodgenLaw PC – International Tax.

Filing Form 5471 and Form 8621 for the same foreign corporation

This is a question that we get a lot:

If I own shares in a foreign corporation, and I file Form 5471, then I do not have to file Form 8621, right?

The answer to this question is “incorrect”. There are situations under which you have to file both Form 5471 and Form 8621 to report the same corporation. Here are a few common situations we have seen arise in the course of our work.

Background to Form 8621 and Form 5471

Form 8621 is a form that US persons use to report investments in passive foreign investment companies (PFICs). Form 8621 instructions, 1. It is not important for this post to know what a PFIC is. We need only know that a PFIC is a type of foreign corporation subject to special treatment under US tax law. For this post, we assume all foreign corporation we discuss satisfy the PFIC definition.

Form 5471 is a form that US persons use to report US ownership in foreign corporations. There are 5 categories of filers, each with different conditions for filing and different information that must be provided. The exact filing requirements are not important for this post, but we make references to the requirements when necessary.

The source of the confusion is an overlap rule for controlled foreign corporations and PFICs

Congress has adopted 2 sets of rules to discourage US persons from using foreign corporations to defer tax. One set applies to controlled foreign corporations (CFCs), and the other set applies to passive foreign investment companies (PFICs). It is possible for a foreign corporation to satisfy both the CFC definition and the PFIC definition.

When a foreign corporation satisfies both the CFC definition and the PFIC definition, a CFC-PFIC overlap rule applies. The CFC-PFIC overlap rule states that if you are a US person who owns at least 10% of the voting power of a CFC, then you do not treat your shares in the CFC as shares in a PFIC, even if the CFC meets the definition of a PFIC. IRC §1297(d).

If you are a US persons who owns at least 10% of the voting power of a controlled foreign corporation (CFC), then you have to file Form 5471 under category 5. Form 5471 instructions, 2. You fall under the CFC-PFIC overlap rule. The general result is that you do not treat your shares in the CFC as PFIC shares, so you do not file Form 8621.

One conclusion that I have seen taxpayers draw is that if he has to file Form 5471 to report a foreign corporation, then it is not necessary to file Form 8621 as well. There is no such exception in general. Only those who fit under the CFC-PFIC overlap rule can avoid filing both.

Here are some common situations we have seen where a US person must file both forms. These are not exhaustive, just what we have seen.

US persons who acquire shares in a non-CFC

Category 3 filers of Form 5471 are US persons who acquire or dispose of enough shares in a foreign corporation. I will not list all the ways you can become a category 3 filer. But one way have a category 3 filing requirement is to start with no shares and acquire at least 10% of the shares. Form 5471 instructions 1.

Suppose you are a US person who joins an investment venture with 3 unrelated nonresident aliens. You incorporate a foreign corporation, and each of you takes 25% of the shares.

You must file Form 5471 under category 3 to report your acquisition of the 25% of shares, but do you fall under the CFC-PFIC overlap rule?

A CFC is a foreign corporation in which 10% voting US shareholders own more than 50% of the shares (by voting power or by value). IRC §957(a).

You own 25% of the shares of a foreign corporation. Nonresident aliens own the other 75%. There is only one 10% voting US shareholder, who owns only 25% of the foreign corporation. The foreign corporation is not a CFC. You do not fall under the CFC-PFIC overlap rule. You must treat your shares in the foreign corporation as shares in a PFIC. You must file Form 5471 under category 3 as well as file Form 8621.

50-50 ownership with your nonresident alien spouse

Category 4 filers of Form 5471 are US persons who control a foreign corporation. Control means owning more than 50% of the voting power or shares of a foreign corporation. Form 5471 instructions, 2.

Suppose you are a US person, and your spouse is a nonresident alien. Each of you owns 50% of the shares of a family holding company, and the family holding company is a PFIC.

When you analyze ownership under category 4, you have to use attribution rules. Reg. §1.6038-2(c). You are treated as the owner of any shares that your spouse owns. IRC §318(a)(1)(A)(i). There is no exception for nonresident alien spouses under the attribution rules for category 4 filers.

Thus, for category 4, you are treated as owning 100% of the shares of the family company. You must file Form 5471 under category 4 to report the family holding company.

As it turns out, the CFC rules also have attribution rules, but there is one crucial difference: Under CFC attribution rules, a US person is not considered the owner of shares of a nonresident alien family member. IRC §958(b)(1).

Thus, for CFC purposes, there is only one US person who owns at least 10% of the voting power of the family company: You. You own only 50% of the shares. The family company is not a CFC. You do not fall under the CFC-PFIC overlap rule. You treat your shares in the family holding company as shares in a PFIC. You must file Form 5471 under category 4 as well as file Form 8621.

Buying out your 50-50 nonresident alien partner

Suppose you are a US person. You started an investment company with a nonresident alien business partner, and each of you owns 50% of the shares. The investment company is a PFIC. A few years later, you buy all shares from the business partner, so the investment company is now a CFC as well.

There is a “once a PFIC, always a PFIC rule”. It says that if you were, at any time during your holding period of shares in a foreign corporation, required to treat your shares as shares in a PFIC, then you must continue to treat your shares as shares in a PFIC. The only way to rid the shares of the PFIC stain is by making a purging election. Reg. §1.1297-3.

What happens after the buyout is this: You are a 10% voting US shareholder of a CFC, so you must file Form 5471 under category 5. But you also must treat your shares as shares in a PFIC, so you must file Form 8621. Both the CFC and PFIC rules apply to your shares. You may want to consider a retroactive purging election to rid the shares of the PFIC taint, starting on the day the foreign corporation became a CFC.

Summary

For a foreign corporation that meets the definition of a passive foreign investment company (PFIC), there is one situation where you have to file Form 5471 but not Form 8621. You must own 10% of the voting power of the foreign corporation, and the foreign corporation must be a controlled foreign corporation (CFC). In addition, you must not fall under a “once a PFIC, always a PFIC rule”.

By contrast, there are many situations where you must file both Form 5471 and Form 8621 to report the same foreign corporation. Therefore, you should take a look at both the Form 5471 filing requirements and Form 8621 filing requirements to determine whether you have to file either or both.

The post When You Have to File Both Form 5471 and Form 8621 appeared first on HodgenLaw PC – International Tax.

Getting a stock option from a PFIC

Here is a question from an email:

I am employee of a PFIC. My employer issued some stock options to me as part of my compensation. Do I have a PFIC problem?

This post describes why you cannot avoid passive foreign investment company (PFIC) taxes by holding onto an option or selling the option directly. But you may want to hold onto the option to reduce annual reporting requirements.

The option is an issue because of attribution rules

A passive foreign investment company (PFIC) is a special subcategory of foreign corporations. US shareholders of a PFIC are subject to punitive tax rules, so US persons want to avoid owning shares of a PFIC.

For this post, I assume you already know that you are dealing with a PFIC, so we only need to address the stock options.

The Internal Revenue Code contains attribution rules for PFIC share ownership to prevent US persons from using wrappers to avoid the PFIC rules. IRC §1298(a). One rule states:

To the extent provided in regulations, if any person has an option to acquire stock, such stock shall be considered as owned by such person… IRC §1298(a)(4).

Depending on what regulations the IRS has issued, your stock options in a PFIC can create PFIC issues for you.

Selling your option is treated as selling a PFIC

The IRS has not issued any final or temporary regulations about stock options, but it did propose 2 rules for options. The first rule says:

If a US person has an option to acquire stock of a PFIC […], such option is considered to be stock of a section 1291 fund for purposes of applying section 1291 and these regulations to a disposition of the option. For purposes of this paragraph (d), the exercise of an option is not a disposition to which section 1291 applies. Prop. Treas. Reg. §1.1291-1(d).

Section 1291 contains the default rules for taxing PFIC income. If you do not make a special election for your PFIC shares, the default rules under section 1291 apply. A section 1291 fund refers to a PFIC share that is taxed under the default rules.

What this proposed rule says is that if you transfer your options, the transfer of the options is treated as a transfer of shares in a PFIC. This rule prevents you from avoiding PFIC taxation by transferring the options directly rather than first converting the options to PFIC shares.

Your option holding period increases your PFIC holding period

The second rule under the proposed regulations says:

The holding period of a share of stock of a PFIC acquired upon the exercise of an option includes the period the option was held. Prop. Treas. Reg. §§.1291-1(h)(3).

This rule is best illustrated with an example. Suppose your employer grants you an option to acquire 100 shares on 2005-01-01. You exercise your options and acquire 100 shares on 2017-01-01, then sell the shares immediately.

Suppose your employer is not a PFIC. Under normal rules for holding period of property, your holding period for the shares begins on 2017-01-01, the day you exercised your options. IRC §1223(5). Thus, you have a holding period of 0 days.

Under the proposed rule, if your employer is a PFIC, then your holding period begins on 2005-01-01, the day the options were issued. Thus, you have a holding period of 12 years.

The holding period rule increases the tax you pay

Why does the IRS want your option holding period to increase your PFIC holding period? It has to do with way taxes are imposed on PFICs under the default rules. Here is an abridged version of the rules that apply to the sale of a PFIC share. IRC §1291.

1. When you sell a PFIC share, all your gain is “excess distribution”.
2. Your excess distribution is allocated evenly, by day, over your entire holding period.
3. Excess distribution allocated to the current year is ordinary income.
4. Excess distribution allocated to prior years is taxed at maximum tax rates for the prior years. This tax is the prior year excess distribution tax.
5. Interest is imposed on the prior year excess distribution tax, as if you owed tax from the prior years.

Returning to our example: Suppose your employer grants you an option to acquire 100 shares on 2005-01-01. You exercise your options and acquire 100 shares on 2017-01-01, then sell the shares immediately.

If your holding period begins on 2017-01-01, then your entire gain is allocated to the current year. Thus, the entire gain is taxed at ordinary income rates for the current year. You avoid interest charges.

If your holding period begins on 2005-01-01, then almost all gain is allocated to the 12 prior years. Thus, you pay a significant interest charge for gains allocated to prior years.

The proposed regulation forces you to include your option holding period in the PFIC share holding period. Thus, regardless of when you actually exercise your options, the holding period begins on the day you receive the options. Thus, you cannot avoid the PFIC interest charge by holding onto options.

You may want to hold onto the options to avoid annual reporting requirements

If you hold more than $25,000 worth of shares in PFICs, you must file Form 8621 annually to report all your PFIC shares. Reg. §1.1298-1T.

The option attribution rules require you to treat stock options as shares in a PFIC under 2 circumstances:

1. You must treat stock options in a PFIC as share in a PFIC when you sell the option.
2. You must include your holding period for the option in your holding period of shares acquired from exercising the option.

There is nothing about treating stock options in a PFIC as shares in a PFIC for the purpose of annual reporting requirements. Thus, if you hold onto the options, you can reduce your annual compliance requirements slightly.

Summary

If you sell stock options in a PFIC, the sale is treated in the same way as if you actually sold shares in a PFIC. If you exercise your options, the PFIC shares you receive have a holding period that start on the day you received options. This makes the tax results the same whether you sell the option or the PFIC shares. It makes the tax results the same regardless of when you exercise your options. Holding onto the option does not affect your tax liability.

But you may want to hold onto the options to avoid annual reporting requirements.

The post Your Stock Options in a PFIC appeared first on HodgenLaw PC – International Tax.

Renting land to yourself

Today’s post is a case study of why you might avoid PFIC classification if you rent land to your own business. This post also shows why 50-50 joint ventures are rather dangerous.

The setup

Suppose you run into this setup:

You, a US person, go into business with an unrelated nonresident alien. You take 40% of the share of an operating company, and your partner takes 60%. You need to buy land for the business to use, but your investors or creditors demand that you hold the land in a separate company. So you and your partner create a separate land company and buy the land using the land company. You have the same 40-60 share split. Then land company then rents to the operating company.

To make this post shorter, I assume that both the land company and the operating companies are foreign corporations. I assume the operating company does not have any passive income or passive assets within the meaning of the PFIC 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)):

1. Income test: At least 75% of the corporation’s gross income is passive income.
2. 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.

We assumed the operating company does not have any passive income or passive assets, so we win by fiat on the operating company. What is more interesting is the land company. After all, it merely collects rent on land. Is it a PFIC?

A related party exception prevents the land company from having passive income

In general, rent is passive income. IRC §§1297(b)(1), 954(c)(1)(A). But there is an exception for rent received from a related person:

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 amount is properly allocable […] to income of such related person which is not passive income… IRC §1297(b)(1)(C).

There are two criteria here for the rent to be non-passive income:

• The rent must be from a related person; and
• The rent must not be allocable to the related person’s passive income

The rent is not allocable to passive income

We assumed that the operating company does not have passive income, so any rent it pays to the land company is not allocable to the operating company’s passive income. In this post, we win by fiat.

Our assumption is not always true: An operating company generally has some passive income. For example, most operating companies buy cash equivalents and invest in securities rather than leaving cash in a non-interest bearing account. In most cases, we expect passive income to be low compared to nonpassive income, so to make it easy, we assumed that the operating company has no passive income.

The operating company is related to the land company

Related person has the same definition as used in IRC section 954(d)(3). IRC §1297(b). Section 954(d)(3) describes several ways of being related, but the one that is important for us is this one:

[A] person is a related person with respect to a [foreign corporation] if […] such person is a corporation […] 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).

Here, the nonresident alien business partner owns 60% of the shares of both the operating company and the land company. Thus, the nonresident alien business partner controls both companies. The companies are related persons.

The rent is not passive income

We know that the rent is not allocable to passive income under our assumptions, and the operating company is related to the land company by having the same controlling shareholder. Therefore, the rent the operating company pays to the land company is not passive income.

The same exception should prevent the land from being passive assets

The land generates nonpassive income: rent from a related person. But it is theoretically possible for the land to generate passive income, such as gain from sale to an unrelated person. Can the land be a passive asset because of the probability of generating passive income when it is sold? The IRS has not answered this question directly.

There are two separate reasons the land should be a nonpassive asset: The text of the Code and an IRS notice.

The text of the code suggests actual use matters, not theoretical possibility

We use passive assets as a shorthand when describing the asset test, but the actual text of the Code for the asset test is as follows:

the average percentage of assets […] held by such corporation during the year which produce passive income or which are held for the production of passive income is at least 50 percent. IRC §1297(a)(2).

There are two ways for an asset to be a passive asset: It produces passive income, or it is held for the production of passive income.

The first way refers to what the asset actually is doing: Is it generating passive income or not? Here, the land is not generating passive income, because it generates nonpassive rent. Under the first way, the land is a nonpassive asset.

The second way refers to intention: Why is it being held? For land, this seems to suggest that land held as investment is passive, while land used in the business of the corporation is nonpassive. Under the second way, the land is a nonpassive asset.

By parsing the Code, it is likely that the land company’s land is a nonpassive asset.

Notice 88-22 suggests actual use matters, not theoretical possibility

Notice 88-22 is one of the few examples of guidance that the IRS has issued on how to classify assets. Unfortunately, the IRS issued this notice back when passive income for PFIC purposes was defined as passive category income under foreign tax credit rules, so it refers to section 904, which deals with foreign tax credits. Notice 88-22; 1988-1 CB 489.

Now, passive income for PFIC purposes is defined as foreign personal holding company income under controlled foreign corporation rules. Thus, it is not clear how much of Notice 88-22 still applies. But when Notice 88-22 is consistent with the text of the Code, the notice is perhaps still a reasonable point of reference.

Notice 88-22 says that generally, an asset is classified according to the type of income it generates (or is expected to generate). Notice 88-22. This is consistent with the text of section 1297(a)(2). Thus, we probably are safe classifying the land as nonpassive based on the fact that it generates nonpassive rent.

Be careful of 50-50 joint ventures

In our particular case, we used a related party exception to classify the rent as nonpassive income, because one shareholder owned more than 50% of the shares of both the operating company and the land company.

In a 50-50 joint venture, no person controls both the land company and the operating company, so they are no longer related parties. Thus, the related party exception no longer saves the rent from being passive income.

In proposed 50-50 joint ventures, it may be well worth it to give the nonresident alien business partner 50.01% of the shares (by voting power or by value) to take advantage of the related party exception.

The post Holding Business Real Estate in a Separate Company appeared first on HodgenLaw PC – International Tax.

Pooling your stock reward

We got a fairly complex question about a US person pooled his stock reward with his coworkers. By doing so, the US person created a potential PFIC problem.

This post is a brainstorming session on how the US person might get out of his PFIC problems.

The scenario

Here is the scenario:

I am a manager of a private foreign business. In advance of an upcoming IPO, the private foreign business offered its managers the chance to buy shares in the top level parent corporation.

For the purpose of pooling our resources, the managers formed a foreign corporation (manager holding company) and bought shares of the parent corporation in the name of the manager holding company. I am the only US person among the managers. I hold a minority stake in the manager holding company.

When the parent corporation went public, the manager holding company dissolved and distributed its assets and liabilities to the managers. In the articles of dissolution, the manager holding company and managers agreed that all transactions that occurred will be deemed to have been conducted by the individual managers. Each manager picks up his or her share of liabilities and assets, income, and expenses of the manager holding company.

All transactions took place in one tax year.

I will add another assumption to this scenario: None of the entities in the foreign business in which our reader bought shares is a PFIC. This way, we do not have to worry about lookthrough rules for the parent corporation or any subsidiary corporations. We focus on the manager holding company only.

The manager holding company looks like a PFIC

A passive foreign investment company (PFIC) is any foreign corporation that meets either an income test or an asset test. IRC §1297(a).

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

The manager holding company is a foreign corporation. Its only assets were cash and stocks in a foreign corporation. Cash can give rise to interest. Stocks give rise to dividends. Interest and dividends are passive income. And the capital gain from selling the stocks is passive income, because the stocks give rise to dividends. IRC §§1297(b), 954(c)(1)(A), (B)(i). Therefore, the manager holding company looks like a PFIC.

The CFC-PFIC overlap rule is not helpful

There is a special rule that says if you are a US person, you own at least 10% of the voting power of a foreign corporation, and the foreign corporation is a controlled foreign corporation (CFC), then you do not treat your shares in the CFC as PFIC shares. IRC §1297(d).

You can check for CFC status using the following test:

• Look at all US persons who own at least 10% of the voting power in the foreign corporation.
• Add up the shares of these 10% US voting shareholders.
• If the sum of their shares is more than 50% of the total voting power, or the sum of their shares is more than 50% of the total share value, then the foreign corporation is a CFC.

Here, our reader is the only US person who owns shares in the manager holding company, and he owns a minority of the shares. Therefore, the manager holding company is not a CFC. The CFC-PFIC overlap rule does not apply.

Maybe the startup year exception applies

A startup exception for PFIC status exists. A foreign corporation can escape PFIC classification for a startup year if all the following conditions are true. IRC §1298(b)(2).

• The foreign corporation does not have any predecessor that was a PFIC;
• The foreign corporation (or a US shareholder) establishes to the IRS that the foreign corporation will not be a PFIC for the next 2 tax years; and
• The foreign corporation is not a PFIC for the next 2 tax years.

This rule looks appealing, because if a foreign corporation liquidates in the first year of its existence, then of course it cannot be a PFIC in the next 2 years.

But we have to wonder whether it is worth using the startup year exception.

Our reader held the shares in the manager holding company for less than 1 year. If the manager holding company is a normal corporation, then the gain our reader realizes from the liquidation of the manager holding company is short-term capital gain. He pays ordinary income tax rates on the gain.

If the manager holding company is a PFIC, then the gain is excess distribution. IRC §1291(b). But because the manager holding company has existed for only 1 year, the entire excess distribution is ordinary income. IRC §§1291(a)(1)(B)(i).

Either way, the gain is taxed at ordinary income rates. The only advantage of using the startup year exception is to reduce the paperwork associated with PFICs.

Maybe the foreign corporation never owned the stocks

An interesting feature of this transaction is that the managers assumed all liabilities of the manager holding company during liquidation. This is an unusual step: Usually the shareholders of an entity with limited liability do not assume the entity’s liabilities upon liquidation.

Perhaps the managers really entered into an informal general partnership, with the manager holding company as the managing partner. A general partnership seems to describe the relationship between the parties fairly well: As an agent for all partners, the manager holding company can incur liabilities that bind the other general partners.

There are difficulties with this solution. For example, the managers did not, from the outset, assume liabilities of the manager holding company. And it is not clear that the creditors of the manager holding company could have sought damages from the shareholders without the liquidation agreement. In this respect, the arrangement is unlike a general partnership.

Then there are issues with formality. There is no general partnership agreement. The manager holding company does not hold itself as a partner in a partnership. And the manager holding company holds itself out as a company in which the manager own shares. The IRS may use the formal structure the manager holding company adopted against our reader.

And then there is the question of whether it is worth it to risk characterizing the arrangement as a general partnership. When a partnership distributes marketable securities, and the value of the securities exceed a partner’s basis in the partnership, the partner must recognize gain. IRC §731(a)(1), (c)(1). Here, the general partnership, if there is one, is distributing shares in a public corporation. Thus, the distribution of the shares would require our reader to recognize gain.

The gain is short-term capital gain, because our reader held his partnership interest for less than 1 year, and the partnership held the shares for less than 1 year. The gain is taxed at ordinary income rates–the same tax rate that would apply if he had PFIC gains. Again, the only advantage of avoiding PFIC classification would be to reduce the associated paperwork.

Last thoughts

Could our reader get out of having to recognize PFIC gains? It is possible. There are reasonable arguments, though not necessarily winning ones. The startup exception might apply, or the managers and the manager holding company entered into a general partnership that held the shares.

But in this particular situation, the advantage to taking risky positions appears to be very small–it saves a bit of paperwork to prepare Form 8621. Whether the manager holding company is a PFIC, a normal corporation, or the general partner of a partnership, it seems that our reader would have to pay tax at ordinary income rates.

The post PFIC Problems when Pooling Stock Reward appeared first on HodgenLaw PC – International Tax.

Debts instruments that sound somewhat like shares

This is a question that came by way of email:

I own some exchange traded notes. Are those PFICs?

In this post, I will discuss the factors that you can examine to check whether buying a particular debt instrument carries any risk related to passive foreign investment companies. Then, we can check if exchange traded notes are debt or shares.

What are exchange traded notes?

Exchange traded notes (ETN) is a type of debt instrument. They have a fixed maturity date. They pay interest, but the rate of interest depends on an index or market benchmark. They are senior, unsecured, and unsubordinated debt securities. They are not backed by any assets. Only the credits of the underwriting bank back the ETNs.

What are PFICs?

Passive foreign investment companies (PFICs) is a specific classification under US tax law. When a US person owns shares in a PFIC, the US person is subject to extremely punitive tax and reporting rules.

There are many rules for determining whether the instrument you own represents shares in a PFIC, but for today’s post, we only care about the following: To be subject to PFIC rules, what you own must represent shares in a foreign corporation.

If all you own is a debt that a foreign corporation owes, then you do not own shares in a foreign corporation. Thus, if we can show that ETNs are debt rather than shares, then we can say that they are not PFIC shares.

ETNs should be debts

In the not too distant past, affiliated corporations issued debts to each other that generated interest deductions but provided benefits of shares of stock to the creditors. Thus, the IRS and the courts developed a set of tests to determine whether an alleged debt instrument is really a share in the debtor, and Congress codified some of the factors used in these tests.

Statutory factors suggest ETNs are not shares

Congress has given us 5 factors for determining if an instrument is debt or stocks. IRC 385(b).

First, is there an unconditional promise to pay, on demand or with a maturity date, a principal sum and a promise to pay interest? An ETN clearly has a promise to pay principal and interest through a maturity date. An ETN is like a debt here.

Second, is the debt subordinate to other debts? An ETN is not subordinate to any other debts, unlike shares. An ETN is like a debt here.

Third, does the debtor corporation have a high debt to equity ratio? We do not know the answer here, but the worth of an ETN is strongly tied to the credit-worthiness of the underwriting bank. Thus, it is unlikely that the bank would have an outrageously high debt to equity ratio. But let us say this factor does not favor debt or shares of stock.

Fourth, can the debt be converted to shares? An ETN cannot be converted to shares. An ETN is like a debt here.

Fifth, what is the relationship between the debtor and creditor? The buyers of ETNs are just buyers on a public exchange. They are not related to the bank. It is unlikely that the buyers and the bank are colluding to disguise shares as debt. An ETN is like a debt here.

Under the Congressional criteria, exchange traded notes are like debts.

Case law suggests ETNs are not shares

The IRS and courts have developed additional factors. See e.g. Notice 94-47; Charter Wire vs US, 309 F.2d 878 (7th Cir. 1962). Here are some relevant examples.

What is the name given to the instrument? ETNs are named notes rather than stock. An ETN is like a debt here.

What is the source of the payment? Here, the ETNs pay interest according to a market index. But even if we assume that the market index is an index of dividends that corporations pay on the market, the interest paid on the ETN is not related to the profits of the issuer. A bank that is making losses must still pay interest on the ETN. An ETN is like a debt here.

What is the intent of the parties? Both the buyers and the issuer appear to what a debtor-creditor relationship. An ETN is like a debt here.

Is there participation in management? Holders of ETNs have no right to vote in shareholder meetings and no right to direct the management of the issuing entity. An ETN is like a debt here.

What is the security for the debt? There is no security for ETNs. The ETN holder is not entitled to any assets of the issuer. An exchange traded note is like a debt here.

Exchange traded notes are most likely debt instruments rather than shares

ETNs are like debts under almost all factors that distinguish between debts and disguised shares. It is almost certain that ETNs are debt instruments rather than shares. Because ETNs are not shares in a foreign corporation, owners of ETNs do not have PFIC issues–they do not own shares of PFICs.

When in doubt, follow the label the issuer gave to the instrument

The test for whether a particular instrument is debt or stock is an “all facts and circumstances test”. What this means is that the IRS and the courts have relatively wide discretion to weigh the factors differently, depending on how they perceive the transaction overall. Sometimes you can look at the factors, and the result does not clearly favor debt or stock.

Congress gave us a bit of confidence in how we should report a publicly traded security, even if it did not opt to give us certainty in the outcome:

The characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but shall not be binding on the Secretary).

Except as provided in regulations, paragraph (1) shall not apply to any holder of an interest if such holder on his return discloses that he is treating such interest in a manner inconsistent with the characterization referred to in paragraph (1). IRC §385(c)(1), (2).

When the result is ambiguous, there is an easy solution. In general, the law requires us to follow what the issuer of the instrument says it is. These alleged debt instruments are labeled as note. So unless it is clear that they are in fact shares, we should follow the label and treat them as notes.

The IRS is free to disagree, but because we are following statutory command, the most the IRS can do is impose taxes and interest for underpayment.

The post Are my Exchange Traded Notes PFICs? appeared first on HodgenLaw PC – International Tax.

Today’s topic is based on some war stories we have seen. Here is the general situation we have had to deal with:

I am a US citizen living abroad and married to a foreign national. She and I both owned some PFICs. We transferred them to a family trust whose trustee is a private company we own 50-50. Our children and we are beneficiaries of the family trust. Do I have to report the PFICs held in the family trust as my own?

Today’s post will discuss some of the uncertainties and possible results for PFIC attribution through a trust.

What are PFICs?

Passive foreign investment company (PFIC) is a special category under US tax law. When a US person has income from a PFIC, the income is taxed and reported under extremely punitive rules. IRC §1291. It is generally a good idea for a US person to avoid owning PFICs.

PFICs can include shares in pooled investment vehicles such as mutual funds, money market funds, exchange traded funds, and the like. It can happen even if the investment vehicle is not organized as a company under foreign law. For this post, we will not get into details about what a PFIC is. We assume the couple owned PFIC shares and transferred them into the family trust.

Report the PFICs the US spouse transferred into trust

Let us divide the PFIC shares into 2 sets: shares that the US spouse transferred into the trust and shares that the foreign spouse transferred into the trust.

For the shares the US spouse transferred into trust, the result is simple: Report the PFIC shares as if the US spouse still owns them. This is the result of how trusts are taxed in general rather than any specific rules about PFICs, so let us go through a quick primer on trusts.

An individual taxed as the owner of a portion of a trust

To discourage the use of trusts to defer tax, the Internal Revenue Code has rules to tax individuals as owners of a trust (or a portion of the trust), as if the individuals owned the assets directly. IRC §§671-679. Usually, the individual is a grantor of the trust (a person who transferred assets into the trust), though it is possible for a beneficiary to be taxed as the owner.

The US spouse is taxed as the owner of the PFICs he transferred into trust

If a US person transfers assets into a foreign trust, and the trust has a US beneficiary, then the US person continues to be taxed on the portion of the trust attributed to the transfer. IRC 679(a).

Here, the family trust is foreign, because its trustee is a foreign private company. Reg. §301.7701-7(a). The US spouse transferred PFICs into the family trust. He is a beneficiary of the family trust. Therefore, he continues to be taxed on the PFICs he transferred into the family trust as if he still owned them. He reports the PFICs as if he owned them directly.

There are also trust reporting requirements (such as Form 3520 and Form 3520-A), but those are beyond the scope of this post.

No clear result for the PFICs the foreign spouse transferred into trust

Now for the PFICs that the foreign spouse transferred into the family trust. The rules are more complicated here.

It is not clear if the foreign spouse is taxed as the owner of her transfers into trust

When a foreign person transfers assets into a trust, the conditions that permit the foreign person to be taxed as the owner of the trust are much more limited than when a US person makes the transfer. IRC §672(f)(1). For a family trust, the foreign spouse can be taxed as an owner only if

• The foreign spouse has sole power to take out trust assets she transferred into trust without the consent of an adverse party; or
• The foreign spouse and her spouse are the only possible recipients of trust distributions during their lifetimes. IRC §672(f)(2).

For a family trust, the children are usually beneficiaries. Therefore, the grantor and her spouse are not the only possible recipients of trust distributions during the grantor’s lifetime. Family trusts almost never satisfy the second rule.

From what I have seen, often neither spouse has any direct powers over the trust–they exercise power indirectly through the trustee company. In these situations, neither spouse has sole power to take out trust assets. Therefore, these trusts do not satisfy the first rule.

Every trust is set up differently, so it would be necessary to examine the trust documents to see who has power over the trust and what powers they have. It is not always clear that the foreign spouse can be taxed as the owner of any portion of the trust.

No clear attribution rules if the PFICs the foreign spouse transferred are not owned by anyone under trust rules

Keep in mind that a trust can be split into more than 1 portion. It is possible for a portion of the trust to be taxed to someone as the owner, and for another portion of the trust to be taxed to the trust itself.

Let us assume that, under the trust rules, no one is taxed as the owner of the PFIC shares the foreign spouse transferred into the family trust. What do the PFICs rules say?

The Code simply says that when a trust owns PFICs, the PFICs are attributed to the beneficiaries proportionately. IRC §1298(a)(3).

The regulations simply add that all the facts and circumstances should be taken into account, and you should use substance over form. Reg. §1.1291-1(b)(8)(i). For now, the IRS permits any reasonable method. 78 Fed. Reg. 79604 (2013).

Some examples of methods we would consider reasonable:

If the trust specifies how the income must be distributed, and the trustee follows the trust instructions, then the trust instructions tell us how to attribute the shares. Unfortunately, most family trusts are discretionary, meaning that the trust instrument does not specify how income must be distributed.

If there was a pattern of distributions between the beneficiaries before the PFICs were transferred into trust, then generally that pattern of distributions controls how income of the trust is taxed. For example, if the trust distributes 100% of its income to the foreign spouse each year, then it would be prudent to attribute all PFICs to the foreign spouse.

If there is no clear pattern of distribution, then we take a reasonable shortcut: Attribute the PFICs to the grantor who transferred them into trust. After all, the family trust is effectively revocable: The spouses control the trustee company, and through the company’s powers as trustee, the spouses can return the trust assets to themselves.

The substance of the arrangement is that the spouses can dissolve the trust at any time, at which time the trust assets presumably return to their original owners. Thus, the substance of the trust arrangement suggests that, for the PFIC shares the foreign spouse transferred to the trust, we should attribute the shares to the foreign spouse.

The post Attribution of PFICs Through a Family Trust appeared first on HodgenLaw PC – International Tax.

PFICs held in a fund

This is a situation we see fairly often:

I have a foreign retirement account. I realized that I am taxed on the income from the account as if it is a normal account. The account owns a single fund offered through the account custodian, which invests in several publicly traded funds. Can I make a mark-to-market election for the underlying publicly traded funds?

For today’s post, we will assume that in fact, the US person is taxed as if the retirement account is just a normal investment account. That is not always the case for foreign retirement accounts.

We will discuss when the US person can, and whether they should, use a mark-to-market election for the underlying funds to reduce the tax burden from passive foreign investment companies (PFICs).

What is the mark-to-market election?

The mark-to-market (MTM) election is a special election you can elect for passive foreign investment companies (PFICs).

Under MTM rules, you are deemed to have sold your MTM shares at the end of each year. IRC §1296(a). You recognize gain as ordinary income. IRC §1296(c)(1)(A). You can use loss, but the amount of your loss you can use is limited. IRC §1296(a)(2).

This sounds rather terrible, but it is actually often better than the default rules for taxing PFICs, so if a US person owns a PFIC, making the MTM election is often desirable.

What is a PFIC, and why does the US person have this problem?

A PFIC is a foreign corporation that either (a) derives 75% or more of its income from passive income, such as dividends, interest, gains from selling property that give rise to dividends and interest, and the like; or (b) has assets that are 50% or more passive. IRC §1297(a).

Foreign funds derive almost all passive income, and they own almost all passive assets. Usually, the only question is whether they are foreign corporations. Most of the time, publicly traded funds have a legal structure that is classified as a corporation under US tax law, even if they are not organized as a company under foreign law.

Let’s assume that the underlying publicly traded funds are PFICs.

Requirements for the MTM election

The MTM election is available for “marketable stock”. IRC §1296(a).

The first requirement for being marketable is that it must be regularly traded on a qualified exchange. Reg §1.1296-2(a)(1).

Regularly traded means more than de minimis (negligible) volume of trade in on at least 15 days during each calendar quarter. Reg. §1.1296-2(b)(1). When a financial firm registers a fund on an exchange for public trading, usually the fund is regularly traded on the exchange.

Qualified exchanges includes any SEC regulated exchange, but it also includes any foreign exchange that (Reg. §1.1296-2(c)(1)):

• Is regulated by a government entity;
• Has volume, listing, financial disclosure, oversight, and other requirements that prevent fraud and manipulation and promote an open, fair, and orderly market that protects investors; and
• The laws of the country are actually enforced.

As far as I know, the IRS has never published a list of exchanges that satisfy these criteria or explained what they mean. We generally assume that large, reputable exchanges exchanges qualify. But there are some uncertainty as to what open, fair, and orderly means. For example, the Shanghai exchange has A shares (which are only available to Chinese nationals and companies) and B shares (which are open to foreigners). Is the Shanghai exchange open and fair, despite the nationality restriction? It is not clear from the IRS guidelines.

For this post, I assume that the underlying publicly traded funds are regularly traded on a qualified exchange.

The intermediate fund creates problems

Recall that the retirement account does not hold the publicly traded funds directly. The retirement account holds a fund that the account custodian offers, and the fund in turn invests in the publicly traded funds.

The intermediate fund may not be eligible for MTM election

In many situations, the intermediate fund is not publicly traded–it is only available to those who hold retirement accounts with the account custodian. Thus, it is not uncommon to see an intermediate fund that is not marketable and thus not eligible for the MTM election.

The intermediate fund may prevent MTM elections for the underlying funds

Normally, when you own a PFIC, and that PFIC owns other PFICs, you must look through the intermediate PFIC to the underlying PFICs, as if you owned them directly. IRC §1298(a)(2)(B).

Unfortunately, MTM uses a different set of lookthrough rules. You look through a foreign partnership, foreign trust, or foreign estate. IRC §1296(g)(1). You cannot look through a foreign corporation. 67 FR 49637. Thus, if the intermediate fund is a PFIC, then you cannot make the MTM election for the underlying funds.

Do not make a MTM election for the intermediate fund, even if you can

Let us assume that the intermediate fund is marketable, so you can make the MTM election. The result of making the MTM election is that the intermediate fund will be subject to MTM, so you are taxed on any increase in value of the intermediate fund during the year.

But you still cannot make MTM elections for the underlying funds, because you own them indirectly through a foreign corporation. This means the underlying funds are taxed under the default rules for PFICs.

Furthermore, under the default lookthrough rules, you must look through the intermediate fund to the underlying funds. Thus, you are taxed on income from the underlying funds directly under the default rules for PFICs.

This results in double taxation. First, you pay tax on the income from the underlying funds using the default rules for PFICs, because you must look through to them. Second, you pay tax on the increase in value of the intermediate fund, because income or growth from the underlying funds tends to increase the value of the intermediate fund.

Unfortunately, this means even if the intermediate fund is marketable, you do not want to make a MTM election for the intermediate fund.

You can get out of this problem if the intermediate fund is a partnership

Under the MTM rules, if you own a PFIC through a foreign partnership, then you can make the MTM election for the underlying PFIC. Thus, if the intermediate fund is a partnership, then you can make the MTM election for the underlying funds.

It is not impossible for the intermediate fund to be a partnership: If the intermediate fund creates personal liability for the investors, then it would be a partnership under US tax law. Reg. §301.7701-3(b)(2)(i)(A). Figuring out whether the intermediate fund is classified as a partnership means looking at local law governing liabilities to creditors, then determining if the investors in the intermediate fund have personal liability for the debts of the fund.

Summary

When you own publicly traded funds that are classified as PFICs, it is often possible to elect the mark-to-market (MTM) treatment for the funds to reduce US tax burden. But when you own an intermediate fund that, in turn, invests in other funds, there are issues.

You often cannot make the MTM election for the underlying funds, because you can make the MTM election only for PFICs you own indirectly through partnerships, estates, and trusts. And the intermediate fund often is not eligible for MTM, because it is not marketable. Even if the intermediate fund is marketable, it is a bad idea to make the MTM election for it, because it results in double taxation under lookthrough rules.

The post Mark-to-Market Election for PFICs You Own Through a Fund appeared first on HodgenLaw PC – International Tax.

Is my pension fund a PFIC?

This is a question we get frequently through email:

I have a pension fund. Is that a PFIC?

Unfortunately, there is no easy answer to this question, because every country has a different pension system, and they can be classified wildly differently depending on how the country’s pension works.

For this post, I will pick on the retail Australian super fund again, because I happen to see a lot of them. This post merely illustrates one process I use to determine if there is a PFIC problem.

What is a super fund?

It is a retirement savings schemes. A super fund can contain up to 3 components:

• Superannuation guarantee, which is a mandatory employer contribution set at a percentage of wage;
• Salary sacrifice, where the employee agrees to contribute a percentage of his salary in return for some level of matching employer contribution; and
• Voluntary contributions.

It is organized as a trust in Australia. The account balance is locked in until the owner is old enough, though there are some early distribution rules such as for extreme hardship.

I will assume that we are talking about a retail fund, meaning a super fund that an established financial institution offers to many clients. This post does not discuss self-managed super fund.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. When a US person owns shares in a PFIC, the US person is subject to extremely punitive tax and reporting rules.

An important element of a PFIC is that it must be a foreign corporation. IRC §1297(a). If you have a foreign arrangement that is something other than a corporation, then you do not have a PFIC, regardless of whether you are receiving the benefits of passive foreign investments or not.

How can a trust be a corporation?

I wrote about this in some detail here, but the basic idea is this.

US tax law has its own classification system that relates to how an entity is classified under local law, but the result is not necessarily the same as under local law. Reg. §301.7701-1(a).

Some trusts are business trusts organized for the purpose of conducting a business; some trusts are investment trusts where the trustee has the power to change the investments; these trusts are business entities rather than trusts. Reg. §301.7701-4(b), (c).

A foreign business entity that provides limited liability for all members is by default a corporation. Reg. §301.7701-3(b)(2)(i)(B).

Based on these rules, foreign investment vehicles such as unit trusts and mutual fund trusts are often (though not always) foreign corporations for US tax purposes.

But the retail super fund probably is not a business entity

Now let us look at the retail super fund and see whether it is a foreign corporation.

It’s not a business trust

A business trust is organized for the purpose of conducting a profit-making business. Reg. §301.7701-4(b). This refers to activities such as retail, providing services, manufacturing, and the like. This is in contrast to making investments. Reg. §301.7701-4(c).

A retail super fund usually makes passive investments, so it is not a business trust.

It is probably not an investment trust

The regulations do not define what an investment trust means, but they appear to refer to a trust organized for holding investments. Commissioner vs North American Bond Trust, 122 F.2d 545 (2nd Cir. 1941). A super fund certainly holds investments.

A retail super fund is organized for the purpose of providing for retirement. It does so by making investments to grow the super fund. But a normal trust also makes investments so it can grow its assets for the beneficiaries. In fact, the trustee is normally required to make prudent investments with the trust funds. Restat. 3d Trusts, §§90-92. So the mere fact that a trust makes investments does not mean it is an investment trust.

We should contrast an investment trust with the definition of an ordinary trust, which is “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…” Reg. §301.7701-4(a).

If the employee selects a conservative (and possibly balanced) investment plan for the retail fund, then we can be fairly certain that the purpose of the trust is to protect or conserve trust assets for retirement. Thus, the super fund is an ordinary trust rather than an investment trust.

If the employee selects an aggressive investment plan, then the result is not quite so clear. But here is my thought: Australia has a comprehensive set of rules about what a super fund can do. They are similar to US retirement fund rules and trust rules. They are (supposedly) intended to protect the retiree’s retirement funds. If a trust can take an action under these rules, then they should fit under the purpose of protecting or conserving property for retirement. Thus, I would still classify the super fund as an ordinary trust rather than an investment trust.

It is not a PFIC

A corporation is a type of business entity. A business entity is not a trust. Reg. §301.7701-2(a). The super fund is probably a trust, so it cannot be a business entity. Thus, the super fund is not a PFIC.

The retirement fund owns one large fund investing in smaller PFICs

A very common practice for these retirement fund is to buy only shares of “pension provider conservative fund”, “pension provider balanced fund”, or “pension provider growth fund”, depending on the employee’s selected investment strategy.

These funds represent separate investment funds that the pension provider organized. They are separate from the retirement fund itself. These very likely are PFICs. So it is quite possible that even though the retirement fund itself is not a PFIC, its assets consist of nothing except shares in a PFIC.

And these PFICs often invest in exchange traded funds, so they own PFICs.

Not suitable for generalization

This post looked at a retail Australian superannuation fund, because I happen to see them fairly often. It might not be suitable for self-managed super funds. It should not be generalized to all foreign pensions, because each country has a different pension system. Other pensions might be PFICs, investment accounts, saving accounts, or annuities, depending on how they are operated and what rules apply to them, and they might not hold PFICs.

The post Is My Retail Super Fund a PFIC? appeared first on HodgenLaw PC – International Tax.

This is a question we get through email and client work fairly often.

I made an investment into a foreign investment vehicle. Maybe it is a partnership rather than a PFIC?

This post is something of a sequel to this post, describing why a unit trust is likely a PFIC, despite being organized as a trust under local law. This post’s focus is on distinguishing between partnerships and corporations.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. When a US person owns shares in a PFIC, the US person is subject to extremely punitive tax and reporting rules.

An important element of a PFIC is that it must be a foreign corporation. IRC §1297(a). If you have a foreign arrangement that is something other than a corporation, then you do not have a PFIC, regardless of whether it makes passive investments or not.

A quick background on classification of foreign business entities

This is a quick summary of how the US classifies foreign arrangements:

1. The investment arrangement is some sort of business arrangement for making investments, so it is a business entity. Reg. §§301.7701-1(a), -2(a), -4(c).
2. It is a foreign business entity, because it is organized outside the US. Reg. §301.7701-5(a).
3. It (usually) is not among the list of entities that are always classified as corporations, so it is eligible to choose its classification. Reg. 301.7701-3(a), -2(b)(8).
4. It has not chosen a US tax classification, so it receives a default classification.

The 4th step is what is important to this post:

• If it has 2+ members, and at least 1 member does not have limited liability, then it is a partnership. Reg. §301.7701-3(b)(2)(i)(A).
• If all members have limited liability, then it is a corporation. Reg. §301.7701-3(b)(2)(i)(B).

How do we know if a member has limited liability?

The regulations tell us what limited liability means:

[A] member of a foreign eligible entity has limited liability if the member has no personal liability for the debts or claims against the entity by reason of being a member. This determination is based solely on the statute or law pursuant to which the entity is organized, except that if the underlying statute or law allows the entity to specify in its organizational documents whether the members will have limited liability, the organizational documents may also be relevant. For purposes of this section, a member has personal liability if the creditors of the entity may seek satisfaction of all or any portion of the debts or claims against the entity from the member as such. Reg. §301.7701-3(b)(2)(ii).

To put this in shorter words: A member has limited liability if he has no personal liability. He has personal liability if the creditors of the entity can seize the member’s assets to satisfy all or part of claims against the entity.

The most familiar example of personal liability is the general partnership. The partners are jointly and severally liable for the liabilities of the partnership. This means a creditor of the partnership can sue any partner (or any combination of partners) and recover any portion of the partnership’s debts when the partnership does not have enough assets to pay the debt.

With this in mind, I will take a look at 2 liability arrangements and see why they are (or are not) personal liability.

Registered capital

This is an arrangement that I have seen in China, Singapore, and Japan. To incorporate a company, it must have a minimum registered capital. It is legal to start operating without the full registered capital, but if the company goes bankrupt, and the shareholders have not contributed the entire registered capital, then they are liable to the creditors for the deficiency.

At first glance, it seems that the members of the company has personal liability, because a creditor may satisfy “any portion of the debts” of the company against the owners. The administrative history of the regulation suggests that is an overly broad interpretation. Here is what the IRS said when it was adopting this regulation:

A member of a foreign entity has limited liability only if, based solely on the controlling statute or law pursuant to which the entity is organized, the member’s personal liability for the debts or claims against the entity is limited (for example, to the amount of the member’s unpaid capital contribution or to the amount of a statutorily limited guarantee). 61 FR 21991.

The administrative history tells us directly that unpaid capital contribution is a limit on liability.

It seems more likely that this is a case of bad wording for the regulation: By using an expansive phrase like “all or any portion of the debts”, the regulation unintentionally made limited liability sound like something that is inconsistent with the common understanding of limited liability–that there is some limit to liability other than how much the member owns or how large the debt is.

These companies are corporations by default, because the members have limited liability.

Proportion of liability

In some cases, you might find an example where the members of the entity are responsible for only a proportion of the entity’s debts. For example, if a unit holder owns 20 out of 100 units of a unit trust, then in these types of arrangements, the unit holder is responsible for 20% of the unit trust’s debts only. Is this personal liability?

We can see this in the administrative history of the regulations. Specifically, when the IRS first proposed section 301.7701-3(b), governing default classifications, it focused on whether there exists a member with unlimited liability, and it defined unlimited liability to mean when a creditor “may seek satisfaction of debts or claims against the entity”. 61 FR 21996.

The IRS then received some comments, pointing out that there are some foreign joint ventures where the partners are not jointly or severally liable, meaning each partner is liable for only a portion of the debts. 61 FR 66586. The comments suggested, and the IRS agreed, that these entities should be partnerships by default. 61 FR 66586. In response, the IRS adopted the current wording of the regulations, focusing on whether all members have limited liability and definition personal liability to mean when a creditor “may seek satisfaction of all or any portion of the debts” from the members (adding “all or any portion”). 61 FR 66591.

From the administrative history, we can see why the regulation has such an expansive wording: It is meant to catch situations where members have personal liability in proportion to their membership interest. In these situations, there is a limit to the personal liability, but it is defined in reference to the amount of debt (amount of debt times membership interest). The member has personal liability.

These types of arrangements are partnerships by default.

Consult with a local expert if you are not sure

As the regulations point out, the question of whether there is limited liability is a matter of local law where the business entity is formed. If you want to determine whether an investment is a PFIC by attacking whether it is a corporation, it is prudent to consult with a local expert on whether the members of the entity have personal liability for the entity’s debts.

The post Is My Investment in a Foreign Corporation? appeared first on HodgenLaw PC – International Tax.

Liquidating distribution from a PFIC

This is a question I received in an email:

I invested in a PFIC. The PFIC decided to liquidate. It sold all its investments, paid its major liabilities, then paid most of the cash proceeds to its investors. Then, after paying miscellaneous, small debts and winding up its business, it distributed the remainder of its cash to the investors. I lost money on the investment. Do I have to pay PFIC tax on the distributions?

This post describes why both the first and second distributions are treated as proceeds from the sale of the investor’s PFIC shares, and why only the gain over investment is subject to tax.

Background on PFICs and how they are taxed

Passive foreign investment company (PFIC) is a special classification for foreign corporations under the Internal Revenue Code. We assume that the investor is a US person, and he has invested in a PFIC.

By default, proceeds from PFICs are subject to 2 sets of rules.

When a PFIC makes a distribution to a shareholder, the distribution is separated into excess distribution and non-excess distribution. The non-excess distribution may comprise dividends, return of basis, and capital gains as normal. The excess distribution is subject to tax, even if it is entirely return of basis. IRC §1291(a), (b); 301(c). Exactly how the tax is calculated is beyond the scope of this post, but an important item to note is that if a distribution is taxed as an excess distribution, then even return of basis, which is normally tax-exempt, is taxable.

When a shareholder realizes a gain from disposing of a PFIC share, the entire gain is taxed as excess distribution. IRC §1291(a)(2). But the way we calculate gain follows the normal rules: Gain equals amount realized minus adjusted basis. IRC §1001. Thus, if a distribution is taxed as a sale of a PFIC, then the return of basis is not taxable.

We need to know whether the 2 distributions from the PFIC undergoing liquidation is subject to the rules of distribution or gain.

Liquidating distributions are normally treated as proceeds from sale

When a shareholder receives a distribution in complete liquidation of a corporation, the distribution is treated as full payment in exchange for stock. IRC §331. This is a special treatment for liquidating distributions, so the transaction is treated as if the shareholder sold the shares in exchange for the liquidating distribution.

Normal rules for calculating gain or loss apply. IRC §331(c). Gain equals amount realized minus adjusted basis. Thus, a portion of the amount realized equal to the adjusted basis (the return of basis) is not gain and is not included in income.

It is possible for a corporation to make a series of liquidating distributions, each of which is treated as a payment in exchange for the shares. Olmsted vs Commissioner, TC Memo 1984-381. As long as the corporation is in a state of liquidation, each of the distributions during the state of liquidation is a liquidating distribution under section 331. Olmsted, TC Memo 1984-381, 22.

Whether a corporation is in a state of liquidation is a question of fact. In our case, the facts are simple. The PFIC sold all its investments, paid its major liabilities, then distributed most of the cash to its investors. Then, after paying small liabilities and formally dissolving, it paid the remaining cash to the investors.

This is a classic case of liquidation, and there is little question that both the initial large cash distribution and the following remainder cash distribution would be liquidating distributions had the corporation been a normal corporation rather than a PFIC. The question is whether the PFIC rules override the liquidating distribution rules.

You get liquidating distribution treatment

The IRS has not adopted any regulations on this matter, but the proposed regulations are fairly clear: Liquidating distributions are treated dispositions of the PFIC shares, not distributions in respect of shares; and a series of liquidating distributions is treated as a series of dispositions on each liquidating distribution date. Prop. Treas. Reg. §1.1291-3(h).

If you determine that a PFIC is liquidating, treat each liquidating distribution as payment in exchange for the shares. When the payment results in a gain according to the normal methods of calculating gain, you recognize gain and calculate tax on the gain under PFIC rules on the date of distribution.

In our scenario, it is clear that the PFIC is liquidating. Thus, the first cash payment is treated as payment in exchange for the PFIC shares. Because our investor lost money on the investment, I assume the payment is less than his adjusted basis in the PFIC shares. Thus, there is no gain. Likewise, the second cash payment is treated as payment in exchange for the PFIC shares. Because our investor lost money on the investment, I assume the payment is still less than his adjusted basis in the PFIC shares–after the reduction from the first payment.

Fortunately, our investor does not need to pay tax on the losses from the PFIC liquidation. As far as I know, there is no special rule for treating losses from the sale of a PFIC. Most likely, the investor has a capital loss.

The post Liquidating Distribution From a PFIC appeared first on HodgenLaw PC – International Tax.

Here is a question we often get from emails:

I own shares in an exchange traded fund. It is a PFIC. I have not made any elections for the shares. What happens if I sell it at a loss?

This post describes why the loss from the sale is most likely a capital loss.

What is a PFIC?

A passive foreign investment company (PFIC) is a special classification under US tax law. It applies to foreign corporations that meet at least 1 of 2 tests (IRC §1297(a)):

• Income test: At least 75% of the foreign corporation’s income is passive income or
• Asset test: At least 50% of the foreign corporation’s assets generate passive income or are held for generating passive income.

Foreign exchange traded funds (ETFs) are often PFICs, even if they are organized as a vehicle that might not be a corporation under foreign law.

Special tax rules apply to PFICs. These are deliberate difficult and punishing to discourage US persons from investing through foreign investment vehicles.

The ETF uses default rules under section 1291

There are 2 special elections a person can make for PFICs that change how the shareholder is taxed on the PFICs. These are the qualified electing fund (QEF) election and mark-to-market (MTM) election.

In our scenario, the reader has not made any elections. We therefore use the default rules under section 1291.

No specific rules about losses

If you take a look at section 1291, you will see detailed rules about how to calculate tax on distributions from a PFIC, and you see that gains are treated as excess distributions from a PFIC. Section 1291 does not mention losses.

We use normal rules for losses

The IRS has proposed regulations that address losses, and the proposition is short:

Unless otherwise provided under another provision of the Code, a loss realized on a disposition of a stock of a section 1291 fund is not recognized. Prop. Treas. Reg. §1.1291-3(a).

Note that this proposed regulation does not specify which section of the Code can be used to recognize losses. Thus, any section of the Code will do, not just the PFIC sections. The preamble to the proposed regulations confirm this result:

The general rules applicable to losses recognized on a disposition of stock apply to losses realized and recognized on the disposition of stock of a section 1291 fund. IL-656-87.

The proposed regulations merely attempt to say that the PFIC rules do not specifically allow recognition of loss in a transaction that normally does not permit recognition of loss–for example, if a domestic trust becomes a foreign trust, loss is not recognized. Reg. §1.684-1(a)(2). The proposed regulations make it clear that the PFIC rules do not provide for recognition of losses in these cases either.

For the sale of a ETC, we can rely on the basic rules about gains and losses: The entire loss from a disposition is recognized under section 1001. IRC §1001(c).

The loss is probably capital in nature

The PFIC rules do not specify whether the loss is ordinary or capital in nature. Thus, we use the general rules for losses recognized on the sale of stock. If our reader simply holds his ETF as a personal investment, then it probably is a capital asset. IRC §1221. Thus, the loss is a capital loss.

Summary

If you sell a PFIC at a loss, you can recognize the loss. The normal rules for determining whether the PFIC is a capital asset or not apply. In the case of a personal investment in a ETF, the loss is capital in nature.

The post Loss From Selling a PFIC appeared first on HodgenLaw PC – International Tax.

This is a question we received through an email:

I bought shares in a foreign mutual fund and sold it in the same year. I made a gain on the sale. I am sure the mutual fund is a PFIC. Do I have any excess distributions to report?

In this post, I will discuss why the gain probably is an excess distribution.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. When a US person owns shares in a PFIC, the US person is subject to extremely punitive tax and reporting rules. They are designed to discourage US persons from investing through foreign investment vehicles.

It is common (though not always) for mutual funds to be PFICs, even if they might not be organized as a company. For this post, let us assume that we already know that the mutual fund in question is a PFIC. We just need to know how the gain is reported and taxed.

Why is there uncertainty?

When you do not make an election for a PFIC, the distributions from the PFIC and gains are subject to special rules under Code section 1291. Losses use normal rules.

Code section 1291 say 2 things:

If the taxpayer disposes of stock in a passive foreign investment company, then the rules of paragraph (1) shall apply to any gain recognized on such disposition in the same manner as if such gain were an excess distribution. IRC §1291(a)(2).

The total excess distribution with respect to such stock shall be zero for the taxable year in which the taxpayer’s holding period in such stock begins. IRC §1291(b)(2)(B).

The Code tells us 2 apparently contradictory things: Gains must be treated as excess distributions, but there is no excess distribution in the 1st year. How do we resolve this apparent contradiction?

When can the treatment method make a difference?

When a person has an excess distribution from a PFIC, he allocates the excess distribution proportionately across all days in his holding period. IRC §1291(a)(1)(A). Excess distributions allocated to the current year is ordinary income. IRC §1291(a)(1)(B)(i).

If we have a gain from selling a PFIC in the 1st year, and the gain is treated an excess distribution, then the gain is ordinary income.

Nonexcess distributions are not subject to special rules. In most cases, this means the gain is a capital gain, specifically short-term capital gain.

If we have a gain from selling a PFIC in the 1st year, and the gain is not an excess distribution, then the gain is short-term capital gain. This affects the taxpayer’s net capital gain and loss for the year.

It also affects how you would report the gain on Form 8621: whether line 5(a) is 0 or the gain.

The gain is probably an excess distribution

As far as I know, the IRS has not specifically addressed this question, but we can piece together a reasonable guess as to what the IRS thinks the right answer is.

Proposed regulation section 1291-2 addresses how to treat a distribution from a PFIC. Proposed regulation section 1291-3 addresses how to treat a disposition of a PFIC.

Section 1291-2 tells us that a nonexcess distribution is treated under general rules for corporate distributions, e.g. under section 301, regarding dividends, return of capital, and capital gains. Prop. Treas. Reg. §1.1291-2(e)(1).

Section 1291-3 does not say anything about nonexcess distributions. In fact, it says “gain is determined on a share-by-share basis and is taxed as an excess distribution as provided in §1.1291-2(e)(2).” Prop. Treas. Reg. §1.1291-3(a).

The omission of any mention from section 1.1291-3 suggests that the IRS does not believe it is possible for a gain from selling a PFIC to be treated as a nonexcess distribution, even if the taxpayer sold the PFIC in the 1st year.

This is consistent with the structure of Form 8621. Line 15e tells us to report excess distribution from the PFIC. Line 15f of Form 8621 tells us to report gains from the sale of the PFIC share. Line 16a then tells us “if there is a positive amount on line 15e or 15f (or both), attach a statement for each excess distribution and disposition.” Once we see a gain, we go directly to calculating tax on an excess distribution.

These circumstantial evidence suggest that the IRS believes gain from selling a PFIC is always an excess distribution, even if the PFIC were sold in the 1st year of the holding period.

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

The post Gain from a PFIC Bought and Sold in the Same Year appeared first on HodgenLaw PC – International Tax.

Asset held in trust and the PFIC asset test

This is a war story from client work:

I own shares of a private company. It is the trustee of a family trust. Should I include the trust’s assets when I determine whether the private company is a PFIC?

In this post, I will discuss the approach we use to this type of question and show why the way the arrangement works in the foreign country is important to answer this question.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for gain, there are special rules that apply. The rules are less than desirable for the taxpayer, so it is useful to avoid the PFIC classification when it is possible.

A PFIC is a foreign corporation that meets at least 1 of 2 tests:

• Income test: At least 75% of the corporation’s income is passive income.
• Asset test: At least 50% of the corporation’s assets produce passive income or are held for the production of passive income. IRC §1297(a).

In this post, we will not be concerned about what passive income and passive assets are. We will limit ourselves strictly to the question of whether the private company should include the assets held in trust under the asset test.

Consider cutting the knot instead

But before we delve into the specifics of trying to determine if this company is a PFIC, consider bypassing the problem altogether. A PFIC must be a corporation. IRC §1297(a). If the entity is anything other than a corporation, then it is not a PFIC.

Regulation section 301.7701-2(b) lists the types of entities that are always corporations. In particular, paragraph (8) has a list of foreign entity types that are always corporations. In practice, most types of foreign entities are eligible to select their tax classification. Reg. §301.7701-3(a).

This is a private limited company, and it runs a family trust. It is quite possible that this company has no income. Thus, it is not important to keep the company from passing income to the shareholders under US tax law. If this is the case, consider making an election to classify it as a partnership or disregarded entity under US tax law instead. After making a partnership election, the company is no longer a corporation under US tax law–and thus cannot be a PFIC.

But let us assume that an election is not possible for some reason. How would we apply the PFIC asset test? Should we include the trust assets?

You cannot escape looking at local law

Neither the Code nor the regulations define what “asset” means in relation to the asset test. We are left with a few possibilities:

• We use the trust law of the foreign country to determine ownership
• We use the US’s Generally Accepted Accounting Principles (GAAP)
• We use foreign accounting standards

Foreign law: Trust relationship controls

The theory behind using foreign law is that state law determines rights to property, and federal tax law determines how those rights are taxed. Aquilino vs US, 363 US 509 (1960). The same should apply when we are talking about foreign law: Foreign law determines rights to property, and federal tax law determines how those rights are taxed.

We are not directly taxing the foreign corporation, but we need to determine how the foreign corporation is classified under federal tax law. And the question of how the foreign corporation is classified explicitly turns on the asset that it owns. It would make sense to turn to the foreign law to determine whether the assets really belong to the corporation.

Let us assume, for this post, that the trust law in the foreign country works essentially like US trust law: The trustee (the company) holds legal title to the assets, i.e. he is the owner of record. The beneficiaries (family members) hold equitable title to the assets, i.e. they have beneficial ownership of the assets, get to enjoy the assets, and get to benefit from income from the assets.

Under these assumptions, the trustee merely holds the assets for the beneficiaries, so the assets held in trust do not belong to the company. They should not be included in the company’s assets for the asset test.

GAAP: look at foreign law

The theory behind using the US’s generally accepted accounting principles (GAAP) is that we are reporting the foreign corporation’s assets to the IRS, a US tax authority. The Internal Revenue Code requires an owner of a foreign corporation to report information about the foreign corporation under some circumstances. IRC §§6038, 6046. The taxpayer makes the report on Form 5471. Form 5471 requires the balance sheet to be reported under GAAP.

One of the authorities for GAAP, the Financial Accounting Standards Board, has made various statements about reporting assets held in trust. Here is an example of what it said about charitable trusts:

The Board concluded that a recipient organization should recognize an asset because it has the ability to obtain and control the future economic benefits of the asset transferred to it, albeit temporarily. The recipient organization has an asset because, until it must transfer cash to the beneficiary, it can invest the cash received, use it to pay other liabilities or to purchase goods or services, or otherwise use the cash for its own purposes. Similarly, most financial assets received also can be temporarily used for the recipient organization’s own purposes. FASB Statement 136, par. 77.

The FASB includes a separate statement about nonfinancial assets that the charitable trust receives:

However, a standard that requires recognition of all nonfinancial assets might result in inclusion of items in the statement of financial position that do not meet the definition of an asset in Concepts Statement 6 because the recipient organization does not control any economic benefits from those items. FASB Statement 136, par. 77.

These statements are not on point, because they refer to charitable trusts rather than family trusts, but it tells us the FASB’s approach: Look at what the owner’s rights are to the asset, then determine whether it is an asset.

This is essentially the same as the tax law concept: Look at local law for rights to the asset, then decide how the asset is taxed. Thus, we need to look at local law on how the trust relationship works to determine how the asset should be reported under GAAP.

Foreign accounting standard: probably not a good idea

The theory behind using foreign accounting standard is that the corporation is foreign, and foreign accounting standards should determine what is an asset and what is not.

I do not recommend this approach, because the federal tax law is supposed to tax a taxpayer’s rights in property, and rights should not change because we chose a different way of stating those rights.

An accounting standard can be best described as a set of rules for translating rights into financial statements–without changing what the rights are. If we use each country’s accounting standards to determine what assets should be included under the asset test, it might lead to the same underlying rights being taxed differently, depending on how the country believes the rights should be stated. This is probably not what Congress intended when it wrote the asset test.

tl;dr

There is no escaping a foray into local law to understand the nature of the trust relationship and the nature of the trustee’s ownership (or lack of ownership) in the asset. If the trust law in the foreign country works essentially like US trust law with respect to property rights, the trust assets probably should not be the trustee’s assets for the PFIC asset test.

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

The post Asset Held in Trust for the PFIC Asset Test appeared first on HodgenLaw PC – International Tax.