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March 10, 2016 - Haoshen Zhong

Is this a PFIC? Part II: Income Test and Asset Test

Greetings from Haoshen Zhong.

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Do we have a foreign corporation?

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

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

Two steps to answer this question

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

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

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

Income test and asset test defined:

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

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

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

(2) the average percentage of assets (as determined in accordance with subsection (e)) held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent. IRC §1297(a)

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

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

Passive income

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

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

Foreign personal holding company income includes a laundry list:

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

Income test

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

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

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

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

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

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

Asset test

Q’s investment club has only cash and stocks.

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

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

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

Getting out of the PFIC treatment

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

QEF election

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

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

MTM election

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

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

Partnership election

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

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

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

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

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

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

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

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

Summary

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

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

Thank you

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

Haoshen

American Business Abroad PFIC and CFCs