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July 28, 2016 - Haoshen Zhong

Lookthrough of Subsidiary when Subsidiary is Liquidated

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Do I create a PFIC problem during corporate reorganizations?

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

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

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

Assumptions

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

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

Definition of a PFIC

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

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

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

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

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

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

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

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

The risk in the year of liquidation

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

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

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

A quote from PLR 200813036:

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

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

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

The holding company should be liquidated in the same year

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

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

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

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

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

Summary

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

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

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

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Haoshen

PFIC and CFCs