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October 22, 2015 - Haoshen Zhong

Why is my unit trust a PFIC?

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Why is my unit trust a PFIC?

This is a question we get from time to time:

My fund (mutual fund, private equity fund, etc) is organized as a unit trust. Why is it a passive foreign investment company (PFIC)?

Ignoring whether foreign trust taxation and reporting is preferable to PFIC taxation and reporting, let’s look at why the unit trust is a PFIC for US tax purposes rather than a trust.

What is a unit trust?

First, a primer on unit trusts. This is a type of investment vehicle that is common in countries that were or are part of the British Commonwealth: UK, Canada, Australia, New Zealand, etc. It is an arrangement that is organized as a trust under local law. The unit trust creates a prospectus of what it will invest in and how profits are distributed, and it invites investors to buy units in the trust. These units represent rights to a share of the profits, similar to shares of a corporation.

A PFIC must be a corporation

Section 1297(a) defines a PFIC as follows:

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).

The tests under (1) and (2) are known as the income test and the asset test. Let’s assume that the fund meets these tests, because investment unit trusts usually do meet these tests. We focus only on this criterion: “any foreign corporation”. To be a PFIC, the entity in question must be foreign, and it must be a corporation.

Tax law is what counts

Treasury Regulation section 301.7701-1(a) says the following about classification of entities:

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

You have a trust under the laws of the jurisdiction under which it was organized, but that is not the final result under US tax law. Tax law may say something else about the entity classification.

The investment trust as a business entity

Regulation section 301.7701-4(a) defines a trust as follows:

In general, the term “trust” as used in the Internal Revenue Code refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Reg. §301.701-4(a).

Usually, a trust in a country that takes after English common law (most countries in the Commonwealth) satisfies this definition, but the definition of a trust doesn’t end here.

Regulation section 301.7701-4(c)(1) contains special rules for an investment trust:

An “investment” trust will not be classified as a trust if there is a power under the trust agreement to vary the investment of the certificate holders. See Commissioner v. North American Bond Trust,122 F. 2d 545 (2d Cir. 1941), cert denied, 314 U.S. 701 (1942). An investment trust with a single class of ownership interests, representing undivided beneficial interests in the assets of the trust, will be classified as a trust if there is no power under the trust agreement to vary the investment of the certificate holders. An investment trust with multiple classes of ownership interests ordinarily will be classified as a business entity under § 301.7701-2; however, an investment trust with multiple classes of ownership interests, in which there is no power under the trust agreement to vary the investment of the certificate holders, will be classified as a trust if the trust is formed to facilitate direct investment in the assets of the trust and the existence of multiple classes of ownership interests is incidental to that purpose. Reg. §301.701-4(c)(1).

What this paragraph tells us is more or less: If a trust is set up as an investment vehicle for the beneficiaries, and it is possible to change the investments of the trust, then the trust will be classified as a business entity under US tax law. If the trust is set up as an investment vehicle, but the investment is fixed, then it is a trust under US tax law.

You will need a copy of the trust deed and the trust prospectus to check whether there is power to change the investments. The trust deed is often not available, but the prospectus should be available to the unit holders. Usually, if the prospectus says the trust will invest in 1 specific entity (for example, a private equity fund formed for the specific purpose of investing in a private company before its IPO), the trust is really a trust under US tax law. If the prospectus says the trust will invest in some class of entities or funds (for example, a fund that says it will invest in a particular business sector in a region), the trust is almost certainly a business entity under US tax law.

The business entity is foreign

Regulation section 301.7701-5(a) gives the following definition of domestic and foreign business entities:

A business entity (including an entity that is disregarded as separate from its owner under § 301.7701-2(c)) is domestic if it is created or organized as any type of entity (including, but not limited to, a corporation, unincorporated association, general partnership, limited partnership, and limited liability company) in the United States, or under the law of the United States or of any State. Accordingly, a business entity that is created or organized both in the United States and in a foreign jurisdiction is a domestic entity. A business entity (including an entity that is disregarded as separate from its owner under § 301.7701-2(c)) is foreign if it is not domestic. Reg. §301.7701-5(a).

The unit trust is almost certainly organized in a country other than the US and is governed under the law of its home jurisdiction. Thus, it is a foreign business entity.

Partnership or corporation?

A business entity with more than 1 owner can be classified as either a partnership or a corporation. Reg. §301.7701-2(a).

Regulation section 301.7701-2(b)(i) gives a list of foreign entities that are always classified as corporations. These are known as “per se corporations”. A unit trust is not in this list, which makes the unit trust an “eligible entity”. As an eligible entity, the unit trust may elect its tax classification. Reg. §301.7701-3(a).

Most of the time, the unit trust never made an election. Regulation section 301.7701-3(b)(2) tells us the default classification of a foreign business entity that does not elect its classification:

(i) In general. Except as provided in paragraph (b)(3) of this section, unless the entity elects otherwise, a foreign eligible entity is—

(A) A partnership if it has two or more members and at least one member does not have limited liability;

(B) An association if all members have limited liability… Reg. §301.7701-3(b)(2)(i)(A), (B).

The default classification will depend on whether any member–that is, a person who is entitled to a share of the profits of the unit trust–has unlimited liability. If at least one member has unlimited liability, then you have a partnership. Otherwise it is a corporation. This requires some knowledge of local law, as Regulation section 301.7701-3(b)(2)(ii) explains:

(ii) Definition of limited liability. For purposes of paragraph (b)(2)(i) of this section, a member of a foreign eligible entity has limited liability if the member has no personal liability for the debts of 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. Reg. §301.7701-3(b)(2)(ii).

Before you check local law regarding liability, first check who are the members–that is, who are entitled to a share of the unit trust’s profits. Very often, the trust is organized so that an outside investment adviser gets a share of the profits, but the trustee only gets paid a flat trustee fee, if anything at all. The trustee is a member if and only if it gets a share of the unit trust’s profits. If the unit trust uses an outside investment adviser and pays the trustee a flat trustee fee, then the trustee is not a member. Be careful when you are checking this: Sometimes a unit trust issues multiple series of units, and the trustee may get a share of the profits from one series but not another.

Usually, the beneficiaries of a trust are not responsible for claims against the trust, so they have limited liability. Sometimes the trustee is responsible for claims against the trust, in which case it has unlimited liability. This is something you will need to check against local law, but only if the trustee is actually a member.

If the trustee does not get a share of the trust’s profits, then the unit trust is almost certainly a corporation, because all members–the beneficiaries and the investment adviser–have limited liability. If the trustee gets a share of the trust’s profits, look more closely at local law to see whether the trustee has personal liability for claims against the trust.

Your most probable result

In the most common scenario, the trustee hires an investment adviser, which is often an affiliated but separate company. The investment adviser advises the trustee on what to invest in from among a class of allowed investments. The investment adviser gets paid a share of the profits. The unit holders get the rest of the profits. The trustee gets a flat fee for being trustee. These types of unit trusts are almost certainly foreign corporations. And because these are investment vehicles, they are probably PFICs.

In summary

If the unit trust invests in a specific asset, then it’s probably a trust. If it invests in one or more classes of assets, then it’s probably a business entity.

Assuming the unit trust is a business entity, if the trustee does not get a share of the profits, then it’s probably a corporation. If the trustee gets a share of the profits, look closely at local trustee liability law to see if the unit trust is a partnership.

The most likely outcome of this analysis is that you have a foreign corporation–and by extension, a PFIC.

Disclaimer

This post is not legal advice to you. You may not rely on this post to avoid penalties imposed under law. You may not use this post as promotional material.

Haoshen

PFIC and CFCs Tax and Trusts