Hello from Debra Rudd.
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Applying the look through rules to figure out if you have a PFIC
This week I will take a look at the following anonymous question I received:
I have shares in a foreign family holding company which buys shares in various foreign businesses. I am not sure if it is a PFIC. What information do I need to ask for to figure out if it is a PFIC?
In today’s newsletter, I will discuss how to apply the PFIC look through rules in conjunction with the PFIC definition to determine whether the family holding company is a PFIC or not.
Some assumptions about Holding Co
I am going to call it “Holding Co” rather than “the family holding company” because, well, I like proper nouns.
I will assume Holding Co is taxed as a corporation under US tax law. If it is not taxed as a corporation, it cannot be a PFIC.
I will further assume that Holding Co has bought shares in two businesses: Business A, of which it owns 10% of the shares, and Business B, of which it owns 40% of the shares. I will assume both businesses are taxed as corporations under US tax law.
I will assume that neither Business A nor Business B paid out any dividends to its shareholders.
Lastly, I will assume that our reader is the only US person owner of Holding Co, and I will assume that she owns less than 10% of the shares of Holding Co so that no Form 5471 filing requirements will be triggered.
A foreign corporation is a passive foreign investment company, or PFIC, if it meets either the income test or the asset test.
The income test says that if 75% or more of its income is passive, then it is a PFIC. IRC §1297(a)(1).
The asset test says that if 50% or more of its assets are passive, then it is a PFIC. IRC §1297(a)(2).
This rule applies no matter what type of entity you are analyzing as it is classified under local law (whether mutual fund, unit trust, hedge fund, startup company, etc.), as long as it is a foreign entity that is taxed as a corporation under US law.
There is nothing particularly mysterious about it. It requires an understanding of what counts as “passive” income and assets, an income statement, a balance sheet, and an Excel sheet or a calculator and some scratch paper.
Look through rule for subsidiaries
Some complication could arise, however, when the entity you are analyzing makes investments in other entities.
If the company owns 25% or more of the stock of another corporation, then that company is treated as receiving its proportional share of the income and owning its proportional share of the assets of that other corporation. IRC §1297(c). This is known as the PFIC look through rule.
The effect of the PFIC look through rule is that a parent company will be attributed its proportional share of the assets and income of its 25% or more subsidiaries when applying the PFIC definition.
In other words, when a company has a 25% or more interest in a subsidiary, you apply the look through rule first before applying the income and asset tests to determine if it is a PFIC.
A company that would not otherwise meet the income test or the asset test, and therefore would not qualify as a PFIC, could end up being a PFIC because of this rule. Conversely, a company that would in itself be a PFIC and owns shares in an active business could end up not being a PFIC because of this rule.
The look through rule only applies to Business B
In our example, Holding Co owns 10% of Business A, so it does not meet the minimum requirement for taking Business A’s income and assets into the calculation. Holding Co must own 25% or more of the shares of the subsidiary company for the rule to be in effect.
However, Holding Co does meet the minimum requirement for taking Business B’s income and assets into the calculation for Holding Co’s PFIC status, owning 40% of Business B’s stock.
Applying the PFIC tests to Holding Co
To determine if Holding Co is a PFIC, you need to have the financial statements of Holding Co, and because you have to apply the look through rule to Business B, you also need to have the financial statements of Business B.
When you are applying the PFIC tests, you will need to separate passive income from non-passive income, and passive assets from non-passive assets. You will do this to the income statement and balance sheet for both Holding Co and Business B. (For brevity I am assuming readers are familiar with what are considered passive assets and passive income for the purposes of these tests).
Then you apply the proportional interest that Holding Co has in Business B. Holding Co owns 40% of Business B, so multiply all the numbers from Business B by 40%.
The income test
Add together the passive income from Holding Co and 40% of the passive income from Business B that you just calculated. That gives you Holding Co’s passive income for purposes of the income test.
Add together the non-passive income from Holding Co and 40% of the non-passive income from Business B that you just calculated. That gives you Holding Co’s non-passive income for purposes of the income test.
Compute the total income by adding the results of the last two steps. Then figure out whether passive income makes up 75% or more of the total.
If so, you can stop now. It is a PFIC. Remember that you only need to meet one of the two tests for it to be a PFIC.
If Holding Co does not meet the income test, go on to see if it satisfies the asset test.
The asset test
Add together the passive assets from Holding Co and 40% of the passive assets from Business B that you just calculated. That gives you Holding Co’s passive assets for purposes of the asset test.
Add together the non-passive assets from Holding Co and 40% of the non-passive assets from Business B that you just calculated. That gives you Holding Co’s non-passive assets for purposes of the asset test.
Compute the total assets by adding the results of the last two steps. Then figure out whether passive assets make up 50% or more of the total.
If so, you have a PFIC.
If not, and if it did not meet the income test, Holding Co is not a PFIC for the year you are looking at.
A brief aside about the asset test
One thing that should not go without mention is that cash is considered a passive asset for the asset test.
Additionally, you must look at the fair market value of assets when computing the value for PFIC determination purposes. Some financial statements show fixed assets and intangibles brought to fair market value each year, but some do not.
Furthermore, intangibles such as goodwill, trade secrets, patents, and copyrights are sometimes not shown on the balance sheet at all when they are developed internally.
It may not be as simple as merely looking at a balance sheet: where a company has an unrecorded non-passive intangible, or where assets are not brought to market value on the balance sheet, it could mean the difference between “PFIC” and “not a PFIC”. For example, a company with a large cash balance and an even larger unrecorded non-passive intangible could appear to be a PFIC when you look at the balance sheet but may in reality not be a PFIC.
If you are aware of these issues when applying the asset test, and if you have some basic information about how the financials were prepared and whether the company has any intrinsic value that may not be reflected on the balance sheet, you will be much more likely to arrive at the correct answer.
Once a PFIC, always a PFIC
It is not sufficient to perform the income test and asset test calculations for only one year. You must do it for each year that you own Holding Co to be sure it is not a PFIC.
According to IRC §1298(b)(1), if a company was a PFIC previously in your holding period, it continues to be taxed as a PFIC for you now and in the future. This is known as the “Once a PFIC, always a PFIC” rule.
That means that if you bought shares in Holding Co in 2008, for instance, and you just recently learned about PFICs, you should do the calculations described above for each year of your holding period.
If it qualified as a PFIC for you in the past, it will continue to qualify as a PFIC in the current year, even if it does not meet the income test or the asset test for the current year.
You may have the option of making a purging election if it was a PFIC in the past but no longer meets the PFIC definition, and the purging election may even be available retroactively, but that is a topic for another time.
The calculations can get complicated
Applying the look through rule over a period of multiple years for multiple subsidiaries can be a lot of work. It can be even more work where the company regularly buys and sells shares in the subsidiaries and there is a great deal of change within the structure.
The most difficult aspect of it can be staying methodical and staying organized. It may be helpful to create an organization chart of the structure at each year end with notes about all the transactions you need to be aware of and possibly report, and by doing so you can isolate the issues and approach them one by one.
Based on the information I have, it sounds like Holding Co probably does not have a lot of activity and the level of complication that goes with it; I am waiving this flag of caution only because I have seen similar structures that do and it can be very difficult to figure out what is a PFIC and what is not.
My guess is that Holding Co is not a PFIC
If Business B is an active operating business, chances are that it has mostly non-passive income and assets, which will all be attributed to Holding Co via the look through rule.
Holding Co itself probably does not have a lot of assets other than Business A and Business B and some cash, and probably does not receive a lot of income.
I would guess that the total non-passive income attributed from Business B is probably enough to prevent Holding Co from meeting the income test, and I would also guess that the total non-passive assets attributed from Business B are enough to prevent Holding Co from meeting the asset test.
These are just guesses, of course – it is necessary to do the math and figure out the answer.
Thank you, as always, for reading. Please send me any PFIC questions you have by clicking “reply” to this message.
Obligatory disclaimer: Do not rely on this newsletter as legal or tax advice. Hire a professional if you need help.
See you in two weeks.