Greetings from Haoshen Zhong.
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This week’s newsletter topic is a question that came by way of an email:
I frequently see stapled securities, where one part is a share in a corporation that receives nonpassive income and another is a unit in a unit trust that receives passive income. Is this one share in a corporation or two separate shares in two corporations, one of which is a PFIC?
Today’s post begins with a brief description of stapled securities and proceeds to discuss how they are treated under PFIC rules.
This is a type of security arrangement, where two different securities must be bought together. In one common setup, a unit trust holds rental real estate and receives rental income (passive). An affiliated corporation manages the rental property and receives a management fee (nonpassive). The shares in the corporation and the units in the unit trust are then “stapled” together, so that an investor must always buy one share in the corporation and one unit in the unit trust together.
A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):
Let us take it as an article of faith that the unit trust, if it were to be considered a standalone entity, is a foreign corporation, and that the rental income is passive. If you would like more details on why, I have previously written about why a unit trust, standing by itself, is a PFIC.
As far as I know, the IRS has not published any guidance on how these securities are treated under PFIC rules. We have a few reasonable interpretations:
The Internal Revenue Code and the regulations do contain sections dealing with stapled securities: Code section 269B and regulations section 1.269B-1.
The specific language that tells us how to view the stapled entities is as follows:
(a) General rule. Except as otherwise provided by regulations, for purposes of this title–
(1) if a domestic corporation and foreign corporation are stapled entities, the foreign corporation shall be treated as a domestic corporation.
(2) in applying section 1563, stock in a second corporation which constitutes a stapled interest with respect to stock of a first corporation shall be treated as owned by such first corporation, and
(3) in applying subchapter M for purposes of determining whether any stapled entity is a regulated investment company or a real estate investment trust, all entities which are stapled entities with respect to each other shall be treated as 1 entity. IRC §269B(a).
Without going into too much detail, each of these rules exist to prevent a US corporation from using a stapled foreign corporation to avoid certain tax rules. Section 269B(a)(1) exists to prevent stapled foreign corporations from being useful for avoiding controlled foreign corporation (CFC) rules. Section 269B(a)(2) exists to prevent a US corporation from avoiding controlled group rules. Section 269B(a)(3) exists to prevent a US corporation from receiving real estate investment trust (REIT) benefits when it is actually engaged in a business that is not real estate. Specifically how they do so is beyond the scope of this post.
But the fact that these rules exist at all suggest that normally, two stapled entities are considered separate entities. There is no deemed parent corporation, deemed trust, or other deemed arrangement except as provided by statute or regulations.
The statutory results of section 269B is limited to 3 specific contexts. They do not apply to PFICs on their own terms.
But section 269B(b) gives the IRS broad power to consolidate stapled entities to prevent taxpayers from avoiding US taxes. Presumably, the IRS can use these rules to force stapled securities to be treated as one entity for PFIC purposes if it considers the stapled entities arrangement to be an abuse of PFIC rules.
So far, the IRS has not published any regulations to this effect under either the staple security rules or the PFIC rules. In their absence, I would prefer to treat the stapled entities as they are under substantive law: Two separate entities. This means the corporation that is engaged in an active business is a normal corporation. The unit trust that receives passive income and holds passive assets is a PFIC.
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