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August 24, 2017 - Haoshen Zhong

Asset Held in Trust for the PFIC Asset Test

Asset held in trust and the PFIC asset test

This is a war story from client work:

I own shares of a private company. It is the trustee of a family trust. Should I include the trust’s assets when I determine whether the private company is a PFIC?

In this post, I will discuss the approach we use to this type of question and show why the way the arrangement works in the foreign country is important to answer this question.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for gain, there are special rules that apply. The rules are less than desirable for the taxpayer, so it is useful to avoid the PFIC classification when it is possible.

A PFIC is a foreign corporation that meets at least 1 of 2 tests:

  • Income test: At least 75% of the corporation’s income is passive income.
  • Asset test: At least 50% of the corporation’s assets produce passive income or are held for the production of passive income. IRC §1297(a).

In this post, we will not be concerned about what passive income and passive assets are. We will limit ourselves strictly to the question of whether the private company should include the assets held in trust under the asset test.

Consider cutting the knot instead

But before we delve into the specifics of trying to determine if this company is a PFIC, consider bypassing the problem altogether. A PFIC must be a corporation. IRC §1297(a). If the entity is anything other than a corporation, then it is not a PFIC.

Regulation section 301.7701-2(b) lists the types of entities that are always corporations. In particular, paragraph (8) has a list of foreign entity types that are always corporations. In practice, most types of foreign entities are eligible to select their tax classification. Reg. §301.7701-3(a).

This is a private limited company, and it runs a family trust. It is quite possible that this company has no income. Thus, it is not important to keep the company from passing income to the shareholders under US tax law. If this is the case, consider making an election to classify it as a partnership or disregarded entity under US tax law instead. After making a partnership election, the company is no longer a corporation under US tax law–and thus cannot be a PFIC.

But let us assume that an election is not possible for some reason. How would we apply the PFIC asset test? Should we include the trust assets?

You cannot escape looking at local law

Neither the Code nor the regulations define what “asset” means in relation to the asset test. We are left with a few possibilities:

  • We use the trust law of the foreign country to determine ownership
  • We use the US’s Generally Accepted Accounting Principles (GAAP)
  • We use foreign accounting standards

Foreign law: Trust relationship controls

The theory behind using foreign law is that state law determines rights to property, and federal tax law determines how those rights are taxed. Aquilino vs US, 363 US 509 (1960). The same should apply when we are talking about foreign law: Foreign law determines rights to property, and federal tax law determines how those rights are taxed.

We are not directly taxing the foreign corporation, but we need to determine how the foreign corporation is classified under federal tax law. And the question of how the foreign corporation is classified explicitly turns on the asset that it owns. It would make sense to turn to the foreign law to determine whether the assets really belong to the corporation.

Let us assume, for this post, that the trust law in the foreign country works essentially like US trust law: The trustee (the company) holds legal title to the assets, i.e. he is the owner of record. The beneficiaries (family members) hold equitable title to the assets, i.e. they have beneficial ownership of the assets, get to enjoy the assets, and get to benefit from income from the assets.

Under these assumptions, the trustee merely holds the assets for the beneficiaries, so the assets held in trust do not belong to the company. They should not be included in the company’s assets for the asset test.

GAAP: look at foreign law

The theory behind using the US’s generally accepted accounting principles (GAAP) is that we are reporting the foreign corporation’s assets to the IRS, a US tax authority. The Internal Revenue Code requires an owner of a foreign corporation to report information about the foreign corporation under some circumstances. IRC §§6038, 6046. The taxpayer makes the report on Form 5471. Form 5471 requires the balance sheet to be reported under GAAP.

One of the authorities for GAAP, the Financial Accounting Standards Board, has made various statements about reporting assets held in trust. Here is an example of what it said about charitable trusts:

The Board concluded that a recipient organization should recognize an asset because it has the ability to obtain and control the future economic benefits of the asset transferred to it, albeit temporarily. The recipient organization has an asset because, until it must transfer cash to the beneficiary, it can invest the cash received, use it to pay other liabilities or to purchase goods or services, or otherwise use the cash for its own purposes. Similarly, most financial assets received also can be temporarily used for the recipient organization’s own purposes. FASB Statement 136, par. 77.

The FASB includes a separate statement about nonfinancial assets that the charitable trust receives:

However, a standard that requires recognition of all nonfinancial assets might result in inclusion of items in the statement of financial position that do not meet the definition of an asset in Concepts Statement 6 because the recipient organization does not control any economic benefits from those items. FASB Statement 136, par. 77.

These statements are not on point, because they refer to charitable trusts rather than family trusts, but it tells us the FASB’s approach: Look at what the owner’s rights are to the asset, then determine whether it is an asset.

This is essentially the same as the tax law concept: Look at local law for rights to the asset, then decide how the asset is taxed. Thus, we need to look at local law on how the trust relationship works to determine how the asset should be reported under GAAP.

Foreign accounting standard: probably not a good idea

The theory behind using foreign accounting standard is that the corporation is foreign, and foreign accounting standards should determine what is an asset and what is not.

I do not recommend this approach, because the federal tax law is supposed to tax a taxpayer’s rights in property, and rights should not change because we chose a different way of stating those rights.

An accounting standard can be best described as a set of rules for translating rights into financial statements–without changing what the rights are. If we use each country’s accounting standards to determine what assets should be included under the asset test, it might lead to the same underlying rights being taxed differently, depending on how the country believes the rights should be stated. This is probably not what Congress intended when it wrote the asset test.

tl;dr

There is no escaping a foray into local law to understand the nature of the trust relationship and the nature of the trustee’s ownership (or lack of ownership) in the asset. If the trust law in the foreign country works essentially like US trust law with respect to property rights, the trust assets probably should not be the trustee’s assets for the PFIC asset test.

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