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September 21, 2017 - Haoshen Zhong

Customer Deposit in a Chinese Investment Firm under the PFIC Asset Test

Cash held for customers

This is a war story from client work:

I own shares of a Chinese investment firm. The firm’s balance sheet, produced under Chinese accounting standards, shows cash of $X, with line below that said $Y out of $X is customer deposits. The total asset on the balance sheet showed $X to be the cash included in the sum. Should I include $X or $X-Y of cash for the asset test for PFICs?

Today’s post is a bit of a followup to a previous post about assets held in trust. It is not about assets held in trust, but it applies the principles outlined in that post in a concrete example.

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).

We are only concerned about the asset test today, so we will skip the income test. Cash is always passive, because it generates interest. See Notice 88-22; IRC §954(c)(1)(A). We want to know whether to include $X of cash (all the cash held) or $X-Y of cash (excluding the cash held for customers).

The investment firm was a foreign corporation

For this particular case, the investment firm was a joint stock company (股份有限公司, or gu fen you xian gong si). A Chinese joint stock company is a corporation, and it cannot elect out of that status. Reg. §301.7701-2(b)(8). This means we cannot get out of PFIC classification by having the investment firm elect to be classified as a partnership.

The investment firm is foreign, because it is organized outside the US. Reg. §301.7701-5(a).

We need to look at the income test and the asset test to determine if it is a PFIC. We are only looking at how cash affects the asset test today.

Look at foreign law for who owns the cash

We got the balance sheet under Chinese financial reporting standards, not GAAP. It is a fair question to ask whether the separately listed customer deposits really should be counted as the investment firm’s assets under the asset test.

We looked at the reasons behind this in more depth in this post, but more likely than not, you look at who owns the cash under foreign law, not how foreign accounting standards require the cash to be reported.

The short version of this is that foreign or state law determine rights to property, and federal tax law determines how those rights are taxed. If the cash belongs to the customers under foreign law, then US tax law should treat the cash as the customer’s, not the investment firm’s. If we follow accounting standards, then the exact same underlying right can be taxed differently depending on how the accounting standards say the assets should be reported.

Chinese law: The cash belongs to the customers

A Chinese securities company must keep customer funds in an account segregated from the company’s own funds, track the customer funds separately from the company’s own funds, and manage the customer funds separately from the company’s own funds. Zhongguo Zhengjuan jiandu guanli weiyuan huiling di 3 hao [China Sec. Reg. Comm. decree no. 3] (promulgated by the China Securities Regulatory Commission, 2001-05-16, effective 2002-01-01), art. 6, St. Council Gaz. 2002 no. 13 (2002) (PRC).

All these requirements about separate management suggests that the investment firm is acting as a custodian or manager of the customer deposits. They cannot use the cash for their own purposes or mingle the cash with their own. And presumably the proceeds from these cash belong to the customers, with the investment firm entitled to only management or transaction fees.

These laws suggest that the customer deposits belong to the customers, not the investment firm. So the cash should be excluded from the asset test. You include $X-Y of cash as passive assets and $X-Y of cash under total assets for the asset test for PFIC classification.

Different rules for bank deposits

Note that this firm is an investment firm. It is not a bank.

While I do not have a citation, I am reasonably confident that Chinese banks function just like any other bank: The bank can take cash deposits you make and use it for its own purposes, such as paying off debts, making investments, making loans, etc. They are only required to pay you an interest. Any return on investments that the bank makes using the cash belongs to the bank. In a bank deposit, you are really lending money to a bank in return for interest. The bank owns the cash and owes you a debt equal to the deposit plus interest.

The relationship is quite different than the investment firm, which holds money for its customers.

PFIC and CFCs