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February 9, 2017 - Haoshen Zhong

Deferring tax on PFIC income using your foreign operating company

Today’s post is a war story about a pair of US citizen former clients whose PFIC issues we helped clean up. The question, paraphrased, is more or less like this:

We are equal shareholders of a successful Portuguese company (LDA). Our company accrued a lot of profits. We really do not want to let the profits sit idle. Can we safely invest them in exchange traded funds?

This post will discuss how to use a mix of the mark-to-market regime for foreign investment companies (PFICs) and the de minimis exception to foreign base company income for controlled foreign corporation (CFCs) to defer US tax on the profits from the exchange traded funds.

Quick background on PFICs and CFCs

The Portuguese LDA as a controlled foreign corporation (CFC)

LDA is short for sodiedade por quotas de responsabilidade limitada. It is a Portuguese business entity that provides limited liability to all shareholders. It is foreign, because it is organized outside the US. Reg. §301.7701-5. It is a corporation under US tax law, because it limits liabilities for all members. Reg. §301.7701-3(b). It is a controlled foreign corporation (CFC), because two US persons own 100% of the company. IRC §§951(b), 957(a).

Why the ETFs are passive foreign investment companies (PFIC)

Passive foreign investment company (PFIC) refers to a foreign corporation who has at least 75% passive income or at least 50% passive assets. IRC §1297(a). The exchange traded funds (ETFs) are foreign, because they are organized outside the US. They are corporations under US tax law, because their investors have limited liability for the funds’ debts. They are PFICs, because the ETFs receive essentially all passive income and hold essentially all passive assets.

The three ways to tax PFIC income

PFICs can be taxed one of three ways, ordered from worst to best: the default regime, the mark-to-market (MTM) regime, or the qualified electing fund (QEF) regime. The QEF regime requires you to receive a statement from the PFIC. Reg. §1.1295-1(f). We assume the QEF regime is not available in the scenario presented.

Background on MTM rules

The mark-to-market (MTM) regime is an election. It is available for marketable stock. “Marketable stock” refers to stock that is publicly traded on an SEC authorized exchange or an exchange that meets IRS criteria. IRC §1296(e)(1)(A). Let us assume that these ETFs are marketable stock.

Under the MTM regime, the shareholder must pretend that he sold the shares for fair market value at the end of each year. Gains from this deemed sale are ordinary income for the year. The character of loss depends on a value called the unreversed inclusions. There are also some basis adjustments. Reg. §1.1296-1(c). You can read more about the MTM rules in Debra Rudd’s post.

Because we are only addressing the deferral of income in this post, we will ignore the (complicate) loss rules. We just look at the MTM gains at the end of each year.

Quick way to avoid PFIC rules

Note that PFICs must be foreign corporations. An easy way to ensure you are never subject to PFIC rules is to invest the profits in something that is not foreign: buy US investments. You can also invest in something that is not a corporation. For example, the company can buy treasury bonds, corporate bonds, annuities, real estate, etc. Our clients wanted to know about ETFs, so let us assume that we have to look at the PFIC rules.

No lookthrough for MTM stock

Normally, if a person owns 50% or more of the shares of a corporation, then the shareholder is treated as the owner of any PFICs that the corporation owns. IRC §1298(a)(2)(A). Here, each of our clients owns 50% of their company, so under this lookthrough rule, they are treated as the owner of any PFICs that the company owns.

But the lookthrough rule is different for MTM stock. For MTM stock, there is lookthrough for foreign partnerships, foreign trusts, foreign estates, and certain regulated investment companies only. Reg. §1.1296-1(e). Here, our clients own a normal corporation, and the corporation owns the MTM stock. Under MTM rules, our clients do not need to look through their company.

But income can be passed to the shareholders under subpart F rules

Controlled foreign corporations (CFC) receive a special designation because they are subject to anti-deferral rules. These rules related to subpart F income, named after the subpart of the Internal Revenue Code in which the rules are found. Briefly:

US persons who own at least 10% of the voting power of a CFC must take into account their share of the CFC’s subpart F income each year, regardless of whether the CFC makes any distributions. IRC §951(a). Worse, the subpart F income is taxed at ordinary rates rather than the advantageous qualified dividend rates. This creates a substantial problem for companies in treaty countries, as those companies normally distribute qualified dividends. IRC §1(h)(11).

Subpart F income includes a number of types of income, one of which is the foreign personal holding company income. Foreign personal holding company income includes items such as interests, dividends, rent, property gain transactions, commodities income, etc. IRC §954(c). In other words, it includes income that you think of as passive investment income.

For MTM stock held in a PFIC, the MTM gains are foreign personal holding company income. Reg. §1.1296-1(g)(2)(ii)(A). This can create subpart F income that US shareholders must include in their US income every year.

A de minimis exception might solve the problem

There is a de minimis exception for subpart F income. It says that if the total foreign base company income (a term which includes foreign personal holding company income) and gross insurance income for a year is less 5% of the CFC’s gross income and less than $1,000,000, then no income is considered foreign base company income. IRC §954(b)(3)(A).

If it is a private operating company investing some of its profits in ETFs on the side, there is a good chance that the MTM gains are less than 5% of the company’s gross income and less than $1,000,000.

But keep one thing in mind: You are calculating the company’s foreign base company income, not its foreign personal holding company income. Foreign base company income is a super category that includes foreign personal holding company income and a few other types of income that I omitted for brevity. See IRC §954(a).

But assuming all these types of income add up to less than 5% of the CFC’s gross income and less than $1,000,000, there would not be a subpart F problem from the MTM gains.

Spoiler alert: Our client decided to invest in bonds and individual stocks instead of ETFs.

Summary

If you own at least 10% of the voting power of a controlled foreign corporation (CFC), and that CFC invests in exchange traded funds (ETFs), get the CFC to elect MTM regime for the ETFs. The MTM regime avoids PFIC lookthrough rules for you (and the other 10% US shareholders). It is possible that the MTM gains will be taxed to you every year under the separate subpart F rules, but you might be able to use a de minimis exception to save yourself from that.

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Haoshen

PFIC and CFCs