June 29, 2017 - Haoshen Zhong

Is My Investment in a Foreign Corporation?

This is a question we get through email and client work fairly often.

I made an investment into a foreign investment vehicle. Maybe it is a partnership rather than a PFIC?

This post is something of a sequel to this post, describing why a unit trust is likely a PFIC, despite being organized as a trust under local law. This post’s focus is on distinguishing between partnerships and corporations.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. When a US person owns shares in a PFIC, the US person is subject to extremely punitive tax and reporting rules.

An important element of a PFIC is that it must be a foreign corporation. IRC §1297(a). If you have a foreign arrangement that is something other than a corporation, then you do not have a PFIC, regardless of whether it makes passive investments or not.

A quick background on classification of foreign business entities

This is a quick summary of how the US classifies foreign arrangements:

  1. The investment arrangement is some sort of business arrangement for making investments, so it is a business entity. Reg. §§301.7701-1(a), -2(a), -4(c).
  2. It is a foreign business entity, because it is organized outside the US. Reg. §301.7701-5(a).
  3. It (usually) is not among the list of entities that are always classified as corporations, so it is eligible to choose its classification. Reg. 301.7701-3(a), -2(b)(8).
  4. It has not chosen a US tax classification, so it receives a default classification.

The 4th step is what is important to this post:

  • If it has 2+ members, and at least 1 member does not have limited liability, then it is a partnership. Reg. §301.7701-3(b)(2)(i)(A).
  • If all members have limited liability, then it is a corporation. Reg. §301.7701-3(b)(2)(i)(B).

How do we know if a member has limited liability?

The regulations tell us what limited liability means:

[A] member of a foreign eligible entity has limited liability if the member has no personal liability for the debts or claims against the entity by reason of being a member. This determination is based solely on the statute or law pursuant to which the entity is organized, except that if the underlying statute or law allows the entity to specify in its organizational documents whether the members will have limited liability, the organizational documents may also be relevant. For purposes of this section, a member has personal liability if the creditors of the entity may seek satisfaction of all or any portion of the debts or claims against the entity from the member as such. Reg. §301.7701-3(b)(2)(ii).

To put this in shorter words: A member has limited liability if he has no personal liability. He has personal liability if the creditors of the entity can seize the member’s assets to satisfy all or part of claims against the entity.

The most familiar example of personal liability is the general partnership. The partners are jointly and severally liable for the liabilities of the partnership. This means a creditor of the partnership can sue any partner (or any combination of partners) and recover any portion of the partnership’s debts when the partnership does not have enough assets to pay the debt.

With this in mind, I will take a look at 2 liability arrangements and see why they are (or are not) personal liability.

Registered capital

This is an arrangement that I have seen in China, Singapore, and Japan. To incorporate a company, it must have a minimum registered capital. It is legal to start operating without the full registered capital, but if the company goes bankrupt, and the shareholders have not contributed the entire registered capital, then they are liable to the creditors for the deficiency.

At first glance, it seems that the members of the company has personal liability, because a creditor may satisfy “any portion of the debts” of the company against the owners. The administrative history of the regulation suggests that is an overly broad interpretation. Here is what the IRS said when it was adopting this regulation:

A member of a foreign entity has limited liability only if, based solely on the controlling statute or law pursuant to which the entity is organized, the member’s personal liability for the debts or claims against the entity is limited (for example, to the amount of the member’s unpaid capital contribution or to the amount of a statutorily limited guarantee). 61 FR 21991.

The administrative history tells us directly that unpaid capital contribution is a limit on liability.

It seems more likely that this is a case of bad wording for the regulation: By using an expansive phrase like “all or any portion of the debts”, the regulation unintentionally made limited liability sound like something that is inconsistent with the common understanding of limited liability–that there is some limit to liability other than how much the member owns or how large the debt is.

These companies are corporations by default, because the members have limited liability.

Proportion of liability

In some cases, you might find an example where the members of the entity are responsible for only a proportion of the entity’s debts. For example, if a unit holder owns 20 out of 100 units of a unit trust, then in these types of arrangements, the unit holder is responsible for 20% of the unit trust’s debts only. Is this personal liability?

We can see this in the administrative history of the regulations. Specifically, when the IRS first proposed section 301.7701-3(b), governing default classifications, it focused on whether there exists a member with unlimited liability, and it defined unlimited liability to mean when a creditor “may seek satisfaction of debts or claims against the entity”. 61 FR 21996.

The IRS then received some comments, pointing out that there are some foreign joint ventures where the partners are not jointly or severally liable, meaning each partner is liable for only a portion of the debts. 61 FR 66586. The comments suggested, and the IRS agreed, that these entities should be partnerships by default. 61 FR 66586. In response, the IRS adopted the current wording of the regulations, focusing on whether all members have limited liability and definition personal liability to mean when a creditor “may seek satisfaction of all or any portion of the debts” from the members (adding “all or any portion”). 61 FR 66591.

From the administrative history, we can see why the regulation has such an expansive wording: It is meant to catch situations where members have personal liability in proportion to their membership interest. In these situations, there is a limit to the personal liability, but it is defined in reference to the amount of debt (amount of debt times membership interest). The member has personal liability.

These types of arrangements are partnerships by default.

Consult with a local expert if you are not sure

As the regulations point out, the question of whether there is limited liability is a matter of local law where the business entity is formed. If you want to determine whether an investment is a PFIC by attacking whether it is a corporation, it is prudent to consult with a local expert on whether the members of the entity have personal liability for the entity’s debts.