February 25, 2016 - Haoshen Zhong

Is this a PFIC? Part I: Foreign corporation or not

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Do we have a foreign corporation?

This week’s newsletter is part 1 of a 2 part series inspired by the following question from a reader I will call Q:

I have shares in a UK investment club. It invests in UK breweries. I think it is a PFIC. How do I determine if it is one??

Two steps to answer this question

This is the definition of a PFIC under section 1297(a):

For purposes of this part, except as otherwise provided in this subpart, the term “passive foreign investment company” means any foreign corporation if–

(1) 75 percent or more of the gross income of such corporation for the taxable year is passive income, or

(2) the average percentage of assets (as determined in accordance with subsection (e)) held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent. IRC §1297(a)

Section 1297(a) prominently lists 2 items. Item (1) is the income test. Item (2) is the asset test. Meeting either of these 2 tests will make a foreign corporation a PFIC. But there is a necessary requirement that is not separately listed in the Code: The arrangement in question must be a foreign corporation under US tax law. If the arrangement is domestic, or if it is not a corporation, then it’s not a PFIC no matter what its income and assets are.

To determine whether we have a PFIC we really ask 2 questions in sequence:

  1. Is it a foreign corporation? Today’s newsletter will cover this question.
  2. Does it meet either the income test or the asset test? The next newsletter will cover this question.

Find out what kind of entity it is under the laws of the foreign jurisdiction

Many of the tax rules we are dealing with will depend on what the entity is and how it operates under the laws of the foreign jurisdiction in which it was formed. The first step when encountering an entity is to find out what it is exactly in the foreign jurisdiction.

In our case, Q did not say what the entity was when she asked us the question. We asked her in a follow-up email and found the answer: Q’s investment club was organized as a private limited company under UK law.

Foreign: Organized outside the US

Whether a corporation is foreign or domestic is entirely straightforward: A corporation is a type of business entity. Reg. §301.7701-2. A business entity is domestic if it it is organized within the US, under a US law, or under a state law. Otherwise it is foreign. Reg. §301.7701-5(a).

Q’s investment club is a UK private limited company. If it is a corporation (or any other types of business entity), then it would be foreign. The more interesting question is: Is it a corporation?

Corporation: Apply a series of rules in sequence

US tax law has its own definition of what a corporation means. Reg. §§301.7701-1. The entity’s classification under foreign law can be helpful, but it’s not determinative of its US tax law classification.

A corporation is a type of business entity. Reg. §§301.7701-2, -3. So first, Q must check whether the investment club is a business entity. The Treasury Regulations define a business entity as follows:

[A] business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under § 301.7701-3) that is not properly classified as a trust under § 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code. Reg. §301.7701-2(a).

To determine whether we have a business entity, we first see whether it is a trust or falls under a special classification.

The investment club does not fall under a special classification

There are a number of special classifications for entities. These are generally based on the activities of the entity. The activities that potentially apply are regulated investment companies and real estate investment trusts.

A regulated investment company must be a domestic corporation, and it must be registered with the SEC. IRC §851(a). If the UK investment club is a corporation, then it is almost certainly foreign. It is unlikely that the investment club is registered with the SEC. So it is not a RIC.

A real estate investment trust must invest in real estate. We know Q’s investment club invests in breweries, so it is not a REIT.

The investment club is not a trust

Some times UK investment vehicles are organized as unit trusts, which are treated as trusts under UK law. Fortunately, we know Q’s investment club was organized as a private limited company, not a unit trust. We do not need to parse the trust rules.

We now know Q’s investment club is a business entity.

The investment club is eligible to elect its US tax classification

A business entity that is not automatically classified as a corporation (per se corporations) is an eligible entity that can elect its US tax classification. Reg. §301.7701-3(a).

The types of per se corporations include various US and state entities, an insurance company, and a laundry list of foreign entities. Reg. §301.7701-3(b)(1), (3)-(8).

Q’s investment club was not organized under US or state laws, and it doesn’t belong to the US or a state. It cannot be a corporation under those classifications.

Q’s investment club is not an insurance company.

If we look in the list of foreign entities, the only per se corporation for UK is a public limited company. Q’s investment club is a private limited company, so it is not a per se corporation.

This means Q’s investment club is an eligible entity. It can elect its tax classification.

Default classification without election: corporation

An eligible entity that does not elect its US tax classification receives a default classification. Reg. §301.7701-3(b). It is unlikely that Q’s investment club made an election with the IRS, so we look at the default classification.

A foreign entity with multiple owners is a partnership if one or more members does not have limited liability (in other words, one or more members have personal liability). It is a corporation if all members have limited liability. Reg. §§301.7701-3(b)(2)(i), -2(b)(2).

The UK authorizes several types of companies (Companies Act 2006, §3):

  1. An unlimited company
  2. A company limited by guarantee
  3. A company limited by shares

We know Q’s investment club is a limited company, so it cannot be an unlimited company.

Q told us that she has shares in the investment club, so it is probably a company limited by shares. There is some risk that Q is using the term “shares” loosely. It is best to ask her whether the investment club is a company limited by shares or limited by guarantee.

For this newsletter, I will assume it was a company limited by shares, because Q referred to shares, and companies limited by guarantee are rare.

In a company limited by shares, the members’ liabilities are “limited to the amount, if any, unpaid on the shares held by them”. Companies Act 2006, §3(2).

The members of a company limited by shares do not have personal liability merely by reason of being members of the company. Their liability is limited to the value of the shares (the sum of paid and unpaid for shares). The members of a company limited by shares have limited liability.

If Q’s investment club is a company limited by shares, then all members have limited liability. The investment club would be a corporation, as you would expect.

Applying the income and asset tests

We know Q’s investment club is foreign, because it is organized in the UK under UK law.

We are reasonably confident Q’s investment club is a corporation, regardless of whether it is limited by guarantee or limited by shares.

Q has shares in a foreign corporation. It is potentially a PFIC. We have to apply the income and asset test rules to check whether it is in fact a PFIC. Stay tuned for how to apply the income and asset tests.

Thank you

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