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February 23, 2017 - Haoshen Zhong

Lookthrough Rules When Your Foreign Corporation Owns PFICs

What happens when a US citizen owns shares of a foreign corporation, and the foreign corporation owns shares in PFICs–for example, foreign mutual funds or money market funds? Does the US citizen need to look through the top level foreign corporation to the PFICs?

When a shareholder looks through a corporation to an underlying PFIC, he must pretend that he owned the underlying PFIC shares directly.

Does the US citizen look through the top level foreign corporation? The answer depends on the percentage of the shares in the top level corporation the US citizen and whether the top level corporation is itself a PFIC.

PFIC defined

A passive foreign investment company (PFIC) is a foreign corporation that meets at least 1 of the following 2 tests (IRC §1297(a)):

  1. Income test: At least 75% of the corporation’s gross income is passive income.
  2. Asset test: At least 50% of the corporation’s assets are passive assets.

Generally, a foreign mutual fund or money market fund meets both tests, because the fund invests in passive assets–assets that give rise to dividends or interest. IRC §1297(b). Thus, when your company invests in foreign mutual funds or money market funds, it most likely is investing in PFICs.

Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad. Thus, it would be useful if a top level foreign corporation can cut off PFIC taxation rules.

Lookthrough if you own at least 50%

This one is simple: If you own 50% or more of the value of the stock of a top level foreign corporation, then you must look through that parent to any shares that the top level foreign corporation owns. IRC §1298(a)(2)(A).

Look at value of the shares, not voting power

An interesting note about this lookthrough rule is that it is based on the value of the shares only. It does not care about voting power. This leads to a rather interesting setup that small businesses can use to invest in PFICs.

Suppose you and a nonresident alien business partner want to start a business–say a wholesale store. It is an active business, not merely a holding company.

You want to invest excess cash (working capital) into PFICs, such as money market funds.

You can do this without having to look through to the underlying PFICs, provided that you are willing to take a small reduction in your profits. Here is how:

Form a foreign corporation that issues two classes of shares. The first class is entitled to 50% of the voting power but only 49.99% of the profits and assets. You own these shares. The second class is entitled to 50% of the voting power but 50.01% of the profits and assets. Your nonresident alien partner owns these shares.

You now have a situation where you, the US citizen, own less than 50% of the value of the foreign parent. You do not need to look through the top level foreign corporation to its underlying PFICs.

A small side: You own exactly 50% of the voting power of the foreign corporation. If you owned more than 50%, then the foreign corporation would be classified as a controlled foreign company (CFC). CFCs are subject to special rules that you may want to avoid, but that is beyond the scope of this discussion.

The 50% threshold is for active businesses, not investment holding companies

You may be thinking: Can you apply the same rule to your advantage for a company that merely holds investments?

Suppose your foreign corporation is not operating an active business. It holds only cash and PFICs. Your foreign corporation that issues two classes of shares. The first class is entitled to 50% of the voting power but only 49.99% of the profits and assets. You own these shares. The second class is entitled to 50% of the voting power but 50.01% of the profits and assets. Your nonresident alien partner owns these shares.

Do you need to look through this foreign corporation and report the underlying PFICs as if you own them directly?

The answer is yes.

This foreign holding corporation is a PFIC, because it holds only cash and PFICs, which produce passive income. When you own shares in a PFIC, you must look through the PFIC to shares it owns, regardless of the percentage of ownership you have in the PFIC. IRC §1298(a)(2)(B).

You cannot use the 50% rule to get around PFIC lookthrough for a foreign corporation that merely holds investments.

Look through a controlled foreign corporation that is also a PFIC

Suppose you own 20% of a foreign corporation. The foreign corporation has 4 other US citizens, each of whom owns 20% of the shares.

Do you need to look through this foreign holding corporation?

Under the income test and the asset test, the foreign holding corporation is a PFIC, because it owns only cash and PFICs, which produce passive income. The most obvious answer is that you must look through this holding corporation, because it is a PFIC.

But the answer is not so simple, because there is an overlap rule for controlled foreign corporations (CFCs) and PFICs.

The CFC-PFIC overlap rule says if you own 10% or more of the voting power of a CFC, then you do not treat your shares in the CFC as shares in a PFIC (even if the foreign corporation is in fact a PFIC). IRC §1297(d).

You can check if a foreign corporation is a CFC using the following method: IRC §957(a)

  1. Take all US persons who own at least 10% of the voting power of the foreign corporation
  2. Add the shares of all these 10% US voting shareholders
  3. If the sum of the value of their shares is above 50%, or if the sum of their voting power is above 50%, then the foreign corporation is a CFC.

In our hypothetical, there are 5 US persons, each of whom owns 20% of the shares of the foreign corporation. Each US person owns at least 10% of the voting power. The sum of these 10% US voting shareholders equals 100% of the voting power and 100% of the value. Therefore, the foreign holding corporation is a CFC.

Under the CFC-PFIC overlap rule, none of the shareholders treats his shares in the foreign holding corporation as shares in a PFIC.

Unfortunately, the CFC-PFIC overlap rule does not help. When we decide whether to look through a foreign corporation, we ignore the CFC-PFIC overlap rule. IRC §1298(a)(2)(B). Thus, solely for purposes of lookthrough, each shareholder owns shares in a PFIC. Each shareholder must look through to the underlying PFICs in proportion to their shares in the foreign holding corporation.

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PFIC and CFCs