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PostedPFIC to CFC transition miniseries #2 - Deemed sale election
Phil Hodgen
Attorney, Principal
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PFIC to CFC transition miniseries
This week is Part II in a miniseries devoted to examining different aspects of the PFIC rules as they apply to the following scenario:On January 1, 2010, five individuals create a foreign startup company. Each person owns 20% of the value and voting power of the company. Two of the owners are US persons. Three of the owners are foreign.Over several years, the company develops extremely valuable IP — it receives two separate offers of $9 million from other companies to purchase the IP, but does not accept the offers and continues the development.It does not receive any income other than small amounts of interest income from its bank account (which contains approximately $1 million).On June 30, 2014, one of the foreign owners sells his shares to a US person.Last week, I discussed how the startup was a PFIC prior to the sale of 20% of the shares from the foreign person to the US person (named Lucky). On the day that Lucky bought 20% of the company, it became a CFC.Lucky was never subject to the PFIC rules because the CFC-PFIC trump rule of IRC §1297(d) applied to him from the first day of his ownership in the company. He has a CFC only.For the two US owners (Sally and David) who owned their shares prior to Lucky’s purchase, the company is both a PFIC and a CFC, unless they make a purging election to remove the PFIC status.This week, I will provide some background, then talk about what happens when Sally makes a deemed sale election — how it is done and what the tax effects are.Next week, I will talk about what happens when David makes a deemed dividend election — how it is done and what the tax effects are.
The company meets both definitions — CFC and PFIC
The company is a PFIC because it meets the income test of IRC §1297(a) — 100% of its income is passive. All it earns is interest income. Passive income for the purposes of IRC §1297(a) is defined in IRC §954(c), and includes interest income. The company only needs to meet one of the two tests described in IRC §1297(a) to qualify as a PFIC. Therefore the company is a PFIC.A company is a CFC when more than 50% of its value or voting power are owned by US shareholders. IRC §957(a). "US shareholder” is a term of art that means a US person who has 10% or more of the voting power of a foreign corporation. IRC §951(b).All the US persons who own shares in the startup are US shareholders because they have more than 10% of the voting power of the company. The company becomes a CFC when Lucky buys his shares on June 30, 2014 because it is 60% owned by US shareholders as of that day, and the threshold for CFC status is 50%.The CFC status was triggered when Lucky bought 20% of the shares of the corporation on June 30, 2014. With respect to the income and asset tests of IRC §1297(a), however, the company is still a PFIC.Does Sally own shares in a PFIC, a CFC, or both?The startup is both a PFIC and a CFC for Sally
IRC §1297(d) says that a PFIC will not be treated as a PFIC for a shareholder during the period that the company is a CFC and the shareholder is a US shareholder of the company. The Code calls this the “qualified portion” of the holding period.The company becomes a CFC on June 30, 2014. Sally is a US shareholder of the company. Therefore the company is not treated as a PFIC starting June 30, 2014…right?Wrong. Regs. §1.1297-3(a) states the following:A shareholder (as defined in § 1.1291-9(j)(3)) of a foreign corporation that is a section 1297(e) passive foreign investment company (PFIC) (as defined in § 1.1291-9(j)(2)(v)) with respect to such shareholder, shall be treated for tax purposes as holding stock in a PFIC and therefore continues to be subject to taxation under section 1291 unless the shareholder makes a purging election under section 1298(b)(1). A purging election under section 1298(b)(1) is made under rules similar to the rules of section 1291(d)(2). Section 1291(d)(2) allows a shareholder to purge the continuing PFIC taint by either making a deemed sale election or a deemed dividend election.(A quick note to readers: Where these regulations refer to IRC §1297(e), they actually mean 1297(d) where the CFC-PFIC trump rule is found. This occurred because the regulations were written before IRC §1297 was renumbered and the language of the regulations was not updated to reflect the renumbering. See TD 9360; 72 FR 54820-54825; PL 110-172, §11(a)(24)(A); 121 Stat. 2486.)Regs. §1.1291-9(j)(2)(v) defines a section 1297(e) PFIC as follows:
A foreign corporation is a section 1297(e) PFIC with respect to a shareholder (as defined in paragraph (j)(3) of this section) if—Sally holds shares of a section 1297(e) PFIC, because before the company became a CFC, it was a PFIC, and she held shares of the company before it became a CFC. Therefore the CFC-PFIC trump rule of IRC §1297(d) is not automatic, according to Regs. §1.1297-3(a).The excess distribution rules of IRC §1291 continue to apply until a purging election (either a deemed sale election or a deemed dividend election) is made. That means that if Sally does not make a purging election, the company will be treated as both a PFIC and a CFC for her, and she will be subject to both sets of rules simultaneously.(A) The foreign corporation qualifies as a PFIC under section 1297(a) on the first day on which the qualified portion of the shareholder’s holding period in the foreign corporation begins, as determined under section 1297(e)(2); and(B) The stock of the foreign corporation held by the shareholder is treated as stock of a PFIC, pursuant to section 1298(b)(1), because, at any time during the shareholder’s holding period of the stock, other than the qualified portion, the corporation was a PFIC that was not a QEF. Reg. §1.1291-9(j)(2)(v).