PFIC to CFC transition miniseries #3 – Deemed dividend electionAugust 6, 2015 - Debra RuddPFIC and CFCs
Hello again from Debra Rudd.
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PFIC to CFC transition miniseries
This week is Part III 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.
Two weeks ago, I discussed how the startup was a PFIC for the US shareholders 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.
Last week, I talked about how Sally made the deemed sale election and what the tax results were.
This week, I will talk about what happens when David makes a deemed dividend election — how it is done and what the tax effects are. I will also do a brief comparison of the results for all three US owners — Lucky, Sally, and David.
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 a still PFIC.
The startup is both a PFIC and a CFC for David
Does David own shares in a PFIC, a CFC, or both?
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 company becomes a CFC on June 30, 2014. David is a US shareholder of the company. Therefore David is treated as a shareholder in a CFC and not a PFIC, because of the CFC-PFIC trump rule, right?
Wrong. He is still a shareholder in a PFIC. The trump rule will not apply until David makes a purging election, and he will be subject to both sets of rules until he does so. 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—
(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).
David holds shares of a section 1297(e) PFIC, because before the company became a CFC, it was a PFIC, and he held shares of the company. Therefore the CFC-PFIC trump rule of IRC §1297(d) is not automatic, according to Regs. §1.1297-3(a).
The PFIC tax 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 David does not make a purging election, the company will be treated as both a PFIC and a CFC for him, and he will be subject to both sets of rules simultaneously.
How the deemed dividend election works
According to Regs. §1.1297-3(a), David may make either a deemed sale or deemed dividend election to remove the PFIC status and operate under the CFC rules only.
In this scenario, David will be making the deemed dividend election. So how, exactly, does that work?
The deemed dividend election as it applies to a shareholder of a section 1297(e) PFIC is described in Regs. §1.1297-3(c).
Under that regulation, the shareholder must determine his proportional share of the post-1986 earnings and profits as of the day before the CFC qualification date. The shareholder includes his share of the E&P in income, and it is taxed as an excess distribution under IRC §1291. After the deemed dividend, the stock will not be treated as PFIC stock anymore unless it ceases to qualify as a CFC but continues to meet the definition of a PFIC. Once you recognize the deemed dividend as income, your adjusted basis in the stock increases by the amount of the deemed dividend recognized. Regs. §§1.1297-3(c).
How to make the election on Form 8621
On Form 8621, Part II, David selects Election G, Deemed Dividend Election With Respect to a Section 1297(e) PFIC.
David computes the company’s E&P, and his proportional share of it as of June 29, 2014. He enters the amount computed on Part V, Line 15e, and fills in Lines 16a-16f according to the excess distribution rules of IRC §1291.
David also must attach a statement to Form 8621, showing a calculation of how he arrived at his portion of the company’s E&P. Regs. §1.1297-3(c)(5)(ii).
David must file both Form 8621 and Form 5471 for 2014
In addition to filing Form 8621 to make the election and report the deemed dividend, David also has to file Form 5471 for 2014 because the company is a CFC.
Effects of deemed dividend election
The company has received substantially zero income in the course of its operations. Therefore, for the purposes of this newsletter, we can consider the E&P to be effectively zero, and David’s share of it is $0.
David has no income to report. If you recall the results of Sally’s deemed sale election from last week ($1.3 million of tax on a pretend $1.8 million gain), you can see that the deemed dividend election in this scenario — where the company’s asset value is high but its earnings are low — is vastly superior to the deemed sale election.
In a scenario where the company has high earnings, it is worth doing the calculations for both the deemed sale and deemed dividend elections to determine the best possible tax outcome.
Lucky’s purchase of shares from a foreign person caused the company to become a CFC at time of his purchase. Because the company was never a PFIC for him, he doesn’t have to do anything to terminate the PFIC rules. He is able to operate under the CFC rules only.
Sally had to make a purging election to terminate the PFIC status and operate under the CFC rules only. She chose to make a deemed sale election. The deemed sale resulted in about $1.3 million of tax for her for a pretend sale, because the company had a high asset value and Sally had a low basis at the time of the deemed sale.
David also had to make a purging election to terminate the PFIC status and operate under the CFC rules only. He chose to make a deemed dividend election. The deemed dividend resulted in $0 tax for him, because the company’s earnings were $0.
As always, thank you for reading, and I’ll see you next week. (And please hire a professional to help you if you need advice.)