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.This week, I will examine the interaction of the PFIC and CFC rules for the US person who buys 20% of the company from the foreign owner on June 30, 2014 (let’s call him Lucky). In the following weeks, I will look at the PFIC-CFC interaction rules for the other two US owners who owned a PFIC that subsequently became a CFC, and two possible ways of handling that transition (I will refer to those two owners as Sally and David).
The startup is a PFICTo be a PFIC, a foreign corporation must meet either the income test or the asset test as described under IRC §1297(a):
- 75% or more of its gross income is passive, or
- 50% or more of its assets are passive or are held for the production of passive income.
PFIC startup exception does not applyIRC §1298(b)(2) contains an exception to PFIC status that applies to a corporation if, for the first two years after the first year it has gross income, it is not a PFIC. In the example given, the company receives gross income in the form of interest earned on its bank account starting in the first year of operations. For several years, it continues to receive only interest income. Therefore it qualifies as a PFIC under the income test. It is a PFIC for this entire period. Therefore the startup exception under IRC §1298(b)(2) does not apply.
The startup became a CFC in 2014“CFC” is an acronym that stands for controlled foreign corporation. A foreign company is a CFC when more than 50% of its value or voting power are owned by US shareholders. IRC §957(a). “US shareholder” in this context is a term of art that means any US person who has 10% or more of the voting power of the corporation. IRC §951(b). The three US persons who each own 20% of the company are US shareholders because they each have more than 10% of the voting power. Prior to June 30, 2014, the company was not a CFC because only 40% of its value and voting power were owned by US shareholders. After June 30, 2014, the company is a CFC because 60% of its value and voting power are owned by US shareholders, 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. Does Lucky own stock in a PFIC, a CFC, or both?
Startup is a CFC with respect to LuckyCongress addressed this specific situation in IRC §1297(d) by saying that a PFIC will not be treated as a PFIC for the “qualified portion” of the shareholder’s holding period. The qualified portion means the portion of the holding period after December 31, 1997 during which the following two statements are true:
- The shareholder is a US shareholder (under the definition described above) of the corporation, and
- The corporation is a CFC. IRC §1297(d)(2).
Startup is both a PFIC and CFC for Sally and DavidSally and David owned shares in the company before it met the definition of a CFC. Regs. §1.1297-3(a) says 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 and David hold shares of a section 1297(e) PFIC, because before the company became a CFC, it was a PFIC, and they 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 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 and David do not make a purging election, the company will be treated as both a PFIC and a CFC for them, and they will be subject to both sets of rules simultaneously. This is consistent with the “once a PFIC, always a PFIC” rule of IRC §1298(b)(1), which in simple terms says that if at any time in your holding period of a foreign corporation it is considered a PFIC, it continues to be treated as a PFIC for you unless you do something to terminate that status. Doing something to terminate that status means making a purging election.
(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. Regs. §1.1291-9(j)(2)(v).