October 6, 2016 - Haoshen Zhong

Reading a Profit and Loss Statement for the PFIC Income Test

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Shortcuts for determining PFIC status

This week’s newsletter topic is a question from email:

I have a client who owns a 10% stake in a European manufacturing company. There are no other US shareholders. I received a profit and loss statement that shows gross receipts from sales, operating expenses that do not distinguish between direct and indirect expenses, and other income. How do I read this to determine if I have a PFIC?

In this newsletter, I will talk about some of the mechanics of applying the income text and how we get around problems in practice.

Why do we care about the income of the company

To discourage passive investments abroad, the US tax law contains a set of punitive rules for passive foreign investment companies.

A passive foreign investment company (PFIC) is a foreign corporation that meets either 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.

A foreign corporation is classified as a PFIC if it meets either 1 of these 2 tests. An European company is a foreign corporation, so it is important to know how to read the P&L to check if the company meets the income test.

Direct expenses affect gross income; indirect expenses do not

Direct expenses and indirect expenses are accounting concepts.

Direct expenses, that is expenses that vary directly with changes in the volume of goods produced, is part of cost of goods sold. Raw materials, for example, is a direct expense of manufacturing. An increase in expenses also increases cost of goods sold. In accounting, the gross profits from sales is the revenue from sales minus cost of goods sold.

Indirect expenses are expenses that are incurred for the business as a whole. The salary of a CEO, or example, is an indirect expense. Indirect expenses do not change cost of goods sold and therefore do not affect gross profits.

It matters whether an expense is direct or indirect because of the way the income test is defined. Specifically, a foreign corporation meets the income test if:

75 percent or more of the gross income of such corporation for the taxable year is passive income… IRC §1297(a)(1); (emphasis added).

The PFIC rules do not give a definition of gross income, so we use the normal tax law definition of gross income. For a manufacturing concern:

In manufacturing, merchandising, or mining business, “gross income” means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. Reg. §1.61-3(a).

The tax law concept of gross income from manufacturing is very much like the accounting concept of gross profits from manufacturing: Cost of goods sold is subtracted to reduce gross income, but indirect expenses are taken into account after gross income is determined. It is important to segregate direct and indirect expenses to know what the gross income to be used in the income test is.

Based on the question in the email, the European company’s P&L does not tell us what the direct expenses and indirect expenses are, so we do not know what gross income is.

You likely need to get additional data from the company accountant

Let us assume a grossly oversimplified P&L. Let us say that the P&L you received from the company says this:

Gross receipts: €600,000
Operational expenses: €700,000
Operating profit (loss): (€100,000)
Income from investments: €10,000
Net profit: (€90,000)

This P&L does not tell you how the operational expenses are divided: What are the direct expenses that go into cost of goods sold and what are the indirect expenses that do not?

This is a relevant question. Suppose we have cost of goods sold of €600,000 and indirect expenses of €100,000. If the expenses were really divided this way, then we have gross income of €0 from manufacturing and €10,000 from investments. This would mean 100% of the income is passive, making the company a PFIC.

But there is no way to tell what were the cost of goods sold and indirect expenses from this P&L. We would need to get more details from the company accountant.

Help from a foreign professional is likely necessary

The foreign country from which you are getting the more detailed financial statement will have its own customs about labeling different revenue and expenses. False friends and specific jargon terms abound in these statements.

It is very common for us to get a financial statement, then have to ask the company accountant many questions along the lines of “what does this label mean”? It is a display of lack of knowledge we find necessary to properly help the client with his tax returns.

Here is our dark secret: When we really need to be sure, we get GAAP conversions, possibly from a Big Four firm. Getting a GAAP conversion from an expert has other potential uses. FOr example, if a US person just acquired a 10% stake in the company, a GAAP financial statement would be necessary to file Form 5471.

What happens if we have a negative gross profit?

Let us assume a grossly oversimplified P&L. Let us say that the P&L you received from the company says this:

Gross receipts: €600,000
Cost of goods sold: €700,000
Gross profit: (€100,000)
Other operating expenses: €100,000
Income from investments: €10,000
Net profit: (€190,000)

As you can see, the cost of goods sold is higher than gross receipts, so we have a negative gross profit. This is how gross income is calculated under tax law:

Nonpassive income: -100,000 (equal to gross profit)
Passive income: 10,000 (equal to income from investments)
Gross income: 0 (cannot be below 0)

The IRS has not published any official guidance on this subject, but it has addressed the situation in a private letter ruling. Specifically, this corporation does not have any gross income, so it cannot be a PFIC under the income test. PLR 9447016.

This outcome makes sense: Congress passed the PFIC rules to discourage US persons from making passive investments abroad. The rules also prevent US persons from getting out of PFIC treatment by changing the corporation’s business before a large distribution or a sale. The rules are not there to ensnare active businesses. It is expected that the IRS would interpret the income test and asset test liberally in favor of classifying active businesses as non-PFICs.

This does leave a gap: Suppose a manufacturing business has gross receipts equal to cost of goods sold, and it has €10,000 of investment income. This manufacturing business has gross income of €10,000, all of which is passive. It would then become a PFIC.

Thank you

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