September 8, 2016 - Haoshen Zhong

Shortcuts We Use to Determine if an Investment is a PFIC

Greetings from Haoshen Zhong.

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Shortcuts for determining PFIC status

This week’s newsletter topic is a question we get quite often:

I have a large number of investments in foreign funds and companies. Is there any way to tell whether they are PFICs without checking their income and assets?

In this newsletter, I will talk about the shortcuts we use to determine PFIC status when we encounter a client with a lot of different foreign investments.

Definition of a PFIC

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

This is a highly mechanical test: If the foreign corporation meets either the income test or the asset test, then it is a PFIC. Technically, there is no shortcut, but in the interest of being reasonably accurate and saving costs for the client, we do employ a number of shortcuts in practice.

Mutual funds and exchange traded funds (ETFs)

Mutual funds and exchange traded funds (ETFs) nearly always meet both the income test and the asset test, so all we check is whether they are foreign corporations. This is defined strictly by whether they are organized in the US. IRC §7701(a)(4).

If the fund has an international securities identification number (ISIN) assigned to it, then it is easy: If the ISIN begins with “US”, then it is a fund that is organized in the US and therefore cannot be a PFIC. If the ISIN does not begin with the US, then it is probably a PFIC–assuming you do not have information to indicate otherwise.

If the fund does not have an ISIN, then we look at the fund’s organizing documents. If the entity is organized under US law, then it is a US entity and cannot be a PFIC. Otherwise, it is a foreign entity and most likely a PFIC.

Check for a PFIC annual information statement

There is a special election that a shareholder in a PFIC can make called a qualifying electing fund (QEF) election. See IRC §§1293-1295.

One of the requirements for making a QEF election is that the shareholder must receive a PFIC annual information statement from the PFIC. Reg. §1.1295-1(g)(1).

Check the investor relations page for the company in question. If it has a PFIC annual information statement from a recent year, then it was a PFIC that year. The client may or may not be able to make a QEF election this year. And even if the client can make the QEF election, it may not be a good idea to do so. Debra has written about the QEF election in a previous post.

Check the SEC disclosures

The SEC disclosure rules require a company that is registered with the SEC to disclose investment risks.

Being classified as a PFIC is considered an investment risk for US persons, because PFICs are subject to extremely punitive tax rules compared to investments in a normal company (especially if the company were in a treaty country). As a result, publicly traded companies in the US disclose the risks of being classified as a PFIC in their SEC filings.

You can check the SEC filing for a company to see if it is a PFIC. Alternatively, the SEC filing may give reasons for why it is not a PFIC. If it does not mention PFICs at all, then the assumption is that it is not a PFIC.

Check the financial statements

This is for companies in which the client has significant investments and for which we can obtain financial statements, but for which we cannot obtain additional details.

An active business–manufacturing, software, service, etc–is very unlikely to meet the income test. But it is possible. For example, suppose you have a manufacturer whose sales revenue is equal to the cost of goods sold. Then the gross income of the manufacturer from sales of inventory is actually 0. Suppose it also has some interest income. Then it will have gross income that is all passive income, making the company satisfy the income test.

For this reason, we check the P&L statement of the company to make sure it is not a PFIC under the income test..

The balance sheet of the financial statement is much less useful for the asset test than the P&L statement is for the income test. This is because the asset test uses fair market value of the company’s assets. An active business has many assets that have nonzero value but do not appear on the balance sheet: patents, copyright, trademarks, trade secrets, goodwill, etc.

For this reason, for an active business, we only check the balance sheet for an enormous disparity between passive assets and nonpassive assets. If the passive assets on the balance sheet exceeds the nonpassive assets by a significant margin, then we assume the company meets the asset test. Otherwise, we assume the nonpassive assets that do not appear on the balance sheet are valuable enough that the company does not meet the asset test.

Real estate companies

This is the most difficult type of company to classify, because real estate can produce either passive or nonpassive income.

If the company merely leases out real estate, then the income is passive. IRC §§1297(b)(1); 954(c)(1)(A). The real estate itself is held for the production of passive income.

If the company actively manages its real estate–for example, by arranging leases, maintaining the building, renovating for new tenants, etc–, then the rent is nonpassive income. IRC §954(c)(2)(A). The real estate itself is held for the production of nonpassive income.

And if a company leases out real estate to a related company, then the rent may or may not be passive income. IRC §1297(b)(2)(C).

A real estate company can very easily have a mix of these businesses: An office building where it arranges for tenants and rearranges offices for the new tenant; a residential complex where it is the management company; and a warehouse where it merely collects rent. The result is a company whose assets and income are not readily classified into passive and nonpassive categories.

We have had the misfortune of trying to classify such a company only once–at least when the client’s holdings were of significant value. We ended up going through the company’s financial statement to find out what subsidiaries it owned, what buildings it owned, whether they were self-managed or tenant managed, etc.

Guess based on what the company does

When all else fails, we make educated guesses: We Google the company in question and see what it does. If it is an active business, then we assume it is not a PFIC. If it looks like an investment entity, then we assume it is a PFIC.

Thank you

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