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January 25, 2018 - Haoshen Zhong

Tax Law Changes Made a CFC-PFIC Overlap Easier

This post notes a change in the way controlled foreign corporation (CFC) rules work now that the newly passed tax law is in effect. This change makes it more likely that a person would fall under the CFC rules instead of the passive foreign investment company (PFIC) rules. Unfortunately, it may have caused some persons to be subject to both the CFC rules and PFIC rules.

What are PFICs and CFCs?

Passive foreign investment company (PFIC) is a classification under US tax law. It is designed to discourage US persons from investing abroad through foreign investment vehicles. When a US person owns shares in a PFIC, the US person is subject to extremely punitive tax and reporting rules. IRC §1291.

Controlled foreign corporation (CFC) is another classification under US tax law. It is designed to reduce the ability of US persons to defer US tax by using foreign corporations to earn income. It does so by requiring “United States shareholders” of the CFC to include the CFC’s subpart F income and global intangible low-taxed income in the shareholder’s income each year. IRC §§951, 951A.

The term “United States shareholder” is in quotes, because it has a specific meaning in the tax Code. United States shareholders of a CFC that is also a PFIC use special overlap rules, and the new tax law changes the definition of United States shareholder.

The CFC-PFIC overlap rule

PFIC and CFC rules are supposed to be complementary. CFC rules apply when US persons control the foreign corporation as the Code defines it. CFCs require US shareholders to include their share of some of the CFC’s income each year. When CFC rules apply, there is no need to apply the PFIC rules.

But it is possible for a CFC to satisfy the definition of a PFIC. There is a rule that addresses the CFC-PFIC overlap in section 1297(d). The overlap rule works like this:

(1) In general For purposes of this part, a corporation shall not be treated with respect to a shareholder as a passive foreign investment during the qualified portion of such shareholder’s holding period with respect to stock in such corporation. (2) Qualified portion For purposes of this subsection, the term “qualified portion” means the portion of the shareholder’s holding period–

(A) which is after December 31, 1997, and (B) during which the shareholder is a United States shareholder (as defined in section 951(b)) of the corporation and the corporation is a controlled foreign corporation. IRC §1297(d).

What this says is that if you are a “United States shareholder”, as that term is defined under section 951(b), of a foreign corporation, and the foreign corporation is a CFC, then you do not treat your shares in the CFC as shares of a PFIC. You avoid the PFIC rules.

Let us assume that you have a foreign corporation, and that it is both a PFIC and a CFC. We need to know if you are a “United States shareholder” to see if you get to use the CFC rules instead of (or in addition to) the PFIC rules.

”United States shareholder” before and after the tax law changes

Here is how the term “United States shareholder” was defined before the tax law changed:

For purposes of this subpart, the term “United States shareholder” means, with respect to any foreign corporation, a United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation. IRC §951(b) (2017).

Here is how the term “United States shareholder” is defined after the change in tax law:

For purposes of this subpart, the term “United States shareholder” means, with respect to any foreign corporation, a United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. IRC §951(b) (2018).

The difference? Before the change, “United States shareholder” includes only those US persons who hold 10% or more of the voting power of the corporation. After the change, you are a United States shareholder if you hold 10% or more of either the voting power or the value of the corporation.

For example, suppose you have a foreign corporation with 2 series of shares. Shareholder 1 owns all series 1 shares, and shareholder 2 owns all series 2 shares. Both are US citizens. Series 1 has voting power but no right to profits or liquidation proceeds. Series 2 has no voting power but has all rights to profits or liquidation proceeds.

Under the previous rules, shareholder 2 is not a United States shareholder, because he holds no voting power. Under the new rules, shareholder 2 may (and probably does) hold sufficient shares to be a United States shareholder, because the nonvoting shares have value.

Because it is now easier to be a United States shareholder of a foreign corporation, more people would be subject to CFC rules, and more people would fall into the CFC-PFIC overlap.

It is easier for a corporation to be a CFC

A CFC is defined as follows (IRC §957(a)):

  • Find all United States shareholders of a foreign corporation
  • Add all shares of United States shareholders
  • If the result is more than 50% of the foreign corporation’s shares by value or by voting power, then the corporation is a CFC.

After the tax law change, there are more United States shareholders. This means we are counting more shares when we determine whether a foreign corporation is a CFC. This means more foreign corporations would be classified as CFCs. This effect also contributes to why more people would fall into the CFC-PFIC overlap rule.

Some may need to purge a PFIC taint

Unfortunately, there is a “once a PFIC, always a PFIC rule”. What it says is that if you treated a share of a foreign as a PFIC share within your holding period of the share, then you must continue to apply the PFIC rules, even if you become a United States shareholder, and the corporation becomes a CFC. Reg. §1.1297-3(a). This is known as the PFIC taint.

The only way to stop applying the PFIC rules is to make a purging election. Reg. §1.1297-3. Debra covered the transition from PFIC to CFC rules in depth in a series of 3 posts.

Here is the short version: To make a purging election, the United States shareholder must either (1) recognize his share of the CFC’s earnings and profits under a deemed dividend election or (2) recognize gain from the shares under a deemed sale election. The deemed dividend or deemed sale election is taxed under PFIC rules, so it can create high tax liability.

Returning to our previous example: Suppose you have a foreign corporation with 2 series of shares. Shareholder 1 owns all series 1 shares, and shareholder 2 owns all series 2 shares. Both are US citizens. Series 1 has voting power but no right to profits or liquidation proceeds. Series 2 has no voting power but has all rights to profits or liquidation proceeds.

This corporation always has been a CFC, because there is 1 US citizen who owned all voting power of the corporation.

Shareholder 1 always has been a United States shareholder of a CFC, so he operates under the CFC rules but not the PFIC rules. Shareholder 2, however, was not a United States shareholder before 2018, because he held no voting power. He became a United States shareholder in 2018. He treated the shares as PFIC shares during his holding period.

Both the CFC rules and PFIC rules apply to shareholder 2 starting 2018. He needs to make a purging election to stop the PFIC rules from applying.

 

PFIC and CFCs