September 7, 2017 - Haoshen Zhong

Unit Trust in Stapled Security Arrangements

This is a question sent to us through email:

I invested in Australian stapled securities. Do I have a PFIC problem?

In this post, I will introduce the concept of stapled securities and go through the questions we ask to determine whether the US person holds a PFIC. Because we have limited space, I am going to assume that the particular stapled security we are discussing is used to hold real estate investments.

What are stapled securities?

It is a type of securities arrangement in Australia.

You have a unit trust that holds property. The unit trust hires a limited company to manage the property. The units of the unit trust and some of the shares of the limited company are contractually bound to be sold together. When the units and shares are bound together this way, they form a stapled security.

In this post, we assume the unit trust is holding rental real estate.

What are PFICs?

Passive foreign investment company (PFIC) is a classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for a gain, special rules apply. The rules are less than desirable for the taxpayer, so it is desirable to avoid PFIC classification.

A PFIC is a foreign corporation that meets at least 1 of 2 tests:

  • Income test: At least 75% of the corporation’s income is passive income.
  • Asset test: At least 50% of the corporation’s assets produce passive income or are held for the production of passive income. IRC §1297(a).

Let us check whether the unit trust is a PFIC first.

Maybe the unit trust is a trust under US tax law

A PFIC is a type of corporation. If the unit trust is not a corporation, then it cannot be a PFIC.

US tax law has its own classification of entities that may not correspond to the entity’s classification under foreign or state law. Reg. §301.7701-1(a). For example, business trusts and certain investment trusts are classified as business entities under US tax law, even though they are organized as trusts under foreign or state law. Reg. §301.7701-4(b), (c).

The unit trust is most likely an investment trust: It is a vehicle to pool investments rather than to protect assets for beneficiaries. Reg. §301.7701-4(a).

When an investment trust’s trustee can vary the investments the trust makes, it is a business entity. Reg. §301.7701-4(c). If the trustee must hold specific investment or investments, it is a trust. Reg. §301.7701-4(c).

Check whether the trust agreement for the unit trust permits the trustee to change what properties it holds.

If the trust does not permit the trustee to change the assets held in trust, then it is a trust, not a business entity. A corporation is a type of business entity. Reg. §301.7701-2(b). Because the trust is not a business entity, it cannot be a corporation. Therefore, it cannot be a PFIC.

Maybe the unit trust is a partnership under US tax law

If we the unit trust is a business entity, it might be a partnership rather than a corporation.

An Australian unit trust that is classified as a business entity under US tax law may elect its US tax classification. Reg. §§301.7701-2(b)(8), -3(a). So if the unit trust has elected to be classified as a partnership under US tax law (by filing Form 8832 and choosing partnership classification), then it is a partnership.

If the unit trust does not choose, then it receives a default classification based on the liability of the unit holders. Reg. §301.7701-3(b). If all unit holders have limited liability, then it is a corporation. If at least one unit holder has personal liability for the unit trust’s debts, then it is a partnership.

Look at the trust agreement. If the trust agreement says that unit holders are personally liable for the trust’s debts, then the trust is by default a partnership. If the trust agreement says the unit holders are not personally liable, check with a solicitor in Australia on the unit holders’ liability: Unit holders by default are personally liable for the trust’s debts in proportion to their unit holders. J W Broomhead (Vic) Pty Ltd vs J W Broomhead Pty Ltd, (1985) 3 ACLR 355 (Vic S C). I do not know if the default result can be changed through the trust agreement.

If at least one unit holder has personal liability for the unit trust’s debts, then the unit trust is a partnership and cannot be a PFIC.

The unit trust’s income is passive

Let us assume that the unit trust is a corporation. It is foreign, because it is organized under Australian law and not US law. Reg. §301.7701-5(a). Now we ask whether the unit trust satisfies either the income test or the asset test.

Passive income is any income that is foreign personal holding company income as defined under IRC §954(c). IRC §1297(b). This includes rent. IRC §954(c)(1)(A). We now check if any of the exceptions apply.

Related person rent exceptions probably do not apply

Under the PFIC rules, there is an exception for rent from a related person, as long as the rent is not allocable to the related person’s passive income. IRC §1297(b)(2)(C). You can check the tenants of the unit trust to see if the tenants are related persons. Usually this exception does not apply.

Active rent exception does not apply

There is another exception to foreign personal holding company income: It does not include rent derived from the active conduct of a trade or business. IRC §954(c)(2)(A). Because the management company is running the rental business in an active manner, it is tempting to assume that the rental income is rent from an active trade or business.

The active rent exception is far narrower than the statutory language makes it sound: It only works if the corporation runs the business through its own officers or staff of employees. Reg. §1.954-2(c)(1). Here, the unit trust is not using its own officers or staff of employees to run the rental business. The officers and staff of employees of a separate corporation (the limited company) run the rental business. The rent does not fit the active rent exception.

It is tempting to argue that because the unit trust and limited company’s shares are stapled together, they are related persons, so the limited company’s employees should be attributed to the unit trust.

Unfortunately, there is no language in the regulations that permit a company to import a related person’s employees as its own for the active rent exception.

By choosing a stapled securities arrangement, where management was delegated to a limited company, the unit trust forwent the active rent exception. The rent is passive income. Because the rent is passive income, the unit trust meets the income test. It is a PFIC.

Not discussed: Is the stapled security itself a PFIC?

This post discusses the unit trust in a stapled security arrangement only. I will leave the discussion of whether the stapled security itself is a PFIC for another post.