October 18, 2016 - Haoshen Zhong

Why a Holding Company for Active Businesses is Probably Not a PFIC

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Holding companies

This week’s newsletter topic is from an email from a reader I will call John Smith.

I was wondering if a foreign conglomerate corporation, with investments in various manufacturing industries, which trades in a foreign stock exchange, can be considered a PFIC. An example of a U.S. conglomerate corporation would be G.E. and a foreign one would be Toshiba (in Japan).

John is really talking about the holding company of a multinational business. The holding company owns subsidiaries and joint ventures, each of which is engaged in an active business. This post will talk about a number of rules Congress put in place to mitigate the risk that the holding company would be classified as a PFIC–and therefore subject its US shareholders to punitive tax rules.

PFIC defined

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 of these tests. We will assume that the holding company is a foreign corporation, so if it meets either the income test or the asset test, then it will be classified as a PFIC.

The 25% lookthrough rule prevents the holding company from becoming a PFIC in its day to day operations

Under section 1297(c):

If a foreign corporation owns (directly or indirectly) at least 25 percent (by value) of the stock of another corporation, for purposes of determining whether such foreign corporation is a passive foreign investment company, such corporation shall be treated as if it–

(1) held its proportionate share of the assets of such other corporation, and
(2) receive directly its proportionate share of the income of such other corporation.

What this tells us is that if a foreign holding company owns at least 25% of a subsidiary foreign company, look through the subsidiary to the underlying income and assets.

For a multinational business, the holding company usually owns wholly-owned subsidiaries, more than 90% of the shares of a subsidiary (for countries that require at least 2 shareholders for a company), or 50% of the shares of a joint venture. These companies do invest in minority shares in other companies, but it is rare for the holding company to own less than a 25% stake.

This means the holding company looks through its subsidiaries to the underlying income and assets. Take a parent company with the following wholly-owned subsidiaries:

Subsidiary 1
Gross profits from sales: $1,000,000
Interest: $1,000

Inventory: $4,000,000
Manufacturing equipment: $6,000,000
Cash: $2,000,000

Subsidiary 2
Gross profits from services: $500,000
Interest: $1,000

Cash: $6,000,000

Because both subsidiaries are wholly-owned, you look through both subsidiaries and combine the income and assets when you apply the income and asset tests for PFICs. This would give us a parent company that looks like the following:

Gross profits from sales: $1,000,000
Gross profits from services: $500,000
Interest: $2,000

Inventory: $4,000,000
Manufacturing equipment: $6,000,000
Cash: $8,000,000

The result is as follows:

Nonpassive income: $1,500,000
Passive income: $2,000

Nonpassive assets: $10,000,000
Passive assets: $8,000,000

This parent company is not a PFIC under either the income test or the asset test.

Intercompany dividends do not present a problem

It is not uncommon for a subsidiary to distribute profits to the holding company in the form of a dividend. Normally, dividends are passive income. IRC §§1297(b)(1), 954(c)(1)(A). The question is whether these dividends are still counted if the holding company looks through the subsidiary to the underlying income and assets.

Similarly, the shares of the subsidiary are technically part of the holding company’s assets. Do these shares count as assets for purposes of the asset test?

It seems that to avoid double counting, the dividends and shares should be ignored. For example, any dividend that a 25% subsidiary distributes to its parent is from income, which under the lookthrough rules would have already been counted as income of the parent at some point. Similarly, counting the shares of the subsidiary as a separate asset would seem to double count the subsidiary’s assets.

Congress seems to be under the impression that dividends and shares of a 25% subsidiary should be ignored, which can be seen it described the law on PFICs. See H. Rpt. 100-1104 at 268.

As a result, a holding company will not become a PFIC because of dividends it receives from a 25% subsidiary.

Liquidation of a subsidiary does not immediately create a PFIC risk

Gain from the sale of stocks is passive income, even if the dividends from the stocks would be nonpassive income. IRC §954(c)(1)(B)(i). If a holding company liquidates or sells a subsidiary in which it owns at least 25% of the shares, does that create passive income?

There is no specific regulation or IRS guidance on this subject, but the IRS is aware that the 25% lookthrough rule exists to prevent a holding company from being classified as a PFIC. The result is for PFIC income test purposes, the IRS’s private letter rulings look at the sale, liquidation, or reorganization of a subsidiary as if the parent sold the underlying assets directly. See PLR 200015028; 200813036.

There is a related change of business rule: Under section 1298(b)(3), a foreign corporation that sells a significant portion of its assets is not a PFIC in the year of sale if all of the following are true:

  1. It was not a PFIC before;
  2. It realizes most of its passive income during the year from selling an active business; and
  3. It is not a PFIC for the next 2 years

Combine this rule with the 25% lookthrough rule for the year a subsidiary is sold, liquidated, or reorganized: The parent’s income would be substantially from the sale (or deemed sale) of the underlying business assets of the liquidated subsidiary. As long as the parent was not a PFIC before, and it will not be a PFIC for the next 2 years, it would not be a PFIC in the year of sale, liquidation, or reorganization.

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