Article by Dr. Oz Halabi, Partner and Eran Shif, Transfer Pricing Specialist
What Is It?
A U.S. tax regime that is applicable to U.S. persons[1] that own interest in a foreign corporation that holds or earns primarily passive investments and income. The “passive foreign investment company” (“PFIC”) tax regime imposes obligations on U.S. persons to report their allocable portion of the PFIC’s taxable income and to comply with certain reporting requirements. The PFIC regime aims to discourage U.S. persons from forming a foreign corporation and using that company to invest in primarily passive investments, thereby attempting to shift income out of the U.S. federal tax net. Harsh tax results may be applied on such U.S. persons that may increase their total U.S. federal income tax liability.
When a Foreign Corporation Is Treated As PFIC?
A foreign corporation is treated as a PFIC, if either the 50 percent asset test or the 75 percent income test is satisfied. Under the income test, a foreign corporation is treated as a PFIC if the average percentage of the value of the assets held by such corporation (calculated on a quarterly basis) during the taxable year which produces passive income, or which are held for the production of passive income, is at least 50 percent. Or if 75 percent or more of its gross income fits within the definition of ‘passive income’, which generally includes dividends, interest, royalties, rents, and annuities.
Are There Any Exceptions?
Start-Up Year Exception. A corporation that would otherwise meet the criteria for a PFIC will not be treated as such for the first taxable year in which such corporation earns gross income. The exception is applicable only if the following conditions are met: (1) no predecessor of such corporation was a PFIC; (2) the U.S. stockholders establishes to the satisfaction of the IRS that such corporation will not be a PFIC for either of the first two taxable years following the start-up year; and (3) such corporation is not, in fact, a PFIC for either of the first two taxable years following the start-up year.
Why Should Founders Be Concerned?
The PFIC tax regime imposes a significant filing requirement and requires U.S. persons to pay tax on an annual basis, irrespective of if the PFIC distributed any money to the U.S. stockholder. To that end, many U.S. investors requires companies to analyze on an annual basis their PFIC status, and to provide the investor with detailed information (and with tax returns prepared pursuant to the Code) to allow them to correctly prepare the U.S. stockholder tax return. Given that the PFIC rules apply to each U.S. stockholder, respective of the interest such stockholder has in the company, companies must be aware of their PFIC requirements under any investment agreement.
Why Should Investors Be Concerned?
The PFIC tax regime aims to discourage U.S. persons from forming (or owning) foreign corporations and using that companies to invest in primarily passive investments, thereby attempting to shift income out of the U.S. federal income tax net. Specifically, if a U.S. person is treated as owning an interest in a PFIC that person may be subject to special tax and interest charges upon receipt of an ‘excess distribution.’ Excess distribution consists of certain distributions from, or gain from the disposition of stock in, the PFIC. This special tax and interest charge approximate the U.S. federal income tax that would have been payable if the foreign corporation had distributed all its income every year. The calculation of excess distributions is performed annually and can be complex.
Investments designated as PFICs are subject to strict and extremely complicated tax guidelines by the Internal Revenue Service (“IRS”). The PFIC itself, as well as stockholders, are required to maintain accurate records of all transactions related to the PFIC, such as share cost basis, any dividends received, and undistributed income that the PFIC may earn.
Every non-US corporation, that solicits investments from U.S. persons, is and will be required to provide the investors an annual determination of the company’s PFIC status, and, in some growing number of cases, information about the income of the company, to allow the investor to comply with the U.S. tax rules.
However, the PFIC regulations exclude investors that fall in one of the following terms:
a. Dual resident taxpayers – taxpayers that are treated as nonresident aliens for the taxable year pursuant to treaty tie-breaker provisions. The treaty-based return position should be disclosed in accordance with regulations;
b. 30 days holding threshold – if a taxpayer acquires a PFIC fund in the taxable year or the immediately preceding taxable year, and only holds that fund for 30 days or less;
c. Residents of certain U.S. territories – residents of Guam, the Northern Mariana Islands, or the United States Virgin Islands;
d. De minimis – If a taxpayer did not receive an excess distribution and the value of the PFIC is less than $25,000 (or $50,000 for shareholders that file joint returns).
Main Takeaways:
PFIC reporting regulations can be an administration burden for relevant U.S. taxpayers and result in tax payments. Therefore, the exceptions provided in the regulations can be a great relief to such taxpayers. Furthermore, the following taxpayers need to be more alert with respect to PFIC:
• U.S. citizens that reside outside of the United States;
• U.S. persons that have interests in foreign mutual funds;
• U.S. persons that have interest in foreign early stage companies.
[1] A U.S. person may be each of the following: A citizen or resident of the United States; A domestic partnership; A domestic corporation; Any estate other than a foreign estate; Any trust if: A court within the United States is able to exercise primary supervision over the administration of the trust, and One or more United States persons have the authority to control all substantial decisions of the trust; Any other person that is not a foreign person.
