Planning opportunities for owners of passive foreign investment companies
What is a passive foreign investment company (PFIC) and why is it important?
To stem a perceived abuse, Internal Revenue Code §§ 1291 to 1298 were enacted in 1986. Without them, a U.S. shareholder of a foreign corporation holding investment-type assets generating current ordinary income such as interest, dividends, royalties or rent could potentially convert these increases to a capital gain, defer paying tax on that gain for years if no distributions/sales of stock occurred and then pay tax on those deferred gains when ultimately realized at lower long-term capital gains rates.
A PFIC is a foreign corporation that holds an average of more than 50 percent passive income-producing assets (those that generate royalties, rents, dividends, interest, capital gains) or more than 75 percent of the gross income is passive-type income. This test is applied each and every year, however, the tenet “once a PFIC, always a PFIC” generally governs. Cash is included as a passive income-producing asset so sometimes corporations in the first years of raising capital for later investment in machinery or other types of infrastructure can be roped into the definition of a PFIC. This often happens with mining companies and oil and gas ventures. Hedge funds and other individual traders unfamiliar with the corporation’s financial condition throughout the year may not be aware of this trap. However, there is some relief for corporations with this predicament in their first year of operation or in the midst of changing businesses.
Controlled foreign corporation and Subpart F income rules and exceptions
If a PFIC were also a controlled foreign corporation (CFC) during the year, the CFC rules trump the PFIC rules that are discussed below. A foreign corporation is a CFC if more than 50 percent of its voting power or its value is owned by U.S. shareholders any day during the taxable year. A U.S. shareholder is defined as any U.S. person (U.S. citizen/resident, domestic partnership, domestic corporation or any nonforeign estate/trust) who owns 10 percent or more of all voting power of the CFC. Those U.S. shareholders must pay tax on their pro rata share of any Subpart F income the CFC earns even if that income is not distributed during the year.
Subpart F income includes items such as dividends, interest, rents and royalties. It also includes many related-party types of income presumably to prevent offshore entities being formed for the primary purpose of reducing U.S. taxes. Subpart F income is not considered a dividend to the U.S. shareholder and is, therefore, not eligible for any lower taxed rates but it is limited to the undistributed earnings and profits of the corporation. There are also some exceptions for de minimis amounts, where the income is already taxed at a high rate by the home country, home country manufacturing income and active financing income among others.
Generally, current earnings and profits are similar to taxable income as unrealized gains or losses are excluded. There are, however, other adjustments that more closely follow economic income such as a reduction for nondeductible expenses like penalties or 50 percent of certain meals and entertainment expenses.
Besides the Subpart F income to be included, U.S. entities or persons owning shares of offshore entities need to be wary of the numerous disclosure requirements presented by Forms 8621, 8865, 8858, 8804, 8938, 5471 and 926 to name a few. Hedge funds and fund of funds need to be especially careful as they may not realize the additional filing requirements, plus the often severe penalties involved when noncompliant, as well as the increased professional fees for this additional work.
Options for PFICs
If the PFIC is not a CFC and subject to the rules just mentioned, the U.S. shareholder generally has three options:
Qualified electing fund (IRC § 1293)
1) Elect to treat the PFIC as a qualified electing fund (QEF) for a direct or indirect ownership share. This option is appealing to many shareholders because individuals can pay tax on long-term capital gains at the lower tax rates both on their pro rata share of the current income as well as on disposal if the stock is held longer than a year. The first U.S. person (defined similarly in the above CFC section) in a chain of ownership must make this election on their timely filed tax return and disclose all relevant information on Form 8621.
With this election, ordinary income and long-term capital gains are recognized by the shareholder. Unrealized gains are not taxed currently, either — another distinct advantage compared to the mark to market election discussed below. Recognized income is limited to current earnings and profits. What this means is that if the shareholder were to receive a loss in one category, the other category of income would be limited to the net increase:
Shareholder’s pro rata ordinary income = $5, pro rata long-term capital loss = $3
Shareholder recognizes $2 of ordinary income ($5 - $3).
Ordinary income includes interest, dividends (including qualifying dividends), short-term capital gains, portfolio deductions and any other items taxed at ordinary rates. Long-term capital gains are calculated on positions held more than one year.
Taxable income is allocated pro rata, based solely on the shareholder’s daily share of the economic income. This is simpler than the methods most hedge fund partnerships employ. Those generally allocate currently realized capital gains based on layering or aggregation so new partners don’t receive gains previously accrued tax-free during times they weren’t participants in the economic gains.
The QEF election isn’t always available, however. If the foreign corporation doesn’t want to make the effort to attract U.S. investors, it may not provide the necessary statement showing the proper calculations for U.S. tax purposes. Hedge fund type entities have to calculate wash sales, straddles, constructive sales and all other tax adjustments required by an entity filing a U.S. tax return. It would also need to make its books and records available to inspection by the IRS so that agency could prove out the corporation’s calculations, if necessary.
Mark to market (IRC § 1296)
2) If the foreign corporation’s stock is traded on a qualified board or exchange, a mark to market election can be made. If the board or exchange is registered with the Securities and Exchange Commission, it is qualified and there are others that also have been included in this qualified definition.
Increases in value during the year are treated as ordinary income. Decreases in value are treated as ordinary loss only to the extent that ordinary income has been recognized in the past (so-called unreversed inclusions) and cannot exceed the original tax basis of the investment when the election was made. When the stock is sold, gain is all ordinary. Loss is ordinary to the extent of ordinary income recognized in the past and then capital in excess of that.
Year 1: Purchase of stock at $100 and mark to market election in place.
End of Year 1: Stock worth $105. Ordinary income of $5 to be recognized ($105 - $100).
End of Year 2: Stock worth $103. Ordinary loss of $2 to be recognized ($103 - $105 and less than $5 recognized in Year 1). If stock was only worth $90, only loss of $5 would be recognized and the rest would be deferred until disposal.
Middle of Year 3: Stock sold for $96. Ordinary loss of $3 (to the extent of ordinary income recognized in earlier years = $5 in Year 1 + $2 loss in Year 2) and capital loss of $4 (difference between original tax basis of $100 and sale price)
Do nothing (IRC § 1291)
3) If neither the QEF election nor the mark to market election is made, the shareholder pays tax on the excess distributions currently as if they were earned ratably throughout the shareholder’s holding period of the stock. Since this can throw tax due back to previous years if the holding period were longer than a year, this is generally the least favorable option because the IRS charges interest and essentially an underpayment penalty (determined following IRC § 6621) on this back tax.
Excess distributions are:
- Proceeds less tax basis if there is a gain. If there is a loss, the loss is capital. Example: Stock purchased Jan. 1, 2016, for $100, sold for $150 on Dec. 31, 2017. The $50 gain is ordinary and is considered earned equally for two years or $25 each year over the length of the holding period. The $25 of gain earned in 2016 would be charged interest and the underpayment penalty.
- Current distributions in excess of 125 percent of the average amount of distributions over the three preceding tax years (or shorter if the holding period is less). If the distribution is not considered excess, it is considered a dividend and does not qualify for the lower qualifying dividend tax rates. Example: Shareholder received distributions in Years 1 to 3 of $100, $100, $100 and in Year 4 received a distribution of $165. The excess distribution would be $40 ($165 – the average of $100*125%) which would be considered earned ratably over Years 1 to 4. So the ratable portion of the excess distribution allocated to Year 1 of $10 ($40/the four-year holding period) would get penalized with three years of interest and underpayment penalties. The ratable portion of the excess distribution allocated to Year 2 would get two years of interest and penalties, etc.; and $125 of the $165 distributed in Year 4 would be taxed as a dividend.
Planning opportunities
Deemed sale election
If a U.S. shareholder didn’t have the opportunity to make a QEF election in years past because a statement wasn’t available or some other reason, the shareholder can make a deemed sale election that allows the stock to be treated as a QEF going forward. There is a separate deemed sale election for a PFIC that no longer qualifies under the income or asset test. Built-in gain at the time of the election in both cases is treated as an excess distribution described above but loss is not recognized; instead is deferred. Both are done so that future gains don’t receive the taint of classification as an excess distribution and long-term capital gains could be earned.
Deemed dividend election
Similar to the deemed sale election, a deemed dividend election is available to pay tax currently on any accumulated earning and profits not distributed so, going forward, the foreign corporation can fall out of PFIC classification if it no longer applies or if it solely wants to be treated as a CFC (generally, the latter is made when it starts being a PFIC and then becomes a CFC because U.S. ownership increases later). This election is especially helpful if the corporation increased in value (and would recognize a gain under the deemed sale election) but has little accumulated earnings and profits.
Choice of PFIC structure for offshore investor hedge funds and private equity vehicles
For hedge funds and private equity vehicles that employ a buy-and-hold investing strategy as opposed to a short-term trading strategy, there can be advantages to being classified as a PFIC. The expenses of a pass-through (partnership, LLC) investment vehicle that is classified as an “investor” flow through to the partners as miscellaneous itemized deductions that need to exceed the 2 percent limitation of adjusted gross income (AGI) of an individual to be taken as a beneficial deduction on their own Form 1040. Expenses such as professional fees, management fees and losses on certain notional principal contracts that are classified this way are further limited when the partners have income in excess of certain limits ($311,300 for married filing joint taxpayers in 2016) or are subject to the alternative minimum tax (where they are fully disallowed). New York-based taxpayers also are limited on their state income taxes and those with AGI of more than $1 million would receive no benefit from these expenses being flowed to them. For the hedge fund or private equity managers themselves who receive a percentage of the profits (the carry/incentive reallocation), the share of these lost expenses could be significant.
If the offshore investor entity is instead classified as a PFIC and makes a QEF election, the shareholder would get an ordinary deduction for these expenses without limitation. Current taxable losses would not be allowed, but this is certainly an option that should be reviewed.
Election to include income only when distributed for purposes of an individual’s Net Investment Income Tax
If a hedge fund or private equity vehicle is structured so that it is a CFC or a PFIC electing to be a QEF and its trading strategy is classified as investing (and not trading), the U.S. shareholder has an option under Treasury Regulation § 1.1411-10(g) to include income for purposes of the Net Investment Income Tax imposed on individuals by IRC § 1411 only when a distribution is received and not when it is picked up for regular tax purposes. Generally, the bookkeeping might be too onerous to take advantage of this election, but if the potential deferred tax is significant, this option is worth consideration. However, with the new Trump administration’s intent to repeal the Affordable Care Act which would also then repeal the Net Investment Income Tax as it currently stands, this option will probably become obsolete.
Conclusion
The tax rules surrounding PFICs are extremely complicated and contain many options, contact your tax advisor if you would like to further discuss this option.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
