‘PFIC’ means potential taxes on foreign investments
Saturday, June 30th, 2007‘PFIC’ means potential taxes on foreign investments
18/06/2002. Source: Testa, Hurwitz & Thibeault. William J Corcoran, Michael J Sutton
US private equity funds and foreign private equity funds with US investors frequently invest in portfolio companies organised outside the United States. Among the many challenges faced by funds investing in foreign corporations, the US passive foreign investment company (PFIC) tax rules can have a significant impact on investment returns. William J Corcoran, Michael J Sutton of Testa, Hurwitz & Thibeault offer some guidance.
Overview of the PFIC rules
The PFIC rules are designed to discourage US investors from deferring tax on investment income by holding passive investments through non-US companies that do not distribute their earnings currently. In order to accomplish this objective, the rules impose a significant additional tax burden on gains and certain dividends derived from investments in a PFIC. The PFIC rules were drafted very broadly; as interpreted by the Internal Revenue Service, they can apply not only to passive investment entities but also to substantial operating companies and high growth technology companies.
A foreign corporation will be classified as a PFIC if, during any taxable year, 75 per cent or more of its gross income is passive income, or 50 per cent or more of its assets are held for the production of passive income. Passive income generally includes interest, dividends, certain rents and royalties, and gains from the sale of investment property. For purposes of this test, a corporation must include its share of the income and assets of any corporate subsidiary of which it owns at least 25 per cent (by value) of the outstanding stock.
Warning signs of PFIC Status
Companies with the characteristics described below raise special issues under the PFIC rules. Sometimes these companies will not be PFICs, but the characteristics are signposts of the need for special attention to PFIC risks.
Start-up companies: A company without significant operating income may be a PFIC (even though it was organized to conduct a substantial business) because its only gross income during the start-up phase is interest from the temporary investment of surplus cash. Although the Internal Revenue Code provides a limited exception from PFIC treatment for start-up companies, this exception generally is only available if a company is a PFIC in a single year and other conditions are satisfied.
Companies with a substantial temporary increase in liquidity: A temporary change in a company’s mix of assets can cause it to become a PFIC even though it is predominantly an operating company. For example, a company may become a PFIC if a securities offering generates substantial proceeds (in proportion to the company’s existing assets) that are not applied immediately to acquire operating assets.
Holding companies with substantial minority investments: In general, if a corporation owns shares representing less than 25 per cent of the value of another corporation, the first corporation will not be entitled to look through to the assets and income of the other corporation for purposes of applying the PFIC tests. Instead, dividends received from the less than 25 per cent-owned corporation generally will constitute passive income, and its shares will represent passive assets.
Consequences of PFIC Status
Tax and interest charge: A US investor in a PFIC (including a US partner in a partnership that owns shares in a PFIC) is required to pay a special additional tax on gains realised from the sale of shares of the PFIC and on dividends from the PFIC that constitute ‘excess distributions.’ An excess distribution includes a distribution received in any year that exceeds 125 per cent of the average distributions for the three preceding years (or, if shorter, the US investor’s holding period). Unless certain exceptions apply, a US investor in a PFIC also may be subject to tax on an otherwise tax-free transfer of the PFIC’s stock.
The special additional tax on the PFIC is computed as follows: The gain from the sale of the PFIC shares (or other excess distributions from the PFIC) must be allocated over a US investor’s holding period as if the US investor had actually received the gain or distribution ratably over that time. The US investor then is required to compute its tax liability (using the maximum ordinary income tax rates) as if it had underpaid its taxes in the relevant years, and is required to pay interest on the deemed underpayment at the rate applicable to such underpayments. In addition, if a foreign corporation satisfies a PFIC test in one year of a US investor’s holding period, the US investor will be subject to the special PFIC tax for each subsequent year regardless of whether the foreign corporation is still a PFIC.
Measures to avoid tax and interest charge
Qualified electing fund: A US investor will not be subject to the tax and interest charge rules described above if it makes a timely election to treat the PFIC as a qualified electing fund (QEF). If this election is made, the US investor must report, and pay tax on, its pro rata share of the PFIC’s ordinary earnings and net capital gains annually, without regard to whether those earnings have been distributed as dividends. The QEF rules require that the US investor therefore must be able to calculate, in accordance with US tax principles, its share of the ordinary earnings and net capital gain of the PFIC. Such principles differ in certain respects from US generally accepted accounting principles, and in the case of a substantial operating company it may be impractical to prepare the required computations, or it may be possible only at a significant accounting cost.
A QEF election, when available, will be most effective if it is made by a US investor for the first taxable year in which it held shares in the PFIC. Otherwise, the PFIC will be treated as an ‘unpedigreed’ QEF, and the tax and interest charge rules described above will continue to apply to a portion of the gain from the sale of shares (or other excess distribution) of the PFIC. Moreover, because a QEF election cannot be made with respect to options, warrants or other rights to purchase shares in a PFIC, shares acquired pursuant to the exercise of such rights may also be treated as ‘unpedigreed’ shares in a QEF. Where the shares in the PFIC are owned by a US private equity fund or other US partnership, the QEF election is made by the partnership, and not by its partners (who would be subject to the PFIC taxes).
Mark-to-market election: A US investor may also avoid the PFIC tax and interest charge by making a mark-to-market election with respect to its PFIC shares. If this election is made, the investor is taxed annually on the increase in value of the PFIC shares. This election generally is available only to US investors in foreign companies that are regularly traded on a US stock exchange (or on certain approved non-US stock exchanges), and thus is of limited use to private equity funds that principally hold shares in privately-held companies.
Conclusion
As the above discussion indicates, a fund manager’s discovery after the fact that a portfolio company is a PFIC can be an unpleasant and costly surprise. If a company’s PFIC status can be identified at the outset, however, a fund manager can usually take steps (such as a QEF election) to manage the resulting tax liability.
