International Tax Corner: Edition 10

Introduction, and perhaps a grammar lesson

My mom taught me not to use four-letter words. Unfortunately, as an International Tax Nerd that’s not always possible. PFIC. PFIC. PFIC. OK, true, that’s not really a four-letter word. For you English grammar folks, it’s an acronym. But it allows us to express a similar level of frustration.

PFICs – Get out your caffeinated beverage of choice

Passive Foreign Investment Company (PFIC) are four words that, luckily, only a small percentage of the population ever hears. Hopefully, they hear about it before there’s an issue. In any case, given that many of our clients are CPA firms that don’t have international tax specialists, we’re understandably often the ones bringing this to their, and their clients’, attention.

In the alphabet soup of US international tax, our conversations with clients on PFIC goes a lot like discussions on other international tax issues – Ms. Jones, I realize you’re a smart, logical and rational thinker/entrepreneur/investor/athlete/salesperson/astronaut/superhero/name it. . .. we’re dealing with the US international tax rules. So, I need you to remove the “I’m a rational and logical person” hat and put on this one. Yes, it’s the one that says “We’re entering the world of international tax. Logic beware. Complexities and traps abound.”

To be clear, it’s not that there’s no logic to the PFIC rules. It’s just that it reminds us that the US international tax rules are unnecessarily complex and convoluted.

In any case, we’ve already discussed the anti-deferral rules as they relate to Controlled Foreign Corporations (CFCs). Those are companies where US Shareholders own more than 50% of the vote or value of a foreign corporation. So that’s not what we’re talking about because Internal Revenue Code Section 1291(d) treats a company that is both a PFIC and a CFC as a CFC to a US Shareholder.

PFIC Importance

So, what’s a PFIC and why do we care? Let’s start with the latter. We don’t really care and wouldn’t spend any time on this except it’s the law. Internal Revenue Code Section 1297 defines PFIC.

(a) In general, For purposes of this part, except as otherwise provided in this subpart, the term “passive foreign investment company” means any foreign corporation if—

(1) 75 percent or more of the gross income of such corporation for the taxable year is passive income, [Income Test] or

(2) the average percentage of assets (as determined in accordance with subsection (e)) held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent. [Asset Test]

The Income Test

The Income Test ensures US persons can’t set up an offshore piggybank and defer US income. Remember US Shareholders in the aggregate own more than 50% of the vote or value of a foreign corporation for it to be a CFC. Anti-deferral rules like Subpart F treat passive income of a CFC as taxable to the US Shareholders in the year earned. But what if a US resident, A, wants to get cute and has a buddy, Z, who’s not a US person? Instead of focusing on her conference call at work, A hops on Google and learns the CFC rules. She and Z create a non-US company with A owning 45% and Z owning 55% (and assume vote and value follow % ownership). It’s not a CFC because US Shareholders in the aggregate own less than 50%. While A’s a US Shareholder because she owns 10% or more (See IRC Section 951(b)), she does not own more than 50%. So, the CFC anti-deferral rules don’t apply to her. All good, right? No. Of course not. Otherwise, you wouldn’t be reading this article, and we might have more fun and productive topics to write about.

For the Income Test, look at the income statement and see what’s happening. Generally, a company that is manufacturing or providing services is not a PFIC under this test as there is active income. This test catches a company where 75% or more of the gross income of such corporation for the taxable year is passive income. So, some passive income is permitted. Remember the company can have a loss and still be a PFIC as it’s a gross income test.

We see only a few clients that are PFICs from this test. Every once in a while, we’ll see a foreign company which is simply a passive investor, and its only income consists of dividends, interest, and gains.

Internal Revenue Code Section 1297(b) defines passive income. It starts with a general rule referring us to Section 954(c), which is the rule for foreign personal holding company income under Subpart F. This is generally dividends, interest, rents, and royalties. There are of course exceptions, right? Because otherwise, we wouldn’t be dealing with US tax law. So, there are times when the term “passive income” does not include any income.

derived in the active conduct of a banking business by an institution licensed to do business as a bank in the United States (or, to the extent provided in regulations, by any other corporation), Section 1297(b)(2)(A
derived in the active conduct of an insurance business by a qualifying insurance corporation(as defined in subsection (f)), Section 1297(b)(2)(B)
which is interest, a dividend, or a rent or royalty, which is received or accrued from a related person(within the meaning of section 954(d)(3)) to the extent such amount is properly allocable (under regulations prescribed by the Secretary) to income of such related person which is not passive income, Section 1297(b)(2)(C) or
which is export trade income of an export trade corporation (as defined in section 971) Section 1297(b)(2)(D).

The Asset Test

It’s the Asset Test we most commonly see those results in PFIC status. Manufacturers are typically not PFICs under the Income Test as there’s active income. For the Asset Test, they likely have a facility or plant, machinery and equipment, and other assets so the quarterly average percentage of assets that produce passive income or that are held to produce passive income (namely cash or investments) is less than 50%. Where we see clients getting surprised by PFIC status is with foreign service companies (e.g., engineering; architects; business consulting; etc.). Their primary asset is likely cash which, although needed for working capital, is passive for PFIC purposes. Note that accounts receivable generated from active operations are not passive. As the aforementioned shows, there is no logical rationale for such firms to be caught in this quagmire. The more logical approach should be an “and” test rather than an “either/or” one.

Also note that 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 foreign corporation shall be treated as if it— (1) held its proportionate share of the assets of such other corporation, and (2) received directly its proportionate share of the income of such other corporation.

The company thus looks through to the assets and income of a 25% owned subsidiary. This rule can operate so a holding company owning operating companies might not be a PFIC.

If there’s a PFIC, US persons likely have reporting obligations and separate income reporting issues. More on those next time.

About Schwartz International

The International Tax Nerds at Schwartz International team with individuals, companies of all sizes, and other accounting and law firms to provide practical international tax planning, structuring, implementation, and compliance advice.

We live and breathe international tax daily, and since we’ve lived in various countries, we understand the diverse cultural challenges you face. We work in four key areas: International Tax Advisory; International Tax Compliance; Cryptocurrency; and Law via our sister company, The Schwartz Law Firm.

Visit our website to learn more International Tax Nerds or contact us at info@internationaltaxnerds.com.