Passive foreign investment companies - or PFICS as they are most commonly known - can have many serious tax ramifications to a U.S. shareholder. Nevertheless, the start-up companies are encountering this concept more and more even though they are not connected to the United States. Why is this happening and what should you be doing about it?
"Is your company a PFIC?" Some may hear this question earlier in the company's development while others may only hear about it as they are in their final push before that big exit. No matter when you encounter it, you should always take the question seriously and give it the appropriate time and thought before answering that dreaded question - Are you a PFIC? The article below discusses the basics of PFICs while touching on some of the more complicated matters so you can understand what you are being asked to represent and where some of the pitfalls may be hiding.
What Is a PFIC?
A passive foreign investment company or a PFIC is exactly what is sounds like -
Passive - The company needs to be deemed passive. In general this is classified as having more than 50% of the company's assets classified as passive assets or more than 75% of the company's income deemed passive income.
Foreign - This tax regime only applies to U.S. people investing in foreign entities. An investment in a U.S. entity will not be subject to the PFIC tax regime.
Company - An entity not classified as a company for U.S. tax purposes will not be subject to this regime. There may be other ramifications for investments in non-corporate entities, but that is not the subject of this article.
Unfortunately, if we look at a classic non-U.S. start-up company - where the largest asset is the cash it successfully fundraised, and the only source of income is the interest accruing on the deposits it holds - we appear to check all the boxes. To add insult to injury, the PFIC regime has a famous slogan - "once a PFIC always a PFIC", which means that even if the start-up company begins earning revenue and turns into a proper operating company, the shareholder who held the company when it was a PFIC will continue to treat it as one unless they take specific actions to "purge" it of its PFIC taint.
(There is a start-up exemption, but the conditions are difficult to meet - not recommended)
Now before you get all up-in-arms about this, it is important to understand the history. The PFIC tax regime was not intended to target these types of companies. Congress enacted these provisions back in 1986 to ensure that U.S. investors' income will be subject to tax on an ongoing basis, even if held in a tax haven offshore. Mutual funds in the United States are generally formed as entities that are required to distribute their earnings on an annual basis. That said, the U.S. investor could invest in a similar mutual fund formed outside of the United States which is not required to distribute on an annual basis, achieve similar returns, and defer paying taxes annually. This would give the offshore funds a huge advantage. The PFIC regime targets these types of investments and subjects them (in one of three ways, as explained below) to ongoing taxation. Nevertheless, as seen with the start-ups, this regime can sometimes "catch" other entities in its net as well.
Asset and Income Testing
The PFIC classification is an annual analysis which performs the following two tests:
Asset Test - More than 50% of the company's assets are classified as passive assets. A passive asset is generally defined as one that is expected to generate passive income such as cash and cash equivalents, stock, certain licenses, etc. The testing is performed annually but is done relying on a quarterly average calculation (the average of the balances at the end of each quarterly).
Income Test - More than 75% of the company's income is classified as passive income. The definition of passive income is taken from the CFC definitions which generally includes dividends, interest, royalties, capital gains, foreign exchange differentials, etc.
This is an either-or test. A company that fails one of the tests will be classified as a PFIC. Deciphering whether an asset or an item of income is passive or non-passive can be tricky. Here are a few examples:
Cash - Until recently, cash was always defined as a passive asset. In 2020, final regulations were issued that allowed for some cash used as working capital to be defined as a non-passive asset. Specifically, cash denominated in functional currency, held in a non-interest bearing account, and necessary for the 90-day current expenses may be classified as non-passive.
Stock - The PFIC regime requires a look-through methodology when the shareholder holds more than 25% of the company's stock. Below that, the holdings will be viewed as passive as they will generate future dividends or capital gains.
Grants - Local GAAP may require the presentation of grants in different manners. In certain cases, the grants will be capitalized or offset current expenses as opposed to being listed as income. U.S. tax treatment is necessary to determine the classification which may be easily missed if the income is not listed on the books.
Foreign exchange differentials - Aside from certain hedging options, this item is largely out of the company's control and may come as a surprise when performing the annual tests.
Rental income - The regulations provide specific details for when a company can be deemed an operating real estate business which would then treat the income as non-passive. In general, this includes assessing the specific activity performed by the company and where the employees (if any) are located.
Intangible Property
Let's talk about the elephant in the room. As noted above, a start-up's largest asset is generally its cash, but that is only what appears on its financial statements. In actuality, the company's largest asset is generally its IP which it is developing. That is the basis of its valuation and that is where all the money is going. This is addressed in one of two ways, depending on how the asset test is being performed:
Fair market value testing - When testing based on the fair market value of the assets, one may derive the company's IP by comparing its total value to its identifiable assets. The difference between the two can generally be assumed to be the unidentifiable IP. If the company has a breakdown of its IP, it may allocate this amongst the different assets to determine how much of the IP will be passive and how much will be non-passive.
Adjusted basis testing - When testing based on the adjusted tax basis of the assets, one may include as a non-passive asset, the research and experimental expenses paid or accrued in the current year and the prior two taxable years. Additionally, one may increase their non-passive assets by three times the licensing fees paid in a taxable year.
In general, an entity should rely on the fair market value testing. That said, a private company may elect to utilize the adjusted basis testing, while a private controlled foreign corporation (CFC) must utilize this adjusted basis method.
The different tests may provide for very different results, and therefore in most scenarios, a company should perform a CFC analysis together with the PFIC analysis to determine the proper methodology for the PFIC testing. In most cases, the investors requesting the PFIC representation will ask for a CFC representation as well so the testing will already need to be performed.
So What If We Are a PFIC?
The foreign corporation is not directly impacted by the PFIC classification. The corporation will not need to file a tax return in the United States nor will they owe any tax there. The concern is for the U.S. shareholder. A U.S. shareholder which owns any interest in a PFIC needs to report the PFIC on their own tax return in one of three ways. There is no threshold for this reporting so even a 0.5% interest would impact the shareholder.
Excess Distributions - The shareholder will be subject to tax upon distribution from the PFIC with a special tax regime for their share of excess distributions, loosely defined as total distributions over 125% of the average amount of distributions received from these shares during the three preceding tax years.
Mark-to-Market Election - The shareholder may make this election and recognize ordinary income or loss based on the stock's annual unrealized appreciation or depreciation. This election is only relevant for marketable stock, generally those which are regularly traded on certain exchanges.
Qualified Electing Fund (QEF) - The shareholder may elect to treat the corporation as a QEF which generally requires the shareholder to report the income as if the corporation was a flow-through entity. That said, a shareholder may not recognize losses that are generated within the corporation. This election requires the cooperation of the foreign corporation as they would need to provide the necessary financial information in order to report it accurately.
A shareholder electing the first two options will recognize all income at ordinary rates, including the gain upon sale, a marginal rate of 37%. Compared to the 20% marginal capital gains rate, this penalty could be quite substantial. Due to this, the QEF alternative is generally preferable. Start-up companies that are classified as PFICs may be required by their investors to provide QEF information so they can apply this alternative.
The Takeaway
The testing for PFIC status may seem straightforward, however when diving into the details, it can become quite difficult, especially if there is a risk the company will also be classified as a controlled foreign corporation. A start-up company in the process of fundraising which is required to provide a rep regarding its PFIC status should give serious consideration prior to approving the rep. Similarly, if an investor requests a renewed analysis on an annual basis, a proper analysis should be performed due to the complexities and how they can impact the testing each year.
The exposure to the shareholders and ultimately to the company upon misrepresentation of the PFIC status can become quite significant as these shareholders should have been reporting their PFIC income on an annual basis. If not addressed properly throughout the life of the start-up, a misrepresentation can hinder or harm the ability for future fundraising. Additionally, this can be expected to be flagged through a due diligence prior to exit which is the last thing any start-up company wants to see when the exit is that close. Giving the appropriate attention to this small one-line rep can help relieve a lot of stress further down the line.
Yehuda Javasky U.S. Tax Consulting has many years of experience preparing CFC and PFIC analyses for funds and start-up companies. We are happy to work together to make sure you have all the documentation you need for your company going forward. Contact us for more details and a free initial consultation.
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