- The recent drop in stock prices resulting from the coronavirus (COVID-19) pandemic has put certain foreign corporations at greater risk of being classified as "passive foreign investment companies" (PFICs).
- Under the PFIC regime, a direct or indirect U.S. shareholder who recognizes income from the disposition of PFIC stock, as well as from certain distributions made by a PFIC with respect to its stock, is taxed at full ordinary income rates, rather than favorable long-term capital gain rates or "qualified dividend" rates.
- Furthermore, such income may also be subject to a penalty "interest charge." This ordinary income treatment combined with a compounded interest charge can result in punitive tax consequences to a U.S. shareholder.
- This Holland & Knight alert provides a look at steps that can be taken to deal with the PFIC challenge.
A U.S. investor in a foreign corporation may suffer significant adverse U.S. tax consequences if the foreign corporation is classified as a "passive foreign investment company" (PFIC).
The recent drop in stock prices resulting from the coronavirus (COVID-19) pandemic has put certain foreign corporations at greater risk of being classified as PFICs. Fortunately, however, there are steps that can be taken to deal with this challenge.
The PFIC regime was enacted in 1986 in order to limit the ability of U.S. persons to avoid current U.S. federal income tax on earnings accumulated in foreign corporations and to convert ordinary income to favorably taxed capital gains income by disposing of the shares in these foreign corporations.
Definition of PFIC
A foreign corporation is classified as a PFIC during a given year if:
- 75 percent or more of its gross income consists of "passive income" (referred to as the "income test"), or
- 50 percent or more of the average percentage of its assets (determined on the basis of a quarterly average) produce (or are held for the production of) passive income (referred to as the "asset test"). The asset test is applied on a gross basis; no liabilities are taken into account, even if secured by assets or otherwise directly traceable to particular assets. The asset test is applied with reference to the fair market values of the corporation's assets if the corporation is publicly traded. In certain specific other cases, adjusted tax basis is used.
For purposes of these rules, passive income includes, among other things, dividends, interest, rents, and royalties not derived in the active conduct of a trade or business, as well as net gains on sales of property producing passive income (although some exceptions apply, such as for rental income that meets certain tests for being deemed "active").
According to the IRS, an asset is a passive asset if it has generated passive income or is reasonably expected to generate passive income in the reasonably foreseeable future. Moreover, according to the IRS, cash and "other assets readily convertible into cash" are passive assets even if they are held as working capital in an active business.
It is important to note that the PFIC regime contains what many consider to be a harsh rule referred to as the "once a PFIC, always a PFIC" rule. Under this rule, if a foreign corporation meets the tests for being a PFIC at any time during the period in which a U.S. shareholder holds stock in the foreign corporation, the PFIC taint will continue for the U.S. shareholder even if the corporation does not meet any of the PFIC tests in subsequent years. Therefore, any subsequent distribution by the PFIC to, or disposition of the PFIC stock by, that U.S. shareholder may be taxed under the PFIC regime, regardless of whether the foreign corporation meets any of the PFIC tests in the year of the distribution or disposition.
Consequences of PFIC Status
Under the PFIC regime, a direct or indirect U.S. shareholder who recognizes income from the disposition of PFIC stock, as well as from certain distributions made by a PFIC with respect to its stock, is taxed at full ordinary income rates (currently, up to 37 percent, plus the 3.8 percent Medicare surtax), rather than favorable long-term capital gain rates or "qualified dividend" rates (currently, up to 20 percent, plus the 3.8 percent Medicare surtax). Furthermore, such income may also be subject to a penalty "interest charge." This ordinary income treatment combined with a compounded interest charge can result in punitive tax consequences to a U.S. shareholder.
There are a number of other adverse consequences and IRS reporting requirements that may apply under the PFIC regime. For example, if a U.S. shareholder owns the stock of a foreign corporation that was a PFIC at any time while that U.S. shareholder owned the stock, the U.S. shareholder's heirs will not receive a "basis step-up" in the stock on the death of the U.S. shareholder.
Concerns Relating to Stock Market Crash
While not necessarily readily apparent, the current stock market conditions can create challenges with respect to the PFIC status of publicly traded foreign corporations. This is explained below.
In the case of a publicly traded company, it is fairly typical to use the foreign corporation's "market capitalization" (i.e., the foreign corporation's stock price multiplied by shares outstanding) plus the sum of its liabilities as a means of determining the gross fair market value of the foreign corporation's assets. This approach is supported by the legislative history to the PFIC rules, which states:
"In applying the PFIC asset test, the Congress intended that the total value of a publicly-traded foreign corporation's assets generally will be treated as equal to the sum of the aggregate value of its outstanding stock plus its liabilities."
In many cases, this approach can be beneficial in avoiding PFIC status. For example, in certain cases, one would take the market capitalization of the foreign corporation plus its liabilities, subtract out the fair market value of its passive assets, and the remainder would be goodwill and going concern value that may be treated as active assets because they are connected to the foreign corporation's active business.
However, in the current financial crisis, the use of the market capitalization method may cause many foreign corporations to be classified as PFICs because, as the market capitalization of the foreign corporations drop, the higher the ratio of their passive assets to their total assets becomes.
Take, for example, a foreign corporation that earns income that is active, rather than passive income. A high percentage of this foreign corporation's assets consists of goodwill and going concern value, while only a small portion of its assets consists of fixed assets used in the business. This goodwill and going concern value is treated as an active asset because it is associated with the foreign corporation's generation of active income.
Assume further that this foreign corporation recently raised funds in the capital markets through a debt or equity issuance, or borrowed substantial funds under its lines of credit, and hence has a significant amount of cash on its balance sheet. If the foreign corporation's stock price plummets, under the market capitalization approach this will reduce the value of its goodwill and hence may cause the company to become a PFIC. Moreover, even if the foreign corporation's stock price subsequently rebounds, if it is a PFIC for a particular taxable year its U.S. shareholders may be treated as holding PFIC stock for all future years under the "once a PFIC, always a PFIC" rule.
In a situation like the one described above, it may be possible to reasonably argue that the use of the market capitalization approach in a time of stock market volatility is not an appropriate measure of the fair market value of the foreign corporation's assets, and that different valuation methodologies may be used. A full discussion of the authorities in this area is beyond the scope of this alert.
Fortunately, however, even if the foreign corporation is in fact a PFIC, the tax law provides for two specific ways of avoiding the most adverse PFIC consequences: 1) the "qualified electing fund" (QEF) election, and 2) the mark-to-market election. Furthermore, even if a U.S. shareholder does not make one of these elections on a timely basis and therefore is caught by the "once a PFIC, always a PFIC" rule, there are certain "purging" elections that can be made to block PFIC status for future years (although, depending on the facts, there may be a tax cost to these elections).
A U.S. shareholder can avoid the PFIC interest charge and the conversion of capital gains into ordinary income by timely filing a QEF election.
A U.S. shareholder that makes a QEF election must include in income each year the sum of 1) the U.S. shareholder's pro rata share of the ordinary earnings of the PFIC for the year, plus 2) the U.S. person's pro rata share of the net capital gain of the PFIC for the year. Ordinary earnings are taxed as ordinary income to the U.S. person making the QEF election (currently, at rates of up to 37 percent, plus the 3.8 percent Medicare surtax). Net capital gain is the excess of net long-term capital gains over net short-term capital losses of the PFIC for the year, and is taxed as long-term capital gains in the hands of the U.S. person making the QEF election (currently, at rates of up to 20 percent, plus the 3.8 percent Medicare surtax).
The QEF election may only be made by a shareholder if the foreign corporation provides an annual statement containing certain information set forth in the regulations.
Importantly, in order to issue the statement, the foreign corporation must compute its ordinary earnings and net capital gain using U.S. federal income tax accounting principles. This may require the foreign corporation to incur significant tax accounting costs.
Another way for a U.S. shareholder of a publicly traded foreign corporation to reduce adverse PFIC tax consequences is to make what is known as the "mark-to-market" election. An owner of "marketable" PFIC stock (the tax law provides specific tests for determining whether stock is marketable) can elect "mark-to-market" treatment, under which the shareholder annually recognizes income or loss equal to the difference between the stock's fair market value at year-end and the taxpayer's adjusted basis in the stock.
An electing shareholder must annually report as ordinary income any amount by which the fair market value of the stock at year-end exceeds the taxpayer's basis for the stock. Any amount by which the stock's basis exceeds fair market value at year-end is an ordinary loss deduction to the extent of the "unreversed inclusions with respect to such stock," which equal the sum of the gross income inclusions for all prior years, less any deductions allowed under this rule for prior years.
Gain on a sale or other disposition of the stock is ordinary income, and loss on a disposition is deductible as an ordinary loss to the extent that it does not exceed the unreversed inclusions attributable to the stock. The stock's adjusted basis is increased by amounts included in gross income and decreased by amounts allowed as deductions.
If the foreign corporation does not meet any of the PFIC tests in a subsequent year, the mark-to-market election will not be operative, and therefore the U.S. shareholder will not be required to recognize income on a mark-to-market basis.
Finally, what happens if a U.S. shareholder fails to make a timely QEF election or mark-to-market election? Is the U.S. shareholder's stock in the foreign corporation perpetually tainted with PFIC status under the "once a PFIC, always a PFIC" rule?
Fortunately, the U.S. federal income tax law provides for certain "purging" elections that allow the U.S. shareholder to pay PFIC tax on the built-in gain in his or her shares of the foreign corporation and prevent the "once a PFIC, always a PFIC" taint from continuing. Although a full discussion of "purging" elections is beyond the scope of this article, it is something that should be seriously considered by a U.S. shareholder who is faced with the "once a PFIC, always a PFIC" taint.
The PFIC rules are highly technical and can result in harsh consequences to U.S. shareholders. The current stock market environment can increase the risk of certain publicly traded foreign corporations being classified as PFICs. Fortunately, if this challenge is addressed on a timely basis, there are ways of minimizing or preventing the damage that can be incurred under the PFIC regime.
For questions or more information regarding your specific situation, contact the author.
H.R. Conf. Rep. No. 220, 105th Cong., 1st Sess. 627–628 (1997).
Originally published as a Holland & Knight Alert on April 2, 2020.