U.S. taxpayers face punitive and complex tax regimes for investing in foreign corporations that require careful planning: the controlled foreign corporation (CFC) and passive foreign investment company (PFIC) rules. Designed to prevent U.S. taxpayers from avoiding or deferring taxation of their overseas passive income, these regimes are highly complex.
Both regimes separate passive “bad” income and assets from active “good” income and assets. Gain from stock and securities, as well as interest income and dividends, belong to the “bad” category, while majority ownership of an operating subsidiary, income from the sale of goods and services, and assets used in an active trade or business count as “good.” The PFIC rules are more punitive than the CFC regime.
CFCs are foreign corporations that are controlled by one or more U.S. shareholders. PFICs are foreign corporations that have predominantly passive income or passive assets, such as many foreign mutual funds. Some stock in a foreign corporation is not subject to either set of rules (including many publicly-traded foreign corporations).
A CFC is a foreign corporation that is more than 50% owned by “U.S. shareholders.” A U.S. shareholder is a U.S. person who owns 10% or more of the CFC’s voting stock. The CFC rules take priority over the PFIC rules.
Under the CFC rules, a “U.S. shareholder” must include in income its share of the CFC’s “subpart F” income, whether or not this income is distributed. Subpart F income is, in general, passive-type income.
Subpart F income is taxable to a U.S. shareholder, whether or not it is distributed by the CFC as a dividend.
The good news is that the tax on a CFC’s active operating income can be deferred until distributed as a dividend. The bad news is that, even it is not distributed, this active income is taxable to a U.S. shareholder if it is repatriated and invested in the United States.
U.S. shareholders of a CFC may be subject to tax on two different types of phantom income: subpart F passive-type income and active earnings that are repatriated to the United States.
The future of the CFC rules is uncertain. Congress last passed a holiday for the repatriation of CFC earnings in 2004. This is an area to watch closely for fundamental tax reform or a more limited repatriation holiday (as in 2004).
U.S. shareholders of a CFC are subject to complex compliance rules. They must keep track of their tax basis in CFC stock, the amount of annual subpart F income, the amount of annual active earnings, the repatriation of active earnings, and the amount of foreign taxes paid by the CFC.
In general, a foreign corporation is a passive foreign investment corporation (PFIC) in a given year if either: (i) 50% or more of its assets consists of passive-type assets or (ii) 75% or more of its gross income consists of passive income. Any gain on the sale of PFIC stock is ordinary income and does not qualify for the special long-term capital gain rate. Dividend income does not qualify for the preferential tax rate for qualified dividend income.
In addition, a U.S. person is subject to a punitive tax on any sale of PFIC stock or on any “excess distribution” by the PFIC. (An excess distribution is a distribution that is significantly larger than the PFIC’s average distribution over the past three years.) The PFIC rules apply an interest charge on the amount of “deferred” tax.
The calculation of the amount of this interest charge is complex. Indeed, the PFIC rules are so complex, the IRS had to create a simplified set of rules to train their own staff in the offshore voluntary disclosure program (OVDP)!
Foreign mutual funds are commonly classified as PFICs. Therefore, many non-U.S. persons who enter the United States hold investments in PFICs. Because the PFIC rules are so harsh, U.S. investors should seek alternatives before making or continuing an investment in a PFIC.
One possibility is to make a “qualifying electing fund” (QEF) election for a PFIC. Under the QEF rules, a shareholder in a PFIC is treated like a partner in a partnership and is taxed on certain items of the PFIC’s income whether or not they are distributed. But to qualify as a QEF, the PFIC must agree to provide a U.S. shareholder with extensive information.
Jon can help you navigate through the CFC and PFIC rules to minimize your tax liability and simplify your tax compliance, including:
- Assisting accountants and individuals with PFIC calculations, including the QEF rules.
- Comparing the PFIC, CFC and foreign partnership rules to determine the optimal tax result for various taxpayers.
- Comparing the after-tax income for the U.S. owner of a UK company if the company is treated as a CFC versus a foreign partnership.
- Comparing the U.S. taxation of investing in a foreign partnership versus the “qualified electing fund” (QEF) rules for PFICs.
- Advised institutional investor making minority investment in a private multinational South American utility company on structuring the investment so that the target company would avoid “passive foreign investment company” (PFIC) status.
- Advised U.S. owner of Swiss pharmaceutical company on tax aspects of part sale and part tax-free merger of his company with a larger UK-based pharmaceutical company.
- Advised U.S. taxpayers on Gain Recognition Agreement (GRA) compliance to obtain tax-free treatment for various transactions involving CFCs.