Despite their enormous importance to tax compliance, there is a shocking level of ignorance of the US international tax anti-deferral regimes that is being displayed by US taxpayers, foreign bankers, foreign accountants, foreign attorneys, US accountants and even many US tax attorneys. In this article, for educational purposes only, I would like to provide a brief overview of the history and features of the main US international tax anti-deferral regimes.
What is a US International Tax Anti-Deferral Regime?
A US international tax anti-deferral regime is a set of US tax laws designed to prevent US taxpayers from utilizing various offshore strategies to defer US taxation of their income for a period of time or indefinitely.
Three Main US International Tax Anti-Deferral Regimes
Since 1937, there have been three main US international tax anti-deferral regimes: Foreign Personal Holding Company (“FPHC”) rules, subpart F rules, and PFIC rules. Let’s review the brief history and main features of each of these US international tax anti-deferral regimes.
First US International Tax Anti-Deferral Regime: FPHC
In 1937, the Congress for the first time addressed the offshore investment strategy problems by enacting the FPHC regime, which were designed to contemporaneously (i.e. in the year the income was earned) tax certain types of foreign corporations. In particular, FPHC rules targeted foreign corporations that had substantial investment income (i.e. passive income) compared to active business income – i.e. the FPHC rules effectively treat certain corporations as pass-through companies for the purposes of certain categories of passive income..
The FPHC rules were triggered only if both conditions of the then-Code §552(a) were satisfied. First, at least 60% of a foreign corporation’s gross income from the taxable year had to consist of “foreign personal holding company income”. The FPHC income included interest income, dividends, royalties, gains from the sale of securities or commodities, certain rents and certain income from personal services provided by shareholders of the FPHC. This was called the “income test”.
The second condition of the §552(a) was known as the “ownership test”. The ownership test was satisfied if at least 50% of either the total voting power or total value of the stock of the foreign corporation was owned by 5 or fewer individuals who were citizens or residents of the United States.
Despite the appearances, the FPHC regime was not very effective. It was actually not very hard to work around the FPHC rules with careful and creative tax planning. This is why, after the enactment of the Subpart F rules and the PFIC rules (which addressed some of the main inefficacies of the FPCH rules and made them redundant as a US international tax anti-deferral regime), the FPHC regime was finally repealed in the year 2004.
Second US International Tax Anti-Deferral Regime: Subpart F Rules
The second US international tax anti-deferral regime, the Subpart F rules, was enacted in 1962 and, despite numerous amendments, forms the core of the anti-deferral rules with respect to Controlled Foreign Corporations (“CFCs”). It is definitely one of the most important and complex pieces of US tax legislation.
The most important feature of the Subpart F regime is that it greatly expands the scope of the former FPHC regime by expanding the contemporaneous (i.e. pass-through) taxation to a much broader range of income and activities, including many kinds of active business activities as well as passive investment activities of a foreign corporation. Obviously, the focus of this US international tax anti-deferral regime is still on passive income or attempts to disguise passive income as active income.
Third US International Tax Anti-Deferral Regime: PFIC Rules
The third US international tax anti-deferral regime consists of the passive foreign investment company (“PFIC”) rules that were adopted by US Congress in 1986. Perhaps because it is the youngest of all US international tax anti-deferral regimes, the PFIC regime is more aggressive and less forgiving than Subpart F rules or FPHC regime. A lot of innocent taxpayers have fallen victims to this severe law.
The PFIC rules impose a unique additional US income tax in two circumstances: where (1) there is a gain on the disposition of the PFIC stock by the US person; or (2) there are PFIC distributions that are considered “excess distributions”. The PFIC rules also impose an additional PFIC interest (calculated similarly to underpayment interest) on the PFIC tax.
The definition of a PFIC is in some ways reminiscent of FPHC rules, but the PFIC regime is a lot more aggressive. Generally, a PFIC is any foreign corporation if it meets either the income tax or the assets test. The income tax is met if 75% of a foreign corporation’s gross income is passive; the assets test is satisfied if at least an average of 50% of a foreign corporation’s assets produce passive income.
Notice that the PFIC rules apply irrespective of the US ownership percentage of the company. This elimination of the FPHC and Subpart F ownership rules makes PFIC rules a much more comprehensive US international anti-deferral tax regime, because it is very easy to trigger PFIC rules – a lot of US naturalized citizens and permanent residents fall into the PFIC trap by simply owning foreign mutual funds as part of their former home countries’ investment portfolio.
Contact Sherayzen Law Office for Professional Help With Dealing with US International Tax Anti-Deferral Regimes
If you have an ownership interest in a foreign business or have foreign investments, you may be facing the extremely complex rules of US international tax anti-deferral regimes.
Please contact Mr. Eugene Sherayzen, an experienced international tax attorney at Sherayzen Law Office. Our international tax firm has helped hundreds of clients around the globe and we can help you!