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Start-Up Year PFIC Exception | International Tax Lawyer & Attorney

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Passive Foreign Investment Company (PFIC) classification of a foreign corporation may have highly undesirable consequences for its US shareholders.  In addition to high PFIC tax, these taxpayers face expensive and burdensome tax reporting requirements.  This is why US taxpayers and their tax advisers generally try to avoid PFIC designation.  This article explores a possible way to do so by utilizing the Start-Up Year PFIC Exception.

Start-Up Year PFIC Exception: PFIC Background Information

PFIC law is a powerful anti-deferral tax regime. PFIC rules are meant to discourage US investment in PFIC companies by eliminating real or perceived benefits of such an investment.

Any company that meets either the income test or the asset test set forth in 26 USC §1297(a) would generally be considered a PFIC for US tax purposes.  This means that it would subject to taxation based on: (a) default IRC §1291 Fund regime; (b) Qualified Election fund (QEF) regime; or (c) Mark-to-Market (MTM) regime.  All of these methods are punitive in one form or another.

PFICs are reported on Forms 8621. Reporting under IRC §1291 method may prevent a taxpayer from e-filing his US tax returns.

In some cases, even if a corporation meets a PFIC test, it may still avoid PFIC treatment if it meets one of the exceptions.  Start-UP Year PFIC exception is one of them.

Start-Up Year PFIC Exception: Purpose

The legislative history explains that the purpose behind this exception is to avoid PFIC designation for a business that will engage in active business operations but has mostly passive income in its first year.  Staff of the Jt. Comm. on Taxation, General Explanation of the Tax Reform Act of 1986, at 1026 (JCS-10-87) (May 4, 1987) (1986 Bluebook).

Start-Up Year PFIC Exception: Main Test

26 USC §1298(b)(2) sets forth the Start-Up Year Exception. It states that, if a corporation would otherwise be a PFIC in its start-up year, it would not be treated as a PFIC in that year if it means the following test:

  1. No predecessor corporation was a PFIC;
  2. It is established to the IRS’s satisfaction that the corporation will not be a PFIC in either of the two years following the start-up year; and
  3. The corporation is not, in fact, a PFIC for either succeeding year.

Despite its apparent simplicity, this test contains important complications.

Start-Up Year PFIC Exception: What is “Start-Up Year”

The first complication arises from the definition of “Start-Up Year”. 26 USC §1298(b) defines this term as the first taxable year in which a corporation earns gross income. In other words, “start-up year” may not actually mean the first year of the corporation’s existence, because a corporation may exist without any income.

What if the corporation has gross income but incurs a net loss? In my opinion, this would qualify as a “start-up year”.

What if the corporation has no gross income whatsoever and just incurs a loss? In my opinion, there is sufficient basis for the argument, based on the strict interpretation of statutory language, that this is still not “start-up year”.

Start-Up Year PFIC Exception: Danger of Prior Interaction With the Asset Test

Another related complication is the fact that this PFIC exception would not apply where a foreign corporation would satisfy the PFIC asset test in a prior year.

For example, let’s suppose that, for the first two years of its existence, a foreign corporation earns no income whatsoever. Since no income is earned, the Start-UP Year PFIC exception would not apply here yet.  If, in one of those years, the corporation satisfies the PFIC asset test, then this corporation would become a PFIC.  This means that, even if the Start-Up Year PFIC exception satisfied in year three, it would not be applicable, because the corporation is already a PFIC under the “once a PFIC, always a PFIC” rule. For example, see 2002 WL 1315676.

Start-Up Year PFIC Exception Only Applies For One Year

The other complication concerning this exception is the fact that it is limited to one year only. This could even mean a short year of one day. In other words, a corporation can only use it once to escape PFIC designation.

Start-Up Year PFIC Exception: Parent Holding Company

The interaction of the exception with the subsidiary look-through rule (which I will explore more in a future article) is very interesting. While it appears that the IRS has not issued any direct guidance on this issue, my analysis shows that the Start-Up Year PFIC exception can be extended to the parent holding company of a start-up corporation under the subsidiary look-through rule.

This conclusion, however, depends very much on the actual fact pattern.  For example, if a foreign holding company is established at the same time as the start-up corporation and the holding company only has its subsidiary’s stock as its asset, then it is very likely that the Start-Up Year PFIC exception would be extended to the holding company.

Contact Sherayzen Law Office for Professional Help With US International Tax

Start-Up Year PFIC Exception is one of the innumerable intricacies of the highly complex US international tax law.  This is why you need to contact Sherayzen Law Office for professional help with US international tax compliance.

Sherayzen Law Office is a leader in US international tax compliance and planning, including PFIC compliance.  We have a profound knowledge of and extensive experience with US international tax law.  We can help you!

Contact Us Today to Schedule Your Confidential Consultation!

International Tax Lawyers | Passive Foreign Investment Company

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Congress enacted the Passive Foreign Investment Company provisions (PFIC) as part of the Tax Reform Act of 1986 in order to deter U.S. investors from deferring or avoiding payment of U.S. taxes by investing in offshore entities. The PFIC rules are structured to provide a disincentive for U.S. investors to defer investment income taxes by owning passive investments in foreign companies that do not regularly distribute their earnings. If it is determined that a U.S. investor is a PFIC shareholder, there can be severe tax implications for the taxpayer.

U.S. taxpayers who are shareholders of PFIC are likely to pay a significant additional tax on realized gains from sales of PFIC shares, and on PFIC dividends that meet the definition of “excess distributions” (an “excess distribution” applies to gains or distributions that exceeds 125% of the average distributions for the previous three years, or less if applicable). In both cases, the tax is applied at the taxpayer’s ordinary income tax rate, regardless of whether capital gains rates would typically apply. Further, an interest charge may be imposed, to offset the years of tax deferral in holding the offshore investment. As an additional disincentive, PFIC shares may not receive a stepped-up cost basis at the shareholder’s death.

Definition of a PFIC and Two-Part Test

In general, a foreign corporation that is determined to be neither a “controlled foreign corporation” (CFC) as defined in IRC section 957, nor a “foreign personal holding company” (FPHC) as defined in IRC section 552, will be determined to be a PFIC if it includes at least one U.S. shareholder and meets either one of the two tests found in IRC section 1297. If at least 75% or more of its gross income is passive income (based upon investments as opposed to operating income), or if at least 50% of the average percentage of its assets are investments that produce, or are held for the production of passive income, the foreign corporation will meet the definition of a PFIC. Passive income generally includes interest, dividends, rents, capital gains, and similar items. There is no requirement of ownership of a certain minimum percentage of shares, as there is with CFCs or FPHCs. Thus, if the test is met, PFIC status will apply, even if a shareholder owns a minimal percentage of shares with no ability to influence the business decisions of the company.

The PFIC rules apply to each U.S. person (the precise definition of who constitutes U.S. person is beyond the scope of this article, but it may become an issue in many situations) regarding who a shareholder of a PFIC is. PFIC rules, however, do not apply to foreign shareholders or the foreign corporation itself. PFICs may include different types of entities such as various investment vehicles and foreign-based mutual funds.

Two options are commonly suggested by the U.S. tax lawyers to the shareholders in order to avoid PFIC taxation burden: Qualified Election Fund and Mark-to-Market. Both of these options, however, have their own peculiar characteristics and impose different types of tax obligations on the shareholders.

Qualified Electing Fund

In general, U.S. shareholders who own shares either directly or indirectly in a PFIC may be able to avoid the burdensome standard PFIC taxation provisions by electing to treat the PFIC as a Qualified Electing Fund (QEF) on Form 8621. Shareholders making this annual election are taxed on their pro rata share of the PFIC’s ordinary earnings as ordinary income, and their pro rata share of the net capital gains as long-term capital gain. A shareholder’s basis in the stock of a QEF is increased by the earnings included in gross income and decreased by a distribution from the QEF to the extent of previously taxed amounts. Finally, U.S. shareholders interested in making this election must also be able to obtain the required information from the PFIC.

While treating a PFIC as a QEF may be beneficial in that it allows taxpayers to opt out of the standard PFIC tax and interest rules, it also forces shareholders to pay taxes currently on undistributed income earned by a foreign corporation. Thus, QEF may be of limited use to taxpayers who lack adequate liquidity to pay taxes. Another important point about a QEF is that, due to the complexity of the rules and possible additional tax amounts, if the decision is made to elect QEF treatment of PFIC, it may be advisable to elect a QEF in the first year of holding an offshore investment.

Mark-to-Market

Another option for U.S. shareholders of a PFIC (who do not elect to treat a PFIC as a QEF), is to elect the mark-to-market method. This election is only available if the shares are considered “marketable stock”. Marketable stock is regularly traded stock with an ascertainable value on recognized exchanges as defined in the IRC regulations. If the shareholder elects to mark the stock to market, he will annually report, as ordinary income, the amount equal to any excess of the fair market value (FMV) of the PFIC stock as of the close of the taxable year over the adjusted basis of the shares (i.e. as if the shares had actually been sold at FMV). If the adjusted basis of the PFIC shares exceeds its FMV as of the close of the taxable year, the shareholder may generally deduct an ordinary loss (subject to certain statutory limitations).

Shareholders who directly own shares in a PFIC electing the mark-to-market method may increase their adjusted basis in PFIC shares through income recognized, and decrease the adjusted basis through deductions taken.

Conclusion

The tax issues surrounding PFICs are very complex and should be handled by a tax professional. Sherayzen Law Office can help you analyze your tax situation, determine whether PFIC rules apply, identify the alternatives in light of your whole tax situation, and implement the tax strategy most suited to your business and investment needs.

Contact Sherayzen Law Office to discuss your tax situation with an experienced tax lawyer!