Start-Up Year PFIC Exception | International Tax Lawyer & Attorney
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:
- No predecessor corporation was a PFIC;
- 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
- 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.
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