Presentation on theme: "Lawrence Pollack, KPMG LLP David Shapiro, Shapiro Tax Law LLC"— Presentation transcript:
1Navigating the U.S. tax rules when starting or expanding a business overseas Lawrence Pollack, KPMG LLPDavid Shapiro, Shapiro Tax Law LLCNYU 71st Institute on Federal TaxationNew York, NY – October 22, 2012San Diego, CA – November 12, 2012
3Agenda Branch versus subsidiary Later conversion of foreign branch into foreign subsidiaryMaintaining U.S. tax deferral by navigating the anti-deferral regimesSubpart FInvestment in U.S. propertyPassive foreign investment company
4Branch operationsTrue foreign branch versus “check the box” hybrid branchU.S. tax benefits of operating as a foreign branchOften considered when local operations would not cause a taxable presence in foreign jurisdictionStart-up losses currently deductible in the U.S., subject to the dual consolidated loss rulesSome foreign countries do not impose a branch remittance tax, but do impose a dividend withholding tax on profit repatriationU.S. tax disadvantages of operating as a foreign branchProfits currently taxable in the U.S.Foreign tax credit limitations may be more difficult to manage with branch rather than subsidiary form
5Incorporation of foreign branch – Potential loss recapture U.S. tax loss recapture provisions to evaluateBranch loss recapture. IRC §367(a)(3)(C)Dual consolidated loss recapture. IRC §1503(d)Overall foreign loss recapture. IRC §904(f)Incorporation when foreign branch achieves “cumulative” break even point can avoid loss recapture
6Deferring U.S. tax on foreign subsidiary earnings – Avoiding direct and indirect U.S. taxation Avoiding U.S. effectively connected income and U.S. permanent establishmentSubpart FForeign Personal Holding Company IncomeForeign Base Company Sales IncomeForeign Base Company Services IncomeOtherInvestment in U.S. propertyPassive foreign investment company
7Overview – Subpart F exception to deferral Certain income of a controlled foreign corporation (CFC) is currently includible in the income of its U.S. shareholders in the year earnedInclusion creates increased tax basis in the CFC shares under IRC §961(a)Amounts distributed by the CFC in current and subsequent taxable years treated first as "previously taxed income" under §959, and reduce U.S. shareholder's U.S. tax basis in the CFC shares under §961(b)Earnings of a CFC invested in "U.S. property" under sec. 956 treated as currently distributed to its U.S. shareholders per sec. 959IRC Sec. 951(a)(1)
8Subpart F – Statutory provision IRC §951(a)(1) provides that if:a foreign corporation is a controlled foreign corporation ("CFC") for an uninterrupted period of 30 days or more during any taxable yearevery person who is a "U.S. shareholder" (as defined in §951(b)) of such corporation and who owns, within the meaning of §958(a), stock in such corporationon the last day (in such taxable year) on which the corporation is a CFCshall include in his gross income his pro rata shareof the corporation's subpart F income for the yearand the amount of Investment in U.S. property as determined under section 956
9"Hopscotch" rule for subpart F inclusion CFC-1CFC-2Subpart F income
10Definition of "U.S. Shareholder" 10% of voting power of FC stock (owned directly, indirectly, or constructively) Value of stock is irrelevant9% voting stock100% nonvoting preferred stockFCU.S.IRC Sec. 951(b), 958, 318
11Definition of controlled foreign corporation (“CFC”) A foreign corporation is a CFC if more than 50 percent of the total combined voting power or total value of the stock of such corporation is owned (directly, indirectly, or constructively) by U.S. shareholders on any day during the tax year of such corporation.Attribution FROM entities:From partnerships and estates (and, generally, trusts): proportionately to partners and beneficiariesFrom corporations: proportionately to 10% or greater shareholdersSpecial rule – If an entity owns > 50% voting power in another corporation, it is treated as owning 100% of such entity, solely for purpose of the "attribution from entity" rule.Attribution TO entitiesFamily attributionIRC Sec. 957(a), 958, 318, Regs
12Example: Special 50% Rule Attribution from Entities Is Foreign Corporation a CFC?U.S. partner "indirectly" owns 36% voting power of FC (60% of 60%).However, since foreign partnership owns more than 50% voting power in FC, it is treated as owning 100% solely for purposes of applying attribution from entity rule. As such, U.S. partner treated as "constructively" owning 60% of 100% of FC, thus causing FC to be a CFC under special rule.The subpart F inclusion is based on 36% indirect ownership.60% Voting PowerForeignCorporationU.S.PartnerPartnershipIRC Sec. 958(b)(2)
13U.S. partnership "blocker”: Notice 2010-41 Treasury and IRS intend to issue regulations that would classify certain domestic partnerships as foreign partnerships solely for purposes of identifying the U.S. shareholders of a CFC that are required to include subpart F (and section 956) incomeIntended to prevent use of a U.S. partnership with foreign corporate partners, and with ultimate U.S. ownership to hold shares of a CFC with a view towards avoiding subpart F inclusionIRS stated this structure is "manifestly incompatible with the intent of §951".
14Notice 2010-41: Partnership blocker U.S. partnership would be treated as a foreign partnership for purposes of determining the U.S. shareholder that has a subpart F inclusion where:The partnership is a U.S. shareholder of a foreign corporation that is a CFC, andIf the partnership were treated as foreign,that foreign corporation would continue to be a CFC, andat least one U.S. shareholder of the CFCwould be treated under §958(a) as indirectly owning stock of the CFC owned by the partnership that is indirectly owned by a foreign corporation, andwould be required to include an amount in gross income under §951(a) with respect to the CFCCFC-1CFC-2100%U.S.CFC-3Ptp50%
15Subpart F Income Insurance income Foreign base company income International boycott factorBribes, kickbacks, or illegal payments to government officialsIncome from certain blacklisted countries designated in accordance with IRC §901(j)IRC Sec. 952(a); 75 F.R , 7/29/10; Rev. Rul
16Exclusions and Limitations Effectively connected incomeCurrent earnings and profits limitationQualified deficitsRecharacterization in later years under IRC Sec. 952(c)(2)IRC Sec. 952(b), (c).
17Foreign Base Company Income (“FBCI”) Foreign personal holding company incomeForeign base company sales incomeForeign base company services incomeOil related incomeIRC Sec. 954(a).
18Special Rules and Exceptions to Foreign Base Company Income Full inclusion ruleAll income treated as foreign base company income or insurance income if FBCI and insurance income exceed 70% of the CFC's total gross incomeDe minimis ruleNo income treated as FBCI if sum of FBCI and insurance income is less than lesser of:5% of the CFC’s gross income, or$1 millionHigh tax exceptionCFC’s foreign base company income taxed at a rate greater than 90% of maximum U.S. rate (currently 31.5%), determined using U.S. tax principlesIRC Sec. 954(b)(3)(B), (b)(3)(A) and (b)(4).
19Foreign Personal Holding Company Income (“FPHCI”) Dividends, interest, royalties, rents, and annuitiesExclusion for "PTI" dividendsExcess of gains over losses from disposition of property that produces FPHCICapital gains from disposition of stock, bond, patentMay avoid by "check and sell" transactionExcess of gains over losses from certain commodities transactionsExcess of foreign currency gains over losses from Sec. 988 transactionsOthers (i.e., income equivalent to interest)IRC Sec. 954(c), 959(b).
20FPHCI – Dividends Exclusion for same country dividends Year Two (internal reorganization)Year OneU.S.U.S.NEWCO – YDividendsYXYXSame country exclusion only applies if earnings areattributable to recipient's holding period in payor's stockIRC Sec. 954(c)(3).
21FPHCI – Gains from Property Transactions Property transactions – FPHCI includes net gains from sale or exchange of:Property that gives rise to FPHCIAn interest in a trust, partnership or REMICException for sale by CFC of 25% or greater interest in partnership (look-through treatment)Property that does not give rise to any income (e.g., gold, options)FPHCI does not include gains and losses from the sale or exchange of inventory-type property or assets used in business operations, including sale of goodwill or going concern value.IRC Sec. 954(c)(1)(B), 954(c)(4).
222005 Tax Act – Temporary "CFC look-through" exception to FPHCI The 2005 Act provides a temporary "CFC look-through" exception from subpart F FPHCI for dividends, interest, rents, and royalties received by a CFC from another CFC that is a related person within the meaning of §954(d)(3)A "related" CFC is a CFC that controls or is controlled by the other CFC, or a CFC that is controlled by the same person or persons that control the other CFCOwnership of more than 50% of the CFC's stock (by vote or value) constitutes controlNotice
232005 Tax Act – Temporary "CFC look-through" exception to FPHCI – cont. To the extent such items (of dividends, interest, rents, or royalty) are attributable or properly allocable to income of the related CFC that is not subpart F income, they are not treated as FPHCI to the recipient CFCEffective for tax years of CFCs beginning after December 31, 2005 and before January 1, 2012 (as extended by the Unemployment Insurance Reauthorization and Job Creation Act of 2010)Most recent proposal to extend the look-through provision for two years has been approved by the Senate Finance Committee and will be considered in the fall of 2012.Notice
24FPHCI planning to avoid subpart F through use of “foreign reverse hybrid entity" Exclusion for same country interestU.S.ParentEquityCountry X OpcoCountry X PartnershipLoanReverseHybridIRC Sec. 954(c)(3)(A)(i).
25FPHCI Planning – CTB election to facilitate cash deployment Often, check the box (CTB) elections are made to facilitate redeployment of cash within a multinational group while avoiding subpart FCTB elections enable dividend flows to be treated instead as branch remittances, which are not treated as FPHCI subpart F dividend incomeU.S.CFC HoldingDividendsBranch remittancesCFC OpcoCFC Opco
26FPHCI Planning – "Check & Sell" Transaction U.K. Holding makes a "check the box" ("CTB") election to disregard U.K. Opco, effective just before U.K. Holding sells shares of U.K. OpcoTax Court held for the taxpayer that the transaction should be treated for U.S. tax purposes as a sale by U.K. Holding of the assets (rather than the shares) of U.K. OpcoHence, subpart F FPHCI gain was avoidedU.S.U.S.U.K. HoldingU.K. HoldingU.K. OpcoU.K. OpcoDover Corporation & Subsidiaries vs. Commissioner, 122 T.C. 324 (2004).
27The “Excess Return” Proposal Obama Administration’s FY 2012 and 2013 Budget Proposals to impose a current U.S. tax on “excess returns” associated with transfers of intangibles to a CFC“Excess returns” on intangibles transferred by a U.S. person to a related CFC that is subject to a low foreign effective tax rate would be treated as subpart F income (in a separate FTC limitation basket)Under the proposal, in the case of an effective tax rate of 10% or less, all excess income from a ‘covered intangible’ would be treated as Subpart F income, and would then phase out ratably for effective tax rates of 10 to 15%.Such excess income will be calculated based upon the gross income from transactions connected with or benefitting from such covered intangible over the costs plus a mark-up attributable to such gross income.Transfers would include sales, leases, and licenses as well as “any shared risk or development agreement (including any cost sharing agreement)”
28Foreign base company sales income Three essential elements: 1. CFC engages in certain related-party transactions associated with the buy/sell process regarding personal property (“goods”) 2. Goods manufactured outside country of CFC's incorporation, and 3. Goods sold for use, consumption, or disposition outside CFC's country of incorporationIRC Sec. 954(d).
29FBC sales income – Related-party transactions CFC engaged in sales operations:CFC buys personal property from related party and sells it to any person (and derives a trading profit), orCFC sells personal property to any person on behalf of related party (and earns a sales commission)CFC engaged in purchasing operations:CFC buys personal property from any person and sells it to related party (and derives a trading profit), orCFC buys personal property from any person on behalf of related party (and earns a buying commission)IRC Sec. 954(d); Regs (a)(1)(i).
30FBC sales income – CFC selling agent U.S.SaleCaymanCFCSwiss CustomersResaleU.S. Parent manufactures personal property and sells to its Cayman CFC at arm's length.Cayman CFC resells to Swiss customers (or sells to Swiss customers on behalf of U.S. parent and earns a sales commission)IRC Sec. 954(d).
31FBC sales income – CFC buying agent U.S.Re-saleCaymanCFCSwiss manufacturersPurchaseCayman CFC purchases goods from unrelated Swiss manufacturers for resale to U.S. parent (or Cayman CFC purchases goods from Swiss manufacturer on behalf of U.S. parent, and earns a buying commission from U.S. parent)IRC Sec. 954(d).
32FBC sales income – Exceptions Agricultural commodities not grown in commercially marketable quantities in the U.S.Bananas, black pepper, cocoa, coconut, coffee, crude rubber, and tea.Manufacture in country of CFC's incorporation (by anyone)Goods sold for use, consumption, or disposition in country of CFC's incorporationManufactured by CFC (anywhere)Perhaps via contract manufacturingSubstantial contribution test – regulations contain seven nonexclusive factors that may be consideredEffective for tax years beginning after June 30, 2009IRC Sec. 954(d)(1); Regs (a)(1), (2), (3) and (4).
33"Manufactured" – Physical manufacturing tests CFC will be treated as having manufactured personal property if through the activities of its employees:The personal property purchased by the CFC is "substantially transformed" by the CFC prior to its salePurchased components – subjective test – sale of personal property will be treated as sale of a manufactured product rather than sale of component parts if the assembly/conversion activities are substantial and generally considered to constitute "manufacture" of propertyPurchased components – safe harbor – conversion costs (direct labor and factory burden) of the CFC account for 20% or more of the total cost of goods soldHowever, in no event will packaging, labeling, or minor assembly operations constitute the manufacture of property for purposes of §954(d)(1).Regs (a)(4); Bausch and Lomb, T.C. Memo
34"Manufactured" – Substantial contribution test Applies where CFC does not itself sufficiently engage in the physical manufacturing process and therefore does not satisfy the physical manufacturing test, but through its own employees makes a "substantial contribution" to the manufacture of personal property (i.e., through contract manufacturer)Seven nonexclusive factors are providedOverall facts and circumstances subjective testNo single activity is provided more weight than others
35"Manufactured" – Substantial contribution test – Seven factors Oversight and direction of the manufacturing activities or processPerformance of some manufacturing activitiesMaterial selection, vendor selection, or control of raw materials, work in process, or finished goodsManagement of manufacturing costs or capacities (including management of the risk of loss, cost reduction, etc.)Control of manufacturing-related logisticsQuality controlDeveloping or directing development of product design and design specifications or IP used in the manufacturing of personal property
36FBC sales income – Sales branch rule Sales branch rule treats branch as a related party subsidiary of CFC if branch income is subject to effective rate of tax that is less than 90% of, and at least 5 percentage points less than, the tax rate that would apply to such income in CFC's country of incorporation.U.S.Netherlands CFCSwisssales branch25.5% tax rate15% tax rateIRC Sec. 954(d)(2); Regs (b)(1)(i).
37FBC sales income – Manufacturing branch rule Manufacturing branch rule treats branch as a related party subsidiary of CFC if income of the remainder of the CFC (i.e., head office) is subject to effective rate of tax that is less than 90% of, and at least 5 percentage points less than, the tax rate that would apply to such income in country where the branch is located.U.S.Netherlands CFCFrenchmanufacturing branch25.5% tax rate33% tax rateIRC Sec. 954(d)(2); Regs (b)(1)(ii).
38Sales branch rule – Purchasing in CFC's home country and selling through low-taxed sales branch Sales branch rule would apply where a Dutch CFC has employees in the Netherlands who purchase goods from unrelated parties and resell the goods to unrelated parties through its low-taxed sales branch in Switzerland.U.S.Netherlands CFCSwissSales Branch25.5% tax rate15% tax rateDutch CFC would have FBC sales income to the extent the goods are manufactured (by another) and sold for use outside the Netherlands.Swiss sales branch (fictional CFC) would also have FBC sales income to the extent the goods are manufactured (by another) and sold for use outside of Switzerland.
39Sales branch rule not applied – Manufacturing/sales branch Sales branch rule does not apply where a CFC has a foreign manufacturing branch that also sells the property manufactured. In such case, the manufacturing exception would apply to avoid FBC sales income.U.S.Netherlands CFCSwissmanufacturing & sales branch25.5% tax rate15% tax rateRegs (a)(2) and (4); T(b)(2)(ii)(e); (b)(4), example 3, TAM and PLR
40purchasing & sales branch Sales branch rule not applied – Purchasing and selling through one branchSales branch rule does not apply where a CFC has a foreign trading branch that purchases finished products from unrelated suppliers and sells the products to unrelated customers, where all purchasing and selling activities occur in country where branch is located.U.S.Netherlands CFCSwisspurchasing & sales branch25.5% tax rate15% tax rateRegs T(b)(2)(i)(b); & (ii)(b); (b)(4), example 3.
41FBC services incomeForeign base company services income includes income derived by a CFC from the performance of services if the services are performed:for or on behalf of a related party, andoutside the CFC's country of its incorporation.IRC Sec. 954(e); Regs
42"For or on Behalf of"Regulations include four nonexclusive situations in which a CFC is treated as performing services "for or on behalf of" a related party:CFC is paid by a related person for performing services.CFC performs services which a related person is, or has been, obligated to perform.CFC performs services with respect to property sold by a related person, and the performance of such services by the CFC constitutes a condition or material term of such sale by the related person.CFC receives substantial assistance furnished by a related U.S. person in the performance of the CFC's services.Regs (b).
43Example – CFC Paid by Related Person USPManufactureand sell machinesCustomerServiceFeeCFCInstall andmaintain machinesCFC has a separate service contract with unrelated customer. USP pays CFC for installation and maintenance services Result: CFC's services are considered performed "for or on behalf of" a related person since CFC is paid by a related person
44Example – Related Person Obligated to Perform Services ConstructionContractUSPAssignment ofContractCustomerCFCUSP assigns construction contract to CFC. Customer releases USP from contractResult:CFC's services are considered performed "for or on behalf of" a related person because USP, a related person, had been obligated to perform such services.Would not have been "for or on behalf of" a related person if CFC had been the original contract party
45Services are a condition or material term of a related person property sale Manufactures and sells industrial machineUSPCustomerCFCInstallation servicesUSP sells machine to customer for special reduced price on condition that customer agrees to employ and pay CFC for installation services.Result:CFC considered to perform services for, or on behalf of, a related person since the services that it performs are a condition or material term of a related-person property sale.If installation contract were truly independent of machine sale, would not be FBC services income.
46“Substantial assistance” furnished by related U.S. person Under certain circumstances, services performed by a CFC will be treated as performed for or on behalf of a related person where a U.S. related person furnishes "substantial assistance" to the CFC contributing to the performance of services by the CFC. Result:FBC services income results if CFC's services are rendered outside country of its incorporation.Note:“Substantial assistance" from another CFC will not in itself trigger FBC services incomeHowever, payments to other CFC could be FBC services income in the hands of the other CFC.Regs (b)(1)(iv); Notice
47Substantial Assistance Assistance furnished by a related U.S. person includes direction, supervision, services, know-how, financial assistance (other than contributions to capital), and equipment, material, or suppliesAssistance is considered substantial if the cost to CFC for U.S. related persons assistance is at least 80% of the total cost to CFC of performing the servicesRegs (b)(2)(ii); Notice , effective for taxable years of foreign corporations beginning after December 31, 2006.
48“Commissions” for CFC’s sales/purchase efforts Commissions or fees derived by a CFC in connection with the purchase or sale of personal property on behalf of a related person is considered as sales income for purposes of applying the foreign base company sales income provision.However, income derived by a CFC from certain post-sales activities may in particular give rise to services (rather than sales) income, such as installation, maintenance or warranty services with respect to personal property sold by a related person.This income would be tested for subpart F under the foreign base company services provisions rather than the foreign base company sales income provisions.IRC §954(d)(1); Regs. § (a)(1); (b)(3), Examples 1, 8 and 10;see also Reg. § (d).48
49Investment of Earnings in U.S. Property U.S. shareholders are taxed on pro rata share of CFC's investment of earnings in "U.S. property"Referred to as a “section 956 inclusion"Amount of U.S. property is based on average of quarterly amounts held by CFCBased on adjusted U.S. tax basis of propertyAmount of section 956 inclusion limited to "applicable earnings" amountApplicable earnings are essentially earnings and profits (current and accumulated) of the CFC, less current distributions and less amounts of previously taxed section 956 inclusions that have not yet been distributedIRC Sec. 951(a)(1)(B); 956(a)(1)(A); 956(b)(1).
50What is "U.S. Property"?Tangible property located in the United StatesStock of a domestic corporationObligations of a U.S. personGuarantee by a CFC of an obligation of a U.S. personIncludes pledge by U.S. shareholder of 2/3 or more of stock of a CFC together with certain negative covenantsCan include global debt facility with joint & several obligor provision to the extent U.S. domestic members draw down on debt facilityTantamount to CFC guarantee of U.S. parent's share of debt obligationRight to use intellectual property in the United StatesIRC Sec. 956(c); Regs (c).
51Items Excluded from "U.S. Property" Obligations of the United States (e.g., U.S. Treasury bonds)Money and deposits with persons carrying on the banking businessProperty located in the United States which is purchased in the United States for export to, or use in, foreign countriesObligation of a U.S. person arising in connection with the sale or processing of property, provided the amount of such obligation does not exceed the amount which would be "ordinary and necessary" had the transaction been between unrelated personsIRC Sec. 956(c)(2).
52Items Excluded from "U.S. Property" (continued) Obligations arising from CFC's provision of services to a U.S. person that are collected within 60 days (safe harbor)Stock or obligations of a domestic corporation which is not a U.S. shareholder of the CFC, provided that U.S. shareholders of the CFC do not control (directly, indirectly or constructively) 25% or more of the voting power of the domestic corporationRegs T(d)(2)(i)(B); IRC Sec. 956(c)(2)(F).
53Items Excluded from "U.S. Property" – Short-term CFC Loans Obligations that are collected within 30 days from the time incurred provided that the 60-day aggregate test is not exceeded (Notice )Temporary rule provided by Notice to facilitate liquidityCFC may choose to exclude from U.S. property an obligation held by the CFC at quarter end that is collected within 60 days from the time it is incurred, so long as the CFC does not hold for 180 or more days during the year obligations that would otherwise constitute U.S. propertyEffective only for the first two taxable years of a CFC ending after October 3, Notice extended application of Notice one additional year.See IRS generic legal advice, 2007 TNT , Sept 25, 2007.
54IRS Disregard – Temporary Period of "Disinvestment" in U.S. Property Rev. Rul :Situation one: CFC held an obligation of its U.S. Parent from February 5 until November 15 in year 1, and a new obligation of the same obligor from January 15 until November 10 in year 2IRS ruled both loans would be collapsed and treated as a continuous loan outstanding at year end, thus triggering section 956284-day loan followed by 60-day disinvestment periodSituation two: CFC held an obligation of its U.S. Parent from February 1 until June 30 in year 1, and a new obligation of the same obligor from January 15 until November 15 in year 2IRS ruled that the period of disinvestment between loans was sufficiently long to be respected150-day loan followed by a 198-day disinvestment period
55Series of Multiple Loans by CFC "Aggregated" as One Continuous Loan (substance vs. form) Series of 12 short-term loans by a CFC to its U.S. parent over 2 1/2 year period were collapsed as one continuous loan to USPFunds borrowed were within control of USP 94% of the 2 1/2 year periodCourt applied step transaction and substance over form doctrinesHeld: the series of short-term loan transactions were in fact a single loan lasting 2 1/2 years, thereby causing a 956 inclusionJacobs Engineering Group, Inc. v U.S. 79 AFTR 2d (CD. CA 1997), affd. 168 F.3d 499 (4th Cir. 1999).
56Passive Foreign Investment Company (“PFIC”) A foreign corporation is a PFIC if either75% or more of its gross income is “passive” (“income test”), orAt least 50% of its assets produce or are held for the production of passive income (“asset test”)IRC §1297; Notice
57Passive Foreign Investment Company (“PFIC”) (continued) “Passive income” is defined as income which is of a kind that would be FPHCI under IRC §954(c)Cash, and other assets that are readily convertible into cash, produce passive income and therefore are treated as passive assets, even if they are part of the working capital of an active business.In determining PFIC status, a look-through rule applies to measure proportionate share of gross income and assets of 25% owned corporationsWhere look-through rule does not apply, shares are treated as a passive asset.No minimal level of U.S. ownership threshold, unlike subpart F and investment in U.S. property57
58PFIC – Income test Determined based on gross income Look-through rules for interest, dividends, rents and royalties from 25% or greater owned corporationsExclusions for:Income derived in the active conduct of a banking business by an institution licensed to do business as a bank in the United Statesor under proposed regulations, any foreign bank that actively conducts a banking business, has substantial bona fide banking activities, and is licensed to take deposits in its country of charter or incorporationIncome derived in the active conduct of an insurance business by a company that would be taxed under subchapter L if it were domesticIRC § 1297(b) and (c), 1298(e), Notice 88-22, Notice 89-81, Prop. Reg. §58
59PFIC – Asset testDivide gross average passive asset amount by gross average total asset amountAverage determined based on quarter end asset amountsPublic companies: asset amount equals fair market value (including goodwill based on implied value from market capitalization)Other companies: asset amount equals gross asset basis, with some adjustments for research expensesReceivables treated as active or passive based on character of income that generated the receivableDealer’s inventory of stock or securities is nonpassive, provided it is specifically identified as inventory (versus investment) on its books and recordsIRC § 1297(e), Notice 88-22, Notice 89-81
60PFIC – “Excess distributions” Unfavorable PFIC interest charge regime applies to “excess distributions” from a PFIC and gains recognized upon disposition of the shares of a PFICExcess distribution is equal to the excess of amount of distribution received in current year over 125% of average distributions received from such PFIC in prior three yearsIn case of gain recognized upon disposition of PFIC stock, entire gain treated as excess distributionIRC §1291.
61PFIC – Unfavorable consequences Excess distributions are subject to an interest charge referred to as a “deferred tax amount”Deferred tax amount is calculated by treating the excess distribution as if it were realized on a ratable basis over shareholders entire holding period in the shares; amount allocable to post-1986 years subject to tax at maximum tax rates, plus interest chargeMaximum tax rates apply even if taxpayer is (or was) otherwise in NOL position for any of the taxable years in the holding period, as PFIC tax is computed independently from regular tax calculationGains from disposition of PFIC shares may be subject to recognition regardless of applicability of non-recognition provision (e.g., reorganizations, etc.)IRC §1291; Prop. Regs. § (b).
62“Qualified electing fund” election Avoids or limits the PFIC interest chargeRequires current inclusion (by U.S. owners) of the ordinary income and capital gain of the PFICReporting requirements may be seen as onerous by foreign managers/ownersNot fully effective unless made in the first year the company is a PFIC – otherwise protects against excess distribution treatment only as to the income included after QEF election is in effectIRC §1295
63Start-up and restructuring exceptions Start-up exception applies during first taxable year the corporation has gross income (the “start-up year”) if:It is not a successor to a PFICIt is not a PFIC in either of the two years immediately following the start-up year (i.e., its second and third taxable years)Restructuring exception applies during any taxable year when a company disposes of a business line (the “restructuring year”) if:Neither the company nor any predecessor was ever a PFICSubstantially all passive income is attributable to proceeds from disposition of one or more active trades or businessesThe company is not a PFIC during the two years immediately following the restructuring yearIRC § 1298(b)(2), (b)(3).
64CFC/PFIC OverlapForeign corporation shall not be treated with respect to a shareholder as a PFIC for the portion of the holding period after 1997 during which the foreign corporation was a “CFC” and the shareholder was a “U.S. shareholder” as defined in IRC §951(b) with respect to the CFC.IRC §1297(d), 951(c).