Client Resources

Passive Foreign Investment Company (PFIC): An Enemy of Tax Deferral

Date Posted: December 13, 2017

Everyone pretty much understands the concept regarding the time value of money. If you have $1,000 and put it an account which earns 10% per year, at the end of the year you will have an additional $100. Consider, then, a company which earns enough profits to where it owes $1,000 of taxes on those profits. Tax deferral occurs in situations where the company earns those profits in one year but can avoid paying tax on those profits for a year or longer. This is good because the company can keep the $1,000 which should have been paid in taxes and effectively re-invest it and if the company earns 10% on that money it will have increased its cash holdings by an additional $100 at the end of one year. Now consider the value of being able to defer paying those taxes for several years.

How does tax deferral happen?

U.S. taxpayers are taxed on their “Worldwide Income” which basically means no matter where a U.S. person earns profits the U.S. has the rights to tax those profits. A U.S. corporation is considered a U.S. person, however a foreign corporation is generally not considered a U.S. person. So the first step in deferral is to form a foreign corporation…..but where? Remember, deferral only works in situations where it is possible to avoid paying tax for at least one year, thus the foreign corporation should be formed in a country which either imposes no taxes or a very low rate of tax. The foreign corporation will therefore not pay income taxes (or will pay a small amount of taxes) on its profits in its home country and, since it is not a U.S. person, the U.S. cannot tax those profits until such time as they are distributed to U.S. shareholders as a dividend or some other form of income to a U.S. person.

The Enemies of Tax Deferral

In the U.S., there are two main enemies of tax deferral which could very well defeat the simplified structure we have outlined above: (1) PFIC and, (2) Foreign Based Company Income of Controlled Foreign Corporations (CFCs). This discussion will focus on PFIC and a later discussion will focus on CFCs.

How is Deferral Defeated?

Remember in our simplified structure of the foreign corporation where its profits were not subject to foreign tax until they were distributed to a U.S. person? Well, deferral is most often defeated by rules which artificially force a U.S. owner of the foreign corporation to be considered as receiving a distribution (often referred to as a “Deemed distribution”) from the foreign corporation. The PFIC rules do this in one of three ways, however this discussion will focus solely on what a PFIC is, and the discussion of the three ways PFIC’s preclude deferral is for another occasion.

What is a PFIC?

A foreign corporation will be considered a PFIC if one of two tests is satisfied: (1) The Assets Test, or (2) The Income Test. Both of these tests generally focus on the types of income which are considered as “passive income” (interest, dividends, capital gains, rents, etc.) and the assets which produce passive income:

  • The Assets Test – 50% or more of the foreign corporation’s assets are considered “passive assets”
  • The Income Test – 75% or more of the foreign corporation’s income is considered “passive income”

At first glance, it would appear that foreign corporations which have an “active” business should have little to fear from these PFIC rules. While that may be true with regard to the income test, the hidden devil-in-the-details relative to PFICS typically involves the Assets Test, and most often the devil turns out to be the unlikeliest of all assets – cash.

Why is Cash the PFIC Devil?

Cash is considered a passive asset for purposes of the PFIC rules….this includes ALL cash, and it also includes highly-liquid cash-type assets. The first reaction we hear after informing our clients of this (and I am sure you may be thinking it right now as well) is, “I can maybe understand cash being considered passive in a business which produces mostly passive types of income, but every active business needs cash to survive so certainly some amount of cash should be excluded from the “passive” designation, right?” In a nutshell... wrong!

Go back to our simplified foreign corporation structure at the beginning of this discussion and note the part where we said the U.S. generally cannot tax the profits of a foreign corporation until there is a distribution to U.S. persons. Clearly, the U.S. wants to compel the foreign corporation to distribute its cash sooner rather than later, and if a foreign corporation keeps too much cash the PFIC rules may artificially “deem” there to have been a distribution.

Keep in mind that designating cash as a passive assets does not necessarily mean the foreign corporation cannot have any cash, it just means it can’t have too much of it. Further, for capitalintensive businesses (such as manufacturers with large investments in machinery & equipment) there may be enough non-passive assets which will allow greater levels of cash to be retained. The businesses which need to be extra careful, then, are businesses which do not require a lot of capital investment, such as service-based businesses.

A Simple Example

To assist in illustrating this issue, assume a service-based business whose only assets are a computer and some office furniture and fixtures and let’s assume these assets in total cost $5,000. Also assume that this company has $2,000 in accounts receivable (accounts receivable is generally not considered a passive asset). If these were the only existing assets other than cash, then the maximum amount of cash that could be on hand at this date would be $6,999 without a foreign corporation being considered a PFIC.

Once a PFIC, Always a PFIC

The determination of whether or not a foreign corporation is a PFIC is determined at the entity level, however the PFIC “taint” is effective only at the shareholder level and applies separately to each respective shareholder, and it only applies to U.S. shareholders. Once a foreign corporation is considered a PFIC with respect to a specific shareholder, that foreign corporation will ALWAYS be considered a PFIC with respect to that specific shareholder. Accordingly, once a U.S. shareholder’s ownership in a foreign corporation is considered as being ownership of a PFIC, that foreign corporation will always be considered a PFIC with respect to that particular shareholder irrespective of future results of the Asset Test or the Income Test which were outlined above. Thus there may be situations where one U.S. shareholder could be subject to the PFIC rules but another U.S. shareholder of the same foreign corporation may not be.

It is easy to see how the PFIC rules can become very complex very quickly, and this is only a very simple overview of the rules which determine whether or not PFIC rules are applicable. Once these rules are applicable, the complexity level increases substantially. Therefore, as always, if you feel you may have a PFIC issue or if you simply want to know more about the topic, please do not hesitate to contact us at Metzler Advisory. We are here to help.