Tax Reform and Its Impact on Passive Foreign Investment Companies (PFIC)
The Tax Reform Act of 2017 (the Act) brought about many significant changes in the international income tax area.
Source:Andersen Tax LLC in the U.S.
Although most of the changes have focused on the new transition tax for specified foreign corporations and other provisions affecting U.S. multinational businesses, the Act also includes some changes that impact passive foreign investment companies, or PFICs, where a qualified electing fund (QEF) election has not been made.
As a brief overview, a PFIC is a foreign corporation that satisfies a number of tests, including an asset and income test. The asset test is met when the average percentage of assets held that produce passive income or are held for the production of passive income is at least 50%. The income test is met when 75% or more of the gross income is from passive activities. Passive income is defined as interest, dividends, rents, royalties, annuities and gains over losses from the sale or exchange of property that gives rise to interest, dividends, rents, royalties and annuities. If either of these tests are met, the corporation is treated as a PFIC.
If a U.S. taxpayer is an owner of a PFIC, absent a QEF election (which treats the PFIC’s ordinary income and net capital gains as flowing through to the taxpayer annually similar to a partnership), no income is recognized and subject to tax unless actual distributions are made by the PFIC. However, when income distributions are made, they are generally taxed as ordinary income at the highest marginal rate regardless of the character of the income at the entity level. In addition, an interest charge is also levied on the deferred tax if there are excess distributions, which is compounded annually. As a result, U.S. taxpayers typically seek to avoid PFIC treatment.
CFC Overlap Rule
As described above, the rules for determining whether a foreign corporation is a PFIC are different than the rules for whether a U.S. person owns an interest in a controlled foreign corporation (CFC). Prior to the Act, to qualify as a U.S. shareholder of a CFC, a U.S. person must own 10% or more of the combined voting power of all classes of stock entitled to vote and, collectively, those U.S. shareholders must own more than 50% of the total combined voting power or value, whichever is greater. If a U.S. person owns less than 10% of a CFC that is also a PFIC, it will be treated as a PFIC with respect to that U.S. person.
Retroactive to January 1, 2017, a U.S. shareholder is now defined as a U.S. person owning either 10% or more of a foreign corporation’s combined voting power or value, whichever is greater. Stock classes are not distinguished for this purpose.
The attribution rules to determine CFC status have also changed under the Act. Now certain stock of a foreign corporation owned by a foreign person could be attributed to a related U.S. person. The effect of these changes will likely cause more PFICs to be treated as CFCs. U.S. taxpayers should review their current ownership in PFICs to determine whether their ownership is now treated as being a U.S. shareholder in a CFC. Due to the complexity of the PFIC rules, the tax implications of an interest in a PFIC now being treated as an interest in a CFC because of the Act are beyond the scope of this article.
Insurance Exception to PFIC Rules
Prior to the Act, passive income did not include any income derived in the active conduct of an insurance business by a corporation that was predominantly engaged in an insurance business and that would be subject to tax under subchapter L (the provisions of the tax code relating to insurance companies), if it were a domestic corporation. Congress has been concerned that many hedge funds have used this exception for insurance companies to invest in assets that produce passive income without assuming the risks that are part of a traditional insurance business and thereby avoid the PFIC rules. IRS was aware of this planning technique and issued a Notice in 2003 warning that such arrangements may be challenged.
Beginning in 2018, the Act eliminates the predominantly engaged in an insurance business test for PFICs and instead provides that passive income does not include any income derived in the active conduct of an insurance business by a qualifying insurance corporation. The statute’s definition of a qualifying insurance corporation will likely subject more foreign corporations to the PFIC rules that were formerly excluded because the test for qualifying as an insurance corporation are more difficult to meet. Specifically, in order to be a qualifying insurance corporation, the foreign corporation’s insurance liabilities have to be more than 25% of the corporation’s total assets as reported on the company’s applicable financial statements for the last year ending with or within the taxable year. Without a QEF election, U.S. investors in theses business will now be subject to the tax inefficient PFIC rules.
The Take Away
Although the Act did little to impact much of the PFIC rules, U.S. taxpayers with PFIC investments must be wary of the broadened definition of a U.S. shareholder, which could cause a PFIC to become a CFC due to the ownership attribution rules. In addition, U.S. taxpayers should review their investment in foreign corporations that claim that they are conducting an insurance business and determine whether such foreign corporations are now subject to the PFIC rules.