Legal | The passive foreign investment company (PFIC) regime aims to discourage US persons from forming a foreign corporation and using that company to invest in primarily passive investments, thereby attempting to shift income out of the US federal tax net. The final PFIC regulations expand this exemption to rents and royalties from a look-through subsidiary. reg. If all the relevant years in the holding period are still open, taxpayers can file amended returns for those years. When it comes to individual investors, one of the most common types of PFIC is ownership of a foreign mutual fund. Section 1.1298-4(e)(2)(i)and(ii)of the 2021 proposed regs provides two safe harbors from the principal-purpose antiabuse rule insection 1.1298-4(e)(1)of the final regs. A company meets the asset test if at least 50 percent of its assets produce or are held to produce passive income. Suppose US person C owned an interest in partnership N, which in turn owned an interest in corporation O, which was not a PFIC. Under the 2019 proposed regulations, a tested foreign corporation could apply the active rent and royalty rules by taking into account the activities of the officers, directors and employees of the tested foreign corporation and any other foreign corporation of which the tested foreign corporation owned more than 50% by value. reg. Without a qualified electing fund election, PFIC status can discourage distributions. If so, you may be subject to another set of reporting rules and elections. So how does one avoid double counting for payments from the look-through subsidiary when the look-throughs subsidiarys income had already been taken into account? reg. If the former PFIC is a CFC, the shareholder instead can elect to be treated as if it had received a deemed dividend equal to its pro rata share of the corporations post-1986 undistributed earnings and profits (regardless of whether the shareholder is a 10% owner of the CFC). reg. As noted, the final regulations do not allow Section 954(h) to be used in determining whether a foreign financial institution is a PFIC. The PFIC Problem | Cerity Partners a US Person investor may prospectively avoid a PFIC tax hit on exit by making a so-called 'Qualified Electing Fund' ('QEF') election in respect of his or her PFIC shares at the beginning of his or her PFIC . clarify the exception to passive income treatment for active insurance income in reg. New regulations issued under sections1291,1297, and1298 clarify whether a foreign corporation is treated as a passive foreign investment company and whether a U.S. person that indirectly owns stock in a PFIC is treated as a shareholder. Section 1297(b)(2)(C) (Related-Party Look-Through Rule) provides that passive income does not include interest, dividends, rents or royalties received or accrued from a related person (within the meaning of Section 954(d)(3)) to the extent that amount is properly allocable to the related persons non-passive income. reg. section 1.1298-4(e)(2)and(3)are reserved in the final regs. the principal-purpose antiabuse rule would disallow planning to manage the PFIC risks of start-up companies and active companies undergoing transition. Section 1298(a)(1)-(5)contains rules for attribution of stock ownership: Section 1298(b)(1)-(8)(called other special rules) contains eight rules of varying complexity that address a wide variety of subjects: Section 1298(c)(1)-(3)provides three rules that apply to PFIC stock held by a pooled income fund (as defined insection 642(c)(5)) when the funds governing instrument allows no gain from a disposition of the PFIC stock to be allocated to fund income: Section 1298(d)(1)-(3)requires any tangible personal property leased to a foreign corporation for at least 12 months to be treated as an asset actually held by the corporation and the unamortized portion of the present value of the lease payments to be taken into account for thesection 1297(a)(2)asset test. USS2 was not created, organized, or acquired within the preceding 36 months and has not disposed of a U.S. active trade or business within the preceding 36 months so there is no testing date or transition period analysis. section 1.1298-4(e)provided thatsection 1298(b)(7)does not apply to determine whether a tested foreign corporation is a PFIC forsection 1298(a)(2)purposes. a tested foreign corporation owns at least 25 percent of the FMV of the stock of a domestic corporation; the 25-percent-owned domestic corporation owns qualified stock in another domestic corporation; and, the tested foreign corporation is subject to the accumulated earnings tax under, the second-tier domestic corporation is created, organized, or acquired (the start-up testing date); or. Final regs issued January 15 (and corrected March 5 and March 10) retained the basic approach and structure of proposed regs issued July 11, 2019. Therefore, companies may be able to plan and avoid classification as a PFIC by failing the asset test, depending on the facts. Services section 1.1298-4(e) that provide safe harbors limiting application of the antiabuse rule in the final regs. reg. Treasuryand theIRSdetermined that disregarding qualified stock is unnecessary to address abuse concerns. A simple way to look at the effect of being a 'disregarded entity' is to view the business that is being carried on as separate from its owner for legal purposes (such as who has legal liability in the event of being sued), but not separate from its owner for tax purposes (such as who has to file tax returns and pay tax on the income earned in t. section1.1298-4(e)(2)(i)). For discussion of these changes, see EY Global Tax Alert, US final and proposed regulations on passive foreign investment companies have both favorable and unfavorable implications for insurance companies, dated 15December 2020. How to avoid a scary PFIC Nightmare - Invest Offshore reg. Suppose a foreign corporation owns an interest in a partnership that owns active assets. The final PFIC regulations allow activities of officers and employees of related entities to be taken into account for this purpose, in a way even more favorable than the 2019 proposed regulations. The distributions also do not qualify for treatment as a qualified dividend income (QDI). If the tested foreign corporation is publicly traded (as described insection 1297(e)(3)), it may include in its public filings a statement that it irrevocably waives treaty protection against the imposition of thesection 531tax, effective for all prior, current, and future tax years. In addition to our PFIC tax services, we help early-stage startup companies in financial and tax matters from emerging growth through expansion and to full maturity. On the seventh day of year 5 (or before the end of the first month),USS2invests the cash in assets that it immediately begins to use in an active U.S. trade or business. Some foreign corporations became CFCs due to the repeal of Section 958(b)(4) in 2017. The rules that allow attribution of activities of related parties when determining whether certain types of income are active are welcome. First, if X is a PFIC, A always is treated as owning its proportionate share of Y. Qualified stock means any stock in a C corporation that is a domestic corporation and that is not aRICora REIT. PFIC - What does PFIC stand for? The Free Dictionary section 1.1291-1(b)that treat U.S. persons as shareholders of PFICs; provide rules related to look-through subsidiaries and partnerships in reg. The method used by a parent corporation to measure assets must be used by lower-tier corporations unless a lower-tier corporation must use a different method specified by Section 1297(e). Reg. Cookies | The PFIC Problem: U.S. Taxpayers Owning Foreign Mutual Funds. They know it will take about two years to bring the product to market, and each person will contribute $50,000 in cash to develop the software. If a foreign investment is a PFIC, sale of the PFIC shares or dividends from the PFIC can result in ordinary gains (rather than favorable capital gains). It assumes that USS2 operates an active U.S. trade or business within the meaning of reg. Notice 88-22 deemed all cash as a per se passive asset for PFIC-testing purposes; the proposed rule reflects the fact that some amount of cash is needed as working capital to support the day-to-day operations of an enterprise. Treas. section 1.1298-4(f)provides that the final regs apply to shareholder tax years beginning on or after January 14, 2021. Before the final PFIC regulations, uncertainty existed about how to apply these corporate attribution rules to tiered entities. Section 1.1298-3 to be treated as if it had sold its PFIC shares for fair market value. Under prop. section 1.1298-4(e)(1)does not apply. A PFIC is a Passive Foreign Investment Company. Section 1298(a)(2)generally provides that if a person owns 50% or more of a corporations stock FMV, that person is considered to own a proportionate share of any stock owned by the corporation. The final PFIC regulations apply to tax years of US persons that are shareholders in certain foreign corporations prospectively, beginning on or after the date of publication of the final PFIC regulations in the Federal Register (e.g., 2021 for a calendar-year taxpayer if the regulations are published in the Federal Register by 31 December 2020). section 1.1298-4(e)(2)(i)by the end of the 36-month transition period that began on the testing date, which was the end of the first month in year 2 when USS2 sold its prior active trade or business. Moreover, safe harbors to address those concerns are provided in the 2021 proposed regs insection 1.1298-4(e)(2)and(e)(3). A corporation is not a PFIC for its start-up year if: There are several ways that an investor can either avoid PFIC designation or mitigate the effects of the designation. Activities of officers and employees of related entities are not taken into account. section 1.1298-4(e)(3)has four examples that illustrate the safe harbor rules in prop. If the requirements of the business transition and start-up safe harbor are not satisfied within the transition period, the benefit of the safe harbor is lost retroactively for the entire period in which the safe harbor was claimed (see prop. If the corporation was treated as a PFIC in a closed year, it will continue to be treated as a PFIC. In many cases, income gains or distributions must be taxed at the highest U.S. marginal tax rate. In short, a "check-the-box" election (sometimes referred to as check the box form as well) is an entity classification election that is made on Internal Revenue Services (IRS) Form 8832, Entity Classification Election. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. Clarify an ambiguity about how ownership of PFIC stock is attributed when owned through a tier of entities, Eliminate reliance on the Section 954(h) active financing rules when determining whether a foreign corporation carrying on a financial business is a PFIC, Eliminate rents and royalties from 25%-owned subsidiaries, and the associated assets, from the PFIC income and asset tests, Eliminate the ability to treat a less-than-25% (by value) interest in a partnership as an active asset (with exceptions), Allow one to take into account activities of related parties when determining whether rents, royalties and certain other types of income are passive or active, Allow foreign corporations that are only controlled foreign corporations (CFCs) because of the repeal of Section 958(b)(4) in 2017 to measure assets by fair market value for purposes of the PFIC asset test, Modify the rules on when stock in a second-tier US subsidiary is treated as per se active, Provide guidance on when a foreign corporation licensed as a bank can avoid being treated as a PFIC, Treat as an active asset a limited amount of working capital held in a non-interest-bearing account, Limit the scope of the rule treating gain on the sale of an interest in certain subsidiaries as active to the extent the subsidiary owns active assets, Further modify the rules on when stock in a second-tier US subsidiary is treated as per se active. reg. These regulations also address the application of Section 1297(e) to tiered ownership structures. reg. section 1.1298-4(e)(2)(ii)for active companies undergoing transition and start-up companies. The preambles to the 2021 final and proposed regs provide additional insight into the rationale and operation of the rules in final and prop. For example, a services company that is otherwise at risk of being designated as a PFIC could carry forward its receivable balances from one quarter to the next to increase its non-passive assets. The 2019 proposed regulations would disregard dividends and interest from look-through subsidiaries for purposes of the income test. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader's specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The attribution rules would be burdensome to minority shareholders that would not be able to obtain information on lower-tier PFICs to comply with the PFIC rules. New Regulations May Help Foreign Corporations Undertaking an IPO Avoid Affiliated group is defined insection 1504(a)as modified by reducing the ownership threshold from at least 80% to more than 50%. PDF Instructions for Form 8621 (Rev. January 2022) - Internal Revenue Service Commentators asserted that this principal-purpose antiabuse rule was overbroad and should be more narrowly drawn or eliminated for several reasons, including: Treasuryand theIRSdetermined that the final regs should retain a principal-purpose antiabuse rule to prevent holding passive assets through a two-tiered chain of domestic subsidiaries to allow foreign affiliates that hold passive assets to avoid the PFIC rules. section 1.1298-4(a)-(f)supplements the rules insection 1298(b)(7). As discussed previously, C would only be treated as a 50% shareholder of O, and thus as owning its share of Os interest in P, if O owned at least 50% of the ownership interests in N. Prop. section 1.1298-4(e)(1). Section 1298(b)(7)provides a special non-passive characterization rule that applies when: In that case,section 1298(b)(7)treats the stock of the second-tier domestic corporation held by the 25-percent-owned domestic corporation as a non-passive asset and the related income as non-passive income. For purposes of the Asset Test, publicly-traded corporations must measure assets by fair market value, CFCs must measure assets by adjusted basis and other foreign corporations measure assets by fair market value unless they elect to measure assets by adjusted basis. The election applies to subsequent tax years unless the taxpayer revokes the election. However, a shareholder of a PFIC is treated as owning stock owned by the PFIC without regard to the 50% limitation. What is a PFIC: Passive Foreign Investment Company Tax Rules section 1.1298-4(d)(1)and(2)addresses thesection 531tax and the waiver of treaty benefits. How Best to Avoid Becoming a Passive Foreign Investment Company (PFIC Passive Foreign Investment Company (PFIC) Rules section 1.532-1(c)are met. The final PFIC regulations eliminate this rule in the 2019 proposed regulations; for purposes of testing, they also clarify that a partnerships indirect ownership stock is always attributed proportionately to all ofits partners, with no ownership threshold. Opt out of all email from EY Global Limited. Since Section 1297(b)(2)(A) only applies to entities licensed as banks, this eliminates the ability of non-bank finance companies that predominantly earn interest income, as well as non-bank affiliates of banks, to avoid PFIC status. from passthrough entities to their owners; is subject to the accumulated earnings tax imposed by. In that case, the foreign corporation is treated as owning its share of the partnerships assets and deriving its share of the partnerships income, characterized as passive or active at the partnership level. Reg. H.R. document.write(new Date().getFullYear()); 800-332-7952. This election potentially allows U.S. investors access to capital gains tax rates on a portion of their holdings of these funds and prevents the application of . A U.S. shareholder should make this election during the first year in which they own the PFIC stock to maximize the benefit. And upside, though, is that we typically get better expense ratios. When determining whether B is treated as indirectly owning stock in R, does one start with the PFIC (R) and apply the rules going up the chain (bottom-up), or does one start with the US person being tested (B) and apply the rules going down the chain (top-down)? In addition to the higher tax rates, an investor is subject to the PFIC tax treatment if the corporation was a PFIC at any time when the taxpayer held the stock, and the designation remains until the investor disposes of the security. a principal purpose of capitalizing or otherwise funding the second-tier domestic corporation is to hold passive assets through the corporation to avoid PFIC classification. Most U.S. expats know they need to file a U.S. tax return, but they do not consider the hidden traps and factors. It is not entirely clear whether this very major change is consistent with Congresss apparent intent in 1993.2. section 1.1298-4(e)(2)(ii)does not apply for any tested foreign corporation year (including previous years) if the second-tier domestic corporation does not engage in an active U.S. trade or business that satisfies prop. All rights reserved. Executive summary. Reg. section 1.1298-4(e)(1)contains an antiabuse rule that operates as an exception to the non-passive treatment of qualified stock and related income inclusions insection 1298(b)(7). A passive foreign investment company (PFIC) is a corporation, located abroad, which exhibits either one of two conditions, based on either income or assets: At least 75% of the corporation's. Attribution of related-party activities. section 1.1298-4(e)(2)(i)applies in year 1, and the general antiabuse rule in reg. Under this election, the investor includes ordinary gains or losses each year instead of incurring an excess distribution in a later year. The bank must carry on one or more specified activities, and regularly receive bank deposits from unrelated customers in the course of those activities. reg. Please note that your decision to decline the use of cookies is limited to this site only, and not in relation to other EY sites or ey.com. MTM election. PFICs are generally foreign corporations with at least 75% passive income or at least 50% of total assets generating passive income. However, officers and employees of related entities as provided in reg. 1297(c) purposes seems sensible, as FP merely turns cash held in . Proposed regs also issued January 15 (not yet finalized) contain additional guidance on reg. Industries section 1.1298-4(e)(2)(i)(D)directs taxpayers to reg. the corporation is not a PFIC for either of the two taxable years following the start-up year. Congresscontemplated that taxpayers would plan into. Under the first safe harbor, the antiabuse rule will not apply if more than 80% of the asset FMV of the second-tier domestic corporation is used in an active U.S. trade or business as determined under modifiedsection 367rules (see prop. Additionally, the asset test noted above to determine whether a foreign corporation might be a PFIC generally evaluates the gross assets at the end of each quarter to confirm whether those assets produce passive income. US final and proposed PFIC regulations provide a mix of favorable - EY section 1.367(a)-2(d)(2),(3), and(5). section 1.1298-4(c)addresses indirect ownership of stock through partnerships. Section 1.1298-4of the final regs clarifies treatment of a tested foreign corporations 25-percent-owned domestic subsidiary and includes an antiabuse rule for taxpayers that house passive assets in domestic corporations in order to avoid PFIC status. Measuring assets. Check The Box Election & Foreign Corporation - Asena Advisors section 1.1298-4(e)(2). Mitigating the Effect of PFIC status: PFIC Informations, Tax Dispensations and QEF Choose. Most startups generally may not be talented to avoid becoming a PFIC. The passive assets may generate a small amount of income, or the domestic subsidiary may be leveraged so that its net income subject to tax is less than the gross income that would have been taken into account under the PFIC rules if the assets were held by a foreign affiliate. Alternative elective treatments are available if the PFIC furnishes necessary information (a QEF election) or if stock in the PFIC is marketable.. Becoming a Passive Foreign Investment Company. Additionally, we assist with any required tax reporting of the PFIC investment. Rep. No. reg. section 1.1298-4(a)contains a useful overview that describes the section as providing rules undersection 1298(b)(7)that apply to foreign corporations that own stock in 25-percent-owned domestic corporations for determining whether a foreign corporation is a PFIC. Passive foreign investment company - Wikipedia First, Section 954(h), which is not limited to banks, and can also cover affiliates, treats certain income derived by a CFC from an active banking, financing, or similar business as passive. section 1.1298-4(e)(1)will not apply if either of two safe harbors in prop. The accumulated earnings tax on tested foreign corporations, the U.S. corporate tax on domestic subsidiaries, and the U.S. withholding tax on distributions to tested foreign corporations already discourage tested foreign corporations from artificially overweighting their investment assets held through domestic subsidiaries. Is the company sitting on mostly cash (from a big investment round)? If US person A owns stock in corporation X, which in turn owns stock in corporation Y, which is a PFIC, Section 1298(a)(2) treats A as indirectly owning stock in Y in two, and only two, circumstances. It assumes the same facts as in example 1 except thatUSS2wholly owns domestic subsidiary USS3. 75% or more of the corporations gross income for the tax year is passive; or, at least 50% of the corporations assets (as determined under. a second-tier domestic corporation that previously satisfied the first safe harbor disposes of substantially all its active U.S. trade or business (the change of business testing date). Suppose Jeff and his friends simply put $200,000 cash into an interest-bearing account and start to develop the software, spending cash as they go. Yes, The IRS Can Sue To Collect On A Debt. A PFIC is defined as any foreign corporation for which at least 75% of the corporation's gross income is passive income (the "income test") or at least 50% of the corporation's assets produce passive income (the "asset test"). section 1.1298-4(e)(1)will apply if the principal purpose for holding passive assets throughUSS2(the second-tier domestic corporation) is to avoid classification of TFC as a PFIC. By clicking 'Yes, I accept' you agree and consent to our use of cookies. As always, I recommend utilizing the knowledge of a professional in these matters. The concept of financial [+] stability,Income Statement. The safe harbor in prop. Section 1.1297-1(f) allows taxpayers to apply the final PFIC regulations on the definition of a PFIC to all open years. We have worked with clients in over 80 different countries, but with India especially it . 1. A shareholder may choose to apply the rules for any open year beginning before that date without regard to whether the rules are applied consistently, provided that once applied, each rule must be applied for the earlier year and all subsequent years. Section 1298(e)(1)-(3)allows the adjusted basis of a controlled foreign corporations total assets to be increased by any research or experimental expense (within the meaning ofsection 174) paid by the CFC during the year and the preceding two years (minus reimbursement received), or by 300% of any licensing payments made by the CFC during the year for the use of intangible property in an active trade or business. The reader should contact his or her Ernst & Young LLP or other tax professional prior to taking any action based upon this information. Prop. Businesses that dont generate operating income in early years. Companies that are controlled foreign corporations (CFC) can avoid PFIC designation under certain circumstances. U.S. shareholders that make a MTM election are required to mark their PFIC shares to market annually. A startup with a balance sheet that is more than 50 percent cash or marketable securities could qualify as a PFIC if the assets produce passive interest income. How Best to Avoid Becoming a Passive Foreign Investment Company (PFIC). Passive income is defined as income that is of a kind [that] would be foreign personal holding company income (FPHCI) under the Subpart F rules. The final PFIC regulations reversed course by allowing a financial institution to avoid PFIC status only through the Section 1297(b)(2)(A) rules. section 1.1298-4(b)(1)are applied. What if a taxpayer owns stock in a foreign corporation that was treated as a PFIC under prior guidance, but is not a PFIC under the final PFIC regulations? One downside of this, though, is that our investments will be in USD, so there is some currency risk. Congresswas aware of the potential for taxpayers to rely onsection 1298(b)(7)to avoid PFIC status by treating otherwise passive investments as non-passive, and it intended for the accumulated earnings tax to mitigate potential abuse. Prop. The asset test for PFIC status is particularly problematic given the current environment. Reg. To receive this treatment however, a US person that would be a shareholder of the entities (under the PFIC ownership attribution rules) must also own stock in all entities that are stapled entities relative to each other. section 1.1298-4(e)(2)(ii)(B)defines testing date as the last day of the month in which either: Prop. The final PFIC regulations appear to make it impossible for a finance company to avoid PFIC status if it is not licensed as a bank. The IRS attempted to provide guidance under the bank exception in Notice 89-81, proposed regulations (Prop. The PFIC regime was enacted in 1986 to eliminate tax deferral on passive earnings of foreign corporations, whether or not closely held. The PFIC reports to be issued by RBC GAM will allow U.S. taxpayers to make an election to treat certain RBC GAM funds as Qualified Electing Funds (QEFs) on their U.S. tax returns. 9936 (pdf); Final Regulations) and proposed regulations (REG-111950-20 (pdf); 2020 Proposed Regulations) under the passive foreign investment company (PFIC) rules include provisions that significantly affect insurance companies.Those provisions include: Detailed guidance on the identification of applicable insurance liabilities, computation of the . Property used in a trade or business within the meaning of section 1231(b) is non-passive, provided the trade or business in question is one that does not produce passive income. section 1.1298-4(e)(2)(ii)(A)-(D)has a safe harbor for businesses undergoing change and for new businesses. Passive Foreign Investment Companies - The Tax Adviser sections1.1297-1and-2,1.1298-2, and1.1291-1(b)(8)(iv)and(b)(8)(v)(A)-(D)for the earlier year and all subsequent years (except that consistent treatment is not required under reg. PDF US final and regulations provide a mix of favorable and - EY