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News Analysis: The TCJA: When a PFIC Becomes a Controlled Foreign Corporation

POSTED ON Sep. 25, 2018
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The Tax Cuts and Jobs Act (P.L. 115-97) includes changes that will affect passive foreign investment companies, especially those that aren’t qualified electing funds (QEFs). New subpart F ownership rules make it easier for foreign corporations, including PFICs, to become controlled foreign corporations, and when a PFIC becomes a CFC, its shareholders must choose whether to elect out of PFIC status or be subject to CFC and PFIC rules simultaneously.

Moreover, a PFIC’s new status as a CFC causes it to be subject to new TCJA regimes that apply only to foreign corporations that are CFCs. Finally, the new PFIC rules themselves make it more difficult for insurance companies to avoid PFIC status.

The PFIC Tests

A PFIC is a foreign corporation that meets either the asset or income test in section 1297(a). The asset test is met when the corporation’s average percentage of assets that produce passive income is at least 50 percent. The income test is met when at least 75 percent of gross income is from passive activities. Passive income generally includes interest, dividends, rents, royalties, annuities, and gains from the sale of property that gives rise to those things described in section 954(c). Passive income doesn’t include income from a banking business; an insurance business by a qualified insurance company; some interest, dividends, rents, or royalties from a related person (under section 954(d)(3)); or export trade income of an export trade corporation (as defined in section 971).

The types of income caught by the PFIC definition of passive income are narrower than the types of income that are subject to the subpart F rules for CFCs, because sales and services subpart F income items aren’t passive income under the PFIC income test. Moreover, the subpart F income exception under section 954(c)(6) for specific payments received from related parties is effective until 2019, while a similar exception for PFIC passive income has no sunset date.

Unlike a CFC, PFIC status doesn’t depend on any threshold of ownership or control by U.S. persons.

If a foreign corporation directly or indirectly owns at least 25 percent of the value of the stock of another corporation, for determining whether the foreign parent corporation is a PFIC, a look-through rule causes the parent to be treated as if it owned its proportionate share of the subsidiary’s assets and received its proportionate share of the subsidiary’s income.

The most common type of PFICs held by U.S. persons are foreign mutual funds. Small-cap biotech companies conducting research can still meet the PFIC income test if they incur losses for many years and their only income is bank interest on their working capital.

Taxing PFICs

A shareholder can choose three options for taxing a PFIC, all of which generally obligate PFIC owners to either include undistributed earnings in gross income in the year earned or be subject to unfavorable tax consequences when earnings are actually distributed or the PFIC stock is sold.

The first option under section 1291 is the default method if the taxpayer does nothing. The PFIC’s prior-year earnings are taxed in the year an excess distribution occurs, at the highest tax rate for those prior years, plus interest. Excess distributions are defined in section 1291(b) as the portion of a current-year distribution that’s greater than 125 percent of the average distributions received during the three preceding tax years, or any capital gain from the sale of PFIC shares.

The amount of an excess distribution is first allocated on a per diem basis to all the days of the U.S. shareholder’s holding period for the PFIC shares. Amounts allocated to days in the current year and days in any period before the foreign corporation was a PFIC are taxed at the highest ordinary income tax rate. Amounts allocated to days in prior years in which the foreign corporation was a PFIC are the basis for a deferred tax amount that consists of a tax and an interest charge. Distributions below the 125 percent threshold are treated as dividends taxable in the year of receipt and aren’t subject to prior highest tax rates or the interest charge.

The second option applies to shareholders who make an election under section 1295 to have the PFIC treated as a QEF under section 1293. QEF shareholders include in gross income their pro rata shares of ordinary income and capital gains, but not losses. The QEF election must be made on or before the due date of the shareholder’s tax return, and may be made only if the shareholder agrees to comply with reporting requirements. The QEF election generally allows a shareholder to elect to be taxed currently on its share of the PFIC’s earnings rather than endure the PFIC’s excess distribution and deferred tax amount regimes. Moreover, U.S. corporations owning at least 10 percent of a QEF still get an indirect foreign tax credit under section 1293(f).

The third option is the mark-to-market election under section 1296: A U.S. person who owns marketable stock in a PFIC can recognize unrealized gain or loss in the shares annually by including as ordinary income the excess of the fair market value of the stock over its adjusted basis, or deducting the reverse as an ordinary loss (up to the amount of reported gains). The PFIC stock’s basis is adjusted upward for gains and downward for losses.

That election may be made for the PFIC only for current and future years. Marketable stock is defined in section 1296(e) as any stock regularly traded on a national securities exchange regulated by the SEC or other exchange identified by the Treasury secretary, corporations comparable to regulated investment companies, and specific options.

As a practical matter, most PFIC shareholders make a QEF election. A shareholder making a QEF election for its entire holding period (a pedigreed QEF) isn’t subject to section 1291 default rules. If a QEF election is made for a year after the shareholder’s first date of ownership (an unpedigreed QEF), the section 1291 and QEF rules apply simultaneously.

Changes to the ownership attribution rules in subpart F to determine CFC status allow stock of a foreign corporation owned by a foreign person to be attributed to a related U.S. person. Also, the 10 percent U.S. shareholder ownership rules were broadened to include both vote and value. Broader ownership and attribution rules will cause more PFICs to also become CFCs.

Either or Both?

Generally, if a U.S. person owns less than 10 percent of a CFC that is also a PFIC, it will be treated as a PFIC for that person. But if the shareholder is a U.S. shareholder as defined in section 951(b), and the corporation is a CFC as defined in section 957, the result is a combination of the “CFC trumps PFIC” rule in section 1297(d) and the “once a PFIC always a PFIC” rule in section 1298(b)(1).

Under section 1297(d), a PFIC won’t be treated as a PFIC by a shareholder during any period when the PFIC is a CFC (under section 957) and the shareholder is a U.S. shareholder (under section 951). The portion of the holding period when the PFIC is also a CFC and the shareholder is a U.S. shareholder is called the “qualified portion” of the holding period.

Section 1298(b)(1) provides that stock will be treated as stock in a PFIC if at any time during the taxpayer’s holding period, the corporation was a PFIC and not a QEF. That rule won’t apply, however, if the taxpayer elects to recognize gain under rules of section 1291(d)(2) that apply to QEF elections, which generally mean electing to recognize income either as a deemed dividend by the PFIC, or as gain from a deemed sale of PFIC stock. After the elections, the PFIC is considered a pedigreed QEF.

Section 1291 and 1297 regulations generally support the notion that a foreign corporation is a PFIC if it qualifies as a PFIC on the first day the PFIC becomes a CFC, and the corporation is a PFIC under section 1298(b)(1) because at some point during the shareholder’s holding period, it was a PFIC that wasn’t a QEF. In other words, the PFIC rules of section 1291 continue to apply until a purging election — either a deemed sale or a deemed dividend election — is made. If no election is made, shareholders will be subject to both the PFIC and CFC rules. Some PFIC shareholders must file Form 8621, and CFC shareholders must file Form 5471.

PFIC shareholders must file Form 8621 if they receive specific distributions from a PFIC, recognize gain on a disposition of PFIC stock, report information for a QEF or mark-to-market election, make a purging election, or are required to file an annual report under section 1298(f). If a shareholder isn’t required to file Form 8621, but the PFIC stock is worth more than $50,000, the shareholder must file form 8938.

Deemed Dividend and Sale Elections

The deemed sale election under section 1291(d)(2)(A) will be treated as a disposition of PFIC stock on the date the PFIC became a CFC. The gain is subject to tax under section 1291 as an excess distribution, and losses aren’t recognized. After the deemed sale, the stock won’t be treated as PFIC stock any longer unless the corporation ceases to be a CFC and still meets the definition of a PFIC. Adjusted basis in the stock is increased by the gain recognized. The shareholder must file both Form 8621 (to make the election) and Form 5471 in the year of the deemed sale.

A deemed dividend election under section 1291(d)(2)(B) is also made on Form 8621. A shareholder may elect to include in gross income as a dividend received an amount equal to the corporation’s earnings and profits. The deemed dividend is also treated as an excess distribution that increases the shareholder’s basis in the stock.

According to section 1298 regulations, a shareholder of a former PFIC can always make a deemed sale election. In other words, any shareholder of a corporation that was a PFIC and ceases to be can make the deemed sale election, whether the corporation stopped being a PFIC because it became a CFC or because it stopped meeting the income and asset tests.

However, a shareholder can’t make the deemed dividend election if the former PFIC isn’t a CFC. A shareholder of a foreign corporation that is a former PFIC can make the deemed dividend election only if the foreign corporation was a CFC during its last tax year as a PFIC. A shareholder can make the deemed dividend election without regard to whether the shareholder is a section 951(b) U.S. shareholder.

If the corporation’s earnings are low and asset values are high, shareholders are generally better off with a deemed dividend election. In those cases, a deemed sale election comes at an especially high price if the shareholder hasn’t received any cash distributions from the company. If the PFIC is also a CFC, however, shareholders can make the deemed dividend election and possibly pay zero tax for the privilege of not having a PFIC. In that way, U.S. tax law gives more favorable treatment to PFICs that are also CFCs. But there are additional consequences under the TCJA when a PFIC becomes a CFC — some favorable and some not.

For example, domestic corporate shareholders of PFICs are not allowed to take the deduction for dividends received from foreign corporations under sections 245 (U.S.-source dividends) and 245A (foreign-source dividends). Under section 245, qualified 10-percent-owned foreign corporations don’t include PFICs at all; section 245A states that specified 10-percent-owned foreign corporations don’t include corporations that are PFICs and aren’t CFCs. In other words, only PFICs that become CFCs will qualify for the 100 percent dividends received deduction.

On the other hand, only PFICs that are CFCs will have global intangible low-taxed income under section 951A and be subject to the transition tax in section 965.

Insurance Income

Before the TCJA was enacted, passive income didn’t include any income earned in the active conduct of an insurance business by a corporation predominantly engaged in an insurance business subject to tax under subchapter L if it were a U.S. corporation.

New section 1297(f) defines the term “qualified insurance company” to mean a foreign corporation that would be subject to tax under subchapter L if it were a domestic corporation (as under prior law). However, a new test is added that requires the insurance company’s applicable insurance liabilities to constitute more than 25 percent of its total assets, determined based on liabilities and assets as reported on the corporation’s financial statements. That means that insurance companies having liabilities that are a small percentage of total assets could suddenly be PFICs, which especially concerns companies insuring risks that have high payout but low probability.

If a corporation fails to qualify as a qualified insurance corporation solely because the liability-asset percentage is too low, a U.S. person owning stock in the corporation can still elect to treat it as a qualified insurance corporation if the liability-asset percentage is at least 10 percent, the facts and circumstances show that the corporation is predominantly engaged in an insurance business, and the liability-asset percentage test isn’t met solely because of runoff- or rating-related circumstances. Insurance companies having liabilities that are less than 10 percent of assets will always be PFICs.

The definition of a qualifying insurance corporation will likely subject more foreign corporations to the PFIC rules. (Prior coverage: Tax Notes Int’l, May 21, 2018.) Without a QEF election, U.S. investors in those foreign corporations will now be subject to the PFIC rules but can elect to be pedigreed QEFs. If these PFICs also become CFCs, they will be subject to the subpart F insurance provisions in sections 952(a)(1), 953, and 954(i).