Funds with U.S. investors, U.S. family offices, and individual U.S. investors (collectively, “U.S. Investors”) must be cognizant of whether their foreign investment in private companies is an investment in a passive foreign investment company (“PFIC”). Typically, a foreign portfolio company would be classified as a corporation for U.S. income tax purposes unless an election was made to have it taxed otherwise. The issue with PFICs is that unless certain elections are made, distributions from a PFIC may be subject to an excess distribution regime resulting in a punitive tax and interest charge. In certain bad circumstances, the punitive tax and interest charge can be the amount of the distribution.
To avoid this extremely negative U.S. tax result, it is important for the U.S. Investor to understand whether the investment is a PFIC from the beginning. In making investments into foreign portfolio companies, it is becoming more common for the U.S. Investors to push the PFIC testing to the foreign portfolio company and require the foreign portfolio company to use one of the large accounting firms to perform the PFIC testing. This often results in the large accounting firm using one of their non-U.S. based offices to perform the PFIC testing and charging the foreign portfolio company an exorbitant fee for outsourced work resulting in a simplistic email stating the foreign corporation should not be considered a PFIC.
Without the background on the basis for the opinion, is there sufficient basis for reliance on the email finding? At Praestans, we bring U.S. tax attorneys and U.S. CPAs together to complete the PFIC testing to provide the foreign portfolio company a more substantiated basis for the determination of PFIC or non-PFIC status. If done any other way, is there really a good faith basis to rely on non-U.S. professionals for such a technical U.S. tax determination?
A foreign portfolio company will be a PFIC if it satisfies either the income or asset test. Under the income test, if 75 percent or more of the corporation’s gross income for its taxable year is passive income then it is a PFIC. Under the asset test, if at least 50 percent of the averaging percentage of assets held by the foreign portfolio company during the tax year are assets that produce passive income or that are held for production of passive income then it is a PFIC.
The asset test presents issues for the typical technology foreign portfolio company since a lot of its assets can be held in cash or working capital. Working capital is considered a passive asset under the PFIC asset test and there is only a very limited exception from this classification. Without understanding how to test the rest of the company’s assets, the requirement that working capital is a passive asset usually results in the technology foreign portfolio company being classified as a PFIC.
If PFIC classification is unavoidable or it is determined a protective election should be made, it is often advantageous for the U.S. Investors to make a qualifying electing fund (“QEF”) election in order to avoid the excess distribution tax regime. The QEF election can only be made if the foreign portfolio company can provide the U.S. Investors with the required information to report under the QEF requirements. Given the required U.S. legal and U.S. accounting knowledge required for QEF reporting, it is important that the team include U.S. tax attorneys and accountants with the required knowledge to complete the reporting. This is our approach at Praestans.
It is essential for U.S. Investors to receive accurate PFIC testing from their foreign portfolio companies. Typically, foreign portfolio companies overspend on a large accounting firm that offshores the work with limited analysis for the position which the U.S. Investor is to rely on. At Praestans, we get the needed legal and accounting professionals to handle the PFIC testing to ensure it is done correctly, as whether a foreign portfolio company is a PFIC or not and the ability to make certain elections are essential to the U.S. Investor’s return. The PFIC testing is too important to be treated as a side item to be checked off with a simplistic analysis.
Praestans Global Advisors is neither a law firm nor a CPA firm.
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