Phantom menace

Steven Bortnick is a partner in the tax practice group of law firm Pepper Hamilton. He can be reached atbortnicks@pepperlaw.com. Benjamin Hussa is an associate in the firm's tax group, and can be reached at hussab@pepperlaw.com.

One of the primary goals in structuring cross-border private equity transactions is to avoid the recognition of phantom income (or dry income) – taxable income without cash receipts. When an investment fund that has US investors invests outside the US, the fund has to consider various US anti-tax deferral regimes. The comprehensive rules applicable to controlled foreign corporations get much of the attention in this respect. However, the passive foreign investment company (PFIC) rules have to be considered and, in some cases, apply to a broad scope of investors and in ways that may surprise many investors. This article discusses some of the problems with PFICs.

Generally, investment in a corporation does not generate phantom income. Shareholders typically are not taxed until the corporation distributes cash or the shareholders sell stock.

What is a PFIC?
A non-US corporation is a PFIC if either (i) 75 percent or more of its gross income for the year is from passive sources, such as interest, dividends, capital gains and royalties or (ii) 50 percent or more of its average gross assets generate passive income or are held to eventually generate passive income. There are certain exceptions for start-up corporations in their first year of operation if the corporations are not PFICs in either of the succeeding two years, as well as exceptions for foreign corporations with active insurance or banking businesses. In addition, there is a look-through rule for passive investments in subsidiary corporations. Under this rule, if a foreign corporation owns at least 25 percent of another entity, the foreign corporation is treated as owning a proportionate share of the assets of the other entity and earning its proportionate share of the income of the other entity for purposes of determining if the entity is a PFIC.

What's the big deal?
Absent certain elections, described below, US shareholders of a PFIC are not required to include income of the PFIC before they receive distributions from the PFIC or sell the stock of a PFIC. However, the PFIC rules create a punitive scheme for taxing deferred income. Excess distributions (i.e., distributions at least 125 percent greater than the average distributions over a three year period) are taxed assuming that the distribution was received ratably over the shareholder's holding period for the shares. Income apportioned to prior years when the foreign corporation was a PFIC is taxed at the highest applicable tax rate in effect for such years, and is subject to an interest charge on the tax deemed to have been deferred. Income apportioned to the current year or to years before the foreign corporation became a PFIC is taxed at current ordinary income rates. Additionally, excess distributions are taxed as just described whether or not the PFIC has any earnings (as opposed to distributions from non-PFICs, which are treated as dividends only to the extent of current or accumulated earnings and profits). Dividends from a PFIC (whether or not excess distributions) are not treated as qualified dividends, and, thus do not qualify for the 15 percent rate of tax in the hands of individuals. Moreover, capital gains on the sale of PFICs are treated as excess distributions. Accordingly, capital gains (which are taxed at the favorable 15 percent rate in the hands of individuals) are converted into ordinary income and subjected to the interest charge.

The Treasury Department is authorized to issue regulations that would treat otherwise tax-free transactions such as mergers and other reorganizations involving PFICs as taxable. Over 15 years ago, proposed regulations were drafted that generally treat such transactions as tax-free if they involve a PFIC and after the transaction, the surviving corporation (or corporation in which the PFIC owner receives stock) is not a PFIC. Although these regulations have never been finalized, they are proposed to apply retroactively once enacted. Accordingly, the taxpayer who engages in such a transaction is betting that the statute of limitations will expire before the regulations are finalized. Given the track record here, that may not be a bad bet.

Importantly, any US shareholder of a PFIC is subject to these rules. Unlike the rules applicable to controlled foreign corporations, there is no minimum ownership requirement by any US person or by US persons in the aggregate. A US person who owns even a single share of stock of a PFIC must deal with these rules. However, a US person who owns 10 percent of the voting stock of a PFIC which also is a CFC will not be subject to the PFIC rules, because the controlled foreign corporation rules (which have the same anti-deferral goal, but often work differently) will apply.

Avoiding PFIC rules by agreeing to phantom income – the QEF election
As the intention of the PFIC regime is to avoid deferral of tax through the use of foreign corporations, it is not surprising that the rules can be avoided by agreeing to accelerate income. The statute allows U.S. taxpayers to make an election to have their investment in a PFIC be taxed as a qualified electing fund (QEF). In the case where an investment fund is a PFIC shareholder, if the fund itself is domestic (e.g., a Delaware partnership), then the investment fund makes the QEF election. If the fund is a foreign partnership, then each US partner (including partners who share in carry) in the investment fund that wants to make the QEF election makes the election for itself.

A US person who makes a QEF election must include in income each year the sum of (1) its pro-rata share of the ordinary earnings of the PFIC for the year, plus (2) its pro-rata share of the net capital gain of the PFIC for the year. Ordinary earnings are essentially earnings and profits of the PFIC, determined under US tax principals, with certain adjustments. Ordinary earnings are taxed as ordinary income to the US taxpayer making the QEF election. Net capital gain is the excess of net long-term capital gains over net short-term capital losses of the PFIC for the year, and are taxed as long-term capital gains in the hands of the US taxpayer making the QEF election. If the fund itself made the QEF election, the income, and character thereof, recognized by the fund as a result of the QEF election will flow through to its investors. Though the flow through of character of the income is generally favorable, losses incurred by the PFIC do not flow through to investors who make QEF elections with respect thereto, and otherwise qualified dividends received by the PFIC will flow through as ordinary earnings, and will not be entitled to special tax rates in the hands of US individual investors.

The general rule is “once a PFIC always a PFIC.” In other words, except for the start-up exception, which treats an entity as not being a PFIC in its initial year of operations if it is not a PFIC in the two succeeding years, the rules discussed above for PFICs apply even if in future years the corporation no longer satisfies the criteria for being considered a PFIC. However, once a QEF election is made, the taxpayer need only include ordinary earnings and net capital gain in years in which the QEF otherwise would be treated as a PFIC.

When a taxpayer includes income as a result of making a QEF election, its basis in the stock of the QEF is increased. Moreover, distributions from the QEF are tax free to the extent of previously-taxed income. Such tax-free distributions reduce the taxpayer's basis in the QEF. This series of rules ensures that the QEF rules only accelerate income inclusion, but do not result in double taxation.

By agreeing to include income as it is recognized by the fund, the US taxpayer can avoid converting capital gain into ordinary income, avoid the interest charge on the deemed deferral of taxable income, avoid paying tax on returns of capital, and have tax-free transactions involving PFICs respected as tax-free. An additional election is available for QEFs. Rather than paying the tax currently, the US taxpayer may agree to include the ordinary earnings and net capital gain of a QEF in income, and defer the payment of the related tax until certain exit events, such as the disposal of the stock of the PFIC, a distribution of the cash or a pledge of the PFIC shares. The taxpayer must pay interest on the tax deferred. Where the QEF election is made by a domestic partnership, the election to pay tax upon an exit event may be separately made by the partners.

Special rules for US tax-exempt shareholders
Regulations clarify that the PFIC rules do not apply to tax-exempt investors, unless a dividend from the PFIC would constitute unrelated business taxable income (UBTI) (e.g., because the tax-exempt organization or a fund in which the tax-exempt organization is an investor incurred indebtedness with respect to the investment in the PFIC). Additionally, a QEF election made by a tax-exempt investor is ignored if dividends from the PFIC would not be UBTI. Similarly, a tax-exempt investor in a US fund that made a QEF election is not required to include any income as a result of the QEF election unless dividends from the PFIC would be UBTI.

Certain planning tools
Determining that a portfolio company is or will be a PFIC is not the end of the planning around the issue. When investing in a PFIC, an investment fund likely will want to ensure that it can obtain the information necessary to make and implement a QEF election. Where the investment fund does not control the foreign corporation, it is important that the stock purchase or shareholders' agreements provide the fund access to the books and records or otherwise provide the fund with information necessary to determine the income inclusions under the rules for QEFs. US tax regulations require that in order for a QEF election to be made, the foreign company generally must agree to make its books and records available for shareholder review in order to establish that the company's earning have been computed in accordance with US income tax principles.

Certain planning tools may be available to minimize the income to be included pursuant to a QEF election. For example, a 338 election (i.e., an election to treat the purchase of stock as a purchase of assets), when available, will result in a step up in the basis of the assets of the PFIC to fair market value for US tax purposes. For purposes of determining ordinary earnings, this stepped up basis will be used in determining depreciation and amortization (including amortization of goodwill generated in the acquisition) deductions, often reducing ordinary earnings compared to what they would be in the absence of such an election.

Additionally, the ability to elect to treat wholly-owned entities as disregarded for US tax purposes may be useful. For example, intercompany dividends and interest from and among foreign subsidiaries could be ignored if the payor was a disregarded subsidiary of the recipient.