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Private Equity or Disguised PFIC?
Private equity funds frequently invest in a host of various investments, including portfolio companies organised outside the United States. Among the many challenges faced by funds investing overseas, the US passive foreign investment company (PFIC) rules under Internal Revenue Code Sections 1291-1297 can have a significant impact on your investment returns. Enacted in 1986, the PFIC rules were designed to discourage US investors from deferring tax on income generated by foreign companies investing primarily in assets that generate passive income. PFIC issues can sneak up and become effective in many ways, and can impact US investors in any private equity fund with investments in a foreign company. The punitive consequences of triggering the PFIC rules can be costly. It is very important for US investors and tax directors to monitor the status of their foreign investments to ensure they are not surprised by the PFIC rules. Taxand US examines the requirements, exceptions and warning signs associated with investing in a PFIC.
A foreign corporation will be classified as a PFIC if it satisfies the requirements of either the income test or the asset test:
- the income test is met if 75 percent or more of a foreign corporation's gross income for a particular taxable year is passive
- the asset test is met if 50 percent or more of the average value of a foreign corporation's assets either produce or are held for the production of passive income. The asset test is applied on a gross basis, without taking into account liabilities. For purposes of the asset test, the average value is computed by taking the average of either the fair market value (FMV) or the adjusted tax basis of the foreign corporation's assets at each quarter-end throughout the corporation's taxable year.
If an asset generates both passive and non-passive income, it is bifurcated between active and passive assets. There is no requirement that an arm's length appraisal be provided, but can be helpful.
Several exceptions to the PFIC rules may apply:
1. Start-up exception: The "start-up" exception applies to a foreign corporation's first taxable year in which it has gross income.
2. Qualified electing fund (QEF): For US investors who invest in a start-up PFIC that has not generated significant active income after the start-up year, a QEF election may be available.
3. Change of business: The change of business exception allows a company transitioning from one active business to another to avoid PFIC status as long as certain requirements are met.
4. Controlled foreign corporation (CFC): A foreign corporation qualifying as a CFC does not trigger the PFIC rules with regard to its US shareholders, but the PFIC rules will apply to any US investor who does not qualify as a US shareholder of a CFC.
Under the "once a PFIC always a PFIC" rule, if the US investor's holding period extends into a year that the foreign corporation no longer qualifies as a PFIC, the tax imposed under the PFIC rules will still apply for those future years, even though they, on their own, do not trigger the PFIC rules.
When investing overseas directly, or through a private equity fund, it is important to be aware of several warning signs that you may be investing in a PFIC:
1. start-up companies with little to no gross income except for interest income on their investments
2. holding companies earning dividend income from their operating entities
3. finance companies earning interest income from loans provided to entities
4. companies with substantial temporary increase in liquidity that can't be attributable to operating assets.
Before making an investment, a P.E. fund investing in a foreign portfolio company must work with that company and its own tax advisors in testing PFIC status. The consequences of unknowingly investing in a PFIC can result in unhappy US investors and concluding on PFIC status prior to investing should be part of any due diligence process. If an investment is being made in a foreign corporation that triggers the PFIC rules, knowledge of this fact can give US investors the time to file a QEF election.
A non-US company should address PFIC concerns, especially if the company has or wishes to have US investors. Under the US securities law, PFIC status may be a material factor requiring disclosure. Conversely, the foreign corporation may have no obligation to disclose PFIC status if the entity is a controlled foreign corporation for other investors. When possible, US investors should ensure the agreements they have with funds include a provision to ensure they receive notice of PFIC status of any investment, and that the fund will assist the investor in making the election. Quarterly testing throughout the life cycle of an investment in a foreign corporation is the only way to confirm PFIC status.
Your Taxand contacts for further queries are:
T. +1 415 602 2330
T. +1 404 260 4082
Jonathan S. Adelson
T. +1 646 243 0219
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