In the previous posts we introduced the passive foreign investment company (PFIC) rules and discussed how they are treated for taxation purposes. We touched on how to determine if a fund is a PFIC and the most common type of PFIC. In this post we’ll describe the look-through rules that are in place to determine if a U.S. person has PFIC ownership through other entities. (Note that for tax purposes, a U.S. person can be an individual taxpayer, a corporation, or another type of entity.)
The most common type of PFIC owner is a U.S. person who directly owns foreign mutual funds. The PFIC regime, however, contains three look-through rules that can also trigger PFIC reporting requirements. These look-through rules can either be applied in favor of the taxpayer or against the taxpayer, and are very complicated. We’ll briefly discuss each rule but it is important to note that further examination and analysis is required in each applicable situation.
The subsidiary look-through rule is applied in determining whether a foreign corporation that owns subsidiary corporations is a PFIC. Under this rule, the foreign corporation is deemed to hold its proportionate share of the assets and to receive its proportionate share of the income from subsidiaries in which it owns 25% or more of the stock.
To illustrate, while at first glance a foreign corporation that primarily holds stock of other corporations might appear to be a PFIC, the subsidiary look-through rule is in place to prevent a holding corporation that owns active trades and businesses through subsidiaries from being classified as a PFIC. This rule is typically beneficial to the taxpayer but can also be applied against the taxpayer. For example, a foreign corporation engaged in an active business could be treated as a PFIC if it owns a 25% or greater share in a subsidiary having passive assets or income, and the amount of the subsidiary’s passive assets or income is enough to cause the parent corporation to be a PFIC.
The second look-through rule involves related persons. Passive income does not include interest, dividends, rents, or royalties received from a related person to the extent allocable to non-passive income of the related person. In general, a person is a related person with respect to a foreign company if such person controls or is controlled by the foreign company, or is controlled by the same person or persons which control the foreign company. The related party rules and the allocation calculations are complex and beyond the scope of this blog. What is important to note is that if passive income is being received from a related party, these look-through rules should be explored.
The third and final rule is the domestic corporation look-through rule. This rule is intended to alleviate the potential difference in tax treatment between U.S. persons who hold their investments through U.S. holding companies and those who hold their investments through foreign holding companies. Under this rule, if a foreign company is subject to the accumulated earnings tax (because of a failure to distribute enough earnings to its shareholders) and owns at least 25% of a domestic corporation’s shares, then the subsidiary look-through rule mentioned above does not apply. Alternatively, any U.S. stock held by the domestic corporation that is owned by the foreign corporation is not considered a passive asset nor is its income considered passive when applying the asset and income tests for determining PFIC classification. Therefore, any foreign company that would otherwise be considered a PFIC would not be considered a PFIC after applying this rule. Instead, they are subject to the accumulated earnings tax in the same manner as domestic corporations.
Although it is important to understand the basics of the look-through rules that determine potential PFIC reporting requirements, they are very intricate and complex. We recommend you consult with a tax professional in applying the concepts of the look-through rules discussed in this post.