A 21st Century PFIC Regime: Must All Working Capital Be Passive?

By Brian Barner, J.D., LL.M.; Julie Olivas, J.D., LL.M.; and Camille Shoff, J.D., LL.M., San José, Calif.

Editor: Kevin D. Anderson, CPA, J.D.

Foreign Income & Taxpayers

Since the enactment of the passive foreign investment company (PFIC) statutes in 1986, the global economy has undergone a dramatic reorientation toward services and information technology. This change has been accompanied by the rise of venture capital. But the draconian penalties of the PFIC rules risk pushing U.S. investors toward missing the proverbial "information age" boat. U.S. investors have been discouraged from investing in foreign startup companies because the IRS has interpreted the PFIC rules to encompass active companies that are in a startup mode for several years, including, for example, technology and internet service companies, biotechnology companies, and companies engaged in long-term infrastructure, such as mining or oil and gas exploration projects.

Background of PFIC Provisions

As evidenced by the legislative history of the PFIC provisions and the General Explanation of the Tax Reform Act of 1986 released by the Joint Committee on Taxation (JCS-10-87 at p. 1023 (May 4, 1987)), the PFIC provisions target U.S. investments in passive foreign funds that would otherwise receive indefinite deferral. A foreign company is deemed a PFIC under Sec. 1297(a) when 75% of the income is passive or when 50% of assets (generally by value) produce or are held to produce passive income. The term "passive income" is defined in Sec. 1297(b)(1) as "any income which is of a kind which would be foreign personal holding company income [FPHCI] as defined in section 954(c)."

Notice 88-22 created significant problems for young foreign enterprises that have plenty of private venture capital (or recently underwent an initial public offering). This capital is often meant for active business purposes-not for passive investing. However, the notice summarily declared all working capital to be passive, without providing any rationale for this treatment. These companies are not the foreign mutual funds that Congress intended to target, yet the notice's result is clear.

The exception in Sec. 1298(b)(2) for startup companies that is aimed at preventing a nascent active business from being misclassified as a PFIC is of little use because it applies only to the first tax year that the corporation has any gross income (e.g., a few dollars of interest on seed capital).

This problem may come to a head now that Treasury has issued Temp. Regs. Sec. 1.1298-1T, requiring U.S. PFIC shareholders to file annual ownership reports on revised Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund , for tax years ending on Dec. 31, 2013, or later. Treasury has not, however, issued any regulations that clarify what is, and is not, a PFIC when startup cash is the culprit. Given the dearth of practical guidance, this item provides suggestions for the IRS in crafting PFIC regulations and for taxpayers who are caught by the outdated interpretation of Notice 88-22.

Policy Considerations for the IRS

For many other purposes of the Code, cash is generally treated as a business asset to the extent held as working capital to be devoted to the business (see generally N.Y. City Bar Ass'n, Report Offering Proposed Guidance Regarding the Passive Foreign Investment Company Rules , 34-35 (9/21/09)). Additionally, regulations under Sec. 864(c) provide that an asset, including cash, is ordinarily treated as held for use in a trade or business if it is held as working capital. Similarly, under Sec. 1202(e)(6), the exclusion from gross income of gain from qualified small business stock provides that assets held to meet reasonable working capital needs (or invested short term for future research and development expenses or increases in working capital) constitute part of an active small business corporation.

A particularly suitable analogy can be found in the accumulated earnings tax rules. A report from the New York State Bar Association Tax Section, Report on Proposals for Guidance With Respect to Passive Foreign Investment Companies , at 26-40 (5/22/01), has a series of proposals for adopting the unreasonable accumulation of earnings test to PFICs. But, as noted in Sec. 532(b)(3), PFICs are specifically excluded from the accumulated earnings tax. Sec. 533(a) provides that cash held for the "reasonable needs of the business" is excluded from earnings taken into account for purposes of the tax. As stated in Sec. 532(a), the accumulated earnings tax is generally imposed on the accumulated taxable income of a corporation formed or availed of for the purpose of its shareholders avoiding income tax through accumulating, rather than distributing its earnings and profits.

The policy reasons for the accumu lated earnings tax are similar to PFICs- both sets of rules are intended to apply to a corporation that is holding liquid assets for investment, rather than its active business needs (see H.R. Rep't No. 100-795, 100th Cong., 2d Sess., at 273 (1988)), describing the accumulated earnings tax rules as "essentially equivalent" to the PFIC rules). The accumulated earnings tax, which has been the law since 1913, has a large body of regulations, case law, and guidance that can be applied in the PFIC context. For example, Regs. Sec. 1.537-1(b)(1) provides that, to justify retaining amounts for the future needs of the business, the corporation must have "specific, definite, and feasible plans for the use" of the retained amounts within a reasonable time.

Considerations for Taxpayers in the Interim

In other areas, the Code characterizes assets based on reality rather than fiat. For example, in the asset-based apportionment methods described in Temp. Regs. Sec. 1.861-9T(g)(3), assets are characterized according to the source and type of income the assets generate or can reasonably be expected to generate (see also Notice 88-22: "[A]n asset will be characterized as passive if it has generated (or is reasonably expected to generate in the reasonably foreseeable future) passive income"). FPHCI classification under Sec. 954(c)(1)(B)(i) (gains or losses on the sale of property) is also based on the type of income that an asset tends to create. Similarly, a foreign company's cash and other current assets should be characterized according to the types of income that they generate, or can reasonably be expected to generate.

Assets can be apportioned to more than one basket of income (see Notice 88-22: "Assets which generate both passive and nonpassive income in a taxable year shall be treated as partly passive and partly nonpassive assets in proportion to the relative amounts of income generated by those assets in that year"). For example, not all working capital produces interest income. Foreign currency may also produce foreign currency exchange gain, which in some situations is a nonpassive asset (see Trinova Corp. , T.C. Memo. 1997-100).

Bringing things full circle, there is an exception to FPHCI in Sec. 954(c)(1)(D) and Regs. Sec. 1.954-2(g)(2)(ii)(A) for foreign exchange gain or loss from a transaction "directly related to the business needs" of the foreign company. To qualify for this specific exception, Regs. Secs. 1.954-2(g)(2)(ii)(B)(1)(i) and (ii) provide that the foreign exchange gain must arise from a transaction entered into or property used in the normal course of business and must not otherwise produce subpart F income (e.g., selling equipment). Even if foreign currency itself generally fails to qualify for the business needs exception because it otherwise produces subpart F income (i.e., interest), an election is available to exclude the foreign exchange gain from FPHCI. A company may elect under Regs. Sec. 1.954-2(g)(3) to include the foreign exchange gain in the category (or categories) of subpart F income to which such gain relates.

Arguably, so long as the foreign exchange property is "used or held for use" in the normal course of business to give rise to a type of subpart F income that is non-FPHCI (e.g., foreign base company sales or services income), the election may exclude the foreign exchange holdings from being considered passive assets for PFIC purposes. For example, a foreign company may elect to exclude from FPHCI any foreign exchange gain from working capital sitting in a non-interest-bearing account (thus not giving rise to interest income) and held to purchase inventory used in the ordinary course of business to produce sales income. Moreover, working capital in an interest-bearing account located in a high-tax jurisdiction may not be passive income either, because of the exception to FPHCI for "high-taxed" income described in Sec. 904(d)(2)(B)(iii)(II).


Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.

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