Ownership of Interest in Non-U.S. Corporations by Persons Who Are Residents of the United States: Watch Out for the Traps

Ownership of Interest in Non-U.S. Corporations by Persons Who Are Residents of the United States: Watch Out for the Traps
Ami Kothari and Dean Demos, KPMG LLP, Stamford, and Kyle Kauffman, KPMG LLP, Washington National Tax
(KPMG LLP in the United States is a KPMG International member firm)

A U.S. citizen or any foreign individual who is a U.S. resident is required to file Form 1040, a U.S. resident individual income tax return. As part of this requirement, the individual may be subject to unfavorable current taxation of income earned with respect to certain foreign corporations, including, in some cases, undistributed corporate income. Additionally, the individual is required to disclose direct or indirect ownership in certain foreign corporations on an informational return. These requirements can pose problems for a foreign national that has not had his or her holdings analyzed by a U.S. tax professional prior to arrival in the United States.

There are general rules that need to be considered when dealing with foreign investments in entities that are classified as Controlled Foreign Corporations (CFC); Foreign Personal Holding Companies (FPHC); and Passive Foreign Investment Companies (PFIC). Generally, for U.S. tax purposes, a shareholder of a corporation is not taxed on income earned by the corporation until that income is distributed as a dividend. There are special tax rules (anti-deferral regimes) that apply to CFCs, FPHCs, and PFICs, that may modify the normal rules of taxation. Under the rules that govern these three types of foreign corporations, a U.S. resident may be taxed currently on undistributed income earned by the foreign corporation or may be subjected to a deferred tax amount, which may include an interest charge for the time period that taxation is deferred. This unexpected tax liability will increase the shareholder's worldwide tax burden immediately, and thus, increase the cost of the international assignment.

Do you know people who have ownership in foreign corporations? With more and more people transferring to and from overseas, there is a good chance that you know someone in this situation. Below, we describe the general definitions and rules associated with the above types of foreign corporations and the potential traps international assignees can fall into with respect to their related investments.

Controlled Foreign Corporation

If a U.S. resident invests in a foreign corporation that is determined to be a CFC, the Subpart F regime of the Internal Revenue Code (IRC) may require the U.S. resident to include in gross income a deemed dividend equal to the shareholder's pro rata share of the foreign corporation's Subpart F income (e.g., certain dividends, interest, rents, royalties, capital gains, and earnings invested in certain U.S. property). The Subpart F rules will apply to a U.S. resident with investments in foreign corporations if three tests are satisfied:

The foreign corporation must be considered a CFC for an uninterrupted period of at least 30 days;
The U.S. resident must be considered a U.S. shareholder and own stock in the CFC at the end of the CFC's tax year; and
The foreign corporation earns certain specified types of income.

Test 1 — A foreign corporation is considered a CFC if, on any day during the foreign corporation's taxable year, more than 50 percent of the combined voting power of all classes of stock or more than 50 percent of the value of the foreign corporation is owned by U.S. shareholders. If a foreign corporation is a CFC for an uninterrupted period of at least 30 days, all U.S. shareholders of that foreign corporation will be subject to the Subpart F regime.

Test 2 — A U.S. resident will be considered a "U.S. shareholder" if he or she owns directly, indirectly, or constructively 10 percent or more of the combined voting power of all classes of stock of the foreign corporation. Subpart F attributes stock owned by lineal family members (e.g., spouse, parents, grandparents, and children, but not brothers and sisters) as stock owned by the taxpayer. However, stock owned by a nonresident alien is not attributable to a citizen or resident alien.

Observation: Stock owned by a nonresident alien may not be attributable to his or her resident spouse.

Test 3 — A U.S. shareholder of a CFC is taxed under Subpart F on a pro rata share of specified income such as certain interest, dividends, royalties, rents, annuities, and certain gains from the sale or exchange of property (i.e., "Subpart F income").

In general, a pro rata share consists of the amount that the shareholder would have received if, on the last day of the taxable year, the CFC had actually distributed a dividend equal to the CFC's Subpart F income. This amount is reduced if the foreign corporation was a CFC for only a portion of the year, or if the U.S. shareholder acquired the CFC's stock at some point during the year.

When individuals fall into this trap, and are subject to taxation under the Subpart F regime, there is a possibility that all of the CFC's deferred income may become taxable currently. Furthermore, unless an election is made, no foreign tax credit is available to individual shareholders to offset the U.S. tax liability incurred on the deemed distribution. Thus, where an assignee, who is a U.S. resident, is taxed on his or her pro rata share of the CFC's earnings in the current year, and the tax equalization policy in effect holds the employer responsible for all U.S. taxes, the cost of the employee's U.S. assignment may be substantially increased. Elections are available that may mitigate the individual's U.S. tax liability, thereby reducing potential assignment costs. A tax advisor should be consulted to determine what, if any, election is beneficial under client specific circumstances.

Foreign Personal Holding Companies

FPHC rules apply to a U.S. resident who is a shareholder in a foreign corporation if the foreign corporation meets the following stock ownership and gross income tests:

More than 50 percent of the total combined voting power or value of all classes of stock of the foreign corporation must be owned directly or indirectly by five or fewer individuals who are U.S. residents or citizens.

Observation: Unlike a CFC, FPHC stock ownership is attributed not only to lineal family members (spouse, parents, grandparent and children), but to brothers and sisters as well. Also, FPHC stock owned by a nonresident alien is attributable to a spouse that is a U.S. resident. Therefore, a foreign corporation can be a FPHC and not a CFC.

Sixty percent or more of the foreign corporation's gross income must be FPHC income which generally includes rent, royalties, and annuities. (It also includes the net gains from sales of property that (a) give rise to this type of income, (b) is an interest in a trust, partnership, or REMIC, or (c) give rise to no income at all.)

Observation: Once an entity is a FPHC, the gross income test is satisfied in any following year if at least 50 percent of the gross income constitutes FPHC income.

Essentially, all U.S. residents who are shareholders of a FPHC on the last day of the corporation's taxable year must report as dividends his or her pro rata share of the FPHC's undistributed income (with a few adjustments) for the year. As a result, U.S. shareholders are taxed currently on both the passive investment income and any active business profits of the FPHC. Like investing in a CFC, the income deferral of a corporation is lost and absent a certain timely election, no foreign tax credit relief is available to offset the U.S. tax on the deemed dividend inclusion. In the assignment context, this may increase the total cost of an employee's U.S. assignment where the employer is responsible for U.S. tax costs. A KPMG tax advisor should be consulted to determine what, if any, election is available to mitigate the U.S. tax liability.

Observation: When Subpart F (CFC) and FPHC rules apply to the same item of income, and the item is included in the U.S. shareholder's income under Subpart F, it will not be taxed again as FPHC income.

Passive Foreign Investment Companies

The PFIC rules apply to any U.S. resident who is a shareholder in a foreign corporation if the foreign corporation meets the definition of a PFIC. A foreign corporation is considered a PFIC if either:

75 percent or more of its gross income is passive income; or
The average market value of the corporation's passive assets during the taxable year is at least 50 percent of the corporation's total assets.

Passive income includes, but is not limited to, interest, dividends, passive rents and royalties, net gains arising from the sale of property producing passive income, and the excess of foreign currency gains over foreign currency losses.

A U.S. resident is considered a shareholder of a foreign corporation for PFIC purposes if he or she directly or indirectly owns stock in the foreign corporation. Unlike CFCs or FPHCs, there is no de minimis U.S. ownership requirement for an entity to be considered a PFIC. Therefore, if a U.S. shareholder owns an interest in a foreign corporation that meets the income or asset test, he or she owns an interest in a PFIC even if his or her ownership is minimal. Once a corporation is classified as a PFIC, it will continue to be so, even if the corporation ceases to meet either the income or asset test. In addition, under the appropriate circumstances, a foreign corporation that is also a CFC will be subject to tax under the Subpart F rules only, and not the PFIC regime.

Observation: A common PFIC trap is an investment in a foreign mutual fund. An individual who owns just a single share in a foreign mutual fund will be subject to the PFIC rules if the foreign company meets the income or asset test.

A U.S. investor who owns stock in a PFIC is taxed at ordinary income tax rates on the actual receipt of an "excess distributions" (a term defined by the IRC) from the PFIC. Although a portion of the excess distribution payment may include capital gain, the U.S. shareholder will not be allowed to take advantage of the lower, more favorable, capital gains tax rates with respect to this income. The excess distribution amount is treated as if it had been realized pro rata over the U.S. shareholder's holding period of the PFIC's stock. Amounts allocated to the current year, to years before the company was a PFIC with respect the shareholder, and any year prior to 1987 (when the PFIC regime was not yet in effect), are included in ordinary income in the U.S. shareholder's current tax year.

Observation: A corporation will not be treated as a PFIC for those days in the shareholder's holding period before the shareholder became a U.S. resident.

The remaining amounts are not included in the U.S. shareholder's income, but are used to calculate a charge referred to as the "deferred tax amount." Specifically, a tax is imposed on amounts allocated to prior PFIC years equal to the highest marginal rate in effect for those years. This tax rate is imposed without regard to the U.S. shareholder's actual tax rate, deductions or credits for the applicable year. In addition, interest is charged to offset any tax deferral benefit a U.S. shareholder may have otherwise realized. The tax and interest make up what is known as the "deferred tax amount" which is added to the U.S. shareholder's U.S. tax liability for the current year. A U.S. shareholder may claim a foreign tax credit with respect to any withholding taxes that may be imposed on the actual distribution by a PFIC.

The application of the excess distribution regime is illustrated in the following example:

A foreign national invests in a foreign mutual fund on January 1, 1996. The foreign national accepts an assignment to the United States, and becomes a U.S. resident beginning January 1, 1997. For the years 1997 through 2001, the foreign mutual fund meets the definition of a PFIC. In 2001, an actual distribution of USD 6,000 is made by the mutual fund and the payment meets the definition of an excess distribution.

The USD 6,000 distribution is treated as if it has been earned ratably over the shareholder's six-year holding period from 1996 through 2001, or USD 1,000 per year. Two thousand dollars (USD 2,000) of the distribution is included by the U.S. shareholder as ordinary income in the current year. This includes the USD 1,000 attributable to the current year, 2001, and the USD 1,000 attributed to the 1996 tax year (for 1996 the corporation is not treated as a PFIC because this portion of the shareholder's holding period is prior to the him becoming a U.S. resident). No penalty is imposed on this portion of the distribution because the U.S. shareholder did not receive any tax deferral benefit for amounts earned in the current year, 2001, or for amounts earned before he became a U.S. resident subject to the PFIC regime.

However, a "deferred tax amount" is calculated for amounts attributable to years 1997 through 2000. First, tax is imposed on the USD 1,000 allocated to each of the four tax years 1997 through 2000, at the highest marginal rate in effect for those years (e.g., 39.6 percent) without regard to the U.S. shareholder's actual marginal rate of tax for that year. In addition, interest is charged (i.e., the interest the U.S. shareholder would have paid had he paid the tax late for the year). The interest charge is imposed to offset the deferral benefits for each of the four years. The sum of the tax imposed and the interest charge (the "deferred tax amount") is added to the U.S. shareholder's 2001 U.S. tax liability. (Note: While USD 4,000 of the excess distribution is allocated to years 1997 through 2000, this amount is never included in the U.S. shareholder's income for the year, but is used only as a basis for calculating the deferred tax amount). Additionally, a foreign tax credit may be claimed for any foreign withholding taxes paid.

Unfortunately, disposing of the PFIC shares after the individual becomes a U.S. resident will not remedy the problem. If a U.S. shareholder attempts to dispose of his or her PFIC shares, all gain recognized on the sale is treated as an excess distribution that is subject to tax at ordinary rates rather than the more favorable capital gain rates.

Observation: When a U.S. resident, (not a U.S. citizen), changes his or her residence to a location outside the United States, the change of residence would trigger a deemed disposition of the PFIC stock, under regulations proposed in 1992 but not yet in effect.

There are, however, two elections that a U.S. shareholder can make to mitigate the tax burden of PFIC stock ownership: (1) the qualified electing fund, or (2) the mark-to-market election.

Qualified Electing Funds (QEF)
A U.S. shareholder may elect to have the PFIC treated as a qualified electing fund (QEF), and as a result, the U.S. shareholder is freed from the onerous PFIC taxing regime. Generally, under the QEF regime, the U.S. shareholder is subject to tax currently on his or her pro rata share of the PFIC's undistributed income (including non-passive income). In other words, the U.S. shareholder will have a current-year income inclusion that is treated as ordinary income to the extent of his or her pro rata share of the QEF's ordinary income, and capital gains to the extent of his or her pro rata share of the QEF's net capital gain. To prevent double taxation, any actual distributions made by a QEF out of its previously taxed earnings and profits are tax-free to the U.S. shareholder. Like the CFC and FPHC rules, no foreign tax credits are available to offset the U.S. shareholder's U.S. tax liability incurred on the deemed distributions from a QEF.

The QEF election should be made the first year the corporation becomes a PFIC, since an election at a later date requires a deemed sale of the PFIC stock with all its consequences.

Observation: To make a QEF election, the shareholder must obtain certain information from the PFIC, including an agreement to allow the IRS to examine the PFIC's books and records. However, obtaining the necessary information from the foreign corporation can prove to be difficult, especially for minority shareholders. This requirement often eliminates the U.S. shareholder's ability to make a QEF election.

Mark-to-Market Election
The mark-to-market election extends the current-income inclusion method to PFIC shareholders who own marketable stock in the PFIC. Marketable stock is generally stock that is regularly traded on a recognized stock exchange. Stockholders who are not able to obtain from the PFIC the information necessary to make a QEF election may welcome this election.

If a mark-to-market election is made, any excess of the fair market value of the PFIC shares at the close of the tax year over the U.S. shareholder's adjusted basis in the shares is included in the U.S. shareholder's income. The U.S. shareholder may deduct losses if the stock's adjusted basis exceeds its fair market value, but only to the extent the net mark-to-market gains were included in income by the U.S. shareholder in prior tax years. Any income or loss recognized under the mark-to-market election is treated as ordinary income.

If the individual makes a mark-to-market election for the PFIC shares, and the company has been a PFIC for all or any part of the period the shareholder held his or her shares, the U.S. resident may suffer negative tax consequences. Coordination rules are in place for U.S. shareholders who wish to make the mark-to-market election for PFIC shares held (for which a QEF was not made in prior years) to make sure shareholders do not avoid the interest charge with respect to amounts attributable to periods before the election.

Conclusion

In summary, a foreign national who has investments in foreign corporations and does not plan appropriately prior to arriving in the United States may face compliance issues and be exposed to higher taxation than otherwise necessary. What was expected to be deferred income becomes taxed currently. If the individual is tax equalized back to his or her home country, the odds are the company will pay the additional taxes, thus increasing the costs of the international assignment. Either way, the company or the assignee will pay unrecoverable taxes — a situation that could have been avoided with some thoughtful planning.