PFIC/CFC Overlap: Not Out of the Woods Yet

In 1997, taxpayers breathed a collective sigh of relief when Congress eliminated a significant headache by enacting the PFIC/CFC overlap rule in Sec. 1297(e), which coordinates the passive foreign investment company (PFIC) and the controlled foreign corporation (CFC) anti-deferral regimes. A U.S. person directly, indirectly or constructively owning 10% or more of the voting power of a CFCs stock (U.S. shareholder) may (depending on its direct and indirect stock holdings) be required to currently recognize certain subpart F income (generally, passive and mobile income) earned by the CFC, thus negating the opportunity for deferral. Under Sec. 957, a CFC is generally any foreign corporation if U.S. shareholders (as defined above) own (directly, indirectly or constructively) more than 50% of the corporations stock (measured by vote or value).

Under Sec. 1297, a PFIC, by contrast, is any foreign corporation meeting either an income test (i.e., 75% or more of its income is passive) or an asset test (i.e., 50% or more of its assets produce passive income). In general, U.S. persons owning stockeven one shareof a PFIC may be subject to tax at top marginal rates, plus an interest charge on certain distributions on, and dispositions of, PFIC stock. Taxpayers may generally avoid the interest charge regime via either a qualified electing fund (QEF) or a mark-to-market election, which generally requires the taxpayer to currently include in income its share of the PFICs earnings or the appreciation in value of the PFIC stock, respectively.

A foreign corporation may be a PFIC and a CFC in any one tax year. Before 1997, it was likely that a shareholder of a foreign corporation could be subject to both the PFIC and CFC regimes on the same investment. Recognizing that applying CFC and PFIC rules to the same investment created unnecessary complexity for taxpayers, the Taxpayer Relief Act of 1997 (TRA 97) enacted Sec. 1297(e) to eliminate the application of the PFIC rules to U.S. shareholders of CFCs. Sec. 1297(e) operates by treating the CFC as not a PFIC with respect to a U.S. shareholder, thus eliminating the prior overlap between the two taxing regimes.

Recently the Joint Committee on Taxation (JCT) drew attention to the seemingly imperfect coordination of the PFIC and CFC regimes under Sec. 1297(e) and recommended certain changes; see JCT, Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JCS-3-03, February 2003) (Enron Report). The Enron Report noted that the exemption from the PFIC rules is based on a persons status as a U.S. shareholder (i.e., 10% voting shareholders as defined in Sec. 951(b)), as opposed to the likelihood of taxation under the CFC regime. The JCT recommended that the exception to the PFIC rules for U.S. shareholders of CFCs be geared more closely to the U.S. shareholders potential taxability under the CFC regime, by precluding application of the PFIC/CFC overlap rule when the likelihood that a U.S. shareholder would have to include income under the CFC provisions is remote. Although the Enron Report mentioned that Congress largely eliminated the overlap to mitigate complexity, it neglected to point out two traps that may ensnare the unwary: tiered PFICs and options to acquire PFIC stock.

Example 1: A U.S. corporation, US1, owns 20% of a foreign corporation, FC1. An unrelated U.S. person, US2, owns 60% of FC1, and an unrelated foreign person, FP, owns 20%. Thus, FC1 is a CFC, and US1 and US2 are U.S. shareholders. FC1 would also be a PFIC under either the income or asset test, but is not treated as such as to both US1 and US2 under Sec. 1297(e). FC1s only asset is 50% of the stock of FC2, which is not a CFC, but is a PFIC under the income or asset test. An unrelated foreign person owns the remaining 50% of FC2.

A taxpayer can be subject to the PFIC rules for stock held indirectly. Under the PFIC attribution rule of Sec. 1298(a)(2)(A), if a person owns 50% or more in value of a non-PFIC corporation directly or indirectly, that person is considered to own a proportionate share of the stock owned by that corporation. According to Sec. 1298(a)(2)(B), however, no such 50% threshold exists for a person owning stock in a PFIC. Thus, if a person owns stock in a PFIC, such person generally is considered to own a proportionate share of any stock owned by the PFIC.

In applying Sec. 1298(a)(2)(B) to Example 1, US1 owns 10% (20% of 50%) of FC2, also a PFIC. Because US1 is a U.S. shareholder and FC1 is a CFC, FC1 is not a PFIC as to US1 under the PFIC/CFC overlap rule. Because US1 owns less than 50% of FC1, an assumption might be made that US1 is not considered to own any FC2 stock under Sec. 1298(a)(2)(A). The last sentence of Sec. 1298(a)(2)(B), however, states that Sec. 1297(e) does not apply in determining whether a corporation is a PFIC for purposes of the attribution rules. Thus, the CFC status of an intermediate foreign corporation does not preclude attribution if such corporation is also a PFIC. Hence, for US1, FC1s status as a CFC does not prevent attribution of FC1s FC2 stock to US1. As such, US1 would be subject to the PFIC rules for its indirect ownership of FC2 stock through FC1. Because US2 owns more than 50% of FC1, US2 would be deemed to own a proportionate share of the FC2 stock owned by FC1 by application of Sec. 1298(a)(2)(A), regardless of FC1s status as a CFC. This rule demonstrates that the potentially broad PFIC/CFC overlap rule is substantially narrowed in certain unexpected instances.

Example 2: A foreign person, FP1, owns 40% of a foreign corporation, FC1; another foreign person, FP2, owns 60% of FC1. FC1 is a PFIC. FC1 owns 100% of the stock of another PFIC, FC2. A U.S. corporation, US1, has an option to purchase all of the FC1 stock owned by FP2, but otherwise does not own any FC1 or FC2 stock.

Under the CFC regime, a U.S. person that holds an option to acquire foreign company stock is treated as owning the stock subject to the option for purposes of determining whether the option holder is a U.S. shareholder and the foreign company is a CFC; see Secs. 318(a)(4) and 958. Merely holding an option, however, will not cause the holder to have an income inclusion under Sec. 951(a), because U.S. persons can be U.S. shareholders and subject to Sec. 951(a) solely via direct and indirect (but not constructive) ownership; see Secs. 318(a)(4), 958 and 951(a)(1). Thus, in Example 2, FC1 is a CFC and, even though US1 is a U.S. shareholder because of its option to purchase FP2s stock in FC1, it would not have to include any income under the CFC regime until the option is exercised.

Under Sec. 1298(a)(4), an option holder is considered to actually own the stock subject to the option. As FC1 is a PFIC and US1 has an option to acquire that stock, under Sec. 1298(a)(4), US1 is considered to actually own the FC1 stock subject to the option. Because US1 is a U.S. shareholder and FC1 is a CFC, US1 might assume that FC1 is not a PFIC as to US1 under the PFIC/CFC overlap rule. Due to Sec. 1297(e)(4), however, Sec. 1297(e)(1) does not apply; thus, US1 is subject to the PFIC provisions.

Under the TRA 97, a person with an option to purchase stock in a foreign entity that was a PFIC/CFC was not subject to the PFIC rules. In early 1998, however, Congress amended the TRA 97 by adding Sec. 1297(e)(4), which provides that the general rule of Sec. 1297(e)(1) does not apply to stock treated as owned by a person under Sec. 1298(a)(4), unless the option holder establishes that the actual owner of the stock is a U.S. shareholder (under Sec. 951(b)) not exempt from U.S. tax. Thus, FC1 is treated as a PFIC and is not subject to the PFIC/CFC overlap rule, because the actual owners (i.e., FP1 and FP2) are not U.S. shareholders under Sec. 951(b). US1 is accordingly treated as owning an interest in FC1, a PFIC, under Sec. 1298(a)(4). Interestingly, US1 is also treated as owning the shares of the second-tier PFIC, FC2, under the attribution rules discussed above.

A close analysis of Sec. 1297(e) demonstrates that Congress contemplated the JCTs concerns that a U.S. shareholder of a CFC might evade the PFIC provisions without being subject to an inclusion under the CFC regime. In Example 2, US1 is a U.S. shareholder and FC1 is a CFC, and hence both are nominally subject to the CFC regime. Under Sec. 1297(e)(4), however, PFIC status is avoided only if the stocks actual owner is a U.S. shareholder not exempt from tax. Thus, though US1 and FC1 are nominally subject to the CFC regime, the PFIC/CFC overlap rule is inapplicable and US1 is subject to the PFIC rules. Congress has thus considered some of the concerns raised by the Enron Report, but opted for a more objective test.

Although Congress apparently intended to eliminate the PFIC/CFC overlap, it lives on and the headaches continue. The Enron Report merely scratches the surface of the tortured complexity of what is supposed to be a taxpayer-friendly rule.

From Chris Bowers, J.D., Robert Laudeman, J.D., LL.M., Sarah Fitzgerald, J.D. and Jeffrey Cowan, J.D., LL.M., Washington, DC