US Government Bond Interest is Not “Passive” PFIC Income for Foreign Banks

Background

A Passive Foreign Investment Company, or PFIC, is a foreign corporation where passive income constitutes 75% or more of gross income during a year. A corporation is also considered to be a PFIC if 50% or more of corporate assets are held for production of passive income.

The PFIC rules deter taxpayers from seeking unlimited income tax deferral inside foreign corporations. They also seek to limit the ability of investors to convert ordinary income into capital gains through the same foreign entities. The PFIC rules impose a hefty interest charge on any deferred payments within a PFIC, and they treat all PFIC distributions as ordinary income regardless of its capital gains status.

In trying to determine if a foreign corporation might be classified as a PFIC, it is important for this discussion to know that income that is derived from “active banking” is excluded from the definition of “passive income.” In other words, banks are allowed to engage in banking activities without the threat of income from those activities being classified as passive, and without the banks being deemed PFICs. For investors, that means you can invest in foreign banks without the risk of hefty charges and the loss of capital gains status under the PFIC tax laws. This exception exists as a policy matter, so that investors in the US won’t fear investing in foreign bank shares.

The Problem

In recent years, economies have been shaky and foreign banks have invested quite heavily in US government securities (bond investments produce passive, non-banking income), rather than putting those funds to work in “active banking” (lending, etc.). The question this forces is, whether the increased degree of passive income in the foreign banks push them over the limit and trigger the harsh application of the PFIC rules? Will foreign banks be deemed PFICs, and will US taxpayers be punished with harsh charges on those investments?

The Solution

To address this question, the IRS issued a notice in late June of 2012. The notice stated that for tax years 2011 thru 2013, income from certain government bonds held by “active banks” will be treated as if it was earned from active banking. Thus, foreign banks can invest in US government securities, US taxpayers can invest in foreign banks, and otherwise passive income from the banks’ US securities investments will be ignored for PFIC determination.

It is important to understand that this does not avoid investor income tax obligations, but rather the imposition of the burdensome PFIC tax penalties. Essentially the IRS is recognizing that in the current global economic environment (low interest rates, soft economies, etc.) banks are going to need to invest more in government securities. Foreign banks investing in US government bonds are not having that income interest counted as passive income, and US investors are being allowed to avoid PFIC penalties on investments in these foreign banks.

Tax-wise Timing of Incentive Options Taxation in a Foreign Country

Many US expatriates work for foreign companies operating under foreign tax regimes. Sometimes the interplay of US and foreign tax laws can become quite complex. One example that requires special planning is in the area of equity incentive compensation by stock options.

For example, many foreign countries income tax an employee’s incentives stock options at the time of grant. The US income taxes the worldwide income of US expatriates, and, more specifically, recognizes incentive stock options that are given to an employee not at the time of grant, but at the time they are exercised. If the year of exercise is in a later tax year than the year of grant, the foreign jurisdiction would impose a tax in the year of grant, and the US would impose a tax in the year of exercise. There would be no foreign income tax credit for the options in the year of exercise since that tax was imposed in a prior year. This would result in very unfortunate double taxation!

Fortunately, there is a way to avoid this terrible outcome. The US expatriate should make an Internal Revenue Code section 83(b) election upon grant of the options. This code section permits taxpayers to make an election to recognize options as income, recognized at the time of the grant, rather than at the later time of option exercise. Doing this should sidestep the double taxation issue by bringing foreign and US income taxation of the options into the same year and allowing the foreign tax credit to offset US income tax on the options.

An additional benefit of making the election is that any gain realized between option grant and exercise would be taxed at the preferential capital gains rate instead of at the ordinary income tax rate.

Example—Double Taxation!

Assume a $1 million option grant is made to a US expatriate, residing in a foreign country. Assume, as well, that the applicable US income tax rate is 35% and that the foreign rate is 20%. At the time the options are granted, foreign income tax would be due in the amount of 20% of $1 million, or $200,000. In the next year, the US expatriate exercised the options, and the US tax is triggered in the amount of 35% of $1 million, or $350,000. Total taxes paid are about $550,000!

Example—83(b) Election, No Double Taxation!

Same facts as above with the exception that the US expatriate elects for the options to be taxed by the US at the time of grant (instead of at the time of exercise). US taxes would be 35% of $1 million and foreign taxes would be 20% of $1 million. On the surface this looks like $550,000 in taxes, just like the previous example. However, since both taxes applied in the same year, the foreign tax credit is triggered to offset US taxes in an amount up to the amount of foreign taxes already paid. Thus, $200,000 in foreign taxes paid is credited against the US tax burden of $350,000, leaving a US taxes owed at only $150,000. The final tax rate is only $350,000 ($150,000 to the US and $200,000 to the foreign jurisdiction).

Separately, it is noteworthy that if a foreign tax is imposed at option grant, rather than at exercise, there is a chance that the options might be taxed and yet expire worthless before they can be exercised in-the-money.

Options can be complex. International taxation can be complex. Combine the two and expert assistance is essential.

Introduction to Controlled Foreign Corporations

Introduction

US persons are taxed on their worldwide income.  Normally, a US person who owns shares of a foreign corporation will only recognize income when and to the extent that the foreign corporation pays dividends to the US person.  Many years ago, US persons seized upon this, formed their own foreign corporation, contributed their assets to the corporation, and made no dividend distributions to themselves.  As the corporation owned the assets and the corporation made no dividend distributions, the US person had no income to recognize.  The foreign corporation itself sidestepped US taxation by not having any US-sourced income.  Eventually, Congress got wise to what was occurring and put into place the Controlled Foreign Corporation (CFC) rules.  The CFC rules prevent US persons from sidestepping income taxes in such a manner.

The Rules

If a corporation is deemed a “Controlled Foreign Corporation” (CFC), then the internal revenue code requires that all net income earned by the CFC is reported proportionally to all “US Shareholders” regardless of whether the income was actually distributed. Essentially, the CFC would be treated like a pass-through entity—all income would be treated, proportionally, as the income of the US Shareholders.

Thus, the US shareholders would have to pay taxes on the income, even if it was not distributed! This closes the tax-dodging loophole that would otherwise be open to US taxpayers.

These provisions only apply if the definitions of a “CFC” and of a “US Shareholder” are met.

  • A foreign corporation is a CFC if more than 50% of the voting stock, or more than 50% of the stock’s value, are owned by US shareholders.
  • A US Shareholder is a US person owning at least 10% of the voting stock.
    • A foreign corporation owned by a sole US person will always be deemed a CFC (the owner will be a US Shareholder with a 100% interest).

The CFC Analysis Asks…

Are there US Shareholders who collectively own MORE than 50% of the voting stock in the foreign corporation? If so, it is a CFC, and the US Shareholders need to pay taxes on undistributed earnings.

The following foreign ownership arrangements are NOT CFCs (no US Shareholders, or US Shareholders do not collectively own 50% of the voting stock). As such, no taxes would have to be paid on undistributed earnings.

  • 11 unrelated individuals own equal interests in the corporation (No US Shareholders because nobody owns 10%).
    • If these 11 were related, or were partners, then it WOULD be a CFC, because they would be deemed to be one US Shareholder, owning 100%.
    • 1 shareholder owns 50%, 6 shareholders own the other 50% equally (only one US Shareholder, and his total ownership is NOT greater than 50%).
    • There are various indirect ownership and constructive ownership rules that can introduce additional complexity to the CFC ownership analysis.

Strategies

Avoid being a US Shareholder—Only invest in less than a 10% interest in foreign corporations to avoid being a US Shareholder. This way, even if a corporation is a CFC, you won’t pay tax on undistributed income.

Avoid CFC Status—If you want to invest in 10%+ of a foreign corporation (you would be a US Shareholder) then be sure the cumulative interest of you and any other US Shareholders is no more than 50% of ownership.

Watch out for ways the IRS could lump your interest in with others to create US Investors and CFCs (partnerships, investment funds, and investments by related individuals are treated as one US Shareholder if their interest is at least 10%).

Note that these strategies do not protect an investor from taxation on dividends that are distributed, but from taxation on undistributed foreign corporation profits.

Also note that even if a foreign corporation is not deemed to be a CFC, there is a separate set of rules that can also result in a heavy tax burden for companies that are deemed to be a Passive Foreign Investment Company (PFIC). The PFIC rules are discussed in a separate article (click here).

Information Returns

The law requires information returns to be filed with the IRS for taxpayers with foreign ownership interests that meet certain criteria. Failure to file can result in harsh and expensive penalties. This can be problematic because some of the required information may not be easily accessed and because the forms are becoming increasingly complex.

Taxation of Investors in Passive Foreign Investment Companies (PFICs)

Introduction

US persons are taxed on their worldwide income.  Normally, a US person who owns shares of a foreign corporation will only recognize income when and to the extent that the foreign corporation pays dividends to the US person.  Many years ago, US persons seized upon this, formed their own foreign corporation, contributed their assets to the corporation, and made no dividend distributions to themselves.  As the corporation owned the assets and the corporation made no dividend distributions, the US person had no income to recognize.  The foreign corporation itself sidestepped US taxation by not having any US-sourced income.  Eventually, Congress got wise to what was occurring and put into place the Controlled Foreign Corporation (CFC) rules.  The CFC rules prevent US persons from sidestepping income taxes in such a manner.

We discuss CFCs in greater depth in another article (click here).

After Congress adopted the CFC rules, non-recognition of income was still on the minds of some US persons.  If one gathered a large enough pool of investors — 11 or more equal shareholders — a corporation would avoid characterization as a controlled foreign corporation.  In such a case, shareholders would only recognize income if and to the extent that dividends were actually paid.  Congress was fit to be tied.

The challenge for Congress was to discern between a foreign operating company — such as Sony or British Telecom — and a foreign company that was formed specifically for investment and shielding of income.  Moreover, Congress needed to discern between publicly traded foreign investment companies (a.k.a. mutual funds) and private foreign investment companies.

Enter the Passive Foreign Investment Company rules.

The Rules

There are two tests for a PFIC. If either is met, a foreign corporation is a PFIC.

The Income Test: A foreign corporation is a PFIC if 75%+ of its income is passive (dividends, rents, interest, etc.).

  • Income derived from certain industries is excluded from “passive income” (thus side-stepping PFIC classification) including:
    • Foreign banking business by a bank that is also licensed as a bank in the US,
    • Foreign insurance business by a corporation that would be taxed for its activities if it were a domestic corporation, AND
    • Export trade corporations.

The Asset Test: A foreign corporation will also be a PFIC if 50%+ of its assets are held for production of passive income.

A “look through” rule applies to subsidiaries. If a foreign corporation has at least a 25% interest in a subsidiary, then a proportionate percentage of the subsidiary’s passive income and assets will be included as if they were the parent corporation’s income and assets for PFIC testing purposes.

What Happens to US Investors if a Foreign Corporation is a PFIC?

There are three possibilities.

If a US investor in a PFIC makes a timely Qualified Electing Fund Election (QEF Election) then the PFIC’s proportional income will be treated as pass-through income to the investor. In this case, any gains on sale of the stock would get capital gains treatment.

Alternatively, a US investor could elect to defer payment of taxes (or simply fail to make a QEF Election) until capital gains are realized upon sale or until an “excess distribution” is made. The problem here is that the deferred payments incur a hefty interest charge for every year that income was not reported and taxed. Also, all income would be treated as ordinary with no capital gains rates applied at sale. An “excess distribution” is made when a distribution is more than 25% higher than the average distributions received during the preceding three years of the investor’s holding period. Deferred interest penalties can actually compound over a long holding period to such an extent that interest penalties exceed the amount of gain and income the investor would receive from the investment!

Finally, a US investor can make a “mark to market” election. A US investor holding a PFIC stock that is listed on a recognized stock exchange may elect to recognize gains and losses each year on the difference between basis and end of year fair market value. In this case, PFIC shares are not eligible for the qualified dividend tax rate.

Because the IRS usually does not have income filings from a PFIC to show the character of earnings (ordinary, capital gains, etc.), all distributions from a PFIC will normally be deemed taxable as ordinary income.

It should be noted that US-based non-profit organizations typically do not need to worry about the PFIC rules.

Take Home…

If you are going to invest in a PFIC be sure to make a QEF Election to avoid the awful deferred interest regime. Alternatively, it may be best not to invest in passive foreign investment vehicles.

Foreign Earned Income Exclusion for US Persons

Introduction
US persons are taxed on their worldwide income. As a matter of public policy, when a US person has foreign-sourced income, the United States seeks to avoid the double-taxation of that income. That is, Congress does not want the US government to impose taxes on top of a foreign government’s tax. To that end, the Internal Revenue Code grants a foreign tax credit. The rules regarding the foreign tax credit are complex and are discussed in another article.

Also as a matter of public policy, the Congress wants US persons to be competitive in the global employment market. To that end, the Internal Revenue Code excludes a certain amount of foreign earned income from reportable wages.  The amount is $75,000 per year indexed to inflation. In 2011, that amount was $92,900.

While US persons working abroad will still be subject to taxation in their country of employment, there is the potential of paying less overall tax.

Various Rules

  • To qualify for the exclusion a taxpayer must be a “qualified individual” (live abroad for 330+ days w/in 12 mos.).
  • The taxpayer’s regular place of business must be abroad (with “residence” determined by: intent, home abroad established for indefinite time period, participation in community activities, etc.).
  • Taxpayer’s compensation must be for personal services while actually abroad.
  • Only up to 30% of income may be excluded if personal services AND capital (plant, machinery, income) are “material income producers” – where personal services are not the only foreign income producing element.
  • One cannot claim an exclusion in excess of the foreign income earned. So, if you only earned $50,000 of foreign earned income, the maximum exclusion would be $50,000.
  • The exclusion only applies to “earned” income (for personal services performed), and does not apply to passive income paid from foreign sources such as from dividends, rents, and interests.

 

Social Security Taxation for US Persons Working in a Foreign Location

For US persons who work in a foreign country for a US company or for a foreign company, there are unique rules for social security taxes.

Background
International social security agreements (called “totalization agreements”) have two primary purposes:
1.    Eliminate dual social security taxation on earnings in circumstances where a person from one country works in another country and both countries could tax the earnings.
2.    To provide social security benefit protection for workers who have divided their careers between the US and another country.

General Social Security Tax Rule
Generally, an employee who could be covered by both the US and foreign social security systems is subject only to the coverage of the country where the employee works (“Territoriality Rule”).

Exception to the Rule for Temporary Assignments (“Detached Workers”)
Under the “Detached Worker Exception,” an employee who is transferred to work for his employer, in another country, for five or fewer years, remains covered only by their home country. Under this exception, the employee and employer continue paying social security taxes only to the US system.

The same exception applies if a company transfers an employee to work for one of its foreign affiliates, but, in that case, the company must enter an agreement with the US Treasury Department. The agreement would extend social security coverage to US persons who works for foreign affiliates of the company. Under such agreements, the American employer pays the amounts equivalent to the employer and employee’s share of FICA for compensation that would be considered FICA wages.

General Rule Applicable for Permanent Assignments (not “Detached Workers”)
In the case of an employee who is permanently transferred (more than 5 years) by the US employer to work in the foreign country, the US person’s wages would be subject only the the foreign social security taxes. This remains true, for permanently transferred employees, even if the company had already entered into a section 3121(l) agreeement regarding that individual employee. In other words, the detached worker rule does not apply here because the employee would be transferred “permanently” (not for five years or less).

US Person Working in a Foreign Country for a Foreign Company
As stated in the general rule above, a US person (ordinarily subject to US taxes) who lives in another country while working for a foreign company (that may not be subject to US taxing authority) will not be subject to both US and foreign social security taxes, if there is a totalization agreement between the two coutnries. Normally, the only social security taxes paid are to the country where the employee is working.

For further details, see the  Social Security Administration’s website is here.

Medicare Benefits Abroad

Does your Medicare Coverage cover you while you are living or traveling abroad? Unfortunately, the answer is most likely going to be no. Original Medicare Coverage includes all 50 states, and U.S. territories (U.S. Virgin Islands, Guam, American Samoa, and the Northern Mariana Islands), but outside of those locations, your medical care probably will not be covered. While you are living abroad, if you remain current on your Medicare Part B premium payments, you can maintain your coverage, but again, that is only for medical care provided in the United States.

In certain cases, Medicare will cover hospital expenses in Canada and Mexico. If you are living in the United States and the hospital in Canada or Mexico is closer than a hospital in the United States, your medical care will be covered. Also, if you have an emergency while traveling in a direct route from Alaska, through Canada, to another state, without unreasonable delay, you can treat the emergency at a Canadian hospital if it is closer than the nearest U.S. hospital. If you do receive health care in a foreign hospital under these circumstances, that hospital can, but is not required to file Medicare claims for you. If the hospital does not file the claim for you, it is your responsibility to have an itemized bill submitted to Medicare for the services you received.

Another possible exception is if you are covered by Medicare Part B while on a cruise ship. If the cruise ship is within six hours of a U.S. port, and the doctor is allowed to provide medical services under certain laws, then your care will be covered.

There is one option that you have for coverage while you are abroad, and that is Medigap. Medigap Plans C, D, F, G, M and N will cover emergency health care coverage when you are traveling outside the United States. Plans E, H, I, and J also provide foreign coverage; however, these plans are no longer for sale. So what coverage do these plans provide? They will cover 80% of medically necessary emergency care after a $250 annual deductible is met. Note that there is a lifetime limit of $50,000 for this foreign travel emergency coverage, and for the care to be covered, it must begin within the first 60 days of your trip. If you would like medical coverage while living abroad, you will need to obtain such coverage through a different provider.

An Introduction to Currency Taxation

A basic understanding of currency exchange principles is critical for U.S. expatriates, international business people, and global investors.

U.S. tax liability is determined in U.S. dollars. Because currency values change relative to one another, many tax issues arise when currencies are bought and sold. Last month, we discussed general factors affecting relative currency values and currency exchange rates. This month we will look at general questions of currency exchange taxation:

  • If foreign currency is purchased and the value of that currency goes up prior to sale (you get more dollars back than you started with), is that gain taxed as a capital gain or as ordinary income?
  • If foreign earned income is exchanged for dollars (no gain on invested capital), how is that taxed? And, what if foreign earned-income is never exchanged for dollars, how is tax computed in that case?

Gain on Sale of Currency: Ordinary Income

Long-term capital gains income is usually taxed at a lower rate than ordinary income (which is taxed at an individual’s marginal tax rate). When foreign currency is purchased and later disposed of, as an investment or as a hedge, the gain or loss on the disposition (sale) of that foreign currency will be taxed as ordinary income. This is distinct from the purchase and later sale of other investment assets, which typically get capital gains treatment. The reason for ordinary income treatment of currency transactions is that Congress views currency fluctuations as tied to interest rate changes. Thus, the fluctuations are taxed as if they were interest earned, as ordinary income.

Taxation of Foreign Currency Wages

If a U.S. citizen earns income (paid in foreign currency) for work performed for a foreign company, the income may be converted to U.S. dollars (often called “translation”). The U.S. income tax rules would apply to the dollar amount calculated from the average annual exchange rate determined at the end of the year. In such cases, there is no gain or loss because there is no initial conversion from dollars and no purchase of assets, just translation of foreign currency income into U.S. dollars. This end-of-year “translation” to U.S. dollars occurs whether or not a U.S. citizen taxpayer has actually exchanged the foreign currency for dollars.

In other words, if a U.S. citizen is paid in foreign currency, and never converts that income into U.S. dollars, the U.S. dollar tax calculation will be based on the average, hypothetical, annual exchange rate.

Gain on Sale of Foreign Assets Purchased in Translated Foreign Currency

The next principle is easiest to explain with an example. Suppose a U.S. citizen converts $100k to Japanese yen so that he can buy a condo. A few years later the citizen sells the condo for a gain. By that time the value of yen increased resulting in a gain (in dollars) upon conversion of the yen back into dollars. In such cases, each transaction is treated separately. The gain on the sale of the condo (capital gains treatment) would get separate tax treatment from the gain on the currency (ordinary income treatment).

Personal Currency Transactions

Personal currency transactions (those not for business or investment purposes, as for a vacation) receive distinct tax treatment. Currency gains or losses less than $200 are de minimis and have no tax effect. If the gain is higher, then it is taxable as a capital gain (not as ordinary income, as above). Losses on currency exchanges from non-profit-seeking endeavors are normally not deductible. Similarly, a currency gain on the sale of a personal residence (sold in foreign currency) in a foreign country is taxable, but a currency loss on the repayment of the mortgage would not be deductible.

At Integrated Wealth Counsel, LLC, we serve our clients by helping them to navigate through the complex issues of international taxation, international investing, and expatriate financial planning.

Why The “Tax Holiday” For Corporations Is Bad

Some U.S.-based corporations have business operations outside the United States.  Often, those non-U.S. operations are conducted by subsidiaries of the U.S. firm.  Those subsidiaries are typically organized in the jurisdiction in which they operate.  The income of each non-U.S. subsidiary is taxed by the jurisdiction in which it derives income.  However, the income is not subject to U.S. income tax until such income is repatriated (bought back into the United States).

Some individuals assert if the cash that remains outside of the United States were to be repatriated, it would spur jobs growth.  Others discount the idea.  Those who support the idea suggest that the Federal government should have a “tax holiday” to encourage the repatriation and thus jobs growth.  Those who discount the idea say a “tax holiday” would allow yet another unfair tax break for corporations.

We oppose the “tax holiday” because a “holiday” implies that corporations should normally be taxed by the United States on their non-U.S. income.  The “holiday” should in fact be the norm.  Indeed, virtually every other country in the world operates contrary to the U.S. tax system in this respect.  And, the Organization for Economic Cooperation & Development (OECD) has been working with U.S. Treasury officials for some time to move U.S. tax policy in line with the rest of the world.

Virtually all other countries only tax income derived from their respective country.  For example, consider a German company with operations in Germany, France, and Italy.  The firm will pay German tax on profits derived in Germany, French tax on profits derived in France, and Italian tax on profits derived in Italy.  It will not pay tax to Germany on its worldwide profits.

U.S. companies will pay income tax in foreign jurisdictions.  They will also pay income tax to the United States on their worldwide income.  To sidestep double-taxation – which the U.S. does not want to impose on businesses – the United States grants a foreign tax credit.  While U.S. firms don’t suffer double-taxation, under the U.S. tax system, they end up paying the higher of the two countries’ tax rates.  This is what the OECD is complaining about.

The OECD seeks to harmonize tax and trade policies.  When such policies are not harmonized, we see companies not be able to deploy capital efficiently and other problems.  U.S. cash being held overseas is a behavior the OECD is trying to eliminate.

Rather than a “tax holiday”, Congress needs to bring U.S. tax policy in line with the rest of the world.