February 23, 2017
Private Canadian and Other Non-US Corporations may be PFICs
US citizens and US residents, including all green card holders, should determine now if they own shares in a “Passive Foreign Investment Company” (“PFIC”). Ownership of such shares may have very disadvantageous US tax consequences. The shareholder may be subject to a US tax rate of 35% - 43.4%, instead of the capital gain/dividend tax rate of about 20%.
PFICs generally are non-US entities (corporations and some trusts) whose income or assets are predominantly passive. Certain private Canadian or other non-US corporations, or non-US investments such as mutual funds, REITs (Real Estate Investment Trusts), or ETFs (exchange traded funds) may be PFICs.
Recently, the IRS is giving more attention to PFICs in its announcements and promulgations, which lends some urgency to reviewing the US tax status of your non-US corporations and investments. One or more may be a PFIC if it earns too much passive income, or owns too many passive assets.
Specifically, Canadian or other non-US corporations, and certain trusts, are potentially PFICs if:
- 75% of the gross income is passive income (interest, dividends, certain rental income, etc.), or
- 50% of the corporation’s assets are assets which produce passive income, or are held to produce passive income.
Example 1, Passive Income. Since July 31, 1987, Michael, a US citizen, and Peter, an unrelated nonresident alien, both living in Canada, have equally owned ABC Inc., a Canadian corporation whose sole asset is a small residential rental apartment building in Canada with annual rentals. Michael’s investment in ABC was $100,000 and he sold his shares for $1,000,000 in 2017. What is his US tax on $900,000 profit?
Assume the corporation had no employees, its sole income was rental profit from the apartments, and Michael and Peter did not manage the property. They have always turned over exclusive management of the property to an independent real estate broker. No elections have ever been made in the US. Therefore it is possible (likely) ABC was a PFIC for US tax purposes.
If this were the case, Michael’s $900,000 profit would be pro-rated back over his 30 years of ownership ($30,000 per year). Because it was a PFIC, Michael’s profit would not be taxed as a capital gain. Instead, it would be taxed at the maximum ordinary US income tax rate in effect in each of those 30 years. Therefore $30,000 of profit would be allocated to 1988, and taxed at the maximum ordinary US tax rate for 1988, $30,000 would be allocated to 1989 and taxed at the maximum ordinary tax rate for that year, etc. Therefore, rather than paying a capital gains tax rate of about 20%, Michael’s tax rate could average 35% or higher. (The maximum US tax rate varied over the period).
There would also be a compound interest charge to Michael! Assuming the tax is actually paid in 2018, there would be compound interest accumulated from 1989 to 2018 on the tax allocated to 1989, compound interest accumulated from 1990 to 2018 on the tax allocated to 2009, and so on.
Similar disadvantageous results could possibly apply to certain distributions received by Michael over the years.
OTHER TYPES OF PFICs
A corporation may also be a PFIC even when it has very little passive income, if 50% of its assets produce passive income. Consider a Canadian corporation, or other non-US corporation, which operates a consulting business, a professional business, a sales business, or other business that may only require minimal physical (“hard”) assets. Its passive income producing assets, - e.g. its working capital, including prior profits retained in the corporation’s interest bearing bank account, may exceed its investment in office furniture and equipment, and other physical assets. (See IRS Notice 88-22). If these passive assets exceed its physical assets the Canadian corporation could be a PFIC.
Example 2, Passive Assets. The facts are similar to Example 1, except in this case ABC’s sole business consists of acting as a manufacturer’s agent, earning commissions by selling industrial equipment. It rents the office space and vehicles it uses, so its sole physical assets are computers and office equipment valued at $50,000. It also has an interest bearing bank account containing undistributed earnings of $100,000. So ABC may be a PFIC, and if Michael sells his interest, he may be subject to income tax at the maximum ordinary tax rate, and an interest charge as described in Example 1.
Exceptions to the above rules may apply if you are eligible to make certain US elections. Completely different rules apply if your corporation is owned more than 50% by “US Shareholders”.
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