The Tax Trap: What VC Funds Need to Know About Passive Foreign Investment Companies
When venture capital funds make investments in foreign corporations, they must be mindful of U.S. tax rules, particularly concerning Passive Foreign Investment Companies (PFICs). Understanding and managing the tax implications of PFICs is crucial, as these rules can lead to significant tax burdens, impacting the fund and its investors. In collaboration with the knowledgeable tax experts at Andersen Tax, this article explores PFICs, outlines their tax consequences, and discusses ways to mitigate these effects through strategic elections such as the Qualified Electing Fund (QEF) election.
What is the definition of PFIC?
PFIC stands for Passive Foreign Investment Company. Anytime someone invests in a foreign corporation, they need to consider whether the foreign corporation is a PFIC because the Internal Revenue Code (the “Code”) has very specific tax consequences for such an investment.
Specifically, the Code has a two-part test that looks at the “passive” income and “passive” assets of a foreign company to determine whether a foreign corporation is a PFIC.
Passive income typically involves the payment of dividends, interest, rents, royalties, annuities.
Passive assets are assets that produce passive income and typically include cash.
Note that PFIC rules are not always intuitive, and it is very possible that even foreign operating companies can be PFICs. For example, a foreign start-up company may have significant cash balances and turn out to be a PFIC. Similarly, a foreign special purpose acquisition corporation (SPAC) may be a PFIC.
What are the tax consequences of investing in a PFIC?
First, consider an investment into a foreign corporation that is not a PFIC.
There are no tax consequences until the foreign company makes a distribution.
If the company makes a distribution that is a dividend, the dividend may be a qualified dividend if the holding period threshold is met, and the foreign corporation is domiciled in a country that has a treaty with the U.S.
Upon exit, assuming the investor holds the foreign investment as a capital asset, then the investor would have capital treatment on gain or loss with the potential for preferential long-term capital gain rates.
In contrast, consider the tax consequences if the foreign corporation is a PFIC and no special elections are made.
Similar to the above, there are no tax consequences until the foreign company makes a distribution. However, the PFIC will be subject to the “excess distribution regime,” which means…
If the company makes a distribution, all or a portion of the distribution may be treated as an “excess distribution,” resulting in the distribution being taxed at the highest ordinary income rates and possibly a separate tax plus an interest charge. The distribution is not eligible for qualified dividend treatment.
Upon exit, even if the investor held the foreign investment as a capital asset, the gain on sale or liquidation would not be eligible for capital treatment. Instead, the entire gain would generally be subject to the “excess distribution regime,” which results in ordinary treatment and potentially an interest charge. The loss of long-term capital gains rates on exit is one of the biggest concerns for these investments.
Further, the PFIC will continue to be treated as a PFIC in future years, even if it no longer passes the income or asset test unless a purging election is made.
What can be done to mitigate the negative tax consequences of investing in a PFIC?
There are two potential elections that a domestic fund could make to mitigate the negative tax consequences. First, the election is a Qualified Electing Fund (QEF) election. The second is a Mark-to-Market (MTM) election. An MTM election is available if the PFIC is traded on a qualified exchange or other market. Investing a foreign corporation traded on an exchange is less common for VC funds, so we will focus on the QEF election.
What does a QEF election do?
If the foreign company is a PFIC and provides a PFIC annual information statement, then a domestic investor, such as a VC fund, can make a QEF election.
The PFIC statement reports ordinary income and long-term capital gains of the foreign company for that year, as well as any distributions made by the company.
The VC fund makes the QEF election and then includes that ordinary income and long-term capital gain in taxable income each year. These amounts are included in taxable income whether the foreign company makes a distribution or not.
This yearly income inclusion potentially creates “phantom income” (i.e., taxable income without receiving the associated cash).
Keep in mind that a basis adjustment is made for the income inclusion, and, later when a distribution is made from the company, the distribution is not taxable to the extent those earnings were already included in income.
Most importantly, on sale or liquidation, the fund would be eligible for capital gain treatment. The preservation of long-term capital gain treatment on exit is the biggest reason for making a QEF election.
Lastly, if a QEF election has been made and the foreign corporation no longer meets the asset or income test in a future year, then the foreign corporation is not treated as a PFIC and no income inclusions are required for that year.
Who can make a QEF election?
Typically, it is the VC fund (or their U.S. SPV that holds the investment) that makes the QEF election because, under the current regulations, the first U.S. owner in a chain of ownership is the only one who can make a valid QEF election. In other words, if the VC fund does not make the election, then the U.S. partner in the fund cannot make the election and is stuck with the consequences of the “excess distribution regime.”
There are proposed regulations that would change this process and make it so that it would be the U.S. partner that would make the QEF election. However, it is not clear if or when those regulations will be finalized.
Also, the QEF election generally needs to be made in the first year the investor holds the PFIC. If the election is not made in the first year of ownership, then the VC fund should discuss with their tax advisor whether a “purging election” would be advisable.
A purging election treats the PFIC as if it was sold and the gain is subject to the excess distribution regime. Then, a QEF election can be made and the benefits of the QEF election apply to future years.
What is a VC fund’s role?
First, anytime a VC fund is looking to make an equity investment (including via a SAFE) in a foreign corporation it needs to consider the PFIC rules. The fund manager should consult with their tax advisor, such as Andersen Tax, during the investment process.
Often the tax advisor can ask the company regarding its PFIC status. Some companies will provide PFIC statements or representations of PFIC status. If PFIC testing is needed, a firm, such as Andersen Tax, can be of service.
Second, the fund manager must communicate with their investors. It may be important to provide investors with an expectation of phantom income. Also, not all PFICs are eligible to make QEF elections and, therefore, the fund and their investors may end up subject to the excess distribution regime.
Third, the VC fund needs to make sure a QEF election, when applicable, is made on the fund’s return with the filing of Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, and the fund’s share of earnings are included in income. The fund should also be tracking the related basis adjustments.
Fourth, PFIC status and potential income inclusion are something that needs to be considered each year. It is important that the fund work with a tax advisor who is well-versed in the PFIC regime to make sure that proper information reporting and taxable income inclusions are done annually. This is an area of expertise for Andersen Tax.
In summary, VC funds need to consider the PFIC rules when making foreign investments because failure to identify PFICs can create unnecessary tax and interest, as well as loss of long-term capital gain treatment for themselves and their investors. Fund managers should consult with their tax advisors, such as Andersen Tax, when looking into such investments.
Venture capital funds must be vigilant when investing in foreign corporations, as they may inadvertently encounter the Passive Foreign Investment Company (PFIC) rules. Failure to identify and address PFICs can result in punitive tax treatment, such as the loss of long-term capital gain rates and the imposition of interest charges. By working closely with tax advisors and considering elections like the QEF election, VC funds can preserve favorable tax outcomes and avoid costly pitfalls. Fund managers must ensure thorough communication with investors and maintain accurate tax reporting to navigate the complexities of the PFIC regime effectively.
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Sincere appreciation to our contributing author Kathryn Dery Leung, Managing Director at Andersen. Along with Shea Tate-Di Donna and Kaego Ogbechie Rust, authors of The Venture Fund Blueprint.
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