PFIC, CFC and K-1s: US tax implications and reporting requirements with US investors in offshore funds
When offshore funds have US investors, all too often the fund administrators to the offshore funds will have to start dealing with the complex US tax reporting, because US tax law applies to US persons no matter where they live and invest their money.
FATCA has a further complicated the situation, funds now have to either file on behalf of the US investors or at a minimum provide the necessary tax information.
The most frequently asked question by funds and the US investors is what is the appropriate US tax reporting for the investment interest: PFIC (Passive Foreign Investment Company) reporting or Sch. K-1 filing. Contrary to the common “belief” that offshore profits are taxed only when repatriated back to the United States, investing in a PFIC requires the US holders to report and pay tax annually on direct or indirect distributions and gains from disposal of the PFIC shares, while K-1s need to be provided by the partnership to US partners to ensure their current year compliance with US tax rules.
Obviously we need first determine, for US tax purposes, whether a fund is classified as a corporation or partnership type of passive foreign (i.e. non-US) investment entity. That is to say, the legal entity form from the local jurisdiction’s standpoint is not always treated in the same way as it is from a US tax perspective. And, as if it were not complicated enough, US tax law allows for non-US investment vehicles to make the “Check-The-Box” election so as to reclassify a “local” non-flow-through entity (i.e. Corporation) as a flow-through entity (i.e. Partnership) for US tax purposes, or vice versa.
Passive Foreign Investment Company (“PFIC”) for US Investors
A PFIC is defined as a foreign (non-US based) corporation that meets one of the following two tests:
- Income Test: 75% or more of its gross income is passive income (earnings derived from rental property, limited partnership or other enterprise not actively involved); or
- Asset Test: 50% or more of the corporation’s assets produce, or are held to produce, passive income.
The PFIC rules were initially designed to catch passive investments placed into foreign corporations, but has also caught unsuspecting taxpayers who have invested in non-US “pooled investments” such as mutual funds, hedge funds, insurance products and pension plans, which usually can be PFICs. And taxpayers can be very surprised in finding out they are subject to the PFIC regime if they invested in a fund which in turn owns a PFIC.
Once we know the US investors have invested in a PFIC, we can look into the implications and reporting requirements so as to determine whether they wish to do nothing, or explore the alternatives.
- Do Nothing – Default
With “do nothing” approach, under PFIC regime, automatically the US investors are subject to the top individual tax rate (39.6%) for any direct or indirect distributions received, and the gains recognized on a direct or indirect disposal of their shares in PFIC are all treated as ordinary income, even though some, depending on the holding period, should have otherwise been counted as capital gains from disposing the investment. Moreover, interest will be charged and accumulated on unpaid “deferred” tax. This is the most common “reporting method” since most US investors misunderstand PFIC as an exotic and highly specialized investment form/type (rather than a US tax regime) thus are not aware of their having a PFIC, and the time of making elections has already passed before they were aware of the consequences.
To avoid the above most punitive “excess distribution”, there are two alternative methods that US tax law allows to elect for: Qualifying Electing Fund (QEF) and Mark-to-Market.
- Qualifying Electing Fund (QEF)
By filing Form 8621 and electing to treat PFIC as a qualified electing fund (QEF), the investors will be able to enjoy the favorable tax rate on capital gains, which otherwise would have been characterized as ordinary income indiscriminately under “do nothing”. The election is basically to allow a PFIC to be treated as a US based fund, it must be made in the first year by the first U.S. person in the ownership chain. To file for the election, the PFIC Annual Information Statement must be issued by the PFIC and signed by a representative of the PFIC for the US shareholder.
There are four main pieces of information that a PFIC Annual Information Statement must have:
First, the PFIC Annual Information Statement must indicate the start and end dates of the time period to which the statement applies.
Second, the PFIC Annual Information Statement must contain any one of the following three things:
- The shareholder’s portion of the ordinary income and capital gains from the fund, or
- Information that allows the shareholder to calculate his/her portion of the PFIC’s ordinary income and capital gains for the year, or,
- A statement that the foreign corporation has permitted the shareholder to examine its books so that the shareholder can calculate his/her portion of the ordinary income and capital gains.
Lastly, it must contain either a statement that the PFIC will allow the shareholder to inspect its books, or alternative documentation requirements approved by the IRS through a Private Letter Ruling and Closing Agreement.
Understandably, to gather the information for the Annual Information Statement is extremely time consuming, and in reality most funds, even those that are similar to US accounts, do not keep US GAAP accounting and tax records nor will they be able to provide US tax specific information to shareholders.
If making a QEF election is impossible to achieve, the US investor can choose to annually treat the investment on a Mark-to-Market basis, that is, include unrealized appreciation or depreciation into ordinary income or loss on Form 8621, though the only way to make it possible is if the interest is marketable stock. Because no US tax is deferred, the PFIC taxation rules will not apply when disposing the stock eventually.
There are two no annual reporting (Filing Form 8621) exceptions that we may want to check to see whether applicable:
- Less than an aggregate USD 25,000 direct investments in PFIC on the last day of tax year;
- Less than USD 5,000 if the PFIC is indirectly owned.
CFC (Controlled Foreign Corporation)
However in many cases the US shareholders (a U.S. person owns 10 percent or more) have directly, indirectly or constructively owned over 50% of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the foreign corporation, which under US tax law is defined as a controlled foreign corporation (CFC). If the interest that the US investors have is both a CFC and PFIC, then the CFC rules prevail and Subpart F inclusion (i.e. deemed dividend) need be reported on their current year US tax returns. Here we will not expand on CFC as it is an even more complicated topic with regard to US taxation.
Partnership and Schedule K-1
We now turn our attention to the offshore which is determined for US tax purposes as a foreign investment partnership. Schedule K-1s will be issued to investors who are partners in the partnership.
The Schedule K-1 reports the partner’s distributive share of the taxable income, gain, loss, deduction and credit from the partnership. Funds issue Schedule K-1s with detailed footnotes which include disclosures regarding additional reporting that may be required by the partners on their respective U.S. federal tax returns.
Fund Schedule K-1s with detailed footnotes typically include certain foreign reporting disclosures regarding the fund’s investments in foreign corporations including PFIC, which will require the US tax reporting as explained earlier in the PFIC section. Here you can see once again how an investor must face PFIC issues.
Above is a general summary of the PFIC, CFC and K-1 tax regimes and/or related reporting requirements. The underlying rules are very complicated and there are many more other issues to consider. Many offshore funds are PFICs or foreign partnerships, as fund managers, we need to be sure that we assist US investors to make appropriate elections or provide sufficient tax information allowing them to properly optimize their US tax reporting and compliance.
Amicorp Fund Services
Amicorp Fund Services has the experience and expertise in administering offshore funds with US and non-US investors and provides administration and corporate services to alternative and traditional investment funds on a global scale, with an organizational model designed for maximum synergy and efficiency. Amicorp Fund Services provides services as a fund administrator in Luxembourg, Curaçao, Chile, Cayman Islands, British Virgin Islands, Bahamas, Barbados, Malta, Mauritius, India, Singapore, Hong Kong and Shanghai. The proficiency of our processes and procedures is evident in our ISAE3402 type II certification − awarded by one of the Big Four audit firms. This certification is the successor of what previously was known as SAS 70 type II.
In Amicorp’s experience we find that an agreement with a minimum period of agreement of between 3 and 5 years is the most beneficial for both parties.
If you have clients who need assistance, please feel free to contact Amicorp’s Private Client Unit or Amicorp’s Fund Services Unit.