Written by Max Reed and Charmaine Ko This blog post addresses a very technical question about the new US repatriation tax. It will only be of interest to US tax...
Many Canadian start-ups, whether junior mining, biotech, or tech, receive funding from investors in the United States (or from US taxpayers who reside in Canada). If the proper steps are not taken, a punitive US tax regime (the passive foreign investment company or “PFIC” rules) may increase the tax cost on an exit of these investors. Amongst other things, the PFIC regime can easily double the tax cost on exit from the investment. These adverse tax consequences can be mitigated if addressed in the first year the investment is owned. Consequently, to ensure tax efficiency for investors and avoid potential civil liability, early stage companies should make US investors aware of the potential application of the PFIC regime and take the steps necessary to address it.
The PFIC regime is a set of US tax rules that are designed to prevent US taxpayers from using foreign corporations to defer US tax on investment income. Importantly, the PFIC regime applies to the US shareholders who are subject to the US tax code and not to the foreign corporation itself (over which the Internal Revenue Code has no claim unless the corporation does business in the US). The PFIC regime was designed to prevent a US taxpayer from setting up a corporation in a tax haven and using that corporation to defer investment income offshore. However, the rules are broadly drafted and they apply to many more innocuous situations as well. The US tax code defines a PFIC as any foreign corporation for which:
at least 75% of the corporation’s gross income is passive (investment) income, or
at least 50% of a corporation’s assets produce passive income.
Passive income is generally defined to include interest, dividends, certain capital gains, and other income that is not generated from an active business. Although unintentional, these rules often apply to foreign, early stage companies. To illustrate, consider the income statement and balance sheet of a classic start-up. The primary asset of most early stage companies is cash that the company has raised from founders or investors. Cash is a passive asset as it only produces interest income. Because the company is in its early stages, the value of the cash will often exceed the real business assets of the corporation. This means that more than 50% of the corporation’s assets are “passive”, and thus it likely meets the definition of a PFIC. Once a foreign corporation has been classified as a PFIC, it remains that way even if the corporation stops meeting the PFIC test in future years.
If an investment is classified as a PFIC, the tax results can be very expensive for a US shareholder. While the PFIC rules are onerous and complex, it is worthwhile to highlight simply one potential consequence of their application. A US taxpayer who sells shares of a PFIC pays US tax at the highest marginal rate, plus an interest charge in certain cases. For a long-term investor, the US federal tax can easily exceed 50% of the gain on the sale of the investment. By contrast, the top US federal tax rate that applies to the sale of a non-PFIC investment that has been held for more than a year is 23.8%. In short, the application of the PFIC rules can double the tax cost to an investor on the sale of the investment or an IPO.
Thankfully, the Internal Revenue Code provides a solution to the PFIC problem. A US taxpayer can make an election on their individual US tax return, the technical name of which is the qualified electing fund or “QEF” election. The QEF election removes the punitive taxation of the PFIC regime. For instance, when an investor sells an investment to which the QEF election applies, the normal long-term capital gains tax rate (23.8%) will apply. The potential downside to making the QEF election is that it will treat the investment as a flow-through entity for US tax purposes.
This means that a US taxpayer will be taxed on their share of the foreign corporation’s profits on a current basis even if no cash is distributed to that investor. To illustrate, assume that a US taxpayer owns 50% of a foreign corporation named InvestCo whose assets are 75% cash, and that corporation makes $100 of business income each year. Because of its high percentage of passive assets, InvestCo would be classified as a PFIC. If the US taxpayer makes the QEF election on their US tax return, then they would pay tax on $50 of interest income even if they never receive that cash. At first glance, then, the QEF election may appear unattractive. But under the QEF election only a taxpayer’s share of net income is taxable. Most early stage companies do not have net income. If the QEF election is made in the first year that the investor owns the investment, it is not necessary for any year in which the foreign corporation would not be otherwise considered a PFIC. Reprise the above example of InvestCo to illustrate. The US taxpayer makes the QEF election in the first year that they own the investment and pays tax on the $50 of interest income. The following year InvestCo’s business assets exceed the value of its cash holdings (meaning that the percentage of passive assets is below 50%) and it earns $150 of business income. Since InvestCo is no longer qualified as a PFIC, then the US taxpayer who has made a QEF election no longer needs to include their share of the profits in their taxable income (unless they are distributed). Under this example, which is a very common trajectory for early stage companies, the downside of the QEF election is no longer applicable once the company is a healthy, growing business. Making the QEF election requires the foreign corporation to provide QEF statements to the investor and those statements must be in accordance with US income tax principles.
In sum, there is a significant risk that the PFIC regime will apply to US investors in Canadian early stage companies, because the balance sheet of those companies is likely to be cash heavy. The application of the PFIC regime can easily double the US tax cost on exit from the investment. The PFIC regime can be negated if the QEF election is filed in the first year that the investment is owned. If done in a timely fashion, future adverse US tax consequences can be negated. Left unaddressed, the PFIC regime poses a material risk to the US investor. A failure to disclose this material risk may incur a civil liability risk on behalf of the company. The PFIC regime packs a punch and should not be discounted.