U.S. start-up investors are increasingly looking overseas for investment opportunities. As U.S. investment in UK and other non-U.S. start-ups rises, founders of those start-ups should be aware of the potential impact of the “controlled foreign corporation” (CFC) and “passive foreign investment company” (PFIC) taxation regimes on U.S. investors who invest in non-U.S. start-ups.
What Are CFCs and PFICs?
A CFC is a non-U.S. corporation of which “10% U.S. shareholders” own more than 50 percent of the corporation. The 10 percent test could be measured by value or by the ability to elect directors, so a shareholder that owns less than 10 percent of the outstanding stock of a start-up could be treated as owning significantly more than 10 percent of the start-up, depending on that shareholder’s economic and control rights. There are also complicated constructive ownership rules that can apply.
A PFIC is any non-U.S. corporation that meets one of two tests. The first is the “income test”: 75 percent or more of the company’s gross income is passive (e.g., interest, rent, dividends, related-party royalties, etc.). The second test is the “asset test”: 50 percent or more of the company’s assets are used to generate passive income (e.g., cash, real estate, securities, etc.). Other than very limited exceptions, cash is treated as a passive asset, even if it is used for working capital purposes. More problematic, interest income on working capital is considered passive income.
The 50 percent asset test is usually based on the fair market value of the start-up’s assets, including goodwill and any IP used in an active trade or business. However, if the PFIC is also a CFC, the asset test is based on the company’s U.S. tax basis in its assets. Since most technology startups don’t have a significant amount of basis in their IP or other intangibles, a start-up that is a CFC is significantly more likely to be a PFIC.
Why Does It Matter?
If a start-up is a CFC, 10% U.S. shareholders will have additional reporting requirements and may be required to pay U.S. taxes on their pro rata share of the start-up’s income. In addition, in an exit, capital gain could be converted to ordinary income for non-corporate taxpayers in certain circumstances.
If a start-up is a PFIC, any gain recognized by a U.S. shareholder on the sale of the start-up’s shares (and certain other “excess distributions”) are taxed at the higher U.S. ordinary income rates (as high as 37 percent federal under current law), rather than the lower preferential capital gains rates (up to 20 percent federal under current law, assuming a more than one-year holding period), unless the U.S. shareholder timely makes certain tax elections. The U.S. shareholder also may be subject to “interest” on a portion of the tax, based on the underpayment rate.
Between the interest charge and the higher ordinary income rates, the tax liability on selling shares of a PFIC could wipe out a U.S. shareholder’s gain on the shares. Although the PFIC rules don’t apply to the 10% U.S. shareholders, they would continue to apply to those U.S. shareholders who own less than 10 percent, so the CFC/PFIC combination can be extremely detrimental.
The PFIC rules can be mitigated if a U.S. shareholder makes a “qualified electing fund” (QEF) election with respect to the PFIC. If a U.S. shareholder makes a QEF election, the shareholder has to report (and pay tax on) his or her pro rata share of the start-up’s earnings (profits) each year that it is a PFIC on the shareholder’s U.S. tax return. However, any gain on a future sale of the start-up is eligible for capital gain treatment, avoiding the ordinary income and deferred interest charge taxes described above. Since many start-ups do not expect to be profitable for several years (and may no longer be a PFIC when profitable), the impact of the QEF election may not be felt for many years, if ever.
Common sense would say that a start-up that is pursuing an active business, not investing cash in securities or other passive investments, would not be a PFIC. However, start-ups can unexpectedly find themselves in PFIC territory. Consider the following hypothetical examples:
1) StealthCo is in “stealth mode” for a couple of years before launching a product. StealthCo has no revenue, other than a small amount of interest income earned from cash in its checking account. Since 100 percent of StealthCo’s income is passive (albeit small), StealthCo appears to be a PFIC. Although there is a “start-up exception” to the PFIC rules, the exception only applies in the first year in which StealthCo has gross income—the exception does not apply in year 2.
2) FundraiseCo, a UK-based start-up, has recently decided to launch U.S. operations. The founder, who owns 30 percent of the company and has the right to select three of the five board members, moves to the U.S. to begin U.S. operations. FundraiseCo has $1 million of cash on its balance sheet (and little else) and hopes to get financing based on a valuation of $10 million, mainly intangibles and goodwill. If the founder becomes a U.S. taxpayer, FundraiseCo is now a CFC, by virtue of the founder’s right to control FundraiseCo’s board of directors. As a CFC, FundraiseCo must determine its PFIC status using its tax basis in its assets, rather than the fair market value of its assets. Since the only asset of significance on its balance sheet is cash, FundraiseCo meets the asset test and is, therefore, a PFIC. Although the founder is subject to the somewhat more favorable CFC rules, U.S. investors in FundraiseCo who own less than 10 percent are subject to the more onerous PFIC regime.
What’s a Start-Up to Do?
First, start-ups should keep in mind the impact of cash on hand on the PFIC tests, particularly when they have or are trying to obtain U.S. shareholders. For example, if and to the extent practical, a startup could stagger funding over time to minimize the amount of cash on the balance sheet at any given point in time. (Of course, this presents different business risks.) In addition, pre-revenue startups should consider putting cash in non-interest-bearing accounts and otherwise avoid the risk of passive income.
Second, start-ups should consult with a U.S. tax advisor before a founder (or any significant stockholder) moves to the United States and becomes a U.S. tax resident. (Side note: founders themselves also should consult with a U.S. tax advisor before moving to the United States). Importantly, the test for residency includes a number of days in the United States test, not just immigration status or intent to stay.
Third, start-ups should be aware of the PFIC issue when negotiating financing terms with U.S. investors (particularly VC investors). The common investor asks to include a representation that a startup is not a PFIC and covenants that a start-up will take good faith efforts not to be a PFIC, will determine its PFIC status annually, and will provide the information required for U.S. investors to make a QEF election. Such requests can require significant ongoing analysis and should be done by a qualified U.S. accounting or law firm.
