A 21st century PFIC regime: must all working capital be passive?

• Author: Barner, Brian
• Position: Passive foreign investment company

Since the enactment of the passive foreign investment company (PFIC) statutes in 1986, the global economy has undergone a dramatic reorientation toward services and information technology. This change has been accompanied by the rise of venture capital. But the draconian penalties of the PFIC rules risk pushing U.S. investors toward missing the proverbial "information age" boat. U.S. investors have been discouraged from investing in foreign startup companies because the 1RS has interpreted the PFIC rules to encompass active companies that are in a startup mode for several years, including, for example, technology and internet service companies, biotechnology companies, and companies engaged in long-term infrastructure, such as mining or oil and gas exploration projects.

Background of PFIC Provisions

As evidenced by the legislative history of the PFIC provisions and the General Explanation of the Tax Reform Act of 1986 released by the Joint Committee on Taxation (JCS-10-87 at p. 1023 (May 4,1987)), the PFIC provisions target U.S. investments in passive foreign funds that would otherwise receive indefinite deferral. A foreign company is deemed a PFIC under Sec. 1297(a) when 75% of the income is passive or when 50% of assets (generally by value) produce or are held to produce passive income. The term "passive income" is defined in Sec. 1297(b)(1) as "any income which is of a kind which would be foreign personal holding company income [FPHCI] as defined in section 954(c)."

Notice 88-22 created significant problems for young foreign enterprises that have plenty of private venture capital (or recently underwent an initial public offering). This capital is often meant for active business purposes--not for passive investing. However, the notice summarily declared all working capital to be passive, without providing any rationale for this treatment. These companies are not the foreign mutual funds that Congress intended to target, yet the notice's result is clear.

The exception in Sec. 1298(b)(2) for startup companies that is aimed at preventing a nascent active business from being misclassified as a PFIC is of little use because it applies only to the first tax year that the corporation has any gross income (e.g., a few dollars of interest on seed capital).

This problem may come to a head now that Treasury has issued Temp. Regs. Sec. 1.1298-1T, requiring U.S. PFIC shareholders to file annual ownership reports on revised Form 8621, Information...