As US investment in UK and other European startups rises, founders of those startups should be aware of the potential impact of the “passive foreign investment company” (“PFIC”) taxation regime on US investors who invest in non-US startups.
US startup investors are increasingly looking overseas for investment opportunities. As US investment in UK and other European startups rises, founders of those startups should be aware of the potential impact of the “passive foreign investment company” (“PFIC”) taxation regime on US investors who invest in non-US startups.
If a startup is a PFIC, any gain recognized by a US shareholder on the sale of the startup’s shares (and certain other “excess distributions”) are taxed at the higher US ordinary income rates (as high as 39.6% federal under current law), rather than the lower preferential capital gains rates (up to 20% federal under current law, assuming a one-year holding period), unless the US shareholder timely makes certain tax elections. The US shareholder also may be subject to “interest” on a portion of the tax, based on the underpayment rate (currently 4%).
Between the interest charge and the higher ordinary income rates, the tax liability on selling shares of a PFIC could wipe out a US shareholder’s gain on the shares.
What’s a PFIC?
A PFIC is any non-US corporation that meets one of two tests. The first is the “income test”: 75% 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% or more of the company’s assets are used to generate passive income (e.g., cash, real estate, securities, etc.). The IRS – the US federal tax authority – has issued a notice that treats cash as a passive asset even if it is used for working capital purposes; not surprisingly, interest income on working capital is considered passive income.
The 50% asset test is usually based on the fair market value of the startup’s assets, including goodwill and any IP used in an active trade or business. However, if the PFIC is also a “controlled foreign corporation” (“CFC”), the asset test is based on the company’s US tax basis in its assets. Since most technology startups don’t have a significant amount of basis in their IP or other intangibles, a startup that is a CFC is much more likely to be a PFIC. A CFC is a non-US corporation of which 10% US shareholders own more than 50% of the corporation. The 10% test is measured in part on the ability to elect directors, so a shareholder that owns less than 10% of the outstanding stock of a startup could be treated as owning significantly more than 10% of the startup, depending on that shareholder’s rights. Although the PFIC rules don’t apply to the 10% US shareholders, they would continue to apply to those US shareholders who own less than 10%.
The PFIC rules can be mitigated if a US shareholder makes a “qualified electing fund” (“QEF”) election with respect to the PFIC. If a US shareholder makes a QEF election, the shareholder has to report (and pay tax on) his or her pro rata share of the startup’s earnings (profits) each year that it is a PFIC on the shareholder’s US tax return. However, any gain on a future sale of the startup is eligible for capital gain treatment, avoiding the ordinary income and deferred interest charge taxes described above. Since many startups 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 startup that is pursuing an active business, not investing cash in securities or other passive investments, would not be a PFIC. However, startups can unexpectedly find themselves in PFIC territory. Consider the following 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% of StealthCo’s income is passive (albeit small), StealthCo arguably would be a PFIC. Although there is a “startup 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 startup, has recently decided to launch US operations. Founder, who owns 30% of the company and has the right to select 3 of the 5 board members, moves to the US to begin US operations. FundraiseCo has $1 mil of cash on its balance sheet (and little else) and hopes to get financing based on a valuation of $10 mil, mainly intangibles and goodwill. If Founder becomes a US taxpayer, FundraiseCo is now a CFC, by virtue of 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 Founder is subject to the somewhat more favourable CFC rules, US investors in FundraiseCo who own less than 10% are subject to the more onerous PFIC regime.
What’s a startup to do?
First, startups should keep in mind the impact of cash on hand on the PFIC tests, particularly when they have or are trying to obtain US 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, startups should consult with a US tax advisor before a founder (or any significant stockholder) moves to the US and becomes a US tax resident. (Side note: founders themselves also should consult with a US tax advisor before moving to the US). Importantly, the test for residency includes a number of days in the US test, not just immigration status or intent to stay.
Third, startups should be aware of the PFIC issue when negotiating financing terms with US investors (particularly VC investors). The common investor asks to include a representation that a startup is not a PFIC and covenants that a startup will take good faith efforts not to be a PFIC, will determine its PFIC status annually, and will provide the information required for US investors to make a QEF election. Such requests can require significant ongoing analysis and should be done by a qualified US accounting or law firm.
Post produced in partnership with Myra Sutanto Shen and Daniel Glazer at Wilson Sonsini Goodrich & Rosati. Myra can be reached at firstname.lastname@example.org and Dan at email@example.com.
The foregoing does not constitute legal advice and should not be relied upon for business or legal decisions.