If you look back to our definition of a PFIC, it appears as though a foreign company can concurrently be a CFC and a PFIC. However, this is merely an illusion as the Code provides a hierarchical order between the two when both classifications would be applicable.
Synopsis on the Definitions:
As previously discussed in our blog, Passive Foreign Investment Companies, a company will be a PFIC if it is a foreign company, and either:
- 70% of the company’s gross income is passive income; or
- 50% of the company’s assets are passive assets.
Alternatively, as described in our blog, The “Controlled Foreign Corporation” Regime: What is a CFC Anyway?, a company will be a controlled foreign company is it is a foreign company that has at least one U.S. Shareholder who owns, on any day during the foreign corporation’s tax year, at least 50% of either:
- The company’s total value; or
- The company’s total voting stock.
Code Section 1297(d)
Under Section 1297(d) of the Code, “a corporation shall not be treated with respect to a shareholder as a passive foreign investment company during the qualified portion of such shareholders holding period with respect to stock in a controlled foreign corporation.” Under this section, the qualified portion of a shareholder’s holding period is the portion in which the shareholder is a U.S. Shareholder and the corporation meets the controlled foreign corporation classification.
An important thing to note here is that this classification occurs “with respect to a shareholder.” This means that a foreign corporation can be a CFC for some shareholders, but a PFIC for others. While this seems somewhat obscure, this diverging classification most commonly occurs where there is a U.S. Person who holds less than 10% of a corporation’s total value or voting stock, as they cannot be a U.S. Shareholder. If they are not a U.S. Shareholder, then the CFC classification will be inapplicable to them because they a CFC classification requires that the U.S. Person be a U.S. Shareholder.
For example, foreign company, X, only owns passive assets. A, B, and C are all U.S. Persons who own shares in X. A owns 50% of X, B owns 45% of X and C owns 5% of X. X may be classified as a PFIC due to it holding all passive assets. X may also be classified as a controlled foreign corporation as U.S. Shareholders own at least 50% of the company’s value. As we have learned, if a comapny can be classified as a CFC and a PFIC then the CFC classification takes priority. At the same time, this analysis must be done on an individual basis. A and B are U.S> Shareholders because they own at least 10% of X, but C’s 5% interest disqualifies from being a U.S. Shareholder. Accordingly, X will be a CFC for A and B, but will remain a PFIC for C.