Introduction
Milton Friedman formulated the theory that businesses have the moral obligation to make profit (Friedman 21). However, some companies go out of their way to ensure the maximization of profits through whichever means necessary, including tax evasion. The government’s prerogative is to ensure that companies run their businesses uninterrupted and pay taxes in return. Most governments encourage foreign investment by allowing companies incorporated in other countries to conduct trade in goods and services in their countries. The resultant outcome is bringing such goods and services closer to the people while attracting income for the government through taxation. However, governments should balance the two needs without jeopardizing income production for these companies. Consequently, the United States government has formulated rules that reduce tax evasion without necessarily interfering with the running of companies, thus keeping company productivity as high as possible. The government has enacted policies such as the rules regulating controlled foreign corporations (CFCs) and Passive foreign investment companies (PFICs) for this purpose. Some of the taxation policies apply to all corporations while others only apply to foreign parties according to 26 USC 163(j) (Miller 128). This paper looks at the impact of rules governing the two types of companies concerning the effects they have on investment in the US. It also discusses the impact of the rules on company policies for controlled foreign corporations, including shareholding policies, incorporation policies, and distribution of dividends, and redistribution of profits into capital.
Controlled foreign corporations (CFC)
Background
Taxation forms the source of most of the government’s revenue. As such, the United States’ Treasury Department through its agency, the Internal Revenue Authority (IRS), ensures the maximization of tax revenue by exploring every avenue that legally allows it to collect taxes from individual citizens, residents, and corporations. Funds collected from taxation enable the federal governments to pay off their debts to other countries and corporations in addition to enabling the federal governments to improve security for everyone within their borders while fostering development through the provision of basic social amenities and infrastructure. On the other hand, most citizens, residents and corporations look for any legal loopholes that prevent them from paying taxes in order to generate as much income as possible and optimize on profits. Therefore, the government and its agencies should make policies that favor its tax collection activities, while facilitating as little interference as possible to the running of businesses (Arnold 86).
Prior to 1962, the government did not charge any taxes on income that foreign corporations generated and distributed as dividends to shareholders, as long as the corporations derived such income from the US sources. The resultant effect was that companies incorporated in the US and American citizens would take advantage and defer their income by investing in foreign corporations, as income they earned through dividends would not be privy to taxation. By doing so, these individuals and corporations were taking advantage of a legal loophole to evade taxation costing the government substantial amounts in revenue. The government thus introduced the controlled foreign corporation rules, mainly aimed at American citizens and corporations with regard to their income from foreign corporations.
CFC rules
Although the CFC rules present some complications with regard to interpretation, they are effective in ensuring the maximizations of tax collection. One of the rules is the government’s requirements for the determination of a controlled foreign corporation. According to the Internal Revenue Code, a CFC is a foreign corporation in which the US shareholders possess fifty percent of the total shareholding in thus obtaining control, by either vote or value according to IRC Sec. 957 (a) (Fatemi, Hasseldine, and Hite 104). Under IRC Section 7701(a) (30), the IRC defines an American as being either an individual American citizen or a domestic company incorporated in the United States. Section 951(b) further stipulates that in order to qualify as a U.S shareholder, the individual or corporation must possess at least ten percent of the property in a foreign corporation as per Section 956 of the IRC (Asbill and Goldman 253). Notably, only the shareholders with at least ten percent of shareholding qualify in the fifty percent shareholding rule in the determination of whether a company qualifies as a controlled foreign corporation. As long as less than 50% of the US persons in the corporation hold at least 10% of the total shareholding, the company would not qualify as a CFC, even if the entire number of shareholders comprises the US persons. The IRC’s attribution rules under “Sections 958(a) and 958(b) apply in the determination of the 10% rule” (Jacobs and Duke 56). Section 958(a) provides for direct ownership of the shares while Section 958(b) talks about constructive ownership (Bedard et al. 64). IRC’s Subpart F Section 954 provided for the types of income from CFCs that are taxable, including foreign personal holdings, company sales income, insurance income from outside the US according to IRC Sec.953 (Peroni 2071), shipping income and oil related income. The IRC also defines some of the income sources that do not form part of subpart F income and thus excluded from taxation. These include deferred income as per IRC Section 952 (Weise 1031), previously taxed dividends defined in IRC section 959, and foreign tax credit deductions defined in IRC Sec. 960 (Fellows and Yuhas 23).
Impact of CFC rules on investment
Advantages and disadvantages
These rules set out in the Internal Revenue Code have had positive and negative effects for the parties involved. One of the positive effects is that the rules provide a means for the government to maximize on revenue collection, without having to interfere with the running of the companies. The government has experienced a rise in tax revenue and developments in most states are proof of the positive impact this has had on the people. Before the initiation of the CFC rules, it was common practice for American citizens and domestic companies to invest in and form foreign corporations for the sole purpose of tax evasion. However, due to the CFC rules, the government now has the authority to collect taxes from individual and corporate shareholders hiding under the corporate veil to earn income, regardless of whether they invest in domestic or foreign corporations. Today, the United States government collects an average of $ 2.4 trillion in tax revenue every year, an enormous improvement from the $ 2.4 million according to a report by Heniff and Keith (16). Taxation is the main means by which the government, as a business, charges for the facilities and services it provides for the people within its territories and therefore evading taxation is paramount to stealing from the government, as the individual or corporation declares intention to use government facilities free of charge.
Another advantage that the implementation of these rules has is the regulations of activities by foreign corporations. The revenue collection process provides the government with oversight opportunities over the activities of the corporations. This ensures that foreign corporations do not use their status of incorporation to conduct illegal activities under the government’s watch. The requirement to declare sources of revenue for income collection purposes ensures that they uphold the integrity of the business they conduct in the US.
Thirdly, CFC rules create a form of regulation on competition between the foreign corporations and domestic corporations. By ensuring that the profitability of the foreign companies through investment by the U.S persons occurs at the same standards as those for domestic corporations, the government creates an even playing field for both types of corporations, giving a chance for domestic companies to attract investments within the US (Bolt-Lee and Plummer 114). The government should make policies attractive for foreign investment; however, it must not do so at the peril of its own domestic corporations as this would kill the need for its people to develop ideas, products and services that its people can sell to other states to attract more revenue for the government.
One of the main disadvantages of these rules is that they repel foreign investment to some extent. Most governments encourage foreign investments as they generate revenue while bringing their products and services to the people. The United States government is no exception. The double taxation effect that the rules enable form part of the reason most people prefer to invest in domestic companies as the peril of foreign corporations. The double taxation effect occurs when the government taxes income from the U.S sources and then taxes profits distributed to shareholders as dividends. The result is a reduction for income that a U.S shareholder stands to earn compared to earnings for foreign shareholders in the same CFC. American citizens and domestic corporations would therefore more likely prefer to invest in alternative domestic corporations, reducing the chances that foreign corporations have to build their capital base and increase productivity.
The second disadvantage that the rules present for foreign corporations is that it creates an environment that prevents foreign companies from fully exploiting their potential with regard to the U.S sources of income. The government only taxes foreign corporations for the income they earn from the U.S sources. Therefore, in a bid to reduce the taxable amount of income, such corporations are likely to explore income sources that are outside the federal government’s jurisdiction. In effect, the government denies the corporations the opportunity to allow the U.S persons adequate investment in their companies while reducing the amount of revenue that the government is capable of earning from the corporations
The third disadvantage is that the rules prevent the U.S persons from taking full advantage of foreign companies with great potential to increase their income, forcing them to opt for domestic corporations with lesser potential. Excessive scrutiny of sources of income for foreign corporations that chose to become CFCs also leads to reluctance for foreign companies to allow the U.S persons to purchase as many shares as they can for maximum earnings. Most of the foreign companies therefore ensure that the U.S persons as per the IRC get less than 10% each or less than 50% in total shares to prevent the formation of a CFC and the resultant double taxation policies that deny them improvement of the capital base necessary for expansion. The second way that the rules prevent the U.S shareholders from taking full advantage of the corporations, investment wise, is by creating strict provisions regarding constructive ownership. Section 958(b) gives provisions for attribution, which is indirect or constructive ownership of shares for an individual’s spouse, children, grand children or parents (Nichols and Price 36). These individuals are obliged under IRC rules to indicate any income they receive indirectly from investments controlled foreign corporations for taxation purposes or create liability for tax evasion. Many people invest in shares from different companies on behalf of their loved ones for the sole purpose of taking care of loved ones even in their absence. However, investing in corporations that are under double taxation policies may not be very suitable logically so most individuals would prefer exploring other options such as setting up small family-run businesses. Additionally, many people consider such income as gifts thus omitting it when filing tax returns, a mistake that ends up creating unnecessary lawsuits.
Another disadvantage is that most American citizens and do not comprehensively understand the CFC rules due to their complexity and thus may not understand why they have to pay taxes on income from controlled foreign corporations. For instance, people who benefit from the CFCs indirectly may not understand why they have to pay taxes from income resulting from companies that they do not directly invest in as per Section 958(b) of the internal revenue code, leading to unnecessary lawsuits between individuals and the IRS. On a legal perspective, ignorance of legal rules is not a viable defense and thus the IRS would not hesitate to prosecute individuals who do not pay taxes on such income. Although it would be appropriate for the government to hold civic education programs, especially on investment matters, the program is a lengthy solution that requires the use of tax revenue the government applies for other projects. The alternative would be a review of the rules so that the government structures the rules in a manner that is more comprehensive for every individual. However, this idea also presents complexities such as ensuring that the rewording or restructuring of the rules does not create loopholes in some areas, allowing for unnecessary tax deferral and evasion. The government also has to ensure that the rules it sets clearly stipulate its intentions regarding various tax issues therefore leading to the bulkiness and complexity of the rules.
The final disadvantage is that the U.S shareholders have to pay taxes “on any profits and earnings the foreign corporations make on the sale of shares, whether such profit or earnings are distributed as shares or not as long as they fall under ‘subpart F income’ in the IRC” (Jacobs and Duke 112). This assertion means that there are times where the U.S shareholders pay taxes on income that is more anticipatory than actual, if the corporations decide to withhold the income whether the main aim is to prevent taxation or not. In effect, this attribute strongly discourages the formation of CFCs for the sole purpose of tax evasion, an aspect that is advantageous to the federal government. However, it also presents a huge disadvantage for the U.S shareholders in foreign corporations that aim at expanding their capital base by redistributing their profits and earnings into the business instead of issuing the same as dividends to shareholders. In creating this rule, the government’s assumption was that CFCs mainly exist as tools for the execution of tax evasion by the U.S persons.
Impact on company policies
The CFC rules not only affect foreign corporations profit wise, they also play a big role in the determination of company policies. One of the policy considerations that depend on the rules is the source of income. The rules stipulate that the federal government can only collect tax revenue from the U.S source income. This means that the more income the CFCs generate in the United States, the more charges they incur in the form of taxes. Therefore, most probably, most CFCs would do their best to keep taxable income as low as possible, including choosing business deals that do not form part of the US source income as their before considering sources of income in the US. Although the government’s main aim in hosting foreign corporations is to gain from them through revenue collection, rules such as the CFC rules prevent it from collecting a lot of potential revenue. It would make sense for big foreign multinational corporations to exploit the U.S sources of income but this case does not apply to smaller foreign CFCs because bigger corporations would attract larger amounts of income, making the tax charges more negligible in comparison to smaller corporations. The smaller corporations would thus be more likely to establish a base in the United States but conduct business outside state borders or the country entirely. Therefore, the companies would only be liable for general operational tax charges and not taxes on their income, increasing the amount of profit they stand to gain. In essence, due to the CFC rules, most corporations are likely to formulate policies that place investment in the U.S sources of income after other options such as investments in other countries.
Another aspect of the CFC rules that affects policies in foreign companies especially with regard to investment is policies regarding ownership. Section 951(b) and Section 7701(a) (30) stipulate that in order to gain regard as a U.S shareholder in a foreign corporation, a person must be a U.S person as per section 7701(a) (30) and own a 10% share in the corporation. However, in order for a foreign corporation to “gain the status of a controlled foreign corporation, the U.S shareholders must own 50% of the total share thus gaining control either through votes or through value” (Jacobs and Duke 82). Keeping in mind that controlled foreign corporations have to account for operational taxes, income on the U.S taxes and taxes on dividends for each individual shareholder, preventing the transformation of a foreign corporation to a controlled foreign corporation may be a preferable option for some foreign corporations. The reason behind this is that most people choose to invest in companies that earn more through dividends an aspect that controlled foreign corporations fall short on. The corporation’s general income is taxed before distribution, and thus shareholders stand to gain less, as what is left and distributed as dividends is also taxable at an individual level. This mechanism reduces the number of investors willing to invest in CFCs as opposed to domestic corporations. As a way of preventing the double taxation rule, most foreign corporations prefer to remain as they are and formulate policies that prevent them from transforming to controlled corporations using ownership policies. By keeping the percentage of the U.S shareholders below fifty percent or ensuring the U.S persons get less than ten percent shareholding each, the companies maintain their status, preventing double taxation and increasing their capability to attract potential investors. The alternative for this dynamic is for the U.S shareholders to incorporate foreign shareholders to their corporations and give it the status of a controlled foreign corporation incorporated in the US. The effect of the latter version is that the corporation has to comply with the double taxation rule or place their source of income outside the federal or national territory. However, this defeats the purpose of the foreign corporation’s establishment in the United States as the strict and complex taxation rules reduce the companies’ productivity in addition to the potential of the state to gain from the tax revenue, which is the whole point of foreign investment. The government ought to create a balance between its interest in gaining revenue and ability of foreign corporations to gain from foreign investment and increase their productivity.
As a way of improving expansion capabilities and productivity through the reapplication of profits and earnings into the base capital, most foreign corporations implement policies that keep shareholding by the U.S persons as low as possible in a bid to prevent the taxation of undistributed profits from the sale of share from the U.S shareholders. The CFC rules provide that any undistributed income in the form of profits and earnings from the sale of shares owned by U. S shareholders is taxable as the shareholder’s income regardless of whether distributed as dividends. The rules treat the income as a form of the US source income and although it does not go through double taxation, the taxation of the undistributed amount in earnings still reduces the overall amount that is available to the company. One of the ways that foreign companies deal with such a situation is by ensuring that the number of the U.S shareholders is as low as possible, which in turn means that the taxable amount in profits from shares, is low. Most small and medium size foreign corporations also do their best to ensure that they keep any earnings from sources outside the United States and that their place of domicile is not permanently in the US. That way, the CFC rules would only allow taxation of income that is distributed to individual U.S persons as dividends as opposed to the taxation of the overall income as is the case with CFCs domiciled in the United States.
The CFC rules also restrict foreign corporations from investing in countries and jurisdictions that the government considers tax havens to prevent tax evasion. The IRC provides eighty regions that fall in this category and provides that income from these regions is taxable upon its distribution to individual U.S shareholder, even though the authorities in charge of the territories and jurisdictions do not apply the same rules. The governments in tax haven keep taxes that result form trade as low as possible in order to make the regions as attractive as possible for foreign investment by multinational corporations and individuals from other regions alike. The essence is to increase the income the governments in these regions generate in terms of revenue from tax collection. The main differences between these regions and most other regions in the world is that the tax amount payable for income generation is low and the governments do not charge on income companies distribute as dividends to shareholders. In effect, shareholders earn more from their investments increasing the number of investors and the amount of money they are willing to invest. In contrast, in the U.S tax system, the more a U.S person invests in a foreign corporation, the more he or she is likely to pay to the government tax wise, reducing the attractiveness of investment in the country, especially by U.S persons. However, the government seems to ‘bully’ the same individuals into not investing in areas where they stand to gain more by imposing double taxation. In effect, this curtails the freedom of American citizens and residents from exploiting opportunities that people in most other parts of the world benefit from. This feature is more likely to dissuade foreign investors from establishing their corporations in the United States creating an inverse effect from what the government’s goals are with regard to foreign investment (Arnold 99). Some of the countries that the United States government considers tax havens include Switzerland, the Cayman Islands, Singapore and Liberia.
A distinction between the taxation regime on domestic corporations and that of foreign corporations reveals that instead of placing the domestic and foreign corporations on equal footing, the CFC rules create a punitive tax system for the U.S persons willing to invest in foreign corporations or build corporations that aim to exploit investment markets outside the federal and country territories. For instance, the government charges taxes on domestic corporations after the removal of various deductions while, in most cases, foreign corporations pay taxes based on their gross income. The U.S shareholders also pay taxes on gross income they receive in the form of dividends without prior determination of deductions as most other income tax calculations apply. The result is that foreign corporations experience a natural disadvantage against domestic corporations due to the punitive nature of the tax regime under which they fall.
There is a need to review the CFC rules to accommodate changes occurring to the American economy and the world in general due to globalization. Although there might have been a need to implement such strict rules in 1997 to protect domestic investments, the effect the rules have on the current economy is undue restriction of investment for the U.S persons even as the rest of the world takes advantage of numerous opportunities in the American economy. For instance, it would have been possible for the U.S persons to mitigate the effects of the 2007-2009 financial crisis triggered by a housing bubble (Soros 18). However, as the rules largely discourage investment in foreign corporations, the American economy suffered a huge blow in terms of alternative income sources (Bogle 10). An example is the restriction of investment in tax havens while most other countries exploit them, which results in the dictation of regions that U.S persons should invest in and regions in which they ought to consider foregoing. If U.S persons had been able to invest in foreign companies and explore other sources of income, the government would have had the income to tax other than that it collected from real estate investments, which were dismal throughout the crisis period. The credit crunch in Europe at around the same time did not have effects as adverse as the American economic crisis as the policies in most European countries allow for investments outside their territories at reasonable tax rates and under more relaxed conditions (Turner 65). The United States government, through congress, should thus consider refining the rules so that they are easier to understand for the U.S persons and adjust the provisions so that they are as favorable to the U.S persons as they are to foreign individuals and companies. The rules should also be accommodative of change so that the American economy has the ability to compete with other countries worldwide on equal ground.
Passive foreign investment corporations (PFIC)
The American government has a different set of legislative rules and regulations with regard to investment machinery, creating a distinction between domestic and foreign corporations. It also has legislations that distinguish between different foreign investment machinery, as is the case with controlled foreign corporations (CFCs) and passive foreign investment corporations (PFIC). Although such distinction between the two types of foreign corporations is important for legal purposes, the main applicability of such separation is in taxation, whereby the two types of corporations receive different treatment from the IRS in terms of percentage of taxable income and the types of taxable income. Passive foreign investment corporations apply mainly as investment vehicles in the same way that mutual funds do. This paper briefly introduces passive foreign investment corporations, concisely giving details on rules that govern such corporations and their sphere of operation in the economy of the United States. It also gives some of the similarities that PFICs have with CFCs and some significant differences between the institutions. This paper provides a detailed analysis of the impact rules governing PFICs have on investment, both domestic and foreign and some of the possible remedies the government should consider in the correction of shortcomings these rules possess regarding investment.
Brief background
The main aim for the formation of the PFIC rules is to prevent unnecessary tax deferral on income by the U.S shareholders. It came to the attention of congress that the U.S persons were taking advantage of foreign corporations by creating controlled foreign corporations and dealing in investments that mostly generated non-U.S income, which enabled them evade taxation. In addition, some U.S persons would defer taxation by converting ordinary income to capital gains through investment in foreign corporations that dealt in passive income investments. In such a case, as the resultant income was through the sale of assets as opposed to distribution of dividends, the government would have to wait indefinitely for corporations to distribute income after the sale of such assets. In some instances, the income would not even need repatriation and thus the government would lose out tax wise. In a bid to prevent such situations, Congress, in 1962, enacted the CFC rules to deal with income that provided for the taxation of income generated in tax havens. However, it noted a loophole in the rules in that the U.S shareholders could acquire minority shares and invest in foreign mutual funds , which operated by accumulating earnings rather than yearly distribution as dividends. The holders of such income would thus only undergo taxation of the entire amount once as opposed to yearly taxation. For this reason, Congress enacted the PFIC rules in 1986 (Lee and Smiley 21). The rules enabled the government to impose taxes on deferred income, whether or not the foreign corporations distributed it to the U.S shareholder, reducing preference of foreign investment options and consequently, unnecessary tax deferral.
PFIC Rules
The determination of whether a foreign corporation falls under the controlled foreign company taxation regime or the passive foreign investment company regime depends on the qualifying criteria. As noted earlier, for CFCs, the percentage of shares that the U.S shareholders hold have to be at least 50% of the total shares of the foreign corporation, regardless of whether the shares belong to one U.S person or numerous U.S persons each holding at least 10% in total shares by vote or value. For PCIF, the Internal Revenue Authority applies two tests namely the income test and the asset test. The income test provides that for a company to attain PFIC status, at least seventy fiver percent of its income has to be passive income. Examples of passive income as per IRC Section 954(c) include dividends, net gains in stock sales, interest, real estate mortgage investments among others (Cohen 16). Generally, these incomes take some time to materialize. The assets test qualifies a foreign corporation to attain PFIC status if the corporation’s assets hold a high likelihood to produce passive income as stipulated in 26 USC 1297 (U.S Congress 10407). Examples of such assets include corporate shares, government bonds and real estate assets.
The default consideration or method the IRS uses in the computation of taxes for PFICs is the ‘excess distribution’ method. In this method, any distribution that exceeds 125% of the average distribution on three of the preceding tax years is divisible into the days in that tax year and chargeable as per the number of days as per 26 USC 1291 (b) (Krieger 59). The result of this type of calculation is the compounding of tax charges creating a hefty final payable charge that is punitive in nature. In addition, any interest on the income is taxable separately, creating a possible scenario whereby a U.S shareholder loses any gains from his or her investment on deferral thus negating the whole purpose of this choice of investment. Mostly, the source of income for PFIC is outside the U.S territory thus, unlike in the CFC, U.S shareholders in PFIC receive individual taxes on their shares regardless of deferral whereas the corporation only pays taxes on the U.S source income. This aspect ensures that income for non-U.S shareholders suffers no loss.
However, the taxpayer has an option to select a regime that he or she thinks more suited to his or her PFIC investment. The qualified electing fund enables a U.S shareholder to decide whether he or she prefers the treatment of PFIC income as it would if it were a mutual fund or the mark to market. This option comprises the comparison of income with current market prices for the establishment of taxable income in terms of interest and gains as per 26 USC 1296 (Office of the Federal Register 883). 26 USC 1298 (a) (1) (A) provides that this option is only available for owners of stock in the public market such as the stock exchange (Congressional Record 224). The IRS treats this type of stock as it would ordinary income as per 26 USC 1296 (a).
Impact of PFIC rules on foreign investment
Advantages and disadvantages
Just as is the case with CFC rules, PFIC rules have generated a lot of controversy especially with regard to their feasibility in the current age. Similarly, the rules possess both advantages and disadvantages depending on the perspective of choice.
One of the advantages of PFIC rules is that they fulfill the purpose for which Congress formulated them, which is the dissuasion of unnecessary deferral of income for tax purposes as per 26 USC 881 (Shannon and Beyer 119). The punitive nature of the rules ensures that the U.S shareholders explore other investment options that do not present the IRS with difficulties in tracing and taxing income in a timely fashion. The taxation of interest also ensures the absence of loopholes through which U.S shareholders can evade taxes, therefore making this criterion very effective in relation to the intention of Congress in creating it. Although the rules may not precisely match the economic state of affairs in the United States, they have gone a long way in ensuring that the government maintains its main source of revenue through the frequent generation of funds for development and loan payment for the entire country.
The second advantage that the rules exhibit is that they increase the amount of collectable revenue the government earns from foreign investments. Domestic corporations do not produce as much tax revenue as foreign corporations generate because domestic corporations operate under a standard tax collection regime. The percentage they pay for their income is standardized providing predictability as to the amount a domestic corporation should pay to the IRS in taxes. In contrast, the tax regime for foreign corporations is complex and involves a number of variables. For instance, possibly, a foreign corporation can change in status from a CFC to a PFIC depending on its shareholding and the type of income and assets it possesses as time lapses. If a foreign corporation begins as a CFC and later acquires assets that are likely to generate passive income worth 50% of the total assets, the corporation changes status to a PFIC for tax purposes. This results in an increase of taxable income, which is always good news for the IRS.
Thirdly, although the nature of the rules proves unfavorable for foreign investment, they promote investment in domestic corporations thus providing these corporations with a chance to grow. The United States’ government should foster the growth of local businesses and ensure that its people benefit from favorable policies. Looking at the rules from this angle, the government does indirectly encourage investment in local corporations through the creation of policies that discourage investments in foreign corporations. The benefit this has for domestic companies is that it increases the capital base for the corporations, raising the possibility of growth and expansion with the overall effect of increasing job opportunities and taxable revenue sources through the creation of subsidiary domestic and multinational corporations. By fostering the growth of domestic corporations, the government improves the overall competitiveness of its economy with other countries on an international level. The larger the capital base for domestic corporations, the better the quality of goods, services and investment power these corporations have and subsequently the better they are in international ranking, attracting more investment from other regions.
As a fourth advantage, the PFIC rules provide options for the U.S shareholder that help mitigate the results the ‘excess distribution’ taxation formula is bound to produce. The IRC provides the treatment of a PFIC as a qualified electing fund (QEF) each tax year, a provision that gives U.S shareholders the option to record their income in a manner that enables the IRS tax it as it would a mutual fund or compare the capital gains to market prices in the mark-to-market option (Gill and Schwartz 96). In the first option, the IRS considers income from the PFIC as it would a mutual fund, charging tax on the income on a constant percentage, usually a little higher than it would use for a domestic mutual fund. The agency calculates the tax amount on a yearly basis as part of the U.S shareholder’s income and the shareholder pays the amount together with any other ordinary income that he or she earns. The advantage in this is that the tax amount does not compound in cases where there is a deferral of income for later distribution as is mostly the case with capital gains. The mark-to-market option allows the IRS to compute a U.S shareholder’s gain in relation to the current fair market prices in determining whether interest earned is taxable. Unlike the ‘excess distribution’ formula where the entire interest amount undergoes a steady charge regardless of other factors, the mark-to-market method allows room for lower tax amounts on interests depending on the state of the market.
One of the main disadvantages that the PFIC rules exhibit, and the source of most of the controversy surrounding the implementation of the rules, is their punitive nature (Bartlette 48). The ridiculous compounding of tax charges on deferred gains and the high tax rates for interests the investments earn for the U.S shareholders makes it difficult for U.S persons to explore beneficial investment opportunities using investment tools of their choice. Although this aspect may have been useful during the time of the rules’ inception, a lot has changed in the American economy since then, creating a necessity to engage in foreign investment through various means, including foreign investment tools such as PFICs. Since the PFIC operates much in the same way as domestic mutual funds, it serves to mitigate the extent of losses that an individual U.S person would incur individually in foreign investment activities while creating a substantial financial backing so that he or she has the ability to access quality investments. For instance, in a hypothetical situation where an individual hopes to invest in assets that produce passive income such as real estate property, the individual would have a better chance of affording such investment and getting substantial returns by pooling his or her funds with other like-minded individuals. PFICs provide U.S persons with such opportunity, with the main investment area of choice being opportunities outside federal and state boundaries. However, the rules create a perception that the only reason that a U.S person would be willing to consider investment in PFICs is for tax deferral, a perception that limits access to numerous opportunities for individuals genuinely looking to grow their income.
The second disadvantage in the application of these rules is that they reduce investment options, especially for American citizens, residents and some corporations incorporated under the U.S laws. Most governments work towards increasing foreign investments as they open up income opportunities for the citizens and people who choose the countries as their preferred states of domicile. An increase in income generation creates a subsequent increase in tax revenue, increasing the ability of the government to improve on service delivery through the creation of social amenities and other infrastructural activities that create other forms of revenue for it. The American government is no exception to this concept. It has done its best over the years to attract as much revenue from foreign investment as possible. One of the ways that governments attract investments is by making policies that allow foreign corporations to gain from the facilities and trade market a country has to offer. The PCFI rules go against this prerogative by discouraging U.S persons from investing in opportunities that foreigners benefit from in the US. Increasing the tax rate for U.S persons in both capital gains and interests negates the purpose that PFICs should serve for Americans while benefiting foreign shareholders, an injustice from the perspective of the government’s prerogative. Another angle to look at the application of the rules and their effect on the ability of U.S persons to invest in ventures of their choice is the possible effects the rules have on company policy. Since the IRS taxes the individual earnings for U.S persons, the more the U.S shareholders, the less income the PFIC can defer back into the investment after each tax year. This means that even though foreign investors in the PFIC do not undergo the same tax charges, the taxation may affect the collective investment fund if the number of U.S persons is substantial enough. For this reason, PFICs are more likely to turn down U.S shareholders even though the capital input from such shareholders increases the initial capital base for the fund. In addition, 26 USC 1293(e) or the IRC requires U.S shareholders to collect accurate information from the corporation regarding their net capital gains and interests in addition to keeping personal updated records, an inconvenience most U.S persons find cumbersome (Cameron and Manning 127).
Thirdly, the PFCI tax regime reduces the government’s tax revenue potential. Although the exorbitant taxation of capital gain by the IRS generates substantial amounts of tax revenue, the taxation regime reduces the chances of increasing tax revenue sources by discouraging local investment in preference of foreign investment. Foreign companies pay substantially higher tax rates in terms of operational costs and income in cases where their location of domicile is within the United States or generate income from U.S sources and sometimes both. However, even these corporations generate more tax revenue than the domestic does or local corporations, foreign corporations are fewer in number in comparison to domestic ones. What this means is those domestic corporations and individuals that form the definitions of U.S persons exceed foreign corporations in numbers. The resultant effect is the generation of numerous relatively smaller amounts of tax revenue as opposed to large amounts foreign corporations generate. Looking at tax revenue from this perspective, it is in the government’s best interest to present U.S persons with more opportunities to increase their income base, increasing the government’s overall income. In addition, U.S persons are reliable tax wise as, unlike foreign corporations, they serve as revenue sources with a sense of permanence. Foreign corporations fall subject to numerous other factors in the determination of their productivity and operation. For instance, diplomatic relations between countries especially with regard to trade play a big role in determining the successful operation of investment activities for corporations between the two countries. If a corporation from Iran was to set up investment activities in the US, the corporation would be likely to suffer from the hostility of the business environment that tense relations between the two countries has caused over the years. In essence, a relaxation of the PFIC rules would have the effects of either increasing the number of U.S persons that opt for PFIC investments, increasing the amount of investments that U.S shareholders in PFICs currently have, or both.
Another significant disadvantage is the implication that classification of the PFIC has on foreign investment corporations. Once the IRS classifies a foreign corporation as a PFIC according to the assets test under 26 USC 1297(a) and the income test with reference to IRC Section 954(c), the PFIC tax rules apply to the corporation in that specific tax year and subsequent years. This situation is known as the ‘PFIC taint’ and takes an intricate process to remedy. The problem with the situation is that the IRS applies the use of the ‘excess distribution’ method in determining tax charges, charging for undistributed income as per Section 553 of the IRC and distributed income as per provisions under Section 1248 of the IRC. This means that U.S shareholders in a corporation that was initially not a PFIC may end up suffering hefty tax charges unexpectedly should a review of the corporation’s assets indicate its qualification as a PFIC during the course of its investment business according to 26 USC 368 (Abrams and Doernberg 68). Another problem that qualification criterion for PFICs presents is the possibility of wrongful classification of companies as PFICs. Many start up corporations’ exhibit most of the requirements the IRC provide for the identification of PFICs. For instance, a foreign corporation may operate on ‘active income’ for the first few months of its establishment but in a bid to increase its capital base, end up investing in assets that generate passive income as it is the surest way to increase profits in a short time. However, such a move would cause the corporation its classification as a PFIC, significantly reducing its chances of obtaining investments funds in the form of capital from U.S persons. The fact that the rules make foreign corporations under the PFIC classification unattractive to U.S persons means that domestic corporations get a better footing in the same field, creating a disadvantage for foreign corporations. The entire process negates the government’s efforts to attract foreign investments because the policies make willing foreign corporations unattractive to American investors. The rules also bully foreign corporations whose investments of choice are assets that create ‘passive income’ into limiting their investment potential on such assets or considering other options that may end up being more ‘active’ but less productive in terms of profitability.
Impact of PFIC rules on company policies
PFIC rules affect corporate policies regarding the type and amount of assets in which the foreign corporations choose to invest. These rules create an environment that discourages investment in PFIC classified corporations, leading to a reduction in potential American investors. Therefore, in order to ensure that they do not fall into the PFIC bracket, foreign corporations have to establish policies that spell out their limit regarding the number of assets that generate passive income in relation to their overall asset count. By avoiding the 50% asset mark for this specific type of assets, a corporation ensures that it keeps its desired status, whether CFC or otherwise. In addition, foreign corporations striving to avoid PFIC classification are more likely to ensure that they limit the amount of ‘passive income’ they possess at the end of every tax year. Keeping the passive income percentage below 75% and ensuring that company policies enact the regulation is one sure way of keeping PFIC classification at bay. This goal is attainable through frequent review of assets and laws governing foreign corporations with regard to taxation. However, these limitations and regulations come at the expense of foregoing potential opportunities once the corporations reach the limit. For instance, a foreign corporation that wishes to apply these regulations would have to forego the acquisition of investments likely to create an excess in percentage of either the assets or the income type and opt for alternative options, regardless of whether they possess the same ability to generate profits and earnings. Alternatively, such corporations may implement policies that require the liquidation and distribution of certain percentages of investments to provide for potential future investment opportunities.
PFIC rules also affect policies regarding the regional investment options corporations are free to explore. Most foreign corporations pick regions that appear favorable in terms of economic policies, including policies on taxation and investment, depending on the form of business the corporations conduct. Some corporations may also consider diplomatic relations between the country of origin of the corporation and the country with potential investment opportunities. Therefore, the policies these corporations make in terms of regions that are suitable for investment reflect these policies and company goals as far as productivity is concerned. Although the American government has put in a lot of effort in attracting foreign investment, the PFIC rules make the country unattractive for corporations that wish to invest in long term assets as these assets mainly generate passive income, creating a high likelihood that such a corporation may fall into the PFIC category with regard to taxation. Since the rules are more punitive than beneficial, such a corporation may have to consider countries with lower tax rates and friendlier policies. According to a report by the New York Times, in 2008, Turkey and Germany had lower corporate tax rates in comparison to the United States at 1.8%, 1.9% and 2.0% respectively (Levin Para.12). This means that a company that wishes to incur less in terms of capital input and earn more in terms of profit would be more inclined to invest in Turkey than the United States. This reduces the competitiveness of the American economy in the international trade market with most foreign corporations taking advantage of tax havens and foregoing the American investment market, in spite of the attractive opportunities it presents in terms of high population, versatility of culture and consumption trends and potential for growth.
Shareholding policies are also subject to PFIC rules for foreign investment corporations operating in the United States. Unlike CFC rules that consider the percentage of U.S shareholders as a qualifying aspect, PFIC rules do not provide a percentage or a specific number of U.S shareholders in the determinations of whether or not a foreign corporation qualifies as a PFIC. However, the PFIC rules affect the shareholding policies indirectly through the provision of strict taxation criteria for U.S shareholders, which in tern affect the overall amount of gain that the corporation has available for redistribution into for the next financial year. Although the rules do not necessarily affect foreign shareholders, a foreign corporation that falls under the PFIC category and has a substantial number of U.S shareholders may suffer a substantial reduction of redistributable gains. The amount of income left for U.S shareholders after taxation affects the overall amount and thus the ability of the corporation to buy certain assets. Foreign corporations that wish to avoid such inconveniences are likely to set up shareholding policies that specify the maximum number of U.S shareholders that they are willing to accommodate. Some corporations may even opt not to admit any U.S shareholders to avoid any deductions in the deferrable gains, improving their capacity to invest in more assets or assets with greater value every year. The overall consideration when implementing shareholding policies is the productivity of the PFIC in terms of its benefits to the shareholders. The more the income a corporation generates, the more attractive it becomes to shareholders. Therefore, the regulation of the type and number of shareholders a foreign corporation has is an important aspect that the PFIC rules highlight.
PFIC rules indirectly affect the distribution of company funds in foreign corporations, necessitating the formulation of policies that categorize the use of funds according to priorities depending on the area of operation. By making foreign corporations under the PFIC classification unattractive to U.S shareholders, the PFCI rules make it necessary for such foreign corporations to use other methods of attracting investors, including the formulation of marketing strategies. The essence is to create policies that enable foreign and domestic corporations to compete for investors on equal grounds despite the handicap PFIC rules create for foreign corporations. Foreign corporations are more likely to spend more money on advertising and production of promotional packages that attract U.S shareholders than domestic corporations. Although a substantial number of U.S shareholders are bound to affect the company’s overall capital gain, startup companies would benefit from the option as one of the ways to raise capital in foreign territory. Such companies have to provide policies that clearly indicate the priority allocation of funds for important obligations such as wages, maintenance charges and contingency funds. Notably, apart from competing with domestic corporations, foreign corporations in different tax classifications operating in the same field compete with each other and as PFCI rules are stricter in nature, corporations in this category have to be extra creative to earn their place in the investment market while maintaining high productivity levels (Stein 86).
Conclusion
Although the rules pose some merits for the affected parties, their demerits outweigh the merits and thus review and amendment of the rules to match the current economic status is necessary and long overdue. The rules need to balance the needs of both domestic and foreign investment for efficiency and effectiveness. They also need to be in a format that is comprehensible yet precise for ease of access and understanding and improvement of revenue collection procedure.
References
Abrams, Howard, and Richard Doernberg. Federal Corporate Taxation (Concepts & Insights). New York: Foundation Press, 2002.
Arnold, Brian. Taxation of Controlled Foreign Corporations: An International Comparison (No.78). Toronto: Canadian Tax Foundation, 1986.
Asbill, Richard, and Steven Goldman. Fundamentals of International Franchising. Chicago: American Bar Association, 2001.
Bartlette, Bruce. “Are taxes in the US high or low?” New York Times 2011: 48.
Bedard, Jean, Diana Falsetta, Ganesh Krishnamoorthy, and Thomas Omer. “Voluntary Disclosure of Auditor-Provided Tax Service Fees.” The Journal of the American Taxation Association 32.1 (2010): 59-77.
Block, Cheryl. Corporate Taxation: Examples and Explanations (The Examples & Explanations Series). Chicago: Aspen Law & Business, 2001.
Bogle, John. The Battle for the Soul of Capitalism. New Haven: Yale UP, 2009.
Bolt-Lee, Cynthia, and Elizabeth Plummer. “Highlights of tax research.” Journal of Accountancy 2013: 114. Cameron, David, and Elliot Manning. Federal Taxation of Property Transactions.
Danvers, MA: Mathew Bender & Company, 2012.
Cohen, Ann. “Renewal Communities Tax Benefits for Distressed Areas.” The CPA Journal 2004: 14-18.
Congressional Record. Proceedings and Debates of the 110th Congress. Washington D.C: U.S Government Printing Office, 2008.
Fatemi, Darius, John Hasseldine, and Peggy Hite. “Resisting Framing Effects: The Importance of Prior Attitude on Estate Tax Preferences.” The Journal of the American Taxation Association 30.1 (2008): 101-121.
Fellows, James, and Michael Yunas. “When Is Real Estate a Capital Asset, and When Is It Not?” The CPA Journal 2009: 21-23.
Friedman, Milton. “The social responsibility of business is to increase profits.” The New York Times Magazine 1970: 21.
Gill, Steven, and Christopher Schwarz. “Tax Equalization in Mutual Funds.” The Journal of the American Taxation Association 33.2 (2011): 89-110.
Heniff, Bill, and Robert Keith. The Federal Budget Process. Alexandria: Capitol Publishers, 2009.
Jacobs, Vernon, and Richard Duke. Controlled Foreign Corporation Tax Guide. Kansas: Offshore Press, 2007.
Krieger, Pau. Trade Secret Law in the United States: Cases and Comments. Massachusetts: LexisNexis, 2012.
Lee, Lucy, and Stanford Smiley. Taxing Passive Foreign Investment Companies: Rules, Problems and Solutions. London: Globe Business Publishing Limited. Levin, Carl. Subcommittee Hearing to Examine Billions of Dollars in U.S. Tax Avoidance by Multinational Corporations, 2012. Web.
Miller, Robert. Law School Confidential: A Complete Guide to the Law School Experience by Students, for Students. New York: Thomas Dunne Books, 2011.
Nichols, Nancy, and John Price. “Does Representation Matter in IRS Office Audits?” The Journal of the American Taxation Association 26.1 (2004): 21-42.
Office of the Federal Register. Code of Federal Regulations, Title 26, Internal Revenue, PT. 1. Washington D.C: U.S Government Printing Office, 2009.
Peroni, Robert. International Income Taxation 2008-2009: Code and Regulations—Selected Sections. Chicago: Aspen Publishers, 2008.
Shannon, Brian, and Gerry Beyer. Skills & Values: Property Law. Massachusetts: Mathew Bender & Company, 2012.
Soros, George. “The worst market crisis in 60years.” Financial Times 2008: 18.
Stein, Jacob. “Tax planning for foreign investment in California real estate.” Los Angeles Lawyer 2013: 86.
Turner, Graham. The Credit Crunch: Housing Bubbles, Globalization and the Worldwide Economic Crisis. London: Pluto Press, 2008.
U.S Congress. Congressional Record, V. 153, Pt. 7 Washington D.C: U.S Government Printing Office, 2007.
Weise, Richard. Representing the Corporation: Strategies for Legal Counsel. New York: Aspen Publishers, 2009.