The European Startup’s Guide to Navigating the US Tax Implications of US VC

Investment
(https://notion.vc/resources/the-european-startups-guide-to-navigating-the-us-tax-implications-of-us-
vc-investment/)

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 msutantoshen@wsgr.com and Dan at daniel.glazer@wsgr.com.
QEF Elections Under PFIC Rules
By Scott F. Usher, MST, CPA, and Diana L. Pitner, E.A., Bader Martin PS, Seattle
October 1, 2012
[https://www.thetaxadviser.com/issues/2012/oct/clinic-story-07.html#:~:text=To%20make%20the
%20initial%20QEF,Election%E2%80%9D%20box%20on%20Form%208621]

Editor: Alan Wong, CPA

Foreign Income & Taxpayers

In enacting Secs. 1291 through 1298 in 1986, Congress created a complex and punitive tax
regime for certain passive foreign investments that continues—nearly three decades later—
to plague U.S. taxpayers and their tax advisers.

U.S. taxpayers who invest in offshore mutual funds or certain other passive foreign
investments without understanding the tax consequences may learn only years later that
those investments are subject to the onerous tax rules for investments in passive foreign
investment companies (PFICs).

Background

The PFIC rules were enacted to eliminate beneficial tax treatment for certain offshore
investments. Under prior law, U.S. taxpayers could accumulate tax-deferred income from
offshore investments and, upon sale of the investment, recognize gain at the long-term
capital gains tax rate.

Under the PFIC rules, absent a beneficial election, PFIC investments are generally subject
to tax on distributions at the highest ordinary income rates in effect for the tax year, rather
than the currently more beneficial dividend and capital gains rates. Sec. 6621 interest
charges accrue on deferred taxes until the due date of the return (without regard for
extensions) for the last PFIC year; losses are disallowed.

Typically, these PFICs are passive investments in offshore mutual funds, hedge funds,
stocks, annuities, or income-producing property.

Under Sec. 1297, a PFIC is defined as a foreign corporation that meets at least one of the
following tests:

 75% or more of its income is derived from passive sources (the income test), or
 50% or more of the average fair market value of the assets it held during the year
are passive income-producing assets (the asset test).

If a U.S. taxpayer’s investment is characterized as a PFIC in one year, it is generally also

treated as a PFIC in future years—commonly referred to as the once-a-PFIC-always-a-
PFIC rule or the PFIC taint.

PFIC Taxation
The U.S. taxpayer-investor in a PFIC is taxed according to an onerous excess-distribution
regime under Sec. 1291 unless the taxpayer cleanses the PFIC taint with either of two
elections: the mark-to-market election under Sec. 1296 (available for assets that are
regularly traded on qualified exchanges or other markets) or the election to be treated as a
qualified electing fund (QEF) under Sec. 1295. The latter is the focus of this item. If either
election is made for a tax year other than the year the asset was purchased, the taxpayer
must first cleanse the PFIC taint—with a deemed-sale election in the case of the QEF
election.

A QEF Election in a Year After the Year of Purchase

Under the QEF tax regime, a U.S. taxpayer’s investment in a PFIC is generally subject to
the same tax rules and rates as a domestic investment—except that dividends are not
considered qualified dividends. The taxpayer elects to include in each year’s taxable income
a pro rata share of the PFIC’s ordinary earnings and net capital gains.

Generally, unless the taxpayer files the QEF election in the tax year the PFIC investment
was made, the excess-distribution regime applies until the PFIC taint is cleansed with a
deemed sale under Sec. 1291(d)(2)(A). Under very limited circumstances—and only when
the taxpayer fails to file the election based on a reasonable belief that the investment was
not a PFIC—the taxpayer may file a retroactive QEF election as described in Regs. Sec.
1.1295-3.

Deemed-sale election: To cleanse the asset’s PFIC taint, the taxpayer must recognize any
gain on the investment; losses are disallowed. The amount of the recognized gain is equal
to the asset’s fair market value as of the first day of the PFIC’s first tax year, less its
adjusted basis. The gain is taxed at ordinary income tax rates, according to the excess-
distribution regime, and is subject to Sec. 6621 interest charges. The gain is reported on
Form 8621, Information Return by a Shareholder of a Passive Foreign Investment
Company or Qualified Electing Fund, filed with the taxpayer’s federal income tax return. The
holding period of a U.S. shareholder for purposes of applying the PFIC rules—but not for
other tax purposes—begins on the date of the deemed sale.

QEF election: The QEF election must be made by the extended due date of the taxpayer’s
federal income tax return. To make the initial QEF election for an asset, the taxpayer must
file Form 8621 with his or her tax return and check the “Election to Treat the PFIC as a
QEF” box. If this tax year is not the year in which the investment was first purchased, the
taxpayer must also check the “Deemed Sale Election” box on Form 8621. The QEF election
is revocable only with the IRS’s consent.

In every subsequent year, the taxpayer must file a separate copy of Form 8621 for each
QEF asset.

To facilitate calculations and reporting under the QEF rules, PFICs are required each year
to provide each investor with a “PFIC Annual Information Statement.” The statement must
contain essential information for the Form 8621 filing, such as the investor’s pro rata share
of the PFIC’s ordinary earnings and any net capital gain for the tax year—or provide the
information on which to base those calculations. Taxpayers who do not have access to this
information cannot elect the QEF tax regime.

Conclusion

The excess-distribution regime—the default tax rules for a PFIC—is generally less favorable
for taxpayers with PFIC investments than the mark-to-market and QEF methods. Because
of restrictions on the use of the mark-to-market method, the QEF election is the more
favorable approach for the majority of U.S. taxpayers—preferably elected in the year the
investment is made or as soon as possible thereafter to begin the running of the holding
period for a subsequent sale.

An example illustrating the results of the excess-distribution rules vs. the QEF tax regime is
available here.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA,
in New York City.

For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986
or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK

International/USA.
EX-1.4 5 u99690exv1w4.htm EX-1.4 PFIC ANNUAL INFORMATION STATEMENT

Exhibit 1.4

PFIC Annual Information Statement – Combined Basis

(1   This Information Statement applies to the taxable year of chinadotcom corporation (Cayman
) Islands) (“chinadotcom”), on a combined basis1 with its subsidiaries, beginning on January 1, 2004 and ending
on December 31, 2004.

(2) (i)   The ordinary earnings of chinadotcom on a combined basis with its subsidiaries for the taxable year
specified in paragraph (1) are US$0.166903 per share. In the event you have made a “qualified electing
fund” (or QEF) election, your pro-rata share of such earnings may be determined as follows:

  (a)  If you owned the same number of chinadotcom shares from January 1, 2004 through December 31,
2004, multiply the number of such chinadotcom shares by US$0.166903.

  (b   If you did not own chinadotcom shares for the entire period beginning January 1, 2004 and ending
) December 31, 2004, multiply the number of shares you owned by US$0.166903, divide the result by
365, and multiply by the number of days during 2004 that you held such shares. 2

  (c)   If you owned different numbers of chinadotcom shares at different times during 2004, perform the
calculation specified in (b) above separately for each lot of shares owned.

  (ii)  The net capital gain of chinadotcom on a combined basis with its subsidiaries for the taxable year specified
in paragraph (1) are US$0.004570 per share. In the event you have made a “qualified electing fund” (or QEF)
election, your pro-rata share of such earnings may be determined as follows:

  (a)  If you owned the same number of chinadotcom shares from January 1, 2004 through December 31,
2004, multiply the number of such chinadotcom shares by US$0.004570.

  (b   If you did not own chinadotcom shares for the entire period beginning January 1, 2004 and ending
) December 31, 2004, multiply the number of shares you owned by US$0.004570, divide the result by
365, and multiply by the number of days during 2004 that you held such shares. 3

  (c)   If you owned different numbers of chinadotcom shares at different times during 2004, perform the
calculation specified in (b) above separately for each lot of shares owned.

1  If you require a list of all PFIC subsidiaries, please contact chinadotcom.

2  For example, if you acquired 10,000 shares on July 1, 2004 and held them throughout the remainder of 2004, your
pro rata share of chinadotcom’s ordinary earnings would be US$841 (i.e., 10,000 shares x 0.166903 x 184/365).
3  For example, if you acquired 10,000 shares on July 1, 2004 and held them throughout the remainder of 2004, your
pro rata share of chinadotcoms net capital gain would be US$23 (i.e., 10,000 shares x 0.004570 x 184/365).

(3   The amount of cash and fair market value of other property distributed or deemed distributed
) by chinadotcom on a combined basis with its subsidiaries during the taxable year specified in paragraph (1) is
as follows:

        

Cash:      None     
    

Fair Market Value of Property:      None     

    

(4   chinadotcom will permit you to inspect and copy chinadotcom’s permanent books of account, records, and
) such other documents as may be maintained by chinadotcom that are necessary to establish that PFIC ordinary
earnings and net capital gain, as provided in section 1293(e) of the Code, are computed in accordance with U.S.
income tax principles.

        

  chinadotcom corporation
 
 

  By:   /s/ Tracey S. Harris    

Date: April 12, 2005  Title:   Director of Reporting