Treatment of Foreign Token Vehicles -- PFIC rules
Disclaimer
I've been thinking about how a foreign corporation formed to hold and manage tokens should be treated for US tax purposes. [Note, all of the following would be changed by the current Tax Bills being reviewed in Congress, but who knows what any new law will actually say.]
Elsewhere on this blog I've discussed whether such a corporation could avoid generating "Subpart F Income" if it is a CFC ("Controlled Foreign Corporation" -- one that is more than 50% owned by US persons who each own more than 10% of the foreign corporation). My conclusion was that there was a significant risk that, other than in the case of certain utility tokens, it was likely the IRS would claim the income of that foreign corporation was "Foreign Personal Holding Company" income ("FPHC income"), which would essentially eliminate the benefits of running the business through a foreign vehicle.
I did not discuss, however, what would happen if you caused the foreign company to avoid CFC treatment by, for example, having distributed ownership so few US persons owned 10% or having a significant foreign ownership that prevented CFC characterization. Many token sponsors might be willing, even happy, to create a capital structure that avoided such treatment if there was a significant enough tax benefit.
In that event, however, you'd have to address the "Passive Foreign Investment Company" ("PFIC") rules. Those rules come into play with foreign companies whose assets are primarily investment assets. It is not clear whether tokens would be treated as investment assets for these purposes, but it's a good bet that the IRS would make the claim.
The PFIC rules impose an interest charge on dividends or capital gains realized by US shareholders of a PFIC that are "Excess Distributions" and taxes those amounts as ordinary income. The idea is that any "excess distribution" must have been earned ratably over the US shareholder's holding period for the stock, and so the holder is taxed as if that distribution were actually paid ratably over that period, tax was imposed at the highest rate applicable to each year, and interest was imposed on the resulting tax as if it was delinquent from the day returns were due for that year until paid.
Most people avoid PFICs if they possibly can because the conversion to ordinary income tax rates and the interest charge are seen as onerous, but it's worth thinking about how it might apply to a token company (assuming, again, that the company is willing to structure its capital to avoid CFC treatment).
It is worth making the point that PFIC status is not necessarily deadly. A distribution or capital gain is only an "excess distribution" if it exceeds 125% of the average of the last 3 years of distributions -- and the first year's distribution doesn't count.
So if you formed a PFIC to hold your Tokens, and your share of those tokens was worth, say $2,000x, you could avoid PFIC tax if you distributed $103.77 in the first year, and increased that distribution by 125% each year over the previous 3 year average. After 10 years, you would have distributed all $2,000 and you would have incurred no PFIC tax. However, if you did take the full distribution at the end of 10 years, you would pay an additional 8% tax (depending on interest rates) -- less if you take the distribution earlier -- plus an additional ~13.2% tax (37% tax on ordinary income over 23.8% on capital gain). 10 years is a long time, but during that time, the PFIC can continue to make investments that are not subject to current US tax. The question is whether the appreciation of Tokens over time (free of US tax) is worth the additional US tax paid in the future.
I've been thinking about how a foreign corporation formed to hold and manage tokens should be treated for US tax purposes. [Note, all of the following would be changed by the current Tax Bills being reviewed in Congress, but who knows what any new law will actually say.]
Elsewhere on this blog I've discussed whether such a corporation could avoid generating "Subpart F Income" if it is a CFC ("Controlled Foreign Corporation" -- one that is more than 50% owned by US persons who each own more than 10% of the foreign corporation). My conclusion was that there was a significant risk that, other than in the case of certain utility tokens, it was likely the IRS would claim the income of that foreign corporation was "Foreign Personal Holding Company" income ("FPHC income"), which would essentially eliminate the benefits of running the business through a foreign vehicle.
I did not discuss, however, what would happen if you caused the foreign company to avoid CFC treatment by, for example, having distributed ownership so few US persons owned 10% or having a significant foreign ownership that prevented CFC characterization. Many token sponsors might be willing, even happy, to create a capital structure that avoided such treatment if there was a significant enough tax benefit.
In that event, however, you'd have to address the "Passive Foreign Investment Company" ("PFIC") rules. Those rules come into play with foreign companies whose assets are primarily investment assets. It is not clear whether tokens would be treated as investment assets for these purposes, but it's a good bet that the IRS would make the claim.
The PFIC rules impose an interest charge on dividends or capital gains realized by US shareholders of a PFIC that are "Excess Distributions" and taxes those amounts as ordinary income. The idea is that any "excess distribution" must have been earned ratably over the US shareholder's holding period for the stock, and so the holder is taxed as if that distribution were actually paid ratably over that period, tax was imposed at the highest rate applicable to each year, and interest was imposed on the resulting tax as if it was delinquent from the day returns were due for that year until paid.
Most people avoid PFICs if they possibly can because the conversion to ordinary income tax rates and the interest charge are seen as onerous, but it's worth thinking about how it might apply to a token company (assuming, again, that the company is willing to structure its capital to avoid CFC treatment).
It is worth making the point that PFIC status is not necessarily deadly. A distribution or capital gain is only an "excess distribution" if it exceeds 125% of the average of the last 3 years of distributions -- and the first year's distribution doesn't count.
So if you formed a PFIC to hold your Tokens, and your share of those tokens was worth, say $2,000x, you could avoid PFIC tax if you distributed $103.77 in the first year, and increased that distribution by 125% each year over the previous 3 year average. After 10 years, you would have distributed all $2,000 and you would have incurred no PFIC tax. However, if you did take the full distribution at the end of 10 years, you would pay an additional 8% tax (depending on interest rates) -- less if you take the distribution earlier -- plus an additional ~13.2% tax (37% tax on ordinary income over 23.8% on capital gain). 10 years is a long time, but during that time, the PFIC can continue to make investments that are not subject to current US tax. The question is whether the appreciation of Tokens over time (free of US tax) is worth the additional US tax paid in the future.
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