Managing Risks Presented by the PFIC Rules

BY KIMBERLY S. BLANCHARD

(WEIL, GOTSHAL & MANGES LLP)

Introduction

Under ordinary circumstances, having a foreign corporation classified as a "passive foreign investment company" (a "PFIC") under §1297 of the Internal Revenue Code is an awful thing for the foreign corporation's US shareholders. Under §1291 of the Code, a US shareholder generally must treat nonperiodic distributions received from a PFIC and amounts realized upon a disposition of PFIC shares as ordinary income. Further, the US shareholder must pay an interest charge for the privilege of deferral.

Fortunately, these results can be mitigated substantially if the US shareholder makes a "qualified electing fund" (a "QEF") election with respect to her PFIC shares. If a QEF election is in effect, the normal PFIC penalty regime does not apply. Instead, the US shareholder will include in income each year her share of the PFIC's income, whether or not it is distributed (the "current inclusion regime").

Note that a QEF election can be made only if the PFIC agrees to provide -- and, in fact, does provide -- to the US shareholder detailed information respecting its income each year. Moreover, a PFIC, to which a QEF applies, must open its books and records to its US shareholders. Thus, while a QEF election may render a PFIC less awful from the standpoint of a US shareholder, the QEF may be awful for the PFIC.

Given that currently there is a dearth of regulatory guidance under the Code's PFIC rules, many foreign companies cannot know with certainty whether they are PFICs. As pointed out recently by the New York State Bar Association's Tax Section, a wide variety of foreign operating companies can be tagged with PFIC status under a literal reading of the current rules, many of which are unclear in their application. See NYSBA Tax Section, Proposals for PFIC Guidance, May 22, 2001, reprinted in 91 Tax Notes 2211 (June 25, 2001).

In this uncertain environment, a foreign corporation may be unwilling to provide the cooperation necessary to allow its US shareholders to make QEF elections. This is especially the case where the shares of the foreign corporation are not publicly traded and/or where the foreign corporation has very few US shareholders (i.e., it is not targeting the US equity market).

Perhaps the most common -- and most overlooked -- case in which a foreign corporation that is not targeting the US equity market will nevertheless "acquire" a US shareholder is where it grants stock or stock options to one or more US employees or service providers. Probably the last thing the foreign employer or US employee would think to ask US counsel -- if US tax advice is sought at all -- is whether the incentive intended by granting the stock options will be destroyed by the unforeseen application of the PFIC rules.

The "Options Problem"

Outside of the compensatory context, the PFIC "option problem" is well known. The option problem is created by the interplay between two PFIC rules. The first of these two rules treats options to acquire PFIC shares as PFIC shares. Thus, the sale of an option to acquire PFIC shares can result in a PFIC inclusion. Moreover, if the option is exercised, the holding period of the PFIC shares received generally includes the period during which the option was held, resulting in a longer interest-charge period.

The second rule that contributes to the option problem is the current IRS position that the holder of an option to acquire PFIC shares cannot make a QEF election. Sections 1.1295-1(b)(2)(iii) and (d)(5) of the regulations flatly state that a US person cannot make a QEF election covering any option to buy stock of a PFIC or the shares of stock issuable upon the exercise of an option. In the preamble to the regulations, the IRS voiced

concerns over the computational nightmares that would result if the QEF current inclusion regime were applied to options.

While these concerns may be valid, the current IRS position leaves the optionholder with respect to a PFIC in an untenable position. The PFIC rules are consciously designed to encourage the making of QEF elections. When a person that is treated as a PFIC shareholder is affirmatively denied the ability to make the QEF election, uncertain and draconian results ensue.

Compensatory Options

Does the PFIC "option problem" extend to compensatory options?

Curiously, neither of the above-mentioned regulations purports to implement §1298(a)(4), which grants the IRS the authority to treat options as PFIC stock.

There is room to argue that certain types of options are not treated as PFIC stock, except perhaps upon a disposition of the option, which appears to be covered by the proposed §1291 regulation. (Section 1.1291-1(d) of the proposed regulations provides that an option to acquire PFIC stock is treated as stock "for purposes of applying [the general penalty regime] to a disposition of the option." There is an exception for options to acquire issued and outstanding PFIC shares already covered by a "pedigreed" QEF election. This exception would rarely apply to employee options.)

However, any such argument is difficult to reconcile with the final regulations noted above, as well as with proposed §1.1291-1(h)(3).

The proposed regulation states that the holding period (for PFIC purposes) of a share of stock acquired upon the exercise of an option includes the holding period of the option. Like the final regulations, the proposed regulation purports to apply to all options.

The best that can be said of the situation is that the PFIC rules are difficult (if not impossible) to reconcile with the Code's rules for taxing compensatory grants of stock and stock options. Unfortunately, the worst that can be said is that, by virtue of the application of the PFIC option rules, employees who receive options on PFIC stock face tax problems that are far worse than those faced by ordinary optionholders or stockholders.

Consequences of Applying

The PFIC Rules

If a compensatory option were treated as PFIC stock, a number of confusing and contradictory tax consequences would result. Presumably, no distributions would be made with respect to the option. However, if the option were sold, the employee could be taxed twice on the same income. First, a sale of a compensatory option at a gain produces ordinary income under usual Code rules. See §1.83-7(a) of the regulations. Second, a sale of a PFIC option is treated as a sale of PFIC stock, converting what is (outside the compensation context) capital gain into an ordinary income PFIC inclusion. No rule exists to offset one of these income recognition events against the other.

If the option were exercised, under the Code's usual compensation-related rules, the exercise itself creates ordinary income equal to the "spread" on the exercise date. However, the PFIC regulations do not treat the exercise of an option as a disposition of PFIC shares. Thus, it is possible that the holder would obtain no basis in the PFIC shares received reflecting his inclusion of the spread in income. Any gain on a later sale of the stock might again be subject to the PFIC regime. Moreover, if the holding period of the PFIC stock received on exercise were deemed to include the period during which the option was held, the PFIC interest charge would be levied with respect to the period over which the compensatory spread accrued.

In the case of an incentive stock option (an "ISO"), the employee generally is not taxed on the exercise of the option and her basis in the shares is only the exercise price paid. (However, under current law, the spread between the fair market value and the exercise price of an ISO is an item of tax preference, which must be included in alternative minimum taxable income under the alternative minimum tax regime. See §56(b)(3) of the Code.)

In this case, if the shares are held for the holding period required by §422(a)(1) of the Code, the employee's gain on a later sale of the shares will qualify as favorably-taxed, long-term capital gain. However, if the PFIC rules apply, the favorable regime sought to be conferred by the ISO rules would be voided. On a sale of PFIC shares, all of the employee's gain would be taxed at ordinary rates and, in addition, an interest charge would be levied back to the original grant date of the ISO.

What's the Solution?

Although the IRS does not appear to have realized the problems created by the apparent treatment of compensatory options as PFIC shares, once the problems are acknowledged there is an easy way out of the mess. Section 1298(a)(4) of the Code grants the IRS the authority to issue regulations treating the holder of an option to acquire PFIC stock as the owner of the underlying stock.

Specifically, §1298(a)(4) states that, "To the extent provided in regulations, if any person has an option to acquire stock, such stock shall be considered as owned by such person." The legislative history of this provision vaguely refers to the potential for abuse of the PFIC rules if options are not treated as stock. Presumably, Congress had in mind a situation in which US shareholders trade in PFIC stock through options or derivatives, rather than direct ownership of shares, to avoid the PFIC penalty regime.

It is conceivable, although probably unlikely, that Congress thought options treated as stock under §1298(a)(4) would include only options on issued and outstanding shares. The abuse to which the option rule appears to be addressed is most evident in those circumstances. The legislative history of the PFIC rules envisages that distributions made by a PFIC to actual shareholders should be treated as made to constructive shareholders. See also Treas. Reg. §1.1291-1(b)(7)-(8).

Notwithstanding the fact that §1298(a)(4) was intended as an anti-abuse rule, the IRS' proposed regulations appear to assume that all options must be treated as stock.

The IRS simply needs to exercise its authority under §1298(a)(4) to remove non-abusive options, including all compensatory options, from the scope of the PFIC rules. In every other case of which this author is aware, the Treasury Department has exercised its regulatory authority to exclude compensatory options from the ambit of tax rules designed to reach abusive transactions. See, e.g., Treas. Reg. §1.382-4(d)(7)(iii) (implementing the grant of authority under §382(k)(6)(B)(i); compensatory options not treated as exercised); Treas. Reg. §1.1361-1(l)(4)(iii)(B)(2) (compensatory options not a second class of stock under §1361(b)(1)(D)); Treas. Reg. §1.1504-4(d)(2)(v) (compensatory options not treated as options for purposes of §1504(a)(5)(A) and (B)). All of these regulations use substantially identical language to describe compensatory options. Presumably, any regulations ultimately issued under §1298(a)(4) would incorporate the same language.

In any event, final regulations should be issued under the authority of §1298(a)(4) to exclude compensatory options from the PFIC regime and to treat such options as "not stock" for PFIC purposes.

If compensatory options were excluded from the constructive ownership rule of §1298(a)(4), then the following results should obtain. First, no tax consequences would arise during the period between the grant and the exercise of the option (including upon any vesting of the option). Second, upon the exercise of the option, the employee would recognize ordinary income exactly as he would in the non-PFIC context (or, if the option qualifies as an ISO, no income would be recognized).

Third, the employee would take a tax basis in the PFIC shares received equal to the value thereof on the exercise date, exactly as if the shares had been purchased for cash on that date. (Regulations should extend this basis step-up, for PFIC purposes, even with respect to the exercise of an ISO.) Fourth, the employee would have the ability to make a QEF election as of the exercise date, assuming a QEF was otherwise possible or advisable. Contrary to the proposed §1291 regulations, the employee's holding period for the PFIC shares should be treated as commencing only on the option exercise date.

Compensatory Stock Transfers

There is no reason to believe that all of the PFIC rules do not apply to the shares of a PFIC received by an employee in connection with the provision of services. When a US employee receives a direct grant of unrestricted PFIC shares, no special issues should be presented. If the employee pays less than fair market value for the shares and therefore recognizes the spread as compensatory income, his basis for PFIC purposes should be the fair market value of the shares. If the requirements of the regulations are met, the employee could make a QEF election.

However, if the PFIC shares are subject to a restriction constituting a "substantial risk of forfeiture," within the meaning of §83 of the Code, then the employee is not treated as the tax owner of the shares, unless he makes the special election provided in §83(b). If no §83(b) election is made, the transfer of the shares is deemed to occur only when the restriction lapses (i.e., when the shares "vest"). At that time, the employee recognizes ordinary income, treated as compensation, equal to the excess of the fair market value of the shares on the vesting date over the amount paid for the shares.

Note that §1291(f) imposes the PFIC penalty regime on "transfers" of PFIC shares when there is not a "full recognition of gain." Read literally, §1291(f) could impose tax on a transfer of PFIC shares to an employee who

does not make a §83(b) election. Nevertheless, it should be clear that §1291(f) is limited to cases involving the Code's general non-recognition of gain rules and should not apply to compensatory transfers. See Treas. Reg. §1.1291-6(a)(2).

Interplay Between the §83 Regime

And the PFIC Rules

When a §83(b) election is not made, the §83 regime raises numerous issues in conjunction with the application of the PFIC rules. The regulations under §83 treat an employee as not owning restricted stock until the stock vests. If the employee were similarly not treated as the owner of the restricted shares for PFIC purposes, it is unclear whether she could make a QEF election with respect to those shares. While most tax advisors would probably view the disregard of tax ownership of the shares under §83 as an inviolable rule "trumping" the PFIC rules, it certainly can be argued that the IRS has the authority to treat restricted stock as PFIC stock in the same way it can treat options as PFIC stock.

If the §83 regime trumps the PFIC rules, then the employee will not be treated as the owner of the shares and will probably not be permitted to make a QEF election. (Despite this rule, the transfer of restricted shares should not be treated as an "option" for purposes of the PFIC option rule. The §83 regulations clearly treat the transfer of restricted shares as a transfer of property and not as an option. See Treas. Reg. §1.83-3(a).)

When the shares vest, the employee should be treated as the owner of the PFIC shares and should be eligible to make a QEF election. Regulations should be issued to clarify that the vesting of restricted PFIC shares is not in itself a taxable event for PFIC purposes and that the employee's tax basis in the shares includes the amount included in income upon vesting. Regulations should also make it clear that, when no §83(b) election is made, the employee's holding period for the PFIC shares should start only on the vesting date.

If the employee were treated as owning the PFIC shares during the vesting period, contrary to the principles of the §83 regime, it appears that he could make a QEF election. However, difficult issues would arise in attempting to reconcile the PFIC rules with the §83 rules during the vesting period. If the QEF current inclusion regime were applied, the employee would be required to include in income each year his share of the PFIC's income, even though there is a chance that the employee's interest in the stock would never vest. These inclusions would likely overlap with the amount eventually reported in income upon the vesting of the shares in accordance with §83.

If the employee does not make the QEF election and the normal PFIC rules apply, similar difficulties arise. The §83 regulations treat distributions received with respect to restricted shares (absent a §83(b) election) as compensation rather than as distributions with respect to stock. There is currently no rule that exempts these distributions from the PFIC regime.

Conclusion

The IRS should issue regulations addressing the application of the PFIC rules to compensatory options and stock. Those regulations should provide that:

• compensatory options are not treated as PFIC shares;
• upon the exercise of a compensatory option, including an ISO, the employee's basis for PFIC purposes is equal to the fair market value of the shares on the exercise date;
• if a compensatory option is sold, the PFIC rules do not apply;
• the holding period for the PFIC shares received upon the exercise of a compensatory option begins only on the exercise date;
• the transfer to an employee of restricted shares subject to §83 is disregarded under the PFIC rules until a §83(b) election is made or the shares vest;
• the basis of PFIC shares received in a §83 context is equal to the fair market value thereof on the §83(b) election date or on the vesting date if no election is made; and
• during the vesting period, when no §83(b) election is made, the PFIC rules do not apply.

Kimberly Blanchard is a partner in the New York office of Weil, Gotshal & Manges LLP, where she concentrates in the international tax area. Ms. Blanchard is a member of the Executive Committee of the New York State Bar Association Tax Section, where she is Co-Chair of the Committee on Foreign Activities of US Taxpayers. She is also an active speaker and panelist with the American Bar Association's committee of the same name, and works closely with the ABA's International Lawyers Group. Ms. Blanchard received her J.D. from the New York University School of Law and her B.A. from Dartmouth College. She can be contacted at 212-310-8799 and kimberly.blanchard@weil.com.

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