Private Equity in Offshore Investment US Income Tax Pitfalls
Each year, the international tax law specialist team at Golding and Golding represents US Taxpayers across the globe and in over 80-countries with international and offshore tax compliance matters. We specialize exclusively in matters involving offshore disclosure of unreported foreign accounts, assets, investments, and income. One common type of investment that many US persons with global investments have as part of their international portfolio is overseas private equity. This could mean several different things: taxpayers may have invested in a pre-IPO or (commonly) may be an investment banker who has one or more private limited investment components to the funds they work with. These are just two of several examples — but two of the most common that we see with private equity in offshore investments. The biggest problem for US person who has investments in private equity overseas is that there may be tax implications on income that they have not even received yet (Subpart F) and inequitable tax treatment on other income once it is distributed (PFIC Excess Distributions) – which occurs when certain elections have not been made, such as a QEF election. There are also RSU and RSA issues to consider as well. Let’s take an introductory look at some of the basics regarding private equity in offshore investments and with some of the US tax pitfalls can be.
When are US Person has an ownership or interest in foreign passive investments, this can lead to the investment being deemed a Passive Foreign Investment Company (aka PFIC) by the IRS. The PFIC comes in many shapes and sizes and may include holding companies, investment companies, and foreign investment funds. The tax treatment of a PFIC is a very important component for US persons – especially those who may have invested in the asset before becoming a US person — and now have to deal with the collateral damage of the PFIC tax regime.
The general proposition is that unless the taxpayer makes an election such as a QEF or MTM, then while the income is not typically taxed while it grows within the PFIC, once it is distributed — it is taxed at whatever the highest tax rate is each year. In addition, there is interest charged for each day in each year that the PFIC was held by the taxpayer. As you can see, this is a brutal tax consequence for PFICs — and therefore taxpayers may want to try to make an election if they can — noting that in order to make elections certain information is required from the foreign institutions and that just requesting the foreign institution for this type of information may lead them to want to cancel the US taxpayer out from the investment.
The two main types of elections are the MTM (Mark-to-Market) and QEF (Qualified Electing Fund). These types of elections should be made during the first year — unless other protective measures are taken — otherwise if the elections are made in future years then they have to still get rid of the PFIC taint at the time they make the late election — presuming they can even make the election at the time. Of the two elections, the QEF election tends to be better, but it requires some cooperation in terms of information provided by the foreign country institution, and there are various pitfalls to consider when requesting this information from a foreign company.
CFC (Controlled Foreign Corporation)
If the company actually qualifies as a controlled foreign corporation, then (of course) there are other tax headaches to consider as well. With a controlled foreign corporation and the introduction of the Tax Cuts and Jobs Act (TCJA) of 2017, came the introduction of new tax regimes such as GILTI. GILTI refers to the Global Intangible Low-Taxed Income regime. And, even though GILTI it’s not the same as Subpart F Income (see below), it too involves income that may be taxed by the United States — even though a taxpayer has not received any distribution of income. While the Taxpayer can make a Section 962 election to be treated as a Corporation for GILTI purposes, it usually only benefits the Taxpayer where there are some foreign tax credits to offset the US income, otherwise making the election may not benefit the taxpayer much and just increase their annual accounting and legal fees substantially. There is also the reporting issue on Form 5471 — which is one of the more comprehensive of the international reporting forms.
Subpart F income of a Controlled Foreign Corporation involves income that the US government is concerned can be hidden or transmuted into another form — such as loans — which is then later forgiven by the foreign corporation — so that the US taxpayer escapes paying tax on the income. It was common for taxpayers to move money offshore back in the 1950s and 1960s when the US tax rates were much higher — and foreign tax rates were much lower — in which income was turned into “loans” — and then forgiven by the foreign corporation. To combat this tax outcome, Subpart F was created — which results in US Taxpayers being taxed on income generated overseas in any year the company has Earnings & Profit (E&P) which is then in part attributed to the ratable share owned by the US taxpayer —even if they have not received any of that money. In fact, they may never receive that money, but the US person still has to pay tax on it.
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