~ Immigration Tax Planning ~
Foreign Personal Holding Company "FPHC"
Repeal of FPHC Rules in 2004
The American Jobs Creation Act of 2004 repealed the foreign personal holding company rules for tax years beginning after Dec. 31 2004. Before repeal, a U.S. shareholder of a foreign personal holding company had to include in income a share of any of the company's foreign personal holding company income that remained undistributed at the end of the company's tax year. The foreign personal holding company (FPHC) rules did not directly impose a tax. Rather, they increased the amount of income of a U.S. shareholder that was subject to U.S. income tax.Definition of FPHC - Pre-2005 Law
A foreign
corporation is a FPHC if both of the following is true:
- at least 60% of its gross income for the taxable year consists of "foreign personal holding company income", which includes interest, dividends, royalties, gains from the sale of securities or commodities, certain rents and certain income from personal services provided by shareholders of the FPHC; and
- at least 50% of either the total voting power or total value of the stock of the corporation is owned by 5 or fewer individuals who are citizens or residents of the United States.
Note that unlike the passive foreign investment company "PFIC" or the controlled foreign corporation "CFC" rules, the definition of a FPHC contains thresholds both as to the ownership and the assets/income of the corporation.
Consequences of Owning Stock in a FPHC - Pre-2005 Law
Prior to the repeal of the FPHC rules in 2004, U.S. shareholders of a FPHC had to include in income, as a dividend, their share of the FPHC's undistributed foreign personal holding company income. This had the effect of converting capital gains recognized by the corporation into ordinary income recognized by the shareholder. Furthermore, any shares of an FPHC were not entitled to a basis step-up at death under Section 1014. To avoid application of the FPHC rules (if the corporation is not a CFC), the corporation had to distribute its FPHC income to the shareholders as a dividend, which again converted capital gains into ordinary income. Obviously, that was not usually desirable.Coordination with Other Anti-Deferral Rules - Pre-2005 Law
There were numerous coordination rules which determined how to tax income which was subject to all of the PFIC, FPHC and CFC rules. Generally, with respect to those U.S. persons who were deemed to be Ten Percent Shareholders with respect to that foreign corporation, income subject to all three rules was treated as Subpart F income taxable under the CFC rules and was not taxed again as undistributed FPHC income or as an excess distribution from a PFIC. Since Subpart F income generally retains its character in the hands of a U.S. Shareholder, being taxed on a pro rata share of Subpart F income should not differ substantially from being taxed on the income from the corporation's assets as if the Ten Percent Shareholders owned their share of the corporation's assets directly, unless the foreign corporation generated substantial earnings and profits which were not taxable income but which generated a current inclusion under Section 956 (earnings and profits invested in U.S. situs assets) or Section 956A (earnings and profits invested in passive assets). This ability to retain the character of capital gains is one of several reasons why it was (and generally still is) advisable to make a QEF election for any PFIC owned by a U.S. citizen or resident who is not a Ten Percent Shareholder or where the foreign corporation is not a CFC.
Prior to repeal of the FPHC rules in 2004, if one or more U.S. persons were treated as shareholders of a FPHC but they were not Ten Percent Shareholders, then, even if the FPHC was also a CFC, the non-Ten Percent Shareholder's share of the capital gains recognized by the corporation was converted into ordinary income included in the shareholder's income. If the U.S. person was not a Ten Percent Shareholder, then there was no current inclusion under the CFC rules. In that case, the coordination rules provided that income which was both undistributed FPHC income and QEF income would be treated solely as undistributed FPHC income, which was treated as a dividend. For this reason, a U.S. person was advised to avoid acquiring any equity interest in a foreign corporation that would qualify as a FPHC if the attribution rules would have created U.S. shareholders who were not also Ten Percent Shareholders.
Reporting Rules - Pre-2005 Law
In addition to the substantive rules, there were significant record-keeping and reporting burdens placed on U.S. shareholders of a foreign corporation that was a FPHC. Transfers to foreign corporations had to be reported on Form 926, and the information required under Section 6038B had to be attached to the form. U.S. shareholders of FPHCs often had to annually file Form 5471 regarding U.S. ownership and control of foreign corporations and the corporation had to file Form 5472 regarding transactions with related parties. Given the number and complexity of these rules, it was usually advisable either to avoid having the foreign corporation qualify as a FPHC or to avoid having the U.S. person be a shareholder in the corporation.