Many Canadian mining companies wishing to access U.S. capital markets find that the U.S. “passive foreign investment company” (PFIC) tax rules can present special problems. Although the rules do not have an adverse impact directly on the non-U.S. issuer, they do impose adverse U.S. tax consequences on taxable U.S. shareholders which, in turn, make shares of a non-U.S. issuer less attractive to U.S. investors. This article includes a summary of how the PFIC rules work, their potential impact on Canadian mining companies and outlines techniques for dealing with the problems these rules create.
What is a PFIC?
A foreign corporation generally qualifies as a PFIC if either: (1) 75% or more of its gross income for a taxable year is passive income (the income test); or (2) the average percentage (based on the value of the corporation’s assets at the end of each quarter of the taxable year) of assets held during the taxable year that produce passive income, or that are held for the production of passive income, is at least 50% (the asset test). Passive income generally includes dividends, interest, royalties, and net gains from certain commodity transactions (unless in the case of commodity transactions the foreign corporation can establish that such gain is earned in connection with an active business conducted by the corporation and certain other requirements are met). In applying these tests to a foreign corporation, it is necessary to look through subsidiary corporations if the tested foreign corporation owns, directly or indirectly, at least 25% (by value) of the outstanding stock of such subsidiary.
What are the PFIC Rules?
The PFIC rules were added to the U.S. Internal Revenue Code in 1986 because Congress was concerned that U.S. persons investing in passive assets indirectly through a foreign investment company were obtaining inappropriate tax advantages compared to U.S. persons investing in those assets directly. The purpose of the PFIC rules was to eliminate these tax advantages. In many cases however, the PFIC rules overreach their mark and can potentially apply not only to foreign companies holding passive investments but also to some foreign operating corporations earning passive income or that are in a start-up phase without operating revenues. This broad reach of the PFIC rules is especially problematic for non-U.S. exploration stage mining corporations.
What Happens to a U.S. Shareholder Holding PFIC Shares?
If one were to review the U.S. tax disclosure contained in a typical prospectus offering stock of a non-U.S. issuer at risk of being a PFIC, there are often pages of intricate disclosure describing the potentially very adverse U.S. federal income tax consequences to a U.S. investor holding stock of a PFIC. While the details can be complex, the basic impact of the PFIC rules is relatively straight-forward. In particular, if the non-U.S. corporation has been a PFIC at any time during a U.S. shareholder’s holding period of the shares, (a) any gain recognized (and certain large dividends received) by the U.S. shareholder is subject to tax at ordinary income rates (rather than significantly lower long-term capital gains rates that may otherwise have been available to the U.S. holder), and (b) such gain (or dividends) is subject to a non-deductible interest charge that is intended to put the U.S. shareholder in essentially the same position they would have been in had they earned this income rateably over their holding period for such shares.
The PFIC rules can also operate to make certain otherwise non-taxable dispositions of shares of a PFIC fully taxable (and therefore subject to the adverse treatment described above). For example, U.S. shareholders of a PFIC that is acquired by a non-PFIC corporation in a stock-for-stock exchange would be ineligible for tax-free rollover treatment and the transaction would generally be fully-taxable to such shareholders (even though they didn’t actually receive any cash in the transaction with which to fund their PFIC tax liability). Additionally, U.S. shareholders of a PFIC also have an obligation to file information returns with respect to their investment in PFIC shares. Under recently enacted legislation, these reporting obligations may become more onerous.
Mitigating the Adverse Effect of the PFIC Rules
A U.S. shareholder of a PFIC may, in certain circumstances, make elections to help mitigate the adverse tax consequences described above. For example, if the foreign corporation’s shares are regularly traded on a qualified stock exchange, the U.S. investor may be entitled to make a “mark-to-market” election for the PFIC shares. In general, such an election would require the U.S. shareholder to include any appreciation (or, to a limited extent, depreciation) in the PFIC shares over each annual period in income as ordinary income (or, to a limited extent, ordinary loss). Alternatively, a U.S. shareholder may be able to make a so-called qualified electing fund (QEF) with respect to their PFIC shares if the foreign corporation agrees to make certain information available to such shareholder on an annual basis. The QEF rules are complicated but in general operate to treat the PFIC as if it were a partnership (so that an allocable share of the PFIC’s income and gain items flow out to the electing U.S. shareholder on an annual basis even if the PFIC does not actually make any distributions to such shareholder). If a QEF election is properly made, it can help reduce the adverse tax effects of the PFIC rules on a U.S. shareholder by allowing that holder to be taxed at long-term capital gain rates on some portion of its return from the PFIC shares and also to avoid the interest charge described above.
PFIC Rules and Canadian Mining Companies
The PFIC rules raise significant issues for mining companies, especially mining companies that are in the exploration stage or are otherwise in a start-up mode and have not yet realized mining revenue. Specifically, a mining company that is expending large amounts of capital in the exploration and development of mining properties generally has little or no active mining income and, as a result, even a trivial amount of passive income (such as interest earned on cash or short-term investments) can cause the company’s passive income to exceed 75% of its gross income during a particular taxable year. While there is an exemption from PFIC status for corporations that fail the income or asset test in their start-up year, this exception applies only for the first taxable year in which the corporation has gross income and, as a result, is of limited utility if exploration activities stretch beyond a single year. In addition, because net gains from transactions in commodities are presumptively treated as “passive” income, even mining companies with actual operating revenues could be at risk of PFIC status if they aren’t able to establish that they are sufficiently “active” in the production of those revenues (for instance, if the mining company holds non-working interests in properties or relies excessively on independent contractors to carry out its activities).
Accordingly, many Canadian mining corporations that are in the exploration/development stage are surprised to learn that they are at risk of being classified as PFICs. Companies that find themselves in this position and wanting access to U.S. capital markets should consider options to help avoid the potential adverse impact of the PFIC rules. First, it may be possible to manage the income levels of the corporation so that passive income stays below 75% of the company’s gross income during any taxable year in which there are, or may be, U.S. shareholders. If this is not possible, a second option would be to consider making an undertaking to provide U.S. investors with the information that they require in order to make a valid QEF election with respect to their investment in the corporation.
In any case, because the PFIC rules can have a very material and adverse affect on the after-tax return realized by U.S. shareholders, a Canadian mining company offering shares to U.S. investors should, at a minimum, engage in some level of self-examination to determine whether it is at risk of being classified as a PFIC so that the company can appropriately disclose this risk to prospective investors