The United States has the most complicated tax system of any country. A major reason for this is that Congress has added so many provisions in efforts to combat tax evasion. Unfortunately, the complexity just creates an opportunity for bright tax planners to find new loopholes, and for the unwary to fall into a trap. I fear that many of the US listed Chinese companies have a tax trap for the unwary.
One of the loophole closing efforts was rules related to passive foreign investment companies. The loophole was that a group of US shareholders could put money in a foreign corporation, earn interest and dividends on the investment, and they pay tax at capital gains rates when they dispose of the stock. Other rules shut down the technique for closely held companies, but the PFIC rules bring in foreign public companies.
A company is a PFIC if 50% of its assets generate passive income (interest, dividends, rents, royalties, etc.) or 75% of its revenue is passive. US shareholders in a PFIC are subject to special tax rules. These rules basically make sure that any gains are taxed at the highest US tax rates and charge interest on any gains deferred. US investors are wise to avoid PFIC investments, due to the complexity and the adverse tax consequences. Foreign investors are not subject to the rules.
Every US listed Chinese company is a potential PFIC, and most make disclosures of their PFIC status in the annual report. Many of these companies use the variable interest entity structure, which adds considerable complexity to the PFIC calculations.
The typical corporate structure of a US listed Chinese company is to list a Cayman Islands holding company, which owns 100% of the shares of a Chinese company, called a WFOE (wholly foreign owned enterprise). Operations are often conducted in a variable interest entity (VIE), which is a Chinese company owned by Chinese individuals. The VIE is controlled by the WFOE through a series of contracts, although the WFOE owns no shares in the VIE. The structure has been used by many companies to circumvent Chinese rules restricting foreign ownership in sensitive sectors.
When calculating the 50% asset and 75% revenue PFIC tests, the assets and revenues of companies that are owned at least 25% are proportionately included. (IRC Sec 1297(c)).
For accounting purposes, VIEs are consolidated under accounting rules that require consolidation based on effective control instead of looking only at stock ownership.
Vipshop Holdings Limited (NYSE:VIPS) says in its annual report on Form 20F that they do not believe they are a PFIC nor are they likely to become one. This is based on including their VIEs in the calculation. They say that if they cannot include the VIEs in the calculation, then they would likely be a PFIC.
That is a big deal. Are they allowed to include the VIEs or not when measuring PFIC status? Vipshop says the law in this regard is unclear. I don't think it is so unclear. The law says that the look through rule applies "if a foreign corporation owns (directly or indirectly) at least 25 percent (by value) of the stock of another corporation (IRC Sec 1297(c))." In the case of Vipshop, they own no shares of the VIE. They are allowed to consolidate for financial reporting purposes because of special accounting rules that focus on control instead of ownership, but the accounting rules do not determine the tax treatment.
Vipshop is not alone in taking this position. I found other similar disclosures on similar companies. This is likely to be a problem only when the following conditions exist:
1.The shareholder is a US person (the rules apply only to US shareholders).
2.Operating assets are mostly in the VIE (some companies pride themselves in keeping operating assets out of the VIE to the extent possible).
3.IPO proceeds and other passive assets have been kept in the parent company or WFOE.
US investors should be careful about investing in Chinese companies that are potentially PFICs.