Investing in a UK startup? What US investors should know

If you’re a US-based investor looking at a UK startup, you might worry that investing in a foreign company will create extra tax work for you.

The good news is that investing itself doesn’t usually trigger US tax. But one thing you should understand is a US tax classification called PFIC (which stands for Passive Foreign Investment Company). If the company counts as a PFIC, it can lead to harsher tax treatment when you sell your shares. The good news is that it can usually be avoided with a single step taken early on – a QEF election – which we’ll cover later.

This guide covers what PFIC is, why a UK startup could count as one, what to ask the company for before you invest, and how a QEF election can protect you.

What is a PFIC, and why should you care?

A PFIC is a non-US company that is considered to be “passive” under US tax rules.

There are two main ways this is tested (if a company meets either of these tests, it’s a PFIC):

1. Too much passive income: 75% or more of the company’s gross income is “passive”, from things like interest, dividends, rent or royalties.
2. Too many passive assets: 50% or more of the company’s assets are held to produce passive income, from things like cash or investments.

The rules were created to stop US taxpayers using foreign companies to defer tax on investment income.

But since the rules are so broad, they don’t just apply to holding companies or investment funds. They can also catch early-stage startups, especially if the company has raised money, is sitting on cash, and hasn’t started generating much operating revenue yet.

That doesn’t automatically make the investment a problem. It just means you need to know whether the company is a PFIC or not. This determines what filings or elections you may need to make, and what information the company will need to give you each year.

Why would an ordinary UK startup count as a PFIC?

At first, PFICs sound like they should only apply to passive investment companies. So you might think a product-building startup is the opposite of that. But the rules can still apply to early-stage companies because of two things:

1. Cash can count as a passive asset – even cash the company is holding to fund its operations.
2. Interest on that cash can count as passive income.

So, imagine a pre-revenue UK startup that has just closed a funding round. It has a big pile of cash on its balance sheet and no operating income yet (maybe just a small amount of bank interest).

On the asset test, the company may look like it mostly holds passive assets. On the income test, its only income may be passive income. On paper, that can make it a PFIC, even though the company is doing exactly what an ambitious startup should be doing (building, hiring and spending the money on growth).

That’s why US investors shouldn’t assume a company is outside the PFIC rules just because it is a regular operating business. The question is how the company looks under the PFIC tests.

Will investing today cost me any more in US tax?

No, it won’t. Buying shares isn’t usually a taxable event for US federal income tax purposes. So you don’t owe US tax simply because you wire money and receive stock in a UK company.

But the PFIC consequences can arise while you hold the shares. Also, you may have some new reporting obligations as a result (we’ll cover those later).

The company’s PFIC status is also relevant when you eventually sell the shares, because it can affect how any gain is taxed.

That’s why it’s worth checking the company’s PFIC position before you invest, rather than waiting until exit.

How PFIC can affect your tax when you sell

The main issue related to investing in a PFIC isn’t usually the day you invest. It’s what happens later, when you sell your shares at a gain.

That could happen if the company is acquired, you sell your shares in a secondary sale, or if there’s another taxable disposal.

If the company was a PFIC (and you didn’t make a valid election), the default PFIC rules can apply. These rules produce a much harsher result than the normal long-term capital gains tax treatment you might expect.

Put simply, here’s how that investment would be treated:

1. The gain is spread back across every year you hold the stock.
2. The portions allocated to earlier years are taxed at the highest ordinary income rate for each of those years – up to 37% – not the roughly 20% long-term capital gains rate you’d normally hope for.
3. An interest charge is added on top, as if you’d owed that tax all along. The longer you hold it, the more it will compound.

That combination can make a long-held PFIC investment much more expensive than a normal startup investment. Between the ordinary income rates and the interest charge, a long-held PFIC can hand a large chunk of your gain (maybe even most of it) to the IRS.

What to do if the company is a PFIC

If you hold shares in a PFIC, you may face the harsher default PFIC tax rules when you sell your stock. But the main way to avoid this is by making a QEF election, which stands for “Qualified Electing Fund”.

A QEF election changes how you deal with the PFIC. Instead of waiting until sale and potentially falling into the default PFIC regime, you include your share of the company’s ordinary earnings and net capital gain on your US tax return each year (even if the company doesn’t distribute the cash).

But in return, when you sell later, you can generally avoid the default PFIC treatment. That means no spreading the gain back across previous years, and no PFIC interest charge.

For an early-stage startup, this can often be a good result. Most startups will have little or no taxable profit in the early years, so there won’t be large amounts for you to report each year. But you still need to make the election properly and keep up with the annual reporting.

That annual reporting is usually done on Form 8621 (the tax form used for PFIC reporting, including QEF elections). You’ll need to file this with your tax return while you hold PFIC stock.

But when it comes to preparing this form, you’ll need information from the company. In practice, that usually means asking the company to provide a PFIC Annual Information Statement each year. That’s why, before investing, it’s a good idea to ask the company about their familiarity with PFIC. The issue is usually manageable, but only if the company is able to provide the right information.

There’s also a de minimis (or small holdings) exception.  It can apply if your total PFIC holdings are worth $25,000 or less – or $50,000 or less for a couple filing a joint tax return. In that case, you may not need to file Form 8621 that year, as long as you haven’t sold stock or received a distribution.

Should you worry that your money makes it a PFIC?

This shouldn’t worry you. It’s normal for an early-stage company to look like a PFIC in the year or two after a raise, while it’s still holding most of the cash from investors like you.

But as we’ve covered, that PFIC status isn’t a tax bill in itself – it mostly means you have some annual reporting to do. Also, a QEF election made early means any eventual gain is still taxed as a normal capital gain. 

So the initial PFIC period isn’t a reason to hold back in making an investment, as long as you elect early and keep up with the reporting.

Checklist: What to look for before you invest

An investment’s PFIC status is usually manageable if it’s dealt with early. Before you invest in a UK startup, you should ask the company these questions (you – or your tax advisor – will need the information):

• Will you check your PFIC status each year? PFIC status can change as the company’s income, assets and business activity change.
• Will you provide a PFIC Annual Information Statement if needed? This gives you the key information you need to make and maintain a QEF election.
• Is the cap table clean and up to date? This helps you understand your ownership position and whether any other US tax regimes could be relevant.
• Are there any future structure plans? This may matter if you are hoping for US tax treatment such as QSBS, or if the company expects to move to a US parent structure later.

The main thing is not to leave these questions until exit. If you only discover the PFIC status when the company sells, it could be too late to get the best tax outcome (and it’ll be much harder to gather all the information you need).

So if a UK founder has sent you this guide, make sure they can, at least, confirm its PFIC position each year and provide the information you need.