The Four-Letter Tax Trap for Simple Agreements for Future Equity (SAFEs): Could yours be a PFIC?

If you spend significant capital investing in early-stage start-ups, you may have recently started using Simple Agreements for Future Equity (SAFEs) for those opportunities in which you had difficulty arriving at an appropriate valuation. A SAFE is essentially a debt-like agreement that converts to provide investors with equity in a company at some point in the future if (and only if) a triggering event occurs. So-called triggering events are defined in the terms of the SAFE and can be anything from the start-up company entering another round of funding to being involved in a merger or acquisition.

While these instruments can be a mutually beneficial way to invest in
start-ups that are not yet generating revenue, if you are investing in foreign companies using SAFEs, there is a chance that this shareholding could be subject to Passive Foreign Investment Company (PFIC) treatment at the end of the tax year.

Created in 1986 as a means to end the practice of sheltering offshore investments from taxation, PFIC treatment not only ensures that taxpayers are properly reporting all foreign investments but also taxes such investments at a punitive rate. Companies can be subject to PFIC treatment if the corporation meets one or both of the below conditions:

1. At least 75% of the corporation’s gross income is “passive” or derived from investments or other sources not related to regular business operations; and/or
2. At least 50% of the company’s assets are investments which produce income in the form of earned interest, dividends or capital gains. Passive assets can include cash, other assets readily convertible into cash, accounts receivable from transactions generating passive income or corporate stock, to name a few.

While entering into SAFE agreements with foreign companies is a fairly common process, there is not much guidance from the IRS on how these investments should be treated. If these agreements are treated as equity and the companies generate significant passive income (e.g., interest) at the early operating stages, they could be subject to the PFIC rules which would apply to subsequent capital gains upon disposal of the investment. One should be mindful when entering into a SAFE, as PFIC filings involve numerous U.S. disclosures and pages of forms, as well as a high tax rate.

The issue of PFIC treatment of SAFE holdings is complex, and whether or not your investment could be treated as a PFIC at the end of the year must be analyzed in full by a tax professional. If your company is investing in foreign ventures using a SAFE, it is important to ensure that the SAFE is not subject to PFIC rules before finalizing the agreement. If you are concerned that your company’s SAFE holdings may cause it to be subject to PFIC tax treatment, contact Gwayne Lai, Director of International Tax, or your Anchin Relationship Partner.