PFIC… What was that again? — A double-edged sword

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My recent posting about MER Telemanagement Solutions, an Israel based technology company whose equity, MTSL, is traded on Nasdaq, resulted in some questions from readers of the blog.

In the posting (read it here,) which broadly speaking discussed MER Telemanagement Solutions’ quarterly earnings announcement in which the company announced (1) a new high in cash (and cash equivalents) on hand almost exclusively on the strength of a very profitable contract with Simple Mobile, a West-coast based MVNO whose managed services contract with MER Telemanagement Solutions had generated a guaranteed $300 thousand in revenues and cash every month throughout MER Telemanagement Solutions’ fiscal 2013 year; and (2) the end of this revenue and cash stream, effective as of December 31st, 2013.

In my posting, I pointed out that the straightforward economic loss of the Simple Mobile contract coupled with tremendous expenses related to capturing and launching new customers to replace the loss of the contract could hit MER Telemanagement Solutions and MTSL in ways that had the potential for simply bleeding MER Telemanagement Solutions out:

Also, with the loss of the contract revenue and its high margin there is now, I believe, a substantial risk that the company will be considered a PFIC by the IRS of the United States with serious tax implications for common shareholders in the United States. As the company wrote in its 20-F filing for its 2012 fiscal year:

We may in the future be classified as a passive foreign investment company, or PFIC, which will subject our U.S. investors to adverse tax rules.

This comment caused a couple of comments and questions to arise, intensifying as the per share price of MTSL inexplicably started rising when it should, in fact, decrease, reflecting the potential for loss in the first quarter.

Sidenote: I say inexplicably, but that is not really so. In fact, the price was rising, I believe, as part of a deliberate pattern of stimulating buys intended to pull a number of loss positions out of the fire (due to a series of speculative run-ups and subsequent implosions in the per share price of MTSL over the last year the majority, if not all, of the true free float of MTSL is seriously under water.) However, we will let this lie for now as it has only a tangential connection with the issue of PFIC, which is the point of this posting.

Let me attempt to address these question here (spoiler alert: A PFIC classification of MER Telemanagement Solutions may be really bad news for current United States based holders of MTSL shares and may adversely and seriously impact the per share price of MTSL.)

PFIC is shorthand for Passive Foreign Investment Company, an oddity in the United States tax code that was introduced because the United States Congress was concerned that persons investing in passive assets indirectly — through a foreign investment company — could gain a tax advantages relative to persons investing in the same assets directly.

The resulting law attempts to eliminate this problem, but, unfortunately, also have the potential to impact genuine foreign operating companies, for instance companies that are earning substantial passive income (such as a company that has a large war-chest, generating income.)

The way the law is written it attempts to identify a PFIC by way of two criteria. Either 75% of its gross income is passive income or more than 50% of its assets generate passive income.

I am grossly simplifying here, but if you read my previous postings, I am sure that you can see that there is a real possibility of MER Telemanagement Solutions being categorized as PFIC given its cash position (the result of cash gushing out of Simple Mobile for three years) and its off-the-cliff drop in revenues and income.

For MER Telemanagement Solutions itself the classification as a PFIC will really have very limited direct implications, but for United States based shareholders in MER Telemanagement Solutions it gets complicated and dirty very quickly.

First, any gain recognized by the shareholders becomes subject to ordinary income rates, rather than capital gains rates (a vast difference) and — hold on to your pants here — the gain is subject to a non-deductible interest charge over the holding period for the shares.

And it doesn’t end there. In special cases the income tax rate assessed will not be the United States based shareholder’s “normal” tax rate, but, rather, the highest marginal income tax rate in the United States.

It may be worth saying this again: Rather than paying between 15% and 20% in gain tax, United States based shareholders will be paying between 30% and 40% and they will be paying interest on the gain (deemed interest, in fact!)

Second, there is a paper burden here that is well beyond the casual investors, traders, and speculators (I, unfortunately, do not believe that casual investors, traders, and speculators are plagued by detailed knowledge of the environment that they are operating in, which, of course is why they a-l-w-a-y-s lose money in the market.) Essentially, he or she must make a baffling election between mark-to-market or qualified electing fund treatment, both of which are just as confusing as they sound and require certain detailed disclosures by the PFIC (good luck in getting a company to provide disclosure beyond what it has provided in its filings with the SEC.)

How bad is PFIC classification for a United States based shareholder? Well, I think it is very bad. In fact, I think the acronym PFIC was chosen by some fiendish soul in United States Congress with a twisted sense of humor because it also is the acronym for Progressive Familial Intrahepatic Cholestasis, a very nasty liver disease, to signify precisely how bad it is.

I said before that for MER Telemanagement Solutions itself the classification as a PFIC will have very limited direct implications. Likewise, the classification will not have any direct implications for MTSL shareholders that are not based in the United States. However, the operative word here is direct.

A classification as an PFIC is adverse and will make any sensible investor think twice before he or she invests in MER Telemanagement Solutions by way of MTSL, and, so, we have an indirect effect on both MER Telemanagement Solutions and its non-United States based shareholders in that the price per share of MTSL will drop — perhaps a lot!

The irony should not escape us here. The successful looting of Simple Mobile and accumulation of loads of cash may very well be a textbook case of a Pyrrhic victory.

Yes, that’s also a beaut of a double-whammy. First, a drop because of the changes in the fundamentals and, second, a further drop because of a perverted tax treatment.

Now, over time, the PFIC issue will, of course, go away, since, in all probability, MER Telemanagement Solutions will start bleeding, rapidly eating away of the cash (and cash equivalent) asset that is the underlying problem. But, as a solution there is not much comfort to be had here, I think.

Perhaps this is why the company was talking about M&A alternatives in its earnings report? Well, this is certainly going to be interesting!

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