Treasury Releases Final and Additional Proposed PFIC Regulations
Summary
On December 4, 2020, the Department of the Treasury and Internal Revenue Service (collectively, Treasury) released an early version of final regulations regarding the determination of whether a foreign corporation is treated as a passive foreign investment company (PFIC) and the application and scope of certain rules that determine whether a U.S. person that indirectly holds stock in a PFIC is treated as a shareholder of the PFIC, to be published in the Federal Register. The final regulations affect U.S. persons with direct or indirect ownership interests in certain foreign corporations.
On the same date, Treasury released an early version of proposed regulations regarding the determination of whether a foreign corporation is treated as a PFIC (the 2020 proposed regulations), to be published in the Federal Register. The 2020 proposed regulations also provide guidance regarding the treatment of income and assets of a qualifying insurance corporation (QIC) that is engaged in the active conduct of an insurance business (PFIC insurance exception). In addition, the 2020 proposed regulations address the treatment of qualified improvement property under the alternative depreciation system for purposes of calculating qualified business asset investment for purposes of the global intangible low-taxed income and the foreign-derived intangible income (FDII) provisions. The 2020 proposed regulations affect U.S. persons with direct or indirect ownership interests in certain foreign corporations, U.S. shareholders of controlled foreign corporations and domestic corporations eligible for the deduction for FDII.
Background
On July 11, 2019, Treasury published proposed regulations (REG-105474-18) under Internal Revenue Code Sections 1291, 1297 and 1298 in the Federal Register (84 FR 33120) (the 2019 proposed regulations) addressing certain PFIC issues including the determination of ownership in a PFIC and the treatment of certain income and assets of a foreign corporation. The final regulations retain the basic approach and structure of the 2019 proposed regulations, with certain revisions.
In addition, on October 2, 2019, Treasury published proposed regulations (REG-104223-18) relating to the repeal of Section 958(b)(4) in the Federal Register (84 FR 52398) (the Section 958 proposed regulations). The final regulations finalize the portion of the Section 958 proposed regulations under Section 1297 regarding the treatment of foreign corporations for purposes of Section 1297(e). The other portions of the Section 958 proposed regulations were finalized in 85 FR 59428.
Final Regulations
The final regulations provide guidance on various PFIC issues including guidance with respect to:
- Attribution rules and application of the “top-down” approach;[1]
- Exceptions to passive income, income subject to the related person look-through rule, the asset test (used to determine whether a company is a PFIC) and stapled entities (any group of two or more entities if more than 50% in value of the beneficial ownership in each of such entities consists of stapled interests);[2]
- Special rules regarding look-through subsidiaries and look-through partnerships;[3]
- QICs, the 25% test and the alternative facts and circumstances test (which are used to determine whether a foreign corporation is a QIC), limitations on the amount of applicable insurance liabilities and the definition of an insurance business;[4]
- Exceptions from the definition of passive income for active insurance income;[5] and
- Rules for certain foreign corporations owning stock in 25%-owned domestic corporations.[6]
The final regulations generally apply to taxable years beginning on or after the date of filing in the Federal Register. Taxpayers may choose to apply the final PFIC insurance regulations to any taxable year beginning after December 31, 2017, provided that all of those rules are applied consistently with respect to that tested foreign corporation for the same year and all succeeding taxable years.
In addition, a taxpayer may choose to apply the final regulations (other than the rules related to the PFIC insurance exception), with respect to a particular tested foreign corporation, to any open taxable year of the taxpayer, provided that all of the rules are applied consistently with respect to that tested foreign corporation for that year and all succeeding taxable years.[7] For taxable years ending on or before December 31, 2020, a taxpayer may rely on proposed Treasury Regulation §1.1297-1(c)(1)(A) in the 2019 proposed regulations concerning the application of Section 954(h) rather than §1.1297-1(c)(1)(i)(A) with respect to a tested foreign corporation.
Taxpayers may apply the final regulations in any open taxable year to all or less than all of the tested foreign corporations whose shares are owned by the taxpayer, subject to the consistency rule described in the prior paragraph with respect to any particular tested foreign corporation. However, if the consequence of applying either the 2019 proposed regulations or the final regulations to prior open taxable years is that, as of the date of application, a tested foreign corporation that was a PFIC ceases to qualify as a PFIC, then the “once a PFIC, always a PFIC” rule is implicated and a taxpayer seeking to end PFIC status must make a purging election or request the consent of the Commissioner to make a late purging election. A taxpayer may choose to apply the rules to open taxable years even if a qualified electing fund election under Section 1295 or a mark-to-market election under Section 1296 was in effect.[8]
The 2020 Proposed Regulations
The 2020 proposed regulations provide guidance on several additional PFIC items, including:
- The active banking business exception and proposed exception for active banking income of foreign banks;
- The valuation of assets for purposes of the PFIC Asset Test. For example, proposed §1.1297-1(d)(1)(v)(D) generally permits a taxpayer to rely upon the information in a tested foreign corporation’s financial statements to determine the value of the corporation’s assets. However, proposed §1.1297-1(d)(1)(v)(D) provides that if a shareholder has reliable information about the value of an asset that differs from its financial statement valuation, that information must be used to determine the value of the asset;
- The treatment of working capital and goodwill for purposes of the PFIC Asset Test, and other PFIC Asset Test rules provided by Notice 88-22. With respect to working capital, under proposed §1.1297-1(d)(2), an amount of cash held in a non-interest bearing account that is held for the present needs of an active trade or business and is no greater than the amount reasonably expected to cover 90 days of operating expenses incurred in the ordinary course of the trade or business of the tested foreign corporation (for example, accounts payable for ordinary operating expenses or employee compensation) is not treated as a passive asset;
- The treatment of dividends paid out of earnings and profits not previously taken into account, such as dividends paid out of pre-acquisition earnings. Proposed §1.1297-2(c)(2) and (f) provide rules that would—for purposes of determining a tested foreign corporation’s PFIC status—eliminate from the gross income of the corporation a dividend it receives from a look-through subsidiary that is made out of earnings and profits not attributable to income of the subsidiary previously included in the gross income of the tested foreign corporation. The rules also would make corresponding adjustments to the basis of a look-through subsidiary’s stock for purposes of determining gain upon the disposition of that stock in applying the PFIC Income Test;
- Safe harbors for application of the principal purpose anti-abuse test that may prohibit the use of the qualified stock rules of Section 1298(b)(7). The proposed regulations provide two safe harbors from the principal purpose anti-abuse rule in §1.1298-4(e)(1). Under the first safe harbor, the anti-abuse rule will not apply if more than 80% of the assets of the second-tier domestic corporation are used in an active U.S. trade or business, as determined under modified Section 367 rules. See proposed §1.1298-4(e)(2)(i). For purposes of the safe harbor, the assets of the domestic subsidiary qualified affiliates (as defined in proposed §1.1298-4(e)(2)(i)(B)) are also taken into account in determining whether the assets of the second-tier domestic corporation are used in a U.S. trade or business.[9] The proposed regulations provide a second safe harbor for active companies undergoing transition and start-up companies.[10] Under this safe harbor, the anti-abuse rule will not apply if the second-tier domestic corporation engages in an active U.S. trade or business that satisfies the first safe harbor by the end of the transition period following the testing date;[11]
- The definition of a QIC, including definitions of applicable financial statements and applicable insurance liabilities, and rules on the optional asset adjustment;
- Rules relating to the passive income exclusion for income derived in the active conduct of an insurance business by a QIC;
- Qualifying domestic insurance corporation non-passive income and asset limitations; and
- Life insurance and annuity contract status.
In addition, the 2020 proposed regulations also contain certain rules announced in Notice 2020-69. Proposed §1.250(b)-2(e)(2) and proposed §1.951A-3(e)(2) clarify that the technical amendment to Section 168 enacted in Section 2307(a) of the CARES Act applies to determine the adjusted basis of property under Section 951A(d)(3) as if it had originally been part of Section 13204 of the Act.
The 2020 proposed regulations contain dates of applicability and rules for when a taxpayer may rely on those proposed regulations.
Next Steps
U.S. investors in foreign corporations, particularly, foreign banks and insurance companies, should review the application of these PFIC rules with respect to their foreign investments.
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