On December 4, 2020, the IRS released final regulations (T.D. 9936) and proposed regulations (REG-111950-20) relating to the modification of the passive foreign investment company (PFIC) rules. These regulations contain rules for determining when a foreign corporation is classified as a PFIC and whether a U.S. person indirectly holding stock in a PFIC is treated as a shareholder of that PFIC.
By way of background, section 1297 classifies a foreign corporation as a PFIC if at least 75 percent of its gross income is passive (the “income test”) or its average percentage of assets producing passive income is 50 percent or greater (the “asset test”). The rules are designed to prohibit U.S. shareholders of PFICs from deferring tax on passive income earned through such corporations.
The Final Regulations generally follow Proposed Regulations that were published in July 2019 with some modifications, including the following:
- The Final Regulations use a “top-down” approach for attributing ownership of stock of a PFIC to a U.S. person through all tiered ownership structures. Under the Proposed Regulations, the “top-down” approach was only applied to structures involving pass-through entities. The Final Regulations expand the approach to encompass all tiered ownership structures, including corporations;
- The Final Regulations remove section 954(h) active financing income rules from the list of exceptions applied to PFICs for purposes of the income test. The Treasury Department determined that such an inclusion was inappropriate. Under the Proposed Regulations, section 954(h) was included in the list of exceptions applied to PFIC;
- The Final Regulations modify the guidance on when a foreign corporation, with respect to the alternative facts and circumstances test, is considered to be predominately engaged in an insurance business. The Proposed Regulations had set forth a predominately engaged test based on various factors to make the determination. It was unclear whether the test is in addition to the insurance company status test, how non-arm’s length insurance transactions are treated and whether the list of factors set forth for the test are exclusive. The Final Regulations clarify that the test is in addition to the insurance company status test, the determination of the inclusion of non-arm’s length insurance transactions is dependent on the character of the business conducted in that taxable year, and the list of factors is not exclusive; and
- The Final Regulations clarify the relationship between the domestic subsidiary rule and section 1298(a)(2) attribution rule. Section 1298(b)(7) provides rules for foreign corporations that own at least 25 percent of the value of a domestic corporation. In this situation, the stock held by the domestic corporation is treated as a non-passive asset and the related income is considered non-passive income. The Proposed Regulations did not apply section 1298(b)(7) when deciding whether a foreign corporation is a PFIC for purposes of the ownership attribution rules in section 1298(a)(2). However, the Final Regulations now apply section 1298(b)(7) for the attribution of ownership rules under section 1298(a) as long as proper measures are provided and enforced to ensure taxpayers are not avoiding PFIC classification by holding passive assets in domestic subsidiaries.
The Proposed Regulations would address various concerns including the following:
- With regard to the income test, the Proposed Regulations would revise how to determine whether a qualifying insurance company (QIC) is engaged in the active conduct of an insurance business by requiring the satisfaction of either a factual requirements test or the active conduct percentage test. Under the factual requirements test, the officers and employees of the QIC must regularly accomplish substantial managerial and operational activities related to its core functions. Additionally, the officers and employees must partake in all relevant decision-making functions. Under the active conduct percentage test, a QIC is engaged in an active insurance business if the total costs of the QIC’s officers and employees carrying out the core functions is greater than 50 percent of the QIC’s total costs. Additionally, any outsourcing of the core functions must be supervised by experienced officers and employees of the QIC;
- The Proposed Regulations would provide two safe harbors from the principle purpose anti-abuse rule. The first safe harbor establishes that the anti-abuse rule will not apply if the amount of the assets of the second-tier domestic corporation used in an active trade or business in the U.S. is more than 80 percent of the assets of the corporation. The second safe harbor provides that the anti-abuse rule will not apply if the second-tier domestic corporation in question 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; and
- The Proposed Regulations would establish a limitation rule on income and assets of a qualifying domestic insurance corporation (QDIC). The Treasury Department stated that where a QDIC has more passive assets than required to meet its insurance and annuity obligations, it may be necessary to limit the amount of a QDIC’s income and assets considered non-passive. The Proposed Regulations provide that the amount of a QDIC’s income and assets considered to be non-passive may be limited by a certain percentage of the corporation’s total insurance liabilities and may not be greater than the corporation’s passive income multiplied by the ratio of the QDIC’s non-passive asset limitation to its total passive assets.
Finally, taxpayers should be mindful that these tax rules are complex and special care should be taken to understand both the benefits and collateral consequences that can arise from the application of these tax rules.