This article applies to owners on non US corporations that may be considered a Passive Foreign Investment Company (PFIC). It also applies to owners of pass-through entities that may own an interest in a PFIC and the attribution of ownership rules are discussed.
Abstract: The IRS has issued final regulations on how to determine whether a foreign corporation is a passive foreign investment company (PFIC) for federal tax purposes. The regs also specify the application and scope of the rules determining who’s treated as a PFIC shareholder. This article discusses a few highlights of how the final regs differ from the proposed regs.
The IRS has issued final regulations on how to determine whether a foreign corporation is a passive foreign investment company (PFIC) for federal tax purposes. The regs also specify 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. The final regs retain the basic approach and structure of the proposed regs, with certain revisions. Here are a few highlights of those changes.
Attribution of Ownership
The final regs don’t adopt the proposed amendments to a regulation relating to pass-through entities such as partnerships, S corporations, estates and nongrantor trusts.
The regulation in question provided that an owner of an interest in a partnership, S corporation, estate or trust would be treated as owning stock owned by the pass-through entity only if the pass-through owner owns 50% or more of the pass-through entity. This proposed rule was intended to ensure that the attribution rules apply consistently whether a U.S. person owns stock of a non-PFIC foreign corporation indirectly through a partnership or directly.
A commenter noted that this rule could prevent a U.S. person from being treated as owning stock of a PFIC owned by a non-PFIC corporation, even though the U.S. person directly and indirectly owned more than 50% of the stock of the non-PFIC corporation in the aggregate. The commenter argued that this result was inappropriate, and the IRS agreed.
Application of “top-down” Approach
The final regs apply a “top-down” approach to the attribution of ownership through all tiered ownership structures. The aforementioned proposed reg applied the attribution rules to a tiered ownership structure involving a pass-through entity using a “top-down” approach, starting with a U.S. person and determining what stock is considered owned at each successive lower tier on a proportionate basis.
For example, U.S. person A owns 49% of the partnership interests in a partnership that owns 95% of the stock of a tested foreign corporation (TFC). The TFC isn’t a PFIC but owns all the single class of stock of a PFIC. U.S. Person A also owns the remaining 5% of the TFC stock directly. Under a “top-down” approach, U.S. Person A is deemed to hold 46.55% of the TFC’s stock through the partnership and owns 5% of the TFC’s stock directly.
One commenter suggested using a “bottom-up” approach instead of the “top-down” approach, but the IRS rejected this approach in the final regs because the “bottom-up” approach may not take into account the PFIC stock that’s owned through the 5% of the TFC’s stock that U.S. Person A owns directly.
The final regs also include a new rule addressing the application of the successive application rule to tiered ownership structures. The new rule specifically provides for a top-down approach to attribution of ownership.
In addition, the examples in the existing and proposed regs have been revised to clarify how the top-down approach applies to those examples. And the IRS added a new example in the regs to illustrate the operation of the successive application rule in a fact pattern in which a U.S. person owns stock of a foreign corporation both directly and indirectly through a partnership.
Related Person Look-Through Rule
A proposed reg provided additional guidance on the application of the tax code’s related person exception for dividends, interest, rents and royalties. Under the final regs, for purposes of the asset test and income test, corporations and partnerships owned in whole or part by a TFC are generally classified into one or more of three categories. Lower-tier entities generally are treated as one or more of:
- A look-through subsidiary or look-through partnership (a “look-through entity”),
- A related person, or
- An entity that’s neither a look-through entity nor a related person.
Dividends and the distributive share of income from a lower-tier entity that’s neither a look-through entity nor a related person generally are treated as passive income, regardless of whether the income of the lower-tier entity is active or passive in its hands. Similarly, ownership interests in such entities are treated as passive assets.
Because the ownership threshold required for an entity to be treated as a related person is higher than the ownership threshold required for an entity to be treated as a look-through entity, there may be many entities that qualify as both or solely as look-through entities. However, because the tax code has broader attribution rules than the rules that apply for purposes of determining look-through entity classification, there may be entities that are treated as related persons with respect to a TFC but not as look-through entities with respect to that TFC.
For tax code purposes, interest, dividends, rents or royalties actually received or accrued by a TFC are considered received or accrued from a related person only if the payor of the interest, dividend, rent or royalty is a related person with respect to the TFC. In the case of income received or accrued from a look-through entity, the rules that eliminate intercompany income apply before the rules applicable to income received or accrued from a related person. Consequently, the rules of the applicable final reg apply to dividends, interest, rents and royalties received or accrued from a look-through entity only if those amounts are treated as regarded after application of the intercompany income rules.
These rules also apply to income from a related person that’s received or accrued by a look-through entity. The determination of whether income received or accrued by a look-through entity is treated as received from a related person is made at the level of the look-through entity — both for purposes of determining whether the look-through entity is a PFIC, if relevant, and for purposes of determining whether an upper-tier TFC is a PFIC.
If a partnership is a related person that’s not a look-through entity with respect to a TFC or look-through entity, and therefore subject to these rules, the TFC’s or look-through entity’s distributive share of income from the partnership is treated as passive or nonpassive in whole or part. This treatment is based on the activities of the partnership, and the partnership interest is correspondingly treated as passive or nonpassive in whole or part.
Finally, an asset that gives rise to income that’s treated as partly passive and partly nonpassive pursuant to these rules is subject to the rules that apply to dual-character assets.
The applicability dates of the final PFIC regs vary depending on the specific regulation in question. We’ve covered just a few noteworthy revisions here; consult your CPA for more information and any questions you might have.
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