July 15, 2019

Proposed Regulations under Passive Foreign Investment Company Regime

By Andre Benayoun, Partner, Tax & Business Services

Tax & Business

On Wednesday, July 10, 2019, the Internal Revenue Service issued proposed regulations regarding the Passive Foreign Investment Company (“PFIC”) regime (under proposed regulations affecting Sections 1291, 1297, and 1298). Below are highlights, along with a brief overview of the PFIC regime.

Background

The PFIC regime is a punitive tax regime established in 1986 with the purpose of denying the benefit of tax deferral to U.S. persons who invest in passive assets through the use of non-controlled foreign companies. The policy behind the PFIC rules stems from the government’s intent to curb U.S. persons from trying to defer tax on passive income through the use of a foreign corporate entity.

From a technical perspective, the PFIC regime affects U.S. persons who own an interest in a foreign company that either: (1) earns 75% or more of its income as passive income (e.g., dividends, interest, rents, and royalties); or (2) receives passive income from at least 50% of its assets (note that cash is considered to generate passive income). In the case where a purported PFIC owns at least 25% in another entity, such other entity’s income and assets may be consolidated in determining whether the above thresholds are met. This is known as the “look-through” test.

There are some exceptions to the PFIC regime, including the exemption for active insurance businesses from having their income qualify as passive for purposes of the PFIC regime if certain requirements are met. (There are many other exceptions and elections a U.S. taxpayer can make to reduce or eliminate the tax burden associated with the PFIC regime, but as they were not affected by the new proposed regulations, they remain beyond the scope of this Tax Flash).

The result of falling within this regime is that distributions from a PFIC, or gains on the sale of PFIC stock, are subject to U.S. tax at the highest rate (21% for corporations and 37% for individuals). In addition to being taxed at the highest rates, an interest charge is imposed on the tax due as if the tax had been owed to the IRS on a pro rata basis over the entire holding period of the PFIC stock. As such, the longer the PFIC stock has been held prior to a distribution or sale, the greater the interest charge added to the tax due. In some extreme cases, the tax due can exceed the amount of cash proceeds from the distribution or sale!

Note that the PFIC regime does not apply to foreign corporations that are controlled by U.S. persons, as such corporations are subject to a separate set of rules, including the Subpart F regime, Global Intangible Low Tax Income (GILTI) regime, and 956 regime. These other regimes are beyond the scope of this Tax Flash, but suffice it to say that the Subpart F regime disallows tax deferral on passive income earned by controlled foreign corporations for similar policy reasons that led to the establishment of the PFIC rules.

Highlights of New Proposed PFIC Regulations

The proposed regulations clarify how to compute attribution of ownership from one entity to another in determining how much PFIC stock a U.S. person is deemed to own. In certain fact patterns, the attribution of PFIC stock to a U.S. person will differ if one begins the attribution process from the bottom of the chain, rather than beginning at the top of the chain and working downward. The proposed regulations suggest a top-down approach should be used for purposes of determining what percentage a U.S. owner holds in PFIC stock.
As discussed above, the PFIC regime can apply when 75% or more of the foreign corporation’s income is treated as passive income. Based on the language of the Tax Code, the definition of passive income is cross-referenced to another section of the Code dealing with Subpart F income. Similar to the PFIC regime, the Subpart F regime denies tax deferral on passive income earned by foreign companies that are controlled by U.S. persons (unlike the PFIC regime, which only applies to foreign corporations that are not controlled by U.S. persons). There are certain exceptions in the Subpart F rules that remove otherwise passive income from constituting Subpart F income. The question answered by the proposed regulations is whether those same exceptions could be used by U.S. taxpayers to remove income from being passive for purposes of the PFIC rules. In short, the proposed regulations deny the use of certain Subpart F exceptions (e.g., the look-through exceptions to Subpart F income) from applying for purposes of the PFIC calculation.
Generally, the aforementioned 75% income test is applied on a gross income basis. The proposed regulations make clear that for certain income (e.g., gains over losses from the sale or exchange of certain property), losses can reduce gains when calculating gross income for purposes of the 75% threshold.
The proposed regulations clarify how to treat an interest in a partnership held by a foreign corporation and whether such partnership interest should be treated as an active or passive asset. In short, the regulations treat a 25% or greater owned partnership interest as subject to look-through, so that the active or passive nature of the assets is determined at the level of the assets within the partnership. For less than 25%-owned partnerships, the partnership interest itself is generally treated as a passive asset. The same is true with respect to income generated by the partnership for purposes of the PFIC income test.
Under the PFIC rules, certain related party payments of dividends, interest, rents, or royalties are exempt from being treated as passive income. The proposed regulations clarify that determination as to whether parties are related is made at the time of receipt of the payment or accrual of such payment, based on the recipient’s method of accounting.
The calculation of the value of assets for purposes of the 50% threshold mentioned above is made on a quarterly basis. The proposed regulations allow for a more frequent recurring period to be used, but does not require it based on the potential administrative burdens involved with measuring assets on a more frequent basis.
The proposed regulations add further clarity with respect to how to treat assets that produce both active and passive assets.
The proposed regulations provide further guidance with respect to dealers in stock which are part of their active trade or business, and confirm that such assets are not treated as passive with respect to these types of businesses.
The proposed regulations provide clarity regarding whether domestic corporate stock held by a purported PFIC is passive or active.
The proposed regulations provide clarity with respect to the active rents and royalties exception to passive income treatment, and clarify that certain active business activities provided by the owner of the entity earning such rental income may be enough to qualify for the PFIC exception to passive income.
The proposed regulations clarify how to treat income from the sale of a 25% or greater owned subsidiary in determining whether such income is passive. In short, the rules state that the income from the sale of such stock is passive, but reduced by any look-through income treated as active under the PFIC look-through rules.
As mentioned above, insurance business-related income may be treated as active instead of passive if certain requirements are met. To be treated as an active insurance business, the foreign entity must be similar to the U.S. definition of an insurance company, and it must have applicable liabilities that constitute more than 25% of its total assets. The new proposed regulations further clarify these two requirements and how to calculate them.