SERVICE ANNOUNCES TEMPORARY RULES FOR PFIC CHARACTERIZATIONS OF INCOME FROM BANKING BUSINESS.

Notice 89-81

I. INTRODUCTION

This notice provides guidance concerning characterization of income derived in the banking business by a foreign corporation that is not licensed to do business as a bank in the United States for purposes of the definitional tests of the passive foreign investment company (PFIC) provisions. The rules contained in this notice will be incorporated into future regulations.

This notice also modifies certain rules concerning designation of dealer inventory and investment assets provided in Notice 88-22, 1988-1 C.B. 489.

II. CHARACTERIZATION OF INCOME OF FOREIGN BANKS

For purposes of applying the 75 percent passive income test and the 50 percent passive asset test of section 1296(a) of the Internal Revenue Code, income derived in the active conduct of a banking business by a foreign corporation licensed to do business as a bank in the United States (U.S. licensed bank) does not constitute passive income. Section 1296(b)(2)(A). The regulations will provide that income effectively connected with the active conduct of a U.S. trade or business pursuant to a license to do business as a bank in the United States (U.S. bank license) as well as income derived in bona fide banking activities (in accordance with paragraph (B)(l) of this notice) conducted abroad by a U.S. licensed bank are nonpassive income.

The regulations also will provide that a foreign corporation that is not licensed to do business as a bank in the United States will qualify for the passive income exception in section 12g6(b)(2)(A) of the Code if it is an active foreign bank under paragraph (A) of this notice. Under this exception, income derived by an active foreign bank in accordance with paragraph (B)(1) of this notice will be considered derived in the active conduct of a banking business and therefore nonpassive income.

(A) ACTIVE FOREIGN BANKS

A foreign corporation will qualify as an active foreign bank for a taxable year if it satisfies the banking activity and gross income tests of paragraphs (A)(1) and (2) of this notice and the licensing requirement of paragraph (A)(4) of this notice for the taxable year.

For purposes of the banking activity and gross income tests of paragraphs (A)(1) and (A)(2) of this notice and the definition of bona fide banking activities in paragraph (A)(3) of this notice, a person will be considered related to the foreign corporation if such person has a relationship described in section 1.954-lT(b)(4)(iii) of the Temporary Income Tax Regulations with the foreign corporation. In applying section 267(b)(2) and (8) of the Code for this purpose, five percent is substituted for 50 percent.

(1) BANKING ACTIVITY TEST. The foreign corporation must actively conduct, within the meaning of section 1.367(a)-2T(b)(3) of the temporary regulations, a banking business that is a trade or business within the meaning of section 1.367(a)-2T(b)(2). In order for the business conducted by the foreign corporation to be considered a banking business, the foreign corporation must either regularly accept deposits and make loans, as described in paragraphs (A)(3)(a) and (A)(3)(b) of this notice, in the ordinary course of its trade or business, or be a qualified affiliate, as defined in this notice.

A qualified affiliate is a foreign corporation that regularly performs, in the ordinary course of its trade or business, at least one bona fide banking activity defined in paragraph (A)(3)(b) through (A)(3)(n) of this notice, and that also is a member of an affiliated group that satisfies the requirements of (a) and (b) of this paragraph (A)(l). For purposes of this notice, the term "affiliated group" has the meaning given the term in section 1504(a) of the Code, but without regard to section 1504(b)(3), (4), and (7) (relating to exclusions for foreign corporations, possessions corporations, and DISCs).

(a) The affiliated group includes either (i) a corporation, whether domestic or foreign, that actively conducts a banking business in the United States pursuant to a U.S. bank license or (ii) a corporation that is an active foreign bank that regularly accepts deposits and makes loans, as described in paragraphs (A)(3)(a) and (A)(3)(b) of this notice, in the ordinary course of its trade or business. An affiliated group will be treated as including a corporation described in either (i) or (ii) of this paragraph (A)(1)(a) only if (1) the corporation has been a member of the affiliated group for the five-year period (or, if shorter, the period the common parent of the affiliated group has been the common parent of the affiliated group that includes the foreign corporation) ended on the last day of the taxable year of the foreign corporation attempting qualification as a qualified affiliate, and actively conducted its banking business throughout that period; and (2) the gross income for the taxable year of the corporation (or corporations) described in (i) or (ii) is at least 20 percent of the total gross income for the taxable year of the affiliated group as defined in this notice. For purposes of the preceding sentence, gross income of a member of the affiliated group does not include income earned in a transaction with another member of the group.

(b) Fifty percent or more of the total gross income of the affiliated group is derived from bona fide banking activities as defined in paragraph (A)(3) of this notice. For purposes of the preceding sentence, gross income of a member of the affiliated group does not include income earned in a transaction with another member of the group.

(2) GROSS INCOME TEST. The foreign corporation must derive at least 60 percent of its total gross income for the taxable year from bona fide banking activity transactions as defined in paragraph (A)(3).

The look-through rules of section 1296(b)(2)(C) and 1296(c) of the Code do not apply for purposes of the 60 percent gross income test. For example, income derived by a foreign corporation in a transaction with a related person that is a U.S. licensed bank or an active foreign bank (described in subdivision (ii) of paragraph (A)(1)(a)) is not income from a bona fide banking activity for purposes of the 60 percent test unless the transaction itself is a bona fide banking activity defined in paragraph (A)(3)(b) (relating to loans and similar transactions).

(3) BONA FIDE BANKING ACTIVITIES. The following activities, to the extent conducted with unrelated persons in the ordinary course of the foreign corporation's trade or business, are bona fide banking activities for purposes of this notice. For purposes of the activities described in (a), (b), and (c), a related person will be treated as an unrelated person if it is either (i) a corporation, whether domestic or foreign, that actively conducts a banking business in the United States pursuant to a U.S. bank license or (ii) a foreign corporation that accepts deposits and makes loans as described in (a) and (b) in the ordinary course of its trade or business, and qualifies as an active foreign bank without regard to deposits accepted from, and loans made to, related persons.

(a) Accepting deposits from unrelated persons. A foreign corporation will be treated as engaged in this activity in the ordinary course of its business only if (i) the average for the taxable year of deposits accepted by the corporation from unrelated persons equals at least 50 percent of the average of total liabilities of the corporation for the year and (ii) the foreign corporation has at least 1,000 qualified depositors. For purposes of this notice, the average of deposits and the average of total liabilities of the corporation for the taxable year are the average of the deposits and liabilities outstanding at the end of each quarter during the taxable year of the corporation. A qualified depositor is a citizen or resident of the country in which the foreign corporation is licensed to accept the deposit who is unrelated to the foreign corporation. The citizenship or residency of a depositor will be determined on the basis of the depositor's address on file with the foreign corporation, provided the foreign corporation has no other knowledge concerning the citizenship or residency of the depositor.

(b) Making or participating in loans or advances to unrelated persons, including banks, and servicing such loans. The acquisition by the foreign corporation of a security (as defined in section 1.864-4(c)(5)(v) of the Income Tax Regulations) is not a loan within the meaning of this paragraph (A)(3)(b), unless the security is an obligation received by the foreign corporation on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of the foreign corporation's trade or business. An interbank deposit is a loan for purposes of this paragraph (A)(3)(b) only if it is placed with a related person that is a corporation described in either paragraph (A)(3)(i) or (ii). A foreign corporation will be treated as engaged in this activity only if at least 50 percent of the average principal for the taxable year of all loans (within the meaning of this paragraph (A)(3)(b)) outstanding during the corporation's taxable year is owed by unrelated persons. For purposes of this notice, the average principal for the taxable year is the average of the total principal of all loans outstanding at the end of each quarter during the corporation's taxable year.

(c) Factoring evidences of indebtedness for unrelated persons.

(d) Purchasing, selling, discounting, or negotiating for unrelated persons notes, drafts, checks, bills of exchange, acceptances, or other evidences of indebtedness.

(e) Issuing letters of credit to unrelated persons and negotiating drafts drawn thereunder.

(f) Performing trust services, including activities as a fiduciary, agent, or custodian, for unrelated persons, provided such trust activities are not performed in connection with services provided by a dealer in stock, securities, or similar financial instruments.

(g) Arranging foreign exchange transactions, or engaging in foreign exchange transactions, for unrelated persons.

(h) Entering into interest rate and currency swaps and other hedging transactions with or on behalf of unrelated persons.

(i) Underwriting issues of stock, debt obligations, or other securities under best efforts or firm commitment agreements with unrelated persons.

(j) Providing charge and credit card services, or factoring receivables obtained in the course of providing such services, for unrelated persons.

(k) Providing traveler's check and money order services for unrelated persons.

(l) Providing correspondent bank services for unrelated persons.

(m) Providing agency paying and collection agency services for unrelated persons.

(n) Any other activity (or variation of an activity described in (a) through (m)) that the Commissioner determines to be a commercial banking activity generally conducted by active foreign banks in the ordinary course of their banking business.

(4) LICENSING REQUIREMENT. The foreign corporation, other than a qualified affiliate, must be licensed or authorized in the country in which it conducts its principal banking operations to conduct the bona fide banking activities that it performs in that country. Such activities must be subject to the banking regulatory authorities of that jurisdiction.

(B) CHARACTERIZATION OF INCOME

(1) Income earned in the performance of bona fide banking activities (as defined in paragraph (A)(3) of this notice) by an active foreign bank will be treated as nonpassive income for purposes of the 75 percent income test of section 1296(a)(1) of the Code. For purposes of the preceding sentence, in determining whether income of an active foreign bank was derived in the performance of a bona fide banking activity, a related person (as defined in this notice) that is either an active foreign bank or an entity that actively conducts a banking business in the United States pursuant to a U.S. bank license will be treated as an unrelated person.

(2) Income earned by an active foreign bank from other activities, such as activities as a dealer in stock and securities, data processing, and management consulting, will not be characterized as nonpassive income pursuant to the exception provided in section 1296(b)(2)(A) of the Code. Income derived in nonbanking activities and the assets held for the conduct of those activities will be characterized according to the general rules under section 1296. See Notice 88-22, 1988-1 C.B. 489.

(3) Passive income received by an active foreign bank from a related person (as defined in section 1296(b)(2)(C)) will be treated as nonpassive income for purposes of the income test of section 1296(a)(1) only to the extent it is allocable to nonpassive income of the related person under section 1296(b)(2)(C).

(C) CHARACTERIZATION OF ASSET.

Generally, an asset that generates income that is treated as nonpassive income under section 1296(b)(2)(A) of the Code will be characterized as a nonpassive asset. An asset that generates both income that is treated as nonpassive income under section 1296(b)(2)(A) and income that is passive income under section 1296(b) will be treated as a nonpassive asset and a passive asset in proportion to the amounts of each type of income generated by the asset during the taxable year. See Notice 88-22, 1988-1 C.B. at 489.

(D) OTHER FOREIGN CORPORATION.

In rare and unusual circumstances, the Service will consider requests for a ruling that, based on the facts and circumstances, a foreign corporation is an active foreign bank for purposes of the passive income exception provided in section 1296(b)(2)(A) of the Code even though the foreign corporation does not satisfy the requirements of this notice.

III. DEALER INVENTORY AND INVESTMENT ASSET.

Notice 88-22, 1988-1 C.B. at 490, provides that a dealer must specifically designate in its books and records the stock and securities that it holds as inventory and those assets that it holds for investment purposes. Starting June 13, 1988, a dealer must specifically designate the inventory and investment assets on their date of acquisition. Notice 88-22 provides that a dealer may not change the initial designation of any share of stock or security; if an asset is not properly designated or the corporation changes the designation of a share of stock or a security, all stock and securities will be treated as passive assets.

The Service has reconsidered the position taken in Notice 88-22 concerning initial designations of stock and securities, and the consequences of improper or changed designations. The regulations will permit a dealer to change an initial erroneous designation of an asset for purposes of the income and asset tests of section 1296(a) of the Code if (A) the erroneous designation was made in good faith by the dealer at the time of acquisition (or at such later time as permitted by this notice), (B) at least 90 percent of the initial designations of all stock and securities are proper, (C) the dealer identifies all changes of designations made in its books and records, and (D) each change in designation is made by the later of (1) 75 days after the day the initial designation was made or (2) 90 days after the publication of this notice. If an erroneous designation of an asset was not changed as provided in this paragraph, the Commissioner may, in his discretion, correct the designation of the asset.

Notice 88-22 provided that beginning 90 days after publication of the notice, a dealer must designate its assets on their dates of acquisition. The notice, however, did not establish a date by which the dealer must designate inventory and investment assets acquired prior to that date ("previously acquired assets"). All previously acquired assets must be identified as inventory or investment assets no later than 90 days after publication of this notice. A previously acquired asset that was not specifically designated prior to its disposition, but was disposed of before the 91st day after the publication of this notice, must be designated according to the type of gain or loss realized on the disposition of the asset for income tax purposes.

EFFECTIVE DATE

This document serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the regulations and may be relied on to the same extent as a revenue ruling or revenue procedure. See Rev. Rul. 87-138 1987-2 C.B. 287. Taxpayers may rely on this notice until the regulations are published. The regulations described in this notice will generally be effective for taxable years beginning after December 31, 1986. However, any modification of the rules contained in this notice will be prospective.

DRAFTING INFORMATION

The principal author of this notice is Gayle Novig of the Office of the Associate Chief Counsel (International). Questions concerning this notice may be directed to Ms. Novig, either by writing to CC:INTL:Br6, Room 4607, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC 20224, or by calling 202-377-9059 (not a toll free number).