Temporary Regs on Purging Elections for PFIC Shareholders

 DEPARTMENT OF THE TREASURY

 ACTION: Temporary regulations.

 SUMMARY: This document contains temporary Income Tax Regulations that provide guidance to shareholders of certain passive foreign investment companies that are qualified electing funds about the time, manner, and other requirements for making the deemed dividend election. This election was enacted by the Technical Corrections Act of 1988. This document also modifies the time and manner of making the deemed sale election, which was enacted by the Tax Reform Act of 1986, and was the subject of temporary regulations published March 2, 1988 (53 FR 6770). The text of a proposed rule based on the text of these temporary rules appears in the Proposed Rules section of this issue of the Federal Register.

 EFFECTIVE DATE: These temporary regulations are effective April 1, 1992.

 FOR FURTHER INFORMATION CONTACT: Gayle E. Novig of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC 20224 Attention: CC:CORP:T:R (202-377-9059, not a toll-free call).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

These regulations are being issued without prior notice and public procedure pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the collection of information contained in these regulations has been reviewed and, pending receipt and evaluation of public comments, approved by the Office of Management and Budget (OMB) under control number 1545-1304.

 The collections of information in these regulations are in 26 CFR sections 1.1291-9T(d) and 1.1291-10(d)(2)(vii). The collections of information are also being published in the notice of proposed rulemaking in the Proposed Rules section of this issue of the Federal Register. This information is required by the Internal Revenue Service to administer elections pursuant to section 1291(d)(2) and sections 1.1291-9T and 1.1291-10T, and verify amounts reported as deemed dividends or gain from deemed sales. The likely respondents and/or recordkeepers are individuals or households, business or other for-profit institutions, non-profit institutions, and small businesses or organizations.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents/recordkeepers may require greater or less time, depending on their particular circumstances.

 Estimated total annual reporting and/or recordkeeping burden is 6,250 hours.

 The estimated annual burden per respondent/recordkeeper is one hour.

 Estimated number of respondents and/or recordkeepers: 6,250.

 Estimated frequency of responses: Annually.

 For further information concerning these collections of information, and where to submit comments on these collections of information, the accuracy of the estimated burden, and suggestions for reducing the burden, please refer to the preamble of the notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register.

BACKGROUND

 This document contains temporary Income Tax Regulations (26 CFR part 1) under section 1291(d)(2)(B) of the Internal Revenue Code of 1986, and amendments to section 1.1291-10T.

NEED FOR TEMPORARY REGULATIONS

 The proper application of section 1291(d)(2)(B) is dependent upon the Internal Revenue Service's detailed specifications of the manner in which the requirements of the statute will be administered. These regulations are necessary to provide taxpayers who are shareholders of certain qualified electing funds with guidance for making the election, which guidance will remain in effect until superseded by final regulations. Section 1291(d)(2)(B) was added to section 1291 by section 1012 of the Technical and Miscellaneous Revenue Act of 1988 (Pub. L. 100-647, 102 Stat. 3342). Similarly, amendments to section 1.1291-10T are necessary to minimize the burden falling on certain shareholders wishing to make the election under section 1291(d)(2)(A). Therefore, good cause is found to dispense with the notice and public procedure requirements of 5 U.S.C. 553(b) and the delayed effective date requirement of 5 U.S.C. 553(d).

EXPLANATION OF PROVISIONS

GENERAL

 The Tax Reform Act of 1986, as amended by the Technical and Miscellaneous Revenue Act of 1988, established special rules for the taxation of U.S. persons that are shareholders of passive foreign investment companies (PFICs). For taxable years beginning after December 31, 1986, a foreign corporation will be classified as a PFIC if either 75 percent or more of its gross income for the taxable year is Passive, or the average percentage of its assets (by value) for the taxable year that produce passive income or are held for the production of passive income is at least 50 percent. Subject to certain exceptions, passive income for these purposes is foreign personal holding income as defined in section 954(c) of the Internal Revenue Code of 1986.

 A shareholder may elect under section 1295 to treat the PFIC as a qualified electing fund (QEF); if such an election is made, the shareholder is taxed under section 1293 on its pro rata share of the earnings of the QEF. If the shareholder makes the QEF election for the first taxable year of the foreign corporation as a PFIC that is included in the shareholder's holding period, the PFIC is a pedigreed QEF with respect to the shareholder. However, if the shareholder makes the QEF election after that first PFIC year in the shareholder's holding period, the PFIC is an unpedigreed QEF with respect to the shareholder. For the reasons described below, shareholders of an unpedigreed QEF may wish to convert it to a pedigreed QEF.

 Absent a shareholder election to treat a PFIC as a QEF, a PFIC is considered a section 1291 fund. Because of the PFIC years included in the shareholder's holding period before the shareholder made the QEF election, an unpedigreed QEF also is considered a section 1291 fund. Generally, once a corporation is a section 1291 fund during the shareholder's holding period, it will continue to be treated as a PFIC even in a taxable year in which it satisfies neither the income nor the asset test.

 Pursuant to section 1291, U.S. persons that are shareholders of section 1291 funds pay tax and an interest charge on receipt of certain distributions and upon disposition of the stock of the section 1291 fund. A shareholder of a pedigreed or unpedigreed QEF is taxed currently on its respective share of the QEF's earnings pursuant to section 1293. If the QEF is an unpedigreed QEF with respect to the shareholder, the shareholder is subject to both sections 1291 and 1293.

 Section 1291(d)(2) provides two elections enabling shareholders of unpedigreed QEFs to purge their holding periods of taxable years during which the QEFs were section 1291 funds, and thereby limit their taxation to section 1293. A shareholder making the election under section 1291(d)(2)(A) is deemed to have sold the stock held in the PFIC on a specified date at its fair market value on that day. The deemed sale is treated as a disposition, and gain realized on the deemed sale is taxed under the special tax rules of section 1291.

 A shareholder of an unpedigreed QEF that also is a controlled foreign corporation (within the meaning of section 957(a)) (CFC) may make the election provided in section 1291(d)(2)(B). A shareholder elects under section 1291(d)(2)(B) to treat as a deemed dividend the shareholder's pro rata share of the post-1986 earnings and profits of the CFC accumulated during the shareholder's holding period while the corporation was a PFIC. The deemed dividend is taxed as an excess distribution (as defined in section 1291(b)).

EXPLANATION OF TEMPORARY REGULATIONS

 DEEMED DIVIDEND ELECTION: Section 1.1291-9T specifies the time and manner for making the election under section 1291(d)(2)(B). This election may be made by a U.S. person that is a direct or indirect shareholder of an unpedigreed QEF that also is a CFC. A shareholder that makes the section 1291(d)(2)(B) election is treated as receiving a dividend on the first day of its taxable year in which it makes the QEF election (qualification date). The deemed dividend, which is taxed as an excess distribution, is the shareholder's pro rata share of the post-1986 earnings and profits of the CFC accumulated during its PFIC years included in the shareholder's holding period. The temporary regulations provide that the shareholder's pro rata share is reduced by the portion thereof that the shareholder satisfactorily demonstrates to the Commissioner was previously included in the income of the shareholder or another U.S. person whose holding period is included in the shareholder's holding period. The election may be made even if the amount of the shareholder's deemed dividend is zero.

 The shareholder makes the deemed dividend election in its return for the taxable year that includes the qualification date. However, the shareholder may make the election within three taxable years after the taxable year of the deemed dividend, by filing an amended return, and paying section 6601 interest on the underpayment of tax for the taxable year that includes the qualification date. Nothing in the statute or temporary regulation prevents the making of a timely election in the final return of a deceased shareholder or with respect to stock disposed of after the qualification date.

 The fact that the qualification date falls on a day other than the first day of the CFC's first taxable year as a QEF will have no effect on the amount that the shareholder must include in income pursuant to section 1293(a) for that first QEF year. As provided in section 1293, the shareholder includes in income its pro rata share of the ordinary earnings and net capital gain of the QEF for the taxable year of the QEF that ends during the shareholder's taxable year. However, the amount of the deemed dividend will not include the portion of the current earnings that the shareholder demonstrates are included in the shareholder's income under section 1293(a).

 The regulations clarify the reference in section 1297(b)(1) to the rules of section 1291(d)(2). Section 1.1291-9T(h)(1) provides that the rules of the deemed dividend election do not apply to the mark-to-market election of section 1297(b)(1). For the rules for making the section 1297(b)(1) election, see section 1.1297-3T.

 Section 1.1291-9T(h)(2) provides that a shareholder may not make the deemed dividend election of section 1291(d)(2)(B) if the CFC will not qualify as a PFIC under section 1296(a) for the first taxable year for which the QEF election was made. In that case, the shareholder of an unpedigreed QEF that no longer qualifies as a PFIC under section 1296(a) may make only the deemed sale election provided in section 1297(b)(1) and section 1.1297-3T.

 THE DEEMED SALE ELECTION. The temporary regulations amend section 1.1291-10T in several respects. First, the temporary regulations change the qualification date for deemed sale elections made after the date of publication of these temporary regulations. The current rule, which sets the qualification date as the first day of the PFIC's first taxable year as a QEF, is retained in section 1.1291-10T(b)(2)(i) for elections made on or before May 1, 1992. For elections made after that date, section 1.1291-10T(b)(2)(ii) defines the qualification date as the first day of the shareholder's taxable year in which the shareholder makes the QEF election. The temporary regulations add section 1.1291-10T(b)(4) to clarify the amount of gain a shareholder recognizes when it makes a deemed sale election with respect to a PFIC of which it is an indirect shareholder. An indirect shareholder recognizes the amount of gain the actual shareholder of the stock would realize if the actual owner sold or otherwise disposed of the PFIC stock that the shareholder is considered to own.

 The temporary regulations also amend section 1.1291-10T(d)(2)(vii) to delete a reference to obsolete section 1.1295-1T for purposes of determining the fair market value of the stock deemed sold under section 1291(d)(2)(A).

 Finally, the temporary regulations amend section 1.1291-10T(e) to provide basis adjustments if the deemed sale election was made with respect to indirectly owned stock, and to add section 1.1291-10T(e)(2) to provide that the shareholder may take into account the section 1293(a) amounts attributable to days during the PFIC's first taxable year as a QEF that precede the qualification date for purposes of determining the amount of gain on the deemed sale. This adjustment prevents double taxation of undistributed earnings that are included in income under section 1293(a) and also reflected in the amount realized on the deemed sale (that is, the fair market value of the stock as of the qualification date).

SPECIAL ANALYSES

 It has been determined that these proposed rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required.

DRAFTING INFORMATION

 The principal author of these proposed regulations is Gayle E. Novig of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. Other personnel from offices of the Internal Revenue Service and Treasury Department participated in developing the regulations.

LIST OF SUBJECTS

26 CFR 1.1231-1 through 1.1297-3T

 Income taxes.

26 CFR Part 602

 Reporting and recordkeeping requirements.

Treasury Decision 8404

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by adding the following citation:

Authority: Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805 * * * Section 1.1291-9T also issued under 26 U.S.C. 1291(d)(2)(B). * * *

Par. 2. Section 1.1291-OT is revised to read as follows:

SECTION 1.1291-OT PASSIVE FOREIGN INVESTMENT COMPANIES -- TABLE OF CONTENTS (TEMPORARY).

This section contains a listing of the headings for sections 1.1291-9T, 1.1291-10T, 1.1294-1T, and 1.1297-3T.

 SECTION 1.1291-9T DEEMED DIVIDEND ELECTION BY A SHAREHOLDER OF A CFC

SECTION 1.1291-9T DEEMED DIVIDEND ELECTION BY A SHAREHOLDER OF A CFC THAT IS A QUALIFIED ELECTING FUND.

(a) DEEMED DIVIDEND ELECTION -- (1) IN GENERAL. This section provides rules for making the election under section 1291(d)(2)(B). Under that section, a U.S. person that is a direct or indirect shareholder of an unpedigreed QEF, as defined in paragraph (i)(3) of this section, that also is a controlled foreign corporation (CFC) within the meaning of section 957(a), may elect to include in income as a dividend the shareholder's pro rata share of the post-1986 earnings and profits of the CFC attributable to the stock owned or considered owned on the first day of the shareholder's taxable year in which it elects to treat the CFC as a QEF (qualification date). The deemed dividend is taxed as an excess distribution received on the qualification date. The excess distribution determined under this paragraph (a) is allocated under section 1291(a)(1)(A) only to those days in the shareholder's holding period during which the CFC qualified as a PFIC. For purposes of the preceding sentence, the holding period of the CFC stock with respect to which the election is made ends on the qualification date. This section does not apply to a shareholder of a pedigreed QEF, as defined in paragraph (i)(2) of this section.

(2) POST-1986 EARNINGS AND PROFITS DEFINED -- (i) IN GENERAL. For purposes of this section, the term post-1986 earnings and profits means the undistributed earnings and profits, within the meaning of section 902(c)(1), as of the qualification date that were accumulated and not distributed in taxable years of the CFC beginning after 1986 during which the CFC was a PFIC, but without regard to whether the earnings relate to a period in which the section 1291 fund was a CFC.

(ii) PRO RATA SHARE OF POST-1986 EARNINGS AND PROFITS ATTRIBUTABLE TO SHAREHOLDER'S STOCK -- (A) IN GENERAL. A shareholder's pro rata share of the post-1986 earnings and profits of the CFC attributable to the stock owned or considered owned by the shareholder on the qualification date is the amount of post-1986 earnings and profits of the CFC accumulated during any portion of the shareholder's holding period ending on the qualification date and attributable, under the principles of section 1248 and the regulations under that section, to the CFC stock owned or considered owned on the qualification date.

(B) REDUCTION FOR PREVIOUSLY TAXED AMOUNTS. A shareholder's pro rata share of the post-1986 earnings and profits of the CFC does not include any amount that the shareholder demonstrates to the satisfaction of the Commissioner (in the manner provided in paragraph (d)(2) of this section) was, pursuant to another provision of the law, previously included in the income of the shareholder, or of another U.S. person if the shareholder's holding period of the CFC stock includes the period during which the stock was owned or considered owned by that other U.S. person.

(b) WHO MAY MAKE THE ELECTION. A direct or indirect shareholder of an unpedigreed QEF that also is a CFC may make the deemed dividend election, without regard to whether such shareholder is a United States shareholder within the meaning of section 951(b). A deemed dividend election may be made by a shareholder whose pro rata share of the post-1986 earnings and profits of the CFC attributable to the CFC stock owned or considered owned on the qualification date is zero.

(c) TIME FOR MAKING THE ELECTION. The shareholder may make the deemed dividend election in the shareholder's tax return for the taxable year that includes the qualification date. The election must be made either by the due date, as extended, for that return, or by filing an amended tax return within three years of the due date, as extended, for the shareholder's tax return for the taxable year that includes the qualification date.

(d) MANNER OF MAKING THE ELECTION -- (1) IN GENERAL. A shareholder makes the deemed dividend election by providing the attachment to Form 8621 described in paragraph (d)(2) of this section, reporting the deemed dividend as an excess distribution, and paying the tax and interest due on the excess distribution. A shareholder that makes the deemed dividend election after the due date of the return (determined without regard to extensions) for the taxable year that includes the qualification date must pay additional interest, pursuant to section 6601, on the amount of the underpayment of tax for that year.

(2) ATTACHMENT TO FORM 8621. The shareholder must attach a schedule to Form 8621 that demonstrates the calculation of the shareholder's pro rata share of the post-1986 earnings and profits of the CFC that are treated as distributed to the shareholder pursuant to this section. If the shareholder is claiming an exclusion from its pro rata share of the post-1986 earnings and profits for an amount previously included in its income or the income of another U.S. person, the shareholder also must include the following information:

(i) The name, address, and taxpayer identification number of the U. S. person that previously included the amount in income;

(ii) A description of the transaction pursuant to which the shareholder acquired, directly or indirectly, the stock of the CFC from another U.S. person, and the provisions of law pursuant to which the shareholder's holding period includes the period the other U.S. person owned or was considered to own the CFC stock; and

(iii) A schedule showing each amount previously included in income by a U.S. person, the name of the U.S. person who included the amount in income, the provision of the law pursuant to which the amount was previously included in income, and the taxable year of inclusion of each amount.

(e) ELECTIONS MADE ON OR BEFORE May 1, 1992. A shareholder that made the election under section 1291(d)(2)(B) on or before May 1, 1992. will satisfy the requirements of paragraphs (c) and (d) of this section by providing the information and representations required by paragraph (d) of this section not previously filed with the shareholder's return for the taxable year that includes May 1, 1992. A shareholder that made a deemed dividend election on or before May 1, 1992. and included the deemed dividend in income as of the date described in section 1.1291-10T(b)(2)(i) will not be required to amend any federal income tax return to include the deemed dividend in income as of the qualification date defined in paragraph (a) of this section.

(f) ADJUSTMENT TO BASIS; TREATMENT OF HOLDING PERIOD. A shareholder increases its adjusted basis of the stock of the CFC owned directly by the amount of the deemed dividend. If the shareholder made the deemed dividend election with respect to a CFC of which it is an indirect shareholder, the shareholder's adjusted basis of the stock or other property owned directly by the shareholder through which ownership of the section 1291 fund is attributed to the shareholder is increased by the amount of the deemed dividend. In addition, solely for purposes of determining the subsequent treatment under the Internal Revenue Code and regulations of a direct or indirect shareholder of the stock of the CFC, the adjusted basis of the actual owner of the stock of the CFC is increased by the amount of the deemed dividend. For purposes of applying sections 1291 through 1297 to the shareholder after the deemed dividend, the shareholder's holding period of the stock of the CFC begins on the qualification date; for other purposes of the Internal Revenue Code and regulations, the shareholder's holding period of the stock of the CFC includes the period the shareholder owned or was considered to own the stock prior to the qualification date.

(g) COORDINATION WITH SECTION 959(e). For purposes of section 959 (e), the entire deemed dividend is treated as included in gross income under section 1248(a).

(h) ELECTION INAPPLICABLE TO SHAREHOLDER OF FORMER PFIC -- (1) COORDINATION WITH SECTION 1297(b)(1). The rules of this section do not apply to an election under section 1297(b)(1).

(2) UNPEDIGREED QEF. The election under this section may not be made if the corporation does not qualify as a PFIC under section 1296(a)(1) or (2) for the first taxable year for which a section 1295 election is intended to apply.

(i) DEFINITIONS -- (1) QEF. A PFIC is a qualified electing fund (QEF) with respect to a shareholder that has elected under section 1295 to be taxed currently on its share of the PFIC's earnings and profits pursuant to section 1293.

(2) PEDIGREED QEF. A PFIC is a pedigreed QEF with respect to a shareholder if it has been a QEF with respect to the shareholder for all taxable years during which it was a PFIC that are included wholly or partly in the shareholder's holding period of the PFIC stock.

(3) UNPEDIGREED QEF. A PFIC is an unpedigreed QEF for any taxable year if --

(i) An election under section 1295 is in effect for that year;

(ii) It has been a QEF with respect to the shareholder for one or more, but not all, of the taxable years during which it was a PFIC that are included wholly or partly in the shareholder's holding period of the PFIC stock; and

(iii) The shareholder has not elected under section 1291(d)(2) and section 1.1291-9T or 1.1291-10T to purge the non-QEF years from the shareholder's holding period.

(4) SECTION 1291 FUND. A section 1291 fund with respect to a shareholder is an unpedigreed QEF or a PFIC that the shareholder has not elected under section 1295 to treat as a QEF.

Par. 4. Section 1.1291-10T is amended as follows:

1. Paragraph (b)(2) is revised.

2. New paragraph (b)(4) is added.

3. Paragraph (d)(2)(vii) is revised.

4. Paragraph (e) is revised.

5. New paragraph (f) is added.

6. The additions and revisions read as follows.

SECTION 1.1291-10T ELECTION BY A UNITED STATES PERSON TO RECOGNIZE GAIN IN A QUALIFIED ELECTING FUND (TEMPORARY).

* * * * *

(b) * * *

(2) QUALIFICATION DATE -- (i) ELECTIONS TO BE MADE ON OR BEFORE MAY 1, 1992. The qualification date with respect to any shareholder of a QEF that, pursuant to section 1.1291-10T(c), made this election on or before May 1, 1992 is the first day of the QEF's first taxable year as a QEF.

(ii) Elections to be made after May 1, 1992. The qualification date with respect to any shareholder of a QEF that, pursuant to section 1.1291-10T(c), makes this election after May 1, 1992 is the first day of the shareholder's taxable year in which the shareholder elects to treat the section 1291 fund as a QEF.

* * * * *

(4) ELECTION BY INDIRECT SHAREHOLDER. An indirect shareholder may make the deemed sale election in the manner provided in this section. The amount of gain to be recognized and taxed as an excess distribution is the amount of gain that the actual owner of the stock of the unpedigreed QEF would have realized on an actual sale or other disposition of the stock indirectly owned by the shareholder.

* * * * *

(d) * * *

(2) * * *

(vii) The fair market value of the stock in the QEF as of the qualification date and a brief statement about the manner in which the fair market value was determined; and

* * * * *

(e) ADJUSTMENTS TO BASIS -- (1) IN GENERAL. An electing shareholder increases its adjusted basis in the stock owned directly by the amount of the gain recognized on the deemed sale. If the shareholder made the election under this section with respect to a PFIC of which it is an indirect shareholder, the electing shareholder's adjusted basis of the stock or other property owned directly by the electing shareholder through which ownership of the PFIC is attributed to the electing shareholder is increased by the amount of gain recognized by the electing shareholder. In addition, solely for purposes of determining the subsequent treatment under the Code and regulations of a direct or indirect shareholder of the stock of the PFIC, the adjusted basis of the actual owner of the stock of the PFIC is increased by the amount of gain recognized by the electing shareholder. An electing shareholder shall not adjust the basis of any stock with respect to which the shareholder realized a loss on the deemed sale.

(2) ADJUSTMENT TO BASIS FOR SECTION 1293 INCLUSION. For purposes of determining the amount of gain on the deemed sale, the adjusted basis of the stock includes the electing shareholder's section 1293(a) inclusion that is attributable to the period beginning with the first day of the PFIC's taxable year as a QEF and ending with the qualification date.

(f) TREATMENT OF HOLDING PERIOD. For purposes of applying sections 1291 through 1297 to the electing shareholder after the deemed sale, the electing shareholder's holding period of the stock of the PFIC begins on the qualification date without regard to whether it recognized gain on the deemed sale; for other purposes of the Code and regulations, the electing shareholder's holding period of the stock of the PFIC includes the period the electing shareholder owned or was considered to own the stock of the QEF prior to the qualification date.

Par. 5. Section 1.1295-1T is removed.

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 6. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 7. Section 602.101(c) is amended by removing the entry in the table for section 1.1291-0T and by adding an entry in the table for section 1.1291-9T and revising the entry for section 1.1291-10T to read as follows:

SECTION 602.101 OMB Control numbers.

(c) * * *

 CFR part or section where                    Current OMB