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Final Regs Clarify PFIC Asset Measurement for Lower-Tier Subsidiaries

Posted on June 14, 2021

New regs issued under sections 1291, 1297, and 1298 (T.D. 9936) clarify whether a foreign corporation is treated as a passive foreign investment company and whether a U.S. person that indirectly owns stock in a PFIC is treated as a shareholder.

Final regs issued January 15 (and corrected on March 5 and March 10) retain the basic approach and structure of proposed regs issued on July 11, 2019 (REG-105474-18) (the 2019 proposed regs). The final regs contain revisions to several of the rules, including methods for measuring the assets owned by lower-tier subsidiaries of tested foreign corporations. Proposed regs also published on January 15 (not yet finalized) propose additional guidance for measuring assets for the asset test (REG-111950-20) (the 2021 proposed regs).

Passive Foreign Investment Companies

PFICs are defined and taxed under sections 1291-1298. If a foreign corporation meets the definition of a PFIC, its U.S. shareholders must pay tax and interest on income from PFIC distributions or gains from PFIC stock dispositions as if they were distributed ratably on each day of the shareholder’s holding period. PFICs are generally foreign corporations with at least 75 percent passive income or at least 50 percent of total assets generating passive income.

A shareholder can avoid the interest charge by electing to have the PFIC treated as a qualified electing fund and pay U.S. tax on income in the year earned, subject to an election to defer tax until a distribution or disposition. The PFIC regime was enacted in 1986 to eliminate tax deferral on passive earnings of foreign corporations, whether or not closely held. Without a QEF election, PFIC status can discourage distributions. Under the PFIC code provisions:

The new regs amend existing regs and add new ones that:

  • clarify ownership attribution rules in reg. section 1.1291-1(b) that treat U.S. persons as shareholders of PFICs;

  • clarify the definition of a PFIC in reg. section 1.1297-1;

  • provide rules related to look-through subsidiaries and partnerships in reg. section 1.1297-2;

  • clarify treatment of qualifying insurance corporations in reg. section 1.1297-4;

  • clarify the exception to passive income treatment for active insurance income in reg. section 1.1297-5 and -6; and

  • provide guidance on treatment of foreign corporations owning stock in 25-percent-owned domestic corporations in reg. section 1.1298-4.

This article will address the rules in reg. section 1.1297-1(d)(1)(v)(C)(2) that govern the methods of measuring assets of lower-tier subsidiaries.

Previous articles addressed:

Section 1297

The new regs that clarify the income and tests accompany section 1297. The following is a summary of section 1297’s provisions.

Section 1297(a) defines a PFIC as a foreign corporation if:

  • 75 percent or more of the corporation’s gross income for the tax year is passive income; or

  • the average percentage of the corporation’s assets (as determined under section 1297(e)) during the tax year that produce passive income or are held to produce passive income is at least 50 percent.

Section 1297(b)(1) defines passive income as any income of a kind that would be foreign personal holding company income as defined in section 954(c) for subpart F purposes.

However, section 1297(b)(2)(A)-(D) contains four exceptions to passive income:

  • income from a banking business;

  • income from an insurance business;

  • interest, dividends, rents, or royalties from a related person that are allocable to non-passive income; and

  • export trade income of an export trade corporation.

Specifically, passive income does not include any income derived in the active conduct of a banking business by an institution licensed to do business as a bank in the United States, or income derived in the active conduct of an insurance business by a qualifying insurance corporation as defined in section 1297(f).

Passive income also does not include interest, dividends, rents, or royalties received or accrued from a related person (within the meaning of section 954(d)(3)) to the extent the income is allocable to non-passive income of the related person. Finally, passive income does not include export trade income of an export trade corporation (as defined in section 971).

Section 954(d)(3) generally defines related party in the context of subpart F and controlled foreign corporations. For the related-party PFIC exception, “foreign corporation” is substituted for “controlled foreign corporation” each place it appears in section 954(d)(3). Related party is defined in section 953(d)(3) as a person who controls (or is controlled by) a CFC, with control meaning ownership of more than 50 percent of vote or value (or of beneficial interests if the related person is a partnership or trust).

Section 1297(c) contains a look-through rule that applies when a foreign corporation owns (directly or indirectly) at least 25 percent (by value) of the stock of another corporation. To determine whether the shareholder foreign corporation is a PFIC under the income and assets tests, it is treated as if it held its proportionate share of the subsidiary corporation’s assets and received its proportionate share of the subsidiary’s income directly.

Section 1297(d)(1)-(4) contains an exception to PFIC status for U.S. shareholders of CFCs. A corporation will not be treated as a PFIC in the hands of a U.S. shareholder during the qualified portion of the shareholder’s holding period, which is the portion that is after December 31, 1997, and during which the shareholder is a U.S. shareholder (as defined in section 951(b)) of the corporation and the corporation is a CFC.

Under section 1297(d)(3), a new holding period begins if the qualified portion ends. If the qualified portion of a shareholder’s holding period ends after December 31, 1997, the shareholder’s holding period is treated as beginning on the following day. However, this rule will not apply if the corporation was a PFIC at any time before the qualified portion of the shareholder’s holding period and no election to recognize gain under section 1298(b)(1) is made.

Section 1297(d)(4) provides that the section 1297(d)(1) exception to PFIC status for U.S. shareholders of CFCs does not apply to stock treated as owned by a person because of section 1298(a)(4) (treating a person with an option to acquire stock as owning the stock), unless the option holder establishes that the stock is owned (within the meaning of section 958(a)) by a U.S. shareholder (as defined in section 951(b)) that is not tax exempt.

Section 1297(e) contains methods for measuring assets to determine whether a tested foreign corporation is a PFIC under the assets test that vary depending on whether the corporation is publicly traded, a CFC, both, or neither. The determination under the section 1297(a)(2) asset test is made based on the fair market value of the foreign corporation’s assets if the corporation is publicly traded or section 1297(e)(2) does not require using adjusted basis instead of FMV.

Section 1297(e)(2) requires using the assets’ adjusted basis if the corporation is not publicly traded and is a CFC or if the corporation elects to use basis instead of FMV. An election to use adjusted basis may be revoked only with the consent of the Treasury secretary.

Section 1297(e)(3) provides that a foreign corporation is publicly traded if its stock is regularly traded on a national securities exchange registered with the SEC, the national market system established under section 11A of the Securities Exchange Act of 1934, or any exchange or other market which the Treasury secretary determines has rules adequate to carry out the purposes of section 1297(e).

Finally, section 1297(f) defines qualifying insurance corporation for the second exception to passive income in section 1297(b)(2)(B).

Reg. Section 1.1297-1(d)

Reg. section 1.1297-1(a) contains a useful overview of reg. section 1.1297-1 that describes it generally as clarifying the income test in section 1297(a)(1) and the asset test in section 1297(a)(2). The rules in reg. section 1.1297-1(b)-(g) are summarized as follows in the order they appear:

  • a rule for dividends that are excluded from gross income under section 1502;

  • rules addressing the definition of passive income;

  • rules addressing the asset test;

  • rules addressing the determination of PFIC status for stapled entities;

  • definitions related to the section 1297 guidance; and

  • applicability dates.

Reg. section 1.1297-1(d) clarifies the assets tests used to determine whether a foreign corporation is a PFIC. This article will focus on the 50 percent asset test rules in reg. section 1.1297-1(d)(1)-(4) ((d)(2) is reserved). The rules for measuring assets of lower-tier subsidiaries are found in reg. section 1.1297-1(d)(1)(v)(C)(2), including three examples in reg. section 1.1297-1(d)(1)(v)(E) (paragraph (v)(D) is reserved).

Reg. section 1.1297-1(d)(1)(i)-(v) requires tested foreign corporations to calculate the average annual value (or adjusted bases) of their assets.

The calculation of the average percentage of assets that produce passive income or that are held for the production of passive income is based on the average of the assets’ FMVs or their adjusted bases and total assets held. This includes assets treated as held under the 25 percent look-through rules in section 1297(c) and reg. section 1.1297-2(b)(2)(i) and (b)(3)(i). The average percentage of assets is calculated on the last day of each measuring period (called the measuring date) of the foreign corporation’s tax year.

The average of the FMVs (or the average of the adjusted bases) of the foreign corporation’s passive assets or total assets for the tax year is equal to the sum of the values (or adjusted bases) of the passive assets or total assets on each measuring date of the foreign corporation’s tax year divided by the number of measuring dates in the year.

Reg. section 1.1297-1(d)(1)(ii) defines the measuring periods for a tested foreign corporation as the four quarters that make up the corporation’s tax year, except as otherwise provided in reg. section 1.1297-1(d)(1)(ii)(B), which offers an election to use alternative measuring periods that are shorter than quarters (like weeks or months).

Measuring Assets

Reg. section 1.1297-1(d)(1)(v)(A)-(C) provides taxpayers with methods of measuring assets for the PFIC asset test. As in section 1297(e), the method varies depending on whether the tested foreign corporation is publicly traded, a CFC, both, or neither.

The assets of a publicly traded foreign corporation must be measured by FMV. This includes assets treated as held under the 25 percent look-through rules in section 1297(c) and reg. section 1.1297-2(b)(2)(i) and (b)(3)(i). This does not include assets of a look-through subsidiary described in reg. section 1.1297-1(d)(1)(v)(B) as a non-publicly traded CFC.

Assets of a CFC that are not publicly traded must be measured by adjusted basis for all measuring periods of the year during which the foreign corporation is a CFC. This includes assets treated as held under the 25 percent look-through rules in section 1297(c) and reg. section 1.1297-2(b)(2)(i) and (b)(3)(i). This does not include assets held by a look-through subsidiary described in reg. section 1.1297-1(d)(1)(v)(A) as a publicly traded corporation.

Except as provided in reg. section 1.1297-1(d)(1)(v)(C)(2) (relating to lower-tier subsidiaries), the assets of a foreign corporation that is neither publicly traded nor a CFC are measured for all measuring periods of the year by FMV, unless a tested foreign corporation or its shareholder makes an election under section 1297(e)(2)(B) to use adjusted basis. This includes assets treated as held under the 25 percent look-through rules in section 1297(c) and reg. section 1.1297-2(b)(2)(i) and (b)(3)(i). This does not include assets held by a look-through subsidiary described in reg. section 1.1297-1(d)(1)(v)(A) as publicly traded or in (d)(1)(v)(B) as a non-publicly traded CFC.

Lower-Tier Subsidiaries

Reg. section 1.1297-1(d)(1)(v)(C)(2)(i)-(iii) provides methods for measuring assets when lower-tier subsidiaries are in the ownership structure. Like the rules for parent tested foreign corporations, these rules also vary depending on whether the lower-tier subsidiary is publicly traded, a CFC, both, or neither.

Reg. section 1.1297-1(d)(1)(v)(C)(2)(i) applies to publicly traded lower-tier subsidiaries. If a lower-tier subsidiary is publicly traded, its assets are measured by FMV under reg. section 1.1291-1(d)(1)(v)(A). These rules apply the section 1297(a)(2) 50 percent asset test to both the lower-tier subsidiary as a tested foreign corporation, and to the parent tested foreign corporation as it relates to the assets of the lower-tier subsidiary.

Reg. section 1.1297-1(d)(1)(v)(C)(2)(ii) applies to lower-tier subsidiaries that are non-publicly traded CFCs. If the lower-tier subsidiary is described in reg. section 1.1297-1(d)(1)(v)(B) as a non-publicly traded CFC, its assets are measured by adjusted basis under reg. section 1.1297-1(d)(1)(v)(B). The previous sentence applies section 1297(a)(2) to both the lower-tier subsidiary as a tested foreign corporation and to the parent tested foreign corporation as it relates to the assets of the lower-tier subsidiary.

Finally, reg. section 1.1297-1(d)(1)(v)(C)(2)(iii) applies to lower-tier subsidiaries that are neither publicly traded nor CFCs. If the lower-tier subsidiary is not described in reg. section 1.1297-1(d)(1)(v)(A) or (d)(1)(v)(B) as neither publicly traded nor a CFC, the assets of the lower-tier subsidiary must be measured under the same rules that apply to the parent tested foreign corporation.

This includes assets treated as held by the lower-tier subsidiary under the 25 percent look-through rules in section 1297(c) and reg. section 1.1297-2(b)(2)(i) and (b)(3)(i). The previous sentence applies section 1297(a)(2) to both the lower-tier subsidiary as a tested foreign corporation and to the parent tested foreign corporation.

If a tested foreign corporation indirectly owns a lower-tier subsidiary that is neither publicly traded nor a CFC through one or more other foreign corporations, the status of any parent foreign corporation in that chain of corporations that is described in reg. section 1.1297-1(d)(1)(v)(A) as publicly traded — or if there is no publicly traded parent foreign corporation, then the status of any parent foreign corporation in the chain that is described in reg. section 1.1297-1(d)(1)(v)(B) as a non-publicly traded CFC — determines the basis on which the assets of the lower-tier subsidiary are measured.

If a foreign corporation is a lower-tier subsidiary of more than one parent tested foreign corporation, these rules apply separately to measure the assets of the lower-tier subsidiary in the hands of each parent foreign corporation.

Owner Election

Reg. section 1.1297-1(d)(1)(iii) provides that an election to use adjusted basis instead of FMV may be made by the tested foreign corporation or its owner as defined in reg. section 1.1297-1(d)(1)(iv). This definition of owner relies on cross-references to regs accompanying sections 1295 and 1291.

An owner is defined as a U.S. person eligible under reg. section 1.1295-1(d) to make a section 1295 QEF election. Reg. section 1.1295-1(d)(1) provides that any U.S. person that is a shareholder of a PFIC may make a section 1295 election for that PFIC. If a chain of ownership is present, only the first U.S. person that is a shareholder of the PFIC may make the election.

Reg. section 1.1295-1(d)(3) addresses indirect ownership of a PFIC through other PFICs. An election under section 1295 applies only to the foreign corporation for which the election is made. Therefore, if a shareholder makes a section 1295 election to treat a PFIC as a QEF, that election applies only to stock in that foreign corporation and not to the stock in any other corporation that the shareholder is treated as owning by virtue of its ownership of stock in the QEF.

The regs provide an example illustrating these rules. In 1988 U.S. person T purchased stock of FC, a foreign corporation that is a PFIC. FC owns the stock of SC, a foreign corporation that is also a PFIC. T makes an election under section 1295 to treat FC as a QEF. T’s section 1295 election applies only to T’s stock in FC. It does not apply to the stock T indirectly owns in SC.

Reg. section 1.1295-1(d)(1) directs taxpayers to reg. section 1.1291-9(j)(3) for the meaning of shareholder, which in turn directs taxpayers to reg. section 1.1291-1(b)(7) and reg. section 1.1291-1(b)(8). Reg. section 1.1291-1(b)(7) defines shareholder as a U.S. person that directly owns stock of a PFIC (a direct shareholder), or a U.S. person that is an indirect shareholder as defined in section 1298(a) and reg. section 1.1291-1(b)(8) (except for tax-exempt organizations as provided in reg. section 1.1291-1(e)).

Under reg. section 1.1291-1(b)(8)(i), an indirect shareholder of a PFIC is a U.S. person that indirectly owns stock of a PFIC. A person indirectly owns stock when it is treated as owning stock actually owned by another person. The determination of a person’s indirect ownership is made on the basis of facts and circumstances and substance, rather than form of ownership, taking into account the purposes of sections 1291 through 1298.

Reg. section 1.1291-1(b)(8)(ii)(A) and (B) specifically addresses ownership through lower-tier non-PFIC and PFIC foreign corporations. A person that directly or indirectly owns 50 percent or more in value of the stock of a foreign corporation that is not a PFIC is considered to own a proportionate amount (by value) of any stock owned directly or indirectly by the foreign corporation.

A person that directly or indirectly owns stock of a PFIC is considered to own a proportionate amount (by value) of any stock owned directly or indirectly by the PFIC. The section 1297(d) exception to PFIC status for CFCs does not apply in determining whether a corporation is a PFIC for the indirect ownership rule in reg. section 1.1291-1(b)(8)(ii)(B).

While an indirect U.S. shareholder of a lower-tier subsidiary PFIC may make a QEF election for the subsidiary under section 1295, it may not make an election to use adjusted basis for measuring its assets under section 1297(e). The rules for measuring assets of lower-tier subsidiaries that are neither publicly traded nor CFCs require use of the same method as the parent-tested foreign corporation.

Examples

Reg. section 1.1297-1(d)(1)(E) provides three examples that illustrate the application of the reg. section 1.1297-1(d)(1)(v) rules for measuring assets when lower-tier subsidiaries are present.

Example 1 illustrates the result when a foreign parent that is publicly traded and a CFC (TFC1) owns a lower-tier subsidiary that is neither publicly traded nor a CFC (FS1). It assumes that domestic corporation USP owns 60 percent of tested foreign corporation TFC1’s stock. The remaining 40 percent of the stock is regularly traded on a national securities exchange (registered with the SEC) until September 1 of the tax year, when USP acquires all TFC1’s stock via a tender offer. TFC1 owns 30 percent of the stock of foreign subsidiary FS1. FS1 is neither a publicly traded foreign corporation nor a CFC.

TFC1 is a CFC and is also a publicly traded foreign corporation until September 1 of the year. The TFC1 assets (including the FS1 assets treated as held by TFC1 under the look-through rules in section 1297(c) and reg. section 1.1297-2(b)(2)(i)) must be measured by FMV for each measuring period ending before September 1 under reg. section 1.1297-1(d)(1)(v)(A). Under reg. section 1.1297-1(d)(1)(v)(C)(2)(iii), to apply section 1297 to FS1 as a tested foreign corporation, the assets of FS1 must be measured using the same method as used for TFC1’s assets, or FMV.

Example 2 illustrates the result when both the foreign parent (TFC2) and its lower-tier subsidiary (FS2) are neither publicly traded nor CFCs. It assumes U.S. person A owns 1 percent of tested foreign corporation TFC2’s stock. TFC2 is neither publicly traded nor a CFC. TFC2 owns 25 percent of foreign subsidiary FS2’s stock. FS2 is also neither publicly traded nor a CFC.

Under reg. section 1.1297-1(d)(1)(v)(C)(1) , TFC2’s assets (including the FS2 assets treated as held by TFC2 under the look-through rules in section 1297(c) and reg. section 1.1297-2(b)(2)(i)) are measured by FMV for all measuring periods of the tax year unless A or TFC2 makes an election under section 1297(e)(2)(B) to use adjusted basis instead in the manner prescribed in reg. section 1.1297-1(d)(1)(iii).

Under reg. section 1.1297-1(d)(1)(v)(C)(2)(iii) , to apply section 1297 to FS2 as a tested foreign corporation in the hands of A, FS2’s assets must be measured using the same method as used for TFC2’s assets.

Example 3 illustrates the result when a lower-tier subsidiary (FS2) has more than one foreign parent (TFC2 and TFC3). It assumes the same facts as in Example 2 except that the 75 percent of FS2’s stock not owned by TFC2 is owned by TFC3, a publicly traded foreign corporation that is not related to TFC2 or A. U.S. person B (not related to A or TFC2, owns 1 percent of TFC3’s stock.

The results are the same as in Example 2 for measuring TFC2’s assets (by FMV unless there has been an election to use basis). To apply section 1297 to FS2 as a tested foreign corporation in A’s hands, FS2’s assets must be measured using the same method as used for TFC2’s assets.

To apply section 1297 to TFC3, TFC3’s assets must be measured by FMV under reg. section 1.1297-1(d)(1)(v)(A) because it is publicly traded. Under reg. section 1.1291-1(d)(1)(v)(C)(2) and (d)(1)(v)(A), to apply section 1297 to FS2 as a tested foreign corporation in B’s hands, FS2’s assets must also be measured by FMV because its parent, TFC3, is publicly traded.

In other words, FS2’s assets are measured by two different methods to determine whether FS2 is a PFIC under the asset test. To test for FS2’s PFIC status in A’s hands, FS2’s assets are measured by reference to TFC2’s method, or FMV unless A or TFC2 makes an election to use basis, because TFC2 is neither publicly traded nor a CFC. To test for FS2’s PFIC status in B’s hands, FS2’s assets are measured by reference to TFC3’s method, or FMV, because TFC3 is publicly traded.

Effective Dates

Reg. section 1.1297-1(g)(1) provides that these rules generally apply to shareholder tax years beginning on or after January 14, 2021. Shareholders may choose to apply the rules for any open year beginning before that date provided they consistently apply the provisions.

Preamble

The final regs’ preamble describes comments and revisions to the prop. reg. section 1.1297-1 definition of a PFIC. Prop. reg. section 1.1297-1 provided general rules and definitions under section 1297 related to the income test in section 1297(a)(1), the asset test in section 1297(a)(2), clarification on the section 1297(b)(1) cross-reference to the section 954(c) definition of passive income, and general rules that address computational and characterization issues that arise in applying the asset test.

The preamble clarifies the application of section 1297(e) when there are tiers of tested foreign corporations in the structure. A commentator recommended that the final regs allow a publicly traded tested foreign corporation to measure all assets — including assets of its non-publicly traded look-through subsidiaries — based on FMV.

Treasury and the IRS generally agreed except in cases in which section 1297(e) plainly requires different treatment for the assets of subsidiaries. For the avoidance of doubt, final reg. section 1.1297-1(d)(1)(i) and (d)(1)(v)(A) includes cross-references to reg. section 1.1297-2(b)(2)(i) (providing that a tested foreign corporation is deemed to directly own the assets of its look-through subsidiaries).

The commentator also observed that the typical situation is for a publicly traded tested foreign corporation to measure all its assets (including the assets of its non-publicly traded look-through subsidiaries) based on FMV in accordance with section 1297(e)(1)(A). It is questionable, however, whether a CFC that is a non-publicly traded subsidiary of a publicly traded parent could also use FMV, rather than basis, for testing its own PFIC status.

The commentator noted that a subsidiary might be a CFC after the repeal of section 958(b)(4). Reg. section 1.1297-1(d)(1)(v)(B)(2) mitigates this concern because it provides that foreign corporations treated as CFCs solely because of the repeal of section 958(b)(4) are not treated as CFCs for purposes of section 1297(e).

If a lower-tier tested foreign corporation is a non-publicly traded CFC, then section 1297(e)(2)(A) requires that adjusted basis be used to measure the CFC’s assets. Therefore, final regs clarify that a lower tier tested foreign corporation that is a non-publicly traded CFC must use adjusted basis and not FMV to measure its assets, regardless of whether it is owned by a publicly traded foreign corporation.

To clarify the application of the statutory hierarchy for measuring a tested foreign corporation’s assets more generally, including the assets of lower-tier tested foreign corporations, the 2019 proposed regs were revised to add the hierarchy in reg. section 1.1297-1(d)(1)(v)(A), (B), and (C)(1) that generally applies to every tested foreign corporation, regardless of whether it is an upper-tier or lower-tier tested foreign corporation.

Under section 1297(e) and this hierarchy:

  • a publicly traded foreign corporation (as defined in reg. section 1.1297-1(f)(7)) must use FMV to measure its assets;

  • a non-publicly traded CFC must use basis to measure its assets unless the CFC becomes a publicly traded foreign corporation during a tax year; and

  • any other tested foreign corporation would use FMV to measure its assets unless an election is made to use adjusted basis — except when the other foreign corporation is a lower-tier subsidiary — in which case additional rules apply.

Revised reg. section 1.1297-1(d)(1)(v)(C)(2) provides the additional rules for measuring the assets of lower-tier subsidiaries, which are usually look-through. These rules follow the same hierarchy, except that the method used to measure the assets of a lower-tier subsidiary may be determined by either of the following:

  • the status of the lower-tier subsidiary if it is publicly traded or a non-publicly traded CFC; or

  • the status of a tested foreign corporation that directly or indirectly owns shares of the lower-tier subsidiary if the parent foreign corporation is publicly traded or a CFC.

As a general matter, the method used by a parent foreign corporation to measure its assets also must be used to measure the assets of a lower-tier foreign corporation owned in whole or part by the parent. This rule applies both for determining whether the parent foreign corporation is a PFIC and for determining whether the lower-tier foreign corporation is a PFIC.

Under reg. section 1.1297-1(d)(1)(v)(C)(2)(iii) , if a tested foreign corporation indirectly owns a lower-tier subsidiary through one or more other foreign corporations, the status of the parent foreign corporation in that chain of corporations that has the highest status in the hierarchy described above governs.

This general consistency rule does not apply, however, if the lower-tier foreign corporation has a status for which section 1297(e) mandates a method for measuring assets — that is, if it’s a publicly traded foreign corporation or a non-publicly traded CFC. In that case, the method mandated by the statute applies to measure the lower-tier foreign corporation’s assets, both for determining whether the parent foreign corporation is a PFIC and for determining whether the lower-tier foreign corporation is a PFIC.

For example, under reg. section 1.1297-1(d)(1)(v)(C)(2)(i) and (ii), if a tested foreign corporation is a publicly traded foreign corporation, then both its assets and the assets of its lower-tier subsidiaries must be measured on the basis of FMV, unless a lower-tier subsidiary is a non-publicly traded CFC, in which case the assets of that subsidiary must be measured using adjusted basis.

Similarly, if a tested foreign corporation is a non-publicly traded CFC, then both its assets and the assets of its lower-tier subsidiaries must be measured using adjusted basis, unless the lower-tier subsidiary is a publicly traded foreign corporation, in which case the assets of that subsidiary must be measured using FMV.

If a lower-tier tested foreign corporation does not have a status for which section 1297(e) mandates a method for measuring assets, and it is a subsidiary of more than one parent foreign corporation, then U.S. shareholders of the two different parent corporations may be required to use different methods to measure the assets of the lower-tier foreign corporation based on the method used for each respective parent foreign corporation. This rule is illustrated by Example 3 in reg. section 1.1297-1(d)(1)(v)(E).

Financial Statement FMVs

In the final regs’ preamble, Treasury and the IRS recognize that section 1297(e)(1) often requires that a valuation be performed for assets of an operating company when no publicly available valuation is available. This is apart from information provided in financial statements prepared under financial reporting standards, and so ascertaining a valuation creates a compliance burden. Treasury and the IRS are studying whether to provide rules permitting taxpayers to rely on financial statement information, and the final regs reserve on this issue in reg. section 1.1297-1(d)(1)(v)(D).

The 2021 proposed regs, however, contain a rule to address this issue. Under prop. reg. section 1.1297-1(d)(1)(v)(D), the FMV of a tested foreign corporation’s assets may be determined on the basis of periodic financial accounting statements provided at least annually during measuring periods in which the tested foreign corporation is not publicly traded.

However, if the tested foreign corporation or its shareholders have actual knowledge, or reason to know based on readily accessible information, that the financial accounting statements do not reflect a reasonable estimate of an asset’s FMV and the accessible information provides a more reasonable estimate of the asset’s FMV, then the information must be used to determine the FMV of the assets.

The 2021 proposed regs’ preamble has a discussion of this provision that provides further insight on measuring assets by FMV based on financial statement information. Under section 1297(e), the determination of whether a tested foreign corporation satisfies the asset test either must or may be made on the basis of FMV unless the tested foreign corporation is a non-publicly traded CFC. Accordingly, it is necessary to determine the relative FMV of a tested foreign corporation’s passive and non-passive assets to determine whether the tested foreign corporation satisfies the asset test.

The FMV of an operating company’s individual assets may not be readily determinable. However, financial accounting standards are intended to provide stakeholders with a realistic understanding of a company’s financial position, including the cost or FMV of its assets. Moreover, financial statement information is generally accessible by tested foreign corporations and their shareholders and is prepared for non-tax purposes. For these reasons, taxpayers often rely on financial statements to determine the FMV of a tested foreign corporation’s assets.

Section 1297(f)(4) specifically requires the use of information from financial statements prepared under U.S. generally accepted accounting principles or international financial reporting standards for qualifying insurance corporation rules, which indicates that Congress believes that this information is an appropriate basis for determining whether a tested foreign corporation qualifies as a PFIC in at least those circumstances.

Accordingly, prop. reg. 1.1297-1(d)(1)(v)(D) generally permits a taxpayer to rely on the information in a tested foreign corporation’s financial statements to determine the FMV of the corporation’s assets. Treasury and the IRS request comments on whether financial statement ordering rules similar to those of section 1297(f)(4) and prop. reg. section 1.1297-4(f)(1) should apply more generally and include additional safeguards requiring that financial statements be audited.

Treasury and the IRS are aware that financial statements do not include FMVs for assets important to companies in some industries, for example self-created intangibles. Prop. reg. section 1.1297-1(d)(1)(v)(D) therefore provides that if a shareholder has reliable information about the FMV of an asset that differs from its financial statement valuation, the reliable information must be used to determine the FMV of the asset.

Whether FMV information is more reliable than financial statement FMV is based on the facts and circumstances, including the experience and knowledge of the FMV information source, whether the information is recent, whether intervening developments affect the information’s accuracy, and whether the information specifically addresses the FMV of the asset in question.

Divergence from a financial statement FMV may also be warranted when a tested foreign corporation or look-through entity owns property subject to a lease or license that is disregarded under reg. section 1.1297-2(c)’s rules for intercompany obligations between a tested foreign corporation and a look-through entity.

Treasury and the IRS request comments on whether the asset test should take into account the FMV of the property subject to the lease or license and the FMV of the lease or license, or whether instead the asset test should take into account the FMV of the property disregarding the lease or license. Treasury and the IRS also request comments on additional considerations relevant to determining when shareholders may use information other than financial statement FMVs for purposes of the asset test.

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