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Firm Raises Issues With Cross Reference Under PFIC Regs

SEP. 9, 2019

Firm Raises Issues With Cross Reference Under PFIC Regs

DATED SEP. 9, 2019
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9 September 2019

CC:PA:LPD:PR (REG-105474-18)
Room 5203
Internal Revenue Service
PO Box 7604
Ben Franklin Station
Washington DC 20224
USA

Re: Regulations 105474-18 — Comments on Proposed Regulations §§1.1297-1 and -2

Dear Sirs

We have reviewed the above-referenced proposed regulations clarifying issues raised under Internal Revenue Code ("IRC") §1297(b) and (c). These are definitions and rules of construction to be applied in the determination of whether a foreign corporation is a "passive foreign investment company" ("PFIC") within the meaning of IRC §1297(a), i.e. a corporation more than 75% of the income of which, in any year, is "passive income" or more than 50% of the value of the assets of which produce passive income.

Our full comments and recommendations relative to the proposed regulations are set out below. They raise the question of whether modifications to IRC §954(c) and regulations under that provision which have occurred subsequent to the enactment of the PFIC rules as part of the Tax Reform Act ("TRA") 1986 should be considered incorporated into IRC §1297(b)(1), which cross-references §954(c), and our submission that it is more consistent with Congressional intent to interpret the cross-reference to §954(c) in §1297(b)(1) as referring to the provisions of §954(c) and regulations interpreting §954(c) as they existed or were contemplated immediately following enactment of the TRA 1986. As discussed below, this would require excluding from the definition of passive income amounts described in IRC §954(c)(1)(H) ("personal service contracts"), as well as a modified application of the active rents and royalties exceptions as set out in IRC §954(c)(2)(A) and interpreted in regulations.

I. Proposed regulations §1.1297-1

Proposed regulations §1.1297-1 would address some of the interpretational issues resulting from the approach taken in IRC §1297(b)(1) of defining "passive income" as meaning income described in IRC §954(c), i.e. income constituting "foreign personal holding company income" ("FPHCI") under the controlled foreign corporation ("CFC") rules.1

Such incorporation by reference is not uncommon in the tax law. However, while it simplifies drafting, as the proposed regulations illustrate it raises many interpretational issues. The proposed regulations address some of these.

We would like to bring to your attention two related interpretational issues not presently addressed in the proposed regulations. The original cross-reference in IRC §1297(b) to §IRC 954(c) dates from the enactment of the PFIC rules as part of the TRA 1986. Since then, IRC §954(c) has been amended, as have regulations interpreting §954(c). This raises the following questions.

A. Should the cross-reference in §1297(b)(1) be considered a reference to a "snapshot" of IRC §954(c) as it existed immediately following the enactment of TRA 1986, or should subsequent amendments to §954(c) be considered also incorporated by reference into the PFIC rules?

B. Assuming, as reflected in the proposed regulations, that regulatory interpretations of IRC §954(c) should be applicable to the interpretation of §954(c) as incorporated by reference into the PFIC rules, should the cross-reference be considered a reference to a snapshot of the regulations under §954(c) immediately following amendment to reflect the enactment of TRA 1986, or should subsequent amendments to the regulations under §954(c) also be considered incorporated by reference into the PFIC rules.

We are aware of two cases in which this timing issue is relevant to the current interpretation of IRC §1297(b), namely:

A. the addition to the definition of FPHCI, effective 1st January 2005, of income described in IRC §954(c)(1)(H) ("personal service contracts"); and

B. the amendment to Treas. Regs. §1.954-2(c)(1)(i), effective for taxable years of CFCs ending on or after September 1, 2015, restricting the "active rents" exception in the case of companies manufacturing or adding substantial value to rental properties to cases where such manufacture/addition to value is effected by the CFC's own employees and officers.2

In our submission, in both cases the only reasonable assumption is that Congress intended the "snapshot" approach. Our analysis is set out A. and B. below, respectively.

A. Income from PHC Personal Service Contracts

Since 1934, in specified circumstances income of a domestic corporation from personal service contracts under the terms of which a greater than 25% shareholder is designated as required to perform the relevant services ("PHC personal service contracts") has been subject to a surcharge under the personal holding company rules of IRC §§541 to 547. In 1937, when the foreign personal holding company ("FPHC") rules of IRC §551 to 557 were enacted as companion provisions to the personal holding company rules, income from PHC personal service contracts was included in the definition of "foreign personal holding company income" under IRC §553. To the extent accumulated within an FPHC, such income was attributed to and taxed to the U.S. shareholders.

The CFC rules were enacted in 1966 to serve somewhat different policy objectives than the FPHC rules, but one of the categories of "subpart F income", includible in the income of "United States shareholders" of the CFC, was income meeting the definition of "foreign personal holding company income" under §553 of the FPHC rules. One of the changes adopted 20 years later in the TRA 1986 was an amendment to §954(c) to eliminate the cross reference to §553 and instead to specifically enumerate the categories of income included within the definition of FPHCI. (In this case Congress came to the conclusion that defining an important term like FPHCI required a more nuanced approach than merely cross-referencing §553.) Income from PHC personal service contracts was not specified as an item of FPHCI in §954(c), presumably because this income was not passive.

In The American Jobs Creation Act 2004 the FPHC rules were repealed as being largely redundant in the light of the treatment of FPHCI as subpart F income under CFC rules. To ensure that income from PHC personal service contracts would continue to be attributed to controlling U.S. shareholders as it had been under the FPHC rules, IRC §954(c)(1)(H) was added to treat income from PHC personal service contracts as a new category of FPHCI. There was no indication in the legislative history of the 2004 Act that this amendment was intended to affect the definition of passive income under IRC §1297(b)(1). As income from PHC personal service contracts continues to be non-passive, the addition of such income to the definition of FPHCI should not be considered to apply under the cross-reference to §954(c) in the PFIC rules. In other words, a 1986 "snapshot" approach is most consistent with Congressional intent.

If adopted, Prop. regs. §1.1297-1 will to a degree detach the definition of passive income under IRC §1297(b) from the meaning given to FPHCI under IRC §954(c), in much the same manner as the definition of FPHCI under IRC §954(c) was detached from the definition of foreign personal holding company income of IRC §553 under TRA 1986. As part of the present detachment exercise, it is clear income described in §954(c)(1)(H) should be unbundled from the other categories of FPHCI that are appropriately treated as passive income.

B. Active Rental Income from Owner-Manufactured Property

Although rental income is included in the definition of passive income under IRC §954(c)(1), IRC §954(c)(2)(A) provides an exception to this rule for rents which are derived in "the active conduct of a trade or business" (commonly referred to as the "active rents" exception). The proposed regulations would confirm both the inclusion of rental income and the exception for active rents in the definition of passive income under §1297(b). Prop. regs. §1.1297-1(c)(1)(i).

The proposed regulations appear to assume that regulations under §954(c) are relevant to the application of §1297(b) notwithstanding that the cross-reference in §1297(b) is solely to §954(c) and not to regulations under that provision.3 However, even if this is appropriate, there is strong reason to question whether all post-TRA 1986 amendments to those regulations should also be considered applicable in the PFIC context.

Regulations under §954(c) set out specific requirements that must be met to satisfy the active rents exception. Following amendments to the CFC rules in 1986, temporary regulations under §954(c) were adopted with effect from 1st January 1987. These regulations introduced the formulation of the active rents exception which continued without modification until 2015. Included within the exception for active rents under paragraph (c)(1) of Treas. Regs. 1.954-2 were rents from leasing:

"(i) Property that the lessor has manufactured or produced, or has acquired and added substantial value to, but only if the lessor is regularly engaged in the manufacture or production of, or in the acquisition and addition of substantial value to, property of such kind;

"(ii) Real property with respect to which the lessor, through its own officers or staff of employees, regularly performs active and substantial management and operational functions while the property is leased;

"(iii) Personal property ordinarily used by the lessor in the active conduct of a trade or business, leased temporarily during a period when the property would, but for such leasing, be idle; or

"(iv) Property that is leased as a result of the performance of marketing functions by such lessor if the lessor, through its own officers or staff of employees located in a foreign country, maintains and operates an organization in such country that is regularly engaged in the business of marketing, or of marketing and servicing, the leased property and that is substantial in relation to the amount of rents derived from the leasing of such property."

Treas. regs. §1.954-2(c)(1) (prior to amendment by T.D. 9733 (09/02/2015)).

Two conditions were required to be fulfilled to meet the "manufactured property" test of subparagraph (c)(1)(i), namely that the lessor have (a) manufactured or added substantial value to the property and (b) regularly engaged in such manufacturing/value adding activities. Unlike the exceptions set out in subparagraphs (c)(1)(ii) (actively managed rental property) and (iv) (actively marketed rental property), the manufactured property exception did not require the CFC to have carried out its manufacturing/value adding activities through its own officers or staff of employees.

Given the circumstances of their promulgation, these regulations may be presumed to have reflected the Treasury Department's view as to the appropriate interpretation of the active rents exception after taking into consideration the broad changes to the international taxation rules effected in the TRA 1986. Clearly the decision not to impose an "officers and staff" requirement to meet the manufactured property exception was deliberate and reflected the Treasury Department's judgment that the requirements imposed under subparagraph (c)(1)(i) were sufficient to ensure that the rental income was derived in the active conduct of a trade or business.

With effect for taxable years beginning after September 1, 2015, subparagraph (c)(1)(i) of Treas. regs. §1.954-2 was amended to read as follows:

"(i) Property that the lessor, through its own officers or staff of employees, has manufactured or produced, or property that the lessor has acquired and, through its own officers or staff of employees, added substantial value to, but only if the lessor, through its officers or staff of employees, is regularly engaged in the manufacture or production of, or in the acquisition and addition of substantial value to, property of such kind;"

This significantly narrowed (and for practical purposes may have virtually eliminated) the manufactured property exception by requiring that the manufacturing and/or value-added activity be carried on through the CFCs own officers or staff, and that the regularity requirement also be fulfilled by the entity's own officers or staff. The preamble to temporary regulations initially adopting the new language stated that this narrowing of the manufactured property exception had been determined by the Treasury Department to be necessary to fulfil the overall objective of the active rents exception as originally envisaged under the CFC rules:

"to distinguish between a CFC that passively receives investment income and a CFC that derives income from the active conduct of a trade or business."

TD 9733 (09/02/2015). As a justification for a significant change to regulations previously considered by the Treasury Department to be appropriate, this explanation seems inadequate. There was no indication whether the change was intended to affect the application of the PFIC rules.

Transitional rules were provided to "grandfather" properties held within a CFC prior to September 1, 2015 that qualified under the previous version of the manufactured property exception, so that rental income and gains from disposals of such properties would continue not to be considered FPHCI and so would not be subpart F income. Application of those rules in a PFIC context would have significantly different consequences, for example once passive income of a foreign corporation exceeded 75% of total income for any year the corporation would become a PFIC and all grandfathering protection would effectively end. This could occur notwithstanding that the majority of the company's property would have remained "grandfathered" for purposes of the CFC rules.

We reiterate that there is no indication the Treasury Department considered whether the 2015 amendment to CFC regulations concerning the manufactured property exception should affect the application of the PFIC rules. Accepting as a general proposition that regulations interpreting the active rents exception under §954(c) of the CFC rules should be considered relevant to the interpretation of the active rents exception under the PFIC rules, we would submit that in the circumstances it best reflects the legislative intent of Congress in enacting the PFIC rules to refer to the CFC regulations as they existed immediately after amendment to reflect enactment of the TRA 1986, i.e. a 1986 "snapshot" approach. Accordingly, the proposed regulations should be modified to make clear that the incorporation by reference of Treas. Regs. §1.954-2(c) is to those regulations as they were worded prior to amendment by T.D. 9733.

Clearly it is open to the Treasury Department to consider independently whether the pre- or post-T.D. 9733 formulation of the active rents exception for manufactured property is the more appropriate in the application of the PFIC rules. In the course of such consideration interested parties would have the opportunity to comment.

II. Proposed Regulation §1.1297-2

Proposed regulations §1.1297-2 address issues raised under IRC §1297(c), which provides that in applying the income and assets tests for PFIC status a corporation will be considered to earn a proportionate share of any income earned by a 25% or greater-owned subsidiary and to own a proportionate share of any property belonging to such a subsidiary.

They also address the related question of how to apply the active rents exception in a group context. Prop. regs. §1.1297-2(e) would provide that in judging whether an item of rental or royalty income is passive, the activities of all officers and staff of 50% or greater subsidiary entities will be attributed to the parent.

We would note that in the event it is accepted that the active rents and royalties exceptions should be based on the regulations that existed prior to T.D. 9733, then it will be necessary also to attribute activities of 50% or greater subsidiaries performed by persons other than its officers and staff and that Prop. regs. §1.1297-2(e) should be modified accordingly.

Indeed, even if it is determined (following notice and comment) that the post-T.D. 9733 formulation of the manufactured property exception should apply to the determination of PFIC status, it would be necessary to modify the activity attribution rules in the manner proposed in order that the transitional rules for the post-T.D. 9733 regulations could be applied. For years after the proposed regulations are made final it will be necessary to apply the pre-T.D. 9733 formulation of the manufactured property exception to properties manufactured/improved prior to the effective date of the T.D. 9733 amendments, and as noted in a group situation this will require attribution between group members of activities performed by persons other than officers and staff.

Thank you for this opportunity to provide our views on these issues. If you have any questions, please contact Jeffrey Gould, James Murray or Matthew Pannell on +4420 7833 3500.

Yours faithfully

Frank Hirth plc
London, UK

FOOTNOTES

1This is subject to certain exceptions and rules of construction set out in IRC §1297(b)(2).

2A similar amendment was made to Treas. regs. §1.954-2(d)(1)(i) concerning the "active royalties" exception. The discussion which follows focuses on the active rents exception but similar considerations apply to the active royalties exception.

3See Prop. regs. §1.1297-2(e)(1), discussed at II. below.

END FOOTNOTES

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