Individual Seeks Clarity in Proposed PFIC Rules

Sarah Stein High-level Comments on Proposed Regulations related to Passive Foreign Investment Companies

Executive Summary

These comments are intended to address certain aspects of the proposed regulations (the “Proposed Regulations”) issued on July 10, 2019, under sections 1291, 1297, and 1298 of the Internal Revenue Code (the “Code”). These comments are intended to be high-level discussions of certain discrete points and concepts in the Proposed Regulations and the passive foreign investment company (“PFIC”) rules.

These comments respond to certain requested areas, specifically:

• Attribution of Activities: The appropriate threshold for attribution of activities under Section 1.1297-2(e) of the Proposed Regulations; and

• Banking Exception: Whether the exemption for banking and finance income provided in Code Section 954(h) should continue to apply when regulations are in force under Code Section 1297(b)(2)(A).

These comments also address some ancillary issues to the concepts listed above, as well as some concerns that arise when applying Treasury Regulation (“Treas. Reg.”) Section 1.1291-1(b)(8)(iii)(C) to trust beneficiaries. In particular, as described in more detail below, the methods for determining proportionate trust “ownership” are unclear under current guidance, and this could lead to varying and inconsistent interpretations when determining whether a beneficiary meets the 50% threshold in the Proposed Regulations.

Attribution of Activities

The possible attribution of activities of subsidiaries to a tested foreign corporation in a group structure under Proposed Regulation Section 1.1297-2(e) will have a significant impact on the treatment of many foreign corporations that rely on, or would like to rely on, the exemption for active rents and royalties under Code Section 954(c)(2)(A). I agree that a multi-entity legal structure should not cause essentially “in-house” activities to be excluded from the activity analysis for the purpose of the exemption. Furthermore, under the current rules, many foreign corporations that have a multi-entity structure have devoted significant time and assets to reorganizing or making “check-the-box” elections which change the formal structure of the group for US federal income tax purposes, but have no meaningful impact on the actual activities conducted by the group overall. If the distinction between “passive” and “active” income for PFIC purposes is intended to distinguish investments in which the foreign corporation has little input or control from investments where the foreign corporation is creating value through operating an active business, the previous emphasis on form over function did not further these objectives. The approach outlined in the Proposed Regulations should streamline the PFIC analysis for these entities without creating a significant possibility of abuse, though as discussed below, certain areas may benefit from additional clarification.

1. Activity Attribution Threshold

You have sought comments on the appropriate ownership threshold for attributing activities of subsidiaries under Proposed Regulation Section 1297-2(e).

The current proposal requires more than 50% ownership by value, so that only one shareholder may benefit from the activities performed by the subsidiary, due to a concern about “double-counting” the subsidiary's activities. However, an emphasis on voting power and control, as opposed to ownership by value, may be more appropriate to measure how much the subsidiary entity is a effectively proxy for the tested foreign corporation in performing the relevant activities.

If a tested foreign corporation has significant input, if not absolute control, over the subsidiary performing the activities, it seems appropriate to attribute a portion of those activities to the tested foreign corporation. The relevant thresholds in this instance are debatable: significant minority control should be a requirement (perhaps 25% of the voting rights), but more than 50% of the voting rights may make sense to assure actual control (and, this threshold would have the secondary effect of preventing “double counting”). To some extent, a partial ownership interest in the subsidiary (e.g., 25% of the vote) can be analogized to a part-time employee: provided the employer has input in the employee's activities during the employee's relevant workdays, the activities of that employee should be attributable to that employer, even if the employee's activities may be attributed to another employer on other days of the week. While this analogy isn't perfect, where activities performed by a subsidiary give rise to income for a tested foreign corporation, it does not seem unreasonable to match the activities to the income regardless of whether another entity may also benefit from similar activities performed by the subsidiary. Limiting the exemption to instances where the tested foreign corporation has at least 25% of the voting power would avoid situations in which there is truly a third-party property manager that performs similar tasks for many clients.

Basing the activity attribution analysis on “control” would be a general departure from the PFIC look-through subsidiary approach outlined in Code Section 1297(c) and many other provisions of the relevant PFIC regulations, but when analyzing how much a tested foreign corporation should benefit from activities performed by other entities, such a departure seems appropriate. Though these comments do not address the treatment of partnership interests for look-through purposes, your requested input on distinguishing between a “general partner” and a “limited partner” interest in look-through partnerships highlights the same consideration — where “control” may be a more relevant metric than “ownership” for attribution purposes.

2. The problem of lower-tier PFICs

Disallowing attribution across subsidiaries in a group that relies on Proposed Regulation Section 1.1297-2(e) could have some outcomes that diminish the value of the regulation. Commonly, in groups that rely on the active rents/royalties exception, the valuable assets are segregated into separate legal entities with no real activities. Such subsidiaries, when viewed independently, would normally be treated as PFICs, as their sole asset would be passive. Similarly, the entities performing the groups' activities may have no assets other than cash and a few office supplies, which could also cause them to be PFICs. The current proposed regulations (in particular, as described in Proposed Regulation Section 1.1297-2(e)(2)(i), Example 1) explicitly intend that the activity attribution have no impact on the classification of look-through subsidiaries themselves. Therefore, under Proposed Regulation Section 1.1298-2(d), upon the disposition of look-through subsidiaries that hold assets that are treated as active in the hands of the tested foreign corporation due to Proposed Regulation Section 1.1297-2(e) but are otherwise passive, residual gains from the sale of that subsidiary would be treated as passive, which seems inconsistent with the intent of the activity attribution in the Proposed Regulations.

While not specifically addressed in the current proposed regulations, for 50% direct/indirect owners of a tested foreign corporation that benefits from the active rent/royalty exception, the aggregate approach to activities would provide relief from PFIC status for the tested foreign corporation at the top of the structure. However, as noted above, many subsidiaries may still remain PFICs, with substantial amounts of rental income or rental assets segregated in these separate legal entities. Consequently, for these owners, the approach outlined in Proposed Regulation Section 1.1297-2(e) would essentially push the PFIC problem down to the lower-tier entities, and may provide very little economic/administrative relief.

a. One possible solution: Tested foreign corporations that rely on look-through subsidiaries whose activities, assets or income are taken into account for the purposes of determining whether the tested foreign corporation meets the “active rents/royalties” exception could be treated as non-PFICs with respect to that tested foreign corporation and its direct/indirect shareholders to the extent that (i) the tested foreign corporation's ownership interest in the entity does not drop below the relevant threshold [still to be determined], and (ii) the subsidiary's assets/income/activities remain relevant to the tested foreign corporation's analysis under Proposed Regulation Section 1.1297-2(e), Code Section 954(c)(2)(A) and Treas. Reg. Section 1.954-2(b)(6). A similar approach is adopted in respect of “qualified bank affiliates” in Prop. Reg. Section 1.1296-4(i), where subsidiaries within a group structure that has active banks may treat their banking income as “active” for the purposes of the analysis for the bank group, but not for third-party shareholders of the subsidiary. These banking rules also set certain banking income requirements for the group in order to treat subsidiaries as qualified bank affiliates, but these income thresholds may be less appropriate in the real estate context, where one is looking to attribute activities across a group.

Banking Exception

The Proposed Regulations address the exception for active banking and finance income outlined under Code Sections 1297(b)(2)(A) and its interaction with Code Section 954(h). Financial businesses such as banks necessarily rely on income and assets that would otherwise be categorized as “passive” without special treatment under the PFIC rules. On the other hand, the banking and financial industries do create potential for investors to use so-called “banks” to create exposure to passive assets outside of the US tax net.

Even with the inclusion of the exceptions under Code Section 954(h), the current guidance may be too limited in its definition of a “bank” in many circumstances. There are many entities that are widely, popularly regarded as “banks” but for whom the analysis under Notice 89-81 (the “Notice”) and Prop Reg. 1.1296-4 (the “Previous Proposed Regulations”) is not as clear. Code Section 954(h) has somewhat more lenient requirements for determining whether an entity is eligible to be treated as an active bank, but it still leaves some important gaps.

Also, an ancillary issue in the context of a PFIC analysis for an entity that is not a CFC is that the entity may not devote significant attention to the needs of its US investors, and therefore the ability of US investors to analyze the entity's PFIC status is often limited. This is particularly important in the context of a bank, where the analysis (under all proposed guidance) is highly fact-specific.

1. Code Section 954(h) and the limitations of “qualified banking or financing income”

You have asked for comments on whether, when final regulations are in place for Code Section 1297(b)(2)(A), Code Section 954(h) should continue to apply in determining a bank's PFIC status. Of course, the answer is dependent on the form that the final regulations take, but this discussion assumes that they would be similar to concepts currently outlined in the Notice and/or the Previous Proposed Regulations.

Code Section 954(h) is somewhat more lenient than the Notice and the Previous Proposed Regulations in determining which entities may be eligible for the exemptions for “qualified banking or financing income.” Specifically, unlike the Notice and the Previous Proposed Regulations, Code Section 954(h) does not have a licensing or deposit-taking requirement. Therefore, entities who do not meet the requirements to be an “active bank” for the purposes of the Notice or the Previous Proposed Regulations due to these requirements may nonetheless be “eligible controlled foreign corporations” for the purpose of 954(h). However, this may be of limited use, due to the narrower definition of active income (among other considerations).

Code Section 954(h) defines “qualified banking or financing income” to include many items of income that are treated as banking income for the purposes of the Notice and the Previous Proposed Regulations. However, Code Section 954(h) lacks certain items that become particularly relevant in the context of a PFIC analysis, where the character of the income is also used to characterize the asset that produces the income. In particular, some items of income/activities that are treated as active in the Notice or Previous Proposed Regulations but are absent from Code Section 954(h) are:

Generally, banks' balance sheets reflect significant assets (specifically, cash, currencies, and securities) that may be still passive under Code Section 954(h) absent a specific exemption. The items of income above therefore become important to ensure that a bank has sufficient active assets for the purposes of its PFIC analysis. Consequently, if a bank is unable to qualify under the Notice or the Previously Proposed Regulations but it does qualify under Code Section 954(h), it's unlikely this additional qualification would be of much use.

As noted above, whether the exceptions under Code Section 954(h) should continue to be included when final bank PFIC regulations are issued is highly dependent on the content of the final regulations. Based on the analysis above, the continued inclusion of Code Section 954(h) is likely to be of limited use due to the inconsistent treatment of certain specified activities and the types of income generated therefrom, but also this Code Section does not appear to present a significant risk of abuse. Therefore, it would be consistent with the intent of the overall banking exception to allow banks to rely Code Section 954(h), should where it is helpful.

2. Low-risk Banks

There are certain financial institutions that appear to be actively pursuing a classic banking business, where an investor is seeking investment exposure to the risk and rewards of the bank's business, and that entity does not risk being a proxy for a mutual fund/PFIC-type investment. When these non-US banks are not marketing their shares to US investors and are not CFCs, they are very unlikely to do a PFIC analysis or provide the significant structural, legal, and financial information that an individual minority investor would need to make its own independent PFIC analysis for the entity. A streamlined procedure for identifying banks that do not present a high risk of being passive investment vehicles could be useful. Specifically, low-risk banks could be banks that:

Ownership Attribution

The clarification of attribution provisions for owners of pass-through entities that hold PFICs through non-PFIC foreign corporations is, overall, extremely helpful. However, one of the areas in which further clarification may be needed is determining when a beneficiary of a trust may be treated as meeting the ownership thresholds in Treas. Reg. Section 1.1291-1(b)(8)(iii)(C).

1. Clarification: Trust ownership calculation

Consistent with the treatment of other pass-through entities, nongrantor trusts were given a 50% ownership threshold for the attribution of ownership of underlying PFICs through non-PFIC foreign corporations under Treas. Reg. Section 1.1291-1(b)(8)(iii)(C). While the consistent approach between pass-through entities is laudable, trusts present unique circumstances and considerations, because the calculation of beneficial ownership of the assets of a trust is often less straightforward than the calculation of ownership interests in a partnership or S corporation. Treas. Reg. 1.1291-8(i) notes that, for all pass-through entities, the ownership determination should be based on “facts and circumstances,” but does not provide further guidance. The lack of additional guidance on this point can lead to confusion in the case of all pass-throughs. However, trusts frequently have beneficiaries whose interests may be entirely speculative and remote, and there is currently little specific guidance on determining ownership of PFICs held through trusts. This open interpretation means that practitioners could apply the 50% threshold in many different and inconsistent ways.

The current PFIC regulations acknowledge the problem of determining trust “ownership” (to some extent) for the purposes of IRS Form 8621. Under Treas. Reg. Section 1.1298-1(b)(3)(ii), beneficiaries of foreign estates and trusts are not required to file the form if the beneficiary is not treated as receiving an excess distribution (within the meaning of section 1291(b)) or as recognizing gain that is treated as an excess distribution (under section 1291(a)(2)) with respect to the stock. While this particular rule may make sense for information reporting purposes, it does not provide much clarity for the purposes of 1298(a).

To determine ownership, there can be clear-cut scenarios where a trust has two beneficiaries with equal rights to the trust assets and income, who have historically received equal distributions from the trust and who are entitled to equal distributions under the trust documents. But, in practice, this is often not the case. For example, a discretionary beneficiary that has never received a distribution from a trust, but that may, in theory, receive the entire corpus and income of the trust according to the terms of the instrument could be argued to have a 100% interest in the trust, or possibly a 0% interest based on the historical lack of distributions. The percentage ownership of this theoretical beneficiary may depend on whether there are other beneficiaries who are receiving current distributions from the trust, and whether there are any conditions limiting the circumstances in which the beneficiary can receive distributions (among other factors). With complex fact patterns, it may be difficult for practitioners to be certain which beneficiaries meet the relevant threshold (or, should be treated as PFIC owners at all). This may be an appropriate time to provide further guidance on how ownership should be calculated for this purpose.

This list is not exhaustive, but merely illustrates some of the considerations that could impact an ownership analysis with respect to trust beneficiaries. Any of these assessments for a given trust would likely need to be reevaluated annually for changes. While many of these factors (and others) are likely taken into account for each practitioner's “facts and circumstances” ownership analysis, more definitive guidance in this area would clear up the existing confusion on PFIC ownership through trusts, as well as provide clarity on how to implement the new threshold proposed in Treas. Reg. Section 1.1291-1(b)(8)(iii)(C).