Miller & Chevalier Seeks Modification of PFIC Regs

September 3, 2019

CC:PA:LPD:PR (REG-105474-18)
Courier's Desk
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024

Re: Comments on Proposed Regulations Regarding Passive Foreign Investment Companies (REG-105474-18)

Dear Sir or Madam,

Miller & Chevalier Chartered respectfully submits this letter in response to the Notice of Proposed Rulemaking under sections 1291, 1297, and 1298,¹ published in the Federal Register on July 11, 2019 (“Proposed Regulations”).²

The Proposed Regulations provide guidance on several aspects of the rules relating to ownership of a Passive Foreign Investment Company (“PFIC”), including the definition of “passive income” for purposes of determining PFIC status. We commend the Treasury Department (“Treasury”) and Internal Revenue Service (“IRS”) for clarifying that the exclusion of active banking and financing income from foreign personal holding company income (“FPHCI”) under section 945(h) (the “FPHCI active finance exception”) applies for purposes of determining whether income is passive income in the PFIC context.³ In order to conform the FPHCI active finance exception to the PFIC context, the Proposed Regulations appropriately provide that the entity whose income is being evaluated is treated as a controlled foreign corporation (“CFC”) for purposes of applying the section 954(h) exception.⁴ We respectfully request that final regulations include an additional conforming change to provide that for purposes of determining whether income is passive income in the PFIC context, the FPHCI active finance exception is applied without regard to section 954(h)(3)(A)(ii)(I), regarding transactions with customers located in the United States.

The purpose of the PFIC rules is to eliminate the benefit of deferral of U.S. tax for passive income earned by U.S. persons indirectly through a foreign investment company. Section 1297 provides that a foreign corporation is generally a PFIC if (1) at least 75 percent of its gross income for a taxable year is passive income or (2) at least 50 percent of its assets produce passive income or are held to produce passive income. Section 1297(b)(1) defines passive income as “any income which is of a kind which would be [FPHCI] as defined in section 954(c).” Section 1297(b) provides exceptions for certain categories of income, including for 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, to the extent provided in regulations, by any other corporation)”. Section 1297(c) provides a look-through rule for 25 percent owned subsidiaries; if a foreign corporation owns at least 25 percent of the stock of another corporation, then for purposes of determining whether such foreign corporation is a PFIC such foreign corporation shall be treated as if it received directly its proportionate share of the income of such other corporation (“the section 1297(c) look-through rule”).

The purpose of the subpart F rules is to tax on a current basis the passive or other mobile income earned by 10 percent U.S. shareholders indirectly through a CFC. Subpart F income includes FPHCI as well as certain categories of business income that has been shifted or deflected to a low-tax jurisdiction.⁵ FPHCI is defined as the portion of gross income made up of dividends, rents, royalties, interest, and annuities, as well as gain from the sale of property that gives rise to such income.⁶ Certain income earned from active businesses, such as rents and royalties derived in an active business, are excluded from FPHCI.⁷ The FPHCI active finance exception of section 954(h) modifies section 954(c)(1) by excluding from FPHCI “qualified banking or financing income from an eligible controlled foreign corporation.” An eligible CFC is a CFC that is predominantly engaged in an active banking, financing or similar business and conducts substantial activity with respect to such business.⁸ A CFC is predominantly engaged in a banking, finance or similar business if it (1) derives more than 70 percent of its gross income from the active and regular conduct of a lending or financing business from transactions with unrelated customers, (2) is an institution licensed to do business as a bank in the United States and is engaged in the active conduct of a banking business, or (3) is engaged in the active conduct of a securities business and is registered as a securities broker or dealer under U.S. law.⁹ Qualified banking or financing income is income of an eligible CFC that (1) is derived in the active conduct of a banking, financial, or similar business by such eligible CFC or by its qualified business unit, (2) is derived from transactions with customers outside of the United States and in which substantially all related activities are conducted in the CFC's or business unit's home country, and (3) is treated as earned by the CFC or business unit in its home country for purposes of its country's tax laws.¹⁰ Additionally, income of an eligible CFC other than a bank or securities dealer is not treated as qualified banking or financing income unless more than 30 percent of the CFC's or business unit's gross income is directly derived from lending or financing transactions with unrelated customers in its home country.¹¹

We applaud the provision of the Proposed Regulations that applies the FPHCI active finance exception to the PFIC rules because it is consistent with the purposes of the PFIC regime and with sound tax policy.¹² The PFIC rules were enacted in the Tax Reform Act of 1986 to tax currently income of U.S. taxpayers from passive investments held through a foreign corporation.¹³ The preamble to the Proposed Regulations explains that “the fact that the PFIC provisions are generally not intended to apply to foreign corporations engaged in active businesses supports the application of” the FPHCI active finance exception in the PFIC context.¹⁴ Similar to the PFIC rules, the FPHCI rules of subpart F are designed to require current taxation of passive income earned by U.S. persons through a foreign corporation. Accordingly, in section 1297 Congress generally referenced the FPHCI rules, which are intended to delineate passive income from other income, in defining passive income for purposes of the PFIC rules. The FPHCI active finance exception provides a detailed set of rules based on the recognition that income that generally is regarded as passive income, such as interest, should instead be treated as active income when earned in the conduct of an active financing business that meets certain criteria. Such income is not subject to current taxation under subpart F. The application of 954(h) to the PFIC rules ensures that the same income is treated comparably in both the PFIC and Subpart F contexts.

The Proposed Regulations modify one technical aspect of the FPHCI active finance exception to conform it to the PFIC context by providing that an entity is treated as a CFC for purposes of applying section 954(h) in the PFIC context.¹⁵ In this regard, the Proposed Regulations recognize that that the PFIC rules and subpart F rules are distinct anti-deferral regimes. Because subpart F applies only to income earned by CFCs, the FPHCI active finance exception refers to income and activities of a CFC. In contrast, the PFIC rules require the evaluation of income earned by foreign corporations that may or may not be CFCs. Accordingly, the Proposed Regulations apply the FPHCI active finance exception without regard to the references in section 954(h) to CFCs. By effectively treating all entities as CFCs for purposes of applying the FPHCI active finance exception in the PFIC context, the Proposed Regulations rationalize the application of section 954(h) in the context of the PFIC rules.

Consistent with this policy, we recommend one additional technical modification to the application of section 954(h) that is necessary to conform the FPHCI active finance exception to the PFIC context. In particular, we request that Treasury and the IRS apply 954(h) in the PFIC context without regard to whether income is derived from transactions with customers in the United States.¹⁶ Under the FPHCI active finance exception, qualified banking or financing income does not include income from customers in the United States. This rule is sensible in the subpart F context because the subpart F rules are intended to tax passive income and income that has been shifted or deflected. However, the PFIC regime, unlike subpart F, is intended only to target income earned through foreign corporations that earn predominately passive income. Moreover, under the section 1297(c) look-through rule, the determination of whether a foreign corporation is a PFIC may include an evaluation of income earned by a U.S. subsidiary of that foreign corporation.¹⁷ If the FPHCI active finance exception were applied in the PFIC context without modifying the rule in 954(h) prohibiting transactions with U.S. customers, the exception would effectively be inapplicable to active financing income earned by U.S. subsidiaries from transactions with local customers. As a consequence, income from the active banking or financing business of a U.S. subsidiary that otherwise meets all requirements of section 954(h), including those requiring home country customers and activity,¹⁸ would be treated as passive income solely by virtue of its location in the United States. We believe that such a result was not intended as it would be contrary to the policies underlying the decision to apply the FPHCI active finance exception in the PFIC context. The Proposed Regulations apply the FPHCI active finance exception to the PFIC rules because income earned in the conduct of an active finance business should not be considered passive income, and this principle is equally valid whether the entity earning the active finance income is a CFC or a U.S. subsidiary earning income from customers in its home country. Accordingly, we recommend that final regulations apply section 954(h) to determine whether income is passive income in the PFIC context without regard to whether income is derived from transactions with customers in the United States.

In the preamble to the Proposed Regulations, Treasury and the IRS request comments regarding the continued application of 954(h) to the determination of PFIC status when regulations are in force under section 1297(b)(2)(A). Section 1297(b)(2)(A) excludes from passive income 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, to the extent provided in regulations, by any other corporation).” We recommend that section 954(h) continue to apply to the determination of PFIC status in the future when regulations under section 1297(b)(2)(A) are issued. The policies animating the Proposed Regulations are equally relevant in considering the scope of the active banking exception and the grant of regulatory authority under section 1297(b)(2)(A). While the PFIC bank exception and section 954(h) overlap in their applications to licensed banks, the breadth of their application differs in two respects, reflecting their respective underlying policies and purposes. The exception under section 954(h) is qualified by the requirement that income be derived from transactions in the entity's home country, a reflection of Subpart F's focus on both passive income and income that is easily shifted to a low-tax jurisdiction.¹⁹ PFIC's singular focus on passive income is reflected in the application of the bank exception to all income from the active banking business of a licensed bank, without regard to its nexus to the taxpayer's home country. On the other hand, section 954(h) applies to a broader class of businesses than the PFIC banking exception, by excluding income from active financing and similar businesses that are not licensed banks. Such income is active business income for subpart F purposes, and therefore should not be considered passive income for PFIC purposes. Therefore, future final regulations under section 1297(b)(2)(A) should not preclude the continued application of section 954(h) for purposes of determining PFIC status.

We appreciate your consideration of our request and would be happy to answer any questions that you may have.

Respectfully submitted,

Layla J. Asali
202-626-5866

Rocco V. Femia
202-626-5823

Miller & Chevalier Chartered
Washington, DC