Firm Seeks Changes to 3 Issues Under Proposed PFIC Regs

April 13, 2021

CC:PA:LPD:PR (REG-111950-20)
Courier's Desk
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024

Re: Comments on Proposed Regulations Regarding Passive Foreign Investment Companies (REG-111950-20)

Dear Sir or Madam:

Miller & Chevalier Chartered respectfully submits this letter in response to the Notice of Proposed Rulemaking under sections 250, 951A, 1291, 1297, and 1298,¹ published in the Federal Register on January 15, 2021 (the “2021 Proposed Regulations”).²

The 2021 Proposed Regulations provide guidance on several aspects of the rules relating to Passive Foreign Investment Company (“PFICs”). We commend Treasury and the IRS for their efforts to provide guidance to address longstanding issues under the PFIC rules. We address three aspects in this letter: (1) the treatment of active financing income, (2) the treatment of trade and service receivables, and (3) the treatment of working capital.

I. ACTIVE FINANCING INCOME

A. Background: Treatment of Active Financing Income In 2021 Final and Proposed Regulations

In general, a PFIC is defined as any foreign corporation if 75 percent or more of its gross income for the taxable year consists of passive income, or if 50 percent or more of the average value of its assets consist of assets that produce passive income.³ Section 1297(b)(1) defines passive income as “any income which is of a kind which would be foreign personal holding company income as defined in section 954(c).” Foreign personal holding company income (“FPHCI”) is a category of foreign base company income, which in turn is a category of subpart F income under the longstanding subpart F rules applicable to U.S. shareholders of controlled foreign corporations (“CFCs”). Section 954(c) identifies categories of income that are treated as FPHCI, such as interest, dividends, and certain gains; provides certain exceptions from such treatment; and provides certain operational rules. Section 954(h) provides that, for purposes of section 954(c)(1), FPHCI “shall not include” active financing income. Section 1297(b)(2) 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).”

Treasury and the IRS issued a Notice of Proposed Rulemaking on July 11, 2019 (the “2019 Proposed Regulations”) that treated active financing income as nonpassive income under section 1297(b)(1).⁴ The 2019 Proposed Regulations requested comments “about whether, when regulations are in force under section 1297(b)(2)(A), the corollary FPHCI exclusion should also continue to apply.”

The 2019 Proposed Regulations were finalized in part and re-proposed in part in final regulations and proposed regulations issued on January 15, 2021 (respectively, the “2021 Final Regulations” and the “2021 Proposed Regulations”). The preamble to the 2021 Final Regulations explains that several comments to the 2019 Proposed Regulations approved of the treatment in those regulations of active financing income as nonpassive income under section 1297(b)(1), and recommended that the active financing exception continue to apply in the PFIC context in the event that final regulations implementing the active banking exception in section 1297(b)(2)(A) are adopted. In response to these comments, all of which endorsed the adoption of the active financing exception in the PFIC context by the 2019 Proposed Regulations, Treasury and the IRS further studied the relevant statutes and legislative histories and determined that the position of the 2019 Proposed Regulations should be reversed.

The preamble to the 2021 Proposed Regulations, referencing the preamble to the 2021 Final Regulations, provides two reasons for reversing the position of the 2019 Proposed Regulations and treating active financing income as income of a kind which would be FPHCI. First, the preamble explains that, unlike most other exceptions to FPHCI in the subpart F rules, the active financing exception of 954(h) requires the foreign corporation to be a CFC to qualify for the exception. Second, the preamble explains that if the active financing exception were interpreted as applying in the PFIC context, it would be duplicative of the statutory active banking exception in section 1297(b)(2)(A), and have the effect of “narrowing the scope” of the active banking exception without clear authorization by Congress in legislative history. In addition, while not stated explicitly, the preamble indicates a desire to treat the active financing exception of section 954(h) in the same manner as the active insurance exception of section 954(i); because Treasury and the IRS believe that there are sound, independent reasons to provide that active insurance exception of section 954(i) does not apply in the PFIC context (notably, statutory changes to the PFIC active insurance exception enacted in 2017), consistent treatment supports the same result for active financing income.

The 2021 Proposed Regulations propose to implement this position by explicitly treating active financing income as income of a kind which would be FPHCI and therefore passive income under section 1297(b)(1) of the PFIC rules.⁵ The Proposed Regulations adopt the principles of the active finance exception as a component of the active banking exception under section 1297(b)(2)(A) but provide that this exception applies only to foreign licensed banks.⁶

B. Recommendation

We respectfully request that Treasury and the IRS reconsider their decision to treat active financing income as passive income under the 2021 Proposed Regulations. Active financing income should be treated as nonpassive income because it is not income of a kind which would be FPHCI and because it is active business income. This result would be consistent with the relevant statutory provisions, the underlying structure and purposes of the PFIC and subpart F rules, and sound tax policy. Alternatively, Treasury and the IRS should interpret the active banking exception to apply to active financing income, consistent with the statutory authority in section 1297(b)(2)(A) to apply the active banking exception to corporations other than foreign licensed banks.

If this recommendation is adopted, then we also respectfully request that Treasury and the IRS adopt regulations that adapt the active financing rules in the PFIC context, in particular with respect to active financing operations of look-through subsidiaries operating in the United States.

C. Discussion

1. Active Finance Income Should Not Be Considered Passive Income

a. Adoption of the Active Finance Exception Is Consistent with Statutory Framework of the PFIC and is Sound Tax Policy

Active financing income should be treated as nonpassive income because it is not income of a kind which would be FPHCI and because it is active business income. This result is consistent with the relevant statutory provisions, the underlying structure and purposes of the PFIC and subpart F rules, and sound tax policy.

Congress enacted the PFIC rules in the Tax Reform Act of 1986 (the “1986 Act”) to supplement the then-existing anti-deferral regimes by ending tax deferral for U.S. taxpayers investing in passive or non-business assets through a foreign corporation, without regard to the size of the interest held by the U.S. taxpayer in the foreign corporation.⁷ This purpose is similar, but not identical, to that underlying the subpart F rules, which were enacted to end tax deferral on both passive income and easily shifted active business income earned by U.S. shareholders of controlled foreign corporations.⁸ Unlike the subpart F rules, the PFIC rules were not intended to affect investments in foreign corporations that earn predominantly active business income (and that hold predominantly active business assets).⁹ Accordingly, Congress tied the general definition of passive income in the PFIC rules, current section 1297(b)(1), to the subcategory of subpart F income, FPHCI, that generally represented non-business income. Income that was not of a kind which would be FPHCI, such as income from sales or services, could not be passive income.

At the same time, Congress in the 1986 Act generally expanded the categories of income included in the definition of FPHCI. In particular, Congress added the following categories of income to FPHCI: (1) net gains from the disposition of non-inventory property that gave rise to FPHCI; (2) net commodities gains (except for transactions that occurred in the active business of a producer, processor, merchant, or handler of commodities); (3) net foreign currency gains (except to the extent related to the business needs of the corporation); and (4) income equivalent to interest. This expanded definition of FPHCI was adopted automatically, by cross-reference, in the new PFIC rules. Congress also repealed certain pre-1986 law exceptions to FPHCI for interest, dividends, and gains earned by banks and insurance companies. Congress determined that these exceptions provided excessive opportunity for interest, dividends, and gains earned by banks and insurance companies to be shifted to low-tax jurisdictions because the activities of such financial institutions could be located in any jurisdiction. Congress therefore determined that it was inappropriate to allow deferral on such income under the subpart F rules regardless of its connection with an active business. Because the PFIC rules were intended to address passive income rather than easily shifted active business income, however, Congress provided in current section 1297(b)(2) an exception from the definition of passive income in the PFIC context for income derived in the active conduct of a banking business by a bank and for income derived in the active conduct of an insurance business.

The relationship between the FPHCI definition in the subpart F rules and the passive income definition in the PFIC rules reflects a coherent statutory scheme that is consistent with the policies underlying each set of rules. Under section 1297(b)(1), passive income includes income of a kind which would be FPHCI; it does not include any other type of income. When Congress expands or contracts the definition of FPHCI under the subpart F rules, that change expands or contracts the definition of passive income for PFIC purposes. Thus, for example, when Congress expanded the definition of FPHCI in the Taxpayer Relief Act of 1997 (the “1997 Act”) to include income from notional principal contracts and substitute dividend payments because such categories of income resembled other FPHCI, that resulted in an expansion of the definition of passive income for PFIC purposes. Similarly, when Congress narrowed the definition of FPHCI in the 1997 Act to exclude income earned by dealers in financial instruments referenced to commodities because it determined that such income was active business income, that change resulted in a contraction in the definition of passive income for PFIC purposes. The 2021 Final Regulations correctly interpret the statute and incorporate each of these subpart F rules into the definition of passive income for PFIC purposes, even though the legislative history to these provisions of the 1997 Act made no reference to the PFIC rules.

Section 954(h) is premised on the proposition that income generally regarded as passive, such as interest, should instead be treated as active income when it is earned in the conduct of an active financing business that meets certain criteria. Such income is therefore not FPHCI and is not subject to current taxation under subpart F. This set of rules applies without regard to whether the income is earned by a licensed bank or another type of financing business, including for example captive consumer financing businesses that facilitate the sale of durable goods manufactured by the group. The application of the active financing exception to the PFIC rules — consistently, without regard to the type of active business — ensures that the same active business income is treated comparably and appropriately in each of the PFIC and subpart F contexts, consistent with the framework and policies underlying each statutory regime.

b. The Justifications Offered for Passive Treatment of Active Financing Income Are Misplaced

Neither of the two arguments offered by the preambles to the 2021 Final and Proposed Regulations in favor of treating active financing income as income of a kind which would be FPHCI supports that conclusion.

First, the preamble explains that the active financing exception is available only for CFCs, not foreign corporations that are not CFCs, and therefore should not be extended to the PFIC context.¹⁰ We disagree based on the statutory language of section 1297(b)(1) and its cross-reference to the subpart F rules. All of the exceptions in the subpart F rules to FPHCI, and the definition of FPHCI itself, apply only to CFCs. The section 954 rules for categorizing income on their face apply only to CFCs, and only for purposes of determining whether income should be included in the income of U.S. shareholders of CFCs when earned. Section 1297(b)(1) incorporates those categorization rules through a cross reference that looks to the nature of the income, not the identity of the entity earning the income, providing that passive income is “any income which is of a kind which would be foreign personal holding company income” under the subpart F rules. Requiring that such income actually be earned by CFCs, and therefore actually be FPHCI (or actually eligible for an exception thereto) fails to give meaning to the underlined statutory language. While the preamble is correct that the active finance exception by its terms applies only to “eligible CFCs” as defined in section 954(h)(2), the preamble does not provide any support for the proposition that that language precludes giving effect to the cross reference in section 1297(b)(1), or that Congress intended the term “eligible CFCs” to have a substantive effect different from “eligible corporation” or other alternative language.

Moreover, Treasury and the IRS sensibly provided in the 2021 Final Regulations that entities will be treated as if they were CFCs for purposes of mechanically applying certain exceptions to FPHCI in the PFIC context.¹¹ This treatment appears to extend to gains described in section 954(c)(1)(B)(i), which exempts from FPHCI characterization gains from the sale of property that would give rise to active financing income described in section 954(h).¹² There is no policy justification for distinguishing gains from the sale of property that produces active financing from the active financing income itself.

Second, the preamble states that excluding active financing income from passive income under section 1297(b)(1) would be duplicative and would narrow the scope of the active banking exception section 1297(b)(2)(A) without explicit congressional authorization. We disagree that the exceptions are duplicative, and we believe that the statutory language of section 1297(b)(1) provides ample evidence of the intent of Congress. While there is some overlap between the active banking exception and the active financing exception as applied to licensed banks, the exceptions apply to different classes of income and to different classes of businesses. These differences reflect the different policy concerns of the two regimes — while the subpart F rules are targeted toward both passive income and active income that is easily shifted to a low-tax jurisdiction, the PFIC rules are targeted toward only passive income. The active financing exception applies to a broader class of businesses than the active banking exception, but is qualified by the statutory requirement that income be derived from transactions with customers in the entity's home country. On the other hand, the statutory PFIC active banking exception applies to all income from the active banking business of a licensed bank, without regard to its nexus to the taxpayer's home country. The subpart F rules and the PFIC rules intersect in their common and cross-referential definition of passive income — passive income under the PFIC rules does not include income that is not FPHCI under the subpart F rules.

Further, given the statutory cross-reference in section 1297(b)(1), any change to the definition of FPHCI, including the enactment of the active financing exception in 1997, has the potential to change the scope of the active banking exception. Since the 1986 Act, Congress has expanded and contracted the definition of FPHCI in ways that affect banks and other financial institutions. In every case, the technical effect of these changes has been to expand or contract the scope of income to which the active banking exception applies. For example, the 1997 Act expanded the definition of FPHCI to include income from notional principal contracts and substitute dividend payments. The effect of this change was to expand the categories of income earned by banks and other financial institutions that could be passive income for PFIC purposes, and thereby also expand the scope of income subject to the PFIC active banking exception where applicable. Similarly, the 1997 Act narrowed the definition of FPHCI for dealers in financial instruments referenced to commodities, thereby narrowing the categories of income earned by banks and other financial institutions that could be passive income for PFIC purposes, and narrowing the scope of income subject to the PFIC banking exception where applicable. Not surprisingly, none of the legislative history to these changes to the definition of FPHCI refers to the PFIC rules; in each case, technical knock-on effects on the PFIC rules occur by operation of the statute, and Congress need not express an intent to accomplish a technical result provided for under the statute.¹³ Where Congress intends that a change to the FPHCI rules not carry over to the PFIC rules, it can say so specifically. For example, the legislative history to the PFIC rules was explicit that the FPHCI rule in section 954(c)(3) for certain income from related persons does not apply for PFIC purposes given the different policies underlying the treatment of related party payments under the CFC and PFIC regimes.¹⁴ Where the statute is otherwise silent, then the language of section 1297(b)(1) creates a strong presumption that changes to scope of FPHCI for subpart F purposes will have an effect on the scope of passive income for PFIC purposes.¹⁵

c. Concerns Regarding Active Insurance Income should not Determine the Treatment of Active Financing Income

While not stated explicitly by the preamble of the 2021 Proposed Regulations, we understand that Treasury and the IRS may wish to treat the active financing exception of section 954(h) in the same manner as the active insurance exception of section 954(i). Moreover, because Treasury and the IRS believe that there are sound, independent reasons to provide that the active insurance exception of section 954(i) does not apply in the PFIC context, consistent treatment would support the same result for active financing income. In our view, the legislative context of the active insurance exception is sufficiently distinct from that of the active financing exception to allow for different treatment. In particular, Congress in 2017 made extensive amendments to the PFIC active insurance exception of section 1297(b)(2)(B), adding comprehensive PFIC-specific rules in section 1297(f).¹⁶ As Treasury and the IRS explained in the preamble to the 2019 Proposed Regulations, these recent amendments show that Congress intended for section 1297(b)(2)(B) to be the only exception for active insurance income.¹⁷ Moreover, unlike the active financing exception, the subpart F and PFIC active insurance exceptions both apply to a coextensive set of businesses: insurance companies. Congress has not made any material changes to the section 1297(b)(2)(A) active banking exception in the last 35 years, and the active financing exception provides to a broader range of businesses than the PFIC active banking exception. These differences provide Treasury and the IRS with ample authority to adopt a different position in the two contexts.

In addition, section 1297(b)(2)(A) itself provides authority to Treasury and the IRS to apply the PFIC active banking exception to corporations other than licensed banks, and as discussed above there are strong policy reasons to exclude active financing income from passive income for purposes of the PFIC rules irrespective of whether it is earned by a licensed foreign bank or other corporation.

D. The FPHCI Active Finance Exception Should Apply in the PFIC Context to Income from Transactions with U.S. Customers.

The active financing exception in section 954(h) applies only to income that is derived from transactions with customers located outside of the United States.¹⁸ This requirement is sensible in the subpart F context because the subpart F rules are intended to apply to income that has been shifted or deflected. However, as discussed above, the PFIC regime is intended to target only income earned through foreign corporations that earn predominantly 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. If Treasury and the IRS reconsider the Proposed Regulations and apply the FPHCI active financing exception in the PFIC context, the exception should apply without regard to the limitation on customers located within the United States. If the FPHCI active finance exception were applied in the PFIC context without modifying the rule in section 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 financing business of a U.S. subsidiary that otherwise meets all requirements of section 954(h), including those requiring home country customers and activity,¹⁹ would be treated as passive income solely by virtue of its location in the United States. We believe that such a result would be contrary to the policies underlying the PFIC rules because income earned from home-country customers in an active financing business is active business income.

It is important to clarify this aspect of the application of the active financing exception in the PFIC context because, where the determination of a foreign corporation's status as a PFIC includes the evaluation of a U.S. subsidiary, section 1298(b)(7) does not adequately protect against the treatment as passive income of a U.S. subsidiary's active financing income. Section 1298(b)(7) provides generally that the stock of a 25%-owned domestic corporation will not be treated as a passive asset and income derived from such stock will not be treated as passive income for purposes of determining whether the foreign corporation is a PFIC.²⁰ This exception was meant to ensure consistent treatment of U.S. investors who hold U.S. equity investments through a U.S. investment company, regardless of whether the U.S. investment company is owned by a foreign corporation.²¹ It applies only when the foreign corporation is subject to the accumulated earnings tax in section 531 or waives any treaty benefit exempting it from such tax,²² and it does not apply to first-tier U.S. subsidiaries. The general look-through rule in 1297(c) applies where section 1298(b)(7) does not. Under 1297(c), active financing income of a U.S. subsidiary, which would otherwise be excluded from FPHCI and passive income, would be considered in determining the tested foreign corporation's PFIC status. But it would be treated as passive income simply because the income was derived from transactions in the United States. Therefore, if Treasury and the IRS apply the FPHCI active finance exception in the PFIC context, we recommend that they do so without regard to whether the income is derived from transactions with U.S. customers.

II. TRADE AND SERVICE RECEIVABLES

A. Background

The preamble to the 2021 Proposed Regulations states that Treasury and the IRS plan to address in final regulations the portions of Notice 88-22 that address the treatment of trade and service receivables, among other assets.²³ The 2021 Proposed Regulations do not propose regulatory language but Treasury and the IRS requested comments on whether final regulations should change Notice 88-22's treatment of those assets.

With respect to trade or service receivables, Notice 88-22 provides that:

A trade or service receivable will be characterized as a passive or nonpassive asset based on the character of the income derived by the corporation from the transaction that generated the receivable. Accordingly, a trade or service receivable derived from sales or services provided by the corporation in the ordinary course of its trade or business which produce nonpassive income will be treated as a nonpassive asset for purposes of the asset test. . . . [I]nterest incidentally received on a trade or service receivable that is otherwise treated as a nonpassive asset will not affect the characterization of the receivable.²⁴

B. Recommendation

We agree with treating trade or service receivables as passive or nonpassive based on the character of the income that generated the receivable. We recommend two clarifications in final regulations. First, we recommend that trade or sales receivables include obligations held by a corporation (or an affiliate) that arise, directly or indirectly, from a retail sale. Second, we recommend that the definition of trade or service receivable be clarified so that it does not distinguish between long- and short-term receivables.

C. Discussion

We agree with the treatment of trade or service receivables as passive or nonpassive assets based on the character of the income that generated the receivable. We recommend two clarifications with respect to the definition of “trade or service receivables” in final regulations.

First, we recommend that trade or sales receivables include obligations held by a corporation (or an affiliate) that arise, directly or indirectly, from a retail sale. A narrow reading of Notice 88-22 would apply only to receivables held by the corporation that sold the products giving rise to the receivables. Such a reading would be problematic; it would treat corporations in the retail sector differently from those in the manufacturing sector.

Consider, for example, a corporation that manufactures engines and equipment. Under the prevailing business model in its industry, consumers do not purchase engines and equipment directly from the manufacturer. Rather, the manufacturer contracts with third parties to operate as the manufacturer's exclusive dealers in regions in which the manufacturer is active. To facilitate the consumer purchases, the manufacturer provides consumers with financing options directly, or through captive customer financing subsidiaries.

Retailers often offer financing options for certain large purchases or allow consumers to purchase certain items on layaway. Under a narrow reading of Notice 88-22, the receivables held by retail companies would be within the scope of the 2021 Proposed Regulations, but the receivables held by the manufacturing financing subsidiary would not. There is no policy rationale for treating these receivables differently. Like the consumer receivables held by retailers, the receivables held by the financing subsidiary are derived from a transaction entered into in the course of an active manufacturing business of the group even if they were made to finance a sale of the equipment from a third party. Thus, in the interest of horizontal equity, we recommend a broader definition of trade or service receivables that encompasses any obligation that is derived from sales or services provided in the course of an active business.

Second, we ask that Treasury and the IRS clarify in final regulations that the definition of trade or service receivable does not distinguish between long- and short-term receivables. Notice 88-22 does not distinguish between long- and short-term receivables. The IRS in P.L.R. 9643011 ruled that interest-bearing obligations arising from sales to customers and outstanding for up to five years are non-passive assets because the terms of the obligations were dictated by market demands and were standard for the particular industry.²⁵ Consistent with P.L.R. 9643011, the treatment of trade and service receivables as nonpassive assets in final regulations should not depend on the length of the obligation.

III. WORKING CAPITAL

A. Background

The 2021 Proposed Regulations provide that functional currency held as working capital will not be considered a passive asset to the extent that: (1) it is held in a non-interest-bearing account that is held for the present needs of an active trade or business; and (2) it is no greater than the amount necessary to cover operating expenses incurred in the ordinary course of business and reasonably expected to be paid within 90 days.²⁶ Cash equivalents cannot be held as working capital.²⁷ Qualifying expenses do not include expenses incurred for the future diversification into a new trade or business, the expansion of a trade or business; future plant replacement; and future business contingencies.

The preamble to the 2021 Proposed Regulations acknowledges that the proposed definition is narrower than the ordinary business meaning of working capital and the definition used in other contexts. The preamble requests comments on the proposed exception for working capital, including “the ways in which the exception might be broadened while maintaining appropriate safeguards to avoid uncertainty as to how to determine the amounts and types of instruments property treated as held for the present needs of a business.”²⁸

B. Recommendation

We applaud the proposed treatment of working capital held in an active business as a nonpassive asset because it is consistent with the purposes of the PFIC regime and with sound tax policy. We recommend that the treatment of working capital in final regulations be extended to cash or cash equivalents as reported on applicable financial statements in an amount no greater than the amount reasonably expected to cover 90 days of operating expense and cost of sales incurred in the ordinary course of the trade or business of the tested foreign corporation. We believe that this test would allow taxpayers and the IRS to determine with some level of precision the amount treated as working capital for PFIC purposes. .

C. Discussion

1. Treatment of Cash and Cash Equivalents as Starting Point to Working Capital Definition

We recommend that Treasury and the IRS expand the definition of amounts that could be considered working capital to include all cash and cash equivalents, as reported on applicable financial statements (as defined more generally for PFIC purposes) of the tested foreign corporation. This standard is consistent with commercial realities, sound tax policy, and tax administration concerns.

Companies hold cash and cash equivalents to fund the current operating expenses and cost of sales that arise in their active businesses. These amounts are reflected as cash and cash equivalents on financial statements prepared in accordance with generally accepted financial accounting standards. U.S. generally accepted accounting principles (“U.S. GAAP”) and international financial reporting standards (“IFRS”) define cash equivalents generally as short-term, highly liquid investments that are readily convertible to known amounts of cash and that are subject to an insignificant risk of changes in value.²⁹ This amount should serve as the starting point for any amount treated as working capital.

A rule limiting “working capital” to functional currency held in non-interest bearing accounts, as proposed by the 2021 Proposed Regulations presents difficulties in administration and compliance and lacks a sound tax policy basis. Cash and cash equivalents are reported on a single line on applicable financial statements and are viewed as one item by investors and other stakeholders. As stated in the preamble to the 2021 Proposed Regulations in the context of the PFIC asset rule more generally, Treasury and the IRS “understand that . . . taxpayers often utilize financial statements in order to determine the value of a tested foreign corporation's assets” because financial accounting standards “generally provide rules that are intended to provide stakeholders with an economically realistic understanding of a company's financial position” and financial statement information “often is accessible by tested foreign corporations and their shareholders, and is prepared for non-tax purposes.”³⁰ The preamble also observes that Congress has indicated that financial statement information is appropriate in some circumstances as a basis for determining whether a tested foreign corporation is a PFIC, noting that the PFIC insurance rules use the term “applicable financial statement,” which is defined as a financial statement prepared in accordance with U.S. GAAP or IFRS.³¹ A working capital exception that starts with cash and cash equivalents as reported on an applicable financial statement, as opposed to functional currency held in non-interest bearing accounts, would be more administrable for the IRS and for taxpayers because it begins with an item reported on the face of financial statements prepared for non-tax purposes and accessible to taxpayers.

A working capital exception that starts with cash and cash equivalents also is consistent with sound tax policy. Working capital held by an active business to fund short-term business obligations should qualify as a nonpassive asset because it is held to facilitate the production of active income in that business, even if the working capital itself generates incidental amounts of passive income such as interest. In this regard, working capital is comparable to other assets, such as property, plant, and equipment, that are held to facilitate the production of active income in the taxpayer's business. As the preamble to the 2019 Proposed Regulations explained, “the PFIC provisions are generally not intended to apply to foreign corporations engaged in active businesses.”³² Cash and cash equivalents held to meet short-term business obligations should be treated as working capital regardless of whether they are held in a deposit account, or a money-market fund, or a 30-day time deposit, because there is no real commercial distinction between these items, each of which are readily converted to cash with insignificant risk of changes in value.³³ Including cash equivalents in working capital would acknowledge commercial realities consistent with sound tax policy, given that working capital would be an amount no greater than the amount reasonably expected to cover 90 days of current business expenses. Therefore, we recommend that Treasury and the IRS include in working capital cash equivalents included in applicable financial statements prepared in accordance with U.S. GAAP or IFRS.

2. Inclusion of Cost of Sales as Short-Term Operating Expenses

We recommend that the IRS and Treasury clarify that working capital includes amounts no greater than the amount reasonably expected to cover 90 days of operating expenses and cost of sales incurred in the ordinary course of the tested foreign corporation's trade or business. Like other operating expenses, cost of sales is a necessary and current period cost incurred in the ordinary course of many active manufacturing and distribution businesses. Cost of sales differs from other operating expenses only in the sense that it is taken into account when computing gross income, rather than as a deduction.³⁴ The 2021 Proposed Regulations provide that cash held to pay for future diversification into a new trade or business, the expansion of a trade or business, future plant replacement, and future business contingencies — all long-term capital expenditures — is not working capital. In contrast, amounts held to pay current expenses, including current cost of sales, should be treated as working capital.

As an example, the regulations under section 385 offer useful guideposts. The section 385 regulations provide that qualified short-term debt instruments will not be treated as stock to the extent they do not exceed the amount of “assets that are reasonably expected to be realized in cash or sold (including by being incorporated into inventory that is sold).”³⁵ Specified current assets under section 385 — the short-term assets that a company uses in its ordinary course of business — include items held as inventory. Likewise, the production or acquisition cost of items held in inventory is a short-term cost incurred in the ordinary course of business. We recommend that final regulations clarify that operating expenses incurred in the ordinary course of business include the production or acquisition cost of items, e.g. cost of sales, held as inventory.³⁶

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We appreciate your consideration of our request and look forward to answering any questions you may have. You can reach Layla Asali at (202) 626-5866, lasali@milchev.com and Rocco Femia at (202) 626-5823, rfemia@milchev.com.

Sincerely,

Layla J. Asali

Rocco V. Femia

Miller & Chevalier Chartered
Washington, DC