PwC Suggests Changes to PFIC Regs, Removal of Antiabuse Rules

Sep 9, 2019

Internal Revenue Service
CC:PA:LPD:PR (REG-105474-18)
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: REG-105474-18 — Comments on the Proposed Regulations under Sections 1291, 1297, and 1298 of the Internal Revenue Code (“Code”) with respect to Passive Foreign Investment Companies (“PFIC”s).

Dear Sir or Madam:

We respectfully submit this comment letter on behalf of a client in response to the request for comments in REG-105474-18, issued by the Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) on July 11, 2019 (the “Proposed Regulations”), which relate to proposed regulations under Sections 1291, 1297, and 1298 of the Internal Revenue Code (“Code”).¹

I. Summary of Recommendations

II. Detailed Discussion

A. Treatment of Partnerships for PFIC Testing Purposes

1. The Proposed Regulations

The preamble to the Proposed Regulations provides that the Treasury and IRS have determined it is appropriate to treat a partnership in a manner similar to a corporate subsidiary for PFIC testing purposes.

Consistent with that approach, the Proposed Regulations provide that a TFC's interest in a partnership is treated as a passive asset and the TFC's distributive share of the partnership income is treated as passive income where the TFC owns less than 25 percent of the value of the partnership.² Thus, each is characterized for PFIC testing purposes in a manner consistent with how it would be treated were the TFC to own less than 25 percent of a corporation. The Proposed Regulations also provide that, with respect to a partnership in which a TFC owns at least 25 percent of its value (a “Look-Through Partnership”), the TFC is treated as (i) receiving its share of the Look-Through Partnership's income and (ii) holding its proportionate share of the Look-Though Partnership's assets.³ Moreover, when characterizing income of the Look-Through Partnership that a TFC is considered to receive, the exceptions to passive income in Section 1297(b)(2) and the relevant exceptions to foreign personal holding company income (“FPHCI”) in Sections 954(c) and (h) are applied by reference to the activities of the partnership.⁴

Before the issuance of the Proposed Regulations, no authoritative guidance had been provided to taxpayers concerning a TFC's treatment of its distributive share of partnership income and its ownership of partnership interests for PFIC testing purposes and many taxpayers had historically applied an aggregate approach to characterize such amounts consistent with the approach taken in the regulations under subpart F, relying on the cross-reference in the PFIC rules to determine passive income under the FPHCI rules. In the preamble to the Proposed Regulations, Treasury and IRS acknowledge their belief that, absent the Proposed Regulations, the rules concerning the classification of a CFC's distributive share of partnership income under subpart F (which generally acts to determine whether such income is FPHCI by treating the partner as if it had earned the amount, taking into account only the activities conducted, and property owned, by the partnership) would generally be applicable by virtue of Section 1297's adoption of FPHCI as the basis of passive income. Notwithstanding, that investors have relied on this treatment since 1986, this approach was rejected in the Proposed Regulations because of asserted differing policies between the subpart F and PFIC regimes.

Specifically, the preamble to the Proposed Regulations provides that a rule similar to that of the subpart F regime (i.e., treating a partnership as a Look-Through Partnership without regard to ownership threshold) was rejected under the Proposed Regulations because the Treasury and IRS believe (i) certain lower thresholds of ownership are unlikely to give a TFC significant control over partnership activities such that a partnership interest could represent an active business interest; (ii) it would create incentives for foreign corporations to hold minority interests in partnerships rather than corporations given the flexibility of entity classification under Treas. Reg. §301.7701-3 and because treating a subsidiary as a partnership may not result in meaningful U.S. income tax consequences to a TFC in the same manner as it would a CFC; and (iii) a minority investment interest would be treated differently depending on tax classification of the investment, notwithstanding the nature of the investment is not substantially different.

Comments were requested on whether a 25 percent threshold for the TFC's percentage ownership in the partnership is the appropriate threshold for distinguishing between a distributive share of partnership income that is automatically treated as passive and a distributive share that is characterized in accordance with the activities undertaken by the partnership, or whether an alternative threshold should be considered.

2. Comment

Given the previous lack of specific guidance over the characterization of partnerships for the purposes of PFIC testing (even if the implicit guidance as an aggregate was widely adopted), the treatment of a Look-Through Partnership as an aggregate where the TFC owns at least 25% by value of the partnership is welcome guidance. However, we believe that an aggregate approach should apply to any partnership interest held by a TFC regardless of the TFC's level of ownership in the partnership for the purposes of PFIC testing.

Generally speaking, tax classification of a business entity is a fundamental driver of the taxation of such entity for U.S. federal income tax purposes. For instance, a shareholder of a corporation does not typically include in its income, for U.S. federal income tax purposes, the taxable income of the corporation unless such earnings are distributed to the shareholder or a specific regime applies (such as, for example, anti-deferral regimes or the joining with the subsidiary in the filing of a consolidated U.S. federal income tax return). Notwithstanding, if provided under a certain provision of the Code, a corporation's income may be taken into account by its shareholder for certain purposes, such as, for example, when a TFC is treated as receiving its proportionate share of the income earned by a subsidiary under the Subsidiary Look-Through Rule of Section 1297(c). Given this statutory modification, it seems evident that Congress intended to respect the tax classification of a corporation as a general matter, but provided taxpayers an ability to look-through the corporation where warranted.

In contrast, a partnership is generally treated as a flow-through entity for U.S. federal income tax purposes and an aggregate of its partners for many provisions of the Code.⁵ In providing a special rule (Section 1297(c)) that would look-through to the assets of a corporate subsidiary while neglecting to provide any statutory rule modifying the flow-through treatment of a partnership for PFIC testing purposes, Congress implied that no such modification was necessary. Rather, it seems reasonable that Congress intended that, for PFIC testing purposes, the general flow-through nature of partnerships would apply in all cases, without regard to specific ownership thresholds.

As Treasury and IRS acknowledge in the preamble to the Proposed Regulations, the subpart F regulations concerning the classification of a CFC's distributive share of partnership income would generally be applicable by virtue of Section 1297's adoption of FPHCI as the basis for passive income (but for the Proposed Regulations). Under these rules, for the purposes of determining whether a CFC's distributive share of an item of income of a partnership is FPHCI, the active trade or business exceptions generally apply only where the exceptions would have applied to exclude the income from FPHCI if the CFC had earned the income directly, taking into account only the activities of, and property owned by, the partnership.⁶ Because this rule is applied without regard to the CFC's ownership percentage in the partnership, the application of an aggregate approach to partnerships for PFIC testing purposes, regardless of ownership percentage, would arguably be consistent with the principles for PFIC testing Congress intended to apply via the linkage with the definition of FPHCI in the subpart F rules.

Notwithstanding the position in the preamble that the subpart F and PFIC regimes have differing policies, Congress chose to incorporate the concepts and rules of the subpart F regime into the PFIC regime, including, importantly, whether income is considered passive for PFIC testing purposes.⁷ Thus, it is important to consider whether the purported concerns over such differences suffice to warrant a material departure from the rules otherwise applicable to partnerships (having been applied by taxpayers for the preceding 33 years) to achieve parity between corporate and partnership vehicles.⁸

As discussed previously, the Treasury and IRS contend that certain lower thresholds of ownership are unlikely to give a TFC significant control over partnership activities such that a partnership interest might not represent an active business interest from the TFC's perspective. That a partner would need significant control over partnership activities in order for such interest to be considered an active business interest for the purposes of the PFIC test appears unfounded based on the treatment of partnerships in other relevant provisions. For instance, consider Section 875, which generally acts to treat a partner that is a non-U.S. individual or corporation as engaged in the U.S. trade or business in which the partner's partnership is engaged, regardless of the level of the partner's ownership. Because the rule applies without regard to a measure of significant control, and partners subject to the rule are treated as in engaged in trade or business the partnership (including those that would be considered non-passive under subpart F and PFIC standards), it stands to reason that a partnership interest can be treated as an active business interest regardless of whether the partner has significant control over the partnership.⁹

Also discussed above, the preamble cites concerns that adopting a pure aggregate approach would create incentives for foreign corporations to hold minority interests in partnerships rather than corporations given the flexibility of entity classification under Treas. Reg. §301.7701-3 and because treating a subsidiary as a partnership may not result in U.S. income tax consequences to a TFC in the same manner as it would a CFC. We believe this concern is unfounded for a couple of reasons. First, although there is generally some flexibility in entity classification under Treas. Reg. §301.7701-3, minority shareholders are rarely able to compel a corporation to be treated as a partnership for U.S. federal income tax purposes.¹⁰ Even if a minority shareholder could compel a corporation to elect to be treated as a partnership for U.S. federal income purposes, doing so in the case of an existing corporation could give rise to a taxable liquidation under Section 331. In addition, though treating a business entity as a partnership would not necessarily result in U.S. income tax consequences to a TFC in the same manner as it would a CFC, there are significant other U.S. and non-U.S. tax consequences that are potentially impacted by such classification.¹¹ Thus, it seems unlikely that the use of a pure aggregate approach to partnerships for PFIC testing purposes would lead to an inappropriate incentive to hold minority interests in partnerships rather than corporate form, in addition to the creation of a new paradigm for taxpayers that cuts against the generally accepted use of the check-the-box regulations and the treatment of partnerships throughout the Code.

For these reasons, we recommend that Prop. Regs. §§1.1297-1(c)(2) and 1.1297-1(d)(3) be modified to provide that a TFC should, with respect to an interest held in any partnership (and without regard to its ownership percentage), be treated (i) as receiving its distributive share of any item of income of the partnership and (ii) as though it held its proportionate share of the assets of the partnership.

B. Elimination of limitations on the application of the Domestic Subsidiary Look-Through Rule Under Section 1298(b)(7)

1. The Proposed Regulations

Section 1298(b)(7) provides that if a TFC owns at least 25 percent (by value) of the stock of a domestic corporation and if the TFC is subject to the accumulated earnings tax (“AET”) (or waives any benefit under any treaty which would otherwise prevent the imposition of AET), then any qualified stock held by such domestic corporation — i.e., stock issued by a domestic C corporation (the lower-tier domestic corporation) that is neither a RIC nor a REIT (“Qualified Stock”) — is deemed to be an asset that does not produce passive income and is not held for the production of passive income, for purposes of determining whether the TFC is a PFIC (the “Domestic Subsidiary Look-Through Rule”).

However, the Proposed Regulations introduce two broadly worded anti-abuse rules that effectively render meaningless (or at least significantly limit the applicability of) the Domestic Subsidiary Look-Through Rule for PFIC testing purposes. The first anti-abuse rule (the “Qualified Stock Anti-Abuse Rule”) “turns off” or makes inapplicable the Domestic Subsidiary Look-Through Rule if the TFC would qualify as a PFIC if the Qualified Stock or any income received or accrued with respect to the Qualified Stock were disregarded.¹² Essentially, this anti-abuse rule only allows for application of the Domestic Subsidiary Look-Through Rule by testing the TFC without taking into account the Qualified Stock and then applying the Domestic Subsidiary Look-Through Rule if the TFC is not otherwise determined to be a PFIC. Under the second anti-abuse rule (the “Principal Purpose Anti-Abuse Rule”), the Domestic Subsidiary Look-Through Rule does not apply if a principal purpose for the TFC's formation or acquisition of the 25-percent owned domestic corporation is to avoid classification of the TFC as a PFIC.¹³ For purposes of this anti-abuse rule, a principal purpose to avoid classification of the TFC as a PFIC is deemed to exist if the 25-percent owned domestic corporation is not engaged in an active trade or business in the United States (the “Active Trade or Business Requirement”).¹⁴

The current drafting of the Proposed Regulations imposes significant restrictions on the applicability of the Domestic Subsidiary Look-Through Rule. This approach strays from historical positions taken by taxpayers, practitioners, and the government. In this regard, the IRS has not historically issued any administrative guidance or restrictions with respect to the application of the Domestic Subsidiary Look-Through Rule except for PLRs which appear to confirm the IRS' view that the Domestic Subsidiary Look-Through Rule can be applied to affect PFIC status.¹⁵ The Treasury and the IRS request comments on the application of the Domestic Subsidiary Look-Through Rule as limited by the Proposed Regulations under the Qualified Stock Anti-Abuse Rule and Principal Purpose Anti-Abuse Rule.

2. Comment

a) The Qualified Stock Anti-Abuse Rule of Prop. Reg. §1.1298-4(f) is inconsistent with Congressional intent and the plain reading of the statute under Section 1298(b)(7)

The legislative history under Section 1298(b)(7) makes clear that the Domestic Subsidiary Look-Through Rule is designed “to mitigate the potential disparate tax treatment resulting from PFIC status if U.S. shareholders hold domestic investments through a foreign holding company over U.S. shareholders that hold domestic investments through a U.S. holding company.”¹⁶ Accordingly, Congress' clear intentions for this rule is to prevent indirect U.S. shareholders of U.S. stock investments from being inappropriately impacted by the PFIC regime when such investments are held through a foreign entity.

Furthermore, the Senate report provides that “[i]f a foreign investment company attempts to use [the Domestic Subsidiary Look-Through Rule] to avoid the PFIC provisions, it will be subject to the accumulated earnings tax [the AET] and, thus, the shareholders of that company will be subject to tax treatment essentially equivalent to that of the shareholders of PFICs.”¹⁷ This clearly signals Congressional intent that taxpayers may take advantage of Section 1298(b)(7) and that the AET would serve as a backstop to mitigate PFIC status abuse or avoidance as the income of a domestic subsidiary and domestic holding company (already subject to U.S. corporate income tax) would again be subject to U.S. corporate tax under the AET regime imposed at the level of the TFC if not distributed to the U.S shareholders.

The Proposed Regulations' preamble states that the Treasury and the IRS intend that the Qualified Stock Anti-Abuse Rule prevent a TFC from using the Domestic Subsidiary Look-Through Rule to avoid the PFIC rules by indirectly holding predominantly passive assets through a two-tiered U.S. structure.

As discussed earlier, the Qualified Stock Anti-Abuse Rule would turn off the Domestic Subsidiary Look-Through Rule to the extent the TFC would be a PFIC when excluding Qualified Stock. Generally, this would address Treasury's concerns by preventing the conversion of passive assets into active qualified stock by reason of Section 1298(b)(7), while taking into account any passive or non-passive assets and income of a second-tier domestic subsidiary under Section 1297(c) (so long as the TFC owns at least 25 percent of the second-tier domestic subsidiary by value). As a consequence, to the extent the domestic subsidiary primarily held passive assets, the TFC's PFIC status would not be altered by the fact that those assets were held by a domestic subsidiary of the TFC. This result does not align with the result intended by Congress with respect to Section 1298(b)(7) which was to prevent disparate treatment between investing in a U.S. corporation directly and investing in a U.S. corporation indirectly through a foreign corporation.

Additionally, the legislative history of Section 1298(b)(7) confirms that Congress understood that a TFC could affirmatively use the Domestic Subsidiary Look-Through Rule to manage PFIC status. Congress permitted this affirmative use because it believed the AET requirement for the TFC sufficiently curtailed any abuse concerns. Also, irrespective of Section 1298(b)(7), the profits and activities of the U.S. corporate entity, in such an example, will be subject to standalone U.S. corporate income tax (and withholding tax when profits are distributed to the TFC). In other words, the cost of avoiding PFIC status is onerous enough to discourage manipulation.

Overall, we view the Treasury's proposed narrowing of the Domestic Subsidiary Look-Through Rule as unsupported by a plain reading of the statutory language and fundamentally inconsistent with the legislative history of Section 1298(b)(7). Furthermore, we would expect the application of the Qualified Stock Anti-Abuse Rule to create a disparity with respect to tax treatment when passive U.S. assets are held through a foreign entity as opposed to a U.S. corporation. In particular, the PFIC status could cause any income indirectly generated by the assets held in the second-tier domestic subsidiary to be subject to character conversion and the acceleration rules under the PFIC regime at the U.S. shareholder level. As noted above, these negative consequences would be in addition to the imposition of two layers of U.S. corporate taxation under the normal rules (once at the level of the second-tier domestic subsidiary and again as a withholding tax when the money is distributed to the foreign entity).

Therefore, given that the PFIC rules provide no relief for income of the PFIC that is already subject to U.S. tax, we recommend that the Treasury and the IRS consider eliminating the Qualified Stock Anti-Abuse Rule of Prop. Reg. §1.1298-4(f)(1) so as to not prevent the application of the Domestic Subsidiary Look-Through Rule.

b) The Principal Purpose Anti-Abuse Rule of Prop. Reg. §1.1298-4(f) is also inconsistent with Congressional intent and long-standing practice during transitional business phases

The second anti-abuse rule under the Proposed Regulations provides that Section 1298(b)(7) will not apply if a principal purpose for the TFC's formation or acquisition of the 25-percent-owned domestic corporation is to avoid classification of the TFC as a PFIC. A principal purpose will be deemed to exist if the 25-percent owned domestic corporation is not engaged in an active trade or business in the United States. Due to the Qualified Stock Anti-Abuse Rule discussed above, we would only expect the Principal Purpose Anti-Abuse Rule to be relevant when the Qualified Stock Anti-Abuse rule is inapplicable, i.e., when a TFC's assets and income do not result in PFIC status determined without regard to the Qualified Stock. This could happen, for example, where a foreign corporation holds predominantly active assets directly and a greater amount of passive assets through a two-tier domestic structure. As discussed above, the legislative history suggests that Congress was fully aware of how the Domestic Subsidiary Look-Through Rule may be used to a taxpayer's advantage but decided that the requirements provided in the statute were sufficient to limit its application. Implementing a rule which disregards the use of the Domestic Subsidiary Look-Through Rule when employed to avoid PFIC status would be contradictory to the statute's intention.

The Principal Purpose Anti-Abuse Rule challenges how taxpayers, practitioners, and the U.S. government have historically relied upon the affirmative application of the Domestic Subsidiary Look-Through rule to reduce the risk of the otherwise inadvertent characterization of an active business as a PFIC, such as managing the PFIC status of active companies during the transition phases of their business (e.g., startup and active business exceptions). Furthermore, the use of domestic subsidiaries to manage PFIC status appears to have been endorsed by the IRS in PLRs.¹⁸ As such, it does not seem fair to restrict reliance on the affirmative use of the Domestic Subsidiary Look-Through Rule when it is used to mitigate negative, unintended results under the PFIC regime.

Therefore, based on the discussion above, we recommend that the Principal Purpose Anti-Abuse Rule under Prop. Reg. §1.1298-4(f)(2) be eliminated as part of the final regulations.

C. Treatment of activities of certain look-through subsidiaries and look-through partnerships for purposes of Section 954(c)(2)(A) active rents and royalties exception

1. The Proposed Regulations

Under Section 1297(b)(1), “passive income” is defined as any income that would be FPHCI, as defined in Section 954(c)(1), which is a type of subpart F income and includes dividends, interest, royalties, rents, income from annuities, and certain gains, except as otherwise provided in Section 1297(b)(2) and Prop. Reg. §1.1297-1(c). In particular, Section 1297(b)(2)(c) and Prop. Reg. §1.1297-1(c)(1)(i)(A) state that passive income does not include any income which is rent or royalty received or accrued from a related person within the meaning of Section 954(c)(2)(A) (relating to active rents and royalties).

Under Section 954(c)(2)(A) and Prop. Reg. §1.954-2(c)(1)(ii), rents derived in the conduct of an active trade or business are excluded from the definition of FPHCI if certain activities are performed with respect to real property by the lessor's own employees. For purposes of applying the exception under Section 954(c)(2)(A), the Proposed Regulations provide that the active rents and royalty exception is “determined by taking into account the activities performed by the officers and staff of employees of the tested foreign corporation as well as the activities performed by the officers and staff of employees of any look-through subsidiary in which the tested foreign corporation owns more than 50 percent by value (as determined under paragraph (b)(1) of this Section)¹⁹ and any look through partnership in which the tested foreign corporation owns, directly or indirectly, more than 50 percent.”²⁰

The preamble to the Proposed Regulations acknowledge that for legal and commercial reasons, businesses commonly structure their organizations in a way where employees are housed in separate legal entities from those receiving rental income. Without a mechanism for the attribution of activities in a similar foreign business structure, a foreign corporation may be treated as a PFIC even though, overall, its income and economic activities relate to active business operations and are not comparable to passive undertakings meant to be addressed by the PFIC regime. The Preamble further explains that the Treasury and IRS considered three alternatives to address the attribution of activities: (1) do not allow any attribution of activities; (2) allow attribution of activities to multiple U.S. owners; or (3) allow attribution only if the TFC owns more than 50 percent of the other foreign corporation or partnership.

The first alternative of no attribution was rejected in the Proposed Regulations based on the argument that a foreign corporation that separated activities and income would be required to undergo corporate and operational reorganization (i.e., such that the TFC received both the active rents and royalties as well as had the employees that performed the related activities) to satisfy the passive income exception. This alternative was determined to create economically undesirable outcomes while also potentially inhibiting U.S. investment in a foreign corporation. The second alternative provided that activities could potentially be attributed based on the principles of the Look-Through Rule (under Section 1297(c)), i.e., with a 25% threshold. However, the Treasury and IRS indicated that in their view while percentage ownership is a good measure in the case of assets and income, percentage ownership is not a useful tool to measure an entity owner's share of underlying activities. Additionally, allowing multiple shareholders to use the activities of a single corporation to treat income as non-passive could result in double counting of activities (i.e., attributing the same activity to multiple parent companies). Therefore, this alternative was deemed to generate significant difficulties in the context of attribution of activities and the Treasury and IRS determined that potential double counting of activities could result in an inappropriate loss of tax revenue. Therefore, the third approach was adopted by the Proposed Regulations to ensure that the activities of a foreign corporation or partnership could only be attributed to a single shareholder and “allow entities to satisfy the passive income exception under conditions consistent with the intents and purposes of the statute without requiring potentially substantial reorganization costs.”

The Treasury and IRS request comments on the application of the activity attribution rules to Look-Through Subsidiaries that are not wholly owned by a TFC, including whether it is appropriate for a TFC to take into account all activities of a Look-Through Subsidiary in which the TFC owns more than 50 percent of the value of the stock, and whether a different ownership threshold for attribution of activities under Prop. Reg. §1.1297-2(e)(1) would be appropriate.

2. Comment

The Proposed Regulations create an attribution rule that achieves the stated objective of not requiring non-commercial restructurings to avoid inadvertent PFIC status in a relatively narrow circumstance, i.e., where an owner has a greater than 50% interest in the entity that conducts the activity. As noted above, the preamble to the Proposed Regulations has requested comments as to whether this is the correct threshold.

A common structure implemented under real estate joint ventures would not benefit from the proposed attribution rule as asset managers may have multiple TFCs that invest alongside each other in the same business venture. For example, TFC 1, TFC 2, and TFC 3 own an equal 33.33% interest by value in a pooling partnership treated as a partnership for U.S. tax purposes (“Pooling Partnership”). The Pooling Partnership in turn owns a greater than 50% interest by value in (i) an asset holding legal entity receiving rental income (“PropCo”) and (ii) an employee holding legal entity, which provides active and substantial management and operational functions with respect to the PropCo assets generating rental income (“OpCo”). Under Prop. Reg. §1.1297-2(e)(1), neither TFC 1, TFC 2, nor TFC 3 can be attributed the activities of OpCo as neither TFC 1, TFC 2, nor TFC 3 hold a greater than 50% indirect interest by value in OpCo. Furthermore, any legal entity restructuring initiatives to address the concerns with the application of Prop. Reg. §1.1297-2(e)(1) would be limited by historical investment decisions, legal entity structuring and substantial financial costs. This example is representative of a situation where inadvertent PFIC status may apply to foreign corporations that own the stock of subsidiaries collectively engaged in an active business. This result does not align with the legislative history of Section 1297(c).²¹

While the preamble suggests that a 50% threshold is needed to address situations where there would be potential for inappropriate double counting of activities in the context of unrelated parties, we recommend that the final regulations are adjusted so as to retain the proposed 50% ownership threshold but modified to be applied as a standard of common control among the activity owner and the income owner in place of direct/indirect control by the TFC requirement. In the absence of a modified affiliation rule, activities performed by a Look-through Subsidiary that is not owned more than 50% (by value) by a TFC, would be entirely disregarded for PFIC testing purposes, i.e., no-one would be able to take credit for such activities. While avoidance of double-counting is a worthwhile objective, failure to give any weight to activities associated with the derivation of rents and royalties conducted by entities under common control would be equally undesirable from a policy perspective. In this type of fact pattern, a greater than 50% threshold is the equivalent of the result rejected by the Treasury and IRS with respect to the first alternative of no attribution. As discussed in the Preamble, an alternative providing for no attribution was determined to create economically undesirable outcomes while inhibiting U.S. investment in a foreign corporation.

Furthermore, the Related Person Look-Through Rule of Section 1297(b)(2)(C), as interpreted by the Proposed Regulations, provides a similar approach to that proposed above. Section 1297(b)(2)(C) generally characterizes dividends, interest, rents, or royalties received or accrued from a related person as non-passive income to the extent such amount is properly allocable to non-passive income of such related person. The Proposed Regulations provide that, in the case of a TFC that owns a look-through subsidiary (or look-through partnership) that receives a payment from a related person, Section 1297(b)(2)(C) applies if the payor is a related person with respect to the look-through subsidiary or partnership, regardless of the level of ownership or control that the TFC has in the payor, and the payment then is taken into account by the TFC under Section 1297(c).²² Similar to the Related Party Look-Through Rule, we would expect that the attribution of activities concept under Prop. Reg. §1.1297-2(e)(1) should be determined at the level of the entity earning the income (i.e., look-through subsidiary or look-through partnership) and not based upon a level of control imposed by the TFC.

While we appreciate the intentions of the Treasury and IRS are to prevent attributions of activities to multiple unrelated entities, we recommend that the final regulations modify Prop. Reg. §1.1297-2(e)(1) to provide for attribution of activities among members of an affiliated group in which the rent or royalty earning entity (corporation or partnership) is a part of, under principles provided by Treas. Reg. §1.904-4(b)(2)(iii). Under such principles, an affiliated group includes all members of a Section 1504(a) affiliated group. However, an “Includible Corporation” should be modified to include foreign corporations and partnerships (i.e., for purposes of attributing activities, a partnership is to be treated akin to a corporation); and the ownership requirement for affiliation should be modified to be more than 50% of the vote or value of any corporation and more than 50% of the value of any partnership. Having the affiliation test at the level of the income earning entity (while maintaining the more than 50% ownership threshold that Treasury and the IRS have settled on in the Proposed Regulations) seems appropriate for determining what income should not be considered passive and reflects how businesses often structure their operations. For example, often real estate businesses divide their property and employees into separate entities even though the results of both the property holding entity and the employee holding entity are tied to the active endeavours of the employees.

D. Character of Dividends and Stock Subject to the Related Person Look-Through Rule

1. The Proposed Regulations

Section 1297(b)(2)(C) (the Related Person Look-Through Rule) provides that, for the purposes of PFIC testing, the term “passive income” 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 such amount is properly allocable to income of such related person which is not passive income. The Proposed Regulations provide that dividends are treated as properly allocable to income of a related payor that is not passive income based on the relative portion of its current-year E&P for the related person's taxable year that ends with or within the taxable year of the recipient that is attributable to non-passive income.²³

The Proposed Regulations also provide that the term “passive asset” means an asset that produces passive income or which is held for the production of passive income, taking into account the rules in paragraphs (c) and (d) of Prop. Reg. §1.1297-1 (which includes, among other rules, the Related Person Look-Through Rule).²⁴ Beyond this generic definition, no general rule is provided to specifically characterize assets that give rise to income subject to the Related Person Look-Through Rule.

The Proposed Regulations do, however, provide a special rule to characterize stock of a related person with respect to which the TFC had received or accrued a dividend in a prior taxable year that was characterized, at least in part, as non-passive income under the Related Person Look-Through Rule, but with respect to which no dividends are accrued or received in the current taxable year. This special rule adopts a dual-character asset approach in that such stock is treated as two assets, one of which is a passive asset and one of which is a non-passive asset.²⁵ The value (or adjusted basis) of the asset is allocated between the two assets in proportion to the average percentage of dividends that were characterized as passive income, and the average percentage of dividends characterized as non-passive income, for the previous two taxable years under the Related Person Look-Through Rule (such rule, hereafter, the “Special Related Person Stock Rule”).²⁶

Comments were requested concerning alternative methods of determining the portion of dividends treated as properly allocable to income of a related person (including if the payor has no current earnings and profits), including by reference to accumulated earnings and profits, and if so, how to address concerns about the availability of information.

2. Comment

The allocation of dividends between passive and non-passive income based upon the related payor's E&P is welcome instruction on the application of the Related Person Look-Through Rule, inasmuch as the allocation works toward providing a look-through exception for dividends received from related persons that are not allocable to passive income of the payor. Notwithstanding, we request clarification concerning the application of this allocation, as well as the characterization of stock of a related person, where it is unclear how the rules should be applied.

With respect to the allocation of dividend income to the income of a related payor based upon current-year E&P under the Related Person Look-Through Rule, we believe the character of accumulated E&P is also relevant in determining whether a dividend is non-passive where the dividend is sourced out of accumulated E&P. Thus, we recommend that the Related Person Look-Through Rule be modified to provide that a TFC should allocate dividend income to both current and accumulated E&P under the principles of Section 316. To address concerns over the availability of information with respect to accumulated E&P, we recommend taxpayers be permitted to apply reasonable methods in determining the character of accumulated E&P. We also recommend that characterizing such accumulated E&P based on the relative portion of the related person's current-year E&P for its taxable year that ends with or within the taxable year of the recipient that is attributable to non-passive income will be considered a reasonable method (i.e., following the method in the Proposed Regulations).

With respect to the characterization of the stock of a related person, it would be helpful to clarify, under the general definition of a passive asset, what it means to take into account the rules in paragraphs (c) and (d) of Prop. Reg. §1.1297-1 for the purposes of determining whether the stock produces, or is held for the production of, passive income. For instance, it would be helpful to clarify that stock of a related person with respect to which a TFC receives a dividend in the current taxable year should be characterized as passive and non-passive in the same proportion as the dividend income received by the TFC is characterized under the Related Person Look-Through Rule.

In addition, it seems the Special Related Person Stock Rule, as currently drafted, would apply to related party stock if a TFC had previously received a dividend from the related person as long as the TFC does not receive a dividend in the current taxable year, regardless of whether dividends were received by the TFC in the two immediately preceding taxable years. It is unclear how the rule should be applied where a dividend was received by the TFC in the third year preceding the year of application or earlier. Moreover, we believe the utility of the character of a prior year dividend as a metric to characterize the stock that gave rise to it generally becomes less meaningful with the increasing passage of time (for instance, an evolving business profile could result in meaningfully different expectations concerning the nature of income to be generated under the Related Person Look-Through Rule, even within a two-year period of time). For these reasons, we recommend Treasury replace the Special Related Person Stock Rule with a general rule on the characterization of related party stock (described below), and instead provide that the Special Related Person Stock Rule is one reasonable method in the application of such general rule.

Because stock of a related person that does not give rise to dividends in the current taxable year can also be a passive asset if it is held for the production of passive income (taking into account the application of the Related Person Look-Through Rule) under the general rule provided under Prop. Treas. Reg. §1.1297-1, we recommend Treasury provide that taxpayers must look to whether such stock is expected to give rise to passive income for the purposes of characterizing the stock. Moreover, we believe Treasury should provide that taxpayers should adopt reasonable methods in determining whether stock is expected to give rise to passive income under the Related Person Look-Through Rule. For instance, as discussed above, where stock of a related person does not give rise to dividends in the current taxable year, but has so done within the two taxable years preceding the current taxable year, the approach provided in the Special Related Person Stock Rule could be one reasonable method in determining whether related party stock is expected to generate passive income. In addition, we also recommend Treasury provide that the proportion of the related person's undistributed E&P that is passive and non-passive shall be considered an appropriate reflection of the character of income the related person stock is expected to give rise to for the purposes of characterizing such stock.

Finally, there may be instances in which related persons are operating active businesses, but which do not generate positive E&P.²⁷ In these cases, we believe Treasury should provide that a reasonable method is adopted. One reasonable method should be to use the proportion of related person's gross income that is passive and non-passive as an appropriate reflection of the character of income the related person stock is expected to generate for the purposes of characterizing such stock.

* * *

If you have questions regarding this comment, please contact Timothy Fox, Philip Fried, or Patrick Courtney.

Yours sincerely,

PricewaterhouseCoopers LLP
New York, NY