Publish Date

Dec 15, 2020

The New PFIC Regulations: A Belated Manual for Investors

A&M Tax Advisor Weekly

On Friday, December 4th, the IRS and Treasury released a pre-Federal Register publication version of the final regulations (the “Final Regulations”) and new proposed regulations (the “2020 Proposed Regulations”) governing direct or indirect investments in a Passive Foreign Investment Company, or PFIC. For U.S. persons who invest in PFICs, the adverse tax consequences range from complex U.S. tax filing requirements to the recognition of annual phantom income amounts (i.e., current U.S. taxation of a pro-rata share of PFIC earnings without a distribution of cash) and, potentially, punitive taxes and interest charges on distributions from the PFIC or gains from the sale of PFIC stock. In this alert, we discuss selected key takeaways from both the Final Regulations and the 2020 Proposed Regulations.

Classification of a Corporation as a PFIC

Historically, the rules for determining whether a corporation is a PFIC have been very difficult to navigate. The general rule is that a foreign corporation is a PFIC if either 75% or more of its income is considered passive income (the “Income Test”) or the average percentage of its assets that produce passive income is at least 50% (the “Asset Test”). Passive income is generally defined, with some modifications, as income that would be foreign personal holding company income described in the subpart F provisions.  While the Income Test and the Asset Test seem relatively straightforward, there are several complex questions that have arisen for which there has not been adequate guidance.  Fortunately, the Final Regulations, which finalize regulations that were proposed in 2019 (the “2019 Proposed Regulations”) with certain modifications, provide some answers; however, they are not always the answers that taxpayers wanted.

Interest and Debt Obligations and Rental and Royalty Income

The Final Regulations retain the taxpayer-favorable rules in the 2019 Proposed Regulations that disregard all, or a portion, of the payments of interest and debt obligations between the foreign corporation being tested for PFIC status and certain related parties, depending on the level of overlapping ownership between the parties. However, the Final Regulations extend the rules to also cover rental and royalty income between related parties.

A&M Insight: The approach adopted in the Final Regulations is a welcome change for taxpayers, as the treatment of intercompany payables/receivables and the corresponding assets have historically been one of the most uncertain areas in the PFIC world, and it is resolved in a taxpayer favorable manner. In addition, the Final Regulations allow taxpayers to apply these regulations to an open taxable year so long as they are consistently applied to that year and all subsequent years.  Therefore, taxpayers should consider whether foreign corporations that they previously treated as PFICs, are not PFICs under the Final Regulations.

Interests in a Partnership

For purposes of the Asset Test and Income Test, another formerly uncertain area that is addressed in the Final Regulations is whether a foreign corporation can look through a partnership for purposes of the income and asset tests. Under the 2019 Proposed Regulations, a look-through partnership was one in which which the tested foreign corporation owned at least a 25% interest.  The Final Regulations expand this treatment to any partnership in which the foreign corporation owns an interest, so long as the foreign corporation satisfies an “active partner” test.

Controlled Foreign Corporations Due to Downward Attribution

As a result of TCJA’s repeal of section 958(b)(4), many more foreign corporations are controlled foreign corporations (CFCs), due to the application of the downward attribution rules. The Final Regulations retain the rule in the 2019 Proposed Regulations which provides that shareholders of a foreign corporation that became a CFC as a result of the repeal of section 958(b)(4) apply the Asset Test based on the adjusted basis of the foreign corporation’s assets under section 1297(e)…