Could you be a PFIC?

Recently, the United States (US) Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations (REG-105474-18) under the passive foreign investment company (PFIC) rules (Proposed Regulations). Some of the changes will be beneficial; others not.

In either case, because the PFIC rules are highly complex and counter-intuitive, and because owning shares of an unexpected PFIC can have significant adverse tax consequences, being aware of their potential application is highly recommended. The IRS is increasingly focused on proper taxation treatment of offshore accounts/account holders and as such it is imperative that taxpayers fully understand the applicability of such rules to their business.

The Proposed Regulations offer welcome clarity on longstanding PFIC issues, including:

1. Clarifying which exclusions from passive income under the Subpart F rules apply for PFIC purposes. Non-bank financial institutions, and lenders located outside the US, should find this beneficial. Specific detail as to which exceptions apply for PFIC purposes can be found in EY’s Global Tax Alert here.
2. Specifying that various look-through rules under the Subpart F definition of passive income are irrelevant for PFIC testing purposes, and that the look-through rules under the PFIC provisions are the only ones to be used for PFIC testing purposes.
3. Reducing the likelihood that a non-US real estate corporation will be a PFIC by providing a more liberal rule for determining the active rents and royalties exception.
4. Discussing in more detail the operation of the PFIC look-through rules for 25% subsidiaries, including 25% US subsidiaries, and payments from related parties.
5. Providing that an interest of less than 25% in a partnership is a passive asset and produces passive income for PFIC testing purposes.
6. Clarifying application of attribution rules for purposes of determining whether a partner in a partnership is subject to the PFIC rules when the partnership owns PFIC stock through a non-PFIC foreign corporation.
7. Providing further guidance on the exception for insurance companies, which was substantially changed by the 2017 Tax Cuts and Jobs Act.

Even when the Proposed Regulations do not provide a welcome rule, the silver lining is the clear decrease of areas in which no one knew, but had to guess, how the IRS might apply the tax law’s vague, inconsistent, and often contrary provisions. For example, adopting the “top-down” approach for PFIC testing (consistent with current industry practice) is a welcome clarification, as is applying the Asset Test to short years. In contrast, the rule treating a potential PFIC’s distributive share of partnership income as passive income if it owns less than 25% of the partnership is unwelcome—but forewarned is forearmed.

Insurance companies that were previously always excepted from PFIC status before the 2017 Tax Cuts and Jobs Act will not find much in the Proposed Regulations to help soften the harshness of the Act’s changes and thus should be re-evaluating their potential PFIC status immediately.

A different proposed regulation [REG-101828-19] could result in minority partners of US partnerships not being ‘US shareholders’ of foreign corporations owned by their partnership. Whether this will be beneficial if the partnership owns PFIC shares is as yet unclear, because the regulation does not address the controlled foreign corporation/PFIC overlap rules. For more detailed information on this topic please see EY’s Global Tax Alert, which can be found here.

Our team would be happy to discuss with you any questions on the Proposed Regulations, how they might affect the determination of PFIC status, whether to make one of the elections available to shareholders of PFICs (or former PFICs), and the needlessly complex rules regarding whether (and how) to satisfy the PFIC reporting requirements.