If you have invested in any foreign corporations, you may be aware that you want to avoid having the investment considered to be in a passive foreign investment company (PFIC). The problem can be it is often difficult to tell (until it is too late) that you have either the COVID-19 or a PFIC. The Internal Revenue Service (IRS) recently released final regulations to provide guidance in making the determination of PFIC status, although it is still difficult to obtain information to make an informed determination.

Purpose of The PFIC Rules

PFICs have been around since 1986, but because of a lack of IRS guidance and understanding of the rules, many US taxpayers have been tripped up and found out the problem only later on upon an audit or when reviewed by an international tax advisor. Moore Doeren Mayhew has had to inform a number of our new clients this was an issue and help them navigate the rules. The rules were enacted to discourage avoidance of current taxation by investing in a foreign corporation with primarily passive income and assets. But the rules often catch start-up foreign companies that have individual investors or private equity firms that have poured money into it in the hopes of funding the next Facebook or Google.

What Is a PFIC?

A PFIC is a foreign corporation if:

• 75% or more of its gross income is passive income (income test); or
• 50% or more of the average value of its gross assets consists of assets producing passive income (asset test).

This is a test each year and can result in a PFIC even if you own a minor percent of the corporation. Also, once you have failed the test, the corporation will always be a PFIC in your hands (“once a PFIC, always a PFIC”).

IRS Issues Final PFIC Ownership Regulations

The final PFIC regulations were published in the Federal Register on January 15, 2021, so right before President Biden put a freeze on all regulations that had not been published by the date he took office. Therefore, they are now officially finalized.

The final regulations address how to determine whether a foreign corporation is a PFIC for federal tax purposes. They also specify the application and scope of certain rules that determine whether a US person that indirectly holds stock in a PFIC is treated as a shareholder of the PFIC. The final regulations retain the basic approach and structure of the proposed regulations, with certain revisions. Here are a few highlights of those changes.

Pass-Through Entities

Proposed regulations on ownership of pass-through entities provided an owner of an interest in a partnership, S corporation, estate or trust would be treated as owning stock owned by the pass-through entity only if the pass-through owner owned 50% or more of the entity. This proposed rule was intended to ensure the attribution rules applied consistently whether a US person owned stock of a non-PFIC foreign corporation indirectly through a partnership or directly.

A commenter noted this rule could prevent a US person from being treated as owning stock of a PFIC owned by a non-PFIC corporation, even though the US person directly and indirectly owned more than 50% of the stock of the non-PFIC corporation in the aggregate. The commenter argued this result was inappropriate, and the IRS agreed. Therefore, the proposed regulation was not adopted.

Application of Top-Down Approach

The final regulations apply a top-down approach to the attribution of ownership through all tiered ownership structures. It uses the top-down approach, starting with a US person and determining what stock is considered owned at each successive lower tier on a proportionate basis.

For example, US person A owns 49% of the partnership interests in a partnership that owns 95% of the stock of a tested foreign corporation (TFC). The TFC isn’t a PFIC, but owns 100 shares of the single class of stock of a PFIC, which is not a CFC. US Person A also owns the remaining 5% of the TFC stock directly. Under a top-down approach, US Person A is deemed to hold 46.55% of the TFC’s stock through the partnership and owns 5% of the TFC’s stock directly. Therefore, it owns over 50% of the TFC and must test for the stock of the PFIC owned by the TFC.

Click here to see an example.

One commenter suggested using a bottom-up approach instead, but the IRS rejected this approach in the final regulations because the bottom-up approach may not take into account the PFIC stock that is owned through the 5% of the TFC’s stock that US Person A owns directly.

The final regulations also include a new rule addressing the application of the successive application rule to tiered ownership structures. The new rule specifically provides for a top-down approach to attribution of ownership.

In addition, the examples in the existing and proposed regulations have been revised to clarify how the top-down approach applies to those examples. And the IRS added a new example in the regulations to illustrate the operation of the successive application rule in a fact pattern in which a US person owns stock of a foreign corporation, both directly and indirectly, through a partnership.

Related Person Look-Through Rule

A proposed regulation provided additional guidance on the application of the tax code’s related person exception for dividends, interest, rents and royalties. Under the final regulations, for purposes of the asset test and income test, corporations and partnerships owned in whole or part by a TFC are generally classified into one or more of three categories. Lower-tier entities generally are treated as one or more of:

1. A look-through subsidiary or look-through partnership (a “look-through entity”),

2. A related person, or

3. An entity that is neither a look-through entity nor a related person.

Dividends and the distributive share of income from a lower-tier entity that’s neither a look-through entity nor a related person generally are treated as passive income, regardless of whether the income of the lower-tier entity is active or passive in its hands. Similarly, ownership interests in such entities are treated as passive assets.

Because the ownership threshold required for an entity to be treated as a related person is higher than the ownership threshold required for an entity to be treated as a look-through entity, there may be many entities that qualify as both or solely as look-through entities. However, because the tax code has broader attribution rules than the rules that apply for purposes of determining look-through entity classification, there may be entities treated as related persons with respect to a TFC but not as look-through entities with respect to that TFC.

For tax code purposes, interest, dividends, rents or royalties actually received or accrued by a TFC are considered received or accrued from a related person only if the payor of the interest, dividend, rent or royalty is a related person with respect to the TFC. In the case of income received or accrued from a look-through entity, the rules that eliminate intercompany income apply before the rules applicable to income received or accrued from a related person. Consequently, the rules apply to dividends, interest, rents and royalties received or accrued from a look-through entity only if those amounts are treated as regarded after application of the intercompany income rules.

Applicability Dates

The applicability dates of the final PFIC regulations vary depending on the specific regulation in question. We’ve covered just a few noteworthy revisions and PFIC rules here; consult your Moore Doeren Mayhew advisor or click here for more information and any questions you might have related to the PFIC rules.

James J. Miesowicz

Steven C. Wedge