AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Withdrawal of notice of proposed rulemaking; notice of proposed rulemaking.

SUMMARY:

This document contains proposed regulations under sections 1291, 1297, and 1298 of the Internal Revenue Code (“Code”) regarding the determination of ownership in a passive foreign investment company within the meaning of section 1297(a) (“PFIC”) and the treatment of certain income received or accrued by a foreign corporation and assets held by a foreign corporation for purposes of section 1297. The regulations provide guidance regarding when a foreign corporation is a qualifying insurance corporation (“QIC”) under section 1297(f) of the Code and the amounts of income and assets that a QIC excludes from passive income and assets pursuant to section 1297(b)(2)(B) (“PFIC insurance exception”) for purposes of section 1297(a). The regulations also clarify the application and scope of certain rules that determine whether a United States person that directly or indirectly holds stock in a PFIC is treated as a shareholder of the PFIC, and whether a foreign corporation is a PFIC. The regulations affect United States persons with direct or indirect ownership interests in certain foreign corporations.

DATES:

Written or electronic comments and requests for a public hearing must be received by September 9, 2019.

ADDRESSES:

Send submissions to: CC:PA:LPD:PR (REG-105474-18), room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-105474-18), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC 20224, or sent electronically via the Federal eRulemaking Portal at www.regulations.gov (IRS REG-105474-18).

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations, Josephine Firehock at (202) 317-4932 (for the PFIC Insurance Exception) or Jorge M. Oben at (202) 317-6934 (for general rules, including indirect ownership and look-through rules); concerning submissions and requests for a public hearing, Regina L. Johnson at (202) 317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

I. In General

This document contains proposed amendments to 26 CFR part 1 under sections 1291, 1297, and 1298. Sections 1291 through 1298 set forth tax regimes for shareholders that own stock of a PFIC. Under section 1297(a), a foreign corporation (“Tested Foreign Corporation”) qualifies as a PFIC if it satisfies either of the following tests: (i) 75 percent or more of the Tested Foreign Corporation's gross income for a taxable year is passive (“Income Test”); or (ii) the average percentage of assets held by the Tested Foreign Corporation during a taxable year that produce (or that are held for the production of) passive income is at least 50 percent (“Asset Test”). Section 1297(b)(1) generally defines passive income as any income of a kind that would constitute foreign personal holding company income (“FPHCI”) under section 954(c), and section 1297(b)(2) provides exceptions to this general definition. Income of a kind not described in section 954(c)(1) (for example, premiums on insurance and annuity contracts) is excluded from passive income.

In addition, section 1297(c) provides a look-through rule that applies when determining the PFIC status of a Tested Foreign Corporation that directly or indirectly owns at least 25 percent of the stock (determined by value) of another corporation.

Section 1298(b)(3) provides an exception from PFIC status for certain Tested Foreign Corporations that change from one active business to another active business. Section 1298(b)(7) provides that certain stock (“qualified stock”) in a domestic C corporation owned by a Tested Foreign Corporation through a 25-percent-owned domestic corporation is treated as an asset generating non-passive income for purposes of section 1297(a), provided that the Tested Foreign Corporation is subject to the accumulated earnings tax or waives any treaty protections against the imposition of the accumulated earnings tax.

Section 1298(a) sets forth special rules applicable to shareholders of PFICs, including attribution rules that treat a United States person as the owner of PFIC stock that is owned by another person (other than an individual). For instance, section 1298(a)(2) sets forth the attribution rules for ownership through a corporation, and section 1298(a)(3) sets forth the attribution rules for ownership through a partnership, estate, or trust. In addition, section 1298(a)(1)(B) provides that, except to the extent provided in regulations, section 1298(a) will not apply to treat stock owned (or treated as owned) by a United States person as owned by another United States person.

The Department of the Treasury (“Treasury Department”) and the IRS announced their intention to issue regulations that address the operation of the Income Test and Asset Test in Notice 88-22, 1988-1 C.B. 489 (“Notice 88-22”).

II. PFIC Insurance Exception

Before its amendment by section 14501 of the Tax Cuts and Jobs Act, Pub. L. 115-97, 131 Stat. 2234 (2017) (the “Act”), former section 1297(b)(2)(B) provided that passive income generally did not include investment income derived in the active conduct of an insurance business by a corporation that is predominantly engaged in an insurance business and that would be subject to tax under subchapter L if it were a domestic corporation. Congress was concerned about a lack of clarity and precision in the PFIC insurance exception, and in particular about the lack of precision regarding how much insurance or reinsurance business a company must do to qualify under the exception, which made the exception difficult to enforce. H.R. Report 115-409 at 409-410. To address these concerns, the Act modified the PFIC insurance exception to provide that passive income does not include investment income derived in the active conduct of an insurance business by a QIC. Thus, for taxable years beginning after December 31, 2017, the PFIC insurance exception provides that a foreign corporation's income attributable to an insurance business will not be passive income if three requirements are met. First, the foreign corporation must be a QIC as defined in section 1297(f). Second, the foreign corporation must be engaged in an “insurance business.” Third, the income must be derived from the “active conduct” of that insurance business.

On April 24, 2015, the Federal Register published a notice of proposed rulemaking at 80 FR 22954 (the “2015 proposed regulations”) under former sections 1297(b)(2)(B) and 1298(g). The 2015 proposed regulations addressed the PFIC insurance exception and provided guidance regarding the extent to which a foreign corporation's investment income and the assets producing that income are excluded from passive income and passive assets for purposes of the passive income and passive asset tests in section 1297(a). Comments were received on the previously proposed regulations. A public hearing was requested and was held on September 18, 2015.

This document withdraws the 2015 proposed regulations and proposes new regulations with respect to the insurance exception as amended by the Act. Accordingly, this preamble does not address the comments received regarding the 2015 proposed regulations unless the comment relates to these new proposed regulations.

Explanation of Provisions

I. General Rules

A. Overview

These regulations provide guidance with respect to a number of issues that are not specifically addressed in the current regulations and resolve some of the complexities that arise in the determination of the ownership of a PFIC and in the application of the Income Test and Asset Test in cases in which the look-through rule of section 1297(c) applies to a Tested Foreign Corporation.

Specifically, these regulations provide guidance on the application of the corporate attribution rules when a partnership indirectly holds a Tested Foreign Corporation through a corporation that is not a PFIC. These regulations also clarify the scope of the section 1297(b)(1) cross-reference to section 954(c) for purposes of defining passive income, and they set forth rules that address certain computational and characterization issues that arise in applying the Asset Test. In addition, these regulations provide rules concerning the treatment of income and assets of a 25-percent-owned subsidiary under section 1297(c). These regulations provide guidance on the application of the section 1298(b)(3) change of business exception and also propose a new rule analogous to the section 1298(b)(3) change of business exception that takes into consideration the assets of the Tested Foreign Corporation. Finally, these regulations provide guidance on the application of the section 1298(b)(7) qualified stock exception and provide a rule for waiving treaty benefits that would exempt a Tested Foreign Corporation from the accumulated earnings tax.

B. Determination of Ownership and Attribution Through Partnerships

Section 1298(a) provides attribution rules that apply to the extent that the effect is to treat stock of a PFIC as owned by a United States person. Except as provided in regulations, the attribution rules do not apply to treat stock owned or treated as owned by a United States person as owned by any other person.

Section 1298(a)(2)(A) provides that if 50 percent or more in value of the stock of a corporation is owned, directly or indirectly, by or for any person, that person is considered to own the stock owned directly or indirectly by or for the corporation in proportion to the person's ownership of the corporation. However, under section 1298(a)(2)(B), the 50 percent ownership threshold does not apply in the case of stock held through a PFIC or a corporation that would be a PFIC if it were not a controlled foreign corporation within the meaning of section 957(a) (“CFC”). Section 1298(a)(3) provides that stock owned, directly or indirectly, by a partnership, estate, or trust is considered owned proportionately by its partners or beneficiaries. The current rules in § 1.1291-1(b)(8) are consistent with these statutory provisions.

Comments have inquired whether the attribution rules are intended to be applied to a tiered ownership structure on a “top-down” basis, by starting with a United States person and determining what stock is considered owned at each successive lower tier on a proportionate basis. Alternatively, the comments have posited, the rules could be applied on a “bottom-up” basis, by starting with a PFIC and attributing ownership of its stock upwards to each successive upper tier until the United States person whose ownership in the PFIC is being tested is reached.

The two approaches can have different ownership consequences when a partnership indirectly owns stock of a Tested Foreign Corporation through a corporation that is not a PFIC. A United States person not treated as a shareholder of PFIC stock indirectly held by a partnership through a non-PFIC corporation under a “top-down” approach may be treated as a shareholder under a “bottom-up” approach as a result of the application of section 1298(a)(3) and § 1.1291-1(b)(8)(iii), which provide that holders of interests in a pass-through entity are considered to proportionately own stock owned directly or indirectly by the pass-through entity. Consider, for example, the following fact pattern. A, a United States citizen, owns 50 percent of the interests in Foreign Partnership, a foreign partnership, the remainder of which is owned by an unrelated foreign person. Foreign Partnership owns 100 percent of the stock of FC1 and 50 percent of the stock of FC2, the remainder of which is owned by an unrelated foreign person. Both FC1 and FC2 are foreign corporations that are not PFICs (determined without applying section 1297(d)). FC1 and FC2 each own 50 percent of the stock of FC3, a foreign corporation that is a PFIC. Under a “bottom-up” approach, Foreign Partnership could be treated as owning 75 percent of the stock of FC3 indirectly through FC1 and FC2, and accordingly, A could be treated as owning 37.5 percent of the stock of FC3. Under a “top-down” approach, however, A would be treated as owning 50 percent of the stock of FC1 and 25 percent of the stock of FC2, and the only stock of FC3 that would be attributed to A would be the 25 percent of the FC3 stock treated as indirectly owned by A through FC1. Comments have noted that a “top-down” approach produces the same result as if the partnership were disregarded and partners were treated as if they directly or indirectly owned a partnership's direct and indirect interests in a non-PFIC foreign corporation; it could thus be viewed as consistent with an aggregate theory of partnerships.

Under the proposed regulations, the attribution rules apply consistently whether a United States person owns stock of a non-PFIC foreign corporation through a partnership or directly, as they would under the “top-down” approach. This ensures that ownership of a foreign corporation that is a PFIC through a partnership will not change the amount of the stock of the PFIC that the United States person is treated as owning. Accordingly, under the proposed regulations, for purposes of determining whether a partner, S corporation shareholder, or beneficiary in a partnership, S corporation, estate, or nongrantor trust is considered under § 1.1291-1(b)(8)(ii)(A) to own a portion of stock of a PFIC owned indirectly by the partnership, S corporation, estate, or trust through a non-PFIC foreign corporation, the partner, shareholder, or beneficiary will be considered to own 50 percent or more in value of the stock of the non-PFIC foreign corporation through the partnership, estate, or trust only if the partner, shareholder, or beneficiary directly or indirectly owns 50 percent or more of the ownership interests in the partnership, estate, or trust. See proposed § 1.1291-1(b)(8)(iii).

If, in the previously posited example, Foreign Partnership were replaced with another foreign corporation, FC4, the proposed regulations would not apply. It may seem less appropriate for the amount of FC3 stock that is treated as owned by A to be limited to the 25 percent of FC3 indirectly owned by A through FC4 and FC1. Instead, FC4 could be treated as owning 25 percent of the stock of FC3 indirectly through FC2, and thus A could be treated as owning 12.5 percent of the stock of FC3 indirectly through FC4 and FC2 in addition to the 25 percent owned indirectly through FC4 and FC1. The Treasury Department and the IRS request comments as to whether a “top-down” attribution analysis or some alternative analysis should apply under section 1298(a) in a purely corporate structure such as this one, such that A would not be treated as owning any stock of FC3 indirectly through FC4 and FC2.

C. Income Test

1. In General

In the Technical and Miscellaneous Revenue Act of 1988 (Pub. L. 100-647, 102 Stat. 3342), Congress amended section 1297(b)(1) to define the term passive income generally as any income of a kind that would constitute FPHCI under section 954(c). FPHCI, and thus passive income, includes interest income that would be tax-exempt under section 103. See §§ 1.954-2(b)(3), 1.952-2(c)(1). Neither the rules under subtitle A, chapter 1, subchapter N, part III, subpart F of the Code (“subpart F”) nor rules under section 1297, however, address the treatment for purposes of FPHCI or the Income Test of other types of income that are otherwise excluded from gross income, such as intercompany dividends that are excluded from the income of a recipient under the consolidated return regulations. See § 1.1502-13(f)(2)(ii). As discussed in more detail in Part I.F of this Explanation of Provisions, a Tested Foreign Corporation may be treated under section 1297(c) as receiving directly income received by a 25-percent-owned subsidiary, including a domestic corporation. As discussed in more detail in Part I.H of this Explanation of Provisions, a Tested Foreign Corporation could own a second domestic corporation through a 25-percent-owned domestic corporate subsidiary and could thus be treated under sections 1297(c) and 1298(b)(7) as receiving intercompany dividends from the lower-tier domestic corporation that would be excluded from the income of the upper-tier domestic corporation under the consolidated return regulations. Accordingly, the operation of the statutory rules under sections 1297 and 1298 indicate that the Income Test is intended to take into account all income of a Tested Foreign Corporation, without regard to reductions or exclusions that might apply for purposes of determining the U.S. Federal income tax imposed on such income. Consistent with those rules, the Treasury Department and the IRS have concluded that intercompany dividends received by a corporation from a member of its consolidated group and treated as received under section 1297(c) by a Tested Foreign Corporation that directly or indirectly owns stock in the corporation should be taken into account for purposes of the Income Test. Thus, the proposed regulations indicate that income for purposes of the Income Test includes all dividend income, including dividends that are excluded from gross income under section 1502 and § 1.1502-13. See proposed § 1.1297-1(b). The Treasury Department and the IRS welcome comments on this approach. However, see Part I.F.3 of this Explanation of Provisions for a discussion of rules that could eliminate such dividends.

2. Exceptions From Passive Income

Furthermore, there are a number of exceptions to the definition of FPHCI in section 954(c), as well as in section 954(h) and (i), and special rules and definitions in section 954(c) that affect the determination of FPHCI. Specifically, in addition to the exceptions contained within the general definition of FPHCI in section 954(c)(1), section 954(c)(2) provides three exceptions: (i) An active rents and royalties exception; (ii) an export financing exception; and (iii) a dealer exception. Section 954(c)(3) provides two additional exceptions: (i) A related person, same country dividend and interest exception; and (ii) a related person, same country rents and royalty exception. In addition, for taxable years of foreign corporations beginning after December 31, 2005, and before January 1, 2020, section 954(c)(6) excludes from FPHCI certain dividends, interest, rents, and royalties received or accrued from a related corporation that is a CFC. Moreover, section 954(h) provides rules that apply for purposes of section 954(c)(1) pursuant to which income derived in an active banking or financing business is excluded from FPHCI. Additionally, under section 954(i), income from an active insurance business is excluded from FPHCI for purposes of section 954(c)(1). Finally, section 954(c)(4) contains a look-through rule that applies in the case of a sale of certain partnership interests, and section 954(c)(5) contains definitions and special rules applicable to commodity transactions.

Separately, section 1297(b)(2) provides explicit exclusions to the general definition of passive income set forth in section 1297(b)(1). Specifically, section 1297(b)(2) provides four exceptions: (i) An active banking exception; (ii) an active insurance business exception; (iii) a related person interest, dividends, rents, and royalties exception; and (iv) an export trade financing exception.

Questions have been raised regarding the scope of the cross-reference to section 954(c) in section 1297(b)(1) for purposes of defining passive income for PFIC purposes. Comments have inquired whether the section 954(c) reference in section 1297(b) incorporates all of the exceptions to FPHCI that are in section 954(c). In addition, by their terms, certain exceptions to FPHCI apply only to a foreign corporation that is a CFC. If these exceptions apply for PFIC purposes, the comments also question whether a Tested Foreign Corporation must also be a CFC in order to benefit from the exceptions.

The Treasury Department and the IRS understand that Congress did not intend for all of the exceptions in section 954(c) to apply for purposes of determining passive income under the PFIC provisions. In particular, the exceptions in section 954(c)(3) (relating to certain income received from related persons) and 954(c)(6) (relating to certain income received from related CFCs) were not meant to be taken into account for PFIC purposes. The legislative history indicates that Congress intended for the section 1297(c) look-through rules or the section 1297(b)(2)(C) exception to apply to income items that otherwise would be entitled to the section 954(c)(3) exception. It indicates:

The bill conforms the PFIC definition of passive income to the definition of passive income under subpart F (sec. 954(c)). This change, in conjunction with the look-through rule for certain 25-percent-owned corporations and the lookthrough rules added by the bill (described below), makes it explicit that earnings of certain related foreign corporations organized in the same country as its shareholder that, if distributed to the shareholder would be excluded from foreign personal holding company income under the same-country exception of subpart F (sec. 954(c)(3)), are subject to either the section [1297(c)] look-through treatment or the look-through treatment for amounts paid by related parties that are not 25 percent owned (described below).

H.R. Rep. No. 100-795, at 271-272 (1988); S. Rep. No. 100-445, at 285-286 (1988).

Thus, the proposed regulations do not incorporate the section 954(c)(3) exception for purposes of determining passive income for PFIC purposes. Similarly, under the proposed regulations, the section 954(c)(6) exception also does not apply for determining PFIC status because the section 1297(b)(2)(C) related-person exception is intended to be the sole related-person exception applicable for determining passive income under the PFIC rules.

Additional questions are raised with respect to the FPHCI exceptions for active banking, financing, and insurance income because section 1297(b) does not specifically cross-reference section 954(h) and (i). As with section 1297(b)(2)(C), it is possible that sections 1297(b)(2)(A) and (B) were intended to be the sole exceptions for active banking, financing, and insurance income applicable for determining passive income under the PFIC rules because section 1297(b) has specific exceptions for active banking, financing, and insurance income. Alternatively, the section 1297(b) cross-reference to section 954(c) could be read to include the exceptions provided in section 954(h) and (i), which apply for purposes of section 954(c) by their terms. It may be appropriate for income that satisfies the requirements in section 954(h) and (i) to be excluded from passive income because Congress generally defined passive income by reference to FPHCI, and when section 954(h) and (i) were enacted, each with a cross-reference to section 954(c), Congress did not provide that section 954(h) or (i) should not apply for PFIC purposes. Moreover, the fact that the PFIC provisions are more generally not intended to apply to foreign corporations engaged in active businesses supports the application of rules excluding active banking, financing, and insurance income from the definition of passive income.

However, with respect to section 954(i), Congress recently amended the exclusion for income derived in the active conduct of an insurance business in section 1297(b)(2)(B) to require that income be earned by a QIC, as discussed in Part II of the Background section of this preamble. Given this statutory change and the tests contained in the definition of QIC in section 1297(f), the Treasury Department and the IRS have determined that the exception for insurance income in section 954(i) should not apply in addition to the newly modified exception in section 1297(b)(2)(B). Accordingly, the proposed regulations provide that the section 954(i) exception to FPHCI does not apply in addition to the PFIC exception. See proposed § 1.1297-1(c)(1)(i)(B). By contrast, given that no final regulations under the PFIC regime provide rules concerning an exclusion of active banking and financing income, these proposed regulations provide that the FPHCI exception for banking and financing income under section 954(h) applies for purposes of determining PFIC status. See proposed § 1.1297-1(c)(1)(i)(A). The application of section 954(h) is in addition to the PFIC exception. The Treasury Department and the IRS request comments about whether, when regulations are in force under section 1297(b)(2)(A), the corollary FPHCI exclusion should also continue to apply.

Comments have noted that the application of section 954(c) for PFIC purposes can be uncertain when a Tested Foreign Corporation is not also a CFC. For instance, the application of section 954(h) for PFIC purposes could be interpreted to apply only to amounts received by a Tested Foreign Corporation that also is a CFC. Passive income for PFIC purposes is defined by cross-reference to section 954(c) because the income items that comprise FPHCI are generally passive in nature. The CFC status of the recipient of an item of FPHCI does not affect the passive nature of the item, and thus is not relevant for purposes of determining whether an item is passive under the PFIC rules. Therefore, it is appropriate for income derived by any Tested Foreign Corporation, and not just Tested Foreign Corporations that also are CFCs, to be eligible for the exceptions to FPHCI, including the section 954(h) exception.

For the reasons discussed in this Part I.C.2, the proposed regulations provide that for purposes of section 1297(b)(1), passive income is determined by reference to the items of income listed in section 954(c)(1), subject only to the exceptions found in section 954(c)(1), section 954(c)(2)(A) (relating to active rents and royalties), section 954(c)(2)(B) (relating to certain export financing interest), section 954(c)(2)(C) (relating to dealers), and section 954(h) (relating to entities engaged in the active conduct of a banking, financing, or similar business). See proposed § 1.1297-1(c)(1)(i) and (c)(1)(i)(A). In addition, the rules in section 954(c)(4) (relating to sales of certain partnership interests) and 954(c)(5) (relating to certain commodity hedging transactions) apply for PFIC purposes. See proposed § 1.1297-1(c)(1)(i)(C). However, for the reasons stated in this Part I.C.2, the exceptions in section 954(c)(3) (relating to certain income received from related persons), section 954(c)(6) (relating to certain amounts received from related controlled foreign corporations), and section 954(i) (relating to entities engaged in the active conduct of an insurance business) are not taken into account for purposes of section 1297(b)(1). See proposed § 1.1297-1(c)(1)(i)(B). The proposed regulations also provide that an entity is treated as a CFC for purposes of applying an exception to FPHCI and for purposes of determining whether a person is a related person with respect to the entity. See proposed § 1.1297-1(c)(1)(i)(D). Comments are requested as to whether regulations should provide any additional special rules concerning the definition of a related person under section 954(d)(3) for purposes of applying an FPHCI exception to a Tested Foreign Corporation that is not a CFC.

3. Income and Gains From Certain Transactions

The Income Test is computed based on a Tested Foreign Corporation's gross income. However, pursuant to section 954(c), certain categories of income are FPHCI only to the extent that gains exceed losses with respect to the category. For instance, under section 954(c)(1)(B) only “the excess of gains over losses from the sale or exchange” of certain property is treated as FPHCI. Similar rules apply to income from commodities transactions under section 954(c)(1)(C), foreign currency gains under section 954(c)(1)(D), and income from notional principal contracts under section 954(c)(1)(F). The proposed regulations provide that for purposes of the Income Test, items of income under section 954(c) that are determined by netting gains against losses are taken into account by a corporation on that net basis, so that only net gains in a particular category of FPHCI are taken into account. See proposed § 1.1297-1(c)(1)(ii). However, the net amount of income in each category of FPHCI is determined separately for each relevant corporation, such that net gains or losses of a corporation, at least 25 percent of the value of stock of which is owned, directly or indirectly, by a Tested Foreign Corporation (“Look-Through Subsidiary”) may not be netted against net losses or gains of another Look-Through Subsidiary or of a Tested Foreign Corporation.

4. Income Earned Through Partnerships

The proposed regulations provide guidance on the treatment of a corporation's distributive share of partnership income for purposes of the Income Test. The Treasury Department and the IRS have determined that income earned by a Tested Foreign Corporation through a partnership should be treated similarly to income earned through a corporate subsidiary. As discussed in more detail in Part I.F of this Explanation of Provisions, if a Tested Foreign Corporation owns a Look-Through Subsidiary, the Tested Foreign Corporation is treated as if it directly received its proportionate share of the income of the Look-Through Subsidiary, and certain items of income received from the Look-Through Subsidiary are proportionately eliminated. If a corporation is not a Look-Through Subsidiary, income received from the corporation is characterized in accordance with the general rules described in Part I.C.2 of this Explanation of Provisions, under which dividends generally will be passive. Accordingly, the proposed regulations provide that a Tested Foreign Corporation's distributive share of any item of income of a partnership is treated as income received directly by the Tested Foreign Corporation, provided the Tested Foreign Corporation owns, directly or indirectly, at least 25 percent of the value of the partnership, in which case the partnership is referred to as a “Look-Through Partnership,” and income elimination rules similar to those for Look-Through Subsidiaries apply. See proposed § 1.1297-1(c)(2)(i). If the Tested Foreign Corporation owns less than 25 percent of the value of a partnership, the corporation's distributive share of any item of income of the partnership is passive income. See proposed § 1.1297-1(c)(2)(ii).

As a result of these rules, in cases in which the Tested Foreign Corporation owns at least 25 percent of the value of the partnership, the exceptions to passive income contained in section 1297(b)(2) and the relevant exceptions to foreign personal holding company income in section 954(c) and (h) that are based on whether income is derived in the active conduct of a business generally apply if, and only if, the partnership engages in the relevant business activities. The focus on partnership activities is consistent with the principles applicable to partnership interests under the regulations under subpart F. See § 1.954-2(a)(5)(ii)(A); § 1.954-3(a)(6). However, as described in Part I.F.5 of this Explanation of Provisions, these proposed regulations also include rules that, in certain circumstances, allow the character of income to be determined at the level of the Tested Foreign Corporation, taking into account activities performed by the Tested Foreign Corporation and certain subsidiaries of the Tested Foreign Corporation, whether such subsidiaries are in corporate or partnership form.

Although the subpart F regulations provide rules concerning the classification of a CFC's distributive share of partnership income that, absent these proposed regulations, would generally be applicable by virtue of section 1297's adoption of FPHCI as the basis for passive income, the Treasury Department and the IRS have determined that the differing policies of the subpart F and PFIC regimes warrant different rules for partnerships. Specifically, the Treasury Department and the IRS have concluded that it is appropriate to generally characterize a corporation's distributive share of partnership income as passive when the corporation owns less than 25 percent of the value of the partnership, consistent with the treatment of Look-Through Subsidiary income, notwithstanding the fact that under the subpart F regulations, such income could have been excluded from FPHCI by virtue of the partnership's activities regardless of the corporation's level of ownership. The different treatment is warranted because of the flexibility that entities have in their characterization for U.S. Federal income tax purposes under § 301.7701-3 and because of the fact that treating a subsidiary as a partnership may not have U.S. income tax consequences for a Tested Foreign Corporation, as it could for a CFC. However, the Treasury Department and the IRS request comments as to whether a 25 percent threshold for the Tested Foreign Corporation'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, as applicable under the rules described in Part I.F.5 of this Explanation of Provisions, the Tested Foreign Corporation and certain subsidiaries of the Tested Foreign Corporation), or whether an alternative threshold should be considered. Furthermore, the Treasury Department and the IRS request comments as to whether different rules should apply with respect to partners in general partnerships than with respect to partners in limited partnerships, or with respect to partners that materially participate in the activities of the partnership.

5. Income From a Related Person

The proposed regulations provide additional guidance on the application of the section 1297(b)(2)(C) related-person exception to dividends, interest, rents, and royalties. The proposed regulations provide that the determination of whether the payor of an item of income is a related person should be made on the date of receipt or accrual, as applicable based on the recipient's method of accounting, of the item of income. See proposed § 1.1297-1(c)(3)(iv).

Under § 1.904-5(c)(2)(ii)(C) (the “cream-skimming rule”), interest paid to a related person is treated as passive income to the payee to the extent that the payor has passive income. Under this rule, if a foreign corporation had $200 of passive gross income and $200 of non-passive gross income, and that foreign corporation made an interest payment of $100 to a related foreign corporation, for purposes of determining the nature of the interest income in the hands of the payee foreign corporation, the entire $100 of interest would be treated as passive income rather than as ratably allocable between passive and non-passive income. Although the Treasury Department and the IRS considered applying a cream-skimming rule for purposes of section 1297(b)(2)(C), the Treasury Department and the IRS have concluded that the PFIC regime does not raise the policy concerns addressed by the cream-skimming rule in the foreign tax credit and subpart F contexts. In those contexts, because interest expense can reduce a foreign corporation's subpart F income or otherwise affect the calculation of foreign tax credits, an interest payment could otherwise be used to try to reduce the passive income of the payor and convert it into non-passive income of the payee. However, because the Income Test is applied on the basis of gross income, an interest payment cannot be used in the same fashion for purposes of the Income Test. Accordingly, under the proposed regulations, for purposes of the section 1297(b)(2)(C) exception, interest is properly allocable to income of the related person that is not passive income based on the relative portion of the related person's income for its taxable year that ends in or with the taxable year of the recipient that is not passive income. See proposed § 1.1297-1(c)(3)(i). Dividends are treated as properly allocable to income of the related person that is not passive income based on the portion of the related payor's current-year earnings and profits for the taxable year that ends in or with the taxable year of the recipient that are attributable to non-passive income. See proposed § 1.1297-1(c)(3)(ii). Comments are specifically 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. The proposed regulations further provide that rents and royalties are allocable to income of the related person which is not passive income to the extent the related person's deduction for the rent or royalty is allocated to non-passive income under the principles of §§ 1.861-8 through 1.861-14T. See proposed § 1.1297-1(c)(3)(iii). Comments are specifically requested regarding any concerns about the availability of information and alternative methods of determining the portion of rents and royalties treated as properly allocable to income of a related person that would address any such concerns.

D. Asset Test

1. Methodology of Application of Asset Test

Section 1297(a)(2) provides that a Tested Foreign Corporation is a PFIC if the average percentage of assets held by the corporation during a taxable year that produce passive income or are held for the production of passive income is at least 50 percent. Notice 88-22 provides that the average percentage of assets of a Tested Foreign Corporation is calculated by averaging the value of the assets of the corporation, determined as of the end of each quarterly period of the corporation's taxable year.

These regulations clarify that the average percentage of a Tested Foreign Corporation's assets is determined using the average of the gross values (or adjusted bases) at the end of each quarter of the foreign corporation's taxable year. See proposed § 1.1297-1(d)(1)(i) and (d)(1)(ii)(A). Alternatively, the assets of a Tested Foreign Corporation can be measured for purposes of the Asset Test more frequently than quarterly (for example, weekly or monthly). The quarter or shorter interval used by a Tested Foreign Corporation is referred to as its “measuring period.” Applying the Asset Test based on a period that recurs more frequently than a quarter provides a more precise measurement of “average,” but the more frequently recurring basis is not required because of the potential administrative burden that it could impose on a shareholder of a Tested Foreign Corporation. The same measuring period must be used for the Tested Foreign Corporation for the initial year (including a short year) that for which the shareholder elects to use the alternative measuring period and any and all subsequent years unless the election to use the more frequently recurring measuring period is revoked. See proposed § 1.1297-1(d)(1)(ii)(B).

If a Tested Foreign Corporation has a short taxable year, the quarterly measuring dates for purposes of the Asset Test are the same as they would be for a full taxable year, except that the final quarterly measuring date will be the final day of the short taxable year. See proposed § 1.1297-1(d)(1)(ii)(C). Thus, for instance, if a Tested Foreign Corporation for which the election for a shorter period has not been made has a short year of eight months, the corporation would have two quarters ending on the foreign corporation's normal quarterly measuring dates and a third quarter ending on the final day of the short taxable year. The asset amounts for those three quarterly measuring dates would be averaged to determine the average percentage of a Tested Foreign Corporation's assets that are passive for the year. The Treasury Department and the IRS have determined that applying the Asset Test based on the taxable year quarters that ended during the short year properly accounts for the administrative difficulties of calculating quarterly measurements with respect to a short year.

Under section 1297(e), the assets of a Tested Foreign Corporation are required to be measured based on (i) value, pursuant to section 1297(e)(1), if it is a publicly traded corporation for the taxable year, or if section 1297(e)(2) does not apply to it for the taxable year; or (ii) adjusted basis, pursuant to section 1297(e)(2), if it is a CFC, or elects the application of section 1297(e)(2). The statute does not specify whether a corporation that is publicly traded during only part of the taxable year is publicly traded “for the taxable year,” and thus whether such a corporation's assets should be measured for the taxable year based on value or on adjusted basis or whether, if the corporation is a CFC for the remainder of the year, a combination of the two should be used. For instance, a Tested Foreign Corporation that is a CFC at the beginning of its taxable year and became publicly traded during the last month of its taxable year could be required under section 1297(e) to have its assets measured based on either adjusted basis or value for all four quarterly measuring periods or based on adjusted basis for its first three quarterly measuring periods and value for its fourth quarterly measuring period. The proposed regulations provide that the Asset Test should apply on the basis of value for the entire year if the corporation was publicly traded on the majority of days during the year or section 1297(e)(2) did not apply to the corporation on the majority of days of the year. Otherwise, the Asset Test should apply on the basis of adjusted basis for the entire year. See proposed § 1.1297-1(d)(1)(v). The Treasury Department and the IRS have determined that allowing a shareholder the option of choosing either method with respect to a Tested Foreign Corporation could facilitate the avoidance of the PFIC rules, and that the rule in the proposed regulation imposes the least administrative burden. The Treasury Department and the IRS welcome comments on these rules.

Under the proposed regulations, the rules described in this Part I.D.1 for making or revoking an election for an alternative measuring period also apply for purposes of the election provided in section 1297(e)(2)(B) to use adjusted bases of assets for purposes of the Asset Test. See proposed § 1.1297-1(d)(1)(iii)(B) and (d)(1)(iv). Both elections may be made by a United States person that is eligible under § 1.1295-1(d) with respect to the Tested Foreign Corporation or that would be eligible if the Tested Foreign Corporation were a PFIC. See proposed § 1.1297-1(d)(1)(iv)(A). Thus, in the case of a Tested Foreign Corporation owned by a domestic partnership in which U.S. individuals are partners, only the domestic partnership and not its partners may make the elections, ensuring that the Tested Foreign Corporation is treated consistently for all of the partners, which would facilitate reporting by the partnership if the Tested Foreign Corporation were a PFIC. However, the Treasury Department and the IRS request comments as to whether either election should be available to any United States person that is a shareholder (within the meaning of § 1.1291-1(b)(7) or (8)) of the Tested Foreign Corporation or that would be a shareholder of the Tested Foreign Corporation if it were a PFIC.

If the person is required to file the Form 8621 (or successor form) with respect to the Tested Foreign Corporation, the elections may be made in the manner provided in the instructions to the Form 8621; until such instructions are provided, the elections may be made by attaching a written statement to the Form 8621 providing for the election to a return for the year for which the election is made. If the person is not required to file the Form 8621 with respect to the Tested Foreign Corporation (for example, because the Tested Foreign Corporation is not a PFIC), the person may make the elections by attaching a written statement providing for the election to a return for the year for which the election is made. Id. The elections are revoked in a similar manner. See proposed § 1.1297-1(d)(1)(iv)(B). A new election for an alternative measuring period or under section 1297(e)(2)(B) may not be made until the sixth taxable year following the year for which the previous such election was revoked, and such subsequent election may not be revoked until the sixth taxable year following the year for which the subsequent election was made. See id.

2. Characterization of Dual-Character Assets

Pursuant to section 1297(a), an asset is considered passive for purposes of the Asset Test if it produces passive income or is held for the production of passive income. Notice 88-22 states that an asset that produces both passive income and non-passive income during a Tested Foreign Corporation's taxable year is treated partly as a passive asset and partly as a non-passive asset in proportion to the relative amounts of income generated by the asset during the year. Proposed § 1.1297-1(d)(2) generally adopts the rule set forth in Notice 88-22, and provides that an asset that produces both passive income and non-passive income during a taxable year is treated as two assets, one of which is passive and one of which is non-passive. Consistent with the rule in Notice 88-22, for purposes of applying the Asset Test, the value (or adjusted basis) of the asset is allocated between the passive assets and non-passive assets based on the ratio of passive income produced by the asset during the taxable year to non-passive income.

The proposed regulation also provides a specific rule for stock of a related person with respect to which no dividends are received or accrued, as applicable based on the recipient's method of accounting, during a taxable year but that previously generated dividends that were characterized as non-passive income, in whole or in part, under section 1297(b)(2)(C). See proposed § 1.1297-1(d)(2)(iii). The stock is characterized based on the dividends received or accrued, as applicable based on the recipient's method of accounting, with respect thereto for the prior two years. Id.

The Treasury Department and the IRS have determined that it may also be appropriate to bifurcate an asset that in part produces income and in part does not produce income between a passive and a non-passive asset for purposes of the Asset Test in order to provide a more accurate measure of the Tested Foreign Corporation's passive assets. For example, if a Tested Foreign Corporation uses a portion of a building, which is depreciable real property, in its trade or business that generates non-passive income, while renting a portion of the building in exchange for rents that are treated as passive, it would be appropriate for the portions of the building to be considered separately as non-passive and passive assets, respectively. Accordingly, the proposed regulations provide that for purposes of applying the Asset Test, if an asset in part produces income and in part does not produce any income, the asset must be bifurcated pursuant to the method that most reasonably reflects the uses of the property. See proposed § 1.1297-1(d)(2)(ii). A similar approach applies to characterize gain for subpart F purposes. See § 1.954-2(e)(1)(iv).

The Treasury Department and the IRS welcome comments on these rules, including suggestions for how to minimize the burden associated with determining how to bifurcate the relevant assets.

3. Characterization of Partnership Interests

The proposed regulations provide guidance on the characterization of a partnership interest for purposes of the Asset Test. As discussed in Part I.C.4 of this Explanation of Provisions, the Treasury Department and the IRS have determined that it is appropriate to treat a partnership in a manner similar to a corporate subsidiary for purposes of determining whether a Tested Foreign Corporation is a PFIC. Accordingly, the proposed regulations provide that for purposes of the Asset Test, a Tested Foreign Corporation that directly or indirectly owns an interest in a partnership is treated as if it held its proportionate share of the assets of a partnership, provided the Tested Foreign Corporation owns, directly or indirectly, at least 25 percent, by value, of the interests in the partnership. See proposed § 1.1297-1(d)(3)(i). A corporation's proportionate share of a partnership asset is treated as producing passive income, or being held to produce passive income, to the extent the asset produced, or was held to produce, passive income in the partnership's hands, taking into account only the partnership's activities, unless the rules described in Part I.F.5 of this Explanation of Provisions apply to allow the character of the income to be determined at the level of the Tested Foreign Corporation, taking into account activities performed by certain subsidiaries of the Tested Foreign Corporation. If a Tested Foreign corporation owns less than 25 percent of the value of the partnership, its interest in the partnership is treated as a passive asset. See proposed § 1.1297-1(d)(3)(ii).

4. Characterization of Dealer Property

For purposes of the Asset Test, an asset is considered passive if it produces passive income or is held for the production of passive income. Under the dealer exception in section 954(c)(2)(C), gain from the disposition of certain dealer property is treated as non-passive income for purposes of the Income Test. However, certain other income derived with respect to the dealer property (such as dividends and interest) is treated as passive income. The exception from passive income for dealer property in section 954(c)(2)(C) is predicated on the fact that a dealer holds the property as part of its trade or business and not for the production of passive income. Accordingly, the Treasury Department and the IRS have determined that, given that the PFIC regime is concerned with whether the asset is part of an active business, it is appropriate to characterize dealer property for purposes of the Asset Test based solely on the character of the gain derived from the disposition of the property. Accordingly, the proposed regulations provide that property that is subject to the dealer exception is characterized as a non-passive asset for purposes of the Asset Test, notwithstanding the dual-character asset rules discussed in Part I.D.2 of this Explanation of Provisions. See proposed § 1.1297-1(d)(4).

E. Treatment of Stapled Entities

The Treasury Department and the IRS understand that, in certain situations, equity interests in two or more foreign entities must be sold together as stapled interests within the meaning of section 269B(c)(3). Stapled entities (as defined in section 269B(c)(2)) may be structured in such a way that income and the assets generating the income are in one entity, while the activities generating the income are engaged in by the other entity. For example, two stapled entities might jointly carry on a real estate business, with one stapled entity owning real property that is leased to third parties to generate rental income, while the other stapled entity provides management services with respect to the real property that, if engaged in by the first stapled entity, would allow the rental income received by it to be characterized as non-passive income pursuant to section 954(c)(2)(A) and these proposed regulations. However, if the PFIC status of the stapled entity receiving the rental income were determined on a stand-alone basis, the income might be treated as passive income. Given that stapled interests represent a single economic interest to their shareholders, the Treasury Department and the IRS have determined that it is appropriate, for purposes of determining whether a stapled entity is a PFIC, to treat them as such. This is consistent with the treatment of stapled entities in section 269B(a)(3) for purposes of determining whether a stapled entity is a regulated investment company (“RIC”) or a real estate investment trust (“REIT”). Accordingly, the proposed regulations provide that for purposes of determining whether any stapled entity is a PFIC, all entities that are stapled entities with respect to each other are treated as one entity. See proposed § 1.1297-1(e). Comments are requested as to whether similar treatment should be provided for purposes of the subpart F rules.

F. Look-Through Rule for 25-Percent-Owned Subsidiaries

As noted in Part I.C.4 of this Explanation of Provisions, in determining PFIC status, section 1297(c) applies when a Tested Foreign Corporation owns, directly or indirectly, at least 25 percent of the value of the stock of another corporation, a Look-Through Subsidiary. In such instance, the Tested Foreign Corporation is treated as if it directly held its proportionate share of the assets and directly received its proportionate share of the income of the Look-Through Subsidiary. Section 1297(c) was enacted to prevent “foreign corporations owning the stock of subsidiaries engaged in active businesses [from being] classified as PFlCs.” H.R. Rep. No. 99-841, at II-644 (1986) (Conf. Rep.).

1. Determining a Tested Foreign Corporation's Ownership of a Look-Through Subsidiary and Proportionate Share of a Look-Through Subsidiary's Assets and Income

Neither the statute nor the regulations provide guidance on how to calculate a Tested Foreign Corporation's indirect ownership in another corporation for purposes of determining whether the corporation is a Look-Through Subsidiary under section 1297(c). In addition, the statute and regulations do not provide a methodology for determining a Tested Foreign Corporation's proportionate share of a Look-Through Subsidiary's income and assets for purposes of section 1297(c).

Under section 1297(c), the determination of whether a Tested Foreign Corporation owns, directly or indirectly, at least 25 percent of the stock of another corporation is based on value. The proposed regulations provide that indirect stock ownership for purposes of section 1297(c) is determined under the principles of section 958(a) applicable for determining ownership by value. See proposed § 1.1297-2(b)(1). The section 958(a) principles apply without regard to whether entities are domestic or foreign, and thus indirect ownership includes corporate ownership through intermediate corporations, partnerships, trusts, and estates, regardless of whether such intermediate entities are foreign or domestic. Id. In addition, stock considered owned by reason of applying the section 958(a) indirect ownership rules is generally considered actually owned for purposes of reapplying the indirect ownership rules. See § 1.958-2(f)(1).

Section 1297(c) provides that a Tested Foreign Corporation is treated as holding its proportionate share of the assets of the Look-Through Subsidiary, and receiving its proportionate share of the income of the Look-Through Subsidiary. The proposed regulations provide guidance on the meaning of “proportionate share” for purposes of section 1297(c). Specifically, proposed § 1.1297-2(b)(2) provides that a Tested Foreign Corporation is treated as owning a share of each asset, and receiving a proportionate share of each item of income, of a Look-Through Subsidiary proportionate to the Tested Foreign Corporation's percentage ownership (by value) of the Look-Through Subsidiary. Comments are requested concerning alternative methods that might better determine a Tested Foreign Corporation's proportionate share of income of a Look-Through Subsidiary that has multiple classes of stock outstanding.

Changes in stock ownership may cause fluctuations in a Tested Foreign Corporation's ownership in a Look-Through Subsidiary during a taxable year. For purposes of the Asset Test, ownership of a Look-Through Subsidiary is determined on each measuring date. See proposed § 1.1297-2(b)(2)(i). If the requisite 25-percent ownership is not met with respect to a corporation on the last day of a measuring period, as defined in Part I.D.1 of this Explanation of Provisions, the stock of the corporation would be a passive asset for purposes of that measuring period, absent the application of a special rule, such as the new rule for dealer property in proposed § 1.1297-1(d)(4), described in Part I.D.4 of this Explanation of Provisions. For purposes of the Income Test, a subsidiary is considered a Look-Through Subsidiary if the Tested Foreign Corporation owns an average of 25 percent of the value of the subsidiary for the year, taking into account its ownership on the last day of each measuring period of the Tested Foreign Corporation's taxable year. See proposed § 1.1297-2(b)(2)(ii)(A). If the Tested Foreign Corporation does not maintain, on average, at least 25-percent ownership of the subsidiary for the taxable year, the Tested Foreign Corporation is not, under the general rule in the proposed regulations, treated as receiving its proportionate share of the income of the subsidiary for that year under section 1297(c). However, the Tested Foreign Corporation may be treated as receiving directly its proportionate share of the income of the subsidiary for each measuring period in a taxable year for which the 25-percent ownership requirement is met on the relevant measuring date, provided the taxpayer can establish gross income for each of those measuring periods. See proposed § 1.1297-2(b)(2)(ii)(B). Comments are requested concerning appropriate methods for a taxpayer to establish gross income for a measuring period.

2. Overlap Between Section 1297(c) and Section 1298(b)(7)

Section 1298(b)(7) provides a special characterization rule that applies when a Tested Foreign Corporation owns at least 25 percent of the value of the stock of a domestic corporation and is subject to the accumulated earnings tax under section 531 (or waives any benefit under a treaty that would otherwise prevent imposition of such tax). In such instance, section 1298(b)(7) treats the qualified stock held by the domestic corporation as a non-passive asset, and the related income as non-passive income. By its terms, the section 1297(c) look-through rule also could apply to the qualified stock, which is stock in a domestic C corporation that is not a RIC or REIT, and look through to the assets of the corporation that issued the qualified stock for purposes of the Income Test and Asset Test. For example, assume a Tested Foreign Corporation owns 50 percent of the value of the stock in a domestic corporation, US1, which, in turn, owns 50 percent of the stock of a lower tier domestic corporation, US2 (which is not a RIC or a REIT). US2 wholly owns the stock of a foreign corporation, FC. The section 1297(c) look-through rule applies to treat the Tested Foreign Corporation as if it held its proportionate share of the assets, and received a proportionate share of the income, of US1. Both the section 1297(c) look-through rule and the section 1298(b)(7) characterization rule, by their terms, would apply to the stock of US2. The section 1297(c) rule would look through to the assets of US2 and FC. The section 1298(b)(7) characterization rule would treat the stock of US2 as a non-passive asset, and the income derived from the stock as income as non-passive income.

The Treasury Department and the IRS have determined that the special characterization rule of section 1298(b)(7) should generally take precedence over the section 1297(c) look-through rule when both rules would apply simultaneously because the characterization rule of section 1298(b)(7) is the more specific rule where the Tested Foreign Corporation owns a domestic corporation. Thus, the proposed regulations provide that the look-through rule of section 1297(c) does not apply to a domestic corporation, and any subsidiaries of the domestic corporation, if the stock of the domestic corporation is characterized, under section 1298(b)(7), as a non-passive asset producing non-passive income. See proposed § 1.1297-2(b)(2)(iii). However, these proposed regulations provide certain limitations on the application of section 1298(b)(7), including a new anti-abuse rule, in which case section 1297(c) would apply. The limitations and anti-abuse rule are described in Part I.H of this Explanation of Provisions. The Treasury Department and the IRS welcome comments on these rules.

3. Elimination of Certain Assets and Income for Purposes of Applying Section 1297(a)

Section 1297(c) aggregates the income and assets of a Tested Foreign Corporation and a Look-Through Subsidiary for purposes of testing the PFIC status of the Tested Foreign Corporation. However, there are no statutory or regulatory rules that prevent the double counting of income and assets arising from contracts and other transactions among a Tested Foreign Corporation and one or more Look-Through Subsidiaries. Intercompany items that are not eliminated for purposes of determining a Tested Foreign Corporation's PFIC status may result in a duplication of passive income or passive assets attributed to the Tested Foreign Corporation. For instance, if a wholly-owned Look-Through Subsidiary earned $100x of passive income during a taxable year, and distributed the $100x as a dividend to a Tested Foreign Corporation, the Tested Foreign Corporation would have a total of $200x of passive income ($100x of passive income under section 1297(c) and a $100x dividend) for purposes of the Income Test, even though only $100 of passive income was earned economically. Any double-counting of intercompany income and assets distorts the effect of section 1297(c) on the Income Test and Asset Test.

The legislative history to the PFIC rules provides an approach that would eliminate certain assets and income in order to prevent double-counting. See H.R. Rep. No. 100-795, at 268 (1988) (“Under this look-through rule, a foreign corporation that owns at least 25 percent of the stock of another corporation is treated as owning a proportionate part of the other corporation's assets and income. Thus, amounts such as interest and dividends received from foreign or domestic subsidiaries are eliminated from the shareholder's income in applying the income test and the stock or debt investment is eliminated from the shareholder's assets in applying the asset test.”); Staff, Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, JCS-10-87, at 1026 (1987). The Treasury Department and the IRS have determined that it is appropriate to follow that approach. Thus, the proposed regulations provide that intercompany payments of dividends and interest between a Look-Through Subsidiary and the Tested Foreign Corporation and stock and debt receivables are eliminated in applying the Income Test and the Asset Test. See proposed § 1.1297-2(c)(1) and (2). In the case of dividends, in order to qualify for elimination, the payment must be attributable to income of a Look-Through Subsidiary that was included in gross income by the Tested Foreign Corporation for purposes of determining its PFIC status. See proposed § 1.1297-2(c)(2). Thus, dividends attributable to income of the Look-Through Subsidiary earned in a year before the Tested Foreign Corporation owned, on average, at least 25% by value of the Look-Through Subsidiary would generally not qualify for elimination. As a result of the elimination rule, for example, interest and dividends received by a Tested Foreign Corporation from a wholly owned Look-Through Subsidiary are eliminated from the Tested Foreign Corporation's gross income for purposes of applying section 1297(a)(1), except to the extent that dividend amounts are attributable to income that has not been treated as received directly by the Tested Foreign Corporation under the section 1297(c) look-through rule. Additionally, the proposed regulations extend this treatment to intercompany payments between two Look-Through Subsidiaries of a Tested Foreign Corporation and the associated stock and debt receivables. Similarly, stock and debt investments in a lower-tier Look-Through Subsidiary are eliminated for purposes of applying the Income Test and Asset Test to the Tested Foreign Corporation. In the case of a Tested Foreign Corporation that owns less than 100 percent of a Look-Through Subsidiary, the proposed regulations provide that while stock and dividends are eliminated in their entirety, eliminations of debt receivables and interest are made in proportion to the shareholder's direct and indirect ownership (by value) in the Look-Through Subsidiary. The proposed regulations also provide for eliminations under these principles for ownership interests in a Look-Through Partnership, as well as intercompany debt receivables and interest paid or accrued thereon between a Tested Foreign Corporation and a Look-Through Partnership. See proposed § 1.1297-2(c)(3). Comments are requested on the application of the elimination rule if the Tested Foreign Corporation owns less than 100 percent of the Look-Through Subsidiary or Partnership. Comments are also requested as to whether the Treasury Department and the IRS should consider the elimination of rents, royalties, or any other types of intercompany income, and any related assets, and if so, how to effectuate the elimination.

4. Section 1297(b)(2)(C) Related Person Determination With Respect to Interest, Dividends, Rents, and Royalties Received by Look-Through Subsidiaries and Certain Partnerships

Section 1297(c) provides that a Tested Foreign Corporation is treated as receiving directly its proportionate share of the income of a Look-Through Subsidiary for purposes of applying the Income Test to the Tested Foreign Corporation. Section 1297(b)(2)(C) provides that, for purposes of the Income Test, 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 the related person that is not passive income. The statute and current regulations do not address the level at which the “related person” determination is made if a Look-Through Subsidiary receives or accrues an item of income that is treated as directly received by a Tested Foreign Corporation pursuant to section 1297(c). Thus, the interaction and application of the two rules is unclear in cases in which the payor of an item of income is a “related person” with respect to either the Look-Through Subsidiary or the Tested Foreign Corporation, but not with respect to both.

The Treasury Department and the IRS have determined that, because section 1297(c) generally applies by classifying an item at the level of Look-Through Subsidiary and then carrying that classification up to the Tested Foreign Corporation, it is appropriate to determine whether the section 1297(b)(2)(C) exception applies (and, thus, determine the passive or non-passive character of an item of income) at the Look-Through Subsidiary level, and then flow up the passive or non-passive character of the item to the Tested Foreign Corporation for purposes of applying the Income Test. Accordingly, proposed § 1.1297-2(d)(1) provides that, in applying section 1297(b)(2)(C), “related person” status is tested with respect to the payor of the item of income and the Look-Through Subsidiary. The same rule applies for items of income received by a partnership and treated as received directly by a Tested Foreign Corporation pursuant to proposed § 1.1297-1(c)(2). The Treasury Department and the IRS welcome comments on these rules.

5. Attribution of Activities of a Look-Through Subsidiary and Certain Partnerships

The interaction of section 1297(c) and certain exceptions from passive income also raises issues that require a threshold determination of whether an exception should apply at a Look-Through Subsidiary level or a Tested Foreign Corporation level. For instance, under proposed § 1.1296-4 in the notice of proposed rulemaking (INTL-0065-93) published in the Federal Register (60 FR 20922) on April 28, 1995, the banking exception in section 1297(b)(2)(A) applies only if a number of requirements are satisfied, including a deposit taking requirement, a lending requirement, and a license requirement. See proposed § 1.1296-4. In a bank holding company structure, in which a Tested Foreign Corporation wholly owns a Look-Through Subsidiary that separately satisfies the section 1297(b)(2)(A) requirements, the banking exception would apply to the income derived by the Look-Through Subsidiary in its banking business if an approach that applied the exception at the Look-Through Subsidiary level were adopted, but would not apply if an approach that applied the exception at the Tested Foreign Corporation level were adopted because the Tested Foreign Corporation would not literally meet all of the banking exception requirements. Similarly, the character of assets held by a Look-Through Subsidiary that is a dealer in property in the ordinary course of its trade or business as a dealer would depend on whether an approach that applied the exception in section 954(c)(2)(C) at the Look-Through Subsidiary level were adopted, or whether an approach were applied that determined the character at the level of a Tested Foreign Corporation that was not itself a dealer.

A corollary issue arises with respect to the application of other exceptions to passive income under section 954(c). For instance, under § 1.954-2(c)(1)(ii), the active rental income exception in section 954(c)(2)(A) applies if certain activities are performed with respect to real property by the lessor's own employees. In a structure in which a Tested Foreign Corporation holds real estate assets directly and employees of its Look-Through Subsidiary conduct the activities related to the Tested Foreign Corporation's real estate business necessary to satisfy the exception, the exception would apply if the character of the income were determined at the level of the Tested Foreign Corporation and the activities of the managers and employees of the Look-Through Subsidiary were attributed to the Tested Foreign Corporation. However, the exception would not apply if the activities were not attributed to the Tested Foreign Corporation, because in such case the relevant activities are not performed by employees of the Tested Foreign Corporation, as literally required in the regulation. Additional complexities arise when the Tested Foreign Corporation owns less than 100 percent of the Look-Through Subsidiary.

Under current law, the character of income or assets is determined at the level of the entity that directly earns the income or holds the assets based on the activities of that entity. However, the Treasury Department and the IRS understand that active businesses in foreign jurisdictions generating rent and royalty income are often organized with assets and income, on the one hand, and activities, on the other hand, contained in separate entities for various business reasons. The Treasury Department and the IRS have determined that if assets are held and activities undertaken in separate entities within a group of wholly-owned Look-Through Subsidiaries headed by a Tested Foreign Corporation, the activities of the Look-Through Subsidiaries should be taken into account for purposes of determining whether an item of rent or royalty income of the Tested Foreign Corporation is passive income, as they would if the Look-Through Subsidiaries were disregarded as separate from the Tested Foreign Corporation for U.S. Federal income tax purposes.

Accordingly, the proposed regulations provide that an item of rent or royalty income received or accrued by a Tested Foreign Corporation (or treated as received or accrued by the Tested Foreign Corporation pursuant to section 1297(c)) that would otherwise be passive income under the general rule is not passive income for purposes of section 1297 if the item would be excluded from passive income, determined by taking into account the activities performed by the officers and employees of the Tested Foreign Corporation as well as activities performed by the officers and employees of certain Look-Through Subsidiaries and certain partnerships in which the Tested Foreign Corporation or one of the Look-Through Subsidiaries is a partner. See proposed § 1.1297-2(e)(1). In some cases, a Look-Through Subsidiary or Look-Through Partnership may have more than one unrelated owner owning at least 25 percent of the entity's value. Activities, unlike income or expense, are qualitative in nature and cannot be easily allocated between owners based on their percentage ownership. If activities are attributed to any owner of 25 percent or more of the Look-Through Subsidiary or partnership, then up to four owners could potentially be able to take into account the same activities. Because it may be difficult to allocate activities among multiple entities but inappropriate to allow double-counting of the activities by attributing the activities of a Look-Through Subsidiary or a partnership to multiple unrelated entities, the proposed regulations provide that a Tested Foreign Corporation may take into account the activities performed only by those Look-Through Subsidiaries or partnerships with respect to which the Tested Foreign Corporation owns (directly or indirectly) more than 50 percent of the value, because at this level of ownership the activities of the Look-Through Subsidiary or Look-Through Partnership could be attributed to only another foreign corporation within the same chain of ownership as the Tested Foreign Corporation and not an unrelated entity.

The Treasury Department and the IRS request comments on the application of the activity attribution rules to Look-Through Subsidiaries that are not wholly owned by a Tested Foreign Corporation, including whether it is appropriate for a Tested Foreign Corporation to take into account all activities of a Look-Through Subsidiary in which the Tested Foreign Corporation owns more than 50 percent of the value of the stock, and whether a different ownership threshold for attribution of activities would be appropriate.

The Treasury Department and the IRS also request comments on whether the ability to apply an exception to passive income at the Tested Foreign Corporation level taking into account the activities of certain subsidiaries should apply for purposes of other exceptions, such as for purposes of the exception in section 1297(b)(2)(A). Comments should consider the interaction of the rules for elimination of intercompany assets and income described in Part I.F.3 of this Explanation of Provisions with the rules for taking into account the activities of certain Look-Through Subsidiaries and Look-Through Partnerships.

6. Gain on the Disposition of Stock of a Look-Through Subsidiary

Section 1297(c) does not address the treatment of a Tested Foreign Corporation's gain from the disposition of stock of a Look-Through Subsidiary for purposes of the Income Test. Questions have been raised as to whether such a disposition should be treated as a disposition of stock or a deemed disposition of the assets of the Look-Through Subsidiary, and how gain on the disposition should be characterized for purposes of the Income Test.

The proposed regulations provide that, for purposes of the Income Test, the disposition of a Look-Through Subsidiary is treated as the disposition of stock, and gain is computed accordingly. However, the proposed regulations limit the amount of the gain taken into account for purposes of the Income Test in order to avoid double-counting any income that the Tested Foreign Corporation takes into account under section 1297(c) in determining the PFIC status of the Tested Foreign Corporation during the year of the disposition or took into account for such purpose in a prior year that has not been distributed as a dividend to the Tested Foreign Corporation. Thus, the amount of gain taken into account for purposes of the Income Test (“Residual Gain”) is equal to the total gain recognized by the Tested Foreign Corporation on the disposition, reduced (but not below zero) by the amount (if any) by which (A) the aggregate income (if any) of the Look-Through Subsidiary (and any other Look-Through Subsidiary, to the extent stock in such other Look-Through Subsidiary is owned indirectly through the Look-Through Subsidiary) taken into account by the Tested Foreign Corporation under section 1297(c)(2) with respect to the disposed Look-Through Subsidiary stock exceeds (B) the aggregate dividends (if any) received by the Tested Foreign Corporation from the Look-Through Subsidiary with respect to the disposed stock (including dividends attributable to stock of any other Look-Through Subsidiary owned indirectly through the Look-Through Subsidiary). The Residual Gain is computed on a share-by-share basis with respect to income of a Look-Through Subsidiary that was taken into account by the Tested Foreign Corporation and dividends received from a Look-Through Subsidiary. See proposed § 1.1297-2(f)(1). Comments are requested on the calculation of Residual Gain for purposes of section 1297(a).

Gain from the disposition of stock generally is treated as FPHCI under section 954(c)(1)(B)(i). However, section 954(c) does not contain a look-through rule comparable to section 1297(c). In order to comport with the policy underlying section 1297(c), the Treasury Department and the IRS have determined that the character of the gain from the disposition of a Look-Through Subsidiary should correspond to the character of the underlying assets of the Look-Through Subsidiary. Accordingly, proposed § 1.1297-2(f)(2) provides that the Residual Gain taken into account by the Tested Foreign Corporation will be characterized as passive income or non-passive income in proportion to the passive assets and non-passive assets of the disposed-of Look-Through Subsidiary (and any other Look-Through Subsidiary, to the extent owned indirectly through the Look-Through Subsidiary) treated as held by the Tested Foreign Corporation pursuant to section 1297(c) on the date of the disposition, measured using the method (value or adjusted bases) that is used to measure the assets of the Tested Foreign Corporation for purposes of the Asset Test.

Pursuant to proposed § 1.1297-1(c)(1)(i)(C), section 954(c)(4) applies with respect to the disposition of interests in a Look-Through Partnership. Comments are requested concerning whether any additional guidance is needed concerning the disposition of interests in a Look-Through Partnership.

G. Change-of-Business Exception (Including Dispositions of Stock of a Look-Through Subsidiary)

Section 1298(b)(3) provides an exception from PFIC status (the “Change-of-Business Exception”) for a Tested Foreign Corporation that is “in transition from one active business to another active business.” H.R. Rep. No. 99-841, at II-644 (1986) (Conf. Rep.). Under section 1298(b)(3), the Change-of-Business Exception applies for a taxable year of the Tested Foreign Corporation if (i) neither the Tested Foreign Corporation nor a predecessor of the Tested Foreign Corporation was a PFIC in a prior taxable year; (ii) it is established to the satisfaction of the Secretary that (A) substantially all of the passive income of the Tested Foreign Corporation for the taxable year is attributable to proceeds from the disposition of one or more active trades or businesses, and (B) the Tested Foreign Corporation will not be a PFIC for either of the two taxable years following such taxable year; and (iii) the Tested Foreign Corporation is not, in fact, a PFIC for either of such two taxable years. Thus, notwithstanding the legislative history and the title of section 1298(b)(3), a Tested Foreign Corporation may qualify for the Change-of-Business Exception even if it does not engage in an active business after a disposition.

The proposed regulations provide general guidance with respect to the Change-of-Business Exception. First, the proposed regulations provide that for purposes of section 1298(b)(3)(B), the existence of an active trade or business and the determination of whether assets are used in an active trade or business is determined by reference to Treas. Reg. § 1.367(a)-2(d)(2), (3), and (5), except that officers and employees do not include the officers and employees of related entities as provided in § 1.367(a)-2(d)(3). See proposed § 1.1298-2(c)(3). If, however, the activity attribution rules described in Part I.F.5 of this Explanation of Provisions or section 954(h)(3)(E) would apply to cause the activities of another entity to be taken into account, they are taken into account for purposes of determining the applicability of the Change-of-Business Exception. Id. In addition, the proposed regulations provide that income attributable to proceeds from the disposition of an active trade or business means income earned on investment of such proceeds but does not include the proceeds themselves. See proposed § 1.1298-2(c)(1). The regulations also provide that section 1298(b)(3) may apply to either a taxable year of the disposition of the active trade or business or the immediately succeeding taxable year, but in any event may apply to only one year with respect to a disposition. See proposed § 1.1298-2(e). Thus, a Tested Foreign Corporation that receives proceeds from a disposition in more than one taxable year may apply the Change-of-Business Exception to only one year. A Tested Foreign Corporation can choose which year it applies the Change-of-Business Exception if the exception can apply in more than one year.

Several comments have inquired regarding the application of the Change-of-Business Exception to the sale or exchange of stock of a Look-Through Subsidiary that conducts an active trade or business. Specifically, these comments have questioned whether, by reason of section 1297(c), the Tested Foreign Corporation should be treated as disposing of an active trade or business conducted by a Look-Through Subsidiary for purposes of the Change-of-Business Exception. The Treasury Department and the IRS have determined that, given that section 1297(c) applies “for purposes of determining whether [a] foreign corporation is a [PFIC],” the Change-of-Business Exception should, in appropriate circumstances, apply to a Tested Foreign Corporation's disposition of its interest in a Look-Through Subsidiary that is engaged in an active trade or business. Thus, the proposed regulations provide that, for purposes of the Change-of-Business Exception, a disposition of stock of a Look-Through Subsidiary is treated as a disposition of a proportionate share of the assets held by the Look-Through Subsidiary on the date of the disposition. See proposed § 1.1298-2(d). Therefore, the portion of the proceeds attributable to assets used by a Look-Through Subsidiary in an active trade or business is considered for purposes of the Change-of-Business Exception to be proceeds from the disposition of an active trade or business.

The Treasury Department and the IRS also understand that Tested Foreign Corporations may not be able to satisfy the requirements of the Change-of-Business Exception provided in section 1298(b)(3) in certain situations in which proceeds from the disposition of an active trade or business cause the Tested Foreign Corporation to qualify as a PFIC pursuant to the Asset Test. The Treasury Department and the IRS have determined that if a Tested Foreign Corporation has historically engaged in an active trade or business and proceeds from the disposition of such business cause it to qualify as a PFIC, it may be appropriate in certain circumstances to which section 1298(b)(3) does not apply to treat the Tested Foreign Corporation as not a PFIC. Accordingly, the proposed regulations expand the Change-of-Business Exception in section 1298(b)(3) to apply if, on the measuring dates that occur during the taxable year to which the Change-of-Business Exception is proposed to apply and after the disposition, on average, substantially all of the passive assets of a corporation are attributable to proceeds from the disposition of one or more active trades or businesses. See proposed § 1.1298-2(b)(2)(ii).

Furthermore, the Treasury Department and the IRS understand that in certain circumstances, the Change-of-Business Exception could apply to the liquidation of a Tested Foreign Corporation if it were not for the fact that foreign law restrictions make it difficult to complete the liquidation within the year for which the exception applies. The Treasury Department and the IRS have determined that it is appropriate to allow the Change-of-Business Exception to be relied upon when such a liquidation is completed within a reasonable period of time after the disposition. Accordingly, in the case of a corporation, substantially all of the passive assets of which are attributable to proceeds from the disposition of one or more active trades or businesses, proposed § 1.1298-2(c)(4) provides that a Tested Foreign Corporation will be deemed to satisfy the requirement that the Tested Foreign Corporation not be a PFIC for the two years following the year for which it relies on the Change-of-Business Exception if it completely liquidates by the end of the year following the year for which it relies on the Change-of-Business Exception. U.S. Federal income tax principles apply to determine whether a Tested Foreign Corporation has completely liquidated. See Rev. Rul. 54-518, 1954-2 C.B. 142 (concluding that if a corporation ceases business operations, has retained no assets, and has no income, the mere retention of a charter does not prevent it from being treated as completely liquidated).

The Treasury Department and the IRS request comments concerning whether any other guidance is necessary concerning the application of section 1298(b)(3), including concerning the conditions under which the requirements of section 1298(b)(3)(C) will be considered satisfied.

H. Domestic Subsidiary Stock Rule

As discussed in Part I.F.2 of this Explanation of Provisions, section 1298(b)(7) provides a special characterization rule that applies if a Tested Foreign Corporation owns at least 25 percent of the value of the stock of a domestic corporation and is subject to the accumulated earnings tax under section 531 (or waives any benefit under a treaty that would otherwise prevent imposition of such tax). The proposed regulations clarify that stock of the 25-percent-owned domestic corporation and the qualified stock generally must be owned by the Tested Foreign Corporation and the 25-percent-owned domestic corporation, respectively, either directly or indirectly through one or more partnerships. See proposed § 1.1298-4(b)(1) and (c).

The Treasury Department and the IRS have determined that the accumulated earnings tax need not actually be imposed on a foreign corporation in a taxable year in order for it to qualify for section 1298(b)(7). Furthermore, a Tested Foreign Corporation's ability to rely on section 1298(b)(7) in a given year should not depend on whether it has U.S. source income in that year, as it would if § 1.532-1(c) applied to determine whether the Tested Foreign Corporation was subject to tax under section 531. Accordingly, the regulations provide that a Tested Foreign Corporation is considered subject to the tax imposed by section 531 for purposes of section 1298(b)(7) regardless of whether the tax actually is imposed on the corporation and regardless of whether the requirements of § 1.532-1(c) are met. See proposed § 1.1298-4(d)(1). Additionally, comments have raised questions concerning the waiver of treaty benefits that would prevent imposition of the accumulated earnings tax. The proposed regulations provide that a Tested Foreign Corporation must waive any benefit under a treaty by attaching to its U.S. Federal income tax return for the taxable year for which it applies section 1298(b)(7) a statement that it irrevocably waives treaty protection against the imposition of the accumulated earnings tax, effective for all prior, current, and future taxable years. See proposed § 1.1298-4(d)(2)(i). If a Tested Foreign Corporation is not otherwise required to file a U.S. Federal income tax return, the waiver can be made in a resolution (or other governance document) to be kept in the entity's records or, in the case of a publicly traded corporation, in a statement in the corporation's public filings. See proposed § 1.1298-4(d)(2)(ii).

The Treasury Department and the IRS understand that foreign corporations may be relying on section 1298(b)(7) to avoid being treated as PFICs notwithstanding their direct and indirect ownership of predominantly passive assets by ensuring that a sufficient amount of such assets are held indirectly through two tiers of domestic subsidiaries. For example, a Tested Foreign Corporation might hold stock of another foreign corporation that is PFIC, but rely on a two-tiered domestic chain holding passive assets to avoid being treated as a PFIC; as a result, a United States person holding stock of the Tested Foreign Corporation would generally not be treated as a shareholder of the PFIC stock owned by the Tested Foreign Corporation. Accordingly, the proposed regulations provide that, notwithstanding the general coordination rule between section 1297(c) and section 1298(b)(7) in proposed § 1.1297-2(b)(2)(iii), section 1298(b)(7) does not apply for purposes of determining if a foreign corporation is a PFIC for purposes of the ownership attribution rules in section 1298(a)(2) and Treas. Reg. § 1.1291-1(b)(8)(ii). See proposed § 1.1298-4(e). Thus, if a Tested Foreign Corporation would qualify as a PFIC if section 1298(b)(7) did not apply, either because section 1297(c) applied to treat the Tested Foreign Corporation as owning directly the assets of a domestic corporation in which it indirectly held qualified stock, or because the qualified stock was treated as a passive asset, then persons that held stock of a PFIC through the Tested Foreign Corporation would be considered under section 1298(a)(2)(B) and Treas. Reg. § 1.1291-1(b)(8)(ii)(B) to own a proportionate amount (by value) of the stock of the PFIC regardless of the level of their ownership interest in the Tested Foreign Corporation.

To address the possibility of passive assets—particularly non-stock assets that could not themselves be eligible for the special treatment of section 1298(b)(7)—being held through a two-tiered chain of domestic subsidiaries in order to avoid the PFIC rules, the proposed regulations further provide anti-abuse rules under the authority of section 1298(g), one of which provides that section 1298(b)(7) will not apply if the Tested Foreign Corporation would be a PFIC if the qualified stock or any income received or accrued with respect thereto were disregarded. See proposed § 1.1298-4(f)(1). Furthermore, under a second anti-abuse rule, section 1298(b)(7) will not apply if a principal purpose for the Tested Foreign Corporation's formation or acquisition of the 25-percent-owned domestic corporation is to avoid classification of the Tested Foreign Corporation 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. See proposed § 1.1298-4(f)(2). No inference is intended as to the application of section 1298(b)(7) under prior law. The IRS may, where appropriate, challenge transactions under the Code, regulatory provisions under prior law, or judicial doctrines. The Treasury Department and the IRS welcome comments on these rules.

II. PFIC Insurance Exception Rules

The proposed regulations provide guidance regarding whether the income of a foreign corporation is excluded from passive income pursuant to section 1297(b)(2)(B) because the income is derived in the active conduct of an insurance business by a QIC. Part II.A of this Explanation of Provisions describes the rules in proposed § 1.1297-4 for determining whether a foreign corporation is a QIC. Part II.B of this Explanation of Provisions describes the rules in proposed § 1.1297-5(c)(2) defining the term insurance business. Part II.C of this Explanation of Provisions describes the rules in proposed § 1.1297-5(c) regarding the active conduct of an insurance business. Part II.D of this Explanation of Provisions describes the rules in proposed § 1.1297-5(f) regarding the application of the section 1297(b)(2)(B) exception to items of income treated as received or accrued or assets treated as held by a QIC pursuant to section 1297(c). Part II.E of this Explanation of Provisions describes the rules in proposed § 1.1297-5(d) regarding the treatment of income and assets of certain domestic insurance corporations owned by a QIC as active for purposes of 1297(a). Part II.F of this Explanation of Provisions describes the rule in proposed § 1.1297-5(g) prohibiting the double counting of any item for purposes of proposed §§ 1.1297-4 and 1.1297-5.

A. QIC Status Requirement

Generally, section 1297(f) provides that a QIC is a foreign corporation that (1) would be subject to tax under subchapter L if it were a domestic corporation and (2) has applicable insurance liabilities that constitute more than 25 percent of its total assets. Proposed § 1.1297-4 provides guidance regarding the requirements under section 1297(f)(1) that a foreign corporation must satisfy to qualify as a QIC.

1. Insurance Company Requirement

Proposed § 1.1297-4(b)(1) provides guidance regarding when a foreign corporation would be the type of corporation that would be taxable under subchapter L (that is, an insurance company) if the corporation were a domestic corporation. See section 1297(f)(1)(A). It provides that a foreign corporation would be subject to tax under subchapter L if it were a domestic corporation if it is an insurance company as defined in section 816(a) (generally requiring more than half of the corporation's business during the taxable year to be the issuing of insurance or annuity contracts, or the reinsuring of risks underwritten by insurance companies).

2. 25 Percent Test

In addition to the insurance company requirement, generally a foreign corporation's “applicable insurance liabilities” (defined in section 1297(f)(3)(A) and proposed § 1.1297-4(f)(2)) must exceed 25 percent of its “total assets” (defined in proposed § 1.1297-4(f)(7) to be a QIC. Section 1297(f)(1)(B); see also proposed § 1.1297-4(c). This determination is made on the basis of the foreign corporation's liabilities and assets as reported on the corporation's applicable financial statement for the last year ending with or within the taxable year. This test hereinafter is referred to as the “25 percent test.” Proposed § 1.1297-4(c) provides guidance regarding the application of the 25 percent test.

3. Alternative Facts and Circumstance Test

If a foreign corporation fails the 25 percent test, section 1297(f)(2) permits a United States person to elect to treat stock in the corporation as stock of a QIC under certain circumstances. Specifically, to make the election, the foreign corporation must be predominantly engaged in an insurance business, and its applicable insurance liabilities must constitute 10 percent or more of its total assets, hereinafter the “10 percent test.” A United States person may only make this election if the foreign corporation fails the 25 percent test solely due to runoff-related or rating-related circumstances involving its insurance business, as further described in Part II.A.3.b of this Explanation of Provisions.

a. Predominantly Engaged in an Insurance Business

Proposed § 1.1297-4(d)(2) provides guidance regarding the circumstances under which a foreign corporation is predominantly engaged in an insurance business. In the case of a foreign corporation that fails the 25-percent test, Congress included the predominantly engaged requirement as part of the alternative facts and circumstances test to ascertain whether a foreign corporation is truly engaged in an insurance business despite the low ratio of applicable insurance liabilities to assets. See H.R. Rep. No. 115-466, at 671 (2017) (Conf. Rep.) (“Facts and circumstances that tend to show the firm may not be predominantly engaged in an insurance business include a small number of insured risks with low likelihood but large potential costs; workers focused to a greater degree on investment activities than underwriting activities; and low loss exposure. Additional relevant facts for determining whether the foreign corporation is predominantly engaged in an insurance business include: Claims payment patterns for the current year and prior years; the foreign corporation's loss exposure as calculated for a regulator or for a rating agency, or if those are not calculated, for internal pricing purposes; the percentage of gross receipts constituting premiums for the current and prior years; and the number and size of insurance contracts issued or taken on through reinsurance by the foreign corporation. The fact that a foreign corporation has been holding itself out as an insurer for a long period is not determinative either way.”). The proposed regulations clarify that each of these factors is intended to be tested based on whether the particular facts and circumstances of the foreign corporation are comparable to commercial insurance arrangements providing similar lines of coverage to unrelated parties in arm's length transactions.

As noted in Part II.A.1 of this Explanation of Provisions, to qualify as an insurance company, more than one half of a corporation's business must be the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. See sections 816(a) and 831(c). Although such a corporation might otherwise be considered to be “predominantly engaged” in an insurance business (where predominantly means “for the most part”), the predominantly engaged requirement of the alternative facts and circumstances test in section 1297(f) is separate from, and in addition to, the requirement that a corporation would be subject to tax under subchapter L if the foreign corporation were a domestic corporation. Therefore, in order to give effect to this predominantly engaged requirement, proposed § 1.1297-4(d)(2) incorporates the specific factors enumerated in the legislative history as a part of a foreign corporation's analysis of whether it is predominantly engaged in an insurance business under the alternative facts and circumstances test, while retaining the requirement that “more than half” of the business be of a certain type, because the foreign corporation must separately satisfy that threshold with respect to the character of its insurance business under section 1297(f)(1)(A).

The Treasury Department and the IRS request comments regarding whether this proposed test appropriately determines whether a foreign corporation is predominantly engaged in an insurance business and invite comments on whether the proposed test would have material effects upon the way in which entities engaged in the provision of insurance are structured.

b. Runoff-Related or Rating-Related Circumstances

To qualify for the alternative facts and circumstances test, proposed § 1.1297-4(d)(3) and (4) clarify the circumstances under which a foreign corporation fails to satisfy the 25 percent test solely due to runoff-related or rating-related circumstances involving its insurance business.

Proposed § 1.1297-4(d)(3) provides that runoff-related circumstances occur when a corporation has adopted a plan of liquidation or termination of operations under the supervision of its applicable insurance regulatory body. Additionally, the corporation may not issue or enter into any new insurance, annuity, or reinsurance contracts during the taxable year (other than contractually obligated renewals of existing insurance contracts or reinsurance contracts pursuant to and consistent with the corporation's plan of liquidation or termination of operations) and must make payments during the annual reporting period covered by the applicable financial statement to satisfy the claims under insurance, annuity, or reinsurance contracts issued or entered into before the corporation ceased entering into new business.

Proposed § 1.1297-4(d)(4) provides that rating-related circumstances occur when a generally recognized credit rating agency requires a foreign corporation to maintain a surplus of capital to receive or maintain a minimum credit rating for the foreign corporation to be classified as secure to write new insurance business for the current year. The Treasury Department and the IRS understand that it is possible that the minimum credit rating required to be classified as secure to write new insurance business may be higher for some lines of insurance business than for other lines of insurance business. For this purpose, the proposed rule is intended to apply to the highest minimum credit rating required to be classified as secure to write new insurance business for any line of insurance business.

The Treasury Department and the IRS understand that there may be certain lines of insurance business, such as financial guaranty insurance, where market realities require a credit rating in excess of the minimum credit rating for a foreign corporation to be classified as secure to write new insurance business in the relevant business line for the current year. The Treasury Department and the IRS request comments regarding this fact pattern and how best to address these lines of business in the context of the rating-related circumstances test.

c. Election To Apply the Alternative Facts and Circumstances Test

Proposed § 1.1297-4(d)(5)(i) generally requires that the foreign corporation with respect to which the election is made directly provide the United States person a statement or make a publicly available statement (such as in a public filing, disclosure statement, or other notice provided to United States persons that are shareholders of the foreign corporation) that it satisfied the requirements of section 1297(f)(2) and § 1.1297-4(d)(1) during the foreign corporation's taxable year and certain information relevant to that statement. A United States person, however, may not rely upon any statement by the foreign corporation to make the election under section 1297(f)(2) if the shareholder knows or has reason to know that the statement made by the foreign corporation was incorrect. Because the foreign corporation possesses the information necessary to make an election under the alternative facts and circumstances test, the Treasury Department and the IRS have determined that it is appropriate to require a United States person to obtain that information from the foreign corporation in order to make the election. Comments are requested regarding the form and content of the statement provided by the foreign corporation to United States persons as set forth in proposed § 1.1297-4(d)(5)(i)-(ii), and whether there are alternative ways of satisfying the requirements of 1297(f)(2).

Proposed § 1.1297-4(d)(5)(iii) describes the time and manner for making the election. To make the election before final regulations are published, a United States person that owns stock of a foreign corporation electing to treat that stock as stock of a QIC under the alternative facts and circumstances test must file a limited-information Form 8621 (or successor form). For this purpose, a United States person must file a Form 8621 with the box checked regarding the QIC election and must provide the identifying information of the shareholder and the foreign corporation. The United States person is not required to complete any other part of Form 8621 if that person is only filing the Form 8621 to make the QIC election under the alternative facts and circumstances test.

The Treasury Department and the IRS request comments on ways to reduce burden on small shareholders with respect to the alternative facts and circumstances test.

4. Limitations on the Amount of Applicable Insurance Liabilities

When applying the 25 percent test to a foreign corporation, section 1297(f)(3)(B) provides that the amount of the foreign corporation's applicable insurance liabilities cannot exceed the lesser of (i) the amount that the foreign corporation reported to its “applicable insurance regulatory body” (defined in section 1297(f)(4)(B) and proposed § 1.1297-4(f)(3)), (ii) the amount required by applicable law or regulation, or (iii) the amount determined under regulations prescribed by the Treasury Department and the IRS.

Proposed § 1.1297-4(e) provides additional guidance regarding the limitation on the amount of applicable insurance liabilities for purposes of the 25 percent test and the 10 percent test. Specifically, the proposed regulations provide that the amount of applicable insurance liabilities may not exceed the lesser of (1) the amount shown on the most recent applicable financial statement; (2) the minimum amount required by applicable law or regulation of the jurisdiction of the applicable insurance regulatory body; and (3) the amount shown on the most recent financial statement made on the basis of U.S. generally accepted accounting principles (“US GAAP”) or international financial reporting standards (“IFRS”) if such financial statement was not prepared for financial reporting purposes. The Treasury Department and the IRS have determined that the additional limitations are necessary to clarify which financial statements are used to apply the 25 percent test and the 10 percent test, and that it is appropriate to limit the amount of applicable insurance liabilities to the minimum amount of liabilities required to be reported by an insurance regulator, even if the foreign corporation's regulator would accept a higher liability amount for regulatory purposes. In addition, under section 1297(f)(4), an applicable financial statement only includes financial statements made on the basis of US GAAP or IFRS if such a statement has been prepared for financial reporting purposes. If a foreign corporation prepares a financial statement on the basis of US GAAP or IFRS for a purpose other than financial reporting, the Treasury Department and the IRS have determined that the amount of applicable insurance liabilities under this financial statement, if lower than the amount on the applicable financial statement, is an appropriate limit on the amount of applicable insurance liabilities. This limitation is appropriate because Congress has expressed a preference for widely used standards of financial accounting through its references to such standards in section 1297(f)(4)(A).

Under the proposed regulations, a special rule applies with respect to applicable financial statements that are neither prepared under US GAAP nor IFRS. To the extent that such an applicable financial statement does not discount losses on an economically reasonable basis, the foreign corporation must reduce its applicable insurance liabilities to reflect discounting that would apply under either US GAAP or IFRS. The Treasury Department and the IRS have determined that a method of determining insurance liabilities that fails to provide for a reasonable discounting rate does not take into account a factor that is necessary to appropriately and accurately report the amount of applicable insurance liabilities. For this purpose, the question of whether losses are discounted on an economically reasonable basis is determined under the relevant facts and circumstances. However, in order for losses to be discounted on an economically reasonable basis, discounting must be based on loss and claim payment patterns for either the foreign corporation or insurance companies in similar lines of insurance business. In addition, a discount rate based on these loss and claim payment patterns of at least the risk free rate in U.S. dollars or in a foreign currency in which the foreign corporation conducts some or all of its insurance business must be used. A loss discounting methodology consistent with that used for US GAAP or IFRS purposes is considered reasonable for this purpose.

Finally, a special rule applies for certain foreign corporations that change their method of preparing their applicable financial statement by ceasing to prepare this statement under either US GAAP or IFRS and have no non-Federal tax business purpose for preparing a statement that is not consistent with US GAAP or IFRS. Under the proposed regulations, absent a non-Federal Tax business purpose, a foreign corporation must continue to prepare its applicable financial statement under either US GAAP or IFRS. If the foreign corporation fails to do so, the foreign corporation will be treated as having no applicable insurance liabilities for purposes of the QIC test. Absent this proposed rule, the Treasury Department and the IRS are concerned that a foreign corporation may change its method for preparing its financial statement to benefit from certain elements of a local regulatory accounting regime, such as a more expansive definition of insurance liability or a method of calculating a larger amount of insurance liabilities, solely for purposes of qualifying as a QIC. Comments are requested on this proposed rule.

B. Insurance Business

For purposes of the PFIC insurance exception, proposed § 1.1297-5(c)(2) defines an insurance business as the business of issuing insurance and annuity contracts or reinsuring risks underwritten by other insurance companies (or both). Under the proposed regulations, an insurance business also includes the investment activities and administrative services required to support (or that are substantially related to) those insurance, annuity, or reinsurance contracts issued or entered into by the QIC. Proposed § 1.1297-5(h)(2) provides that investment activities are any activities that generate income from assets that a QIC holds to meet its obligations under insurance and annuity contracts issued or reinsured by the QIC.

C. Active Conduct

To give effect to the active conduct requirement, the 2015 proposed regulations differentiated between activities performed by a corporation through its officers and employees and activities performed by other persons (for example, employees of other entities or independent contractors) for the corporation. The 2015 proposed regulations accomplished this separation by defining the term “active conduct” in section 1297(b)(2)(B) to have the same meaning as in § 1.367(a)-2T(b)(3) (now § 1.367(a)-2(d)(3)), except that officers and employees would not have included the officers and employees of related entities. Hence, under the 2015 proposed regulations, only insurance investment business activities performed by a corporation's officers and employees would be included in the corporation's active conduct of its insurance business. Accordingly, under the 2015 proposed regulations, investment income would have qualified for the PFIC insurance exception only if the corporation's own officers and employees performed the insurance business activities that produce the income.

Proposed § 1.1297-5(c)(3)(i) provides that the term active conduct is based on all of the facts and circumstances and that, in general, a QIC actively conducts an insurance business only if the officers and employees of the QIC carry out substantial managerial and operational activities. For this purpose, active conduct is intended to be interpreted consistently with the active conduct standard in § 1.367(a)-2(d)(5). The proposed regulation further provides that a QIC's officers and employees are considered to include the officers and employees of another corporation if the QIC satisfies the control test set forth in proposed § 1.1297-5(c)(3)(ii). Generally, to satisfy the control test, (i) the QIC must either own, directly or indirectly more than 50 percent of the vote and value (for a corporation) or capital and profits interest (for a partnership) of the entity whose officers or employees are performing services for the QIC or (ii) a common parent must own, directly or indirectly, more than 80 percent of the vote and value or capital and profits interest of both the QIC and the entity performing services for the QIC. In addition, the QIC must exercise regular oversight and supervision over the services performed by the other entity's officers and employees for the QIC. The QIC must also either (i) pay directly all the compensation of the other entity's officers and employees attributable to services performed for the QIC for the production or acquisition of premiums and investment income on assets held to meet obligations under insurance, annuity, or reinsurance contracts issued or entered into by the QIC; (ii) reimburse the other entity for the portion of its expenses, including compensation and related expenses (determined in accordance with section 482, taking into account all expenses that would be included in the total services costs under § 1.482-9(j) and § 1.482-9(k)(2)) and add a profit markup, as appropriate, for these services performed for the QIC by the other entity's officers and employees; or (iii) otherwise pay arm's length compensation in accordance with section 482 on a fee-related basis to the other entity for the services provided to the QIC. For example, it is common to charge for investment advisory or management services via a fee calculated as a percentage of the underlying assets under management (AUM), and a fee calculated on this basis may be arm's length under section 482 principles.

Under proposed § 1.1297-5(c)(4), a QIC determines the annual amount of its income that is derived in the active conduct of an insurance business (the active conduct test) and excluded from passive income under section 1297(b)(2)(B) for purposes of section 1297(a). To make this determination, the QIC must determine its active conduct percentage.

If the QIC's active conduct percentage is greater than or equal to 50 percent, then all of the QIC's passive income (as defined in § 1.1297-1, taking into account the exceptions in section 1297(b)(2) other than section 1297(b)(2)(B) and § 1.1297-5) is excluded from passive income pursuant to the exception in section 1297(b)(2)(B) for the active conduct of an insurance business. If the QIC's active conduct percentage is less than 50 percent, then none of its income is excluded from passive income pursuant to the exception in section 1297(b)(2)(B) for the active conduct of an insurance business. In response to comments made to the 2015 proposed regulations, the active conduct percentage is based on the QIC's expenses to provide a bright-line test for measuring the QIC's active conduct. The Treasury Department and the IRS determined that the amount of expenses for insurance activities performed by the QIC (or by a related party) as compared to the total expenses of the QIC indicates the extent to which the QIC conducts the business itself and therefore, actively engages in an insurance business.

The Treasury Department and the IRS request comments on the following topics:

1. Whether the relative amount of expenses for insurance activities performed by the QIC accurately assesses whether a QIC is engaged in the active conduct of an insurance business.

2. The contours of the control test, which allow for a QIC to benefit from a higher active conduct percentage based on activities (paid for by the QIC) of an entity in which a common parent, but not the QIC itself, owns more than 80 percent of the interests. The Treasury Department and IRS propose this standard based on an understanding of common ownership structures in the insurance industry, and note that the attribution of activities described in Part I.F.5 of this Explanation of Provisions (regarding the active rent or royalty exception) is more limited as it provides that a Tested Foreign Corporation may take into account the activities performed only by those Look-Through Subsidiaries or partnerships with respect to which the Tested Foreign Corporation owns (directly or indirectly) more than 50 percent of the value.

3. The active conduct percentage calculation in general, including whether this test should be the only test for determining whether income is derived in the active conduct of an insurance business or whether such a percentage would better serve as an objective safe harbor alongside a facts and circumstances test.

D. Treatment of Income and Assets of Certain Look-Through Subsidiaries and Look-Through Partnerships Held by a QIC

Proposed § 1.1297-5(f) provides that certain items of income and assets that are passive in the hands of a look-through subsidiary or look-through partnership may be treated as active by a QIC. Under this provision, a Tested Foreign Corporation is treated as if it directly holds its proportionate share of the assets and as if it directly receives its proportionate share of the income of the Look-Through Subsidiary or Look-Through Partnership. Generally, if the income or assets are passive in the hands of the Look-Through Subsidiary or Look-Through Partnership, the income or assets are treated as passive income and passive assets of the Tested Foreign Corporation. However, if the Tested Foreign Corporation is a QIC, the income and assets are tested under section § 1.1297-5(c) and (e) to determine if they qualify for the section 1297(b)(2)(B) insurance exception to passive income. However, for this rule to apply, the Look-Through Subsidiary or Look-Through Partnership, as the case may be, must have its assets and liabilities included in the applicable financial statement of the foreign corporation for purposes of the 25 percent test and the 10 percent test. This rule does not change the character of the items of income or assets as passive income or passive assets to the Look-Through Subsidiary or Look-Through Partnership.

E. Qualifying Domestic Insurance Corporations

Proposed § 1.1297-5(d) provides that income of a qualifying domestic insurance corporation is not treated as passive income. Similarly, proposed § 1.1297-5(e)(2) provides that assets of a qualifying domestic insurance corporation are not treated as passive assets. A qualifying domestic insurance corporation is a domestic corporation that is subject to tax as an insurance company under subchapter L of chapter 1 of subtitle A of the Code and is subject to Federal income tax on its net income. This rule is intended to address situations where a Tested Foreign Corporation owns a domestic insurance corporation through a structure to which section 1298(b)(7) does not apply.

F. No Double Counting Rule

Proposed § 1.1297-5(g) provides that nothing in proposed § 1.1297-4 or § 1.1297-5 permits any item to be counted more than once (for example, for determining a reserve or an applicable insurance liability for purposes of the 25 percent test and the 10 percent test). Including this general principle is consistent with subchapter L provisions that do not allow double counting. For example, section 811(c)(2) provides that the same item may not be counted more than once for reserve purposes, section 811(c)(3) provides that no item may be deducted (either directly or as an increase in reserves) more than once, and section 832(d) prohibits the same item from being deducted more than once.

Applicability Dates

These regulations are proposed to apply to taxable years of United States persons that are shareholders in certain foreign corporations beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register. However, until these regulations are finalized, taxpayers may choose to apply these proposed regulations (other than the proposed regulations under §§ 1.1297-4 and 1.1297-5) in their entirety to all open tax years as if they were final regulations provided that taxpayers consistently apply the rules of these proposed regulations. Until finalization, United States persons that are shareholders in certain foreign corporations may apply the rules of §§ 1.1297-4 and 1.1297-5 for taxable years beginning after December 31, 2017, provided those United States persons consistently apply the rules of §§ 1.1297-4 and 1.1297-5 as if they were final regulations. In addition, taxpayers may continue to rely on Notice 88-22 until these regulations are finalized.

Special Analyses

I. Regulatory Planning and Review—Economic Analysis

Executive Orders 13771, 13563, and 12866 direct agencies to assess costs and benefits of available regulatory alternatives and, if regulation is necessary, to select regulatory approaches that maximize net benefits, including potential economic, environmental, public health and safety effects, distributive impacts, and equity. Executive Order 13563 emphasizes the importance of quantifying both costs and benefits, reducing costs, harmonizing rules, and promoting flexibility. The Executive Order 13771 designation for any final rule resulting from the proposed regulation will be informed by comments received. The preliminary Executive Order 13771 designation for this proposed rule is regulatory.

The proposed regulation has been designated by the Office of Information and Regulatory Affairs (OIRA) as significant under Executive Order 12866 pursuant to the Memorandum of Agreement (MOA, April 11, 2018) between the Treasury Department and the Office of Management and Budget regarding review of tax regulations.

A. Background

Various provisions of the tax code allow tax on certain sources of income to be deferred, which means that the income is not taxed when it is earned but at some later date, based on specific events or conditions. Tax deferral is advantageous to taxpayers because the taxpayer can in the meantime earn a return on the amount that would otherwise have been paid as tax. Prior to the Act, income earned abroad generally was not taxed until it was repatriated to the United States. After the Act, income earned abroad by a CFC is generally taxed immediately to the United States shareholders of the CFC, but income earned by foreign corporations that are not CFCs, particularly where the owners of the foreign corporations are individuals or other entities not eligible for the dividends received deduction under section 245A, may still be eligible for deferral. However, deferral is not available with respect to income of foreign corporations that earn primarily certain kinds of passive income, which in general includes dividends, interest, royalties, rents, and certain gains on the exchange of property, commodities, or foreign currency. Limiting deferral of foreign source income discourages U.S. taxpayers from holding mobile, passive investments, such as stock, in a foreign corporation in order to defer U.S. tax.

A particular set of rules limiting deferral applies to U.S. persons who own interests in passive foreign investment companies (“PFICs”). In general, a PFIC is a foreign corporation that, in a given year, has income that is 75 percent or more passive income or that owns, on average, assets that are 50 percent or more passive-income-producing. Taxpayers subject to another set of rules limiting deferral, the subpart F rules, are not subject to the PFIC rules.

Long-standing sections 1291 through 1298 provide rules regarding the tax treatment of income from PFICs. The PFIC itself is not subject to U.S. tax under the PFIC regime; rather, only the U.S. owner of the PFIC is required to determine whether he or she has invested in a PFIC, and if so, what tax is due as a result. The U.S. owner is responsible for getting the appropriate information from the foreign corporation to determine if the corporation is a PFIC.

Before its amendment by the Act, the PFIC provisions provided an exception from passive income for any income (including investment income) earned in the active conduct of an insurance business by a foreign corporation that (i) was predominantly engaged in an insurance business and (ii) would be taxed as an insurance company if it were a domestic corporation. Congress determined that this exception enabled U.S. owners of some foreign insurance companies to escape the PFIC regime. This exception, (the “PFIC insurance exception”), was established because insurance companies must hold significant amounts of investment assets (which generate income that would otherwise be classified as passive under the PFIC rules) in the normal course of business to fund obligations under the insurance contracts they issue. Staff, Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, JCS-10-87, at 1025 (1987); IRS, Corporate Income Tax Returns Complete Report, 2013, Table 1).

The Act modified and narrowed the PFIC insurance exception by requiring that the excepted income be derived in the active conduct of an insurance business by a “qualifying insurance corporation” (“QIC”). To be a QIC, a foreign insurance corporation must be an entity that would be taxed as an insurance company if it were a domestic corporation (consistent with prior-law requirements) and, in addition, be able to show that its “applicable insurance liabilities” constitute more than 25 percent of its total assets. The Act specifically defines applicable insurance liabilities for this purpose as including a set of enumerated types of insurance-related loss and expense items. Failing this test, the Code provides that U.S. owners of the foreign corporation may elect to treat their stock in the corporation as stock of a QIC, provided the corporation can satisfy an “alternative facts and circumstances test.” However, once a corporation has been identified as a QIC, only income that is derived in the active conduct of an insurance business qualifies as income eligible for the PFIC insurance exception.

Congress modified section 1297 under the Act out of concern that the active insurance company exception to the PFIC rules lacked clarity and precision. This lack of clarity with respect to how much insurance business the company must do to qualify under the exception raised concerns that certain companies with U.S. shareholders were structuring themselves to take advantage of the exception but conducting a token insurance business while focusing primarily on investment activities. Such strategies erode the U.S. tax base, and reflect inefficient investment incentives for U.S. taxpayers. As a result, the Act adopted a more formulaic rule that is easier to enforce and apply, while still allowing a facts and circumstances approach for showing insurance activity. See Senate Budget Explanation of the Bill (2017-11-20) at p. 397.

B. Need for the Proposed Regulations

The Treasury Department and the IRS view the Act modifications regarding PFIC determination as generally self-executing (although regulatory guidance is needed in order for U.S. owners to elect QIC status under the facts and circumstances test), which means that the statute is binding on taxpayers and the IRS without further regulatory action. The Treasury Department and the IRS recognize, however, that the statute provides interpretive latitude for taxpayers and the IRS that could, without further guidance, prompt inefficient investment patterns due to divergent interpretations. Consequently, many of the details behind the relevant terms and necessary calculations required for the determination of PFIC status would benefit from greater specificity. The proposed regulations provide details and specifics for the definitions and concepts described in sections 1291, 1297, and 1298 so that taxpayers can readily and accurately determine if their investment is in a PFIC, given the significant consequences of owning a PFIC, which may continue to be treated as such even after the foreign corporation ceases to satisfy the Income Test or Asset Test. See section 1298(b)(1). The regulations further resolve ambiguities in determining ownership of a PFIC and in the application of the Income Test and Asset Test under the statutory provisions that existed prior to the Act.

The Treasury Department and the IRS have also identified actions that foreign companies might take to qualify for QIC designation even though the nature of their active insurance business would not merit QIC designation under the intents and purposes of the statute. The proposed regulations are needed to avoid the inefficient economic decisions that would arise from those tax avoidance actions. For example, in the absence of the proposed regulations, taxpayers may be incentivized to adopt accounting methods that inappropriately inflate applicable insurance liabilities or exaggerate the degree to which income of a QIC is derived in the active conduct of an insurance business.

C. Overview of the Proposed Regulations

The proposed regulations can be divided into two parts. The rules described in Part I of the Explanation of Provisions section of this preamble provide general guidance regarding PFICs (the “General Rules”). See Part I.D.2 of this Special Analyses section. The rules described in Part II of the Explanation of Provisions section of this preamble relate specifically to the implementation of the PFIC insurance exception (the “PFIC Insurance Exception Rules”). See Part I.D.3 of this Special Analyses section. Among other things, the General Rules (1) describe and clarify how assets are measured for the asset test; and (2) clarify attribution rules for determining some forms of active income. The PFIC Insurance Exception Rules provide guidance regarding qualification for the PFIC insurance exception, define statutory terms relevant to QIC status, and provide instructions on electing QIC status under the alternative facts and circumstances test.

D. Economic Analysis

1. Baseline

The Treasury Department and the IRS have assessed the benefits and costs of the proposed regulations relative to a no-action baseline reflecting anticipated Federal income tax-related behavior in the absence of these proposed regulations.

2. Summary of Economic Effects

The proposed regulations provide certainty and consistency in the application of sections 1291, 1297, and 1298 with respect to PFICs and QICs by providing definitions and clarifications regarding the statute's terms and rules. In the absence of such guidance, the chances that different U.S. owners (or potential owners) of foreign companies would interpret the statute differentially, either from each other or from the intents and purposes of the statute, would be exacerbated. This divergence in interpretation could cause U.S. investors to choose investment vehicles based on different interpretations of, for example, whether particular income would avoid qualifying as passive income and thus avoid the less favorable tax treatment applied by the PFIC regime. If economic investment is not guided by uniform incentives across otherwise similar investors and across otherwise similar investments, the resulting pattern of investment is generally inefficient, conditional on the Code's provisions governing passive income.^[1] In the context of U.S. investment in foreign insurance corporations, the proposed regulations help to ensure that similar economic activities, representing similar passive and non-passive attributes, are taxed similarly. Thus, the Treasury Department and the IRS expect that the definitions and guidance provided in the proposed regulation will lead to an improved allocation of investment among taxpayers contingent on the overall Code.

The Treasury Department and the IRS have not quantified the expected economic benefits or the costs to the U.S. economy, or the scope of taxpayers benefitting from or burdened by the proposed regulations. The Treasury Department and the IRS request comment on these issues and particularly solicit comments that provide data, evidence, or models that would enhance the rigor by which the non-revenue economic effects might be determined and quantified for the final regulations.

The following sections describe the economic effects of specific major provisions of these proposed regulations relative to possible alternative provisions. The Treasury Department and IRS solicit comments on each of the items discussed subsequently and on any other provisions of the proposed regulations not discussed in this section. The Treasury Department and the IRS particularly solicit comments that provide data, other evidence, or models that could enhance the rigor of the process by which these or further provisions might be developed for the final regulations.

3. Economic Analysis of Specific Provisions of the General Rules

a. Averaging Period for the Asset Test

A foreign corporation is considered a PFIC if it satisfies either of the following tests: (i) 75 percent or more of the corporation's gross income for a taxable year is passive (“Income Test”); or (ii) the average percentage of assets held by the corporation during the year producing passive income is at least 50 percent (“Asset Test”). If a foreign corporation is a PFIC, the U.S. owner of the PFIC is subject to tax under the PFIC regime. Regarding the Asset Test, section 1297(e) provides rules for how to determine the value of assets using either the fair market value or the adjusted basis, but does not indicate what period should be used to determine the “average percentage.” Notice 88-22, which was issued following the enactment of the PFIC regime to provide guidance on a number of issues related to the Income and Asset Tests pending regulations, required taxpayers to determine value at the end of each quarter and average those numbers on an annual basis for the test. See Part I.D.1 of the Explanation of Provisions section of this preamble. Notice 88-22 announced the intention of the Treasury Department and IRS to issue regulations addressing this and other issues under the PFIC regime; however, no regulations addressing the Asset Test were issued until the proposed regulations.

To remedy this omission and specify the period over which the average percentage would be calculated, the Treasury Department and the IRS considered three alternatives: (i) Semi-annual measurement, (ii) quarterly measurement, and (iii) daily measurement.^[2] The Treasury Department and the IRS also considered, once a default measuring period was set, offering flexibility to shareholders to determine their own measurement period as long as the period was shorter than the default period. In each respective case, the Asset test would be based on the annual average of the semi-annual, quarterly, or daily asset values.

The first option, to require taxpayers to determine the average value of assets that produce passive income on a semi-annual basis, has lower costs than the other suggested approaches since calculations have to be done just twice a year and these costs (or cost-savings) are borne directly or indirectly by the owners of the corporation. The benefit of these lower costs to U.S. taxpayers must be balanced against the projected accuracy of semi-annual measurement. Because the period examined is long, semi-annual amounts are relatively easy for the corporation to manipulate so as to avoid having 50 percent or more passive-income producing assets as measured by value over the averaging period discussed here (the Asset Test) and therefore avoid PFIC treatment, even in cases where the company held significant amounts of passive-income-producing assets during the year.

The third option, to require taxpayers to average daily asset values for the asset test, provides a more exact measure of the assets of the company but the costs for the company to provide such information to their owners can be significant and some companies might choose not to provide such calculations to their small U.S. owners.^[3] On the other hand, daily measurement would make it costly for the entity to avoid PFIC determination by “removing” assets generating passive income at measurement times.

The proposed regulations, consistent with the second option, require at least quarterly measurement and further allow taxpayers to elect to use a shorter period, such as monthly or daily measurement of asset values. Shorter period alternatives (relative to a semi-annual period) curtail the ability of foreign corporations to avoid PFIC designation through asset management strategies that would be tax-driven rather than market-driven. The Treasury Department and the IRS project that the increase in compliance costs of quarterly measurement over semi-annual measurement would be minor, because quarterly measurement aligns with general accounting practices, and because many taxpayers were likely already relying on the provision in Notice 88-22 that provided for quarterly measurement. The election to choose monthly or daily measurement allows U.S. persons who own interests in foreign corporations to use even more precise measurement of asset holdings if, based on business-specific accounting practices and the availability of that information to the U.S. person, the U.S. person deems that any higher compliance costs they might incur are warranted.

The Treasury Department and IRS solicit comments on this proposal, particularly comments that provide data, other evidence, or models that could enhance the rigor of the process by which the average percentage period might be developed for the final regulations.

b. Attribution of Activities

For purposes of determining whether a corporation is a PFIC, section 1297(c) treats a foreign corporation (FC1) that owns 25 percent or more of another foreign corporation (FC2) as owning and earning the proportional amount of FC2's income and assets under the so called Look-Through Subsidiary rules.^[4] However, the statute is silent on whether the activities of FC2 can be attributed to FC1 for purposes of determining whether the income of FC1 qualifies as being treated as non-passive income. Under current practice, some businesses structure their organization for legal or commercial reasons to have all employees for a business in one corporation, say FC2, while the rents and royalties are received by FC1. Without attribution of activities, FC1 could not qualify for an exception that treats these rents and royalties as active, as opposed to passive, income. This could result in FC1 being treated as a PFIC even though, on the whole, its income and economic activities were related to active business operations and not comparable to the passive income generating activities generally undertaken by PFICs.

To address the attribution of activities in foreign businesses in structures similar to those described, the Treasury Department and the IRS considered three alternatives: (1) Do not allow any attribution of activities; (2) allow attribution of activities to multiple U.S. owners; or (3) allow attribution only if there is greater than a 50 percent ownership percentage; that is, if the foreign corporation owns more than 50 percent of the other foreign corporation.

Under the first alternative (no attribution), a foreign corporation that separated activities and income could satisfy the passive income exception only if it reorganized such that the entity being tested as a PFIC received both the active rents and royalties as well as had the employees that performed the related activities. This is potentially costly or even infeasible, depending on local requirements. The Treasury Department and the IRS determined that this alternative would potentially lead to costly reorganization, a cost that would either be passed on to U.S. investors or that, in the absence of such reorganization, would inhibit U.S. investment in a foreign corporation that was otherwise similar to corporations that were not PFICs. These are economically undesirable outcomes in light of the intents and purposes of the statute, relative to the proposed regulations.

Under the second alternative, activities could be attributed similarly to how the Look-Through Rule attributes income and assets. In general, because the Look-Through Rule requires ownership of only 25 percent of a foreign corporation in order to apply, the income and assets of a foreign corporation may be attributed to multiple owners. The statute specifies that this be done on a pro rata basis—for example, if a U.S. person owns 100 percent of foreign corporation (FC1) that owns 60 percent of FC2, 60 percent of the income and assets of FC2 could be attributed to FC1 for purposes of applying the Income and Asset tests, and 40 percent of the income and assets could be allocated to another shareholder of FC2. This alternative generates significant difficulties, however, in the context of attribution of activities. While income and assets can be allocated between owners based on percentage ownership, activities are not measured by a numerical amount and thus are not easily separated between two owners. 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). The Treasury Department and the IRS determined that potential double counting of activities could result in less tax revenue being raised than intended by Congress.

Under the third alternative, the activities of a foreign corporation could only be attributed to one shareholder. The proposed regulations adopt this third alternative, specifically by allowing attribution if there is an ownership percentage greater than 50 percent. Thus, where FC1 owns 60 percent of FC2 and another shareholder owns the remaining 40 percent, only FC1 could get credit for the activities of FC2 for purposes of applying the active rents and royalties test. No other shareholder of FC2 would qualify for attribution. The Treasury Department and the IRS project that this proposed regulation would 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 Department and the IRS solicit comments on this proposal and in particular solicit data, evidence, or models that could enhance the rigor of the process by which the ownership percentage might be developed for the final regulations.

c. Look-Through Partnerships

As discussed in Part I.D.3.b of this Special Analyses, for purposes of determining whether a corporation is a PFIC, section 1297(c) treats a foreign corporation (FC1) that owns 25 percent or more of another foreign corporation (FC2) as owning and earning the proportional amount of FC2's income and assets under the so called Look-Through Subsidiary rules. Absent this rule, any distributions from FC2 to FC1 would generally be treated as passive income to FC1 for purposes of the Income Test, and the stock of FC2 would generally be treated as a passive income-producing asset for purposes of the Asset Test. The statute does not provide any specific rule for the treatment of a partnership interest owned by a foreign corporation for purposes of determining whether the foreign corporation is a PFIC.

In order to provide guidance on the treatment of partnership interests owned by foreign corporations for purposes of the Income and Asset Tests, the Treasury Department and the IRS considered three principal alternative thresholds regarding when to treat the income and assets of a partnership as earned or held directly by the foreign corporation. These thresholds are: (1) Apply no threshold; (2) apply a 10 percent threshold; or (3) apply the same 25 percent ownership threshold to partnership interests as is applied to interests in corporations.

Under the first alternative, a proportionate share (based on the foreign corporation's capital or profits interest in the partnership) of the income and assets of the partnership would be considered as earned or held directly by the foreign corporation for purposes of determining whether the foreign corporation is a PFIC, no matter how much of the partnership was owned by the foreign corporation. A similar rule to this applies for purposes of the subpart F regime, and thus there could be benefits in applying consistent rules across the two regimes. However, the purpose of the Income and Asset Tests is to determine whether the foreign corporation has a primarily active or passive business. An ownership interest of less than 10 percent is unlikely to give the foreign corporation significant control over the partnership activities such that it represents an active business interest. Additionally, providing a lower threshold for partnership interests, by contrast to the threshold applicable to corporate interests, creates incentives for foreign corporations to hold minority interests in partnerships rather than corporations, and in some cases, because of the U.S. entity classification rules, the classification of the entity as a partnership may be solely for U.S. tax purposes. This means that the same investment that Congress determined could only be active if it accounted for 25 percent of the value of the entity would now qualify as active even though the nature of the investment has not substantially changed. This latter case is economically undesirable since it can result in differential tax treatment of corporations and partnerships. Moreover, this outcome is less consistent with the intents and purposes of the statute, than the approach taken in the proposed regulations. Under the second alternative, a proportionate amount of the income and assets of the partnership would be considered as earned or held directly by the foreign corporation only if the foreign corporation owned 10 percent or more of the partnership. Existing rules under section 904, which relates to the foreign tax credit limitation, utilize a 10 percent threshold for purposes of determining whether to characterize income and assets of a partnership as passive category income and assets. There could be benefits in applying an existing threshold from the foreign tax credit regime to PFICs since taxpayers would be familiar with this regime. However, similar to the no threshold option, because section 1297(c)(2) requires a 25 percent ownership for corporations to apply for the Look-Through Subsidiary rules, this alternative would still lead to differing treatment of minority interests in subsidiary corporations as opposed to partnerships. Again, this could lead to similarly situated entities being treated differently and resultant economic distortions.

Under the third alternative, the same 25 percent ownership threshold is applied to partnership interests as is applied to interests in corporations. The Treasury Department and IRS project this will maintain parity between the treatment of minority interests in corporations and partnership interest for purposes of the Income and Asset test, and it gives effect to the 25 percent limitation in section 1297(c)(2). The Treasury Department and the IRS project that this proposed regulation would achieve consistent treatment across entity types as well as the appropriate treatment of minority interests in corporations and partnerships under conditions consistent with the intents and purposes of the statute.

The Treasury Department and the IRS solicit comments on this proposal and in particular solicit data, evidence, or models that could enhance the rigor of the process by which the treatment of partnership interests might be developed for the final regulations.

4. Economic Analysis of PFIC Insurance Exception Rules

Under the statute, the income of a qualifying insurance corporation (QIC) derived in the active conduct of its insurance business is not treated as passive income for purposes of deciding whether the corporation is a PFIC. The test for a QIC under section 1297(f) is based on the ratio of the foreign insurance company's “applicable insurance liabilities” to its total assets. The statute limits the applicable insurance liabilities to the smallest of: (1) The insurance liabilities shown on the company's most recent applicable financial statement (“AFS”); (2) the amount of such liabilities required by applicable local law or regulation, and (3) as provided under Treasury regulations.

Under the statute, the AFS is the financial statement used by the foreign corporation for financial reporting purposes that is: (i) Made on the basis of U.S. generally accepted accounting principles (“US GAAP”); (ii) made on the basis of international financial reporting standards (“IFRS”), if there is no statement that is made on the basis of US GAAP; or (iii) the annual financial statement required to be filed with the applicable insurance regulatory body (“local accounting”), if the company does not prepare a statement for financial reporting purposes based on US GAAP or IFRS. Thus, the statute has a preference for financial statements prepared on the basis of US GAAP or IFRS, which are rigorous and widely-respected accounting standards, but will permit a foreign corporation to use a local accounting AFS if it does not do financial reporting based on US GAAP or IFRS.

The statute creates an incentive for foreign insurance companies (FCos) to inflate applicable insurance liabilities in order to qualify as QICs and avoid PFIC status. This strategy (inflating applicable insurance liabilities to qualify as a QIC) could make the FCo more attractive to U.S. investors relative to investing in a domestic company or a company that is a PFIC, which could potentially lead to investment patterns that are inefficient. Although the statutory caps on applicable insurance liabilities provide a check on this behavior, FCos (and thus their U.S. owners) might look for options under their financial reporting rules to increase the amount of insurance liabilities reported on their AFS, or even shift to a different financial reporting standard with more favorable rules. The proposed regulations address this issue in a number of ways.

a. Change in Accounting Rules Used for an AFS

The statute may, in some circumstances, introduce an incentive for an FCo to change its method of preparing its AFS to benefit from certain elements of a local accounting regime, such as a more expansive definition of insurance liability or a method of calculating a larger amount of insurance liabilities, solely for purposes of increasing its applicable insurance liabilities in order to qualify as a QIC. This strategy, by allowing a company to avoid being characterized as a PFIC and thus providing an incentive for U.S. investors to route their investment dollars through foreign corporations that otherwise would fail the QIC test, yields a potential tax advantage to U.S. investors relative to other investments they might make, an outcome that is economically inefficient in light of the intents and purposes of the statute.

To address this issue, the proposed regulations provide a special rule for FCos that change their method of preparing their AFS by ceasing to prepare this statement under either US GAAP or IFRS without a non-Federal tax business purpose for the change. Under the proposed regulations, an FCo must continue to prepare its AFS under either US GAAP or IFRS and if it fails to do so, it will be treated as having no applicable insurance liabilities for purposes of the QIC test.

The Treasury Department and the IRS considered as an alternative not providing regulations to address a change in the method of preparing an AFS. The Treasury Department and the IRS do not have readily available data to allow estimation of the tax advantage or volume of investment that might be drawn to such companies (and away from others) in the absence of regulations to address a change in the method of preparing an AFS. The Treasury Department and the IRS further have not estimated the benefit that arises from the improved integrity of the tax system under the proposed regulations relative to not providing regulations to govern changes in the FCo's AFS method. The Treasury Department and the IRS solicit comments on all aspects of these proposed regulations, including comments on (1) the determination of a “non-Federal tax business purpose,” and (2) how an FCo that changes its AFS method should be treated. The Treasury Department and the IRS particularly solicit comments that would provide data, other evidence, or models that would enhance the rigor of evaluating FCos that change their AFS method, for purposes of developing the final regulations.

b. Cap on Applicable Insurance Liabilities

Under the statute, a foreign corporation that does not prepare an AFS using US GAAP or IFRS may use an AFS prepared under local accounting rules to determine the amount of its applicable insurance liabilities. However, it is possible that local accounting rules in some foreign jurisdictions may permit reporting of insurance liabilities in a way that is economically unreasonable and inconsistent with the intent of the QIC rules. For example, US GAAP and IFRS both require discounting of insurance liabilities to determine the present value of an insurance company's liabilities. However, the Treasury Department and the IRS understand that local accounting rules in some foreign jurisdictions might not require discounting or might not adequately discount reserves (or other applicable insurance liabilities). This would make it easier for a foreign corporation that uses local accounting to qualify as a QIC. This could provide an incentive for U.S. investors to route their investment dollars through foreign corporations that otherwise would fail the QIC test, yielding a potential tax advantage to U.S. investors relative to other investments they might make, an outcome that is economically inefficient.

To address this issue, the proposed regulations provide that, if a foreign insurance company prepares its AFS under a local accounting standard that does not require discounting of unpaid losses and other loss reserves on an economically reasonable basis, for purposes of the QIC test, the company's AFS insurance liabilities must be reduced using US GAAP or IFRS discounting principles. Local accounting rules will otherwise continue to apply for determining amounts relevant to the QIC test. Applicable insurance liabilities may not exceed the discounted amount. As a point of reference, the discounting of unpaid losses is required by all domestic insurance companies that are taxed on their underwriting income or that file US GAAP-based financial statements.

The question of whether losses are discounted on an economically reasonable basis is determined under the relevant facts and circumstances. However, in order for losses to be discounted on an economically reasonable basis, discounting must be based on loss and claim payment patterns for either the foreign corporation or insurance companies in similar lines of insurance business. In addition, a discount rate based on these loss and claim payment patterns of at least the risk free rate in U.S. dollars or in a foreign currency in which the foreign corporation conducts some or all of its insurance business must be used. A loss discounting methodology consistent with that used for US GAAP or IFRS purposes will be considered reasonable for this purpose.

The Treasury Department and the IRS considered as alternatives (i) issuing no regulations to govern discounting of insurance losses for purposes of determining whether applicable insurance liabilities exceed the statutory cap, and (ii) capping the amount of applicable insurance liabilities at the amount that would be permitted to an insurance company subject to the insurance reserve calculation rules under Subchapter L of the Code.

Under the first approach, U.S. investors would have an incentive to seek out those corporations that do not file US GAAP or IFRS statements, an outcome that would provide an economically inefficient tax advantage to U.S. investors in those companies.

The second approach would be considerably more burdensome to a foreign corporation because, as a practical matter, it would require foreign corporations to apply complex U.S. tax rules with which they are likely not familiar. An excessive compliance burden on foreign corporations not subject to U.S. taxation would make it less likely that they would do the work necessary to enable their minority U.S. owners to determine if the corporation is a PFIC. Thus, this alternative was rejected because it could unduly inhibit U.S. investors from placing their funds in profitable foreign corporations that are legitimate active insurance companies, an economically desirable activity in light of the intents and purposes of the statute, relative to the proposed regulations.

The Treasury Department and the IRS do not have data available and models sensitive enough to estimate the additional volume of U.S. investment that might be drawn under this alternative approach to QICs that did not discount insurance losses in an economically reasonable manner, relative to the proposed regulations. The Treasury Department and the IRS also do not have data available and models sensitive enough to estimate the benefit that arises from the improved integrity of the tax system arising from the proposed regulations relative to not issuing such regulations. Further, the Treasury Department and the IRS do not have data available to estimate the additional accounting burden that would fall on FCos under the proposed regulations, relative to not issuing such regulations, a cost that would potentially be passed on to U.S. investors.

The Treasury Department and the IRS also do not have data available to estimate the increased loss to minority U.S. shareholders if the second alternative approach (capping liabilities to the amount that would be permitted under Subchapter L) were adopted.

The Treasury Department and the IRS solicit comments on all aspects of these proposed regulations and particularly solicit comments that would provide data, other evidence, or models that would enhance the rigor by which conditions on the cap on applicable insurance liabilities will be developed for the final regulations.

II. Paperwork Reduction Act

The collections of information in these proposed regulations are in proposed § 1.1297-1(d)(1)(ii)(B), (d)(1)(iii)(B), and (d)(1)(iv), proposed § 1.1297-4(d)(5)(i) and (iii), and proposed § 1.1298-4(d)(2). The information in all of the collections of information provided will be used by the IRS for tax compliance purposes.

A. Collections of Information Under Existing Tax Forms

The collections of information in proposed § 1.1297-1(d)(1)(ii)(B), (d)(1)(iii)(B), and (d)(1)(iv) are required to be provided by taxpayers that make an election or revoke an election to use an alternative measuring period or adjusted bases to measure assets for purposes of the Asset Test with respect to a foreign corporation. These collections of information are satisfied by filing Form 8621 or attachments thereto. For purposes of the Paperwork Reduction Act, 44 U.S.C. 3501 et seq. (“PRA”), the reporting burden associated with the collection of information in the Form 8621 will be reflected in the Paperwork Reduction Act Submission associated with that form (OMB control number 1545-1002). If a Form 8621 is not required to be filed, the collections of information under proposed § 1.1297-1(d)(1)(ii)(B), (d)(1)(iii)(B), and (d)(1)(iv) are satisfied by attaching a statement to the taxpayer's return. For purposes of the Paperwork Reduction Act, the reporting burden associated with these collections of information will be reflected in the Paperwork Reduction Act Submissions associated with Forms 990-PF and 990-T (OMB control number 1545-0047); Form 1040 (OMB control number 1545-0074); Form 1041 (OMB control number 1545-0092); Form 1065 (OMB control number 1545-0123); and Forms 1120, 1120-C, 1120-F, 1120-L, 1120-PC, 1120-REIT, 1120-RIC, and 1120-S (OMB control number 1545-0123).

The collection of information in proposed § 1.1297-4(d)(5)(iii) is required to be provided by taxpayers that make an election under section 1297(f)(2). This collection of information is satisfied by filing Form 8621. For purposes of the Paperwork Reduction Act, the reporting burden associated with the collection of information in the Form 8621 will be reflected in the Paperwork Reduction Act Submission associated with Form 8621 (OMB control number 1545-1002).

The following table displays the number of respondents estimated to be required to report on Form 8621 or, in the case of individual filers, on attachments to Form 1040, as applicable, with respect to the collections of information in these regulations. Due to the absence of available tax data, estimates of respondents required to attach a statement to other types of tax returns, as applicable, are not available.

The numbers of respondents in the table were estimated by the Research, Applied Analytics and Statistics Division (“RAAS”) of the IRS from the Compliance Data Warehouse (“CDW”).

Data for Form 1040 represents estimates of the total number of taxpayers that may attach a statement to their Form 1040 to make or revoke the elections in proposed § 1.1297-1(d)(1)(ii)(B), (d)(1)(iii)(B), and (d)(1)(iv). The lower bound estimate reflects the CDW-based estimate of unique individual taxpayers filing Form 8621 between 2014 and 2017. The upper bound estimate reflects the CDW-based estimate of unique individual taxpayers that filed Form 8938 between 2016 and 2017 indicating that they owned an interest in a foreign partnership or corporation.^[5] Accordingly, the difference between the lower bound and upper bound estimates reflects an estimate of the possible change in the number of respondents as a result of the changes made by the Act and the proposed regulations.

Data for Form 8621 represent estimates of the total number of taxpayers that may be required to file Form 8621. The lower bound estimate reflects the CDW-based estimate of unique taxpayers filing Form 8621 between 2014 and 2017. The upper bound estimate reflects an estimated 10 percent increase in the amount of taxpayers that may file to make or revoke the elections in proposed § 1.1297-1(d)(1)(ii)(B), (d)(1)(iii)(B), and (d)(1)(iv) and proposed § 1.1297-4(d)(5)(iii). Accordingly, the difference between the lower bound and upper bound estimates reflect an estimate of the possible change in the number of respondents as a result of the changes made by the Act and the proposed regulations.

The current status of the PRA submissions related to the tax forms on which reporting under these regulations will be required is summarized in the following table. The burdens associated with the information collections in the forms are included in aggregated burden estimates for the OMB control numbers 1545-0047 (which represents a total estimated burden time for all forms and schedules for tax-exempt entities of 50.5 million hours and total estimated monetized costs of $3.59 billion ($2018)), 1545-0074 (which represents a total estimated burden time for all forms and schedules for individuals of 1.784 billion hours and total estimated monetized costs of $31.764 billion ($2017)), 1545-0092 (which represents a total estimated burden time for all forms and schedules for trusts and estates of 307.8 million hours and total estimated monetized costs of $9.95 billion ($2016)), and 1545-0123 (which represents a total estimated burden time for all forms and schedules for corporations of 3.157 billion hours and total estimated monetized costs of $58.148 billion ($2017)). The burden estimates provided in the OMB control numbers in the following table are aggregate amounts that relate to the entire package of forms associated with the OMB control number, and will in the future include, but not isolate, the estimated burden of only those information collections associated with these proposed regulations. These numbers are therefore unrelated to the future calculations needed to assess the burden imposed by these regulations. To guard against over-counting the burden that international tax provisions imposed prior to the Act, the Treasury Department and the IRS urge readers to recognize that these burden estimates have also been cited by regulations (such as the foreign tax credit regulations, 83 FR 63200) that rely on the applicable OMB control numbers in order to collect information from the applicable types of filers.

In 2018, the IRS released and invited comment on drafts of Forms 990-PF (Return of Private Foundation or Section 4947(a)(1) Trust Treated as Private Foundation), 990-T (Exempt Organization Business Income Tax Return), 1040 (U.S. Individual Income Tax Return), (U.S. Income Tax Return for Estates and Trusts), 1065 (U.S. Return of Partnership Income), 1120 (U.S. Corporation Income Tax Return), and 8621 (Return by a Shareholder of a Passive Foreign Investment Co. or Qualified Electing Fund). The IRS received comments only regarding Forms 1040, 1065, and 1120 during the comment period. After reviewing all such comments, the IRS made the forms available on December 21, 2018 for use by the public.

No burden estimates specific to the forms affected by the proposed regulations are currently available. The Treasury Department and the IRS have not estimated the burden, including that of any new information collections, related to the requirements under the proposed regulations. The Treasury Department and the IRS request comments on all aspects of information collection burdens related to the proposed regulations, including estimates for how much time it would take to comply with the paperwork burdens described above for each relevant form and ways for the IRS to minimize the paperwork burden. In addition, drafts of IRS forms are posted for public review at https://apps.irs.gov/​app/​picklist/​list/​draftTaxForms.htm. Comments on these forms can be submitted at https://www.irs.gov/​forms-pubs/​comment-on-tax-forms-and-publications. These forms will not be finalized until after they have been approved by OMB under the PRA.

B. Collections of Information Generally Not Included on Existing Forms

The collection of information in proposed § 1.1298-4(d)(2) is required for a foreign corporation that relies on the rule in section 1298(b)(7) and proposed § 1.1298-4(b)(1). This collection of information is satisfied by filing a statement attached to the foreign corporation's return. For purposes of the Paperwork Reduction Act, the reporting burden associated with this collection of information will be reflected in the Paperwork Reduction Act Submissions associated with Form 1120-F (OMB control number 1545-0123). The number of affected filers, burden estimates, and Paperwork Reduction Act status for this OMB control number are discussed in connection with the Form 1120 in Part II.A of the Special Analyses.

Alternatively, if a foreign corporation is not required to file a return, the collection of information in proposed § 1.1298-4(d)(2) is satisfied by the foreign corporation's maintaining a statement in its records or including it in its public filings.

The collection of information in proposed § 1.1297-4(d)(5)(i) is required for a foreign corporation for which a taxpayer makes an election under section 1297(f)(2). This collection of information is satisfied by a foreign corporation providing a statement to a shareholder.

The collection of information contained in proposed § 1.1298-4(d)(2) (for foreign corporations that are not required to file Form 1120-F) and proposed § 1.1297-4(d)(5)(i) will be submitted to the Office of Management and Budget in accordance with the Paperwork Reduction Act. Comments on the collections of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by September 9, 2019.

Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the duties of the IRS, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information;

How the quality, utility, and clarity of the information to be collected may be enhanced;

How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques or other forms of information technology; and

Estimates of capital or start-up costs and costs of operation, maintenance, and purchases of services to provide information for the collections discussed in Part II.B of this Special Analyses.

Estimated total annual reporting burden: 200 hours.

Estimated total annual monetized cost burden: $19,000.

Estimated average annual burden hours per respondent: One hour.

Estimated number of respondents: 200.

Estimated annual frequency of responses: Once.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

III. Regulatory Flexibility Act

Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that the proposed regulations will not have a significant economic impact on a substantial number of small entities within the meaning of section 601(6) of the Regulatory Flexibility Act (“small entities”).

The statutory provisions in sections 1291 through 1298 (the “PFIC regime”) generally affect U.S. taxpayers that have ownership interests in foreign corporations that are not controlled foreign corporations (“CFCs”). The reporting burdens in proposed § 1.1297-1(d)(1)(ii)(B), (d)(1)(iii)(B), and (d)(1)(iv) and proposed § 1.1297-4(d)(5)(iii) generally affect the described U.S. taxpayers that elect to make or revoke certain elections related to the PFIC regime. The reporting burdens in proposed § 1.1297-4(d)(5)(ii) and proposed § 1.1298-4(d)(2) affect only foreign corporations. In general, foreign corporations are not considered small entities. Nor are U.S. taxpayers considered small entities to the extent the taxpayers are natural persons or entities other than small entities. Data estimating the number of filers for the PRA section indicate that individuals (Form 1040 filers) make up approximately 70 percent of those who report PFIC income while U.S. businesses of all sizes make up approximately 20 percent of Form 8621 filers. Most of these U.S. businesses are partnerships that do not pay entity level taxes. Accordingly, only small entities that have ownership interests in foreign corporations that are not CFCs and that wish to make or revoke an election pursuant to proposed § 1.1297-1(d)(1)(ii)(B), (d)(1)(iii)(B), and (d)(1)(iv) and proposed § 1.1297-4(d)(5)(iii) are affected by the proposed regulations.

The data to assess the number of small entities potentially affected by proposed § 1.1297-1(d)(1)(ii)(B), (d)(1)(iii)(B), and (d)(1)(iv) and proposed § 1.1297-4(d)(5)(iii) are not readily available.

Regardless of the number of small entities potentially affected by the proposed regulations, the Treasury Department and the IRS have concluded that there is no significant economic impact on such entities as a result of the proposed regulations.

Data on U.S. businesses that invest in a PFIC is limited. To get a sense of the magnitude of the taxes currently collected by businesses that invest in PFICs, the ratio of PFIC regime tax to (gross) total income was calculated for 2012 through 2017 for C corporations that filed the Form 8621. Total income was determined by matching each C corporation filing the Form 8621 to its Form 1120. Ordinary QEF income was assumed to be taxed at 37 percent while QEF capital gains and mark-to-market income was assumed to be taxed at the lower 20 percent capital gains rate. The section 1291 tax and interest charge tax were included as reported. Only those corporations where a match was found and that had positive total income were included in the analysis.^[6] While the number was small, approximately 150 to 250 C corporations per year, the ratio of the tax to total income was less than 0.01 percent even when $100 million of the additional tax estimated by the Joint Committee on Taxation was included each year. Looking only at the approximately 50 to 150 C corporations per year with $25 million or less of total income resulted in the tax to total income percentage increasing to at most 1.39 percent in 2017.

Thus, even if the economic impact of the proposed regulations is interpreted broadly to include the tax liability due under the PFIC regime, which small entities would be required to pay even if the proposed regulations were not issued, the economic impact should not be regarded as significant under the Regulatory Flexibility Act.

Additionally, the economic impact of the proposed regulations when considered alone should be minimal. Any economic impact of the final regulations stems from the collection of information requirements imposed by proposed § 1.1297-1(d)(1)(ii)(B), (d)(1)(iii)(B), and (d)(1)(iv) and proposed § 1.1297-4(d)(5)(iii). The Treasury Department and the IRS have determined that the average burden is 1 hour per response. The IRS's Research, Applied Analytics, and Statistics division estimates that the appropriate wage rate for this set of taxpayers is $95 per hour. Thus, the annual burden per taxpayer from the collection of information requirement is $95. Furthermore, these requirements apply only if a taxpayer chooses to make an election or rely on a favorable rule.

Accordingly, it is hereby certified that the proposed rule would not have a significant economic impact on a substantial number of small entities. Notwithstanding this certification, the Treasury Department and the IRS invite comments from the public on both the number of entities affected (including whether specific industries are affected) and the economic impact of this proposed rule on small entities.

Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses.

IV. Unfunded Mandates Reform Act

Section 202 of the Unfunded Mandates Reform Act of 1995 (UMRA) requires that agencies assess anticipated costs and benefits and take certain other actions before issuing a final rule that includes any Federal mandate that may result in expenditures in any one year by a state, local, or tribal government, in the aggregate, or by the private sector, of $100 million in 1995 dollars, updated annually for inflation. In 2018, that threshold is approximately $150 million. This rule does not include any Federal mandate that may result in expenditures by state, local, or tribal governments, or by the private sector in excess of that threshold.

V. Executive Order 13132: Federalism

Executive Order 13132 (entitled “Federalism”) prohibits an agency from publishing any rule that has federalism implications if the rule either imposes substantial, direct compliance costs on state and local governments, and is not required by statute, or preempts state law, unless the agency meets the consultation and funding requirements of section 6 of the Executive Order. This proposed rule does not have federalism implications and does not impose substantial direct compliance costs on state and local governments or preempt state law within the meaning of the Executive Order.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any comments that are timely submitted to the IRS as prescribed in this preamble under the Addresses heading. The Treasury Department and the IRS specifically request comments on all aspects of the proposed rules. All comments will be available for public inspection and copying at www.regulations.gov or upon request. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time and place for the public hearing will be published in the Federal Register.

Statement of Availability of IRS Documents

IRS Revenue Procedures, Revenue Rulings, notices, and other guidance cited in this document are published in the Internal Revenue Bulletin (or Cumulative Bulletin) and are available from the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402, or by visiting the IRS website at www.irs.gov.

Drafting Information

The principal drafters of these regulations are Josephine Firehock, Rose E. Jenkins, and Jorge M. Oben of the Office of Associate Chief Counsel (International). Other personnel from the Treasury Department and the IRS also participated in the development of these regulations.

List of Subjects in 26 CFR Part 1

• Income taxes
• Reporting and recordkeeping requirements

Withdrawal of Proposed Regulations

Accordingly, under the authority of 26 U.S.C. 7805, the notice of proposed rulemaking (REG-108214-15) that was published in the Federal Register on April 24, 2015, (80 FR 50814) is withdrawn.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding entries for §§ 1.1297-1, 1.1297-2, 1.1297-4, 1.1298-2, and 1.1298-4 in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.1297-1 also issued under 26 U.S.C. 1298(g).

Section 1.1297-2 also issued under 26 U.S.C. 1298(g).

Section 1.1297-4 also issued under 26 U.S.C. 1297(b)(2)(B) and 1298(g).

Section 1.1298-2 also issued under 26 U.S.C. 1298(b)(3) and (g).

Section 1.1298-4 also issued under 26 U.S.C. 1298(g).

Par. 2. Section 1.1291-0 is amended by revising the heading for § 1.1291-1 and adding entries for § 1.1291-1(b)(8)(iv)(A) and (B), (b)(8)(iv)(B)(1) and (2), (b)(8)(iv)(C), and (b)(8)(iv)(C)(1) and (2) to read as follows:

Par. 3. Section 1.1291-1 is amended by:

1. Revising the section heading.

2. Revising the second sentence of paragraph (b)(8)(ii)(B).

3. Revising paragraphs (b)(8)(iii)(A), (B), and (C).

4. Designating Example 1 in paragraph (b)(8)(iv) as paragraph (b)(8)(iv)(A).

5. Adding paragraphs (b)(8)(iv)(B) and (C).

6. Revising paragraph (j)(3).

7. Adding paragraph (j)(4).

The revision and additions read as follows:

Par. 4. Section 1.1297-0 is amended by revising the introductory text and adding entries for §§ 1.1297-1, 1.1297-2, and 1.1297-4 in numerical order to read as follows:

Par. 5. Sections 1.1297-1 and 1.1297-2 are added to read as follows:

Par. 6. Sections 1.1297-4 and 1.1297-5 are added to read as follows:

Par. 7. Section 1.1298-0 is amended by:

1. Revising the introductory text.

2. Adding entries for §§ 1.1298-2 and 1.1298-4 in numerical order.

The revision and additions read as follows:

Par. 8. Section 1.1298-2 is added to read as follows:

Par. 9. Section 1.1298-4 is added to read as follows:

Footnotes