[Federal Register Volume 86, Number 10 (Friday, January 15, 2021)]
[Proposed Rules]
[Pages 4582-4610]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-27003]
[[Page 4581]]
Vol. 86
Friday,
No. 10
January 15, 2021
Part VI
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Guidance on Passive Foreign Investment Companies and the Treatment of
Qualified Improvement Property Under the Alternative Depreciation
System for Purposes of Sections 250(b) and 951A(d); Proposed Rule
Federal Register / Vol. 86, No. 10 / Friday, January 15, 2021 /
Proposed Rules
[[Page 4582]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-111950-20]
RIN 1545-BP91
Guidance on Passive Foreign Investment Companies and the
Treatment of Qualified Improvement Property Under the Alternative
Depreciation System for Purposes of Sections 250(b) and 951A(d)
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Withdrawal of notice of proposed rulemaking; notice of proposed
rulemaking.
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SUMMARY: This document contains proposed regulations regarding the
determination of whether a foreign corporation is treated as a passive
foreign investment company (``PFIC'') for purposes of the Internal
Revenue Code (``Code''). The proposed regulations also provide guidance
regarding the treatment of income and assets of a qualifying insurance
corporation (``QIC'') that is engaged in the active conduct of an
insurance business (``PFIC insurance exception''). This document also
contains proposed regulations addressing the treatment of qualified
improvement property (``QIP'') under the alternative depreciation
system (``ADS'') for purposes of calculating qualified business asset
investment (``QBAI'') for purposes of the global intangible low-taxed
income (``GILTI'') and the foreign-derived intangible income (``FDII'')
provisions, which were added to the Code in the Tax Cuts and Jobs Act.
The proposed regulations affect United States persons with direct or
indirect ownership interests in certain foreign corporations, United
States shareholders of controlled foreign corporations, and domestic
corporations eligible for the deduction for FDII.
DATES: Written or electronic comments and requests for a public hearing
must be received by April 14, 2021. Requests for a public hearing must
be submitted as prescribed in the ``Comments and Requests for a Public
Hearing'' section.
ADDRESSES: Commenters are strongly encouraged to submit public comments
electronically. Submit electronic submissions via the Federal
eRulemaking Portal at www.regulations.gov (indicate IRS and REG-111950-
20) by following the online instructions for submitting comments. Once
submitted to the Federal eRulemaking Portal, comments cannot be edited
or withdrawn. The IRS expects to have limited personnel available to
process public comments that are submitted on paper through mail. Until
further notice, any comments submitted on paper will be considered to
the extent practicable. The Department of the Treasury (Treasury
Department) and the IRS will publish for public availability any
comment submitted electronically, and to the extent practicable on
paper, to its public docket.
Send paper submissions to: CC:PA:LPD:PR (REG-111950-20), Room 5203,
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044.
FOR FURTHER INFORMATION CONTACT: Concerning proposed regulations
Sec. Sec. 1.250(b)-1(b)(2) and 1.250(b)-2(e)(2), Lorraine Rodriguez,
(202) 317-6726; concerning proposed regulations Sec. 1.951A-3(e)(2),
Jorge M. Oben and Larry R. Pounders, (202) 317-6934; concerning
proposed regulations Sec. Sec. 1.1297-0 through 1.1297-2, 1.1298-0 and
1.1298-4, Christina G. Daniels at (202) 317-6934; concerning proposed
regulations Sec. Sec. 1.1297-4 through 1.1297-6 (the PFIC insurance
exception), Josephine Firehock at (202) 317-4932; concerning
submissions of comments and requests for a public hearing, Regina L.
Johnson at (202) 317-6901 (not toll-free numbers) or by sending an
email to publichearings@irs.gov (preferred).
SUPPLEMENTARY INFORMATION:
Background
I. Passive Foreign Investment Companies
A. In General
This document contains proposed amendments to 26 CFR part 1 under
sections 1297 and 1298. 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. 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)(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.
B. PFIC Insurance Exception
Before its amendment by section 14501 of the Tax Cuts and Jobs Act,
Public Law 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 409-10. 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.
C. Prior Proposed Regulations
On April 24, 2015, the Federal Register published a notice of
proposed rulemaking (REG-108214-15) at 80 FR 22954 (the ``2015 proposed
regulations'') under former sections 1297(b)(2)(B) and 1298(g). The
2015 proposed regulations addressed the
[[Page 4583]]
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.
On July 11, 2019, the Federal Register published a notice of
proposed rulemaking (REG-105474-18) at 84 FR 33120 (the ``2019 proposed
regulations'') under sections 1291, 1297, and 1298. The 2019 proposed
regulations provided guidance with respect to the application of the
Income Test and the Asset Test under section 1297(a), the look-through
rule under section 1297(c), and indirect ownership rules under section
1291. The 2019 proposed regulations also addressed the PFIC insurance
exception under section 1297(b)(2)(B), including the definition of a
QIC under section 1297(f) and the requirements for a foreign
corporation to be engaged in the active conduct of an insurance
business.
A public hearing on the 2019 proposed regulations was scheduled for
December 9, 2019, but it was not held because there were no requests to
speak. The Treasury Department and the IRS received written comments
with respect to the 2019 proposed regulations. Concurrently with the
publication of these proposed regulations, the Treasury Department and
the IRS are publishing in the Rules and Regulations section of this
edition of the Federal Register (RIN 1545-BO59) final regulations under
sections 1291, 1297, and 1298 (the ``final regulations''). In response
to certain comments, the Treasury Department and the IRS are publishing
this notice of proposed rulemaking to provide additional proposed
regulations under sections 1297 and 1298.
II. QBAI Rules for GILTI and FDII
A. GILTI and FDII--In General
Section 951A(a) requires a United States shareholder (as defined in
section 951(b)) (``U.S. shareholder'') of any controlled foreign
corporation (as defined in section 957) (``CFC'') for any taxable year
to include in gross income the U.S. shareholder's GILTI for such
taxable year (``GILTI inclusion amount''). The U.S. shareholder's GILTI
inclusion amount is calculated based on its pro rata share of certain
items--such as tested income, tested loss, and QBAI--of each CFC owned
by the U.S. shareholder. See Sec. 1.951A-1(c). Section 951A(d)(3) \1\
requires a taxpayer to calculate QBAI by determining the adjusted basis
of property using the ADS under section 168(g) ``notwithstanding any
provision of this title (or any other provision of law) which is
enacted after the date of the enactment of [section 951A].'' Section
1.951A-3(e)(2) states that ``[t]he adjusted basis in specified tangible
property is determined without regard to any provision of law enacted
after December 22, 2017, unless such later enacted law specifically and
directly amends the definition of qualified business asset investment
under section 951A.'' The GILTI provisions in section 951A apply to
taxable years of foreign corporations beginning after December 31,
2017, and to taxable years of U.S. shareholders in which or with which
such taxable years of foreign corporations end. See section 14201(d) of
the Act.
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\1\ As enacted, section 951A(d) contains two paragraphs
designated as paragraph (3). The section 951A(d)(3) discussed in
this preamble relates to the determination of the adjusted basis in
property for purposes of calculating QBAI.
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The definition of QBAI in section 951A(d) also applies for purposes
of determining deemed tangible income return under section 250. See
section 250(b)(2)(B) and Sec. 1.250(b)-2(b). Section 250 generally
allows a domestic corporation a deduction equal to 37.5 percent (21.875
percent for taxable years after 2025) of its FDII (as defined in
section 250(b)(1) and Sec. 1.250(b)-1(b)). For purposes of FDII, QBAI
is used to determine the deemed tangible income return of a
corporation, which in turn reduces the amount of FDII of a corporation.
See section 250(b)(1) and (2). Section 250(b)(2)(B) and Sec. 1.250(b)-
2 incorporate the definition of QBAI in section 951A(d)(3), with some
modifications. Similar to the GILTI rule provided in Sec. 1.951A-
3(e)(2), Sec. 1.250(b)-2(e)(2) provides that ``[t]he adjusted basis in
specified tangible property is determined without regard to any
provision of law enacted after December 22, 2017, unless such later
enacted law specifically and directly amends the definition of QBAI
under section 250 or section 951A.'' The FDII provisions in section 250
apply to taxable years beginning after December 31, 2017. See section
14202(a) of the Act.
B. ADS Depreciation
ADS depreciation under section 168(g) is determined by using the
straight-line method (without regard to salvage value), the applicable
convention determined under section 168(d), and the applicable recovery
period as determined under section 168(g)(2)(C).\2\ On December 22,
2017, the date the Act was enacted, section 168(g)(2)(C)(iv) provided
that the recovery period for purposes of ADS depreciation for
nonresidential real property under section 168(e)(2)(B) was 40 years.
Nonresidential real property is defined under section 168(e)(2)(B) as
section 1250 property (that is, real property not described in section
1245) that is not residential rental property or property with a class
life of less than 27.5 years.
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\2\ Although the applicable convention for nonresidential real
property under section 168(d)(2)(A) is the mid-month convention,
Sec. 1.951A-3(e)(1) provides that for the purpose of determining
QBAI, the period in the CFC inclusion year to which such
depreciation relates is determined without regard to the applicable
convention under section 168(d).
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Section 168(g)(2)(C)(i) provided that the recovery period for
property not described in section 168(g)(2)(C)(ii) or (iii) \3\ is the
property's class life. Class life is generally determined under section
168 or Rev. Proc. 87-56; 1987-42 I.R.B. 4; however, section 168(g)(3)
specifies class lives for certain types of property for ADS purposes.
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\3\ Section 168(g)(2)(C)(ii) and (iii) refer to personal
property with no class life and residential rental property,
respectively.
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C. Qualified Improvement Property
1. The Act
Effective for property placed in service after December 31, 2017,
section 13204 of the Act amended section 168(e) by removing references
to qualified leasehold improvement property, qualified restaurant
improvement property, and qualified retail improvement property, and
instead referring only to QIP. Under section 168(e)(6), QIP includes
certain improvements made by a taxpayer \4\ to the interior of a
nonresidential building that are placed in service after the building
was first placed in service. The conference report under the Act states
that Congress intended QIP to be classified as 15-year property under
the general depreciation system and be assigned a 20-year ADS recovery
period. See Conference Report to Accompany H.R. 1 at 366-367.
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\4\ The phrase ``made by a taxpayer'' was added by section
2307(a)(2) of Public Law 116-136, discussed below.
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2. The CARES Act
The Coronavirus Aid, Relief, and Economic Security Act, Public Law
116-136 (the ``CARES Act'') was enacted on March 27, 2020. According to
the Description of the Tax Provisions of Public Law 116-136, the
Coronavirus Aid, Relief, and Economic Security
[[Page 4584]]
(``CARES'') Act, prepared by the Staff of the Joint Committee on
Taxation, when Congress added the definition of QIP in section
168(e)(6) of the Code, it intended for QIP to be classified as 15-year
property under section 168(e)(3)(E) of the Code, with a 15-year
recovery period under the general depreciation system in section 168(a)
of the Code and a 20-year ADS recovery period but inadvertently omitted
from the statute such language. See Joint Committee on Taxation,
Description of the Tax Provisions of Public Law 116-136, The
Coronavirus, Relief, and Economic Security (``CARES'') Act (JCX-12R-20)
at 69-70 (Apr. 23, 2020) (``JCT CARES Act Report''). Section 2307(a)(2)
of the CARES Act amended section 168(e) by adding clause (vii) to
paragraph (E)(3), providing that QIP is classified as 15-year property,
and amending the table in section 168(g)(3)(B) to provide a recovery
period of 20 years for QIP for purposes of the ADS (the ``technical
amendment''). The technical amendment is effective as if it had been
included in the Act.\5\
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\5\ Rev. Proc. 2020-25, 2020-19 I.R.B. 785, generally allows a
taxpayer to change its depreciation method under section 168 for QIP
placed in service by the taxpayer after December 31, 2017, by
amending the applicable tax returns or requesting an accounting
method change. The determination of a taxpayer's adjusted basis for
purposes of determining QBAI is not addressed in the revenue
procedure and is not treated as a method of accounting. T.D. 9866,
84 FR 29288, 29304 (2019).
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D. Notice 2020-69
Notice 2020-69, 2020-30 I.R.B. 604, announced that the Treasury
Department and the IRS intend to issue regulations addressing the
treatment of QIP under the ADS depreciation provisions in section
168(g) for purposes of calculating QBAI under the FDII and GILTI
provisions. The notice provided that the Treasury Department and the
IRS expect the regulations under sections 250 and 951A to clarify that
the technical amendment to section 168 enacted in section 2307(a) of
the CARES Act applies to determine the adjusted basis of property under
section 951A(d)(3) as if it had originally been part of section 13204
of the Act.
Explanation of Provisions
The proposed regulations provide guidance on the valuation of
assets and on the treatment of working capital for purposes of the
Asset Test. They modify the treatment of dividends paid out of earnings
and profits not previously taken into account, such as dividends paid
out of pre-acquisition earnings, and provide safe harbors for
application of the principal purpose anti-abuse test that may prohibit
the use of the qualified stock rules of section 1298(b)(7). The
proposed regulations also 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 I.A of this Explanation of Provisions describes rules for
income derived in the active conduct of a banking business, asset
valuation, and working capital in proposed Sec. 1.1297-1; the special
dividend rules in proposed Sec. 1.1297-2; and the proposed safe
harbors for the qualified stock principal purpose anti-abuse test in
proposed Sec. 1.1298-4(e). Part I.B of this Explanation of Provisions
describes the rules in proposed Sec. 1.1297-4 for determining whether
a foreign corporation is a QIC. Part I.C of this Explanation of
Provisions describes the rules in proposed Sec. 1.1297-5 for
determining whether a foreign corporation is engaged in the active
conduct of an insurance business. Part I.D of this Explanation of
Provisions describes the rules in proposed Sec. 1.1297-6 regarding the
treatment of income and assets of a qualifying domestic insurance
company.
The proposed regulations also provide guidance on the treatment of
QIP under the ADS for purposes of calculating QBAI under the GILTI and
FDII provisions. See Part II of this Explanation of Provisions.
I. Passive Foreign Investment Companies
A. General PFIC Rules
1. Income Derived in the Active Conduct of a Banking Business
a. Active Banking Business Exception
Section 1297(b)(1) generally defines the term passive income to
mean any income which is of a kind which would be FPHCI as defined in
section 954(c). Section 1297(b)(2) provides exceptions to this general
definition. Section 1297(b)(2)(A) provides that passive income does not
include any income derived in the active conduct of a banking business
by an institution licensed to do business as a bank in the United
States (or, to the extent provided in regulations, by any other
corporation) (the ``section 1297(b)(2)(A) banking exception''), and
section 1297(b)(2)(B) provides a similar exception for income derived
in the active conduct of an insurance business. The Treasury Department
and the IRS have determined that in light of this statutory framework,
qualifying banking income should be treated as non-passive under the
section 1297(b)(2)(A) banking exception (and qualifying insurance
income should be treated as non-passive under the similar rule in
section 1297(b)(2)(B)) and not under the general rule of section
1297(b)(1). Otherwise, an exception for active banking and insurance
income of a tested foreign corporation would apply indirectly under
section 1297(b)(1) and also directly under sections 1297(b)(2)(A) and
(B), which would be duplicative and would effectively narrow the scope
of the statutory exceptions in section 1297(b)(2). Accordingly, the
Treasury Department and the IRS have determined that section 954(h)(1),
which provides that for purposes of section 954(c)(1) FPHCI does not
include qualified banking or financing income of an eligible controlled
foreign corporation, does not apply for purposes of section 1297(b)(1).
See Part III.B.1 of the preamble to the final regulations.
Notice 88-22, 1988-1 C.B. 489, states that assets held by foreign
corporations described in section 1297(b)(2)(A) (then section
1296(b)(2)(A)) that are utilized to produce income in the active
conduct of a banking business will be treated as non-passive assets.
Notice 89-81, 1989-2 C.B. 399, provides guidance addressing the
characterization of income derived in a banking business by a foreign
corporation that is not licensed to do business as a bank in the United
States for purposes of the definitional tests of the PFIC provisions,
and states that the rules contained in Notice 89-81 will be
incorporated into future regulations. In 1995, regulations were
proposed to implement the section 1297(b)(2)(A) banking exception. See
proposed Sec. 1.1296-4, 60 FR 20922, April 28, 1995. In light of the
fact that the 1995 proposed regulations have not been finalized, the
Treasury Department and the IRS are aware that taxpayers need guidance
on how to properly apply section 1297(b)(2)(A).
Section 1297(b)(2)(A) requires that income be derived in the active
conduct of a banking business, and grants authority for regulations to
expand the scope of entities that are eligible for the section
1297(b)(2)(A) exception beyond U.S.-licensed banks. The preamble to the
1995 proposed regulations states that the Treasury Department and the
IRS believe that Congress intended to grant the banking exception only
to corporations that conform to a traditional U.S. banking model. 1995-
1 C.B. 978. The Treasury Department and IRS continue to believe that
the section 1297(b)(2)(A) banking exception should apply to foreign
banks and not to other
[[Page 4585]]
types of financial institutions, based on both the statutory framework
and the history of section 1297(b).\6\
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\6\ See Joint Committee on Taxation, General Explanation of the
Tax Reform Act of 1986, at 1025 (JCS-10-87) (May 4, 1987) (``The Act
provides regulatory authority to expand the exception to passive
income for income derived by a foreign bank licensed to do business
in the United States to any other foreign corporation engaged in the
active conduct of a banking business, as well.'') (emphasis added);
cf. H.R. Rep. No. 99-841, at II-644 (1986) (Conf. Rep.) (providing
that ``the Secretary has regulatory authority to apply the PFIC
provisions to any `bank' where necessary to prevent U.S. individuals
from earning what is essentially portfolio investment income in a
tax deferred entity'') (emphasis added).
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In the Tax Reform Act of 1986, Congress repealed broad FPHCI
exceptions under section 954, including an exception for active banks,
while simultaneously enacting PFIC rules, including current section
1297(b)(2)(A) (as subsequently renumbered in 1997). Thus, when the PFIC
rules were enacted, section 1297(b)(2)(A) was the exclusive means by
which an active bank could avail itself of a passive income exception
to the PFIC rules.
Since 1986, Congress has repeatedly amended section 1297(b) to add,
repeal, and modify the exceptions therein as they apply to financial
institutions. For example, in 1993 a new paragraph (3) was added to
section 1297(b) (then section 1296(b)) providing that income earned in
the active conduct of a securities business by a CFC was not treated as
passive for PFIC purposes for a United States shareholder (``U.S.
shareholder'') as defined in section 951(b). Public Law 103-66, Omnibus
Budget Reconciliation Act of 1993, section 13231(d)(3). In 1997, that
paragraph was repealed, in connection with the enactment of section
1297(d) (then section 1297(e)), which eliminated the need for rules
relating to CFCs in section 1297 with respect to US shareholders.
Public Law 105-34, Taxpayer Relief Act of 1997, section 1122(d)(4). In
2017, TCJA amended section 1297(b)(2)(B), relating to income earned in
the active conduct of an insurance business, and added section 1297(f).
Congress has thus expressly addressed when income of a kind earned by
various active financial institutions should be treated as non-passive.
Because section 1297(b)(2)(A) applies to income derived in the active
conduct of a banking business, the relevant class of foreign financial
institutions is foreign banks.
The Treasury Department and the IRS have considered alternatives to
the analysis set forth above. In particular, because the PFIC rules
when enacted in 1986 provided broader exclusions for income of active
foreign financial institutions than the subpart F rules did, and
because broader exclusions for active financial businesses for PFIC
purposes may be appropriate in light of the fact that U.S. investors in
a PFIC do not control the PFIC, the Treasury Department and the IRS
have considered whether a wholesale incorporation of section 954(h)
into either section 1297(b)(1) or section 1297(b)(2)(A) would be
appropriate as an exercise of regulatory discretion. A broader approach
of that kind could be of particular relevance to finance companies
whose income is eligible for the section 954(h) exception.
The Treasury Department and the IRS concluded that such a broader
approach is not warranted by the statutory language or history, as
described in Part I.A.1.a of this Explanation of Provisions.
Furthermore, the 1993 legislative history to the expansion of section
1297(b)'s passive income exceptions makes clear that the PFIC rules as
in effect at that time did not apply to finance companies, that is,
entities that did not engage in the deposit-taking activities
characteristic of banks.\7\ Consequently, if all of section 954(h) were
permitted to apply for purposes of section 1297(b)(2)(A), finance
companies, which can qualify for the section 954(h) exception, would
obtain a privileged treatment for PFIC purposes that Congress intended
to deny in 1993 and has not expressly approved in the interim.
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\7\ See H.R. Conf. Rep. No. 103-213, Omnibus Budget
Reconciliation Act of 1993, at 641 (Aug. 4, 1993) (``These rules
[the banking exception and the securities dealer exception],
however, do not apply to income derived in the conduct of financing
and credit services businesses'').
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However, section 954(h) provides some useful guideposts that can be
applied to interpret section 1297(b)(2)(A) in the absence of final
regulations, because the two provisions have similar and complementary
purposes. Sections 954(h)(2)(B)(ii) and 1297(b)(2)(A) construe the same
statutory phrase: Income ``derived in the active conduct of a banking
business.'' And they both are limited to banks licensed to do business
as a bank in the United States or any other corporation as prescribed
by the Secretary. Moreover, the legislative history to section 954(h)
explicitly states that the phrase ``active conduct of a banking
business'' under section 954(h) is intended to have the same meaning as
under the 1995 proposed regulations issued under section
1297(b)(2)(A).\8\ Finally, section 954(h) is a more recent expression
of Congressional intent as to the conditions under which banking income
of a foreign entity should be treated as non-passive than section
1297(b)(2)(A).
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\8\ H.R. Rep. No. 817, 105th Cong. 2d Sess. 37 (Oct. 12, 1988)
(``It generally is intended that these requirements for the active
conduct of a banking or securities business be interpreted in the
same manner provided in the regulations proposed under prior law
section 1296(b) . . . See Prop. Treas. Reg. secs. 1.1296-4 and
1.1296-6. Specifically, it is intended that these requirements
include the requirements for foreign banks under Prop. Treas. Reg.
sec. 1.1296-4 as currently drafted.''); see also H.R. Rep. No. 220,
105th Cong. 1st Sess. 642 (July 30, 1997) (similar language); Joint
Committee on Taxation, General Explanation of Tax Legislation
Enacted in 1997, at 330 (JCS-23-97) (Dec. 17, 1997) (``The Congress
generally intended that the income of a corporation engaged in the
active conduct of a banking or securities business that would have
been eligible for this exception would have been the income that is
treated as nonpassive under the regulations proposed under prior law
section 1296(b). See Prop. Treas. Reg. secs. 1.1296-4 and 1.1296-
6.'').
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Accordingly, in order to provide guidance to foreign banks and in
light of the close connection between section 1297(b)(2)(A) and section
954(h)(2)(B)(ii), the Treasury Department and the IRS propose to apply
certain principles of section 954(h) for purposes of section
1297(b)(2)(A), under section 1297(b)(2)(A)'s specific grant of
regulatory authority. See proposed Sec. 1.1297-1(c)(2). Alternatively,
taxpayers also may rely upon Notice 89-81 or proposed Sec. 1.1296-4
(relating to banking income of active banks) to determine whether
income of a foreign entity may be treated as non-passive under section
1297(b)(2)(A).
b. Proposed Exception for Active Banking Income of Foreign Banks
Proposed Sec. 1.1297-1(c)(2) provides that income of a tested
foreign corporation will not be treated as passive if the income would
be eligible for section 954(h) if the tested foreign corporation were a
CFC, and the income is derived in the active conduct of a banking
business by a foreign bank. The term active conduct of a banking
business has the meaning given to it by section 954(h)(2)(B)(ii). See
proposed Sec. 1.1297-1(c)(2)(i)(B). The term foreign bank is defined
in a manner similar to the definition of active bank under proposed
Sec. 1.1296-4, and is intended to have the same meaning, except where
the proposed regulations provide a different rule. For example, a
foreign bank must engage in one or more of the list of relevant banking
activities provided by section 954(h)(4) rather than being required to
make loans. See proposed Sec. 1.1297-1(c)(2)(ii). Some clarifying
changes have been made to the definition to ensure that it applies only
to entities that are banks as that
[[Page 4586]]
term is ordinarily understood, and not, for example, to payment service
providers or money transmitters. As is the case under section 954(h),
the exception is intended to apply to the income of qualified business
units of a foreign bank.
As proposed, the exception does not apply to affiliates of a
foreign bank that do not independently qualify for the exception, in
light of the fact that section 954(h) takes affiliates into account
only for purposes of treating the activities of same-country related
persons that are CFCs as activities that are conducted directly by an
eligible CFC if certain conditions are satisfied. See section
954(h)(3)(E). Proposed Sec. 1.1297-1(c)(2)(i)(A) permits such related
persons to be treated as if they were CFCs so that section 954(h)(3)(E)
may apply for purposes of proposed Sec. 1.1297-1(c)(2).
A comment on the 2019 proposed regulations suggested that the
attribution of activities of look-through subsidiaries to other
affiliates that is permitted by Sec. 1.1297-2(e) for purposes of
specified provisions of section 954(c) be extended to apply for
purposes of section 954(h). The comment indicated that such treatment
would be proper because financial businesses generally segregate assets
and operations that are part of an integrated business into different
entities for non-tax reasons. Because section 954(h)(3)(E) operates to
attribute activities among entities for purposes of determining whether
income constitutes qualified banking income, the Treasury Department
and the IRS have determined that it would be inappropriate to adopt
additional rules for attribution of activities for purposes of the
incorporation of section 954(h) into section 1297(b)(2)(A) and did not
adopt this comment in the final regulations. However, as an alternative
to proposed Sec. 1.1297-1(c)(2), taxpayers may rely upon Notice 89-81
or proposed Sec. 1.1296-4, which provide rules treating banking income
of qualified bank affiliates as non-passive. If a foreign bank is a
look-through subsidiary of a tested foreign corporation, then under
section 1297(c) and Sec. 1.1297-2(b)(2) the income and assets of the
foreign bank are treated as passive or non-passive at the level of the
tested foreign corporation to the extent they are treated as passive or
non-passive at the level of the foreign bank. If that foreign bank
itself owns a look-through subsidiary, then under section 1297(c) and
Sec. 1.1297-2(b)(2) the income and assets of the look-through
subsidiary are treated as passive or non-passive at the level of the
foreign bank to the extent they are treated as passive or non-passive
at the level of the look-through subsidiary.
Another comment noted that, in the case of tested foreign
corporations with look-through subsidiaries that are domestic
corporations, section 954(h)(3)(A)(ii)(I) would result in the section
954(h) exception being inapplicable to active financing income earned
by these subsidiaries from transactions with local customers, even
though it would otherwise be of a type that would not be passive. The
comment suggested that section 954(h) should be applied in the PFIC
context by treating income as qualified banking or financing income
even if the income is derived from transactions with customers in the
United States.
Section 1298(b)(7) provides an exception for income derived from
certain 25-percent owned domestic subsidiaries that treats such income
as non-passive. The Treasury Department and the IRS do not agree that
an additional rule should be provided to treat income of a domestic
subsidiary that is not eligible for section 1298(b)(7) as non-passive,
and accordingly these proposed regulations do not adopt this
recommendation.\9\
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\9\ The legislative history of section 954(h) states that the
active banking test is not intended to apply to affiliates that do
not independently satisfy the test. H.R. Rep. No. 817, 105th Cong.
2d Sess. 37 (Oct. 12, 1988) (``[I]t is not intended that these
requirements be considered to be satisfied by a CFC merely because
it is a qualified bank affiliate . . . within the meaning of the
proposed regulations under former section 1296(b).'')
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The preamble to the 2019 proposed regulations requested comments
addressing the question of whether the section 954(h) exception, if
adopted as proposed in the 2019 proposed regulations, should continue
to apply if final regulations implementing section 1297(b)(2)(A), for
example final regulations similar to proposed Sec. 1.1296-4, are
adopted. Several comments recommended that the section 954(h) exception
continue to apply in the PFIC context under section 1297(b)(1) in such
a case. In light of the different approach taken by these proposed
regulations compared to the 2019 proposed regulations, the Treasury
Department and the IRS request comments on whether proposed Sec.
1.1297-1(c)(2) provides sufficient guidance to foreign banks, such that
Notice 89-81 and proposed Sec. 1.1296-4 can be withdrawn, whether
alternatively proposed Sec. 1.1296-4 should be finalized rather than
proposed Sec. 1.1297-1(c)(2), whether both proposed Sec. 1.1296-4 and
proposed Sec. 1.1297-1(c)(2) should be finalized, or whether a single
harmonized set of rules should be provided. Until Notice 89-81 and
proposed Sec. 1.1296-4 are withdrawn, taxpayers may rely upon them as
alternatives to proposed Sec. 1.1297-1(c)(2).
The Treasury Department and the IRS also request comments on the
general approach taken by proposed Sec. 1.1297-1(c)(2), on whether
further guidance is needed to address when income is derived in the
active conduct of a banking business, on whether the definition of
foreign bank is drafted in a manner that does not exclude bona fide
foreign banks and does not include other types of financial
institutions, and on how income of affiliates of foreign banks should
be taken into account.
2. Valuation of Assets for Purposes of the Asset Test
Under section 1297(e), the determination of whether a tested
foreign corporation satisfies the Asset Test either must or may be made
on the basis of the value of the assets of the tested foreign
corporation, unless the tested foreign corporation is a controlled
foreign corporation the shares of which are not publicly traded.
Accordingly, it is typically necessary to determine the relative value
of a tested foreign corporation's passive and non-passive assets in
order to determine whether the tested foreign corporation satisfies the
Asset Test.
The value of individual assets of an operating company may not be
readily determinable. However, financial accounting standards generally
provide rules that are intended to provide stakeholders with an
economically realistic understanding of a company's financial position,
including the cost or value of its assets. Financial statement
information also often is accessible by tested foreign corporations and
their shareholders, and is prepared for non-tax purposes. The Treasury
Department and the IRS understand that, for these reasons, taxpayers
often utilize financial statements in order to determine the value of a
tested foreign corporation's assets. Section 1297(f)(4) specifically
requires the use of information from financial statements prepared
under U.S. generally accepted accounting principles (``GAAP'') or
international financial reporting standards (``IFRS'') for purposes of
the QIC rules, indicating that Congress believes that such information
is appropriate in some circumstances as a basis for determining whether
a tested foreign corporation qualifies as a PFIC.
Accordingly, proposed Sec. 1.1297-1(d)(1)(v)(D) generally permits
a taxpayer to rely upon the information in a tested foreign
corporation's financial
[[Page 4587]]
statements in order to determine the value of the corporation's assets.
The Treasury Department and the IRS request comments on whether
ordering rules similar to those of section 1297(f)(4) and proposed
Sec. 1.1297-4(f)(1) should apply, and whether other safeguards such as
requiring that financial statements be audited should be required.
The Treasury Department and the IRS are aware that financial
statements do not include values for some types of assets that are
important to companies in certain industries, for example self-created
intangibles. Accordingly, proposed Sec. 1.1297-1(d)(1)(v)(D) provides
that if a shareholder has reliable information about the value of an
asset that differs from its financial statement valuation, that
information must be used to determine the value of the asset. Whether
valuation information is more reliable than financial statement
valuation is based on the facts and circumstances, including the
experience and knowledge of the source of the information, whether the
information is recent and whether there have been intervening
developments that would affect the accuracy of the information, and
whether the information specifically addresses the value of the asset
in question. Another fact pattern that may raise questions as to
whether divergence from a financial statement valuation is warranted is
when a tested foreign corporation or look-through entity owns property
that is subject to a lease or license that is disregarded under the
rules for intercompany obligations between a tested foreign corporation
and a look-through entity, and similar fact patterns. See Sec. 1.1297-
2(c)(1)(ii). The Treasury Department and the IRS request comments on
whether the Asset Test should take into account the value of the
property subject to the lease or license and the value of the lease or
license, or whether instead the Asset Test should take into account the
value of the property disregarding the lease or license. The Treasury
Department and the IRS request comments on additional considerations
that may be relevant to determining when shareholders may use
information other than financial statement valuations for purposes of
the Asset Test.
3. Treatment of Working Capital and Goodwill for Purposes of the Asset
Test, and Other Asset Test Rules Provided by Notice 88-22
Notice 88-22, 1988-1 C.B. 489 (``Notice 88-22''), provides guidance
on the application of the Asset Test pending the issuance of
regulations. The Treasury Department and the IRS propose to adopt final
regulations that will address the portions of Notice 88-22 that have
not already been addressed by regulations, for example the guidance
relating to depreciable property used in a trade or business, trade or
service receivables, intangible property, working capital, and tax-
exempt assets. After the issuance of those regulations Notice 88-22
would be obsoleted. Except as described in the remainder of this Part
I.A.3 of this Explanation of Provisions section, the rules provided in
Notice 88-22 are proposed to be adopted in final form as set forth in
Notice 88-22. The Treasury Department and the IRS request comments on
whether any changes should be made to those rules when they are adopted
in final regulations.
Notice 88-22 provides that cash and other current assets readily
convertible into cash, including assets that may be characterized as
the working capital of an active business, are treated as passive
assets for purposes of the Asset Test. Notice 88-22 indicated that
passive treatment is warranted because working capital produces passive
income (that is, interest income).
Comments have noted that the approach taken in Notice 88-22 with
respect to working capital may be inconsistent with the intent of the
PFIC regime to distinguish between investments in passive assets and
investments in active businesses. It has been asserted that the working
capital rule in Notice 88-22 causes many foreign corporations otherwise
engaged in active operating businesses to be classified as PFICs
because Notice 88-22 treats working capital as a passive asset even
though it is an asset used in the active conduct of business
operations. Critics of Notice 88-22's working capital rule have also
noted that, for some purposes of the Code, cash is treated as a
business (non-passive) asset to the extent it is held as working
capital for use in a trade or business. See generally section
1202(e)(6) and Sec. Sec. 1.864-4(c)(2) and 1.897-1(f)(1)(iii).
The Treasury Department and the IRS recognize that, because any
active operating company must have some cash or cash equivalents on
hand to pay operating expenses, Notice 88-22's working capital rule,
which treats all working capital as a passive asset, does not reflect
the manner in which bona fide businesses operate. The Treasury
Department and the IRS also are aware that some foreign companies
engaged in active businesses hold cash or liquid securities in amounts
that substantially exceed the present needs of the business for
extended periods. Therefore, the proposed regulations provide a limited
exception to the treatment of working capital as passive. Under
proposed Sec. 1.1297-1(d)(2), an amount of cash held in a non-interest
bearing account that is held for the present needs of an active trade
or business and is no greater than the amount reasonably expected to
cover 90 days of operating expenses incurred in the ordinary course of
the trade or business of the tested foreign corporation (for example,
accounts payable for ordinary operating expenses or employee
compensation) is not treated as a passive asset.
The Treasury Department and the IRS understand that this definition
is narrower than the ordinary business meaning of working capital and
the definitions used in some other Treasury regulations. Because the
PFIC rules are based on numeric formulas, it is important that
taxpayers and the IRS can determine what the amount treated as working
capital is for purposes of the PFIC asset test with some level of
precision. Moreover, because the statutory PFIC rules (and FPHCI rules)
generally treat an asset held to produce interest as passive, it may
not be appropriate to treat an interest-bearing instrument held by an
operating company as working capital other than as an asset that
produces passive income. Those rules permit interest-bearing assets to
be treated as active assets for limited classes of taxpayers like
banks, insurance companies and securities dealers, and also permit
interest from related persons to be treated in whole or part as active,
but in those cases there are specific statutory exceptions from passive
treatment. See sections 1297(b)(2)(A) (banks), 1297(b)(2)(B) and (f)
(insurance companies), 1297(b)(2)(C) (interest from related persons)
and 954(c)(2)(C) (securities dealers). The Treasury Department and the
IRS request comments on this exception to the general rule of Notice
88-22 that cash is a passive asset, including the scope of statutory
authority to treat interest-bearing accounts or instruments held as
working capital as an active asset and the ways in which the exception
might be broadened while maintaining appropriate safeguards to avoid
uncertainty as to how to determine the amounts and types of instruments
properly treated as held for the present needs of a business and to
ensure that a business's investments and capital held for future needs
continue to be characterized as passive assets.
Like working capital, goodwill was not addressed by the 2019
proposed
[[Page 4588]]
regulations. Notice 88-22 provides that, for purposes of the Asset
Test, goodwill or going concern value must be identified with a
specific income-producing activity of the corporation and characterized
as a passive or non-passive asset based on the income derived from the
activity. The Treasury Department and the IRS understand that some
taxpayers believe that Notice 88-22 takes an improper approach with
respect to the treatment and characterization of goodwill for purposes
of the Asset Test and argue that goodwill related to an active trade or
business should be treated in its entirety as a non-passive asset or,
in the alternative, that the dual-character asset rule in the proposed
regulations should be read to apply to goodwill.
The Treasury Department and the IRS agree that goodwill should be
allocated to business activities but do not agree that goodwill should
always be treated entirely as a non-passive asset because the PFIC
rules may treat certain business assets as passive and it is therefore
possible that goodwill would be associated with those assets. Because
companies in different lines of business may be valued as an economic
matter under different valuation models, some of which may give more
weight to income and others to assets or to other aspects of a business
like customer relationships, there is no single basis for allocating
goodwill that is likely to be best suited to every company as an
economic matter. The Treasury Department and the IRS believe that the
approach provided by Notice 88-22 for determining the character of
goodwill for purposes of the Asset Test is a reasonable approach
although other approaches may be more economically accurate for a
particular tested foreign corporation. In light of the complex nature
of goodwill as an economic and accounting matter, and developments in
tax law since 1988 with respect to the treatment of goodwill and
similar assets, the Treasury Department and the IRS request comments on
alternative approaches to addressing the treatment of goodwill for
purposes of the Asset Test.
4. Elimination of Intercompany Dividends for Purposes of the Income
Test and Related Adjustments
Proposed Sec. 1.1297-2(c)(2) provided that, for purposes of
applying the Income Test, intercompany payments of dividends between a
look-through subsidiary and a tested foreign corporation are eliminated
to the extent the payment is 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. The preamble
to the proposed regulations indicated that the Treasury Department and
the IRS intended for the elimination of such items to prevent double
counting of intercompany income and assets.
A comment expressed concern that the proposed regulation did not
eliminate a payment of a dividend by a look-through subsidiary to a
tested foreign corporation that is made out of earnings and profits not
attributable to income of the subsidiary previously included in the
gross income of the tested foreign corporation for purposes of
determining its PFIC status (``dividends from non-accounted-for
earnings''), for example a dividend paid out of earnings and profits
accumulated before the tested foreign corporation's acquisition of the
look-through subsidiary. The comment recommended that final regulations
provide for the elimination of all dividends from look-through
subsidiaries and made a number of alternative suggestions intended to
reduce or eliminate the likelihood that a dividend from a look-through
subsidiary would be treated as a dividend from non-accounted-for
earnings. The final regulations did not adopt these recommendations,
because treating a distribution from a look-through subsidiary as not
giving rise to gross income to the tested foreign corporation for
purposes of the Income Test could reduce gain on a future sale of the
stock of the look-through subsidiary unless a basis or other adjustment
were made to the stock or gain.
The final regulations indicate that for purposes of applying the
Income Test, a tested foreign corporation must take into account its
gain on the disposition of stock in a look-through subsidiary. See
Sec. 1.1297-2(f)(2). In the final regulations, the amount of gain
derived from a tested foreign corporation's direct disposition of stock
of a look-through subsidiary, or an indirect disposition resulting from
the disposition of stock of a look-through subsidiary by other look-
through subsidiaries or by look-through partnerships, that is taken
into account by the tested foreign corporation for purposes of section
1297(a)(1), section 1298(b)(3), and Sec. 1.1298-2 is the residual
gain. See Sec. 1.1297-2(f)(2). The residual gain equals the total gain
recognized by the tested foreign corporation from the disposition of
the stock of the look-through subsidiary reduced (but not below zero)
by unremitted earnings. Id. Unremitted earnings are the excess of the
aggregate income taken into account by the tested foreign corporation
pursuant to section 1297(c) with respect to the stock of the disposed-
of look-through subsidiary over the aggregate dividends received by the
tested foreign corporation from the disposed-of look-through subsidiary
with respect to the stock. Id.
Reducing unremitted earnings to take dividends into account as
provided by the final regulations does not fully account for the effect
of dividends from non-accounted-for earnings, for example where there
are no unremitted earnings after taking into account distributions of
earnings and profits previously included in the gross income of the
tested foreign corporation for purposes of determining its PFIC status
but the stock of the look-through subsidiary is sold at a gain.
Consequently, either such dividends should be treated as giving rise to
income to the recipient, as provided by the final regulations, or some
other adjustment such as to basis should be made in order to prevent
the disappearance of potential gain. See Part IV.D.1 of the Summary of
Comments and Explanation of Revisions for the final regulations.
The PFIC regulations do not provide rules for determining or
adjusting the basis of the stock of a look-through subsidiary. In
addition to the fact pattern described above, many other fact patterns
could raise questions about how the basis of stock of a look-through
subsidiary should be adjusted. Examples of such transactions include
unremitted earnings, certain reorganizations the parties to which are
look-through subsidiaries, in-kind dividend distributions that could
give rise to gain at the level of the distributing subsidiary but the
elimination of dividends from the income of the dividend recipient, and
other transactions governed by subchapter C. Additional questions arise
if a subsidiary becomes, or ceases to be, a look-through subsidiary
while its shares continue to be held by the same shareholder, and with
respect to transactions that shift property between a look-through
entity and a tested foreign corporation that owns the look-through
entity (or between two look-through entities) in light of the fact that
the transaction may give rise to gain or loss if it is regarded but the
tested foreign corporation is treated as owning the asset for Asset
Test purposes both before and after the transaction.
Rules addressing similar issues exist for members of a consolidated
group, which might provide a possible model for rules addressing
``corporate'' transactions between a look-through subsidiary and its
owner(s). However, the consolidated return regulations are
[[Page 4589]]
highly complex and may not be suitable for foreign corporations that do
not follow U.S. tax principles. The consolidated return regulations are
also based on a single-entity paradigm that may not be relevant for
section 1297(c) given that the stock ownership threshold for treating a
subsidiary as a look-through subsidiary is 25 percent rather than 80
percent. Accordingly, those rules may not be an appropriate model for
basis and related rules for look-through subsidiaries.
Proposed Sec. 1.1297-2(c)(2) and (f) provide rules that would--for
purposes of determining a tested foreign corporation's PFIC status--
eliminate from the gross income of the corporation a dividend it
receives from a look-through subsidiary that is made out of earnings
and profits not attributable to income of the subsidiary previously
included in the gross income of the tested foreign corporation. The
rules also would make corresponding adjustments to the basis of a look-
through subsidiary's stock for purposes of determining gain upon the
disposition of such stock in applying the Income Test. For the reasons
already described, these rules may or may not be a desirable approach
to addressing the issues with respect to earnings and distributions of
look-through subsidiaries. For example, the basis reduction rule could
apply if a subsidiary paid a dividend when it was not a look-through
subsidiary but later became one. The Treasury Department and the IRS
invite comments addressing these issues--in particular, comments are
requested on the treatment of pre-acquisition earnings and profits.
5. Safe Harbors for the Domestic Subsidiary Anti-Abuse Rule
Section 1298(b)(7) provides a special characterization rule that
applies when (i) a tested foreign corporation owns at least 25 percent
of the value of the stock of a domestic corporation (``25-percent-owned
domestic corporation''), (ii) the 25-percent-owned domestic corporation
owns stock in another domestic corporation (``the second-tier domestic
corporation), and (iii) the tested foreign corporation 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
that case, section 1298(b)(7) treats the stock of the second-tier
domestic corporation held by the 25-percent-owned domestic corporation
(``qualified stock'') as a non-passive asset, and the related income as
non-passive income.
The 2019 proposed regulations provided that section 1298(b)(7) did
not apply if, among other matters, a principal purpose for the tested
foreign corporation's formation or acquisition of the 25-percent-owned
domestic corporation was to avoid classification of the tested foreign
corporation as a PFIC (``principal purpose anti-abuse rule''). See
proposed Sec. 1.1298-4(f)(2). A modified version of the principal
purpose anti-abuse rule is adopted in the final regulations. See Sec.
1.1298-4(e)(1).
The proposed regulations provide two safe harbors from the
principal purpose anti-abuse rule in Sec. 1.1298-4(e)(1). The Treasury
Department and the IRS request comments on the application of the safe
harbors discussed in this Part I.A.5 of the Explanation of Provisions.
Under the first safe harbor, the anti-abuse rule will not apply if
more than 80 percent of the assets of the second-tier domestic
corporation are used in an active U.S. trade or business, as determined
under modified section 367 rules. See proposed Sec. 1.1298-4(e)(2)(i).
For purposes of the safe harbor, the assets of the domestic subsidiary
qualified affiliates (as defined in proposed Sec. 1.1298-
4(e)(2)(i)(B)) are also taken into account in determining whether the
assets of the second-tier domestic corporation are used in a U.S. trade
or business. See proposed Sec. 1.1298-4(e)(2)(i)(A).
The proposed regulations provide a second safe harbor for active
companies undergoing transition and start-up companies. See proposed
Sec. 1.1298-4(e)(2)(ii). Under this safe harbor, the anti-abuse rule
will not apply if the second-tier domestic corporation engages in an
active U.S. trade or business that satisfies the first safe harbor by
the end of the transition period following the testing date. See
proposed Sec. 1.1298-4(e)(2)(ii). Proposed Sec. 1.1298-4(e)(2)(ii)(B)
defines testing date as the last day of the month in which either (i)
the second-tier domestic corporation is created, organized, or acquired
(``start-up testing date'') or (ii) a second-tier domestic corporation
that previously satisfied the first safe harbor disposes of
substantially all its active U.S. trade or business (``change-of-
business testing date''). Proposed Sec. 1.1298-4(e)(2)(ii)(C) provides
that the transition period is thirty-six months after a testing date.
If the requirements of the business transition and start-up safe harbor
are not satisfied within the transition period, the benefit of the safe
harbor is lost retroactively for the entire period in which the safe
harbor was claimed. See proposed Sec. 1.1298-4(e)(2)(ii)(D). In these
instances, the general anti-abuse rule in Sec. 1.1298-4(e)(1) will be
applied to the tested foreign corporation to determine whether a
principal purpose to avoid PFIC classification existed for the
preceding years, which would be within the normal statute of
limitations on assessments under section 6501.
B. Proposed Revisions to Sec. 1.1297-4--Qualifying Insurance
Corporation
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) either (A) has applicable insurance liabilities
(``AIL'') constituting more than 25 percent of its total assets on its
applicable financial statement (``AFS'') (``the 25 percent test''), or
(B) meets an elective alternative facts and circumstances test which
lowers the required AIL-to-total assets ratio to 10 percent
(``alternative facts and circumstances test'').
Most of the rules for determining whether a foreign corporation is
a QIC under section 1297(f) are provided in the final regulations under
Sec. 1.1297-4. Proposed Sec. 1.1297-4 contains additional rules
relating to the definition of an applicable financial statement, the
definition of applicable insurance liabilities, and an optional
adjustment to total assets.
1. Definition of Applicable Financial Statement
Proposed Sec. 1.1297-4(f)(1) defines the term applicable financial
statement (``AFS'') in a manner that provides ordering rules for how to
prioritize between multiple financial statements prepared at the same
level of priority, for example multiple financial statements prepared
on the basis of GAAP or multiple financial statements prepared on the
basis of IFRS, and between multiple financial statements prepared
taking into account the assets and liabilities of different legal
entities. The definition is modeled on similar definitions elsewhere in
the Code and Treasury regulations, such as regulations under section
451, but has been adapted to the QIC context.
The term financial statement is defined to mean a complete balance
sheet, income statement, and cash flow statement, or the equivalent
statements under the relevant accounting standard, and ancillary
documents typically provided together with such statements. As regards
an AFS, in addition to the general levels of priority set forth in
section 1297(f)(4)(A) (GAAP, IFRS, and insurance regulatory (statutory)
statements), ordering rules provide sub-priority levels (based on the
purpose for which the statement is prepared), with higher priority
being accorded to
[[Page 4590]]
accounting statements viewed as more reliable. Since the AFS is the
financial statement of a non-U.S. entity, financial statements provided
to foreign regulatory bodies generally are treated as having the same
priority as if provided to an equivalent U.S. regulatory body. The
requirement that a non-U.S. regulatory agency have standards not less
stringent than those of the U.S. Securities & Exchange Commission is
intended to provide a standard similar to the definition of a qualified
exchange or other market for purposes of section 1296, with respect to
reporting standards. Because audited financial statements have been
reviewed by independent auditors, and it is anticipated that insurance
regulators will require audited financial statements, only audited
statements can qualify as AFS.
If a tested foreign corporation has multiple financial statements,
the order of priority described above is determinative. However, if
there are multiple financial statements within a single level of
priority and sub-priority (for example, multiple GAAP financial
statements provided to creditors), additional ordering rules are
provided to assign priority first to a financial statement that is not
prepared on a consolidated basis (and that accounts for investments in
the tested foreign corporation's subsidiaries (if any) on a cost or
equity basis), and then to a consolidated financial statement that has
the tested foreign corporation as the parent of the consolidated group.
These rules are intended to make it more likely that the AFS reflects
the same or similar assets and liabilities as the financial statement
used to determine whether the section 1297(f)(3)(B) limitation on the
amount of applicable insurance liabilities applies.
A financial statement prepared on a consolidated basis that takes
into account affiliates that are not owned by the tested foreign
corporation (for example, sister companies) is not treated as the AFS
unless it is the only financial statement of the tested foreign
corporation and is provided to an insurance regulator. It is
anticipated that the only financial statement likely to fall within
that category is a financial statement that includes the tested foreign
corporation and subsidiaries if any, and a parent corporation.
Accordingly, if there are multiple financial statements with the
same level of priority, non-consolidated financial statements take
priority over consolidated financial statements. However, a
consolidated financial statement prepared on the basis of GAAP that has
the tested foreign corporation as the parent of the consolidated group
has priority over a non-consolidated statement prepared on the basis of
statutory accounting standards, because financial statements prepared
on the basis of GAAP are higher priority than financial statements
prepared on the basis of statutory accounting standards. Similarly, a
consolidated statement prepared on the basis of IFRS would have
priority over a non-consolidated statement prepared on the basis of
statutory accounting standards.
The Treasury Department and IRS request comments on the expanded
definition of an AFS and the priority rules provided, including whether
special rules are needed to properly apply the limitation under Sec.
1.1297-4(e)(2) if the statutory accounting statement covers a different
period than the AFS, and whether other more detailed rules are
necessary in order to identify the AFS when a foreign corporation
operates in multiple jurisdictions and is subject to the authority of
more than one insurance regulatory body.
2. Definition of Applicable Insurance Liabilities
As described in Part V.A.2 of the Summary of Comments and
Explanation of Revisions to the final regulations, section 1297(f)(4)
contemplates that a foreign corporation can use GAAP, IFRS, or the
accounting standard used for the annual statement required to be filed
with the local regulator (if a statement prepared for financial
reporting purposes using GAAP or IFRS is not available) as the starting
point to determine AIL. The preamble to the final regulations notes,
however, that AIL is defined more specifically so that only those
liabilities that meet the requirements of section 1297(f)(3) and the
related regulatory definitions in Sec. 1.1297-4(f)(2) are included in
AIL, irrespective of differences in nomenclature and methods that may
be used by different financial reporting standards.
Proposed Sec. 1.1297-4(f)(2)(i)(D)(3) clarifies that, in
determining AIL, liabilities are reduced by an amount equal to the
assets reported on the corporation's financial statement that represent
amounts relating to those liabilities that may be recoverable from
other parties through reinsurance. The rule is necessary because GAAP
and the newest IFRS accounting standard for insurance contracts, IFRS
17, (and possibly local statutory accounting depending on the laws of
the foreign jurisdiction) record amounts recoverable from other parties
as reinsurance with respect to unpaid insurance losses and other
reserves on the asset side of the balance sheet, rather than reducing
balance sheet liabilities. In contrast, insurance regulatory accounting
rules (including those in the United States) often reduce a ceding
company's insurance liabilities by those amounts instead of including
them as assets on the balance sheet. Both methods result in the same
amount of shareholder equity for a foreign corporation but create
different ratios of AIL to total assets and, thus, can potentially
produce a difference in a foreign corporation's QIC status.
The Treasury Department and IRS have determined that AIL should
exclude amounts that have been reinsured because the ratio test would
otherwise be subject to manipulation, and because the Treasury
Department and IRS believe that a uniform approach is appropriate for
the treatment of reinsured risk regardless of the particular accounting
standard that may apply. In addition, proposed Sec. 1.1297-
4(f)(2)(i)(D)(3) clarifies that, if a tested foreign corporation's
financial statement is prepared on a consolidated basis, liabilities of
the tested corporation must be reduced (to the extent not reduced under
other provisions) by an amount equal to the assets relating to those
liabilities that may be recoverable through reinsurance from another
entity included in the consolidated financial statement, regardless of
whether the reinsurance transaction is eliminated in the preparation of
the consolidated financial statement. This proposed rule is consistent
with the rules of Sec. 1.1297-4(f)(2)(i)(D)(1) and (2), which provide
that no item may be taken into account more than once and that AIL
include only the liabilities of the foreign corporation whose QIC
status is being tested, and not liabilities of other entities within a
consolidated group.
The Treasury Department and IRS are aware that certain arrangements
permit a ceding company to continue to hold the reserves and assets
required to support the insurance liabilities for the reinsured
contracts during the policy term (so-called modified coinsurance or
modco). It has been held that life insurance reserves on policies
reinsured under a modco arrangement are attributed to the ceding
company, and not the assuming company. See Rev. Rul. 70-508, 1970-2
C.B. 136 (1970). See generally Colonial Am. Life Ins. v. United States,
491 U.S. 244, 248, n.2 (1989); Anchor National Life Ins. v.
Commissioner, 93 T.C. 382, 423 (1989). Proposed Sec. 1.1297-
4(f)(2)(i)(D)(3) is not intended to apply to modco arrangements where
the ceding
[[Page 4591]]
company retains the assets supporting the insured risks (because they
do not create an amount recoverable from another party), but the
Treasury Department and IRS request comments as to whether the rule
appropriately addresses modco arrangements and whether additional rules
may be necessary in the final regulations. The Treasury Department and
IRS also request comments as to whether to more specifically define
amounts recoverable from another party through reinsurance and whether
there are other special circumstances in which modification of the
definition of AIL is appropriate.
3. Optional Asset Adjustment
Due to the manner in which AIL are defined under Sec. 1.1297-
4(f)(2), it may be necessary to adjust the amount of a foreign
corporation's total assets to avoid distortions in applying the 25
percent test and the 10 percent test. First, if a foreign corporation's
AFS is prepared on a consolidated basis, total assets may be reduced by
the amount equal to the amount of insurance liabilities of affiliated
entities that are reported on the AFS and would be included in AIL if
its definition did not limit AIL to the AIL of the subject foreign
corporation. See proposed Sec. 1.1297-4(e)(4)(i). This adjustment is
appropriate because insurance liabilities of an affiliate, though
excluded from the definition of AIL, can have the effect of reducing
the assets available to satisfy the foreign corporation's insurance
liabilities.
Second, if a foreign corporation reports amounts recoverable from
other parties through reinsurance as assets on its AFS, proposed Sec.
1.1297-4(e)(4)(ii) provides that total assets may be reduced by the
amount by which AIL are reduced under proposed Sec. 1.1297-
4(f)(2)(i)(D)(3). As explained in Part I.B.2 of this Explanation of
Provisions, proposed Sec. 1.1297-4(f)(2)(i)(D)(3) requires a foreign
corporation's AIL to be reduced to reflect those amounts. Without a
corresponding adjustment to total assets, the same reinsurance contract
could have the effect of reducing a foreign corporation's AIL while
also increasing its total assets. The Treasury Department and IRS
request comments as to whether there are other situations that warrant
an adjustment to total assets.
C. Proposed Sec. 1.1297-5: Active Conduct of an Insurance Business
Section 1297(b)(2)(B) provides an exclusion from the definition of
passive income for income derived in the active conduct of an insurance
business by a QIC. As described in Part VI.A of the Summary of Comments
and Explanation of Revisions to the final regulations, proposed Sec.
1.1297-5 revises previously proposed rules for determining whether a
QIC is engaged in the active conduct of an insurance business.
1. Overview
As explained in Part VI.A of the Summary of Comments and
Explanation of Revisions to the final regulations, the Treasury
Department and the IRS have determined that the active conduct of an
insurance business is a requirement mandated by the statute in addition
to (and separate from) the requirements of subchapter L and section
1297(f), but that in response to comments, the active conduct test
should be amended to provide more flexibility in determining whether a
QIC is engaged in the active conduct of an insurance business. Proposed
Sec. 1.1297-5(b)(1) provides that a QIC is treated as engaged in the
active conduct of an insurance business if it satisfies either the
factual requirements test under proposed Sec. 1.1297-5(c) or the
active conduct percentage test under proposed Sec. 1.1297-5(d). The
Treasury Department and IRS request comments on the active conduct
test, including the addition of the new factual requirements test and
revisions to the active conduct percentage test.
2. Exclusions From Active Conduct
Under Sec. 1.1297-5(b)(2), two categories of insurance companies
are precluded from meeting the active conduct test. First, a QIC is not
engaged in the active conduct of an insurance business if it has no
employees (or a nominal number of employees) and relies exclusively (or
almost exclusively) on independent contractors to perform its core
functions. Second, the active conduct test excludes securitization
vehicles (such as vehicles used to issue catastrophe bonds, sidecars,
or collateralized reinsurance vehicles) and insurance linked securities
funds that invest in securitization vehicles. These vehicles are
excluded because they are designed to provide a passive investment
return tied to insurance risk rather than participation in the earnings
of an active insurance business.
3. Factual Requirements Test
As noted in Part VI.A of the Summary of Comments and Explanation of
Revisions to the final regulations, several comments requested the
addition of a facts and circumstances test; other comments recommended
that the active conduct test focus on the assumption of insurance risk;
and a comment specifically identified underwriting as a core insurance
function that must be performed by an insurance company's officers and
employees. The factual requirements test has been added in response to
these comments. The active conduct percentage test has been retained
(in modified form) as an alternative means of satisfying the active
conduct requirement.
Proposed Sec. 1.1297-5(c) provides that the factual requirements
test is satisfied if the QIC's officers and employees carry out
substantial managerial and operational activities on a regular and
continuous basis with respect to all of its core functions and perform
virtually all of the active decision-making functions relevant to
underwriting. A QIC's core functions are generally defined to include
underwriting, investment, contract and claim management, and sales
activities. See proposed Sec. 1.1297-5(f) for definitions of these
terms. See Part I.C.5 of this Explanation of Provisions for rules
concerning officers and employees of related entities.
A QIC's officers and employees are considered to carry out
substantial managerial and operational activities relevant to its core
functions only if they are involved in all levels of planning and
implementation related to the QIC's core functions as described in
proposed Sec. 1.1297-5(c)(2). The required activities must be
conducted by officers or senior employees with appropriate experience
who devote all (or virtually all) of their work to those activities and
similar activities for related entities.
The active decision-making functions relevant to a QIC's
underwriting activities are those underwriting activities most
important to decisions of the QIC relating to the assumption of
specific insurance risks. See proposed Sec. 1.1297-5(c)(3). To meet
this requirement, officers and employees of the QIC must carry out
virtually all of the activities related to a QIC's decision to assume
an insurance risk and must conduct virtually all of the decision-making
with respect to the execution of an insurance contract on a contract-
by-contract basis. Development of underwriting policies and parameters
that are changed infrequently is not an active decision-making function
in the absence of further ongoing involvement by the QIC's officers and
employees. See proposed Sec. 1.1297-5(c)(3)(iii)(A).
4. Active Conduct Percentage Test
The active conduct percentage test is provided in proposed Sec.
1.1297-5(d). To meet this test, two requirements must be satisfied.
First, the total costs incurred by a QIC with respect to its officers
and employees for services rendered with
[[Page 4592]]
respect to its core functions (other than investment activities) must
equal at least 50 percent of the total costs incurred for all services
rendered with respect to the QIC's core functions (other than
investment activities). In response to comments to the 2019 proposed
regulations, investment activities have been excluded from both the
numerator and denominator of the percentage calculation. Second, if any
part of a QIC's core functions (including investment management) is
outsourced to an unrelated entity, the QIC's officers and employees
must conduct robust oversight with respect to the outsourced
activities. See proposed Sec. 1.1297-5(d)(2).
The proposed regulations provide a definition of total costs that
is used to apply the active conduct percentage test. See Sec. 1.1297-
5(f)(8). With respect to a QIC's own officers and employees, total
costs are defined as compensation costs plus other expenses reasonably
allocable to the services provided (determined in accordance with
section 482 and taking into account all expenses that would be included
in the total services costs under Sec. 1.482-9(j) and Sec. 1.482-
9(k)(2)). With respect to services performed by employees of another
entity (whether related or unrelated), total costs are equal to the
amount paid or accrued by the QIC to the other entity for the relevant
services. Ceding commissions paid with respect to reinsurance contracts
and commissions paid to brokers or sales agents to procure reinsurance
contracts are excluded from the definition of total costs.
5. Officers and Employees of Related Entities
For purposes of applying the factual requirements test and the
active conduct percentage test, a QIC's officers and employees are
considered to include the officers and employees of related entities,
where such entities are qualified affiliates of the QIC within the
meaning of Sec. 1.1297-2(e)(2), except that the 50 percent ownership
standard is based on both value and voting power. See proposed Sec.
1.1297-5(e). A qualified affiliate is a corporation or a partnership
that is included in an affiliated group that includes the QIC.
Affiliated group has the meaning provided in section 1504(a),
determined without regard to section 1504(b)(2) and (3) (which would
otherwise exclude foreign corporations and life insurance companies
from membership) and substituting ``more than 50 percent'' ownership
for ``at least 80 percent''. In addition, consistent with the rules of
Sec. 1.1297-2(e)(2), the common parent of the group must be a foreign
corporation or foreign partnership, and a corporation or a partnership
is included in the affiliated group only if it is a look-through
subsidiary or look-through partnership, as applicable, of the common
parent. Also, a partnership is included in the affiliated group only if
more than 50 percent of the value of its capital interests, profits
interests and any other partnership interests is owned by one or more
corporations that are included in the affiliated group. The related
entity rule applies only if the QIC bears the compensation costs on an
arm's length basis and exercises oversight and supervision with respect
to the services provided by affiliated officers and employees. See
proposed Sec. 1.1297-5(e)(3).
As noted in Part VI.A of the Summary of Comments and Explanation of
Revisions to the final regulations, comments requested broader
attribution rules that would cover employees of entities that are
related to the QIC within the meaning of section 954(d)(3) or are under
common practical control with the QIC. These comments have not been
adopted. Because the active conduct test is designed to assess the
activities of a QIC on a separate entity basis (rather than the
activities conducted by an insurance group as a whole), services
performed by officers and employees of other entities cannot be
attributed to a QIC except in the circumstances described in proposed
Sec. 1.1297-5(e). However, the Treasury Department and the IRS
determined that it was appropriate to align the common ownership
requirements for purposes of the insurance active conduct rule with the
ownership requirements used in Sec. 1.1297-2(e)(2) for look-through
subsidiary activity attribution purposes, except including a vote as
well as value requirement to ensure a heightened level of common
control of the related entity officers and employees.
D. Proposed Sec. 1.1297-6(e)(2): Qualifying Domestic Insurance
Corporation Non-Passive Income and Asset Limitations
1. Qualifying Domestic Insurance Corporation Rule
Sections 1.1297-6(b)(2) and (c)(2) of the final regulations provide
that income and assets, respectively, of a qualifying domestic
insurance corporation (``QDIC'') are non-passive for purposes of
determining whether a non-U.S. corporation is treated as a PFIC (the
``QDIC Rule''). Section 1.1297-6(e)(1) of the final regulations defines
a QDIC as a domestic corporation that is subject to tax as an insurance
company under subchapter L, is subject to Federal income tax on its net
income, and is a look-through subsidiary of a tested foreign
corporation. The QDIC Rule is intended to address situations where a
tested foreign corporation owns a 25 percent or greater interest in a
domestic insurance corporation through a structure to which section
1298(b)(7) does not apply, such that the income and assets of the QDIC
are taken into account in determining whether the tested foreign
corporation is a PFIC.
The previous 2019 proposed regulations also provided that the QDIC
Rule did not apply for purposes of section 1298(a)(2) and determining
if a U.S. person indirectly owns stock in a lower tier PFIC (``Proposed
QDIC Attribution Exception''). Consequently, for attribution purposes,
the 2019 proposed regulations required a tested foreign corporation to
apply the Income Test and Asset Test without applying the QDIC Rule.
Several comments on the 2019 proposed regulations requested that
the Proposed QDIC Attribution Exception be removed because U.S.
shareholders of a tested foreign corporation that would not otherwise
be a PFIC but owns a PFIC and a U.S. insurance subsidiary that is a
QDIC could become indirect owners of a PFIC as a result of the section
1298(a)(2) attribution rule. Comments asserted that turning off the
QDIC Rule when testing for lower-tier PFIC ownership attribution would
undermine the purpose of the rule and create significant burden for
U.S. minority shareholders of the tested foreign corporation, who would
have to separately evaluate the PFIC status of all of the tested
foreign corporation's foreign subsidiaries.
2. Proposed Sec. 1.1297-6(e)(2) QDIC Limitation Rule
The Treasury Department and IRS agree that the Proposed QDIC
Attribution Exception was overbroad and removed it from the final
regulations. However, the Treasury Department and IRS believe that
limits on the amount of a QDIC's assets and income that are treated as
non-passive may be appropriate in cases where a QDIC holds
substantially more passive assets than necessary to support its
insurance and annuity obligations. Thus, proposed Sec. 1.1297-6(e)(2)
provides that the amount of a QDIC's otherwise passive income and
assets that may be treated as non-passive is subject to a maximum based
on an applicable percentage of the QDIC's total insurance liabilities
(``QDIC Limitation Rule'').
Proposed Sec. 1.1297-6(e)(2)(i) provides that the amount of a
QDIC's passive
[[Page 4593]]
assets that are treated as non-passive under the QDIC Rule may not
exceed an applicable percentage of the corporation's total insurance
liabilities. This amount is the QDIC's non-passive asset limitation.
Proposed Sec. 1.1297-6(e)(2)(ii) provides that the amount of a QDIC's
passive income that is treated as non-passive under the QDIC Rule may
not exceed the corporation's passive income multiplied by the
proportion that the QDIC's non-passive asset limitation bears to its
total passive assets (determined without the application of the rules
under Sec. 1.1297-6(c)(2)).
Under proposed Sec. 1.1297-6(e)(2)(iii), the applicable percentage
is 200 percent for a life insurance company and 400 percent for a
nonlife insurance company. Proposed Sec. 1.1297-6(e)(2)(iv)(A)
provides that, for a QDIC taxable under Part I of Subchapter L (that
is, a life insurance company), total insurance liabilities means the
sum of the company's total reserves (as defined in section 816(c)) plus
(to the extent not included in total reserves) the reserve items
referred to in paragraphs (3), (4), (5), and (6) of section 807(c). For
a company taxable under Part II of Subchapter L (that is, a nonlife
insurance company), the term total insurance liabilities means the sum
of unearned premiums and unpaid losses. See proposed Sec. 1.1297-
6(e)(2)(iv)(B). Because a QDIC will be subject to tax under Subchapter
L, it is appropriate to determine the amount of its insurance
liabilities for purposes of the QDIC Limitation Rule in accordance with
Subchapter L rules governing insurance liabilities because the QDIC
will already be determining these amounts for U.S. income tax purposes.
See proposed Sec. 1.1297-6(e)(3) for an example illustrating the
application of these rules.
The Treasury Department and the IRS request comments on the QDIC
Limitation Rule and in particular on whether the specified applicable
percentages are reasonable based on industry data. The Treasury
Department and IRS expect most QDICs to not exceed the passive asset
and income limitations based on the applicable percentages. In
addition, a tested foreign corporation may hold less than 50 percent
passive assets and receive less than 75 percent passive income without
being classified as a PFIC. Thus, the QDIC Limitation Rule provides a
disincentive for a foreign corporation to shift excessive passive
assets into its U.S. insurance subsidiary in order not to qualify as a
PFIC and is likely to affect the PFIC classification of only a very
small number of companies. Comments are also requested on whether final
regulations should specifically allow for the applicable percentages to
be adjusted or supplemented in subregulatory guidance (for example, to
reflect possible future changes in industry practice).
E. Life Insurance and Annuity Contract Status
Section 1297(f)(1)(A) provides that a QIC must be a foreign
corporation that would be subject to tax under subchapter L if it were
a domestic corporation. An insurance company is defined in sections
816(a) and 831(c), which limit insurance company status to a company
more than half the business of which during the taxable year is the
issuing of insurance or annuity contracts or the reinsurance of risks
underwritten by insurance companies. Thus, the status of a company as
an insurance company under subchapter L depends upon the
characterization of the contracts that a company issues or reinsures.
In addition, section 816(a) provides that if more than half of the
company's total reserves (as defined in section 816(c)) are life
insurance reserves (as defined in section 816(b)) or unearned premiums
and unpaid losses on non-cancellable life, accident, or health
contracts, then the company is a life insurance company taxable under
part 1 of subchapter L; otherwise, an insurance company is taxable
under part II of subchapter L.
Life insurance contracts and annuity contracts must meet certain
statutory requirements to be treated as contracts giving rise to life
insurance reserves for subchapter L purposes. Section 7702(a) defines a
life insurance contract for purposes of the Code as a life insurance
contract under applicable law (which includes foreign law) that
satisfies one of two actuarial tests set forth in section 7702.
Similarly, section 72(s) sets forth distribution on death requirements
that an annuity contract must satisfy in order to be considered an
annuity contract for purposes of the Code. In addition, if a contract
is a variable contract within the definition of section 817(d), it must
satisfy the diversification requirements for variable contracts under
section 817(h) to be treated as a life insurance or annuity contract
for purposes of subchapter L. These statutory requirements reflect
Congress's concern that the tax-favored treatment generally accorded to
life insurance and annuity contracts under the Code should not be
available to contracts that are too investment oriented or provide for
undue tax deferral.
A taxpayer request (and follow-up submission) was received by the
Treasury Department and the IRS regarding promulgating regulations that
would provide that these statutory requirements do not apply for
purposes of determining whether a foreign corporation satisfies the
section 1297(f)(1)(A) requirement that the corporation would be subject
to tax under subchapter L if it were a domestic corporation (as well as
for other PFIC purposes), if certain requirements are met. The request
suggested an approach to the statutory requirements analogous to the
approach Congress took in section 953(e)(5). Section 953(e)(5) waives
the statutory requirements for purposes of the subpart F insurance and
foreign base company income rules if a contract is regulated as a life
insurance or annuity contract in the issuer's home country and no
policyholder, insured, annuitant, or beneficiary with respect to the
contract is a U.S. person. The request asserts that such a waiver is
warranted for PFIC purposes because contracts issued by non-U.S.
insurance companies are unlikely to satisfy the statutory requirements,
since non-U.S. insurance companies that do not target sales to the U.S.
market typically do not take the statutory requirements into account
when setting the terms of their life insurance and annuity contracts.
The request also states that local law requirements may in some cases
conflict with the statutory requirements. The follow-up submission
suggested that additional qualification rules could be imposed that
restrict the rule to cases in which the issuing company meets
substantial home country requirements (such as deriving more than 50
percent of its aggregate net written premiums from insuring or
reinsuring home country risks of unrelated persons).
The proposed regulations do not address the request as it is beyond
the scope of the current rulemaking. The Treasury Department and the
IRS are evaluating whether further guidance is necessary or appropriate
regarding the application of these provisions in the context of PFICs
and request comments on this issue.
II. QIP's 20-Year ADS Recovery Period Applies To Determine QBAI for
FDII and GILTI
The proposed regulations contain certain rules announced in Notice
2020-69. Proposed Sec. 1.250(b)-2(e)(2) and proposed Sec. 1.951A-
3(e)(2) clarify that the technical amendment to section 168 enacted in
section 2307(a) of the CARES Act applies to determine the adjusted
basis of property under section 951A(d)(3) as if it had originally been
[[Page 4594]]
part of section 13204 of the Act. The Treasury Department and the IRS
have determined that this clarification is consistent with
congressional intent. See JCT CARES Act Report at 69-70.
The Treasury Department and the IRS request comments on whether a
transition rule should be provided that would allow a corrective
adjustment in the first taxable year ending after the date of
publication in the Federal Register of the Treasury Decision adopting
proposed Sec. 1.250(b)-2(e)(2) and proposed Sec. 1.951A-3(e)(2) as
final regulations for taxpayers that took a position that is
inconsistent with proposed Sec. 1.250(b)-2(e)(2) and proposed Sec.
1.951A-3(e)(2) on a return filed before September 1, 2020 and that do
not file an amended return with respect to such year.\10\
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\10\ The Treasury Department and the IRS requested comments on
the need for a transition rule in Notice 2020-69. The Treasury
Department and the IRS will consider comments that are timely
submitted in response to the request for comments in Notice 2020-69,
along with any comments received in response to this notice of
proposed rulemaking, when finalizing proposed Sec. 1.250(b)-2(e)(2)
and proposed Sec. 1.951A-3(e)(2).
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Applicability Dates
I. Applicability Dates Relating to the General PFIC Rules
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 filing of the Treasury Decision
adopting these rules as final regulations in the Federal Register.
However, until these regulations are finalized, taxpayers may rely on
one or more of the following proposed rules with respect to a tested
foreign corporation for any open taxable year beginning before the date
of publication of the Treasury decision adopting these rules as final
regulations in the Federal Register, provided they consistently follow
each such rule for each subsequent taxable year beginning before the
date of filing of the Treasury decision adopting these rules as final
regulations in the Federal Register: Proposed Sec. 1.1297-
1(c)(1)(i)(B) (exceptions to section 954 not taken into account);
proposed Sec. 1.1297-1(c)(2) (exception for active banking income of
certain foreign banks); proposed Sec. 1.1297-1(d)(1)(v)(D) (valuation
of assets); proposed Sec. 1.1297-1(d)(2) (regarding working capital);
proposed Sec. 1.1297-2(b)(2)(ii)(A), (b)(3)(ii)(A), and (e)(4)
(regarding application of exception for active banking income of
certain foreign banks); proposed Sec. 1.1297-2(c)(2)(i) and (4)(ii)(A)
(regarding not taking into account certain dividends); proposed Sec.
1.1297-2(f)(1) and (2) (regarding gain on disposition of stock in a
look-through subsidiary), and proposed Sec. 1.1298-4(e) (regarding
safe harbors to the domestic subsidiary anti-abuse rule). For a taxable
year ending on or before December 31, 2020, a taxpayer may rely on
proposed Sec. 1.1297-1(c)(1)(A) of the 2019 proposed regulations
concerning the application of section 954(h) rather than proposed Sec.
1.1297-1(c)(2) with respect to a tested foreign corporation, without
regard to whether the taxpayer consistently applies all of the
provisions of these proposed regulations or the 2019 proposed
regulations with respect to the tested foreign corporation. As
discussed in greater detail in the preamble to the final regulations
published in the Rules and Regulations section of this edition of the
Federal Register (RIN 1545-BO59), when a tested foreign corporation no
longer qualifies as a PFIC (due to a change in facts or law), the
foreign corporation nonetheless retains its PFIC status with respect to
a shareholder unless and until the shareholder makes an election under
section 1298(b)(1) and Sec. 1.1298-3 (``purging election'') on Form
8621 attached to the shareholder's tax return (including an amended
return), or requests the consent of the Commissioner to make a late
election under section 1298(b)(1) and Sec. 1.1298-3(e) (``late purging
election'') on Form 8621-A.
II. Applicability Dates Relating to the Insurance Exception
For a taxable year beginning after December 31, 2017 and before the
date of filing of the Treasury Decision adopting these rules as final
regulations in the Federal Register, taxpayers may rely on Sec. Sec.
1.1297-4, 1.1297-5, and 1.1297-6 of the proposed regulations with
respect to a tested foreign corporation, provided they consistently
follow the rules of Sec. Sec. 1.1297-4, 1.1297-5, and 1.1297-6 of the
proposed regulations with respect to such tested foreign corporation
for such taxable year and for each subsequent taxable year beginning
before the date of filing of the Treasury decision adopting these rules
as final regulations in the Federal Register. In addition, taxpayers
may rely on proposed Sec. 1.1297-4(e)(4), provided they consistently
apply Sec. 1.1297-4 of the final regulations for the same taxable
year.
Alternatively, for a taxable year beginning after December 31, 2017
and before January 14, 2021, taxpayers may rely on proposed Sec. Sec.
1.1297-4 and 1.1297-5 of the 2019 proposed regulations with respect to
a tested foreign corporation, provided they consistently apply the
rules of proposed Sec. Sec. 1.1297-4 and 1.1297-5 of the 2019 proposed
regulations with respect to such tested foreign corporation for such
taxable year.
III. Applicability Dates Relating to Regulations Under Sections 250 and
951A
Consistent with section 2307(b) of the CARES Act, the proposed
regulations addressing QIP are proposed to apply retroactively. The
modification to proposed Sec. 1.951A-3(e)(2) is proposed to apply to
taxable years of foreign corporations beginning after December 31,
2017, and to taxable years of U.S. shareholders in which or with which
such taxable years of foreign corporations end. The modification to
proposed Sec. 1.250(b)-2(e)(2) is proposed to apply to taxable years
beginning after December 31, 2017.\11\ See section 7805(b)(2). U.S.
shareholders and domestic corporations (including any individuals that
elect to apply section 962) may, before the date of publication of the
Treasury Decision adopting these rules as final regulations in the
Federal Register, rely on proposed Sec. Sec. 1.951A-3(e)(2) and
1.250(b)-2(e)(2) for any taxable year beginning after December 31,
2017, provided they consistently apply those rules for purposes of FDII
and GILTI under sections 250 and 951A to such taxable year and all
subsequent taxable years.
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\11\ The rule in proposed Sec. 1.250(b)-2(e)(2) in this notice
of proposed rulemaking applies to taxable years beginning after
December 31, 2017 and before January 1, 2021 regardless of whether
the taxpayer has relied on proposed Sec. Sec. 1.250(a)-1 through
1.250(b)-6 (as proposed in REG-104464-18, 84 FR 8188), the final
regulations under Sec. Sec. 1.250(a)-1 through 1.250(b)-6 under
Sec. 1.250-1(b) (T.D. 9901, 85 FR 43042), or neither.
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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 final regulations will be informed by comments received.
[[Page 4595]]
This proposed regulation has been designated by the Office of
Information and Regulatory Affairs (OIRA) as subject to review 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. OIRA has
determined that the final rulemaking is significant and subject to
review under Executive Order 12866 and section 1(b) of the Memorandum
of Agreement. Accordingly, the final regulations have been reviewed by
OMB.
A. Background
The passive foreign investment company (PFIC) rules of the Internal
Revenue Code address situations in which taxable U.S. persons
indirectly hold assets that earn ``passive income'' (generally,
interest, dividends, capital gains, and similar types of income)
through a foreign corporation. If not subject to the PFIC rules, the
income earned on these assets would be subject to U.S. tax only when
that income is distributed as dividends by the foreign corporation or
when shares of the foreign corporate stock are sold for a gain by the
U.S. shareholder. If the income were subject to a low or zero rate of
foreign tax, the U.S. investor would have a tax incentive to hold
passive assets in this manner rather than hold the securities directly.
By creating tax-deferral opportunities, these types of investment
arrangements could significantly lower the effective tax rate on
passive income ultimately received by participating U.S. investors.
This potential result would decrease U.S. tax revenues and possibly
lower the cost of capital faced by foreign and domestic corporations
whose securities were held in this manner.
A foreign corporation is considered a PFIC if at least 75 percent
of the corporation's gross income for a given taxable year is passive
income or if assets that produce passive income, or that are held for
the production of passive income, comprise at least 50 percent of the
corporation's total assets. A PFIC is not subject to U.S. tax under the
PFIC regime; rather, U.S. shareholders of a PFIC are subject to tax on
a current, or current-equivalent, basis in proportion to their
ownership share in the PFIC's income.
Passive income generally consists of dividends, interest, rents,
royalties, annuities, gains on the sale of property that is not
inventory or property used in an active business, and similar forms of
income. Passive income is distinguished generally from non-passive
income in that it is not earned in the active conduct of a trade or
business by the foreign corporation, by a party closely affiliated with
the foreign corporation, or by other corporations or partnerships that
can be assumed to be controlled by the foreign corporation.
The ``subpart F'' rules in the Code also address the taxation of
passive income earned by foreign corporations but only in the context
of U.S. controlled foreign corporations (CFCs), defined as being more
than 50 percent owned by U.S. shareholders (where a U.S. shareholder of
a CFC is a U.S. person owning at least ten percent of the vote or value
of the foreign corporation's shares). There is no such minimum
ownership requirement for a U.S. shareholder of a PFIC. A PFIC that is
also a CFC during a portion of a U.S. PFIC shareholder's holding period
is not treated as a PFIC with respect to a U.S. shareholder of a CFC
during that portion of the holding period.
A U.S. shareholder of a PFIC is responsible for determining its
proportionate share of ownership in the PFIC and the appropriate amount
of PFIC income to include on the shareholder's tax return. The Code and
regulations provide ownership attribution rules for determining
indirect ownership of PFICs by U.S. persons and rules for determining
amounts of a corporation's annual total and passive income and the
amounts of total and passive assets on each of several measuring
periods (generally quarterly) throughout the year. Compliance with the
PFIC regime requires an ability to negotiate its often-complicated
rules and generally means that those willing to invest in potential
PFICs are relatively sophisticated taxpayers that have access to
professional tax advice in order to navigate the tax complexities
presented by the PFIC regime. It is also possible that a less
sophisticated taxpayer could invest in a PFIC without a full
understanding of the tax treatment of that investment.
The PFIC definition of passive income refers to the passive income
definition of ``foreign personal holding company income'' (FPHCI) used
for purposes of the CFC rules. That definition contains exceptions from
passive income that involve certain income derived by a CFC in the
active conduct of a banking or financing business and certain income
derived by a CFC in the active conduct of an insurance business.
However, the PFIC statutory rules have separate exceptions from the
definition of passive income that include any income ``derived in the
active conduct of a banking business by an institution licensed to do
business as a bank in the United States (or, to the extent provided in
regulations, by any other corporation)'' and any income ``derived in
the active conduct of an insurance business by a qualifying insurance
corporation.'' Regulations under the PFIC banking exception were
proposed in 1995 (the ``1995 proposed regulations'') to provide greater
clarity and additional specification of this exception to passive
income. These 1995 proposed regulations have not been finalized.
Regulations under the PFIC insurance exception were proposed in 2015 to
clarify further the meaning of ``active conduct'' in this context, but
these regulations have not been finalized. More recently, the Tax Cuts
and Jobs Act (TCJA) of 2017 amended the statutory provision by
requiring that the PFIC insurance exception applies only to an
insurance business conducted by a qualifying insurance corporation
(QIC) and provided a statutory definition of a QIC.
The Treasury Department and the IRS previously published proposed
regulations pertaining to sections 1291, 1297, and 1298 of the Code
(the ``2019 proposed regulations''). See 84 FR 33120. These regulations
dealt with several general PFIC implementation issues and with the new
requirement (beginning in 2018) that a foreign corporation must be a
QIC for its insurance-related income to qualify as non-passive under
the insurance business exception. Regulations to finalize these
proposed regulations (the ``2020 final regulations'') are being
published contemporaneously with these newly proposed regulations
(``these regulations'' or the ``2020 proposed regulations''). See TD
9936. Upon further reflection on certain issues, and in response to
public comments received with respect to the 2019 proposed regulations,
certain revised rules and additional specifications are being re-
proposed.
B. Need for the Proposed Regulations
These regulations are needed because a number of the details behind
the relevant terms and necessary calculations required for the
determination of PFIC status would benefit from greater specificity
beyond that provided by the 2020 final regulations. In particular,
these 2020 proposed regulations further clarify the determination of
the banking and insurance ``active conduct'' statutory exceptions to
the definition of passive income.
[[Page 4596]]
C. Economic Analysis
This economic analysis provides a summary of the economic effects
of the regulations relative to the no-action baseline. It further
analyzes, first, proposed regulations under the general rules that
implement the exception from passive income for income derived in the
active conduct of a banking business and, second, proposed regulations
under the passive income exception for income earned in the active
conduct of an insurance business by a qualifying insurance corporation
(QIC). This latter analysis covers, in particular, elements of these
proposed regulations as they relate to the primary test ratio that must
be satisfied by a QIC. This test requires measurement of certain
applicable insurance liabilities (AIL) and total assets of a tested
corporation.
1. Baseline
In this analysis, the Treasury Department and the IRS assess the
benefits and costs of these 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
These 2020 proposed regulations will provide improved certainty and
consistency in the application of sections 1297 and 1298 of the
Internal Revenue Code with respect to passive foreign investment
companies (PFICs) and qualified insurance corporations (QICs) by
providing definitions and clarifications regarding application of the
statute's terms and rules. Efficient investment requires planning, and
good planning requires knowledge of the proper and consistent
application of tax rules. Furthermore, uncertainty regarding the
applicability of tax rules invites aggressive taxpayer interpretations
and increased enforcement costs, including increased litigation.
Divergence in taxpayers' interpretations of the statute can cause
similarly situated U.S. persons to allocate investment funds
differently. If economic investment is not guided by uniform tax
incentives, the resulting pattern of investment may be inefficient,
leading to relatively lower incomes. By providing clarity to the law
and greater uniformity in its application, the 2020 proposed
regulations, when finalized, will help to ensure that similar economic
activities are taxed similarly. Thus, the Treasury Department and the
IRS expect that the definitions and guidance provided in the proposed
regulations will lead to an improved allocation of investment among
U.S. taxpayers as well as more equitable treatment of those taxpayers.
To the extent that certain regulatory provisions provide greater
opportunities for foreign corporations to avoid PFIC status relative to
the no-action baseline, they provide U.S. investors with additional tax
deferral opportunities relative to a no-action baseline. An increased
use of these tax deferral opportunities would decrease effective
shareholder taxes and generally lower the cost of real investment by
both domestic businesses and foreign corporations for which U.S.
investors are investment funding sources. This would likely increase
such investment and thereby increase U.S. GNP relative to the no-action
baseline. However, such actions would reduce U.S. tax revenues,
although this effect could be offset to a degree by increased taxable
capital gains due to a resultant increase in the valuation of corporate
equities.
To the extent that other provisions of the regulations reduce the
opportunities for foreign corporations to avoid PFIC status, they would
eliminate deferral by U.S. persons and thereby increase U.S.
shareholder tax burdens. This may dissuade U.S. persons from pursuing
profitable investment opportunities in active foreign corporations that
would be sought under a no-action baseline. Such provisions also could
cause some active foreign corporations to incur additional economic
costs in order to avoid designations as PFICs, resulting in lower
investment returns and less investment in such corporations. The
avoidance of otherwise profitable foreign investment opportunities by
U.S. persons can result in a loss of U.S. GNP.
It is unclear whether these proposed regulations have a net effect
of increasing or decreasing the ability of foreign corporations to
avoid PFIC status relative to the no-action baseline.
The Treasury Department and the IRS have not estimated the
differences in economic activity that might result from implementation
of these proposed regulations relative to alternative regulatory
approaches, including the no-action baseline. They do not have readily
available data or models that capture in sufficient detail the economic
activities that taxpayers might undertake under each of these
regulatory approaches. The Treasury Department and the IRS have
similarly not estimated the differences in compliance costs of U.S.
persons or IRS administrative burden that would arise under each of the
alternative regulatory approaches because they do not have readily
available data or models that capture these aspects in sufficient
detail.
The Treasury Department and the IRS solicit comments on this
economic analysis and particularly solicit data, models, or other
evidence that could be used to enhance the rigor with which the final
regulations are developed.
3. Economic Analysis of Specific Provisions
a. Income Derived in the Active Conduct of a Banking Business
The PFIC provisions define passive income as income which is of a
kind that would be foreign personal holding company income (FPHCI) as
defined in section 954(c), which is part of the subpart F rules of the
Internal Revenue Code. A related provision, section 954(h), excludes
from FPHCI for subpart F purposes the ``qualified banking or financing
income'' of an ``eligible controlled foreign corporation,'' that is, a
CFC that is predominantly engaged in the active conduct of a banking,
financing, or similar business and that conducts substantial activity
with respect to such business. A banking, financing or similar business
includes (i) a lending or finance business, (ii) a banking business
conducted by an institution that is licensed to do business as a bank
in the United States or is a corporation specified in regulations, and
(iii) a securities business conducted by a corporation that is either
registered with the SEC as a securities broker or dealer or is
otherwise specified in regulations.
The 2019 PFIC proposed regulations would have incorporated this
section 954(h) exception to FPHCI into the definition of passive income
for the purpose of the PFIC rules. However, the Treasury Department and
the IRS subsequently determined that this exception does not apply for
purposes of the PFIC definition of passive income absent regulations
and that any such regulations should be issued under the separate PFIC
statutory rule described in the next paragraph. Accordingly, these 2020
proposed regulations specify that the FPHCI exception for active
banking income of CFCs is not to be taken into account in the general
definition of passive income for the purpose of the PFIC regime.
The Treasury Department and the IRS considered two options for the
implementation of an active banking exception under the PFIC tax
regime. The first alternative would re-propose the 1995 proposed
regulations. The second alternative would adopt the statutory rules of
the FPHCI exception for CFCs, with modifications (such as
[[Page 4597]]
not limiting the rule to CFCs). Each alternative is discussed in turn.
i. 1995 Proposed Regulations
The 1995 proposed regulations treat ``banking income'' of ``active
banks'' and ``qualified bank affiliates'' as non-passive. An active
bank is either a domestic or foreign corporation that is licensed by
federal or state regulators to do business as a bank in the United
States or a foreign corporation that satisfies the following
requirements:
1. It must be licensed or authorized to accept deposits from its
home country residents and must actively conduct a banking business;
2. It must regularly accept such deposits in the ordinary course of
business; in addition, the amount of deposits shown on the
corporation's balance sheet must be substantial; and
3. It must regularly make loans to customers in the ordinary course
of business.
Banking income is defined as gross income that is derived from the
active conduct of a specified banking activity. The regulations list 14
banking activities (plus a provision that allows the IRS Commissioner
to specify additional banking activities). The major activities listed
include lending activities, the purchasing or selling of notes or other
debt instruments for customers, issuing of letters of credit,
performing trust services, arranging foreign exchange transactions,
interest rate or currency futures, etc., underwriting issues of
securities for customers, engaging in finance leases, and providing
credit card services.
The 1995 proposed regulations also extend the banking income
definition to certain affiliates of active banks that are not
themselves active banks. To be a qualified bank affiliate, at least 60
percent of a foreign corporation's gross income must be income that
qualifies as non-passive income under the PFIC active conduct
exceptions. In addition, a qualified bank affiliate must be a member of
an affiliated group (based on an affiliation ownership standard of more
than 50 percent voting power), and at least 30 percent of the group's
``aggregate gross financial services income'' (defined in foreign tax
credit regulations) must be banking income earned by active banks that
are group affiliates. Also, at least 70 percent of such group income
must be income excepted under the PFIC active conduct rules.
ii. FPHCI Exception for Banking, Finance, or Similar Income of CFCs
The FPHCI exception, while limited to eligible CFCs, applies to a
broader group of eligible corporations and qualified financial
activities than the 1995 proposed regulations for banking income. The
FPHCI rules for CFCs define an eligible business as including a banking
business, a securities business, and a ``lending or finance'' business.
While the FPHCI statutory rules include identical language regarding
banks as does the PFIC statutory exception; neither set of statutory
rules specifically define eligible banks, leaving the definition to
regulations.
The FPHCI exception for CFCs applies to qualified banking or
financing income. A CFC that is not engaged in a banking or securities
business must derive more than 70 percent of its gross income from a
lending or finance business with unrelated customers. A ``lending or
finance'' business includes a business that is making loans, purchasing
or discounting accounts receivable or certain other assets, engaging in
leasing, issuing letters of credit or providing guarantees, providing
credit card services, and rendering services related to the other
listed activities. This list is similar to, but not the same as, the
list of banking activities provided in the 1995 proposed regulations.
Qualified banking or other financing income can be derived in the
active conduct of a branch or other ``qualified business unit'' (QBU)
of an eligible CFC. A QBU is a separate and clearly identified unit
that maintains its own separate books and records. Qualified banking or
financing income must be derived from transactions with customers
located in a country other than the United States. Substantially all of
the activities of the business must be conducted directly by the
corporation in its home country, or by its QBU in the home country of
the QBU. There are no similar requirements in the 1995 proposed
regulations. Under the FPHCI exception for CFCs, business activity may
include the activity of the employees of a related CFC located in the
same home country as that of the corporation or QBU, provided the
activity is conducted in the home country of the related person. Unlike
the 1995 proposed regulations, the FPHCI exception for CFCs does not
treat income of affiliates of an eligible CFC that are not themselves
eligible CFCs as non-passive income.
iii. 2020 Proposed Regulations--Definition of a Foreign Bank
The 2020 proposed regulations generally adopt the approach taken
under the FPHCI statutory language but substitute a tested foreign
corporation (TFC) (or a related person of the TFC) for a CFC. As in the
case of the PFIC banking exception adopted in the 1995 proposed
regulations, the 2020 proposed regulations apply only to foreign banks.
Similar to the ``active bank'' definition of the 1995 regulations,
the 2020 proposed regulations require a ``foreign bank'' to be either
licensed as a bank in the United States or as a bank in the country in
which it is chartered or incorporated (its ``home country''). The 2020
proposed regulations also require that a foreign bank accept bank
deposits from home country residents, and indirectly incorporate the
``substantial deposits'' requirement of the 1995 proposed regulations.
Unlike the 1995 proposed regulations, the 2020 proposed regulations do
not require a foreign bank to regularly make loans to customers in the
ordinary course of its business. Instead, the bank must carry out with
unrelated customers one or more of the activities listed in the FPHCI
statute that constitute a lending or finance business. One of those
activities is the making of loans, but a foreign bank can have as its
business activity any of the other listed finance business activities
in order to qualify for the PFIC banking exception. This change in the
definition of a qualifying foreign bank may be a significant difference
from the 1995 proposed regulations, depending on what activities are
required of and permitted to be carried out by a bank under bank
regulatory rules. If bank regulatory rules do not require a bank to
make loans to customers as part of a banking business, the definition
of foreign bank may represent a broadening of the type of institutions
that may qualify for an exception under the PFIC active conduct
exception for banking compared to the 1995 proposed regulations.
In contrast to the 1995 proposed regulations, the 2020 proposed
regulations provide that the banking exception applies separately to
the income and activities of a qualified branch (i.e., a QBU) of a
foreign bank. Depending on the activities of a branch, this may either
increase or decrease the likelihood that income of a foreign bank is
treated as non-passive.
iv. 2020 Proposed Regulations--Banking Income
While it may be easier to qualify as a foreign bank under the 2020
proposed regulations than as an active bank under the 1995 proposed
regulations, the conditions that must be satisfied in order to treat
income as qualified banking or financing income eligible for
[[Page 4598]]
the FPHCI exception are more stringent than the requirements for
treating income as banking income under the 1995 proposed regulations.
The 2020 proposed regulations require that substantially all activities
that produce active banking income must be performed by the TFC or its
QBU in the home country of the bank or that of the QBU, respectively.
However, an affiliated entity can provide employees to perform the
requisite activity, but only if the affiliate is created or organized
in the relevant home country and the activity is performed in the home
country of the related person. No such requirement exists under the
1995 proposed regulations. This home country activity requirement
limits the variety of organizational structures that foreign banks may
use in order to qualify for the new PFIC banking exception. If a bank
must restructure its operations in order to satisfy the home-country
requirement, this might be considered a significant PFIC compliance
cost by foreign banks and therefore it may impact the investment
choices of U.S. persons.
In addition, under the FPHCI exception, eligible income must be
derived in transactions with customers located in a country other than
the United States. Relative to the 1995 regulations, this rule imposes
an additional compliance burden on foreign corporations that desire to
access the U.S. investment community. It requires them to distinguish
income derived from U.S.-based customers from income derived from other
customers.
v. 2020 Proposed Regulations--Affiliates
Under the 2020 final regulations, a tested foreign corporation
(TFC) that owns at least 25 percent (by value) of a corporation or
partnership may be treated as if it held its proportionate share of the
assets of the look-through subsidiary (LTS) or look-through partnership
(LTP) and received its proportionate share of the income of the LTS or
LTP. The income and assets of the subsidiary entity are treated as
passive or non-passive in the hands of the TFC in the same manner as
such items are treated in the hands of the LTS or LTP. In general, an
exception to the passive income rules applies to income of an LTS or
LTP only if the exception would have applied to exclude the income from
passive income in the hands of the LTS or LTP. For this purpose, the
activities of a specified affiliated group of entities that includes
the TFC may be taken into account to judge the active conduct nature of
the LTS's or LTP's income.
Under certain conditions, the 1995 proposed regulations permit the
banking income of a qualified bank affiliate to be treated as non-
passive income for the purpose of determining the PFIC status of its
affiliated companies. No similar rule applies under the 2020 proposed
regulations for bank affiliates. Thus, for banking income of an LTS to
be treated as excepted income, the LTS must itself be an eligible
foreign bank.
The income of an LTS that is a U.S. bank conducting business with
U.S. residents does not qualify as having excepted income under the
2020 proposed regulations. Such a bank would likely qualify as an
active bank under the 1995 proposed regulations and, under the look-
through rules, that income would be considered non-passive in the hands
of the TFC. In this respect the 2020 proposed regulations make it more
difficult for certain foreign corporations to avoid PFIC status
relative to the 1995 proposed regulations.
vi. Summary of Economic Effects
The Treasury Department and the IRS expect that the 2020 proposed
regulations may produce different outcomes relative to the no-action
baseline. However, whether ``on net'' these different outcomes make it
more difficult for income of certain foreign corporations to qualify as
non-passive under the banking active conduct exception or make it more
likely that income of foreign banking institutions will be treated as
non-passive depends heavily on the individual facts and circumstances
of the TFC and its affiliates, so that no general conclusion can be
drawn in that regard.
b. Applicable Financial Statement and Applicable Insurance Liabilities
For PFIC purposes, passive income does not include income derived
in the active conduct of an insurance business by a qualifying
insurance corporation (QIC). Under the statute, a QIC must have
``applicable insurance liabilities'' (AIL) that constitute more than 25
percent of its total assets (the ``QIC test''). AIL generally include
amounts shown on a financial statement for unpaid loss reserves
(including unpaid loss adjustment expenses) of insurance and
reinsurance contracts and certain life and health insurance reserves
and unpaid claims with respect to contracts providing coverage for
mortality or morbidity risks.
i. Definition of an AFS
For the purpose of the QIC test, AIL are based on insurance
liabilities as they are accounted for on the taxpayer's applicable
financial statement (AFS). Under the statute and the 2020 final
regulations, an AFS is a financial statement prepared for financial
reporting purposes that is based on U.S. generally accepted accounting
principles (GAAP), or international financial reporting standards
(IFRS) if there is no statement based on GAAP. If neither of these
statements exist, then an AFS can be an annual statement that is
required to be filed with an applicable insurance regulatory body. Such
a statement would be one that is prepared on the basis of a local
regulatory accounting standard. Thus, the statute has a preference for
financial statements prepared on the basis of GAAP or IFRS, which are
rigorous and widely-respected accounting standards, but will permit a
foreign corporation to have an AFS that is prepared on the basis of a
local regulatory accounting standard if the foreign corporation does
not do financial reporting based on GAAP or IFRS.
This definition of an AFS does not necessarily produce a single
financial statement that can be deemed ``the'' AFS of a foreign
insurance company. GAAP and IFRS statements may be prepared for several
financial reporting purposes, and there may be differences in the value
of assets or in the presentation of results, depending on the purpose
and jurisdiction for which it is prepared. This may be particularly
true in the case of a financial statement filed with local regulatory
bodies. For example, a company that operates branches in more than one
jurisdiction may be filing multiple regulatory financial statements,
each based on a separate local accounting standard. This variability
may be tempered, however, if the local regulatory authorities require
their regulatory statements to be filed on a GAAP or IFRS basis.
The Treasury Department and the IRS determined that it was
appropriate to modify the definition of AFS in order to impose greater
structure on the identification of the AFS used for purposes of the QIC
test. These 2020 proposed regulations refine the definition of a
financial statement to ensure that an AFS includes a complete balance
sheet, statement of income, a statement of cash flows and related
exhibits, schedules, forms, and footnotes that are normal components of
such a filing. A complete financial statement is more likely to present
an accurate picture of a company's financial position. These 2020
proposed regulations also require that an AFS be an audited financial
statement. While an audit requirement may impose additional accounting
costs on the
[[Page 4599]]
foreign corporation (and, therefore, on its shareholders), a financial
statement reviewed by independent auditors insures adherence to the
relevant accounting standard. The Treasury Department and the IRS have
determined that local jurisdictions generally will require audited
financial statements to be filed with insurance regulatory bodies, so
that this requirement should not impose a significant additional
compliance burden on foreign corporations.
The 2020 proposed regulations impose a new set of sub-priorities on
financial statements prepared under GAAP and a similar set of sub-
priorities on statements prepared under IFRS. These sub-priorities have
been used in other regulatory contexts. They are based on the purpose
for which a financial statement is being released or filed. In the
opinion of the Treasury Department and the IRS, these different
priorities represent the reliability of the statement. Thus, a GAAP
statement filed by publicly regulated corporations with the Securities
and Exchange Commission or with an equivalent foreign agency is deemed
highly reliable and is preferred to a statement that is used, say, for
credit purposes or for reporting in shareholder reports.
The new rule narrows the potential number of financial statements
that might be considered as AFSs relative to the no-action baseline and
should thereby reduce compliance and tax administrative costs, while
bringing taxpayer behavior closer in line with the intent and purpose
of the statute.
If an AFS is a consolidated financial statement in which the tested
corporation is not the parent, such statement could include AIL and
assets of the parent, as well as AIL and assets of other sibling
corporations. Nevertheless, under the 2020 final regulations, the
amount of AIL on an AFS that can be AIL for the purpose of the QIC test
includes only the AIL of the corporation being tested. Consequently,
the 2020 proposed regulations stipulate that a financial statement that
includes parent and sibling assets and liabilities cannot be an AFS
unless it is a financial statement filed with a local regulator and is
the only such financial statement available, in which case the AIL as
reported on the statement would have to be adjusted to remove the
double counted parental and sibling AIL. This rule is expected to
reduce the likelihood that the AIL shown on an AFS would have to be
adjusted prior to the application of the QIC test and thereby reduce
compliance costs relative to alternative regulatory approaches. The
Treasury Department and the IRS have not estimated this reduction in
compliance costs because they do not have data or models with this
level of specificity.
If more than one financial statement exists for an AFS subcategory
and that subcategory is the highest priority subcategory of AFS for
which an AFS is available, then the 2020 proposed regulations dictate
that any financial statement prepared on a non-consolidated basis has
priority over a statement prepared on a consolidated basis. In most
cases, a non-consolidated AFS will be preferred by the tested
corporation because assets of the tested corporation will generally
include the corporation's net equity share of its subsidiaries and not
the full value of its assets. A consolidated statement will include all
assets and liabilities of lower-tiered subsidiaries (whether fully or
partially owned) other than eliminated items that represent intra-
corporate transactions when viewed from a consolidated perspective.
Nevertheless, AIL eligible to be taken into account for purposes of the
QIC test includes only AIL of the tested corporation. Therefore, use of
a consolidated AFS requires that any AIL of entities other than the
tested corporation (such as subsidiaries) that are recorded on the
consolidated statement must be eliminated for the purpose of the QIC
test. Because this would bias downward the QIC test statistic (because
the subsidiary assets supporting these eliminated AIL remain on the
AFS), the 2020 proposed regulations allow a tested corporation to
reduce its assets by the amount of AIL that are eliminated for this
reason.
Any AIL of the tested corporation that have been eliminated because
of the preparation of a consolidated statement (for example, if the
tested corporation had insured or reinsured a subsidiary) are not added
back to the AIL reported on the AFS. The corresponding subsidiary
assets have also been eliminated in the preparation of the consolidated
AFS, so that the reverse process of that described in the previous
paragraph is accomplished automatically.
ii. Limitations on Applicable Insurance Liabilities
Pursuant to statutory mandate and explicitly granted regulatory
authority, the 2020 final regulations specify that any amount of AIL
used in the QIC test cannot exceed the smallest of following three
amounts:
(1) The amount of AIL of the tested corporation shown on any
financial statement that is filed or required to be filed with the
corporation's applicable insurance regulatory body;
(2) The amount of AIL determined on an AFS that is prepared on the
basis of GAAP or IFRS, whether or not such statement is filed by the
tested corporation with its applicable insurance regulatory body;
(3) The amount of AIL required by law or regulation to be held by
the tested corporation (or a lesser amount, if the corporation is
holding a lesser amount as a permitted practice of the applicable
insurance regulatory body).
These limitation amounts may induce local regulators to require the
filing of financial statements based on GAAP or IFRS instead of filing
statements based on a local regulatory accounting standard. Such
actions would eliminate limitation amount 1) above, and assuming that
limitation amount 3) does not apply, would leave the amount of AIL
reported on a GAAP- or IFRS-prepared statement as the relevant AIL.
This approach will improve the application of the QIC test, relative to
the no-action baseline, by increasing the likelihood that AIL and total
assets are both derived from consistent accounting principles by the
tested corporations affected by the PFIC insurance rules.
A tested corporation that has an AFS based on GAAP or IFRS may be
required to file a financial statement with its home country regulator
using local statutory accounting rules, where the AIL on the latter
statement are less than those shown on the AFS. The difference in AIL
could perhaps be due to the use of dissimilar accounting rules, the use
of different discounting assumptions or other assumptions regarding the
measurement of liabilities, or disparate methods of valuing assets.
Under the 2020 proposed regulations, such accounting differences are
not accounted for by prescribed asset adjustments or by other means.
As a regulatory alternative, the Treasury Department and the IRS
considered whether to require asset or liability adjustments based on
certain identified differences between an AFS based on GAAP or IFRS and
a financial statement based on local accounting standards, where the
differences were due solely to different accounting standard
requirements. For example, in preparing the 2020 final regulations, the
Treasury Department and the IRS considered imposing the discounting
rules specified by the Code for measuring property and casualty unpaid
losses for domestic tax purposes on losses measured on a non-GAAP or
non-IFRS basis. Such an option was rejected due partly to its
anticipated heavy compliance costs (and thus the
[[Page 4600]]
possibility that the foreign corporation may not take the steps
necessary to attract U.S. investors) without any accompanying,
identifiable general economic benefit. The Treasury Department and the
IRS determined that prescribing other requirements or adjustments could
have similar compliance costs and that the impacts of such accounting
discrepancies on the QIC test ratio are generally either unknown or
without a consistent bias. In this regard, the Treasury Department and
the IRS further determined that they did not have and could not
practically obtain sufficient information regarding the differences
among GAAP, IFRS, and the various local accounting standard
requirements that might apply to tested corporations in different
foreign jurisdictions to formulate additional appropriate rules.
iii. Reinsurance Recoverable
In the context of reinsurance, however, the differences in the
measurement of AIL and assets under different accounting standards are
in some cases due merely to a different presentation of the accounting
results with respect to reinsurance, rather than more fundamental
differences in measurement or accounting methods. Companies that have
ceded business to another insurer under a contract of reinsurance will
have amounts recoverable from those reinsurers that could represent a
reimbursement of AIL. These amounts may be related to claims that have
been paid or unpaid. Generally, if the insurer has paid a claim, the
reinsurance recoverable is shown as a receivable (that is, an asset) on
its balance sheet. However, the treatment of amounts recoverable with
respect to unpaid losses and unpaid loss adjustment expenses can differ
amongst different accounting standards. For example, under current
GAAP, reinsurance recoverable with respect to unpaid claims is reported
as an asset. The same is true under IFRS 17 (an insurance accounting
standard that will be effective generally beginning in 2023), where a
single reinsurance asset may be reported with respect to both paid and
unpaid claims. The situation is different under U.S. statutory
accounting rules as specified by the National Association of Insurance
Commissioners and implemented by the various states. Under U.S.
statutory accounting, reinsurance recoverable for unpaid losses and
loss adjustment expenses is treated as an offset to the unpaid loss
reserves and would thus reduce AIL. It is likely that some non-U.S.
local statutory accounting standards similarly reduce unpaid loss
reserves (and thus AIL) by amounts recoverable through reinsurance.
Measuring AIL on a ``gross'' basis, as under GAAP and IFRS 17,
necessarily increases the QIC test ratio relative to a ``net'' AIL
measure. However, if the local accounting standard governing the
financial statement filed with an applicable regulatory body requires a
``net'' measure of AIL, then the AIL of the GAAP- or IFRS-based AFS
will generally be limited for the purpose of the QIC test.
Reporting AIL on a ``gross'' basis could enable a foreign insurer
to raise its QIC test ratio to almost any desired level simply by being
a reinsurance conduit (that is by reinsuring business and then
retroceding all, or virtually all, of that business to other
reinsurers). Such a possibility could allow corporations that might
otherwise be designated as PFICs instead to qualify as QICs and thereby
avoid PFIC status.
For these reasons the 2020 proposed regulations specify that
amounts recoverable from reinsurance and related to AIL, if reported as
assets on a financial statement of the tested corporation, must be
subtracted from the reported AIL. That is, all AIL are to be determined
on a ``net'' basis with respect to reinsurance recoverable.
Furthermore, if such reinsurance amounts are recoverable from an
insurance subsidiary of the tested corporation, and such amounts of
reinsurance recoverable are eliminated in the preparation of a
consolidated financial statement, the AIL of the tested corporation
nevertheless must be reduced by the recoverable amount. Under the 2020
proposed regulations, total assets reported on the AFS of the tested
corporation may be reduced by amounts equal to the reductions in AIL
for the purpose of the QIC test.
4. Number of Potentially Affected Taxpayers
An entity must file a separate Form 8621 for each PFIC for which it
has an ownership interest. The accompanying table indicates how many
entities have filed at least one form 8621 between 2016 and 2018. These
data are based on IRS master files of tax return filings and do not
encompass late filings that have not yet been received. For 2018,
nearly 62,000 Forms 8621 were filed. Over 70 percent of the entities
filing a Form 8621 are individuals, although certain individuals are
exempt from filing a Form 8621 if their aggregate holdings are less
than $25,000 ($50,000 if filing a joint return) and they do not have
PFIC income to report. Another 27 percent are pass-through entities,
the overwhelming number of which are partnerships, but which also
include S corporations, estates, and non-grantor trusts. These pass-
through entities primarily have individuals as partners, shareholders,
or beneficiaries. It is possible there is some double counting whereby
both partnerships and partners are filing a Form 8621 for the same
PFIC. C corporations comprise just over one percent of total entities,
while another nearly two percent of Forms 8621 do not identify on the
form the filing status of the filer.
In general, only the taxpayer that is the lowest tier U.S. entity
owning a PFIC needs to file a Form 8621. Thus, an individual that is a
PFIC shareholder because he or she owns an interest in a U.S.
partnership that holds shares of a PFIC does not need to file a Form
8621 if the individual is not required to report PFIC-related income on
the Form 8621. This may happen if, for example, the individual and the
partnership have made a Qualifying Electing Fund (QEF) election with
respect to the PFIC. In that case, only the partnership files the Form
8621. The partnership records the QEF income for the year, and that
taxable income is reported to the taxpayer as part of his or her
distributive share of partnership income.
Table
----------------------------------------------------------------------------------------------------------------
Number of entities filing Form 8621
-----------------------------------------------
2016 2017 2018
----------------------------------------------------------------------------------------------------------------
Individuals..................................................... 36,978 40,891 43,406
Passthrough Entities............................................ 15,326 16,133 16,607
C Corporations.................................................. 713 733 739
Unreported Filer Type........................................... 1,114 1,053 1,084
-----------------------------------------------
[[Page 4601]]
All Entities................................................ 54,131 58,810 61,836
----------------------------------------------------------------------------------------------------------------
In 2018, each reporting taxpaying entity filed an average of 12
Forms 8621. This average was 11 forms per entity for individuals, 16
forms per entity for partnerships and other pass-through entities, and
28 forms per entity for C corporations.
The Treasury Department and the IRS do not have information in
current tax filings regarding how many shareholders own shares in
qualifying insurance companies or qualifying banks.
5. Regulatory Flexibility Act
It is hereby certified that these 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 (5 U.S.C. chapter 6). The proposed regulations provide
guidance with respect to the statutory provisions in sections 1291
through 1298 (the ``PFIC regime''), which generally affect U.S.
taxpayers that have ownership interests in foreign corporations that
are not CFCs. The proposed regulations do not impose any new costs on
taxpayers. Consequently, the Treasury Department and the IRS have
determined that the proposed regulations will not have a significant
economic impact on a substantial number of small entities.
Notwithstanding this certification, the Treasury Department and the IRS
invite comments on the impact of these rules on small entities.
Pursuant to section 7805(f), 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 business. The
Treasury Department and the IRS request comments on the impact of these
proposed regulations on small business entities.
II. 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. 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.
III. 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 amendments to the regulations are adopted as
final regulations, consideration will be given to comments that are
submitted timely to the IRS as prescribed in the preamble under the
ADDRESSES section. The Treasury Department and the IRS request comments
on all aspects of the proposed regulations. See also the specific
requests for comments in the following Parts of the Explanation of
Provisions: I.A.1 (concerning rules for foreign banks and the ongoing
application of Notice 89-81 and proposed Sec. 1.1296-4), I.A.2
(regarding financial statement valuation), I.A.3 (on the treatment of
working capital in applying the Asset Test), I.A.4 (concerning the
elimination of intercompany dividends and the treatment of pre-
acquisition earnings and profits), I.A.5 (on the safe harbor for the
anti-abuse rule for section 1298(b)(7)), I.B.1 (on the expanded
definition of an AFS and the priority rules provided), I.B.2
(concerning modco arrangements and other special circumstances in which
modification of the definition of AIL is appropriate), I.B.3 (on
situations that may warrant an adjustment to total assets), I.C.1
(concerning the active conduct test), I.D.2 (on the QDIC Limitation
Rule), I.E (concerning the application of statutory requirements
relating to life insurance contracts and annuity contracts), and II
(concerning a transition rule). Any electronic comments submitted, and
to the extent practicable any paper comments submitted, will be made
available at www.regulations.gov or upon request.
A public hearing will be scheduled if requested in writing by any
person who timely submits electronic or written comments. Requests for
a public hearing are also encouraged to be made electronically by
sending an email to publichearings@irs.gov. If a public hearing is
scheduled, notice of the date and time for the public hearing will be
published in the Federal Register. Announcement 2020-4, 2020-17 I.R.B.
667 (April 20, 2020), provides that until further notice, public
hearings conducted by the IRS will be held telephonically. Any
telephonic hearing will be made accessible to people with disabilities.
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 Publishing Office,
Washington, DC 20402, or by visiting the IRS website at www.irs.gov.
Drafting Information
The principal drafters of these regulations are Christina G.
Daniels, Josephine Firehock, Jorge M. Oben, and Larry R. Pounders 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.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
[[Page 4602]]
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 2. In Sec. 1.250-1 amend paragraph (b) by revising the first
sentence and adding a sentence at the end of the paragraph to read as
follows:
Sec. 1.250-1 Introduction.
* * * * *
(b) * * * Except as otherwise provided in this paragraph (b)(2),
Sec. Sec. 1.250(a)-1 and 1.250(b)-1 through 1.250(b)-6 apply to
taxable years beginning on or after January 1, 2021. * * * The last
sentence in Sec. 1.250(b)-2(e)(2) applies to taxable years beginning
after December 31, 2017.
* * * * *
0
Par. 3. Section 1.250(b)-2 is amended by adding a sentence at the end
of paragraph (e)(2) to read as follows:
Sec. 1.250(b)-2 Qualified business asset investment (QBAI).
* * * * *
(e) * * *
(2) * * * For purposes of applying section 250(b)(2)(B) and this
paragraph (e), the technical amendment to section 168(g) enacted in
section 2307(a) of the Coronavirus Aid, Relief, and Economic Security
Act, Public Law 116-136 (2020) is treated as enacted on December 22,
2017.
0
Par. 4. Section 1.951A-3 is amended by adding a sentence at the end of
paragraph (e)(2) to read as follows:
Sec. 1.951A-3 Qualified business asset investment.
* * * * *
(e) * * *
(2) * * * For purposes of applying section 951A(d)(3) and this
paragraph (e), the technical amendment to section 168(g) enacted in
section 2307(a) of the Coronavirus Aid, Relief, and Economic Security
Act, Public Law 116-136 (2020) is treated as enacted on December 22,
2017.
* * * * *
0
Par. 5. Section 1.1297-0 is amended by:
0
1. Revising the entries for Sec. 1.1297-2(f)(1) and (2).
0
2. Revising the entries for Sec. 1.1297-4(e)(4) and (5), (f)(1)(iv),
(f)(6)(i), (ii), and (iii), and (g)(1) and (2).
0
3. Adding an entry for Sec. 1.1297-5.
0
4. Revising the entries for Sec. 1.1297-6(e)(2) and (3) and (f)(1) and
(2).
The revisions and additions read as follows:
Sec. 1.1297-0 Table of contents.
* * * * *
Sec. 1.1297-1 Definition of passive foreign investment company.
* * * * *
(c) * * *
(2) Exception for certain income derived in the active conduct
of a banking businesses by a foreign bank.
(i) In general.
(ii) Foreign bank determination.
* * * * *
(d) * * *
(1) * * *
(v) * * *
(D) Valuation.
* * * * *
(2) Working capital.
* * * * *
(g) * * *
(3) Paragraphs (c)(1)(i)(B), (c)(2), (d)(1)(v)(D), and (d)(2) of
this section.
Sec. 1.1297-2 Special rules regarding look-through subsidiaries and
look-through partnerships.
* * * * *
(e) * * *
(4) Active banking business.
(f) * * *
(1) Stock basis adjustment.
(2) Amount of gain taken into account.
* * * * *
Sec. 1.1297-4 Qualifying insurance corporation.
* * * * *
(e) * * *
(4) Corresponding adjustment to total assets.
(i) Consolidated applicable financial statement
(ii) Insurance risk transferred through reinsurance.
(5) Example.
(i) Facts.
(ii) Results.
(A) AIL reduction.
(B) Asset reduction.
* * * * *
(f) * * *
(1) * * *
(iv) Priority of financial statements.
* * * * *
(6) * * *
(i) In general.
(ii) Consolidated and non-consolidated financial statement.
(iii) Audited financial statement.
* * * * *
(g) * * *
(1) General applicability date.
(2) Exception.
(3) Early application.
Sec. 1.1297-5 Active conduct of an insurance business.
(a) Scope.
(b) Active conduct of an insurance business.
(1) In general.
(2) Exceptions.
(c) Factual requirements test.
(1) In general.
(2) Substantial managerial and operational activities with
respect to core functions.
(i) Substantial managerial and operational activities.
(ii) Regular and continuous basis.
(3) Performance of virtually all of the active decision-making
functions relevant to a QIC's underwriting activities.
(i) Active decision-making functions.
(ii) Performance requirements.
(iii) Exclusions.
(4) Number of officers and employees.
(d) Active conduct percentage test.
(1) Percentage test.
(2) Outsourcing.
(e) Related officers and employees.
(1) Modified qualified affiliate requirement.
(2) Oversight and supervision requirement.
(3) Compensation requirement.
(f) Definitions.
(1) Applicable reporting period.
(2) Compensation costs.
(3) Contract and claims management activities.
(4) Core functions.
(5) Investment activities.
(6) Qualifying insurance corporation or QIC.
(7) Sales activities.
(8) Total costs.
(9) Underwriting activities.
(10) Virtually all.
(g) Applicability date.
Sec. 1.1297-6 Exception from the definition of passive income for
active insurance income.
* * * * *
(e) * * *
(2) Qualifying domestic insurance corporation non-passive asset
and income limitations.
(i) Qualifying domestic insurance corporation's non-passive
assets.
(ii) Qualifying domestic insurance corporation's non-passive
income.
(iii) Non-passive asset limitation.
(iv) Total insurance liabilities.
(A) Companies taxable under Part I of Subchapter L.
(B) Companies taxable under Part II of Subchapter L.
(3) Example.
(i) Facts.
(ii) Result.
(A) Non-passive asset limitation.
(B) Non-passive income limitation.
(f) * * *
(1) General applicability date.
(2) Exception.
(3) Early application.
0
Par. 6. Section 1.1297-1 is amended by:
0
1. Revising paragraphs (c)(1)(i)(B), (c)(2), (d)(1)(v)(D), and (d)(2).
0
2. Revising the first sentence of paragraph (g)(1).
0
3. Adding paragraph (g)(3).
The revisions and addition read as follows:
Sec. 1.1297-1 Definition of passive foreign investment company.
* * * * *
(c) * * *
(1) * * *
[[Page 4603]]
(i) * * *
(B) The exceptions in sections 954(c)(3) (relating to certain
income received from related persons), 954(c)(6) (relating to certain
amounts received from related controlled foreign corporations), 954(h)
(relating to entities engaged in the active conduct of a banking,
financing, or similar business), and 954(i) (relating to entities
engaged in the active conduct of an insurance business) are not taken
into account; * * *
* * * * *
(2) Exception for certain income derived in the active conduct of a
banking business by a foreign bank--(i) In general. For purposes of
section 1297(b)(2)(A), income of a tested foreign corporation is
treated as non-passive if--
(A) The income would not be treated as foreign personal holding
company income under section 954(h) (relating to entities engaged in
the active conduct of a banking, financing, or similar business) if the
tested foreign corporation (and, to the extent relevant, any related
person as defined by section 954(d)(3)) were a controlled foreign
corporation within the meaning of section 957(a); and
(B) The tested foreign corporation is a foreign bank that is
engaged in the active conduct of a banking business (within the meaning
of section 954(h)(2)(B)(ii)) and the income is derived in the conduct
of that banking business.
(ii) Foreign bank determination. A tested foreign corporation will
be treated as a foreign bank only if it--
(A) is licensed by federal or state bank regulatory authorities to
do business as a bank in the United States, or is licensed or
authorized by a bank regulatory authority in the country in which it is
chartered or incorporated (or, in the case of a qualified business
unit, in the country in which the unit maintains its principal office)
to do business as a bank in that country, including to--
(I) Accept bank deposits from residents of that country; and
(II) Carry out one or more of the activities listed in section
954(h)(4), and
(B) regularly receives bank deposits from and carries out one or
more of the activities listed in section 954(h)(4) with unrelated
customers in the ordinary course of a banking business.
* * * * *
(d) * * *
(1) * * *
(v) * * *
(D) Valuation. For purposes of determining the value of assets
during a measuring period when the shares of a tested foreign
corporation are not publicly traded, valuation may be determined on the
basis of periodic financial accounting statements provided at least
annually. If the tested foreign corporation or one or more shareholders
has actual knowledge or reason to know based on readily accessible
information that the financial accounting statements do not reflect a
reasonable estimate of an asset's value and the information provides a
more reasonable estimate of the asset's value, then the information
must be used to determine the value of the assets to which it relates.
* * * * *
(2) Working capital. For purposes of section 1297(a)(2), an amount
of currency denominated in functional currency (as defined in section
985(b)) held in a non-interest bearing financial account that is held
for the present needs of an active trade or business and is no greater
than the amount necessary to cover operating expenses incurred in the
ordinary course of the trade or business of the tested foreign
corporation (for example, accounts payable for ordinary operating
expenses) and reasonably expected to be paid within 90 days is not
treated as a passive asset. For purposes of the preceding sentence,
cash equivalents are not treated as currency, and amounts held for
purposes other than to meet the ordinary course operating expenses of
the trade or business, including for the purpose of providing for (i)
future diversification into a new trade or business, (ii) expansion of
trade or business activities, (iii) future plant replacement, or (iv)
future business contingencies, are treated as passive assets.
* * * * *
(g) * * *
(1) In general. Except as otherwise provided, the rules of this
section apply to taxable years of shareholders beginning on or after
January 14, 2021. * * *
* * * * *
(3) Paragraphs (c)(1)(i)(B), (c)(2), (d)(1)(v)(D), and (d)(2) of
this section. Paragraphs (c)(1)(i)(B), (c)(2), (d)(1)(v)(D), and (d)(2)
of this section apply to taxable years of shareholders beginning on or
after [the date these regulations are filed as final regulations in the
Federal Register]. A shareholder may choose to apply the paragraphs in
the preceding sentence for any open taxable year beginning before [the
date these regulations are filed as final regulations in the Federal
Register] without regard to whether the rules of this section are
applied consistently, provided that once applied, each rule must be
applied for each subsequent taxable year beginning before [the date
these regulations are filed as final regulations in the Federal
Register].
0
Par. 7. Section 1.1297-2 is amended by:
0
1. Revising the third sentence in paragraph (b)(2)(ii)(A), the second
sentence in paragraph (b)(3)(ii)(A), the first sentence in paragraph
(c)(2)(i), and the second sentence in (c)(4)(ii)(A).
0
2. Adding subparagraph (e)(4).
0
3. Revising the first sentence and adding two sentences to the end of
paragraph (h).
The revisions and additions read as follows:
Sec. 1.1297-2 Special rules regarding look-through subsidiaries and
look-through partnerships.
* * * * *
(b) * * *
(2) * * *
(ii) * * *
(A) * * * The exceptions to passive income in section 1297(b)(2)
and the relevant exceptions to foreign personal holding company income
in sections 954(c) and (h) that are based on whether income is derived
in the active conduct of a business or whether a corporation is engaged
in the active conduct of a business apply to such income only if the
exception would have applied to exclude the income from passive income
or foreign personal holding company income in the hands of the
subsidiary, determined by taking into account only the activities of
the subsidiary except as provided in paragraph (e) of this section. * *
*
* * * * *
(3) * * *
(ii) * * *
(A) * * * The exceptions to passive income in section 1297(b)(2)
and the relevant exceptions to foreign personal holding company income
in sections 954(c) and (h) that are based on whether income is derived
in the active conduct of a business or whether a corporation is engaged
in the active conduct of a business apply to such income only if the
exception would have applied to exclude the income from passive income
or foreign personal holding company income in the hands of the
partnership, determined by taking into account only the activities of
the partnership except as provided in paragraph (e) of this section. *
* *
* * * * *
(c) * * *
(2) * * *
(i) LTS stock. For purposes of section 1297, a tested foreign
corporation does
[[Page 4604]]
not take into account dividends derived with respect to LTS stock,
including dividends that the tested foreign corporation is treated as
receiving on a measurement date pursuant to section 1297(c) and
paragraphs (b)(2) or (b)(3) of this section. * * *
* * * * *
(4) * * *
(ii) * * *
(A) * * * During the first quarter of the taxable year, TFC
received $20x of dividends from LTS1 and $30x of interest on the loan,
both of which were paid in cash.
* * * * *
(e) * * *
(4) Active banking business. For purposes of Sec. 1.1297-1(c)(2),
the activities of the employees of a person that is a related person
with respect to a look-through subsidiary or partnership are taken into
account to the extent provided in section 954(h)(3)(E).
* * * * *
(f) Gain on disposition of a look-through subsidiary or look-
through partnership--(1) Stock basis adjustment. For purposes of
determining gain in paragraph (2) of this paragraph (f), a tested
foreign corporation's basis in the stock of a look-through subsidiary
is decreased, but not below zero, by the aggregate amount of
distributions made by the look-through subsidiary with respect to the
look-through subsidiary's stock that are attributable to income of the
look-through subsidiary not treated as received directly by the tested
foreign corporation pursuant to paragraph (b)(2) of this section.
(2) Amount of gain taken into account. The amount of gain derived
from a tested foreign corporation's direct disposition of stock of a
look-through subsidiary, or an indirect disposition resulting from the
disposition of stock of a look-through subsidiary by other look-through
subsidiaries or by look-through partnerships, that is taken into
account by the tested foreign corporation for purposes of section
1297(a)(1), section 1298(b)(3), and Sec. 1.1298-2 is the residual
gain. The residual gain equals the total gain recognized by the tested
foreign corporation (including gain treated as recognized by the tested
foreign corporation pursuant to section 1297(c) and paragraph (b)(2) of
this section or Sec. 1.1297-1(c)(2)) from the disposition of the stock
of the look-through subsidiary reduced (but not below zero) by
unremitted earnings. Unremitted earnings are the excess (if any) of the
aggregate income (if any) taken into account by the tested foreign
corporation pursuant to section 1297(c) and paragraph (b)(2) of this
section or Sec. 1.1297-1(c)(2) with respect to the stock of the
disposed-of look-through subsidiary (including with respect to any
other look-through subsidiary, to the extent it is owned by the tested
foreign corporation indirectly through the disposed-of look-through
subsidiary) over the aggregate dividends (if any) received by the
tested foreign corporation from the disposed-of look-through subsidiary
with respect to the stock other than dividends described in paragraph
(f)(1) of this section. For purposes of this paragraph (f)(2), the
amount of gain derived from the disposition of stock of a look-through
subsidiary and income of and dividends received from the look-through
subsidiary is determined on a share-by-share basis, determined under a
reasonable method.
* * * * *
(h) Applicability date. Except as otherwise provided, the rules of
this section apply to taxable years of shareholders beginning on or
after January 14, 2021. * * * Paragraphs (b)(2)(ii)(A), (b)(3)(ii)(A),
(c)(2)(i), (c)(4)(ii)(A), (e)(4), (f)(1), and (f)(2) of this section
apply to taxable years of shareholders beginning on or after [the date
these regulations are filed as final regulations in the Federal
Register]. A shareholder may choose to apply the paragraphs in the
preceding sentence for any open taxable year beginning before [the date
these regulations are filed as final regulations in the Federal
Register] without regard to whether the rules of this section are
applied consistently, provided that once applied, each rule must be
applied for each subsequent taxable year beginning before [the date
these regulations are filed as final regulations in the Federal
Register].
0
Par. 8. Section 1.1297-4 is amended by revising paragraphs (e)(4),
(e)(5), (f)(1), (f)(2)(i)(D)(3), (f)(6)(i), (ii), and (iii), and (g) to
read as follows:
Sec. 1.1297-4 Qualifying insurance corporation.
* * * * *
(e) * * *
(4) Corresponding adjustment to total assets. For purposes of
determining whether a foreign corporation satisfies the 25 percent test
or the 10 percent test, the amount of total assets reported on the
foreign corporation's applicable financial statement may be reduced as
described in paragraphs (e)(4)(i) through (iii) of this section.
(i) Consolidated applicable financial statement. If a foreign
corporation's applicable financial statement is prepared on a
consolidated basis, the amount of total assets may be reduced by the
amount of liabilities of another entity that are reported on the
applicable financial statement and would be treated as applicable
insurance liabilities but for the application of paragraphs (e)(2) or
(f)(2)(i)(D)(2) of this section.
(ii) Insurance risk transferred through reinsurance. If the
applicable financial statement is prepared on the basis of an
accounting method that measures insurance liabilities without a
reduction for amounts that may be recovered from other parties through
reinsurance and the amount that may be recovered through reinsurance is
reported as an asset on the applicable financial statement (rather than
as a reduction in the amount of an insurance liability), the foreign
corporation's total assets may be reduced by the amount of the
corporation's insurance liabilities that are reinsured to another party
and are excluded from the definition of applicable insurance
liabilities under paragraph (f)(2)(i)(D)(3) of this section.
(iii) No amount may be used more than once to reduce total assets
under paragraphs (e)(4)(i) and (ii) of this section.
(5) Example. The following example illustrates the application of
paragraph (e)(4) of this section.
(i) Facts. P, a foreign corporation, issues property and casualty
insurance contracts and has a consolidated applicable financial
statement (AFS) constructed using IFRS accounting principles, including
those of IFRS 17, for the applicable reporting period. The AFS reports
insurance contract liabilities for incurred claims that meet the
requirements of paragraphs (f)(2)(i)(A) and (f)(2)(i)(B) of this
section in an amount equal to 1,100x, 200x of which are liabilities
under contracts issued by S, a wholly owned insurance subsidiary, and
900x of which are liabilities under contracts issued by P. The AFS also
reports 2,500x of total assets, including 250x of assets related to P's
insurance contract liabilities for incurred claims that are recoverable
from unrelated parties through reinsurance.
(ii) Results--(A) Reduction to applicable insurance liabilities
(AIL). Under paragraph (f)(2)(i)(D)(2) of this section, only AIL of the
foreign corporation whose QIC status is being determined may be
included in AIL. Thus, P's AIL do not include the 200x of insurance
contract liabilities on P's consolidated AFS that are liabilities under
contracts issued by S. Under paragraph (f)(2)(i)(D)(3) of this section,
the amount of insurance liabilities determined under paragraphs
(f)(2)(i)(A)
[[Page 4605]]
through (C) and (D)(1) and (2) of this section are reduced by an amount
equal to the assets reported on P's AFS that represent amounts relating
to those liabilities that may be recoverable from other parties through
reinsurance. Thus, P's AIL are reduced by an amount equal to the 250x
of assets for incurred claims related to the insurance liabilities of P
that are recoverable from another party through reinsurance. Assuming
no other limitation applies (such as those contained in paragraph (e)
of this section), P's AIL equals 650x (1,100x-200x-250x).
(B) Reduction to total assets. Pursuant to paragraph (e)(4)(i) of
this section, P may reduce its total assets by amounts of liabilities
of another entity that are excluded from P's AIL because of paragraphs
(e)(2) or (f)(2)(i)(D)(2) of this section. Under paragraph
(f)(2)(i)(D)(2) of this section, P's AIL may include only the
liabilities of P, the entity whose QIC status is being determined.
Therefore, P may reduce its total assets by 200x, the amount of
liabilities under contracts issued by S that are included on P's AFS
but excluded from P's AIL. Pursuant to paragraph (e)(4)(ii) of this
section, P may also reduce its total assets by 250x, the amount of P's
liabilities that are reinsured by another party and excluded from the
definition of AIL under paragraph (f)(2)(i)(D)(3) of this section.
After these adjustments, P has total assets of 2,050x (2,500x-200x-
250x).
(C) AIL to total assets tests. Accordingly, for purposes of the 25
percent and 10 percent tests, P has AIL of 650x and total assets of
2,050x, for a test ratio of 650x/2,050x, or 31.7%.
(f) Definitions. * * *
(1) Applicable financial statement. The term applicable financial
statement means the foreign corporation's financial statement prepared
for the financial reporting purposes listed in paragraphs (f)(1)(i)
through (iii) of this section that has the highest priority, including
priority within paragraphs (f)(1)(i)(B) and (f)(1)(ii) of this section.
Subject to paragraph (f)(1)(iv) of this section, the financial
statements are, in order of descending priority--
(i) GAAP statements. A financial statement that is prepared in
accordance with GAAP and is:
(A) A Form 10-K (or successor form), or annual statement to
shareholders, filed with the United States Securities and Exchange
Commission (SEC), or filed by the taxpayer with an agency of a foreign
government that is equivalent to the SEC, and has reporting standards
not less stringent than the standards required by the SEC;
(B) An audited financial statement of the taxpayer that is used
for:
(1) Credit purposes;
(2) Reporting to shareholders, partners, or other proprietors, or
to beneficiaries;
(3) Filing with the Federal government or any Federal agency, other
than the SEC or the Internal Revenue Service or an applicable insurance
regulatory body, or filing with a state or foreign government or an
agency of a state or foreign government, other than an agency that is
equivalent to the SEC or the Internal Revenue Service or is an
applicable insurance regulatory body; or
(4) Any other substantial non-tax purpose, including filing with
the applicable insurance regulatory body; or
(ii) IFRS statements. A financial statement that is prepared in
accordance with IFRS and is described in paragraphs (f)(1)(i)(A) or (B)
of this section, in the order of priority set forth in those
paragraphs; or
(iii) Regulatory annual statement. An audited financial statement
required to be filed with the applicable insurance regulatory body that
is not prepared in accordance with GAAP or IFRS.
(iv) Priority of financial statements.
(A) A financial statement that takes into account assets and
liabilities of affiliates of the foreign corporation that are not owned
in whole or part by the foreign corporation is not treated as an
applicable financial statement for purposes of paragraphs (f)(1)(i) and
(ii) of this section, and is not treated as an applicable financial
statement for purposes of paragraph (f)(1)(iii) of this section unless
it is the only financial statement described in paragraph (f)(1)(iii)
of this section.
(B) A financial statement that is described in more than one clause
listed in paragraphs (f)(1)(i) through (iii) of this section is treated
for purposes of this paragraph (f)(1) as described solely in the
highest priority clause. If a foreign corporation has more than one
financial statement with equal priority under paragraphs (f)(1)(i)
through (iii) of this section, a non-consolidated financial statement
has priority over other financial statements.
(2) Applicable insurance liabilities. * * *
(i) * * *
(D) * * *
(3) Amounts of liabilities determined under paragraphs (f)(2)(i)(A)
through (C) and (D)(1) and (2) are reduced by an amount equal to the
assets reported on the corporation's financial statement as of the
financial statement end date that represent amounts relating to those
liabilities that may be recoverable from other parties through
reinsurance. If a foreign corporation's financial statement is prepared
on a consolidated basis, to the extent not reduced already under
paragraphs (f)(2)(i)(A) through (C) and (D)(1) and (2), liabilities are
reduced by an amount equal to the assets relating to those liabilities
that may be recoverable through reinsurance from another entity
included in the consolidated financial statement, regardless of whether
the reinsurance transaction is eliminated in the preparation of the
consolidated financial statement.
* * * * *
(6) Financial statements--(i) In general. The term financial
statement means a statement prepared for a legal entity for a reporting
period in accordance with the rules of a financial accounting or
statutory accounting standard that includes a complete balance sheet,
statement of income, a statement of cash flows (or equivalent
statements under the applicable reporting standard), and related
exhibits, schedules, forms, and footnotes that usually accompany the
balance sheet, income statement and cash flow statement.
(ii) Consolidated and non-consolidated financial statement. The
term consolidated financial statement means a financial statement of a
consolidated group of entities that includes a parent and its
subsidiaries presented as those of a single economic entity, prepared
in accordance with GAAP, IFRS or another financial or statutory
accounting standard. A non-consolidated financial statement means a
financial statement that is not prepared on a consolidated basis and
that accounts for investments in subsidiaries on a cost or equity
basis.
(iii) Audited financial statement. The term audited financial
statement means a financial statement that has been examined by an
independent auditor that has provided an opinion that the financial
statement presents fairly in all material respects the financial
position of the audited company (and its subsidiaries and controlled
entities, if relevant) and the results of their operations and cash
flows in accordance with GAAP or IFRS, or an equivalent opinion under
GAAP, IFRS or another financial accounting or statutory accounting
standard.
* * * * *
(g) Applicability date--(1) General applicability date. Except as
provided in paragraph (g)(2) of this section, this section applies to
taxable years of shareholders beginning on or after January 14, 2021.
[[Page 4606]]
(2) Exception. Paragraphs (e)(4), (e)(5), (f)(1), (f)(2)(i)(D)(3),
and (f)(6) of this section apply to taxable years of United States
persons that are shareholders in foreign corporations beginning on or
after [the date these regulations are filed as final regulations in the
Federal Register].
(3) Early application--(i) A shareholder may choose to apply the
rules of this section (other than paragraphs (f)(1), (f)(2)(i)(D)(3),
and (f)(6) of this section) for any open taxable year beginning after
December 31, 2017 and before the applicability dates described in
paragraphs (g)(1) and (2) of this section, provided that, with respect
to a tested foreign corporation, it consistently applies those rules
and the rules described in Sec. 1.1297-6(f)(3) for such year and all
subsequent years.
(ii) A shareholder may choose to apply paragraphs (f)(1),
(f)(2)(i)(D)(3), and (f)(6) of this section for any open taxable year
beginning after December 31, 2017 and before [the date these
regulations are filed as final regulations in the Federal Register],
provided that, with respect to a tested foreign corporation, it
consistently applies the rules of this section, Sec. 1.1297-5, and
Sec. 1.1297-6 for such year and all subsequent years.
0
Par. 9. Section 1.1297-5 is revised to read as follows:
Sec. 1.1297-5 Active conduct of an insurance business.
(a) Scope. This section provides rules pertaining to the exception
from passive income under section 1297(b)(2)(B) for income derived in
the active conduct of an insurance business. Paragraph (b) of this
section sets forth the options for a qualifying insurance company (QIC)
to qualify as engaged in the active conduct of an insurance business
and describes circumstances under which a QIC will not be engaged in
the active conduct of an insurance business. Paragraph (c) of this
section describes the factual requirements that are sufficient to show
that a QIC is engaged in the active conduct of an insurance business
for purposes of section 1297(b)(2)(B). Paragraph (d) of this section
describes an alternative active conduct percentage test, pursuant to
which a QIC may be deemed to be engaged in the active conduct of an
insurance business for purposes of section 1297(b)(2)(B). Paragraph (e)
of this section describes the circumstances under which officers and
employees of certain entities related to a QIC may be treated as if
they were employees of the QIC. Paragraph (f) of this section provides
definitions applicable to this section. Paragraph (g) of this section
provides the applicability date of this section.
(b) Active conduct of an insurance business--(1) In general. A QIC
is engaged in the active conduct of an insurance business only if it
satisfies--
(i) the factual requirements test in paragraph (c) of this section;
or
(ii) the active conduct percentage test in paragraph (d) of this
section.
(2) Exceptions. Notwithstanding paragraph (b)(1) of this section, a
QIC is not engaged in the active conduct of an insurance business if
either of the following circumstances apply--
(i) It has no employees or only a nominal number of employees and
relies exclusively or almost exclusively upon independent contractors
(disregarding for this purpose any related entity that has entered into
a contract designating its status as an independent contractor with
respect to the QIC) to perform its core functions;
(ii) It is a vehicle that has the effect of securitizing or
collateralizing insurance risks underwritten by other insurance or
reinsurance companies or is an insurance linked securities fund that
invests in securitization vehicles, and its stock (or a financial
instrument, note, or security that is treated as equity for U.S. tax
purposes) is designed to provide an investment return that is tied to
the occurrence of a fixed or pre-determined portfolio of insured risks,
events, or indices related to insured risks.
(c) Factual Requirements Test--(1) In general. A QIC satisfies the
factual requirements test of paragraph (b)(1)(i) of this section if all
the following are met--
(i) The officers and employees of the QIC carry out substantial
managerial and operational activities on a regular and continuous basis
with respect to its core functions as described in paragraph (c)(2) of
this section; and
(ii) The officers and employees of the QIC perform virtually all of
the active decision-making functions relevant to underwriting functions
as described in paragraph (c)(3) of this section.
(2) Substantial managerial and operational activities with respect
to core functions--(i) Substantial managerial and operational
activities. Substantial managerial and operational activities with
respect to a QIC's core functions requires all of the following--
(A) Establishing the strategic, overall parameters with respect to
each core function;
(B) Establishing, or reviewing and approving, detailed plans to
implement the strategic, overall parameters for each of the QIC's core
functions;
(C) Managing, controlling and supervising the execution of the
detailed plans to carry out each of the QIC's core functions;
(D) Establishing criteria for the hiring of employees or
independent contractors to execute the detailed plans to carry out each
of the QIC's core functions, and if independent contractors are hired,
prescribing the goals and objectives of the engagement, the scope of
work, evaluation criteria for contractor eligibility and for
submissions by prospective contractors, and criteria and budget for the
work to be performed;
(E) Reviewing the conduct of the work performed by employees or
independent contractors to ensure that it meets the goals, standards,
criteria, timeline and budget specified by the QIC, and taking
appropriate action if it does not; and
(F) Conducting each of the requirements above by officers or senior
employees of the QIC, which officers or employees are experienced in
the conduct of those activities and devote all or virtually all of
their work to those activities and similar activities for related
entities.
(ii) Regular and continuous basis. Carrying out managerial and
operational activities on a regular and continuous basis requires that
the parameters and plans described in paragraphs (c)(2)(i)(A) and (B)
of this section are regularly reviewed and updated and that the
activities described in paragraphs (c)(2)(i)(C) and (E) of this section
are carried out on a daily or other frequent basis as part of the
ordinary course of the QIC's operations.
(3) Performance of virtually all of the active decision-making
functions relevant to a QIC's underwriting activities--(i) Active
decision-making functions. Active decision-making functions are the
underwriting activities that are most important to decisions of the QIC
relating to the assumption of specific insurance risks.
(ii) Performance requirements. Performance of virtually all of the
active decision-making functions relating to underwriting activities
requires all of the following--
(A) Carrying out virtually all of the activities related to a QIC's
decision to assume an insurance risk, as set forth in the definition of
underwriting activities, by employees and not by independent
contractors; and
(B) Evaluating, analyzing, and conducting virtually all of the
decision-making with respect to executing an insurance contract on a
contract-by-contract basis, including determining whether the contract
meets the QIC's criteria with respect to the risks to be
[[Page 4607]]
undertaken and pricing and is otherwise sound and appropriate.
(iii) Exclusions. The following activities are not active decision-
making functions relevant to a QIC's core functions--
(A) Development of underwriting policies or parameters that are
changed infrequently without further ongoing, active involvement in the
day-to-day decision-making related to these functions; and
(B) Clerical or ministerial functions with respect to underwriting
that do not involve the exercise of discretion or business judgment.
(4) Number of officers and employees. The number of officers and
employees actively engaged in each core function is a relevant factor
in determining whether the factual requirements in paragraph (c)(1) of
this section have been satisfied.
(d) Active conduct percentage test. A QIC satisfies the active
conduct percentage test of paragraph (b)(1)(ii) and will be deemed to
be engaged in an active insurance business for the applicable reporting
period only if it satisfies the percentage requirement in paragraph
(d)(1) of this section and, to the extent core functions are
outsourced, the oversight requirement in paragraph (d)(2) of this
section.
(1) Percentage test. For the applicable reporting period covered by
the applicable financial statement, total costs incurred by the QIC
with respect to the QIC's officers and employees for services rendered
with respect to its core functions (other than investment activities)
equals or exceeds 50 percent of total costs incurred by the QIC with
respect to the QIC's officers and employees and any other person or
entities for services rendered with respect to its core functions
(other than investment activities).
(2) Outsourcing. To the extent the QIC outsources any part of its
core functions to unrelated entities, officers and employees of the QIC
with experience and relevant expertise must select and supervise the
person that performs the outsourced functions, establish objectives for
performance of the outsourced functions, and prescribe rigorous
guidelines relating to the outsourced functions which are routinely
evaluated and updated.
(e) Related officers and employees. For purposes of this section, a
QIC's officers and employees are considered to include the officers and
employees of a related entity if the requirements of this paragraph (e)
are satisfied. In determining whether an activity is carried out by
employees, the activities of persons that are independent contractors
and that are not related entities are disregarded. An entity may be a
related entity regardless of whether it has entered into a contract
designating its status as an independent contractor with respect to the
QIC. An entity is treated as a related entity only if the requirements
of this paragraph (e) are satisfied.
(1) Modified qualified affiliate requirement. The entity is a
qualified affiliate of the QIC within the meaning of Sec. 1.1297-
2(e)(2) (determined by treating the QIC as the tested foreign
corporation) except that, for purposes of this section, section
1504(a)(2)(A) (with ``more than 50 percent'' substituted for ``at least
80 percent'') also applies for purposes of determining qualified
affiliate status.
(2) Oversight and supervision requirement. The QIC exercises
regular oversight and supervision over the services performed by the
related entity's officers and employees for the QIC.
(3) Compensation requirement. The QIC either--
(i) Pays directly all the compensation costs of the related
entity's officers and employees attributable to core functions
performed by those officers and employees on behalf of the QIC;
(ii) Reimburses the related entity for the portion of its expenses,
including compensation costs and related expenses (determined in
accordance with section 482 and taking into account all expenses that
would be included in the total services costs under Sec. 1.482-9(j)
and Sec. 1.482-9(k)(2)) for the performance by its officers and
employees of core functions on behalf of the QIC; or
(iii) Otherwise pays arm's length compensation in accordance with
section 482 on a fee-related basis to the related entity for services
related to core functions.
(f) Definitions. The following definitions apply solely for
purposes of this section.
(1) Applicable reporting period. The term applicable reporting
period has the meaning set forth in Sec. 1.1297-4(f)(4).
(2) Compensation costs. The term compensation costs means all
amounts incurred by the QIC during the applicable reporting period with
respect to an officer and employee (including, for example, wages,
salaries, deferred compensation, employee benefits, and employer
payroll taxes).
(3) Contract and claims management activities. The term contract
and claims management activities means performing the following
activities with respect to an insurance or annuity contract: Monitoring
a contract (or group of contracts) over its life cycle (that is,
maintaining the information on contractual developments, insured risk
and occurrences, and maintaining accounts on premiums, claims reserves
and commissions); performing loss and claim reporting (establishing and
maintaining loss reporting systems, developing reliable claims
statistics, defining and adjusting claims provisions and introducing
measures to protect and reduce claims in future); and all the
activities related to a policyholder's claim, including processing the
claims report, examining coverage, handling the claim (working out the
level of the claim, clarifying causes, claims reduction measures, legal
analysis) and seeking recovery of funds due to the QIC.
(4) Core functions. The term core functions means the QIC `s
underwriting, investment, contract and claims management and sales
activities; however, contract and claims management activities will not
be considered to be a core function of a reinsurance company with
respect to indemnity reinsurance contracts to the extent that the
ceding company has agreed to retain this core function under a
reinsurance contract.
(5) Investment activities. The term investment activities means
investment in equity and debt instruments and related hedging
transactions and other assets of a kind typically held for investment,
for the purpose of producing income to meet obligations under the
insurance, annuity or reinsurance contracts.
(6) Qualifying insurance corporation or QIC. The term qualifying
insurance corporation or QIC has the meaning described in Sec. 1.1297-
4(b).
(7) Sales activities. The term sales activities means sales,
marketing and customer relations with respect to insurance or
reinsurance policies.
(8) Total costs. With respect to the QIC's own officers and
employees (and without regard to related officers and employees
described in paragraph (e) of this section), the term total costs means
the compensation costs of those officers and employees and related
expenses (determined in accordance with section 482 and taking into
account all expenses that would be included in the total services costs
under Sec. 1.482-9(j) and Sec. 1.482-9(k)(2)) for services performed
related to core functions. With respect to services performed by
related officers and employees and unrelated persons or entities, the
term total costs means the amount paid or accrued to the related or
unrelated persons or entities for the services related to core
functions. For purposes of this section, total costs,
[[Page 4608]]
however, do not include any ceding commissions paid or accrued with
respect to reinsurance contracts or commissions or fees paid or accrued
to brokers or sales agents to procure reinsurance contracts.
(9) Underwriting activities. The term underwriting activities means
the performance of activities related to a QIC's decision to assume an
insurance risk (for example, the decision to enter into an insurance or
reinsurance contract, setting underwriting policy, risk classification
and selection, designing or tailoring insurance or reinsurance products
to meet market or customer requirements, performing actuarial analysis
with respect to insurance products, and performing analysis for
purposes of setting premium rates or calculating reserves, and risk
retention).
(10) Virtually all. The term virtually all means all, other than a
de minimis portion, measured on any reasonable basis.
(g) Applicability date. This section applies to taxable years of
shareholders beginning on or after [the date these regulations are
filed as final regulations in the Federal Register]. A shareholder may
choose to apply the rules of this section for any open taxable year
beginning after December 31, 2017 and before [the date these
regulations are filed as final regulations in the Federal Register],
provided that, with respect to a tested foreign corporation, it
consistently applies the rules of this section, Sec. 1.1297-4, and
Sec. 1.1297-6 for such year and all subsequent years.
0
Par. 10. Section 1.1297-6 is amended by adding a sentence to the end of
paragraph (b)(2), adding a sentence to the end of paragraph (c)(2), and
revising paragraphs (e)(2), (e)(3), and (f), to read as follows:
Sec. 1.1297-6 Exception from the definition of passive income for
active insurance income.
* * * * *
(b) Exclusion from passive income of active insurance income. * * *
(2) * * * See paragraph (e)(2)(i) of this section for additional
rules regarding the amount of income of a qualifying domestic insurance
corporation that is treated as non-passive.
* * * * *
(c) Exclusion of assets for purposes of the passive asset test
under section 1297(a)(2). * * *
(2) * * * See paragraph (e)(2)(ii) of this section for additional
rules regarding the amount of assets of a qualifying domestic insurance
corporation that are treated as non-passive.
* * * * *
(e) Qualifying domestic insurance corporation. * * *
(2) Qualifying domestic insurance corporation non-passive asset and
income limitations. For purposes of section 1297 and Sec. 1.1297-1--
(i) Qualifying domestic insurance corporation's non-passive assets.
The amount of passive assets of a qualifying domestic insurance
corporation that may be treated as non-passive is equal to the lesser
of the passive assets of the corporation (determined without
application of paragraph (c)(2) of this section) or the corporation's
non-passive asset limitation (as defined in paragraph (e)(2)(iii) of
this section).
(ii) Qualifying domestic insurance corporation's non-passive
income. The amount of passive income of a qualifying domestic insurance
corporation that may be treated as non-passive is equal to the lesser
of the passive income of the corporation (determined without
application of paragraph (b)(2) of this section) or the corporation's
passive income multiplied by the proportion that its non-passive asset
limitation (as defined in paragraph (e)(2)(iii) of this section) bears
to its total passive assets (determined without application of
paragraph (c)(2) of this section).
(iii) Non-passive asset limitation. For purposes of paragraph (e)
of this section, the non-passive asset limitation equals the
corporation's total insurance liabilities multiplied by the applicable
percentage. The applicable percentage is--
(A) 400 percent of total insurance liabilities, for a company
taxable under Part II of Subchapter L; and
(B) 200 percent of total insurance liabilities, for a company
taxable under Part I of Subchapter L.
(iv) Total insurance liabilities. For purposes of paragraph (e) of
this section--
(A) Companies taxable under Part I of Subchapter L. In the case of
a company taxable under part I of Subchapter L, the term total
insurance liabilities means the sum of the total reserves (as defined
in section 816(c)) plus (to the extent not included in total reserves)
the items referred to in paragraphs (3), (4), (5), and (6) of section
807(c).
(B) Companies taxable under Part II of Subchapter L. In the case of
a company taxable under part II of Subchapter L, the term total
insurance liabilities means the sum of unearned premiums (determined
under Sec. 1.832-4(a)(8)) and unpaid losses.
(3) Example. The following example illustrates the application of
this section.
(i) Facts. X, a qualifying domestic insurance corporation within
the meaning of paragraph (e)(1) of this section, is a nonlife insurance
company taxable under part II of Subchapter L. X has passive assets of
$1000x, total insurance liabilities of $200x, and passive income of
$100x.
(ii) Result--(A) Non-passive asset limitation. The applicable
percentage for nonlife insurance companies is 400%. Pursuant to
paragraph (e)(2)(iii) of this section, X has a non-passive asset
limitation of $800x, which is equal to its total insurance liabilities
of $200x multiplied by 400%. Under paragraph (e)(2)(i) of this section,
$800x of X's passive assets (equal to the lesser of the non-passive
asset limitation ($800x) or passive assets ($1000x)) are treated as
non-passive, and $200x remains passive.
(B) Non-passive income limitation. X has a non-passive asset
limitation of $800x. The proportion of its non-passive asset limitation
($800x) to its total passive assets ($1000x) is 80%. Pursuant to
paragraph (e)(2)(ii) of this section, X has $80x of passive income
treated as non-passive (equal to the lesser of passive income ($100x)
or 80% times $100x) and $20x remains passive.
(f) Applicability date--(1) General applicability date. Except as
provided in paragraph (f)(2) of this section, this section applies to
taxable years of shareholders beginning on or after January 14, 2021.
(2) Exception. Paragraphs (e)(2) and (e)(3) of this section apply
to taxable years of shareholders beginning on or after [the date these
regulations are filed as final regulations in the Federal Register].
(3) Early application. A shareholder may choose to apply the rules
of this section (other than paragraphs (e)(2) and (e)(3) of this
section) for any open taxable year beginning after December 31, 2017
and before January 14, 2021, provided that, with respect to a tested
foreign corporation, it consistently applies those rules and the rules
described in Sec. 1.1297-4(g)(3)(i) for such year and all subsequent
years.
0
Par. 11. Section 1.1298-0 is amended by adding entries for Sec.
1.1298-4(e)(2)(i) and (ii); Sec. 1.1298-4(e)(2)(ii)(A), (B), (C), and
(D); Sec. 1.1298-4(e)(3); Sec. 1.1298-4(e)(3)(i), (ii), (iii), and
(iv); Sec. 1.1298-4(e)(3)(i)(A) and (B); Sec. 1.1298-4(e)(3)(ii)(A)
and (B); Sec. 1.1298-4(e)(3)(iii)(A) and (B); and Sec. 1.1298-
4(e)(3)(iv)(A) and (B) to read as follows:
[[Page 4609]]
Sec. 1.1298-0 Table of contents.
Sec. 1.1298-4 Rules for certain foreign corporations owning stock
in 25-percent-owned domestic corporations.
* * * * *
(e) * * *
(2) Safe harbor.
(i) Active business within Unites States.
(ii) Businesses undergoing change and new businesses.
(A) In general.
(B) Testing date.
(C) Transition period.
(D) Inapplicability.
(3) Examples.
(i) Example 1.
(A) Facts.
(B) Results.
(ii) Example 2.
(A) Facts.
(B) Results.
(iii) Example 3.
(A) Facts.
(B) Results.
(iv) Example 4.
(A) Facts.
(B) Results.
* * * * *
0
Par. 12. Section 1.1298-4 is amended by:
0
1. Revising paragraphs (e)(2) and (3).
0
2. Revising the first sentence and adding two sentences to the end of
paragraph (f).
The additions and revisions read as follows:
Sec. 1.1298-4 Rules for certain foreign corporations owning stock in
25-percent-owned domestic corporations.
* * * * *
(e) * * *
(2) Safe harbor. Paragraph (e)(1) of this section will not apply if
paragraph (e)(2)(i) or (e)(2)(ii) of this section applies.
(i) Active business within United States. The value of the assets
of the second-tier domestic corporation used or held for use in an
active trade or business within the U.S. is more than 80 percent of the
fair market value of the gross assets of such corporation. For purposes
of this paragraph (e)(2)--
(A) The value of the assets of the second-tier domestic corporation
takes into account its pro-rata share of the value of the assets of its
domestic subsidiary qualified affiliates and does not take into account
the stock of such affiliates;
(B) The term domestic subsidiary qualified affiliate means each
member of the affiliated group (as defined in section 1504(a) applied
by substituting ``more than 50 percent'' for ``at least 80 percent''
each place it appears), treating the second-tier domestic corporation
as the common parent of such affiliated group; and
(C) For purposes of this paragraph (e)(2), the determination of the
existence of an active trade or business and whether assets are used in
an active trade or business is made under Sec. 1.367(a)-2(d)(2), (3),
and (5) except that officers and employees of related entities as
provided in Sec. 1.367(a)-2(d)(3) include only the officers and
employees of related domestic entities within the meaning of section
267(b) or 707(b)(1).
(ii) Businesses undergoing change and new businesses--(A) In
general. The second-tier domestic corporation engages in an active U.S.
trade or business that satisfies paragraph (e)(2)(i) of this section by
the end of the transition period following the testing date.
(B) Testing date. For purposes of this paragraph (e)(2)(ii), the
term ``testing date'' means the last day of the month in which either--
(1) The second-tier domestic corporation is created or organized or
is acquired, directly or indirectly, by the tested foreign corporation;
or
(2) A second-tier domestic corporation that previously satisfied
(e)(2)(i) of this paragraph (e) disposes of, to a person that is not
related within the meaning of section 267(b) or 707(b)(1),
substantially all of the assets used or held for use in its active U.S.
trade or business.
(C) Transition period. For purposes of this paragraph (e)(2)(ii),
the term ``transition period'' means thirty-six months after the
testing date as defined in paragraph (e)(2)(ii)(B)(1) or (2) of this
section.
(D) Inapplicability. This paragraph (e)(2)(ii) does not apply for
any taxable year (including previous taxable years) of the tested
foreign corporation if the second-tier domestic corporation does not
engage in an active U.S. trade or business that satisfies paragraph
(e)(2)(i) of this section by the end of the transition period following
a testing date.
(3) Examples. The following examples illustrate the rules of this
paragraph (e). For purposes of these examples, TFC is a foreign
corporation that is not a controlled foreign corporation (within the
meaning of section 957(a)) and that is subject to the section 531 tax,
USS1 and USS2 are domestic corporations for TFC's entire taxable year,
TFC owns 100% of the single class of stock of USS1, and USS1 owns 100%
of the single class of stock of USS2.
(i) Example 1--(A) Facts. USS2 operates an active trade or business
within the United States within the meaning of Sec. 1.367(a)-2(d)(2),
(3), and (5). Throughout TFC's Year 1, the value of USS2's assets is
$100x, and the value of USS2's assets that are used or held for use in
its active trade or business within the United States is $20x. USS2 was
not created, organized, or acquired within the preceding thirty-six
months and has not disposed of an active trade or business within the
United States within the preceding thirty-six months.
(B) Results. Paragraph (e)(2)(i) of this section does not apply in
Year 1 even though USS2 is engaged in an active trade or business
within the United States because only 20% ($20x/$100x) of its assets
are used or held for use in an active U.S. trade or business within the
meaning of Sec. 1.367(a)-2(d)(2), (3), and (5), an amount that is not
more than 80% of the fair market value of the total gross assets of
USS2. Accordingly, the general rule in paragraph (e)(1) of this section
will apply if there is a principal purpose to hold passive assets
through USS2, the second-tier domestic corporation, to avoid
classification of TFC, the tested foreign corporation, as a PFIC.
(ii) Example 2--(A) Facts. The facts are the same as in as in
paragraph (e)(4)(i)(A) of this section (the facts in Example 1), except
that USS2 also has an investment in USS3, a wholly owned domestic
subsidiary of USS2. Throughout TFC's taxable Year 1, the value of
USS3's assets is $400x and USS3 uses 100% of its assets in an active
trade or business within the United States within the meaning of Sec.
1.367(a)-2(d)(2), (3), and (5).
(B) Results. Because USS3 is a domestic subsidiary qualified
affiliate of USS2, USS2's pro-rata share of the assets of USS3 is taken
into account to determine whether USS2 satisfies paragraph (e)(2)(i) of
this section. Accordingly, USS2 takes into account $400x (its pro-rata
share) of USS3's assets in addition to the $100x of its own assets and,
thus, is treated for purposes of paragraph (e)(2)(i) of this section as
owning $500x of assets, with 84% ($420x/$500x) of such assets being
used or held for use in an active trade or business within the United
States within the meaning of Sec. 1.367(a)-2(d)(2), (3), and (5).
Therefore, paragraph (e)(2)(i) of this section applies in Year 1 and
the general rule in paragraph (e)(1) of this section does not apply.
(iii) Example 3--(A) Facts. Throughout Year 1, USS2 uses 100% of
its assets in an active trade or business within the United States
within the meaning of Sec. 1.367(a)-2(d)(2), (3), and (5), and thus
satisfied paragraph (e)(2)(i) of this section in Year 1. On the first
day of Year 2, USS2 disposes of all of those assets for cash. On the
seventh day of Year 5 (before the end of the first month
[[Page 4610]]
in Year 5), USS2 invests the cash in assets that it immediately begins
to use in an active trade or business in the United States.
(B) Results. Because USS2, the second-tier domestic corporation,
engages in an active U.S. trade or business that satisfies paragraph
(e)(2)(i) of this section by the end of thirty-six months after the
last day of the month in which it disposed of its entire active U.S.
trade or business that previously satisfied paragraph (e)(2)(i) of this
section, paragraph (e)(2)(ii) of this section applies in Year 2, Year
3, and Year 4, and the general rule in paragraph (e)(1) of this section
does not apply.
(iv) Example 4--(A) Facts. The facts are the same as in paragraph
(e)(4)(iii)(A) of this section (the facts in Example 3), except that at
the end of the first month of Year 5, USS2 is still in negotiations to
purchase assets to be used in an active trade or business in the United
States within the meaning of Sec. 1.367(a)-2(d)(2), (3), and (5), and
USS2 does not complete the purchase of such assets until the third
month of Year 5.
(B) Results. The safe harbor in paragraph (e)(2)(ii) of this
section does not apply for Year 2, Year 3, or Year 4, because USS2, the
second-tier domestic corporation, did not engage in an active U.S.
trade or business that satisfied paragraph (e)(2)(i) of this section by
the end of the thirty-six month transition period after the end of the
month in which it sold its prior active trade or business. Accordingly,
the general rule in paragraph (e)(1) of this section will apply if
there is a principal purpose to hold passive assets through USS2, the
second-tier domestic corporation, to avoid classification of TFC, the
tested foreign corporation, as a PFIC.
(f) Applicability date. Except as otherwise provided, the rules of
this section apply to taxable years of shareholders beginning on or
after January 14, 2021 * * * Paragraphs (e)(2) and (3) of this section
apply to taxable years of shareholders beginning on or after [DATE OF
FILING OF FINAL RULE IN THE FEDERAL REGISTER]. A shareholder may choose
to apply the paragraphs in the preceding sentence for any open taxable
year beginning before [DATE OF FILING OF FINAL RULE IN THE FEDERAL
REGISTER] without regard to whether the rules of this section are
applied consistently, provided that once applied, each rule must be
applied for each subsequent taxable year beginning before [DATE OF
FILING OF FINAL RULE IN THE Federal Register].
Sunita Lough,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2020-27003 Filed 1-14-21; 8:45 am]
BILLING CODE 4830-01-P