On July 22, 2009, John Merrick, Special Counsel to the IRS Associate Chief Counsel (International), spoke at the International Fiscal Association USA Branch meeting in New York. At the meeting, Mr. Merrick indicated, in part, that the IRS had adopted an ad hoc strategy of providing guidance through private letter rulings (PLR’s) rather than taking on big regulations projects. One area in which this new policy is unfolding is with respect to the passive foreign investment company (PFIC) regime. Numerous rulings have been issued by the IRS in recent years while no regulations, either proposed or temporary, have been issued. The only other guidance has been to modify the PFIC reporting requirements in response to a comment.

The PFIC regime is increasingly becoming relevant as to many different provisions of the Internal Revenue Code, including (1) qualifying dividend income as described under § 1(h)(11); (2) related person deductions under § 267(a)(3)(B); (3) the application of grantor trust rules under § 672(f); and (4) the constructive ownership rules of § 1260. Additionally, several legislative proposals aim at increasing information reporting requirements relating to PFIC interests. Altogether PFIC guidance is increasingly becoming more imperative with the passage of time.

PFIC Regime

A PFIC is defined as any foreign corporation (the Tested Foreign Corporation) if, for the taxable year, (1) 75% or more of its gross income is passive income (the PFIC Income Test) or (2) at least 50% of its assets is held for the production of passive income (the PFIC Asset Test). The PFIC Income Test is determined by taking into account all gross income of the Tested Foreign Corporation for its taxable year. The PFIC Asset Test is determined by taking into account the average quarterly value of the assets of the Tested Foreign Corporation, as measured on the last date of each quarter of the corporation’s taxable year.

“Passive income” means, for these purposes, “any income which is of a kind which would be foreign personal holding company income as defined in [§] 954(c).” The PFIC rules, however, exclude from the definition of “passive income” certain income earned in the active conduct of a banking business or insurance business.

Under § 1297(c), a look-through provision treats a foreign corporation that owns at least 25% by value of the stock of another corporation as owning its proportionate share of the assets and of the income of the other corporation. This provision permits a holding company to escape classification as a PFIC by looking through to the assets and income of its operating subsidiaries.

A U.S. shareholder of a PFIC may be subject to one of three alternative taxing regimes: the Excess Distribution regime, the Qualified Electing Fund (QEF) regime, or the § 1296 Mark-to-Market (MTM) regime. The latter two regimes are elective and more taxpayer-favorable.

Recent IRS PFIC Ruling Guidance

Consistent with Mr. Merrick’s recent statement, the IRS has issued several significant PFIC rulings in the past few years addressing a number of complex, heretofore unresolved issues.

§ 1297(c) Look-Through Treatment on Dispositions of Subsidiary Stock

In PLR 200813036 (Dec. 19, 1997), Corporation A, a foreign corporation with U.S. shareholders, indirectly held a greater than 25% interest in the value of Corporation B, a foreign corporation actively engaged in Business B. The direct shareholder of Corporation B, a wholly owned indirect subsidiary of Corporation A, was sold to an unrelated third party, along with certain loan amounts due, for cash. Corporation A planned to invest a portion of the cash from the sale in assets that could be used in Business X.

Citing first PLR 200604020 (Oct. 21, 2005), the IRS ruled that, in applying the PFIC Income Test, the character (active or passive) of the gain attributable to the disposition of the Corporation B stock should be determined by reference to the percentage of active or passive assets in the disposed subsidiary at the time of the sale. Then, citing PLR 200015028 (Jan. 12, 2000), the IRS ruled that, for purposes of § 1298(b)(3), which provides an exception to PFIC status for a company that sells a business, the disposition of the Corporation B stock was treated as a disposition of an active trade or business by Corporation A, Corporation B’s indirect owner. Finally, PLR 200813036 interpreted § 1298(b)(3) as available by Corporation A to avoid PFIC status in either the year of disposition or the year immediately after such disposition, but not both years. This is an important ruling because the statute is silent as to the taxable year to which the exception may be applied. The ruling is taxpayer-friendly because it permits a taxpayer to apply the exception to either the year of disposition or the subsequent year.

Effect of Intermediary U.S. Partnership on QEF and MTM Electing Shareholders

In PLR 200838003 (Jun. 17, 2008), U.S. investors owned some of the class A shares of PFIC A (PFIC A Shareholders). PFIC A, together with another party, formed Partnership X under the laws of country J. Partnership X was the sole shareholder of PFIC B, also organized in country J. Partnership X and PFIC B formed Partnership Y, a U.S. partnership. Partnership Y owned directly and indirectly interest in various PFICs (Subsidiary PFICs).

Certain PFIC A Shareholders were expected to make a QEF or MTM election with respect to their direct interest in PFIC A, and QEF elections with respect to their indirect interest in PFIC B (Electing Shareholders). Similarly, Partnership Y was expected to make QEF elections with respect to its direct and indirect interest in Subsidiary PFICs.

Each of PFIC A, PFIC B, Partnership X, and Partnership Y adopted (or were required to adopt) a taxable year ending on November 30 in order to allow the Subsidiary PFICs additional time to provide accurate Annual Information Statements.

The IRS ruled, subject to numerous representations, that, only with respect to the Electing Shareholders, Partnership Y was the first U.S. person in the chain of ownership and was treated as the sole U.S. owner for PFIC purposes of the Subsidiary PFICs. The Electing Shareholders were not deemed to own for PFIC purposes the shares of the Subsidiary PFICs. To be an Electing Shareholder, the U.S. person needed to make either a QEF or an MTM election as to PFIC A and a QEF election as to PFIC B. To be a Subsidiary PFIC, Partnership Y was required to have a QEF election in effect for all periods in which it held stock in the Subsidiary PFIC.

The singular purposes for the structure was apparently to reduce the compliance burden imposed on Electing Shareholders under a publicly traded, multi-tier PFIC structure that actively buys and sells annually tens of investments that are (or may be) PFICs and to reduce the information reporting complexities of each of these Subsidiary PFICs in providing Annual Information Statements and access to their books and records to hundreds (if not thousands) of unrelated public shareholders.

The Partnership Y Structure, as to Electing Shareholders who made QEF elections as to PFIC A and PFIC B, aimed at ensuring that the character, timing and amount of the QEF inclusions with respect to the Subsidiary PFICs approximated the character, timing and amount of the QEF inclusions in a multi-tier PFIC structure where no U.S. partnership was interposed, without violating the policy of the PFIC regime of eliminating deferral and avoiding character conversion.

The Partnership Y Structure, as to an Electing Shareholder who made an MTM election as to PFIC A and a QEF election as to PFIC B, provided a more integrated approach to the MTM regime to a publicly traded multi-tier PFIC structure, preserving the principal goals of the PFIC regime of avoiding deferral and character conversion, reducing administrative burdens to the Electing Shareholders, Subsidiary PFICs, and the U.S. government, while more closely achieving the expected legislative benefits of an MTM election and significantly avoiding timing and character mismatch under the MTM rules.

Application of § 1298(b)(5) to Trust Beneficiaries

PLR 200733024 (Aug. 17, 2007), provides guidance as to the application of § 1298 to the liquidation of a foreign corporation some of the shares of which were held by a foreign trust with U.S. beneficiaries. The U.S. beneficiaries had an ascertainable interest in the trust. Although the facts are lengthy and complicated, the pertinent facts are that a foreign trust held stock of a foreign corporation the only asset of which was stock in another corporation. The second corporation was an operating company and, thus, if the foreign corporation were treated as owning 25% or more by value of the second corporation, the look-through rule of § 1297(c) would apply to treat the foreign corporation as if it owned its proportionate share of the assets and income of the second corporation, which presumably would defeat PFIC status of the foreign corporation. The taxpayer argued that the § 318 rules apply to interpret the “directly or indirectly” language so that the ownership of a related individual would be counted. The IRS determined that the § 318 constructive ownership rules do not apply because § 1297(c) does not contain or reference constructive ownership rules.

The more interesting question concerned the treatment of the U.S. beneficiaries on the liquidation of the foreign corporation. Section 1298(a)(3) provides that stock owned directly or indirectly by a trust is treated as owned proportionately by its beneficiaries. Further, § 1298(a)(5) addresses the disposition of an indirectly owned PFIC, the foreign liquidating corporation in this case, and treats a trust beneficiary (as a result of § 1298(a)(3)) as having made an indirect disposition of PFIC stock. Although proposed regulations under § 1291 provide general rules for the application of § 1298(b)(5), the proposed regulations reserve with respect to trusts and beneficiaries. The taxpayer argued that because there are no regulations, § 1298(b)(5) cannot apply. The IRS, however, disagreed that the lack of regulations should prevent § 1298(b)(5) from applying because the intent of the statute is clear on its face. Consequently, the IRS concluded that § 1291(a) applied to impose on the U.S. beneficiaries PFIC tax and interest charges on the gain from the liquidation of the foreign corporation stock, which was treated as a disposition of the PFIC stock.

QEF Inclusions Treated as Qualifying Income for RIC and PTP Purposes

In PLR 200728025 (Mar. 23, 2007), X, a holding company formed to invest, through certain subsidiaries, in fixed income assets consisting primarily of commercial mortgage-backed securities, residential mortgage-backed securities, corporate securities, consumer and commercial asset-backed securities, loans, and trust preferred securities. Each Subsidiary was treated as a CFC under § 957(a) or a PFIC under § 1297(a). X made a QEF election with respect to each PFIC.

The IRS ruled that X’s income (Subpart F and QEF inclusions) from Subsidiaries will be qualifying income under § 851(b)(2)(A) (for regulated investment company purposes) and § 7704(d)(4) (for publicly traded partnership purposes) without regard to whether the income has been distributed and without regard to whether the income results from a Subpart F or QEF inclusion, or is income in excess of cash distributions.

Changes to Form 8621 Reporting Requirements

Prior to 2008, the instructions to Form 8621 provided that U.S. partners of a U.S. partnership, U.S. shareholders of an S corporation, or U.S. beneficiaries of a U.S. trust or estate were required to file a Form 8621 if the particular U.S. pass-through entity failed to file its Form 8621 or the U.S. person was required to recognize any income under either § 1291 or § 1293. Thus, for example, where a U.S. partnership made a QEF election, each and every U.S. partner in such partnership had to file a separate Form 8621 despite the fact that this information was already reflected in their yearly partnership information return. This instruction to Form 8621 appeared to have its origin in Prop. Reg. 1.1291-1(i). In response to comments made by practitioners (including Christopher Ocasal), effective for taxable year 2008, the IRS changed the instructions to the Form 8621 to minimize the necessary PFIC reporting requirements.

More Guidance Needed

While the recent IRS private letter rulings in the PFIC context are a very helpful first step in resolving uncertainty regarding some significant issues, many more PFIC issues remain unanswered or unaddressed. The government’s new approach of resolving these still-to-be-answered PFIC issues on a case-by-case basis may finally settle, for both the taxpayer and the government, many of these items. However, the guidance-by-PLR approach, while helpful and welcome, does not permit a taxpayer other than the one who obtained the ruling to rely on such rulings as they explicitly may not be used or cited as precedent.

Sutherland partners have significant experience in obtaining IRS PFIC guidance, through administrative pronouncements or rulings (and have obtained some of the rulings discussed above). Further, Sutherland attorneys have prepared preliminary or full assessments as to a company’s status as a PFIC, have consulted on issues relating to the filing of IRS tax returns or tax audits on PFICs, have reviewed public disclosures on PFIC issues, and have generally assisted companies with other technical as well as practical PFIC issues and planning.