The U.S. Department of the Treasury and the Internal Revenue Service on July 10, 2019, released proposed regulations relating to the tax treatment of investors that own stock of a passive foreign investment company (“PFIC”) and withdrew prior proposed regulations issued in 2015. The proposed regulations offer guidance on the treatment of investments in foreign insurance corporations, and address a variety of rules that apply generally to determining whether a foreign corporation is a PFIC.
The 2017 tax reform modified the provisions in the Internal Revenue Code (“Code”) relating to the exception for investments in foreign insurance corporations from the PFIC regime. The Code now provides that investment income derived in the active conduct of an insurance business by a “qualifying insurance corporation” is not passive income. The preamble to the proposed regulations clarifies that a foreign corporation’s income attributable to an insurance business will not be passive income if the following three requirements are met:
- The foreign corporation is a “qualifying insurance corporation.”
- The foreign corporation is engaged in an “insurance business.”
- The income is derived from the “active conduct” of that insurance business.
The proposed regulations discuss in detail the following issues arising under the new rules:
- The determination of whether a foreign corporation is a “qualifying insurance corporation,” and more specifically:
- The requirement that the foreign corporation would be subject to tax under subchapter L if it were a domestic corporation.
- The requirement that the foreign corporation’s “applicable insurance liabilities” constitute more than 25 percent of its total assets.
- An election to treat the stock of a foreign corporation as stock of a “qualifying insurance corporation” when such foreign corporation fails the 25 percent requirement.
- The activities that constitute “insurance business,” including issuing insurance and annuity contracts, reinsuring risks of other insurance companies, investing, and providing administrative services substantially related to insurance activities
- The definition of an “active conduct” of an insurance business.
- The treatment of certain income and assets that are passive in the hands of a look-through subsidiary or partnership held by a “qualifying insurance corporation” as active.
- The treatment of income and assets of certain domestic insurance corporations owned by a “qualifying insurance corporation” as active.
- The prohibition of double counting items of income when applying the new rules.
The proposed regulations also provide guidance on various PFIC rules:
- The application of the corporate attribution rules on a top-down basis when a partner owns 50 percent or more of the ownership interest in a partnership that indirectly holds a foreign corporation tested for PFIC status through another corporation that is not a PFIC.
- The determination of “passive income” for purposes of the PFIC regime:
- The exception for active financing income from the definition of “passive income” under the controlled foreign corporation provisions of the Code applies to PFICs.
- Items of income that are determined by netting gains against losses are taken into account on a net basis with restrictions on netting gains or losses of one entity against net losses or gains of another entity.
- A foreign corporation tested for PFIC status that owns 25 percent or more of the value of a partnership is treated as if it directly received its distributive share of any item of partnership income; however, if the foreign corporation owns less than 25 percent of the value of the partnership, its distributive share of partnership income is treated as passive income.
- Additional rules about the treatment of related parties.
- The determination of whether at least 50 percent of the assets of a foreign corporation tested for PFIC status during a taxable year produce or are held for the production of passive income, commonly referred to as the “asset test”:
- An asset that in part produces income and in part does not produce any income must be bifurcated pursuant to a method that most reasonably reflects its uses.
- A foreign corporation tested for PFIC status that owns 25 percent or more of the value of a partnership is treated as if it held its proportionate share of the assets of the partnership; however, if the foreign corporation owns less than 25 percent of the value of a partnership, its partnership interest is treated as a passive asset.
- Property subject to the dealer exception is characterized as a non-passive asset.
- The treatment of stapled entities as one entity for purposes of determining whether any one stapled entity is a PFIC.
- The application of the look-through rules when a foreign corporation tested for PFIC status owns at least 25 percent of the value of the stock of a subsidiary.
- The application of the change-of business exception when a foreign corporation tested for PFIC status is “in transition from one active business to another active business.”
- The application of the qualified stock exception when a foreign corporation tested for PFIC status owns at least 25 percent of the value of the stock of a domestic corporation and is subject to accumulated earnings tax.
The proposed regulations will become effective when they are finalized. However, taxpayers may generally apply the proposed regulations, except for the rules relating to the insurance exception, to all open tax years as if they were final regulations as long as the rules are consistently applied, and may continue to rely on IRS Notice 88-22 (which also relates to the PFIC income and asset tests). Taxpayers may apply the rules relating to the insurance exception for taxable years beginning in 2018 as long as these rules are consistently applied as if they were final.