Tax Executive, The

Proposed passive foreign investment company regulations

Proposed passive foreign investment company regulations

On February 3, 1993, Tax Executives Institute submitted the following comments to the Internal Revenue Service on proposed regulations under sections 1291-1297 of the Internal Revenue Code, relating to passive foreign investment companies. The comments were prepared under the aegis of TEI’s International Tax Committee, whose chair is Lisa Norton of Ingersoll-Rand Company. Richard L. Sartor of The Boeing Company, Karen A. Radtke of General Motors Corporation. and Joseph E. Bernot of NCR Corporation materially contributed to the preparation of the comments.

On March 31, 1992, the Internal Revenue Service issued proposed regulations under sections 1291-1297 of the Internal Revenue Code, relating to the treatment of shareholders of certain passive foreign investment companies. The regulations were published in the Federal Register on April 1, 1992 (57 Fed. Reg. 11024), and in 1992-1 C.B. 1124.

For simplicity’s sake, the proposed regulations are referred to as the “proposed regulations.” Specific provisions are cited as “Prop. Reg. [section].” References to page numbers are to the proposed regulations (and preamble) as published in the Cumulative Bulletin.


Tax Executives Institute is the principal association of corporate tax executives in North America. Our 4,700 members represent more than 2,400 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association. TEI is firmly committed to maintaining a tax system that works — one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under sections 1291-1297 of the Code, relating to the treatment of shareholders of certain passive foreign investment companies.

Specific Comments

Under section 1296(a) of the Code, a foreign corporation is a passive foreign investment company (PFIC) if (1) 75 percent or more of its gross income during the taxable year consists of passive income, or (2) at least 50 percent of the average fair market value of its assets during the taxable year consists of assets that produce passive income or are held for the production of passive income. A U.S. shareholder that owns a PFIC must choose between the current taxation of income under section 1293 (by becoming a “qualified electing fund” (QEF) or the deferred tax amount and interest charge of section 1291.

Under section 1295(a), a shareholder of a PFIC can elect QEF status for any taxable year during which the foreign corporation is a PFIC and for any subsequent year, whether or not it meets section 1296(a)’s income and asset test. Section 1297(b)(1) of the Code provides that, once a foreign corporation attains PFIC status, it will maintain its PFIC status for all subsequent years (the “once a PFIC, always a PFIC” rule).

The proposed regulations effectively establish three PFIC classifications:

* A section 1291 non-qualified fund whose shareholder has not elected to treat such PFIC as a QEF. A U.S. shareholder of a section 1291 fund will pay tax and an interest charge based on the value of the tax deferral at the time the shareholder disposes of the shares and on receipt of an “excess distribution.”

* A “predigreed” QEF whose shareholder has elected to treat such PFIC as a QEF at all times during the holding period of the PFIC shares. A shareholder of a pedigreed QEF must annually include in its income the current earnings and profits of the QEF.

* An “unpedigreed” QEF whose shareholder did not elect QEF status for the PFIC for all PFIC years during which the shareholder held the shares. A shareholder of an unpedigreed QEF is subject to the deferred tax and interest charge on excess distributions allocated to the fund years and the annual income inclusion for all years during which the PFIC is a QEF.

Prop. Reg. [section] 1.1291-1(j): Effective Date

Prop. Reg. [section] 1.1291(j)(1) provides that the proposed regulations are generally effective on April 1, 1992 — the date the regulations were published in the Federal Register. The proposed regulations also state that, since sections 1291 through 1297 are effective for taxable years beginning after December 31, 1986, a taxpayer must apply reasonable interpretations of the statute to these provisions. The preamble to the proposed regulations states that the proposed regulations will be considered by the IRS as reasonable interpretations. 1992-1 C.B. at 1130. Thus, the language of the proposed regulations and the preamble could arguably empower a revenue agent to apply the regulations retroactively to a taxpayer’s detriment. TEI is generally opposed to the retroactive application of taxpayer-adverse regulations. Thus, we believe that the IRS should confirm that the proposed regulations are not the only reasonable interpretation of the statute and, in fact, should not be applied to the taxpayer’s detriment. The IRS should further clarify that taxpayers who in good faith attempted to comply with the statute will not be penalized.

Moreover, at least with respect to the nonrecognition provisions, retroactive application may be contrary to the statute. Section 1291(f) of the Code specifically provides that, “to the extent provided in regulations,” certain nonrecognition transactions will be taxable. The use of the quoted language requires that section 1291(f) itself not be applicable until final (or temporary) regulations have been issued. The regulations should specifically clarify that the nonrecognition rules of Prop. Reg. [section] 1.1291-6 will not be applied retroactively.

Prop Reg. [section] 1.1291-2(f): Indirect Distributions by Section 1291 Funds

a. Section 1291 Fund to Section 1291 Fund Transactions. Section 1297(a) provides attribution rules for determining whether a U.S. shareholder is an indirect owner of a PFIC. If a U.S. person is treated as an indirect shareholder, that person is taxable on any distribution made by the PFIC to the actual owner of the PFIC stock (“indirect distributions”), and on any disposition by the actual owner if, as a result of the disposition, the U.S. person is no longer treated as owning the stock under section 1291(a) (“indirect dispositions”). Thus, the U.S. person is taxed as if it had received the distribution or made disposition. The indirect distribution and disposition rules thus operate as a general exception to the tax principle that a U.S. shareholder is taxed only when income is realized by that shareholder.

Prop. Reg. [section] 1.1291-2 provides rules for taxing an indirect shareholder of a section 1291 fund on a distribution from the fund. Prop. Reg. [section] 1.1291-2 (f)(4) provides a limited exception to the general rule that all indirect distributions are taxable on an indirect distribution paid by a section 1291 fund to its sole shareholder that is also a section 1291 fund owned directly by the shareholder, if the distributing fund has distributed all its earnings and profits for such year which is included in the shareholder’s holding period. The preamble to the proposed regulations requests comments on whether there are additional circumstances in which an indirect shareholder of a section 1291 fund should not be taxed on distributions by, or dispositions of stock of, the section 1291 fund. 1992-1 C.B. at 1127.

TEI believes that Prop. Reg. [section] 1.1291-2(f) properly carries out the statute’s anti-avoidance purpose by subjecting the U.S. person to the deferred tax and interest charge when the lower-tier section 1291 fund makes a distribution to a non-PFIC or a QEF. This treatment is necessary because the deferred tax and interest charge of a section 1291 fund is not preserved when the upper-tier shareholder is a non-PFIC or a QEF. When the indirect ownership of a section 1291 fund is effected through another section 1291 fund, however, the proposed regulations improperly subject the U.S. shareholder to tax. In such a fund-to-fund distribution, the interest charge is preserved, thereby obviating the need for current taxation of the U.S. shareholder.

The purpose of the indirect distribution provisions is to ensure that a U.S. shareholder does not avoid the deferred tax and interest charge through indirect ownership. If the indirect ownership is through a section 1291 fund, however, the potential deferred tax and interest charge is not avoided upon a distribution to an upper-tier section 1291 fund. The charge still inheres in the upper-tier fund and will be “triggered” upon an excess distribution from that fund. Accordingly, the proposed regulations should be amended to exclude section 1291 fund-to-fund transfers from the indirect distribution rules.[1]

b. Distribution Amount. Distributions from a section 1291 fund are classified as excess and nonexcess distributions. A nonexcess distribution is taxed according to the general rules applicable to corporate distributions. Section 1291(a) of the Code imposes a “deferred tax amount” charge on the “excess distribution” received by a U.S. person in respect of its PFIC stock. Section 1291(b) defines the term “excess distribution” as any distribution in respect of stock received during the taxable year to the extent such distribution does not exceed the U.S. person’s ratable portion of the total excess distribution for the taxable year. Prop. Reg. Section 1.1291-2(f) provides, however, that an indirect shareholder will be taxed on the total amount of the distribution from a lower-tier section 1291 fund, not just the “excess distribution” amount. This conflicts with Prop. Reg. Section 1.1291-2(f)(1), Example (iii), wherein the tax is limited to the excess distribution.

The proposed regulations should be clarified to provide that the amount subject to the deferred tax and interest charge is only the “excess distribution” amount calculated under principles similar to those for direct U.S. shareholders. The portion of the distribution that is not an excess distribution or the portion of an excess distribution that is allocated to the current year and pre-PFIC years should not give rise to a current income inclusion to the indirect shareholder. Such items should be included in the income of the actual owner or under other provisions of the Code, if applicable (i.e., under the provisions for controlled foreign corporations or foreign personal holding companies).

Prop. Reg. Section 1.1291-3(e)(2)(iii): Indirect Dispositions

Prop. Reg. Section 1.1291-3(e) provides for the taxation of the U.S. shareholder on the indirect disposition of stock of a section 1291 fund. Prop. Reg. Section 1.1291-3(e)(2)(iii) treats a U.S. shareholder of a section 1291 fund as having disposed of all or a portion of its shares in the fund if its interest in the section 1291 fund is reduced or terminated.

TEI recognizes that the dilution rule may be defensible where the U.S. shareholder owns its section 1291 fund through a non-PFIC and ownership in the non-PFIC falls below 50 percent, thereby removing the lower-tier PFIC from the indirect ownership rules. In situations where the dilution does not result in such removal,(2) however, there is no sound policy reason for treating the dilution of the U.S. shareholder’s percentage interest as a disposition.

Section 1297(b)(5) of the Code provides that “under regulations” the Secretary may issue regulations to prevent the circumvention of the indirect ownership rules. TEI believes that this provision implicitly grants the authority to craft a rule that excludes certain transactions from the reach of the indirect ownership rules. The Institute submits that amending the regulations to apply the dilution rules only where the lower-tier PFIC is removed from the indirect ownership rules would be consistent with congressional intent.

Prop. Reg. Section 1.1291-9: Deemed Dividend Purging Election

A shareholder of an “unpedigreed” QEF is subject to the deferred tax and interest charge of section 1291 and the annual inclusion of income under section 1293. Congress sought to temper the harshness of this treatment by providing the shareholder of an unpedigreed QEF the opportunity to “purge” itself of its section 1291 taint. Subsequent to the purging election, the PFIC becomes a “pedigreed” QEF, whose shareholder is subject to only the annual income inclusion. The purging elections are provided in the section 1291(d)(2)(A) deemed sale election and the section 1291(d)(2)(B) deemed dividend election. The elections are available only in the year in which the shareholder elects QEF status.

With respect to the deemed sale election, Prop. Reg. Section 1.1291-10 permits a taxpayer to purge a QEF of its taint for the first taxable year in which a shareholder elects QEF status, even if the PFIC does not satisfy the income and asset test of section 1296(a). This result is consistent with the statute. Prop. Reg. Section 1.1291-9(h)(2), however, imposes an unjustified limitation on the deemed dividend election under section 1291(d)(2)(B) by providing that the election cannot be made “if the corporation does not qualify as a PFIC under section 1296(a)(1) or (2) for the first taxable year for which a section 1295 election (QEF election) is intended to apply.”

TEI believes that the proposed regulations improperly restrict the availability of the deemed dividend election. Section 1291(d)(2)(B) provides that a shareholder may make such an election if three conditions are satisfied:

* The PFIC becomes a QEF with respect to the taxpayer for a taxable year beginning after December 31, 1986;

* The shareholder holds stock in the company on the first day of the taxable year; and

* The PFIC is a controlled foreign corporation (CFC) within the meaning of section 957(a).

A shareholder may make a QEF election with respect to a PFIC whether or not the income and asset tests of section 1296 are met in the year for which the election is to apply. A deemed dividend election should be permitted under the same circumstances.

The restriction on the availability of the purging election also violates section 1297(b)(1)’s maxim of “once a PFIC, always a PFIC.” Once a foreign corporation attains PFIC status, it remains a PFIC whether or not it meets the income and asset test in subsequent years. There is no evidence that Congress intended to preclude any CFC from making the purging election as long as the statutory requirements of either section 1291(d)(2)(A) or (B) were satisfied. The Institute therefore recommends that the restriction of Prop. Reg. Section 1.1291-9(h)(2) be removed and that a deemed dividend election be permitted for any first year of QEF status.(3)

Interaction of Sections 1296(a) and 956

Section 956 of the Code requires a CFC’s earnings to be taxed to its U.S. shareholder in certain situations where the earnings are made available to the U.S. shareholder. The U.S. shareholder is treated as receiving a constructive dividend equal to the CFC’s investment in U.S. property on the last day of the CFC’s taxable year. The proposed regulations are silent on the interaction of the income and asset test of section 1296(a) and the investment in U.S. property rules of section 956.

An investment in U.S. property, while constituting an asset for the purposes of the CFC’s books, is treated as a deemed dividend for U.S. tax purposes under section 956. To treat such an asset as remaining on the CFC’s books for PFIC testing purposes is inconsistent with this deemed dividend inclusion. TEI believes that the proposed regulations should exclude investments of property subject to section 956 from the PFIC asset test.


Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations relating to sections 1291 through 1297 of the Code. If you have any questions, please do not hesitate to call Lisa Norton, chair of TEI’s International Tax Committee, at (201) 573-3200 or Mary L. Fahey of the Institute’s professional staff at (202) 638-5601.

(1) We recognize that differences in the holding periods of the lower-tier fund and upper-tier section 1291 funds may result in complete or partial avoidance of the deferred tax and interest charge. In such circumstances, it may be appropriate for the U.S. shareholder to recognize the deferred tax and interest charge.

(2) These circumstances would include ownership by a section 1291 fund.

(3) At a minimum, if the restriction is retained, it should be applied prospectively with respect to elections made after April 1, 1992.

COPYRIGHT 1993 Tax Executives Institute, Inc.

COPYRIGHT 2004 Gale Group