Washington Tax Alert May 31, 2022
Washington Tax Alert from Don Barnes, [email protected]
May 31, 2022
In January 2022, Treasury issued final regulations (T.D. 9960) and proposed regulations (REG-118250-20) which affect foreign corporations that are controlled foreign corporations (CFCs) or passive foreign investment companies (PFICs).
Final regulations (T.D. 9960). Adopting the position taken in proposed regulations issued in 2019, the final regulations provide that if a U.S. partnership owns stock in a foreign corporation that is a CFC, the partners of the U.S. partnership (rather than the partnership itself) are treated as shareholders of the foreign corporation for purposes of income inclusions under IRC 951 (subpart F income) and IRC 951A (GILTI income). Although the U.S. partnership is ignored for purposes of income inclusion, the U.S. partnership is treated as a shareholder of the foreign corporation for purposes of determining whether the foreign corporation is a CFC. The final regulations are effective for taxable years of foreign corporations beginning on or after January 25, 2022.
If a U.S. partnership with partners who are U.S. persons owns 50.1% or more of the stock of a foreign corporation, the foreign corporation is a CFC, but the U.S. partnership’s partners are not subject to income inclusion with respect to the foreign corporation’s subpart F income unless they are United States shareholders. A partner of the U.S. partnership is a United States shareholder only if it owns directly, indirectly through the partnership or other entity, or constructively 10% or more of the stock of the foreign corporation.
One effect of these final regulations is to change the application of the overlap rule in IRC § 1297(d). Under the overlap rule, if a foreign corporation is both a CFC and a PFIC, the corporation is not treated as a PFIC with respect to shareholders that are United States shareholders and subject to the subpart F rules. Many foreign corporations are PFICs, not just foreign investment funds, because of the broad definition of PFICs.
Prior to the final regulations, U.S. taxpayers that owned any interest in a U.S. partnership which owned 10% or more of the stock of a foreign corporation that was both a CFC and PFIC qualified for the overlap rule. In that event, the partners of the U.S. partnership were only subject to the CFC rules.
Under the final regulations issued in January, a U.S. person who is a partner of a U.S. partnership that owns stock in a foreign corporation that is both a CFC and PFIC is eligible for the overlap rule only if the partner owns 10% or more of the CFC. For example, if a U.S. individual has a 5% interest in a U.S. partnership that owns 100% of a foreign corporation, the partnership is a United States shareholder and the foreign corporation is a CFC, but the U.S. individual who has a 5% interest in the U.S. partnership is not a United States shareholder and does not have income inclusions under IRC § 951 or GILTI inclusions under IRC § 951A. As a result, the U.S. individual is not entitled to the overlap rule and is subject to the PFIC rules.
Proposed regulations (REG-118250-20). The proposed regulations issued in January 2022 would, if finalized, require U.S. persons who are partners or shareholders of U.S. partnerships or S corporations, respectively, to make all PFIC elections and file Form 8621 (Information Return by a Shareholder of a PFIC or Qualified Electing Fund). This is a change from current law. Under current law, U.S. partnerships and S corporations that own stock in a PFIC are responsible for making all PFIC elections and filing information returns on Form 8621.
The new proposed regulations, coupled with expanded Schedules K-2 and K-3 for partnerships filing Form 1065 and S corporations filing Form 1120-S, will have the following effects:
- Greater tax compliance work for U.S. partnerships and S corporations that own stock in foreign corporations that are PFICs. The U.S. partnership and S corporation will be required to maintain separate records for its owners which make different PFIC elections or fail to make elections.
- New tax compliance responsibilities for U.S. taxpayers who own stock in PFICs through domestic pass-through entities, such as hedge funds or private equity funds. These compliance responsibilities will include making all PFIC elections, such as qualified electing fund (QEF) elections, mark-to-market elections and purging elections, and filing information returns on Form 8621. U.S. investors in pass-through entities that own stock in PFICs will have these tax compliance responsibilities even though the pass-through entities will be responsible for identifying whether the foreign corporations in which they own stock are PFICs. U.S. investors with a relatively small interest in a U.S. partnership or S corporation that has investments in scores of PFICs will incur significant costs filing PFIC elections and information returns with respect to each PFIC.
- Because the proposed regulations represent a change in tax practice, the proposed regulations provide that preexisting QEF and mark-to-market elections made by a U.S. partnership or S corporation with respect to a PFIC prior to the publication of final regulations will continue in effect for its partners or shareholders.
The proposed regulations will apply to taxable years beginning on or after the date they are issued as final regulations.
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