Final and proposed passive foreign investment company regulations issued

Final regulations

Indirect ownership – corporations. Before the final regulations, uncertainty existed about how to apply the corporate attribution rules to tiered entities when determining whether there is a U.S. owner. Suppose U.S. person A owns stock in X, a foreign corporation, which owns stock in Y, also a foreign corporation, which in turn owns stock in Z, which is a PFIC. When determining whether U.S. person A is treated as indirectly owning stock in Z, does one start with Z and apply the rules going up the chain (bottom-up), or does one start with U.S. person A being tested and apply the rules going down the chain (top-down)? The method applied can affect whether U.S. person A is treated as indirectly owning stock in Z. Favorably, the final regs provide that the "top-down" rule applies.

Indirect ownership – partnerships. Under the attribution rules, PFIC stock owned by a partnership is owned proportionately to its partners. The 2019 proposed regulations would have modified this rule by requiring a U.S. person to own at least 50% of the partnership in order to be treated as owning any stock of a PFIC owned by the partnership. The final PFIC regulations eliminate this rule and clarify that a partnership's indirect ownership of stock always is attributed proportionately to all partners, regardless of any U.S. person’s percentage of ownership.

Active financing income. The final regulations replace the rule in the 2019 proposed regulations that excepted from PFIC testing income received in the conduct of an active financing trade or business (as defined under IRC Section 954(h)) with a rule that limits the type of financing entities eligible for the exception. Under the final regulations, only entities licensed as banks are eligible for the active financing trade or business exception to PFIC testing. This change is significant for investors in nonbank foreign finance companies because they now are subject to the PFIC regime.

2021 proposed regulations

Working capital. The 2021 proposed regulations provide a limited exception from passive asset treatment for certain cash that is held in a noninterest-bearing account, provided the cash held is not greater than the amount needed to cover 90 days of operating expenses of the entity holding the cash. 

Tightening the definition of a foreign bank. The 2021 proposed regulations provide that to qualify for the banking exception to passive income, a foreign bank must be licensed as a bank in its jurisdiction and carry on certain activities, such as taking deposits. As noted in the active financing trade or business rule, a finance company that is not a licensed bank does not qualify for this exception. However, nonbank finance companies may rely on the 2019 proposed regulations for PFIC testing for tax years beginning before Jan. 1, 2021. The U.S. Department of the Treasury has asked for comments on this issue. 

Looking ahead

While the final regulations generally follow the 2019 proposed regulations, the new rules affecting nonbank foreign finance companies mean that more U.S. investors will be subject to the complexities of the PFIC regime. Given the significance of these changes, taxpayers that might be affected should consult with their tax advisers to better understand the implications.