5 things to know about the domestic pass-through and PFIC regulations

| 3/17/2022
5 things to know about the domestic pass-through and PFIC regulations

On Jan. 25, the U.S. Department of the Treasury and the IRS published final regulations under IRC Section 958 regarding the treatment of Subpart F income with respect to domestic pass-through entities (2022 final regulations). In addition, they issued proposed regulations with respect to the treatment of passive foreign investment corporations (PFICs) owned by pass-through entities (2022 proposed PFIC regulations). Following are five things to know about the 2022 final regulations and the 2022 proposed PFIC regulations.

1. The 2022 final regulations now require aggregate treatment for Subpart F and 956 inclusions.

Under U.S. tax law, a pass-through entity is treated either as an entity that is separate from its owners or as an aggregate of its owners, depending on the operative codes section being applied. When entity treatment applies for partnerships, the tax impact of items that flow into the partnership is determined at the partnership level and then allocated to the partners. When aggregate treatment applies, partners take into account pro rata shares of the components of an affected tax item rather than a distributive share of the item. Final regulations published in 2019 (2019 final regulations) treat domestic partnerships and pass-through entities as aggregates of their owners for purposes of the global intangible low-taxed income (GILTI) inclusion. In addition, proposed regulations issued in 2019 (2019 proposed regulations) applied aggregate treatment to Subpart F, which was a substantial change from entity treatment that was required under the rules at the time.

The 2022 final regulations closely follow the 2019 proposed regulations and provide for aggregate treatment for GILTI, Subpart F, and Section 956 inclusions. Although the 2022 final regulations do not address PFICs, related-person insurance income, previously taxed earnings, or basis issues, the preamble states that these issues will be addressed in future guidance.

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2. The 2022 proposed PFIC regulations apply aggregate treatment for purposes of determining the controlling domestic shareholder.

Currently, a partnership owning more than 50% of a foreign corporation can be the controlling domestic shareholder and can make elections with respect to the foreign corporation on behalf of its partners. Under the 2022 proposed PFIC regulations, a partnership that controls a foreign corporation no longer will be able to make elections with respect to the foreign corporation on behalf of its partners. Instead, an election (such as accounting method changes) will be required to be made by the controlling partner of the partnership that is the controlling domestic shareholder, and that partner is required to provide notice to the partnership, assuming it keeps the books and records of the foreign corporation, of any elections made.

3. The 2022 proposed PFIC regulations adopt an aggregate approach to inclusions.

The PFIC regime applies to both direct and indirect shareholders whereby the first U.S. owner of the foreign entity is subject to the PFIC regime. The current PFIC regulations use an entity approach for partnerships, allowing them to be treated as a direct shareholder in the PFIC, making their partners indirect shareholders. The 2022 proposed PFIC regulations no longer treat partnerships as shareholders of PFICs. Instead, they treat any partner who is not a partnership as a direct shareholder under an aggregate approach. This change means that treatment for inclusions from a PFIC under the excess distribution regime, qualified electing fund (QEF) regime, and mark-to-market (MTM) regime (including who makes any elections with respect to these regimes) is determined at the partner – rather than the partnership – level. Therefore, partners are required to inform partnerships that are PFIC shareholders of any QEF or MTM elections, and the partnership needs to provide the relevant information to that partner via Schedule K-3, “Partner’s Share of Income, Deductions, Credits, etc. – International,” which has the potential to increase the partnership’s compliance burden. Any QEF or MTM elections made by a partnership or pass-through entity prior to the date the 2022 proposed PFIC regulations become effective will be considered valid elections at the partner level. Comments are requested on the potential of providing an option for a pass-through to make QEF, MTM, and other elections on behalf of its partners.

4. The 2022 proposed PFIC regulations clarify the application of the CFC overlap rule for domestic partnerships and pass-through entities.

Under the current PFIC regulations, PFIC shareholders (including U.S. pass-through entities) subject to the inclusion rules under Subpart F are not subject to the PFIC rules under what is referred to as the controlled foreign corporation (CFC) overlap rule. As discussed earlier, the 2022 final regulations take an aggregate approach and provide that the GILTI and Subpart F inclusions are determined at the partner level rather than at the partnership level. As a result, the 2022 proposed PFIC regulations clarify that the CFC overlap rule does not apply to domestic partnerships and is applied at the partner level instead. The preamble to the 2022 proposed PFIC regulations explains that a person who is not a U.S. shareholder (a U.S. person holding a 10% or more interest in the foreign corporation) in a foreign corporation that otherwise would be subject to the PFIC rules should not be able to avoid the PFIC rules simply because the person’s ownership is through a U.S. pass-through entity. The 2022 proposed PFIC regulations include a transition rule that preserves the benefit of the CFC overlap rule for indirect PFIC shareholders that are not U.S. shareholders but are subject to the current inclusion rules under GILTI or Subpart F on a distributive share basis.

5. S corporations with AE&P get entity treatment.

The 2022 proposed PFIC regulations adopt Notice 2020-69 entity treatment for GILTI and Subpart F inclusions for S corporations with accumulated earnings and profits (AE&P). Applying entity treatment to S corporations means that GILTI and Subpart F inclusions will increase accumulated adjustment accounts, allowing S corporations to make distributions without reducing AE&P, which results in dividends.

Takeaways

U.S. international tax rules moving toward an overall aggregate approach is a significant trend for pass-throughs and their investors. This trend is likely to add a significant compliance burden for affected pass-throughs and their owners that will differ depending on whether the pass-through’s owners independently qualify as U.S. shareholders of subsidiary foreign corporations. In addition, because it was not addressed by either the 2022 final regulations or the 2022 proposed PFIC regulations, the treatment of previously taxed income and basis remains unsettled. Taxpayers should work with their tax advisers to stay abreast of the latest developments to determine the effect of the final and proposed regulations.

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