Guidance on the PFIC Income and Asset Tests

After over 30 years from the issuance of Notice 88-22, promised guidance in the form of proposed regulations related to the Income and Asset Tests were finally issued.  It is interesting that this basic PFIC guidance on when a foreign corporation is a PFIC has taken over three decades since the PFIC law was enacted to be issued.  While there were no major surprises, there were a number of clarifying points contained in the proposed regulations.
 
The PFIC area is one that trips up many US taxpayers that have an investment in foreign corporations through a foreign mutual fund and believe it is the same as owning foreign stocks through a US mutual fund.  PFIC is also an issue for US citizens who are living overseas for extended periods of time and prudently invest locally towards their retirement; just ask any US citizen who has been living and working in Canada for the last decade.
 
It is also possible to have a PFIC in a situation where an individual owns less than 10% of a controlled foreign corporation (CFC) where the CFC is owned over 50% by US Shareholders.  The CFC escapes the PFIC taint for the US Shareholders (10% or more owners) but not for the minority US individual who owns less than 10%.
 
General Guidance
 
The code sets forth the general rules that a foreign corporation owned by a US person qualifies as a PFIC if it satisfies either the Income Test (deriving 75% or more of its gross income from passive income) or the Asset Test (holding passive assets of at least 50).  Passive income is generally foreign personal holding company income (FPHCI) under the rules of Sec. 954(c).  Certain exceptions are allowed (e.g., for active rents and royalties), but others that are otherwise allowed for controlled foreign corporations (CFCs that are owned over 50% by US Shareholders) are not available (e.g., certain amounts received from related persons and active insurance business income).

The regulations allow a look-through rule related to 25% subsidiaries of the tested foreign corporation, where the pro-rata income and assets of the subsidiary are considering in the two tests.  This also applies for partnerships where there is a 25% partnership interest by the tested foreign corporation.  However (maybe surprisingly) a less that 25% partnership interest results in the income (or assets) being considered passive (even if it would not be so considered at the partnership level).
 
Asset Test
 
The proposed regulations confirm that the asset test is calculated based upon the values of the assets and not the percentages determined for each quarter.  Alternatively, the Asset Test can be calculated more frequently than on a quarterly basis (weekly or monthly), which is referred to as the “measuring period”.  This more frequent measuring period is an election that must be used for all subsequent years and can only be revoked under specific rules in the proposed regulations.
 
              Example:
             
  1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Totals % for Year
Passive Assets               500                400               550      1,750.00        3,200  
Total Assets           1,000             1,100            1,100      3,000.00        6,200 51.6%
             
% for Quarter 50.0% 36.4% 50.0% 58.3%   48.7%
 
In this example, the foreign corporation would be considered a PFIC because it had at least 50% passive assets.
 
Look-Through Subsidiary
 
The ownership rules are to be determined under rules similar to the CFC direct and indirect ownership rules under Sec. 958(a).  This can involve a look-through involving both foreign and domestic intermediary ownership structures.  The percentage look-through is determined at each measuring period for the Asset Test, so it may change over the year.  Even if there is no ownership at the end of the year, there may be assets that are considered if the 25% ownership threshold is met during interim measuring periods.  For the Income Test, it is the average for the entire year that is determinative.  If information is available on gross income for each measuring period, and the 25% ownership is met on those dates, then the income can be included even though the average for the year is below 25%.
 
Other Provisions
 
The proposed regulations also cover issues such as the change-of-business exception (Sec. 1298(b)(3)) that references the outbound active trade or business rules of Sec. 367, clarification of the qualified stock exception rule of Sec. 1298(b)(7) that deals with PFICs that are owned through a 25% domestic corporation and the insurance exception rule for income derived  in the active conduct of an insurance business by a qualifying insurance corporation (QIC).
 
Takeaways
These long-awaited regulations finally provide much needed guidance and clarification on a number of PFIC issues, especially the basic Income and Asset Tests necessary for determining PFIC status.  Depending on what a taxpayer has done to avoid PFIC status (or fall afoul of it) it would be prudent to review your calculations in determining PFIC status for foreign corporation ownership.

This will probably renew interest by the IRS in examining situations where there may be PFIC ownership, especially by US taxpayers located outside the US.  There are purging elections that might be considered if one has a PFIC and wants to eliminate the taint.  However, these are typically not easy or inexpensive procedures. 
With the new downward attribution rules, this also may be an opportunity to review the actually ownership structure of the PFIC and determine it is actually a CFC.  While there is still the PFIC taint from prior years (“once a PFIC, always a PFIC”), this transition might be easier than other purging elections in the past.

This new guidance can be complicated. Contact us for assistance with your personal situation. Thank you.