PFICs: Applying the Subsidiary Look-through Rules to Intercompany Transactions

When it comes to the rules governing passive foreign investment companies (PFICs), cruel is not unusual. In making the threshold determination of whether a foreign corporation is a PFIC, taxpayers need not look much farther than the Sec. 1297(c) subsidiary look-through rule to see the truth of this statement.

Background

In general, any U.S. investor (no matter the size of his holdings) in a PFIC is subject to tax at top marginal rates and must pay a special interest charge on the PFIC's earnings, unless he timely elects to currently include in income a pro-rata share of the PFIC's earnings; see Secs. 1291, 1293 and 1296.

A PFIC is any foreign corporation that satisfies either an income or asset test under Sec. 1297. The income test requires that 75% or more of a foreign corporation's gross income must be passive income, which generally means "foreign personal holding company income," defined in Sec. 954(c).

Under Sec. 1297(a)(2), the asset test requires that at least 50% of the foreign corporation's assets (based on either fair market value or, if elected, adjusted tax basis) held during the tax year must be passive assets. Passive assets are assets that produce passive income, or are reasonably expected to produce such income; see Notice 88-22. Both the income and asset tests apply on a gross basis; liabilities do not reduce the amount of income or assets.

Applying the Look-through Rule

The asset and income tests are subject to various look-through rules; see, e.g., Sec. 1297(b)(2)(C). One rule of particular potency is Sec. 1297(c). Under this provision, for purposes of determining whether a foreign corporation is a PFIC, the foreign corporation is deemed to hold its proportionate share of the assets and to receive directly its proportionate share of the income of subsidiaries in which it owns (directly or indirectly) 25% or more of the stock (determined by value). This rule generally benefits taxpayers because it prevents holding companies from being classified as PFICs. However, it leaves several questions unanswered.

Example: Foreign parent FP is a holding company that wholly owns A and B, two foreign subsidiaries. FP's only assets are A and B stock, and its only income is that earned on that stock. A is FP's finance arm, and B operates an active business conducted with unrelated third parties. In January 2002, B borrowed $1,000 from A, issuing a note and using the cash to replace old machinery. In 2002, B earns $200 of operating income from its active business and $25 from short-term investments of its working capital. During 2002, B pays $100 of interest to A under the note's terms. In the same year, A also has $25 of income from short-term investments. A's only assets are the $1,000 note from B and $500 of short-term investments. B's only assets are $1,000 of operating assets and $450 of working capital. FP has several shareholders who are U.S. persons.

PFIC status is determined by applying the Sec. 1297(c) look-through provisions. FP is treated as directly owning B's $1,000 of operating assets and $450 of working capital, as well as directly receiving B's $200 of active income and $25 of investment income. FP is also treated as directly owning A's $1,000 note and $500 of short-term investments, as well as directly receiving A's $125 of passive income. For purposes of the income test, FP earns $350 of income, 43% ($150/$350) of it passive. Therefore, FP is not a PFIC under the 75%-passive-income test. For purposes of the asset test, FP owns $3,000 of assets, 66% ($1,950/$2,950) of it passive. At this point, FP is a PFIC under the 50%-passive-asset test.

Certain other look-through rules (discussed later) may also help FP avoid PFIC status. Before applying these more complicated rules, however, FP must determine how to treat the intercompany loan under the subsidiary look-through rule. Disregarding the intercompany loan for Sec. 1297(c) purposes seems sensible, as FP merely turns cash held in one pocket (A) into active assets held in another (B), and "economically" owns only one asset, not two. Moreover, if FP is treated as owning A's and B's assets, the note between A and B is arguably a loan between divisions, and a taxpayer cannot make a loan to itself (or otherwise transact with itself). The existence of the intercompany loan simply does not transform FP into the kind of offshore reservoir of passive income that Congress intended the PFIC rules to tax. Thus, looking at FP's assets and disregarding the intercompany loan, FP has $1,000 of active assets and $950 of passive assets, and hence just meets the 50%-passive-asset test to avoid PFIC status.

However sensible this result may appear in theory, several technical obstacles loom.

The statute. First, nothing in Sec. 1297(c) states that a taxpayer may ignore intercompany transactions (such as loans between subsidiaries) when applying the subsidiary look-through rules to determine a parent's PFIC status. Sec. 1297(c) would treat FP as if it "held its proportionate share of the assets" of A and B. The provision does not state that FP assumes A's and B's liabilities, does not expressly treat A and B as branches or divisions of FP and does not otherwise put FP in A's and B's shoes.

Related-party look-through rules. Second, if Sec. 1297(c) allows taxpayers to eliminate intercompany debt and similar transactions between sister subsidiaries like A and B, what would be the role of Sec. 1297(b)(2)(C), which allows taxpayers to look through dividends, interest, rents and royalties received from a "related person," as defined in Sec. 954(d)(3)? Income subject to the Sec. 1297(b)(2)(C) look-through rules is not passive income to the extent that a taxpayer can properly allocate it to active income earned by the related-person payor. In the example, A can rely on Sec. 1297(b)(2)(C) to characterize the interest it receives from B as active or passive. A can allocate the interest that it receives from B against the active and passive income earned by B (presumably following in rough outline the Sec. 904(d) allocation rules). A portion of the note's value is then characterized as active, to the extent that the note's interest is characterized likewise. Assuming that the note between A and B is not disregarded as an asset of A, FP might seek to rely on Sec. 1297(c) to look through and recharacterize A's assets, potentially avoiding PFIC status. This analysis, however, raises at least two concerns.

First, reliance on Sec. 1297(b)(2)(C) is fraught with uncertainties, and the application of this provision in practice is not as simple as in the example. Taxpayers could avoid the uncertainties and complications of the related-party look-through rule if they could simply disregard the intercompany debt between corporations wholly owned by the same parent.

Second, the interaction of Sec. 1297(b)(2)(C) and 1297(c) is not well defined. Its legislative history suggests that Sec. 1297(b)(2)(C) applies to related persons not subject to Sec. 1297(c). This history, however, does not otherwise coordinate these provisions or even mention Sec. 1297(c)'s effect on intercompany transactions, beyond parent-subsidiary debt or equity investments. Perhaps Sec. 1297(b)(2)(C) is inapplicable when intercompany loans or other transactions occur between two subsidiaries wholly owned by a common parent. In addition, how would both look-through rules apply if the parent owns more than 50%, but less than 100%? Would the parent disregard a portion of the debt or other transaction under Sec. 1297(c) to the extent of its ownership, subjecting the remaining portion to the Sec. 1297(b)(2)(C) related-person look-through rules? Instead, does the inclusion of the related-person look-through rule demonstrate that Congress wanted taxpayers to use this rule for intercompany loans and not rely on Sec. 1297(c) to disregard this kind of transaction? The Sec. 1297(b)(2)(C) related-party lookthrough rules point to no particular technical answer on a taxpayer's ability to disregard intercompany transactions.

Legislative history. The strongest support for ignoring intercompany transactions generally stems from an often-cited passage in the Blue Book to the Tax Reform Act of 1986 (TRA '86), which states:

[A]mounts such as interest and dividends received from foreign or domestic subsidiaries are to be eliminated from the recipient's income in applying the Act's income test and the shareholder's stock investment is to be eliminated from its assets in applying the Act's asset test.

A similar passage is included in the description of "Present Law" in the House and Senate reports to the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), though these reports specifically add that "the stock or debt investment is eliminated from the shareholder's assets" in applying Sec. 1297(c). (Emphasis added.)

These passages pose at least three problems. First, the history says nothing about intercompany transactions other than debt and equity (such as leasing, licensing, consulting or administrative support transactions). Second, these passages are directed at parent-subsidiary loans and stock investments, and do not specifically discuss brother-sister loans or similar transactions. Finally, the passages are not the most persuasive or the strongest indications of Congressional intent. The passage from the TRA '86 was included only in the Blue Book and nowhere else in the legislative history to that law or to the TAMRA. The Blue Book is not properly considered legislative history, and the late inclusion of this passage casts doubt on its pedigree. The TAMRA passage is similarly weak, as it represents a mere description of "present law," blunting its force and authority. Thus, under closer scrutiny, the Sec. 1297(c) legislative history does not provide an unassailable basis on which to disregard brother-sister transactions.

IRS rulings. The IRS has offered no guidance on the application (if any) of Sec. 1297(c) to disregard intercompany transactions. In Rev. Rul. 87-90, the IRS confirmed that the parent of a wholly owned subsidiary is treated as owning all of the subsidiary's assets for Sec. 1297(c) purposes. The IRS also implicitly disregarded the subsidiary's stock in applying the asset test to the parent. The ruling, however, did nothing to elucidate or otherwise expressly address the question of intercompany transactions or of any other question on the subsidiary look-through rule. Moreover, in Notice 88-22, the IRS stated quite clearly that the asset test will be applied on a gross basis and that "[n]o liabilities, whether secured by particular assets or otherwise traceable to particular assets, will be taken into account." This statement reads as if it were meant to apply only to third-party liabilities, or that it was simply not intended to prevent the disregard of intercompany transactions after applying the subsidiary look-through rule. Nothing in Notice 88-22, however, directly supports these interpretations, and the notice's categorical nature presents yet another technical obstacle to taxpayers.

Conclusion

The treatment of intercompany transactions between subsidiaries subject to the Sec. 1297(c) look-through rule is only one instance of how taxpayers need additional guidance in applying the PFIC rules. In the meantime, taxpayers are left to deal with these rules and the clients to whom they apply on a daily basis. In many cases, taxpayers may choose the uncertain application of the Sec. 1297(b)(2)(C) related-party look-through rule to characterize income and assets from brother-sister transactions to determine whether the common parent is a PFIC. If they do not, taxpayers make a leap of faith (albeit a rather short one), reasoning that the Sec. 1297(c) look-through rules disregard intercompany transactions between brother-sister corporations in determining whether the common parent is a PFIC. This conclusion makes eminent sense when taxpayers consider what Congress intended the PFIC rules to accomplish, but the technical roadblocks hamper easy attainment of this policy goal. Such is the practitioner's lot in the cruel world of PFICs.

From Chris Bowers, J.D., and Robert Laudeman, J.D., Washington, DC