Applying the Indirect Ownership Rules to PFICs

If uncertainty and ambiguity are the bane of commerce, the passive foreign investment company (PFIC) rules are certainly an annoyance. To get a flavor for the uncertainty, taxpayers need only attempt to navigate the rules governing indirect ownership of PFIC stock.

The PFIC provisions were enacted as part of the Tax Reform Act of 1986. A PFIC is a foreign corporation primarily used as a passive investment vehicle. Characterization of a foreign corporation as a PFIC turns on satisfaction of either an income or asset test under Sec. 1297. The income test requires that 75% or more of a foreign corporations gross income consist of passive income, which generally means foreign personal holding company income as defined in Sec. 954(c). The asset test requires that at least 50% of the foreign corporations assets (based on either value or, in certain circumstances, adjusted tax basis) held during the tax year be passive assets. Passive assets are assets that produce (or are reasonably expected to produce) passive income; see Sec. 1297(a)(2) and Notice 88-22.

In general, U.S. persons owning stockeven one shareof a PFIC may be subject to tax at top marginal rates, plus an interest charge, on certain distributions on, and dispositions of, PFIC stock. Both the gain from a disposition and a targeted distribution are taxed generally at 35% for corporations, without regard to the tax attributes of the PFIC stockholder (for example, ignoring its net operating losses); see Sec. 1291(a). An interest charge also may be imposed based on the shareholders holding period for the PFIC stock; see Sec. 1291(c). As discussed below, even an indirect owner of PFIC stock may be subject to the regime.

A taxpayer may avoid the Sec. 1291 regime by means of two alternative elections: (1) the qualified electing fund (QEF) or (2) the mark-to-market election; see Secs. 1291, 1293 and 1296. If a QEF election under Sec. 1293 is made, a taxpayer generally includes in income each year its pro-rata share of the PFICs ordinary earnings and its pro-rata share of the PFICs net capital gain. Taxpayers holding marketable PFIC stock may make the mark-to-market election under Sec. 1296 to include annually in gross income the excess of the fair market value (FMV) over the PFIC stocks adjusted basis (or, in certain circumstances, take a deduction if adjusted basis is greater than FMV).

In addition to directly owning PFIC stock, a U.S. investor may also be attributed the PFIC stock owned directly or indirectly by an intermediate entity. As discussed below, PFIC stock owned directly or indirectly by a partnership may be treated as being owned proportionately by its partners; PFIC stock owned directly or indirectly by an intermediate corporation may be attributed to the U.S. owner of the intermediate corporation; see Sec. 1298(a)(2) and (3). Under Prop. Regs. Sec. 1.1291-1(b)(8) and -2(f)(1), the indirect owner of PFIC stock may be taxed on certain PFIC distributions as if the indirect owner had actually received them. For example, the U.S. owner of stock in an intermediate corporation, in turn owning PFIC stock, can be taxed on a distribution by the PFIC to the intermediate corporation.

Similarly, the indirect owner of PFIC stock may be taxed on an indirect disposition of PFIC stock to the extent of the indirect owners pro-rata share of the actual owners gain inherent in the PFIC stock; see Prop. Regs. Sec. 1.1291-3(e). According to Prop. Regs. Sec. 1.1291-3(e)(2), an indirect disposition may occur as a result of a disposition by the actual owner or by any transaction that results in the reduction or termination of the indirect shareholders PFIC ownership. For example, if an intermediate entity issues additional stock or disposes of PFIC stock in a Sec. 355 transaction, a disposition would be deemed to have occurred if it dilutes the indirect shareholders ownership interest.

Under Sec. 1298(b)(6), if a U.S. investor uses any PFIC stock as security for a loan, the investor would be treated as having disposed of such stock. Such a pledge may even be deemed to occur under Prop. Regs. Sec. 1.1291-3(d)(2) if PFIC stock serves indirectly as security for the performance of an obligation, such as when a U.S. investor pledges the stock of an intermediate entity that in turn owns a PFIC. Again, such dispositions are subject to tax at top marginal rates, plus an interest charge.

Even though an indirect owner of a PFIC may be taxed on certain distributions and dispositions, it is not clear how the PFIC provisions attribute ownership to make a taxpayer an indirect owner. Sec. 1298(a)(1) provides in part that for purposes of the PFIC rules, the Sec. 1298 attribution provisions will apply to the extent that the effect is to treat PFIC stock as owned by a U.S. person. Sec. 1298(a)(2)(A) provides that, for corporations, if 50% or more in value of a non-PFIC corporations stock is owned directly or indirectly by, or for, any person, such person will be considered as owning the stock owned directly or indirectly by, or for, such corporation. Sec. 1298(a)(3) provides in part that stock owned, directly or indirectly, by, or for, a partnership will be considered as being owned proportionately by its partners. Sec. 1298(a)(5) provides in part that stock considered to be owned by a person by reason of the application of Sec. 1298(a)(2) or (a)(3) shall, for purposes of applying such paragraphs, be considered as actually owned by such person. Some complications may arise from these seemingly innocuous rules.

Example: A U.S. corporation, US1, owns 30% of a foreign partnership, FP, and an unrelated foreign corporation owns the remaining 70%. FP owns 100% of the stock of a German corporation, G1, that is not a PFIC. G1, in turn, owns 100% of the stock of a Japanese corporation, J1. J1s only asset is a 20% interest in a Japanese operating company, J2; the only income J1 receives is dividends from J2. Dividends received as to the J2 stock are passive income and the stock of J2 is a passive asset. Thus, under both the income and asset tests, J1 is a PFIC.

Is US1 treated as owning the stock of J1, a PFIC? Whether US1 would be treated as owning an interest in J1 depends on how the rules are applied to US1s holdings. There are two competing interpretations of the attribution rulesone that subjects US1 to the PFIC regime, and one that does not.

Bottom-up analysis. The first alternative uses a bottom-up analysis to ultimately treat US1 as an owner of J1. This analysis starts with J1 (the PFIC) and works its way up the ownership chain. J1 is 100% owned by G1. FP, in turn, owns 100% of G1. Because FP owns more than 50% of G1s stock, FP is deemed to own a proportionate share of the stock held by G1. Here, FP is treated as owning 100% of J1s stock, under Sec. 1298(a)(2)(A). Under Sec. 1298(a)(3), the stock owned indirectly by FP is deemed owned proportionately by its partners. Because US1 is a 30% partner in FP, is deemed to own 30% of FPs stock holdings, which includes the 100% interest in J1. Hence, US1 is treated as owning 30% of J1, subjecting it to the PFIC regime.

Top-down approach. This analysis starts with US1 and moves down the ownership chain. US1 owns 30% of FP; thus, under Sec. 1298(a)(3), it is treated as owning its proportionate share of the stock owned directly or indirectly by FP (i.e., US1 owns 30% of G1). Because US1 is not deemed to own 50% or more of G1, it is not deemed to own any of the stock held by G1 under Sec. 1298(a)(2), and, hence, is not treated as owning any PFIC stock.

Neither regulations nor IRS guidance addresses this issue, and Sec. 1298 does not plainly dictate which approach is proper. The bottom-up analysis is arguably correct, because Sec. 1298(a)(1) commands that the attribution rules apply to the extent that the effect is to treat PFIC stock as owned by a U.S. person. Moreover, because Sec. 1298(a)(3) treats a partner as owning stock owned directly or indirectly by the partnership, the stock owned by the partnership must first be determined. In other words, Sec. 1298(a)(2) would apply first to determine which stock the partnership owns; Sec. 1298(a)(3) would then apply to determine which stock the partners own.

The top-down analysis has support as well. For example, assume US1 owns the same 30% interest in G1 directly. Under Sec. 1298(a)(2)(A), the PFIC stock owned indirectly through G1 would not be attributed to US1, because US1 owns less than 50% of G1. Thus, ownership of G1 indirectly through the FP partnership makes US1 worse off than if it owned G1 directly. To the extent that Sec. 1298(a)(3) reflects a choice by Congress to treat a partnership as a mere aggregate of its participants and not as a separate entity, the top-down analysis better reflects such aggregate principles, by putting US1 in the same position whether it owns lower-tier foreign corporations directly or through a partnership. Moreover, US1 arguably controls only 30% of G1 through FP. This quantum of control falls short of the Congressionally prescribed minimum threshold of 50% to continue attributing J1 stock owned by G1 up the chain under Sec. 1298(a)(2).

Depending on the manner in which the attribution rules apply, US1 is treated differently under the indirect dispositions and distributions regime. Under the top-down analysis, US1 is not treated as owning J1 stock and, thus, is not subject to the Sec. 1291 indirect shareholder tax regime described above. Under the bottom-up analysis, however, certain distributions in the chain of ownership are taxable to US1. For example, a distribution by J1 (the PFIC) to G1 is taxable to US1 under the indirect distribution rules (Prop. Regs. Sec. 1.1291-2(f)). On the other hand, a distribution by a non-PFIC (such as G1 or J2) should not trigger those rules. Certain stock dispositions may also trigger tax under Prop. Regs. Sec. 1.1291-3(e). Generally, a disposition of J1 stock or an interest in any higher-tier entity triggers taxation under Prop. Regs. Sec. 1.1291-3(e)(2). Thus, the disposition of (1) FP by US1, (2) G1 by FP or (3) J1 by G1 triggers tax. Indeed, any diminution of US1s interest in J1 triggers Sec. 1291, such as the addition of a new partner to FP or the issuance of stock by G1 or J1 to raise capital or to compensate employees; see Prop. Regs. Sec. 1.1291-3(e)(2) and (3), Examples (13). Even FPs pledge of G1 stock triggers the indirect disposition rules; see Prop. Regs. Sec. 1.1291-3(d)(2). The disposition of J2 by J1, however, does not trigger taxation under these rules. Alternatively, US1 may make a QEF election. As a practical matter, however, owners often face insurmountable difficulties obtaining the needed information from a fourth-tier entity such as J2, to effectuate QEF treatment.

The disparate treatment under the attribution rules is one reason taxpayers need more guidance under the PFIC regime. Meanwhile, taxpayers are left to navigate these turbid waters as best they can.

From Chris Bowers, J.D., Robert Laudeman, J.D., LL.M., and Jeffrey Cowan, J.D., LL.M., Washington, DC