Exemption from PFIC regime for indirect ownership expanded

The IRS clarifies that shares held through a variety of tax-exempt organizations, plans, and accounts are generally excluded.

On April 14, Treasury and the IRS announced they will amend the regulations under Sec. 1291 to provide that a U.S. person who indirectly owns stock of a passive foreign investment company (PFIC) through a tax-exempt organization or account will not be treated as a U.S. shareholder of the PFIC (Notice 2014-28).

In general, a foreign corporation is a PFIC if at least 75% of its gross income is passive or at least 50% of its assets produce passive income or are held for the production of passive income (Sec. 1297(a)). Sec. 1291 imposes interest charges on U.S. shareholders with respect to “excess distributions” from PFICs (which are taxed as ordinary income) unless certain elections are made to include income currently or mark to market (if applicable). The consequences of the excess distribution regime can be onerous if a PFIC is sold at a significant gain, because Sec. 1291(a)(2) treats the entire gain as an excess distribution.

Sec. 1298(a) provides attribution rules that treat a person as a U.S. shareholder with respect to shares of a PFIC held through other entities. Ownership may be attributed from one U.S. person to another only as provided in the regulations. On Dec. 31, 2013, Treasury and the IRS published temporary and proposed regulations under Secs. 1291 and 1298 laying out attribution rules for “indirect” owners of PFICs (T.D. 9650 and REG-140974-11). Temp. Regs. Sec. 1.1291-1T(b)(7) defines “shareholder” to mean any U.S. person who owns stock of a PFIC directly or indirectly. Temp. Regs. Sec. 1.1291-1T(b)(8) lays out attribution rules for indirect ownership through domestic and foreign corporations, partnerships, S corporations, estates, and trusts.

Exempt organizations (including qualified plans and other tax-exempt account arrangements) generally are not subject to the Sec. 1291 regime or the reporting requirements under Sec. 1298(f) (unless, e.g., a dividend from a PFIC would be unrelated business taxable income or debt-financed income—see Regs. Sec. 1.1291-1(e)). However, other than carving out interests in Sec. 401(a) employees’ trusts from the indirect-ownership rules, the regulations in their current form do not address indirect ownership of a PFIC through exempt organizations or accounts.

Notice 2014-28 greatly expands this exemption from the indirect-ownership rules. Specifically, shares of a PFIC owned by the following accounts, plans, and organizations will not be attributed to their U.S. beneficiaries or interest holders:

• An organization exempt under Sec. 501(a) because it is described in Sec. 501(c), 501(d), or 401(a);
• A state college or university described in Sec. 511(a)(2)(B);
• A plan described in Sec. 403(b) or 457(b);
• An individual retirement plan or annuity as defined in Sec. 7701(a)(37); or
• A qualified tuition program described in Sec. 529 or 530.

Thus, U.S. beneficiaries and interest holders will not be subject to the excess distribution regime and reporting rules for PFICs solely on account of their interests in such an account, plan, or organization.

The regulations incorporating this guidance will be effective for tax years ending on or after Dec. 31, 2013.

– Notice 2014-28

By Dahlia B. Doumar, J.D., LL.M., and Carl A. Merino, J.D., LL.M., both tax counsel at Patterson Belknap Webb & Tyler LLP in New York City.