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Rules and regs for passive foreign investment companies.

Section 1296 of the Internal Revenue Code of 1986, as amended, defines a passive foreign investment company (PFIC) as any foreign corporation which, in any taxable year, has either more than 50 percent of its assets invested to generate passive income or has more than 75 percent of its gross income in passive income.

If a foreign corporation is characterized as a PFIC, its U.S. shareholders generally will be required to pay an interest charge in addition to the tax on distributions, in other words, dividends or gain on the sale of shares. Simply stated, the tax and additional charge are calculated by allocating the income, or gain, rated over the period the shares have been held.

The PFIC rules can be avoided by a shareholder election to include the pro-rata share of earnings in each year. In addition, Internal Revenue Code Section 1291 (b)(3)(F) coordinates with the controlled foreign corporation provisions so the additional charge will not apply if amounts are included in income under the Controlled Foreign Corporation rules.

For most foreign insurers with U.S. owners, however, avoidance of the PFIC rules has come via an election under Internal Revenue Code Section 953 (d)-to have the company treated as a domestic company-or via Internal Revenue Code Section 1296 (b)(2)(B), which provides that income earned in connection with the active conduct of an insurance business will not be considered as passive income for purposes of the PFIC rules. A foreign insurer may encounter difficulty in determining whether income is earned as a result of the active conduct of an insurance business. Clearly, the issue arises when a foreign insurer is in "run-off," when operations, like new writings, are suspended for a period. The Tax Simplification Act of 1991 provides a unified set of rules to partially or fully eliminate deferral of U.S. tax on income earned indirectly by Americans through foreign corporations. Generally, U.S. shareholders are not taxed on the income earned by a foreign corporation until that corporation repatriates the income by payment to the U.S. shareholders. Currently, the code contains six anti-deferral regimes to prevent the deferral of U.S. tax on income earned by Americans indirectly through foreign corporations: the controlled foreign corporation rules of subpart F, the foreign personal holding company rules, the PFIC rules, the personal holding company rules, the accumulated-earnings tax, and the foreign investment company rules. These rules often overlap when applied to foreign corporations owned by U.S. shareholders. The significant additional tax complexity resulting from this overlap generally does not generate greater tax revenues. The 1991 act consolidates the various anti-deferral regimes. Under this unified regime, the controlled foreign corporation of sub-part F is retained and the PFIC regime is modified, while the other anti-deferral regimes are eliminated. The modified PFIC regime will apply to any foreign corporation that is passive. A passive foreign corporation is defined as any foreign corporation in which at least 60 percent of its gross income is passive or in which at least 50 percent of its assets are either produced or held for the production of passive income, or if the foreign corporation is registered under the Investment Company Act of 1940, as amended, as a management company or unit investment trust. The current law's definition of passive income and the exceptions to the definition, including the exception for income derived from an insurance business' active conduct, are retained by the 1991 act.

The modified PFIC regime provided by the 1991 act establishes the following rules to eliminate tax deferral by U.S. shareholders of passive foreign corporations:

Mandatory Current Inclusion. Any American who owns more than 25 percent of the shares of a passive foreign corporation or any shares in a "U.S.-controlled" passive foreign corporation must include, on a pro-rata basis, the entire gross income of this corporation under a modified application of the subpart F rules.

Elective Current Inclusion. An American who owns less than 25 percent of the shares in a non-U.S. controlled passive foreign corporation may elect the application of the mandatory current inclusion rules. If so elected, the passive foreign corporation is characterized by a "qualified electing fund" with respect to that person.

Mark-to-Market Method. An American who owns less than 25 percent of the shares in a non-U.S. controlled passive foreign corporation and does not elect to apply the mandatory current inclusion rules must mark-to-market his shares annually if the shares are "marketable." Shares are marketable if they are regularly traded on a qualified U.S. or foreign exchange. Gross income equal to the excess, if any, of the fair market value of his shares at the close of the taxable year over his adjusted basis must be included.

If the adjusted basis exceeds the fair market value, the shareholder may deduct this excess to the extent of prior gross-income inclusions under the mark-to-market method with respect to his shares.

Interest Charge Method. A person who owns less than 25 percent of the shares in a non-U.S.-controlled passive foreign corporation and that does not elect to apply the mandatory current inclusion rules will be subject to the interest-charge method if the shares are not marketable.

The PFIC Tax Simplification Act of 1991 provides for the elimination of the asset test in determining whether a foreign corporation is a PFIC, and lowers the threshold of the gross-income test from 75 percent to 50 percent. This act was introduced because many foreign corporations predominantly engaged in the conduct of active business operations currently are characterized as PFICs based on the asset test under the current PFIC rules. The rules were never intended to apply to foreign corporations with active business operations. Neither this act nor the 1991 act should materially affect any foreign insurance companies. P. Bruce Wright is a member of the New York law firm LeBoeuf, Lamb, Leiby and MacRae.
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Title Annotation:Legal Considerations
Author:Wright, P. Bruce
Publication:Risk Management
Article Type:Column
Date:Nov 1, 1991
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