The U.S. Treasury Department and the IRS on January 24, 2022, released final regulations that treat domestic partnerships as aggregates for income inclusions purposes under the controlled foreign corporation (CFC) regime and proposed regulations that would extend that aggregate treatment for some purposes under the passive foreign investment company (PFIC) regime.
Comments on the proposed PFIC regulations must be submitted to the IRS by April 25, 2022.
Final Sec. 958 Regulations
The final regulations under IRC Sec. 958 -- T.D. 9960 -- largely adopt regulations that had been proposed in 2019 (Prop. Treas. Reg. §1.958-1(d)) whereby domestic partnerships are treated in the same manner as foreign partnerships for Subpart F income inclusion purposes. For taxable years ending after December 31, 2017, domestic partnerships have been treated as aggregates for global intangible low-taxed income (GILTI) inclusion purposes under final GILTI regulations set forth in Treas. Reg. §1.951A-1(e) that were published in the Federal Register on June 21, 2019 (TD 9866).
Under the aggregate approach, the partners in a partnership are treated as directly deriving their distributive share of income of a partnership, in contrast to the entity approach whereby the income is treated as being directly derived by a partnership followed by an allocation of such income to the partners. Accordingly, under the aggregate approach, the status of the partners as U.S. shareholders under Sec. 951(b) is relevant for Subpart F income and GILTI inclusion purposes, while the status of the partnership as a U.S. a shareholder is relevant under the entity approach.
As a result of the final Sec. 958 regulations, only partners in a domestic or foreign partnership that are U.S. shareholders have Subpart F income inclusions under Sec. 951(a). This was achieved by amending Treas. Reg. §1.958-1(d)(1) to provide that domestic partnerships are treated in the same manner as foreign partnerships for income inclusions under Sections 951, 951A and 956, and by amending the final GILTI regulations to specifically refer to Treas. Reg. §1.958-1(d).
Application of Final Regulations to Sec. 956
In the final Sec. 958 regulations, the IRS clarified that the application of the aggregate treatment of domestic partnerships applies to Sec. 956(a). While Sec. 951(a)(1)(B) requires a U.S. shareholder to include in gross income amounts determined under Sec. 956, Sec. 956 does not include a reference to Sections 951 and 951A. To avoid any ambiguity, the IRS added a reference to Sec. 956(a) in the Treas. Reg. §1.958-1(d)(1). However, a domestic partnership is treated as a separate entity for purposes of characterizing loans, pledges and guarantees as U.S. property under Sec. 956(c) and Sec. 956(d).
CFC Testing and Application of Sec. 1248 Under Final Sec. 958 Regulations
Similar to the proposed Sec. 958 regulations, the final Sec. 958 regulations treat domestic partnerships as U.S. shareholders for purposes of determining whether a foreign corporation is a CFC under Sec. 957 and for the application of Sec. 1248. Thus, even though no U.S. partner of a domestic partnership is a U.S. shareholder under Sec. 951(b) of a foreign corporation, that foreign corporation may be a CFC as a result of the domestic partnership’s ownership of CFC stock. Furthermore, if a domestic partnership that is a U.S. shareholder of a CFC sells CFC stock, Sec. 1248 is applicable to characterize gains as dividends to the extent of any untaxed earnings and profits of the CFC, regardless of whether any U.S. partners are U.S. shareholders of that CFC.
Form 5471 Information Reporting
The final Sec. 958 regulations do not appear to change a domestic partnership’s obligation to file Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations) if it meets the conditions for filing Form 5471 under the different filing categories set forth in the instructions to the form.
Effective Date
The final Sec. 958 regulations apply to taxable years of a foreign corporation that begin on or after January 25, 2022 -- the regulations’ publication date in the Federal Register. Thus, if a domestic partnership, the partners and a CFC each use the calendar year as their taxable year, the final Sec. 958 regulations begin to apply for the taxable year beginning January 1, 2023. However, the aggregate treatment of domestic partnerships under the final GILTI regulations has applied for GILTI inclusions for taxable years beginning after December 31, 2017, and continues to apply.
With respect to Subpart F income inclusions, domestic partnerships have been permitted to elect to apply the proposed Sec. 958 regulations for taxable years beginning on or after December 31, 2017, subject to a consistency rule. If taxpayers have not elected and will not elect to apply the Proposed Section 958 Regulations, taxpayers continue to apply the final regulations that are currently in effect for taxable years beginning before January 25, 2022. Under those regulations, a domestic partnership is treated as a separate entity for Subpart F income inclusions purposes. Thus, under the final regulations now in effect, a domestic partnership that is a U.S. shareholder of a CFC is subject to Subpart F income inclusions, which are then allocated to its U.S. partners without regard to whether any of the U.S. partners are U.S. shareholders on a look-through basis.
Transition Year Issues
If a domestic partnership that has a fiscal year as its taxable year is a U.S. shareholder that has not elected to rely on the proposed Sec. 958 regulations, it is possible that partners who are U.S. shareholders could incur two Subpart F income inclusions with respect to the same CFC for the same taxable year.
The preamble to the final Sec. 958 regulations provides an example in which a domestic partnership has a taxable year that ends on June 30, while the CFC and the partners of the partnership have a taxable year that ends on December 31. In this example, the partnership did not elect to adopt the proposed Sec. 958 regulations. Therefore, the domestic partnership incurred Subpart F income that was allocated to its U.S. partners for the CFC’s taxable year ending December 31, 2021 for the domestic partnership’s taxable year ending June 30, 2022. Because the final Sec. 958 regulations apply for the taxable year that ends on December 31, 2022 in this example, partners who are U.S. shareholders should have a direct Subpart F income inclusion under the final Sec. 958 regulations for the taxable year ending on December 31, 2022. The IRS commented that this result is intended to prevent the opportunity for deferral during the transition year. A change in accounting method does not occur as a result of the application of the final regulations.
Like the final Sec. 958 regulations that treat a domestic partnership as an aggregate for income inclusions under the CFC regime, the proposed PFIC regulations also treat a domestic partnership as an aggregate under the PFIC regime.
Qualified Electing Fund (QEF) Elections and Mark-to-Market (MTM) Elections
Currently, domestic partnerships are generally permitted to make a QEF election under Sec. 1295 or an MTM election under Sec. 1296 for an equity investment in a foreign corporation that is characterized as a PFIC. When a domestic partnership makes a QEF election, it includes its proportionate share of ordinary earnings and net capital gains of the PFIC in income for each year in which a foreign corporation is characterized as a PFIC. Similarly, if a domestic partnership makes an MTM election, it includes the excess amount of the fair market value of PFIC stock at the end of the taxable year over the adjusted tax basis in the PFIC stock as taxable income for each year in which the foreign corporation is a PFIC. The U.S. partners are then required to include their distributive share of such QEF or MTM inclusions in income.
Under the proposed PFIC regulations, U.S. partners would be required to make QEF and MTM elections because domestic partnerships would no longer be treated as shareholders of a PFIC for that purpose. This proposed change is warranted because U.S. partners are most impacted by QEF and MTM elections. Accordingly, U.S. partners in domestic partnerships that make QEF or MTM elections under the proposed PFIC regulations are required to notify the domestic partnerships of such elections so that the domestic partnerships may provide assistance with information reporting and tracking the tax basis of PFIC stock.
Taxpayers may provide comments to the IRS as to whether final PFIC regulations should permit domestic partnerships to make QEF or MTM elections in connection with the general rule under the proposed PFIC regulations, which require partners to make such elections. The IRS specifically requested comments on the following:
Existing QEF and MTM elections made by domestic partnerships under the current regulations remain in effect. Furthermore, until the proposed PFIC regulations are finalized, domestic partnerships are permitted to continue to make QEF and MTM elections under the existing rules.
PFIC Purging Elections
Similar to the proposed regulations regarding QEF and MTM elections, the proposed PFIC regulations provide that PFIC purging elections must be made by U.S. partners instead of by domestic partnerships. The rationale for this modification is that purging elections may result in the recognition of excess distributions under Sec. 1291 with respect to U.S. partners.
PFIC Information Reporting
Domestic partnerships that own PFIC stock -- rather than U.S. partners of a domestic partnership -- have been required to file Form 8621 (Information Return for a PFIC or a QEF). Under the proposed PFIC regulations, the requirement to file Form 8621 would become the obligation of U.S. partners, and domestic partnerships would no longer file Form 8621. This proposed change mirrors the changes to the CFC-PFIC overlap rule and the manner in which QEF and MTM elections are made.
If the proposed PFIC regulations are finalized in their current form, domestic partnerships would have to assist U.S. partners in filing Form 8621 by providing Schedule K-3 to its partners with Part VII, which includes information that U.S. partners would need for PFIC information reporting. Under existing regulations, domestic partnerships have undertaken the obligation to gather information to file Form 8621, to make QEF or MTM elections and to report income inclusions under the PFIC regime.
The proposed change in PFIC information reporting is likely to result in additional burdens and complexity for U.S. investors, particularly in the investment management industry. In this regard, the proposed PFIC regulations have adopted a different approach to information reporting compared to the final Sec. 958 regulations.
CFC-PFIC Overlap Rule
The CFC-PFIC overlap rule in Sec. 1297(d)(1) provides that a foreign corporation is not treated as a PFIC with respect to a shareholder during the portion of its holding period for the stock of the foreign corporation in which the shareholder is a U.S. shareholder under Sec. 951(b) and the foreign corporation is a CFC. As a result, a U.S. person that owns stock of a foreign corporation that is a CFC and a PFIC is subject to the CFC regime but not the PFIC regime for taxable years in which the foreign corporation is a CFC and the U.S. person is a U.S. shareholder under Sec. 951(b).
Because of the final Sec. 958 regulations, the IRS is proposing to treat domestic partnerships as aggregates so that the CFC-PFIC overlap rule is consistent in the characterization of domestic partnerships as aggregates under the final Section 958 Regulations. As a result, the proposed PFIC regulations propose the application of the CFC-PFIC overlap rule to U.S. partners that are subject to direct income inclusions under the CFC regime. U.S. partners that indirectly own stock of a foreign corporation that is a CFC and a PFIC would be subject to the PFIC regime under the proposed PFIC regulations if they are not U.S. shareholders under Sec. 951(b).
A transition rule would apply to shareholders’ taxable years before the proposed PFIC regulations become final regulations and enter into effect. Under the transition rule, U.S. partners that are not U.S. shareholders may benefit from the CFC-PFIC overlap rule during the periods in which the U.S. partners were subject to income inclusions under the CFC regime resulting from their indirect ownership of CFC stock through a domestic partnership that is a U.S. shareholder subject to Subpart F income inclusions before the effective date of the final Section 958 regulations.
The final Sec. 958 regulations do not specifically state that S corporations are treated in the same manner as domestic partnerships. However, the understanding is that S corporations are intended to be treated as aggregates under the final Sec. 958 regulations. Conversely, the proposed PFIC regulations clearly state the intent to characterize S corporations as aggregates.
Ben Vesely
bvesely@bdo.com
David Hemmerling
dhemmerling@bdo.com
Sean McGrady
smcgrady@bdo.com