These synopses are intended only as aids to the reader in

HIGHLIGHTS

OF THIS ISSUE





Bulletin No. 2021–5

February 1, 2021

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be

relied upon as authoritative interpretations.

ADMINISTRATIVE

REG-115057-20, page 714.

These proposed regulations amend regulations under sections 165 and 7508A, interpreting new section 7508A(d)

relating to mandatory postponements of time to perform

time-sensitive tax acts by reason of a federally declared disaster, and clarifying the definition of federally declared disaster under section 165(i)(5). Under section 7508A(a), the

Secretary has discretion to determine which taxpayers are

affected by a federally declared disaster and to specify both

the time-sensitive acts that are postponed and a period of

time that may be disregarded, up to one year, in determining whether such acts are timely performed. The proposed

regulations clarify that the phrase “in the same manner

as a period specified under [section 7508A(a)]” in section

7508A(d)(1) means that the time-sensitive acts postponed

for the mandatory 60-day period are those determined by the

Secretary under section 7508A(a). The proposed regulations

further provide that the mandatory 60-day period will only

apply if the Secretary bases his discretionary determination

on a disaster declaration that specifies an incident date. The

proposed regulations also clarify that the mandatory 60-day

period cannot exceed the one-year limitation provided under

section 7508A(a).

EMPLOYEE PLANS

Notice 2021-9, page 678.

This notice sets forth updates on the corporate bond monthly yield curve, the corresponding spot segment rates for January 2021 used under § 417(e)(3)(D), the 24-month average

segment rates applicable for January 2021, and the 30-year

Treasury rates, as reflected by the application of § 430(h)(2)

(C)(iv).

Finding Lists begin on page ii.

Rev. Rul. 2021-3, page 674.

This revenue ruling provides tables of covered compensation

under § 401(l)(5)(E) of the Internal Revenue Code and the Income Tax Regulations thereunder, effective January 1, 2021.

INCOME TAX

REG-111950-20, page 683.

These proposed regulations provide guidance under sections

1297 and 1298, including rules regarding the treatment of

certain income received or accrued by a foreign corporation

and assets held by a foreign corporation for purposes of

section 1297 and rules on whether a foreign corporation is

engaged in the active conduct of an insurance business for

purposes of section 1297(b)(2)(B). The proposed regulations

also include rules addressing the treatment of qualified improvement property under the alternative depreciation system for purposes of the global intangible low-taxed income

and the foreign-derived intangible income provisions.

Rev. Proc. 2021-12, page 681.

This revenue procedure extends to September 30, 2021,

the expiration dates relevant to the application of the safe

harbors in Rev. Proc. 2020-26, 2020-18 I.R.B. 753, and Rev.

Proc. 2020-34, 2020-26 I.R.B. 990.

T.D. 9936, page 508.

These final regulations provide guidance under sections

1291, 1297, and 1298, regarding the determination of

ownership in a passive foreign investment company and the

treatment of certain income received or accrued by a foreign corporation and assets held by a foreign corporation for

purposes of section 1297. The final regulations also provide

guidance regarding the exclusion from passive income under section 1297(b)(2)(B) for income derived by a qualifying

insurance corporation in the active conduct of an insurance

business.

T.D. 9943, page 577.

This document contains final regulations that provide additional guidance regarding the limitation on the business interest expense deduction limitation to reflect changes made

by the Tax Cuts and Jobs Act and the Coronavirus Aid, Relief, and Economic Security Act. The final regulations provide

guidance regarding which taxpayers and trades or businesses are subject to the limitation, and how the limitation applies

in consolidated group, partnership, international, and other

contexts.

T.D. 9945, page 627.

Section 1061 recharacterizes certain net long-term capital

gains of a partner that holds one or more applicable partnership interests as short-term capital gains. An applicable

partnership interest is an interest in a partnership that is

transferred to or held by a taxpayer in connection with the

performance of substantial services by the taxpayer, or any

other related person, in any applicable trade or business.

The final regulations also amend existing regulations on holding periods to clarify the holding period of a partner’s interest

in a partnership that includes an applicable partnership interest and/or a profits interest.

The IRS Mission

Provide America’s taxpayers top-quality service by helping

them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all.

Introduction

The Internal Revenue Bulletin is the authoritative instrument

of the Commissioner of Internal Revenue for announcing official rulings and procedures of the Internal Revenue Service

and for publishing Treasury Decisions, Executive Orders, Tax

Conventions, legislation, court decisions, and other items of

general interest. It is published weekly.

It is the policy of the Service to publish in the Bulletin all substantive rulings necessary to promote a uniform application

of the tax laws, including all rulings that supersede, revoke,

modify, or amend any of those previously published in the

Bulletin. All published rulings apply retroactively unless otherwise indicated. Procedures relating solely to matters of internal management are not published; however, statements of

internal practices and procedures that affect the rights and

duties of taxpayers are published.

Revenue rulings represent the conclusions of the Service

on the application of the law to the pivotal facts stated in

the revenue ruling. In those based on positions taken in rulings to taxpayers or technical advice to Service field offices,

identifying details and information of a confidential nature are

deleted to prevent unwarranted invasions of privacy and to

comply with statutory requirements.

Rulings and procedures reported in the Bulletin do not have the

force and effect of Treasury Department Regulations, but they

may be used as precedents. Unpublished rulings will not be

relied on, used, or cited as precedents by Service personnel in

the disposition of other cases. In applying published rulings and

procedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered,

and Service personnel and others concerned are cautioned

against reaching the same conclusions in other cases unless

the facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on provisions

of the Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows: Subpart A,

Tax Conventions and Other Related Items, and Subpart B,

Legislation and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.

To the extent practicable, pertinent cross references to these

subjects are contained in the other Parts and Subparts. Also

included in this part are Bank Secrecy Act Administrative

Rulings. Bank Secrecy Act Administrative Rulings are issued

by the Department of the Treasury’s Office of the Assistant

Secretary (Enforcement).

Part IV.—Items of General Interest.

This part includes notices of proposed rulemakings, disbarment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative index

for the matters published during the preceding months. These

monthly indexes are cumulated on a semiannual basis, and are

published in the last Bulletin of each semiannual period.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

February 1, 2021 

Bulletin No. 2021–5

Part I

26 CFR 1.1291-1; 1.1297-1; 1.1297-2; 1.1297-4;

1.1297-6; 1.1297-6; 1.1298-2; 1.1298-4

Firehock at (202) 317-4932 (not toll-free

numbers).

T.D. 9936

SUPPLEMENTARY INFORMATION:

DEPARTMENT OF THE

TREASURY

Internal Revenue Service

26 CFR Part 1

Background

Guidance on Passive

Foreign Investment

Companies

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations regarding the determination of whether a foreign corporation

is treated as a passive foreign investment company (“PFIC”) for purposes

of the Internal Revenue Code (“Code”),

and the application and scope of certain

rules that determine whether a United

States person that indirectly holds stock

in a PFIC is treated as a shareholder of

the PFIC. The regulations affect United States persons with direct or indirect

ownership interests in certain foreign

corporations.

DATES: Effective date: These regulations

are effective on January 14, 2021.

Applicability dates: For dates of applicability see §§1.1291-1(j), 1.1297-1(g),

1.1297-2(h), 1.1297-4(g), 1.1297-6(f),

1.1298-2(g), and 1.1298-4(f).

FOR FURTHER INFORMATION

CONTACT: Concerning the regulations §§1.1291-0 and 1.1291-1, 1.1297-0

through 1.1297-2, 1.1298-0, 1.1298-2,

and 1.1298-4, Christina G. Daniels at

(202) 317-6934; concerning the regulations §§1.1297-4 and 1.1297-6, Josephine

1

On July 11, 2019, the Department of

the Treasury (“Treasury Department”)

and the IRS published proposed regulations (REG-105474-18) under sections

1291, 1297, and 1298 in the Federal

Register (84 FR 33120) (the “proposed

regulations” or “2019 proposed regulations”). All written comments received in

response to the proposed regulations are

available at www.regulations.gov or upon

request. A public hearing on the proposed

regulations was scheduled for December

9, 2019, but it was not held because there

were no requests to speak. Terms used

but not defined in this preamble have the

meaning provided in these final regulations.

In addition, on October 2, 2019,

the Treasury Department and the IRS

published proposed regulations (REG104223-18) relating to the repeal of section 958(b)(4) by the Tax Cuts and Jobs

Act, Pub. L. 115-97, 131 Stat. 2054 (2017)

(the “Act”) in the Federal Register (84

FR 52398) (the “section 958 proposed

regulations”). As in effect before its repeal, section 958(b)(4) provided that section 318(a)(3)(A), (B), and (C) (providing

for downward attribution) was not to be

applied so as to consider a United States

person (as defined in section 7701(a)(30))

as owning stock owned by a person who

is not a United States person (a “foreign

person”). After the Act repealed section

958(b)(4), stock of a foreign corporation

owned by a foreign person could be attributed to a United States person under

section 318(a)(3) for various purposes,

including for purposes of determining

whether the foreign corporation is a controlled foreign corporation within the

meaning of section 957 (“CFC”). The section 958 proposed regulations generally

made modifications to ensure that the operation of certain rules outside of subpart

F of part III of subchapter N of chapter 1

of subtitle A of the Code (“subpart F”) are

consistent with their application before the

Act’s repeal of section 958(b)(4). A public

hearing on these regulations was not held

because there were no requests to speak.

This rulemaking finalizes the portion of

the section 958 proposed regulations under section 1297 regarding the treatment

of foreign corporations for purposes of

section 1297(e).1 See Part III.D.1 of the

Summary of Comments and Explanation

of Revisions section.

A notice of proposed rulemaking published in the Proposed Rules section of

this issue of the Federal Register (REG111950-20) (the “2020 NPRM”) provides

additional guidance on the treatment of

income and assets of a foreign corporation for purposes of the PFIC rules and on

the exception from passive income under

section 1297(b)(2)(B) (“PFIC insurance

exception”).

Summary of Comments and

Explanation of Revisions

I. Overview

The final regulations retain the basic

approach and structure of the proposed

regulations, with certain revisions. This

Summary of Comments and Explanation

of Revisions section discusses those revisions as well as comments received in response to the solicitation of comments in

the notice of proposed rulemaking. Comments outside the scope of this rulemaking are generally not addressed but may

be considered in connection with the potential issuance of future guidance.

II. Comments and Revisions to Proposed

§1.1291-1 – Taxation of U.S. persons that

are shareholders of section 1291 funds

Section 1298(a) provides attribution

rules that apply to the extent the effect

is to treat stock of a PFIC as owned by

a United States person. These rules apply

when a United States person directly or

indirectly owns an interest in a PFIC, a

The other portions of the section 958 proposed regulations were finalized at 85 FR 59428.

February 1, 2021

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Bulletin No. 2021–5

partnership, an estate or a trust, or when

a United States person directly or indirectly owns 50 percent or more in value

of the stock of a corporation that is not a

PFIC. In such cases, the attribution rules

of section 1298(a) may apply to treat the

United States person as owning shares of a

PFIC owned directly or indirectly by such

an entity. Stock considered to be owned

by a person by reason of any of the foregoing rules is treated as actually owned

by that person for purposes of the further

application of those rules (the “successive

application rule”). Except as provided in

regulations, the attribution rules do not

apply to treat stock owned or treated as

owned by a United States person as owned

by any other person. The current rules in

§1.1291-1(b)(8) are consistent with these

statutory provisions.

A. Attribution of ownership through a

partnership, S corporation, estate or trust

Proposed §1.1291-1(b)(8)(iii) provided that an owner of an interest in a partnership, S corporation, estate or trust (a

“pass-through entity”) would be treated as

owning stock owned by the pass-through

entity only if the pass-through owner owns

50 percent or more of the pass-through entity. Examples in the proposed regulations

illustrated the operation of this rule in

cases where a United States person owns

50 percent, in one case, or 40 percent, in

another case, of a foreign partnership. The

preamble to the proposed regulations indicated that the proposed rule was intended

to ensure that the attribution rules apply

consistently whether a United States person owns stock of a non-PFIC foreign corporation indirectly through a partnership

or directly.

The only comment received on this

proposed rule agreed with the results of

the first example but recommended that a

different approach be taken with respect

to attribution through partnerships. The

comment responded to the statement in

the preamble that the proposed regulations would have results consistent with

an aggregate approach to partnerships by

noting that in certain circumstances the

proposed rule would deviate from a true

aggregation approach. It posited an example in which application of the rule in

the proposed regulations would prevent

Bulletin No. 2021–5

a United States person from being treated as owning stock of a PFIC owned by

a non-PFIC corporation, even though the

United States person directly and indirectly owned, in the aggregate, more than

50 percent of the stock of the non-PFIC

corporation and argued that this result was

inappropriate. Accordingly, the comment

suggested that the final regulations, instead of adopting the rule included in the

proposed regulations, adopt a rule that

uses an aggregation approach to attribution through partnerships.

The Treasury Department and the IRS

agree with the comment that the rule in

the proposed regulations could have inappropriate results, and that a partner in a

partnership should be treated as indirectly

owning the same number of shares of a

non-PFIC corporation owned by the partnership as if the partner held those shares

directly. Accordingly, the final regulations

do not adopt the rules in the proposed regulations to amend the rules of §1.12911(b)(8)(iii), relating to pass-through entities (partnerships, S corporations, estates

and nongrantor trusts).

B. Application of “top-down” approach

The preamble to the proposed regulations indicated that proposed §1.12911(b)(8)(iii) was intended to apply the

attribution rules to a tiered ownership

structure involving a pass-through entity

on a “top-down” basis, by starting with

a United States person and determining

what stock is considered owned at each

successive lower tier on a proportionate

basis. The preamble requested comments

as to whether the “top-down” approach

should be extended to attribution through

corporations.

The only comment received on the

issue indicated that the “top-down” approach should not be so extended, on the

grounds that the successive application

rule of section 1298(a)(5) requires a “bottom-up” approach (that is, applying the attribution rules to a tiered ownership structure by starting with the lowest-tier entity

and determining which persons are treated

as owning stock of that entity at each successive higher tier on a proportionate basis) for corporate structures. The comment

acknowledged that this would result in

inconsistency in attribution of ownership

509

between stock of a PFIC held through a

partnership (which, in many cases, may

be a foreign corporate entity treated as a

partnership for U.S. federal income tax

purposes as the result of a check-the-box

election) and stock of a PFIC held through

a corporation.

The Treasury Department and the IRS

have determined that the same approach

should apply to attribution through a

pass-through entity, a PFIC or a 50 percent-owned non-PFIC corporation. In

each case, the statutory language provides

that an owner of an interest in such an entity is treated as owning its proportionate

share of stock owned by the entity. The

same approach to attribution therefore

should apply regardless of which entity a

United States person holds an interest in.

The successive application rule of

section 1298(a)(5) can be applied either

under a “top-down” or “bottom-up” approach. While both approaches to attribution may treat a United States person as

owning an amount of stock of a PFIC that

is less than that person’s economic interest in the PFIC, a “top-down” approach

takes into account both the direct and indirect ownership of stock of a corporation

by the same person while the bottom-up

approach may not do so. For example, assume that U.S. individual A owns 49 percent of the partnership interests in a partnership that owns 95 percent of the stock

of a tested foreign corporation. The tested foreign corporation is not a PFIC but

owns all of the single class of stock of a

PFIC. Individual A also owns the remaining 5 percent of the tested foreign corporation’s stock directly. Under a “top-down”

approach, individual A is deemed to hold

46.55 percent of the tested foreign corporation’s stock through the partnership

and owns 5 percent of the tested foreign

corporation’s stock directly. Therefore,

individual A is treated as owning 51.55

percent of the tested foreign corporation’s

stock and 51.55 percent of the PFIC stock.

Under a “bottom-up” approach, the tested

foreign corporation owns all of the PFIC

stock; the partnership owns 95 percent

of the tested foreign corporation’s stock

and therefore is treated as owning 95 percent of the PFIC stock; and individual A

is treated as owning 49 percent of what

the partnership owns, or 46.55 percent of

the PFIC stock. In this example, the “top-

February 1, 2021

down” approach treats individual A as

owning its economic share of the PFIC’s

stock, while the “bottom-up” approach

may not take into account the PFIC stock

that is owned through the 5 percent of the

tested foreign corporation’s stock that individual A owns directly. Accordingly,

the final regulations apply a “top-down”

approach to the attribution of ownership

through all tiered ownership structures.

The final regulations also include a

new rule addressing the application of the

successive application rule to tiered ownership structures. The new rule specifically provides for a top-down approach to attribution of ownership. See §1.1291-1(b)

(8)(iv). The examples in the existing and

proposed regulations have been revised

to clarify how the top-down approach

applies to those examples. See §1.12911(b)(8)(v). A new example is added to

illustrate the operation of the successive

application rule in a fact pattern in which

a United States person owns stock of a

foreign corporation both directly and indirectly through a partnership. See §1.12911(b)(8)(v)(D).

C. Ownership attribution through

nongrantor trusts

A comment requested that the final

regulations provide additional guidance

on attributing PFIC stock held by a nongrantor trust to the beneficiaries of the

trust, suggesting that determining ownership by U.S. beneficiaries of PFIC stock

held directly or indirectly by a nongrantor

trust warrants more specificity than determining ownership in PFIC stock held directly or indirectly by other pass-through

entities.

Section 1298(a)(3) and §1.1291-1(b)

(8)(iii)(C) provide that each beneficiary is

considered to own a proportionate amount

of stock held by a foreign or domestic estate or nongrantor trust. Section 1.12911(b)(8)(i) provides that the determination

of a person’s indirect ownership is made

on the basis of all the facts and circumstances of each case and that the substance

rather than the form of the ownership is

controlling, taking into account the purposes of sections 1291 through 1298.

On December 31, 2013, the Treasury Department and the IRS published

final and temporary regulations under

several Code sections including section

1291 (78 FR 79602, as corrected at 79

FR 26836) (“2013 temporary and final

regulations”). The preamble to those

regulations provided that pending further guidance, beneficiaries of estates

and nongrantor trusts that hold PFIC

stock subject to the section 1291 regime

should use a reasonable method to determine their ownership interests in the

PFIC. The preamble to those regulations

also provided that section 1291 and the

principles of subchapter J must be applied in a reasonable manner with respect to estates and trusts, and beneficiaries thereof, to preserve or trigger the tax

and interest charge rules under section

1291. Accordingly, the preamble provided that the estate or trust, or the beneficiary thereof, must take excess distributions into account under section 1291 in

a reasonable manner, consistent with the

general operating rules of subchapter J

and that it would be unreasonable for the

shareholders of the section 1291 fund to

take the position that neither the beneficiaries nor the estate or trust are subject

to the tax and interest charge rules under

section 1291.

The Treasury Department and the IRS

remain aware of the need for guidance

regarding both the ownership attribution rules and the interaction of the rules

in subchapter J with the PFIC rules. The

Treasury Department and the IRS are also

aware that in some cases, the application

of the PFIC attribution rules may impose

tax on U.S. beneficiaries of foreign trusts

that never receive the related distributions.

The Treasury Department and the IRS believe that further guidance with respect to

the identification of indirect shareholders

in such circumstances requires coordination of the PFIC rules with the rules of

subchapter J, which is beyond the scope

of this regulation project. Pending the

issuance of further guidance, taxpayers

should continue to apply these rules in

a reasonable manner as expressed in the

preamble to the 2013 temporary and final

regulations.

III. Comments and Revisions to Proposed

§1.1297-1 – Definition of passive foreign

investment company

Proposed §1.1297-1 provided general

rules and definitions under section 1297

including general rules concerning the

application of the income test of section

1297(a)(1) (“Income Test”) and the asset

test of section 1297(a)(2) (“Asset Test”),

clarification on the scope of the section

1297(b)(1) cross-reference to section

954(c) for purposes of defining passive income, and general rules that address certain computational and characterization

issues that arise in applying the Asset Test.

A. Definition of passive income

1. In General

Section 1297(b)(1) defines passive income, for purposes of the PFIC rules, as

income of a kind that would be foreign

personal holding company income (“FPHCI”) under section 954(c), and proposed

§1.1297-1(c)(1)(i) provided accordingly

that passive income means income of a

kind that would be FPHCI under section

954(c)(1). A comment suggested that

the cross-reference to section 954(c)(1)

should incorporate only those provisions

of section 954(c) (and the regulations

thereunder) that were in effect in 1986

when section 1297 was enacted and not,

for example, section 954(c)(1)(H), relating to income from personal services

contracts, or recent revisions to the regulatory rules for active rents and royalties

under section 954(c)(2)(C). The Treasury

Department and the IRS disagree, and

believe that, in view of the original purpose of referencing section 954(c), section

1297 incorporates the law in respect of the

referenced provisions—both statutory and

regulatory—when it is applied. Compare

section 951A(d)(3).2 Therefore, the final

regulations do not adopt this comment.

2. PFIC/CFC Overlap Rule and RPII

Income

Section 1297(d) provides that, for

PFIC purposes, a corporation shall not be

As enacted, section 951A(d) contains two paragraphs designated as paragraph (3). The section 951A(d)(3) referenced in this preamble relates to the paragraph on determination of the adjusted basis in property for purposes of calculating QBAI.

2

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treated as a PFIC with respect to a shareholder during the qualified portion of such

shareholder’s holding period with respect

to stock in such corporation during which

time the corporation is a CFC (“PFIC/

CFC overlap rule”). The qualified portion of a shareholder’s holding period

generally is the period during which the

shareholder is a United States shareholder

(“U.S. shareholder”), as defined in section 951(b). Section 951(b) defines a U.S.

shareholder, for purposes of the Code, as a

U.S. person that owns 10 percent or more

of the voting power or value of a foreign

corporation. Section 957(a) provides that,

for purposes of the Code, a CFC means

any foreign corporation more than 50 percent owned (by vote or value, taking into

account section 958(b) constructive ownership rules) by U.S. shareholders on any

day during the taxable year of the foreign

corporation.

In certain circumstances, the subpart

F insurance rules lower the CFC ownership threshold requirements used to determine CFC status and eliminate the 10

percent vote or value test for determining

U.S. shareholder status that are otherwise

applicable for purposes of the Code. Under section 957(b), a special definition of

a CFC applies and lowers the more than

50 percent ownership rule to a more than

25 percent ownership rule for taking into

account section 953(a) insurance income,

but only if the foreign corporation’s gross

amount of premiums or other consideration in respect of reinsurance or the issuing of insurance or annuity contracts not

described in section 953(e)(2) exceeds 75

percent of the gross amount of all premiums or other consideration in respect of

all risks. Also, under section 953(c)(1)

(B), for purposes of taking into account

related party insurance income (“RPII”)

as defined in section 953(c)(2), the CFC

ownership requirement is reduced to a “25

percent or more” requirement. In addition,

for purposes of determining RPII, the 10

percent of vote or value test for determining U.S. shareholder status is eliminated.

See section 953(c)(1)(A). Instead, for

RPII purposes, a U.S. shareholder means

any U.S. person that directly or indirectly

owns any of the stock of the foreign corporation at any time during the foreign

corporation’s taxable year. See section

953(c)(1)(A). Constructive ownership

Bulletin No. 2021–5

under section 958(b) is not taken into account for this purpose.

A comment requested that the proposed regulations be modified to provide

an exception to the PFIC rules for all U.S.

shareholders (meaning without regard to

the 10 percent vote or value test in section 951(b)) of all CFCs (including those

that satisfy the 25 percent threshold applicable solely for the subpart F purposes

described above). The final regulations do

not adopt this comment. Consideration of

the scope of the PFIC/CFC overlap rule,

including the interaction with the RPII

rules, is beyond the scope of this rulemaking. The Treasury Department and the IRS

continue to study the interaction of these

provisions and if necessary, will provide

guidance in the future.

B. Exceptions from passive income

1. Application of Active Banking and

Active Insurance Exceptions

Proposed §1.1297-1(c)(1)(i)(A) provided that section 954(h), which excludes

from FPHCI income derived by a CFC

in the active conduct of a banking or financing business from customers outside

of the United States, applied for purposes

of determining PFIC status. The proposed

regulations also provided that section

954(i), which excludes from FPHCI certain income derived in the active conduct

of an insurance business, did not apply for

purposes of determining PFIC status. See

proposed §1.1297-1(c)(1)(i)(B). Several comments approved of the application

of section 954(h) to the determination of

whether income is treated as passive for

purposes of section 1297. One comment

noted that, in the case of tested foreign

corporations with look-through subsidiaries that are domestic corporations, section

954(h)(3)(A)(ii)(I) would result in the

section 954(h) exception being inapplicable to active financing income earned by

these subsidiaries from transactions with

local customers, even though it would

otherwise be of a type that would not be

passive. The comment suggested that section 954(h) should be applied in the PFIC

context by treating income as qualified

banking or financing income even if the

income is derived from transactions with

customers in the United States. Several

511

comments recommended that the section

954(h) exception continue to apply in the

PFIC context in the event that final regulations implementing the active banking

exception in section 1297(b)(2)(A) are adopted. Comments also requested that the

final regulations apply the section 954(i)

insurance exception for purposes of determining PFIC status of an insurance

company in a parallel manner as section

954(h).

In response to these comments, the

Treasury Department and the IRS have

further studied sections 954 and 1297 and

their legislative history. As described in

more detail in the remainder of this Part

III.B.1 of this Summary of Comments

and Explanation of Revisions section, the

Treasury Department and the IRS have

determined that sections 954(h) and (i) do

not apply for purposes of section 1297(b)

absent regulations and that the appropriate

statutory authority for any such regulations is section 1297(b)(2) rather than section 1297(b)(1). The Treasury Department

and the IRS have further concluded that

section 954(i) does not apply for purposes

of section 1297(b)(2)(B), and that certain

principles of section 954(h) should be applied for purposes of section 1297(b)(2)

(A) but that a different approach is warranted with respect to section 954(h) than

the approach taken in the proposed regulations. Accordingly, the 2020 NPRM proposes rules that would treat qualifying income of certain taxpayers that satisfy the

requirements of section 954(h) as income

derived in the active conduct of a banking

business within the meaning of section

1297(b)(2). See proposed §1.1297-1(c)

(2).

As previously discussed, section

1297(b)(1) provides that, except as otherwise provided in section 1297(b)(2),

passive income means any income of a

kind that would be FPHCI as defined in

section 954(c). The definitions of the categories of FPHCI listed in section 954(c)

describe types of gross income, for example interest, dividends, gains from the sale

of property and foreign currency gains,

as well as exceptions to those definitions.

While these definitions and exceptions in

some places refer to CFCs, the definitions

and exceptions themselves do not require

that a foreign corporation be a CFC. By

contrast, although sections 954(h) and (i)

February 1, 2021

apply “for purposes of section 954(c)(1),”

those provisions explicitly require that a

foreign corporation be a CFC to qualify

for an exception to FPHCI. Section 954(h)

applies only to eligible CFCs, as defined in

section 954(h)(2), and section 954(i) applies only to qualifying insurance company CFCs, as defined in section 953(e)(3).

Accordingly, sections 954(h) and (i) do

not apply for purposes of section 1297(b)

(1) unless a tested foreign corporation is

treated pursuant to regulations as a CFC

for that purpose or otherwise qualifies as a

CFC. See proposed §1.1297-1(c)(1)(i)(D)

of the 2019 proposed regulations (treating

a tested foreign corporation as a CFC for

purposes of applying section 954(h)).

The Treasury Department and the IRS

have further determined that any regulations treating sections 954(h) and (i) as

applicable for purposes of section 1297(b)

should be issued under section 1297(b)

(2) and not under section 1297(b)(1). As

originally enacted, section 1297(b)(1)

provided a rule of general application, and

section 1297(b)(2) provided a limited set

of exceptions to section 1297(b)(1). While

the list of exceptions in section 1297(b)(2)

has changed from time to time, that statutory scheme remains intact today. Section 1297(b)(2) provides exceptions for

income derived in the active conduct of a

banking or insurance business, subject to

various conditions. If section 954(h) or (i)

were treated as applicable for purposes of

section 1297(b)(1), section 1297(b)(2)(A)

and (B) would provide duplicative exceptions for banking or insurance income, respectively. Moreover, interpreting section

1297(b)(1) in this manner would have the

effect of narrowing the scope of the exceptions provided by section 1297(b)(2),

because the income of some foreign banks

or insurance companies would already

be treated as non-passive under section

1297(b)(1). No explicit action by Congress authorizes the narrowing of section

1297(b)(2) in this manner. The legislative

history of the enactment of section 954(h)

(as a temporary rule relating to both banking and insurance income) in 1997 and

the enactment of sections 954(h) and (i)

in 1998 are void of any indication that

Congress intended such an interpretation

of section 1297(b)(1).3 The legislative

history provides further evidence that section 954(h) was not intended to apply for

purposes of section 1297(b)(1); the conference report states that “the conferees

intend that a corporation will be considered to be engaged in the active conduct

of a banking … business if the corporation would be treated as so engaged under

the regulations proposed under” section

1297(b)(2).4 Incorporating this standard

into section 1297(b)(1) would limit the

scope of section 1297(b)(2). Accordingly,

given the specialized nature of these exceptions within the subpart F regime, the

Treasury Department and the IRS have

determined that it is inappropriate to apply

them in defining the types of income that

are “of a kind” described in section 954(c)

(that is, FPHCI) for purposes of section

1297(b)(1).

In addition, as explained in the preamble to the 2019 proposed regulations,

the Treasury Department and the IRS

have determined that because the recent

changes to section 1297(b)(2)(B) require

that income eligible for the exception be

earned by a qualifying insurance corporation, section 954(i) should not apply in addition to the newly modified exception in

section 1297(b)(2)(B). See 84 FR 33120,

at 33123. Therefore, the final regulations

do not adopt the comments requesting

that the section 954(i) exception apply for

purposes of determining PFIC status. As

a result, section 954(i) remains listed in

§1.1297-1(c)(1)(i)(B) as one of the exceptions in section 954 that is not applied in

the PFIC context.

Section 954(h) has been removed from

the list of exceptions that are applied to

PFICs with respect to section 1297(b)

(1). See §1.1297-1(c)(1)(i)(A). Despite

the conclusion that it is inappropriate to

incorporate section 954(h) as an exception to the definition of passive income

under section 1297(b)(1), the Treasury

Department and the IRS have considered

whether principles of section 954(h) could

apply in the context of the rules of section 1297(b)(2)(A). Section 1297(b)(2)

(A) provides that passive income does not

include any income derived in the active

conduct of a banking business by an institution licensed to do business as a bank

in the United States (or, to the extent provided in regulations, by any other corporation). Pursuant to this grant of regulatory

authority, the 2020 NPRM proposes an

active banking exception that incorporates

certain principles of section 954(h) in defining other corporations that are eligible

to apply this exception in addition to U.S.

licensed banks. See proposed §1.12971(c)(2). The preamble to the 2020 NPRM

discusses comments that address issues

relating to the potential application of section 954(h) in the PFIC context.

2. Treatment of Gains from Certain

Transactions

Proposed §1.1297-1(c)(1)(ii) provided

that for purposes of the Income Test, categories of income under section 954(c) that

are determined by netting gains against

losses are taken into account by a corporation on that net basis. However, under

the proposed regulations, the net amount

of income in each category of FPHCI

was calculated separately for each relevant corporation, such that net gains or

losses of a look-through subsidiary may

not be netted against net losses or gains

of another look-through subsidiary or of

a tested foreign corporation. See proposed

§1.1297-1(c)(1)(ii).

One comment recommended that the

final regulations not adopt the separate

entity approach in proposed §1.1297-1(c)

(1)(ii) and, instead, permit a tested foreign

corporation to net its gains and losses with

those of its directly or indirectly owned

look-through subsidiaries and its directly or indirectly owned partnerships. The

comment noted that the separate entity

approach could result in an overstatement

of FPHCI of an integrated business that is

conducted through multiple subsidiaries.

See H.R. Rep. No. 220, 105th Cong. 1st Sess. 623-28 (July 30, 1997) (discussing adoption of section 1297(d) CFC overlap rule and section 1296 mark-to-market rule; no discussion of contemporaneous adoption of section 954(h)); id. at 639-45 (discussing adoption of active financing income (section 954(h)) rule; no suggestion that rules apply for PFIC purposes).

4

Id. at 642; see also H.R. Rep. No. 105-825, at 1555 (Oct. 19, 1998) (Conf. Rep.) (“[I]n this regard, a corporation is considered to be engaged in the active conduct of a banking or securities

business if the corporation would be treated as so engaged under the regulations proposed under prior law section 1296(b) (as in effect prior to the enactment of the Taxpayer Relief Act of

1997)”).

3

February 1, 2021

512

Bulletin No. 2021–5

The Treasury Department and the IRS

have determined that the integrated treatment proposed by the comment with respect to look-through subsidiaries and

look-through partnerships is consistent

with the statutory language treating the

owner of a look-through subsidiary as

receiving directly its proportionate share

of the income of the subsidiary, and with

the policies underlying section 1297(c).

Accordingly, §1.1297-1(c)(1)(ii) provides

that the net gains or income for a category of FPHCI that is determined by netting

gains against losses are determined at the

level of a tested foreign corporation taking

into account individual items of the tested

foreign corporation and its look-through

subsidiaries and look-through partnerships. Because these regulations do not

adopt an overall look-through approach

with respect to all partnerships, netting

is not provided with respect to gains and

losses derived from partnerships that are

not look-through partnerships. For example, netting does not apply to gains and

losses that are part of a tested foreign corporation’s distributive share from a partnership that is a related person within the

meaning of section 954(d)(3) but not a

look-through partnership.

3. Treatment of Effectively Connected

Income and Income Attributable to U.S.

Permanent Establishments

Section 952(b) excludes from subpart F

income the U.S. source income of a CFC

that is effectively connected with the conduct by such CFC of a trade or business in

the United States (“effectively connected

income”). Comments noted that the proposed regulations did not address the treatment of effectively connected income, or

the assets held to produce such income, of

a foreign corporation or the treatment of

income that is attributable to a U.S. permanent establishment, or the assets held

to produce such income. The comments

noted that section 952(b) can exclude

from subpart F income amounts that are

FPHCI in order to prevent such amounts

from being double-taxed, once directly to

the foreign corporation, and a second time

to United States shareholders of the foreign corporation, and stated that the PFIC

rules should not discriminate against income earned through a U.S. branch rather

Bulletin No. 2021–5

than through a domestic subsidiary that

may qualify for the special rules of section 1298(b)(7). These comments suggested that the final regulations either characterize such income, and the assets held to

produce such income, as non-passive or

not include such income for purposes of

the Income and Asset Tests.

As noted in Part III.B.1 of this Summary of Comments and Explanation of

Revisions, the determination of whether

amounts should be taken into account

for purposes of the Income Test or the

Asset Test is based on whether income

would be FPHCI under section 954(c),

not whether the income is treated as subpart F income. The PFIC rules address

whether income is passive, which is a

different question from whether it should

be treated as subpart F income. Section

1298(b)(7) does not provide non-passive

treatment for all income of domestic subsidiaries, but rather only for income of

domestic subsidiaries that meet specified

requirements, indicating that Congress

did not consider it appropriate to exclude

all income of domestic subsidiaries that

are subject to U.S. net income taxation

from passive income treatment. As a

corollary, the limited scope of section

1298(b)(7) implies that a broad exception for effectively connected income

is not warranted. Furthermore, section

1293(g)(1)(B)(ii) provides authority to

exclude effectively connected income of

a PFIC that is subject to U.S. net income

taxation from inclusion in the hands of a

shareholder of the PFIC that has made a

qualified electing fund election, indicating that effectively connected income is

otherwise treated as income of a tested

foreign corporation for PFIC purposes.

The Treasury Department and the IRS

have determined that an exclusion of effectively connected income (and income

attributable to a U.S. permanent establishment) from passive income would be

inconsistent with the statutory definition

of passive income in section 1297(b)(1),

with the limited application of section

1298(b)(7) and with the exclusion provided by section 1293(g)(1)(B)(ii), and that

the treatment of effectively connected income (and income attributable to a U.S.

permanent establishment) is contemplated

and appropriately addressed by the existing PFIC rules. Consequently, the final

513

regulations do not adopt the suggestions

in these comments.

C. Income subject to the related person

look-through rule

Section 1297(b)(2)(C) characterizes

dividends, interest, rents, and royalties

received or accrued from a related person

as non-passive income to the extent those

amounts are properly allocable to income

of such related person that is not passive.

Proposed §1.1297-1(c)(3) provided additional guidance on the application of

the section 1297(b)(2)(C) related person

exception for dividends, interest, rents,

and royalties. In response to comments,

changes have been made to these regulations and additional guidance has been

provided.

Under the final regulations, for purposes of the Asset Test and Income Test,

corporations and partnerships owned in

whole or part by a tested foreign corporation are generally classified into one or

more of three categories. Lower-tier entities generally are treated as one or more

of (i) a look-through subsidiary or lookthrough partnership (a “look-through entity”), (ii) a related person or (iii) an entity

that is neither a look-through entity nor a

related person. The rules for look-through

entities are discussed in Part IV of this

Summary of Comments and Explanation

of Revisions. Dividends and the distributive share of income from a lower-tier

entity that is neither a look-through entity

nor a related person generally are treated

as passive income, regardless of whether

the income of the lower-tier entity is active or passive in its hands. See §1.12971(c)(3). Similarly, ownership interests in

such entities are treated as passive assets.

See §1.1297-1(d)(4).

For purposes of section 1297(b)(2)(C),

the term related person has the meaning

provided by section 954(d)(3). See section

1297(b)(2) and §1.1297-1(f)(8). Because

the ownership threshold required for an

entity to be treated as a related person

is higher than the ownership threshold

required for an entity to be treated as a

look-through entity, there may be many

entities that qualify as both or solely as

look-through entities. However, because

section 954(d)(3) has broader attribution

rules than the rules that apply for purposes

February 1, 2021

of determining look-through entity classification, there may be entities that are

treated as related persons with respect to a

tested foreign corporation but not as lookthrough entities with respect to that tested

foreign corporation.

For purposes of section 1297(b)(2)(C),

interest, dividends, rents or royalties actually received or accrued by a tested foreign

corporation are considered received or

accrued from a related person only if the

payor of the interest, dividend, rent or royalty is a related person with respect to the

tested foreign corporation. In the case of

income received or accrued from a lookthrough entity, the rules that eliminate intercompany income described in Part IV.D

of this Summary of Comments and Explanation of Revisions apply before the rules

applicable to income received or accrued

from a related person. See §1.1297-1(c)(4)

(ii). Consequently, the rules of §1.12971(c)(4) apply to dividends, interest, rents,

and royalties received or accrued from a

look-through entity only if those amounts

are treated as regarded after application

of the intercompany income rules. These

rules also apply to income from a related person that is received or accrued by

a look-through entity. The determination

of whether income received or accrued

by a look-through entity is treated as received from a related person is made at

the level of the look-through entity, both

for purposes of determining whether the

look-through entity is a PFIC, if relevant,

and for purposes of determining whether

an upper-tier tested foreign corporation is

a PFIC. See §1.1297-2(d).

If a partnership is a related person (that

is not a look-through entity) with respect

to a tested foreign corporation or lookthrough entity, and therefore subject to

these rules, the tested foreign corporation’s

or look-through entity’s distributive share

of income from the partnership is treated

as passive or non-passive in whole or part

based on the activities of the partnership,

and the partnership interest is correspondingly treated as passive or non-passive in

whole or part. See §1.1297-1(c)(4)(vii),

(d)(3)(i), and (d)(4). An asset that gives

rise to income that is treated as in part passive and in part non-passive pursuant to

these rules is subject to the rules that apply

to dual-character assets. See §1.1297-1(d)

(3)(i).

February 1, 2021

1. Treatment of Interest

The proposed regulations provided

that, for purposes of the section 1297(b)

(2)(C) exception, interest is properly allocable to income of the related person that

is not passive income based on the relative portion of the related person’s income

for its taxable year that ends in or with the

taxable year of the recipient that is not

passive income. See proposed §1.12971(c)(3)(i). Comments generally supported

the pro rata approach taken in the proposed regulations. One comment noted

that the final regulations should clarify

that the allocation is based on the ratio of

gross non-passive income to gross total

income. Another comment that supported the pro rata approach in the proposed

regulations recommended that the final

regulations address situations in which

the related person does not have income

during the taxable year of the payment.

In such a case, this comment suggested

that the final regulations apply the principles of §1.861-9T, which provides rules

for allocating and apportioning interest

expense, to determine whether the interest payments are allocated to passive or

non-passive income of the related person.

The comment also requested that the approach using the principles of §1.861-9T

to allocate interest when the related person does not have gross income be made

available as an alternative method at the

election of the tested foreign corporation.

As suggested by the first comment, the

final regulations clarify that the ratio for

allocating interest to income is based on

gross income. See §1.1297-1(c)(4)(iii).

Similar clarifications are made for the

rule for rents and royalties. See §1.12971(c)(4)(v). The Treasury Department and

the IRS have determined that the pro rata

approach provided in the proposed regulations is the most straightforward and

consistent with the purposes of the section

1297(b)(2)(C) exception if the related person has gross income in the taxable year,

and accordingly, the final regulations do

not provide a generally applicable election to apply the principles of §1.861-9T

in lieu of the general rule. See §1.12971(c)(4)(iii).

It is anticipated that it will rarely be the

case that a related person will not have

gross income, because gross income for

514

most taxpayers is determined without taking expenses into account. However, in

the case of taxpayers that determine gross

income after taking operating expenses

into account, it is possible that a taxpayer

will not have gross income for a taxable

year. In such a case, the Treasury Department and the IRS agree that the principles

of §1.861-9T may properly apply for a

year in which the related person does not

have gross income, because §1.861-9T is

a general rule — the default rule in the

absence of a more specific rule – relating

to the allocation of interest expense. Alternatively, because section 1297(b)(2)(C)

characterizes interest received or accrued

from a related person as non-passive income to the extent it is properly allocable

to non-passive income of the related person, it may also be appropriate for interest

received or accrued by the tested foreign

corporation to be allocated entirely to passive income in such a case, and that treatment may be simpler for a tested foreign

corporation to determine. Accordingly, the

final regulations provide that for a year in

which the related person does not have

gross income, a tested foreign corporation may use the principles of §1.861-9

through -13T, applied in a reasonable and

consistent manner taking into account the

general operation of the PFIC rules and the

purpose of section 1297(b)(2)(C) in order

to allocate interest received or accrued

from the related person between passive

and non-passive income. Alternatively, at

a tested foreign corporation’s election, it

may treat the interest income entirely as

passive income.

2. Treatment of Dividends

The proposed regulations provided

that, for purposes of the section 1297(b)

(2)(C) exception, dividends are treated as

properly allocable to income of the related person that is not passive income based

on the portion of the related payor’s current earnings and profits (“E&P”) for the

taxable year that ends in or with the taxable year of the recipient that is attributable to non-passive income. See proposed

§1.1297-1(c)(3)(ii).

A comment observed that foreign corporations often do not maintain E&P based

on U.S. tax principles. The comment recommended that dividends be treated as al-

Bulletin No. 2021–5

located between passive and non-passive

amounts based on the ratio of passive to

non-passive gross income.

Two comments requested that proposed §1.1297-1(c)(3)(ii) be modified to

allocate dividend income based on both

current and accumulated E&P of the related payor to which the dividend income is

attributable, in accordance with the principles of section 316. A third comment

observed that there are administrative

benefits to characterizing dividends by

reference to current E&P, because it may

be easier to obtain relevant information

for current E&P and because the nature of

a company’s activities may change. This

comment further requested that dividends

be determined by reference to gross income over a reasonable look-back period

such as three to five years, rather than by

reference to E&P under section 316 principles, in order to reflect the economic reality of the corporation’s activities and to

avoid undue emphasis on the timing of the

dividends. The comment suggested as an

alternative that this method might apply

only if the related payor does not maintain

E&P using U.S. tax principles, while if the

related party does maintain E&P based on

U.S. tax principles, then, to the extent of

current E&P, dividends would be characterized based on the portion of the related

payor’s current-year E&P that is attributable to non-passive income, and the remaining amount would be characterized

based on the relative portion of accumulated E&P that is attributable to non-passive income. The comment suggested that

the ratio for accumulated E&P could be

based on accumulated E&P for the period

in which the related payor was a related

person under section 954(d)(3).

Another comment suggested that the

difficulty in obtaining information necessary to determine the character of accumulated E&P with respect to foreign

corporations could be addressed by allowing taxpayers to use reasonable methods

to determine the character of accumulated

E&P and proposed that characterizing the

accumulated E&P based on the current

year’s E&P be considered a reasonable

method.

The Treasury Department and the IRS

agree that dividends from related parties

should be allocated between passive and

non-passive E&P based on the principles

Bulletin No. 2021–5

of section 316, which apply generally

for purposes of the U.S. international tax

rules. Accordingly, the final regulations

adopt the recommendation to characterize

dividends in accordance with first current

and then accumulated E&P of the related

payor to which the dividend income is

attributable. See §1.1297-1(c)(4)(iv)(A).

In order to address concerns that foreign

corporations that are not CFCs may not

maintain E&P based on U.S. tax principles, taxpayers are permitted to allocate

E&P in proportion to the ratio of passive

gross income to non-passive gross income

for the relevant period. See §1.1297-1(c)

(4)(iv)(B).

The Treasury Department and the IRS

also agree with the premise of all of the

comments that if dividends are paid out

of E&P other than current E&P, either because there is no current E&P or because

the amount of the dividends exceeds the

current E&P, it would be appropriate to

take into account the character of the income supporting the dividend. The final

regulations provide that dividends paid

out of accumulated E&P are allocated between passive and non-passive E&P under

the same rules that apply with respect to

dividends paid out of current E&P. See

§1.1297-1(c)(4)(iv)(C).

The Treasury Department and the IRS

understand that it may be difficult for

shareholders to determine the character of

accumulated E&P with respect to foreign

corporations, particularly for E&P from

pre-acquisition periods. The suggestion of

referring to a look-back period of several

years is consistent with the rule for characterizing stock, discussed in Part III.D.4

of this Summary of Comments and Explanation of Revisions, which is intended to

effectively treat stock as, in whole or part,

held for the production of non-passive income if dividends received with respect

to it within a three-year period constitute

non-passive income due to the application

of section 1297(b)(2)(C). Accordingly, the

final regulations permit taxpayers to use

the default approach, consistent with general U.S. federal income tax principles, of

allocating dividends paid out of accumulated E&P based on the ratio of passive

to non-passive E&P for each prior year

(beginning with the most recently accumulated), or to use one of two administratively simpler alternatives. See id. The

515

first alternative is to allocate dividends

paid out of accumulated E&P based on the

ratio of passive to non-passive E&P that

is attributable to E&P accumulated in the

years in which the payor was related to the

recipient. If the payor has been related to

the recipient for more than three years, a

second alternative is available, which is to

allocate dividends paid out of accumulated E&P based on the ratio of passive to

non-passive E&P that is attributable to

E&P accumulated during a look-back period of the three years before the current

taxable year. See id.

D. Asset test

1. Section 958 Proposed Regulations

Shareholders of a foreign corporation

that became a CFC as a result of the repeal

of section 958(b)(4) would have to apply

the Asset Test based on the adjusted basis

of the foreign corporation’s assets under

section 1297(e). The section 958 proposed

regulations modified the definition of a

CFC for purposes of section 1297(e) to

disregard downward attribution from foreign persons. See proposed §1.1297-1(d)

(1)(iii)(A). No comments were received

with respect to this rule in the section 958

proposed regulations. Accordingly, the

rule is finalized without modification. See

§1.1297-1(d)(1)(v)(B)(2).

2. Determination of Average Amount of

Assets Based on Value or Adjusted Basis

Section 1297(e) provides that the assets of a tested foreign corporation are to

be measured based on (i) value, pursuant

to section 1297(e)(1), if it is a publicly

traded corporation for the taxable year, or

if section 1297(e)(2) does not apply to it

for the taxable year; or (ii) adjusted basis,

pursuant to section 1297(e)(2), if it is a

CFC or elects the application of section

1297(e)(2). These statutory provisions

create a hierarchy for determining the

method for measuring the assets of a tested foreign corporation, as follows: (a) first

by value, if the tested foreign corporation

is a publicly traded corporation for the

taxable year; (b) second by adjusted basis,

if the tested foreign corporation is not a

publicly traded corporation and is a CFC;

and (c) third by value, or at the election

February 1, 2021

of the tested foreign corporation, by adjusted basis, in other cases. The Treasury

Department and the IRS understand that

taxpayers typically prefer to use value to

measure assets of a tested foreign corporation.

The proposed regulations provided

that, for purposes of the Asset Test, companies that were publicly traded for only

part of the year were required to measure assets on the basis of value for the

entire year if the corporation was publicly traded on the majority of days during

the year or if section 1297(e)(2) did not

apply to the corporation on the majority

of days of the year. If the tested foreign

corporation was not publicly traded on

the majority of days during the year, the

tested foreign corporation was required to

use adjusted basis to measure assets if it

was a CFC or if an election to use adjusted basis was made under section 1297(e)

(2)(B). See proposed §1.1297-1(d)(1)(v).

The majority of days rule in the proposed

regulations would have required a tested

foreign corporation that was a CFC and

whose shares were publicly traded for less

than the majority of days during the year

to use adjusted basis to measure its assets

for that taxable year because the corporation would not have been treated as a publicly traded corporation. The requirement

to use adjusted basis might apply, for example, to a foreign corporation treated as

a CFC that issues publicly traded shares in

an initial public offering in the second half

of the year.

A comment requested that the proposed

regulations be modified to provide that

the Asset Test be applied based on value

if shares of the tested foreign corporation

were publicly traded at any time during

the taxable year. The comment asserted

that the use of value more appropriately

reflects the purposes of the PFIC rules in

general, and that the statute requires only

non-publicly traded CFCs to use basis

for purposes of the Asset Test and otherwise allows a tested foreign corporation

to apply the Asset Test based on value.

The comment also noted that, due to the

repeal of section 958(b)(4), there may be

more tested foreign corporations that are

CFCs. In such cases, less-than-10-percent

shareholders of those tested foreign corporations would be required to use basis

rather than value in determining PFIC sta-

February 1, 2021

tus. The comment requested relief from

this result. The comment further noted

that publicly traded corporations required

to use basis would not be able to take into

account goodwill and other self-created

business intangibles for purposes of the

Asset Test because such items often do not

have tax basis.

The Treasury Department and the IRS

agree with the concerns expressed by the

comment regarding the effects of the repeal of section 958(b)(4). As discussed

in Part III.D.1 of this Summary of Comments and Explanation of Revisions, this

rulemaking finalizes the portion of the

section 958 proposed regulations concerning the definition of the term CFC for

purposes of the Asset Test, which accordingly allows use of the value method of

measuring assets to the extent permissible

under the statute. See §1.1297-1(d)(1)(v)

(B)(2) (treating foreign corporations that

are CFCs solely due to the repeal of section 958(b)(4) as not CFCs for purposes

of section 1297(e)). The Treasury Department and the IRS believe that this change

may alleviate much of the concern expressed about the proposed rule because

the change makes it less likely that a tested foreign corporation will be treated as a

CFC that is required to use adjusted basis

to measure its assets.

The Treasury Department and the IRS

also agree that section 1297(e) favors the

use of value as a method to measure assets

and that the use of value aligns with the

objective of the PFIC rules. As a result,

the final regulations expand the definition

of publicly traded corporation for purposes of section 1297(e) to include more

circumstances in which a tested foreign

corporation is treated as a publicly traded foreign corporation. See §1.1297-1(f)

(7). However, the Treasury Department

and the IRS believe that it would be inappropriate to require a corporation to use

value for purposes of the Asset Test if it

was publicly traded for a de minimis period during its taxable year. Accordingly,

the final regulations provide that a publicly traded corporation, which is defined as

a corporation that has been publicly traded

in more than de minimis amounts for at

least twenty trading days (approximately

one month) during a taxable year, is required to apply the Asset Test based on

value. See §1.1297-1(d)(1)(v)(A) and (f)

516

(7). Pursuant to section 1297(e), a tested

foreign corporation that does not qualify

as a publicly traded foreign corporation

may use value to measure assets as long

as it is not a non-publicly traded CFC, but

it is not required to do so.

The comment also requested clarification on the application of section 1297(e)

in the case of tiers of tested foreign corporations. The comment recommended the

final regulations provide that, for purposes

of applying the Asset Test, a publicly traded tested foreign corporation should measure all of its assets—including the assets

of its non-publicly traded look-through

subsidiaries—based on value. The Treasury Department and the IRS generally

agree with the premise of this comment,

except in cases where section 1297(e) requires a different treatment for the assets

of subsidiaries (as discussed in the next

paragraph). For the avoidance of doubt,

the final regulations include cross-references to §1.1297-2(b)(2)(i) (which provides the rule that a tested foreign corporation is deemed to directly own the assets

of the look-through subsidiary) in the final

section 1297(e) rules. See §1.1297-1(d)(1)

(i) and (d)(1)(v)(A).

The comment also observed that, unlike the typical situation where a publicly

traded tested foreign corporation would

measure all of its assets (including the

assets of its non-publicly traded lookthrough subsidiaries) based on value in

accordance with section 1297(e)(1)(A),

it is questionable whether a CFC that is a

non-publicly traded subsidiary of a publicly traded parent corporation could also

use value, rather than basis, for purposes

of testing its own PFIC status. The comment noted that such a subsidiary might be

a CFC as a result of the repeal of section

958(b)(4). As discussed in Part III.D.1 of

this Summary of Comments and Explanation of Revisions, §1.1297-1(d)(1)(v)

(B)(2), which provides that foreign corporations that are CFCs solely due to the

repeal of section 958(b)(4) are not treated

as such for purposes of section 1297(e),

mitigates this concern. Further, if a lower-tier tested foreign corporation is a CFC

that is not publicly traded, section 1297(e)

(2)(A) requires that adjusted basis be used

as the method for measuring its assets.

Therefore, the final regulations clarify that

a lower-tier tested foreign corporation that

Bulletin No. 2021–5

is a non-publicly traded CFC must use adjusted basis and not value to measure its

assets, regardless of whether it is owned

by a publicly traded foreign corporation.

In order to clarify the application of the

statutory hierarchy for measuring a tested

foreign corporation’s assets more generally, including with respect to lower-tier

tested foreign corporations, §1.1297-1(d)

(1)(v) has been revised. The regulation

provides a hierarchy that generally applies

to every tested foreign corporation, regardless of whether it is an upper-tier or lower-tier tested foreign corporation. Pursuant

to section 1297(e) and this hierarchy, (i) a

publicly traded foreign corporation (as defined in §1.1297-1(f)(7)) must use value

to measure its assets, (ii) a non-publicly

traded CFC must use basis to measure its

assets, unless the CFC becomes a publicly traded foreign corporation (as defined

in §1.1297-1(f)(7)) during a taxable year,

and (iii) any other tested foreign corporation would use value to measure its assets

unless an election is made to use adjusted

basis, except if it is a lower-tier subsidiary

in which case additional rules apply. See

§1.1297-1(d)(1)(v)(A), (B), and (C)(1).

Section 1.1297-1(d)(1)(iii) clarifies that

the election to use adjusted basis may be

made by the tested foreign corporation or

its shareholders.

Revised §1.1297-1(d)(1)(v) provides

specific rules for measuring the assets of

lower-tier subsidiaries, which in the usual case are expected to be look-through

subsidiaries. These rules follow the same

hierarchy described in the prior paragraph,

except that the method used to measure

the assets of a lower-tier subsidiary may

be determined either by the status of the

lower-tier subsidiary if it is a publicly

traded foreign corporation or a non-publicly traded CFC, or by the status of a

tested foreign corporation that directly or

indirectly owns all or part of the shares

of the lower-tier subsidiary (a parent foreign corporation), if the parent foreign

corporation has one of those statuses. See

§1.1297-1(d)(1)(v)(C)(2).

As a general matter, the method used

by a parent foreign corporation to measure

its assets also must be used to measure the

assets of a lower-tier foreign corporation

owned in whole or part by that parent foreign corporation. This rule applies both

for purposes of determining whether the

Bulletin No. 2021–5

parent foreign corporation is a PFIC and

for purposes of determining whether the

lower-tier foreign corporation is a PFIC.

If a tested foreign corporation indirectly

owns a lower-tier subsidiary through one

or more other foreign corporations, the

status of the parent foreign corporation

in that chain of corporations that has the

highest status in the hierarchy described

above governs. See §1.1297-1(d)(1)(v)(C)

(2)(iii).

This general consistency rule does not

apply, however, if the lower-tier foreign

corporation has a status for which section

1297(e) mandates a method for measuring

assets (that is, it is a publicly traded foreign corporation or non-publicly traded

CFC). In such a case, the statutorily mandated method applies to measure the lower-tier foreign corporation’s assets, both

for purposes of determining whether the

parent foreign corporation is a PFIC and

for purposes of determining whether the

lower-tier foreign corporation is a PFIC.

For example, if a tested foreign corporation is a publicly traded foreign corporation, then both its assets and the assets of

its lower-tier subsidiaries must be measured on the basis of value, unless a lower-tier subsidiary is a non-publicly traded

CFC, in which case the assets of that subsidiary must be measured using adjusted

basis. Similarly, if a tested foreign corporation is a non-publicly traded CFC,

then both its assets and the assets of its

lower-tier subsidiaries must be measured

using adjusted basis, unless a lower-tier

subsidiary is a publicly traded foreign corporation, in which case the assets of that

subsidiary must be measured using value.

See §1.1297-1(d)(1)(v)(C)(2)(i) and (ii).

If a lower-tier tested foreign corporation

does not have a status for which section

1297(e) mandates a method for measuring

assets, and it is a subsidiary of more than

one parent foreign corporation, then U.S.

shareholders of the two different parent

corporations may be required to use different methods to measure the assets of

the lower-tier foreign corporation based

on the method used for each respective

parent foreign corporation. See the last

sentence of §1.1297-1(d)(1)(v)(C)(2)(iii)

and §1.1297-1(d)(1)(v)(E)(3) (Example

3).

The Treasury Department and the IRS

recognize that section 1297(e)(1) requires

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in many cases that a valuation must be

performed for assets of an operating company for which no publicly available valuation is available, apart from information

provided in financial statements prepared

under widely-used financial reporting

standards, and that ascertaining such a

valuation creates a compliance burden.

The Treasury Department and the IRS are

studying whether to provide rules permitting taxpayers to rely on financial statement information in appropriate cases,

and the final regulations reserve on this issue. See §1.1297-1(d)(1)(v)(D). The 2020

NPRM proposes a rule to address this issue and solicits comments on the proposed

rule. See proposed §1.1297-1(d)(1)(v)(D).

3. Treatment of Working Capital for

Purposes of Asset Test

The proposed regulations did not address the treatment of working capital for

purposes of the Asset Test. Notice 88-22,

1988-1 C.B. 489 (“Notice 88-22”) provides that cash and other current assets

readily convertible into cash, including

assets that may be characterized as the

working capital of an active business, are

treated as passive assets for purposes of

the Asset Test. Notice 88-22 indicated that

passive treatment is warranted because

working capital produces passive income

(interest income).

A comment on the proposed regulations asserted that the approach taken in

Notice 88-22 with respect to working capital undermines the purpose of the PFIC

regime to distinguish between investments

in passive assets and investments in active

businesses. The comment requested that

the final regulations adopt an approach,

similar to the treatment of dual-character

assets, pursuant to which working capital

would be bifurcated between passive and

non-passive assets in proportion to the relative amount of gross income that is passive or non-passive.

The Treasury Department and the

IRS continue to study the appropriate

treatment of working capital, and the final regulations reserve on this issue. See

§1.1297-1(d)(2). The 2020 NPRM proposes a limited exception to the treatment

of working capital to take into account the

short-term cash needs of operating companies. See proposed §1.1297-1(d)(2).

February 1, 2021

4. Assets that Produce Income Subject to

the Related Person Look-Through Rule

The proposed regulations defined the

term passive asset, consistent with section

1297(a), as an asset that produces passive

income, or which is held for the production of passive income, taking into account the rules in proposed §1.1297-1(c),

which defined passive income, and proposed §1.1297-1(d), which provided rules

for the application of the Asset Test. See

proposed §1.1297-1(f)(6). The proposed

regulations also provided that an asset

that produces both passive income and

non-passive income during a taxable year

is treated as two assets, one of which is

passive and one of which is non-passive,

with the value (or adjusted basis) of the

asset being allocated between the passive

asset and non-passive asset in proportion

to the relative amounts of passive and

non-passive income produced by the asset during the taxable year. See proposed

§1.1297-1(d)(2)(i).

A number of comments expressed concern that the proposed regulations did not

provide a general rule to characterize assets—in particular shares of stock—that

give rise to income subject to the related person look-through rule of section

1297(b)(2)(C), discussed in Part III.C of

this Summary of Comments and Explanation of Revisions. The comments suggested that the final regulations include

a rule that treats assets that give rise to

income subject to section 1297(b)(2)(C)

as a passive or non-passive asset to the

extent the income that is received with

respect to such asset is treated as passive

or non-passive by the tested foreign corporation. The Treasury Department and

the IRS agree that it is consistent with the

statutory language and intent of section

1297(a)(2) to treat assets that give rise to

both passive and non-passive income as

partly passive and partly non-passive. The

Treasury Department and the IRS believe

that it was clear under proposed §1.12971(d)(2)(i) and (f)(6) that assets that produced income subject to the related person look-through rule of section 1297(b)

(2)(C) were treated as non-passive in proportion to the non-passive income produced by the asset, subject to the special

rules in §1.1297-1(d). However, for the

avoidance of doubt, the final regulations

February 1, 2021

provide an explicit cross-reference to section 1297(b)(2)(C) to clarify that assets

that produce income subject to the related

person look-through rule are subject to

the general and special rules with respect

to treatment of assets under §1.1297-1(d),

for example related party stock, loans,

leases or licenses that produce dividends,

interest, rent or royalties that are treated

as passive and non-passive under section 1297(b)(2)(C). See §1.1297-1(d)

(3)(i). Accordingly, assets that give rise

to income subject to section 1297(b)(2)

(C) generally are treated as a passive or

non-passive asset to the extent the income

that is received with respect to such asset

is treated as passive or non-passive by the

tested foreign corporation.

The proposed regulations also provided that stock of a related person with respect to which no dividends are received

or accrued during a taxable year but that

previously generated dividends that were

characterized as non-passive income, in

whole or in part, under section 1297(b)

(2)(C) is characterized based on the dividends received or accrued with respect

thereto for the prior two years. See proposed §1.1297-1(d)(2)(iii).

Comments noted that there may be

instances in which the related person has

not paid dividends in more than two years.

One comment suggested that, in this instance, stock be apportioned in proportion

to the average percentage of the dividends

that were characterized as passive and

non-passive in the last two years in which

the related person paid dividends. If the

related person never paid a dividend that

was excluded under section 1297(b)(2)

(C), the comment recommended that the

stock be characterized based on the earnings during the last two years in which

the related person generated earnings or,

if the related person has never generated

earnings, based on the earnings that are

reasonably expected to be generated in the

future. Another comment requested that

proposed §1.1297-1(d)(2)(iii) be replaced

with a general rule with respect to stock

of a related party that would characterize

the stock based on whether the stock is

expected to generate passive income. The

comment asserted that this rule would allow for taxpayers to use reasonable methods to determine if the stock is expected to

generate passive income.

518

One comment argued that, for purposes of characterizing stock that does not

generate dividends in the current year, a

look-back period of two years would be

appropriate if the final regulations adopt

an approach that characterizes the stock

based on the character of hypothetical dividends and uses the proportionate amount

of non-passive gross income over the

look-back period to determine the character of the dividends. If such an approach is

not adopted, the comment recommended

that, instead of a look-back period of two

years, the stock could be characterized

based on dividends paid during the preceding five years or, if shorter, the period

during which the subsidiary was a related

person under section 954(d)(3).

Proposed §1.1297-1(d)(2)(iii) was

premised on the understanding that stock

that has recently generated dividends that

are, in whole or in part, non-passive under

the related person look-through rule can

be understood to be held for the production of non-passive income. If, however,

the stock has not recently generated dividends, it is more appropriate to treat the

stock as held for the production of gains

upon disposition, which would generally

be passive income. Accordingly, the Treasury Department and the IRS have determined that it would not be appropriate to

allow stock to be treated as a non-passive

asset on the basis of speculation that dividends might be received with respect to

the stock and that such dividends could be

non-passive under section 1297(b)(2)(C)

as most of the comments’ recommendations would provide. Moreover, the changes to the rules for determining the passive

or non-passive character of dividends, discussed in Part III.C.2 of this Summary of

Comments and Explanation of Revisions,

also take into account the actual history

of the stock and allow taxpayers to treat

the most recent prior years as most relevant in determining the character of the

stock. Thus, the final regulations do not

adopt these comments and, instead, the final regulations provide that stock that did

not produce dividends within the current

taxable year or within either of the preceding two taxable years is characterized as a

passive asset. See §1.1297-1(d)(3)(iii); but

see section 1297(c) and §1.1297-2(c)(1)(i)

(eliminating stock of look-through subsidiaries for purposes of the Asset Test).

Bulletin No. 2021–5

E. Stapled entities

Proposed §1.1297-1(e) provided that,

for purposes of determining whether

any stapled entity (as defined in section

269B(c)(2)) is a PFIC, all entities that are

stapled entities with respect to each other

are treated as one entity. A comment suggested that the definition of stapled entities provided in section 269B(c)(2) and

§1.269B-1 could be overbroad and thus

lead to planning opportunities for purposes of PFIC testing. Therefore, the comment recommended that the final regulations provide a more restrictive definition

for stapled entities so that, for purposes

of PFIC testing, single-entity treatment

would be limited to situations in which

nearly 100 percent of the outstanding equity interests in both entities are stapled

to each other. Alternatively, the comment

suggested, the Treasury Department and

the IRS could issue rules applicable to the

holders of stapled interests clarifying the

application of the anti-abuse rule in section 1298(b)(4) (which would treat separate classes of stock (or other interests) in

a corporation as interests in separate corporations, pursuant to regulations, where

necessary to carry out the purposes of the

PFIC regime) to such stapled interests by

providing that the rule would apply only

if unusual features exist and the arrangement would allow avoidance of the PFIC

rules. The comment also highlighted the

inappropriateness of potentially applying

the rule in proposed §1.1297-1(e) to treat

a shareholder of an entity that would not

be a PFIC, but for the rule, as the shareholder of a PFIC.

Another comment requested clarification on the extent to which stapled entities

that were treated as a single entity for purposes of PFIC testing would be treated as

a single entity with respect to other provisions in the PFIC regime. In particular, the

comment requested that the final regulations indicate whether the stapled entities

are treated as one PFIC for purposes of

including income under the PFIC regime

and for purposes of making an election

with respect to income inclusions under

the PFIC regime. Like the first comment,

it also requested guidance when not all interests are stapled.

The Treasury Department and the IRS

have determined that it is appropriate to

Bulletin No. 2021–5

apply the single entity treatment of proposed §1.1297-1(e) even when not all

interests in the stapled entities are stapled

because section 269B(c)(2) applies only

when controlling interests in the stapled

entities are stapled, but that the application of the rule should be limited to apply

only to U.S. persons that hold stapled interests and should not affect U.S. persons

that directly or indirectly own only one of

the stapled entities. Accordingly, the rule

in proposed §1.1297-1(e) is modified to

apply only if a U.S. person that would be

a shareholder of the stapled entities owns

stock in all entities that are stapled entities

with respect to each other. In this case, the

stapled entities are treated as an interest

in a single entity for all purposes of the

PFIC rules, which may have the effect of

causing a stapled entity that would not be

a PFIC on a stand-alone basis to be treated as a PFIC when stapled, or the reverse.

See §1.1297-1(e). Given these modifications to the rule and the fact that the definition of stapled entities in section 269B(c)

(2) already limits stapling to situations in

which more than 50 percent in the value

of the beneficial ownership in each of the

entities consists of stapled interests, the

Treasury Department and the IRS have

determined that it is not necessary at this

time to provide guidance on the application of section 1298(b)(4) or to further

limit the interests that can be stapled.

IV. Comments and Revisions to Proposed

§1.1297-2 – Special rules regarding lookthrough subsidiaries and look-through

partnerships

Proposed §1.1297-2 provided guidance

on the application of the look-through rule

of section 1297(c) for purposes of the Income Test and the Asset Test.

A. Overview

1. Treatment of Income and Assets

Under the final regulations, a tested

foreign corporation is treated as directly

owning the assets of, and directly deriving the gross income of, a look-through

subsidiary or look-through partnership.

See §1.1297-2(b)(2) and (b)(3). The tested

foreign corporation disregards the equity

interest in the look-through entity for pur-

519

poses of the Asset Test. See §1.1297-2(c)

(1)(i) and (c)(3). As discussed in more

detail in Part IV.D of this Summary of

Comments and Explanation of Revisions,

dividends from a lower-tier subsidiary and

distributions and the distributive share of

income from a lower-tier partnership generally are treated as if they did not exist

(“eliminated”) for purposes of the Income

Test. See §1.1297-2(c)(2)(i) and (c)(3).

For Income Test purposes, the proposed

regulations provided that the disposition

of the stock of a look-through subsidiary

is treated as the disposition of stock and

provided rules for the calculation of gain.

See proposed §1.1297-2(f)(1). The final

regulations also include rules addressing

the disposition of partnership interests in a

look-through partnership, which are similar in concept to the rules that apply to

the disposition of stock of a look-through

subsidiary, and rules addressing the disposition of partnership interests in a partnership described in section 954(c)(4)(B). See

§1.1297-2(f)(4). Where both rules could

potentially apply, the disposition is subject to the rules of section 954(c)(4). See

§1.1297-2(f)(4)(i) and (ii). Consequently,

it is anticipated that the sale of interests

in a partnership that a tested foreign corporation owns at least 25 percent of by

value generally will be subject to section

954(c)(4), and therefore will be treated as

a disposition of assets rather than a disposition of the partnership interest, while

the sale of interests in a partnership that a

tested foreign corporation owns less than

25 percent of by value may or may not be

subject to section 954(c)(4) in light of the

different 25-percent ownership test in that

statutory provision. The effect on the determination of gain under section 954(c)

(4) of partnership earnings that have been

included in income by the tested foreign

corporation but not distributed is beyond

the scope of these regulations.

Payments of interest, rent and royalties,

and the related debt obligation, lease or license, between the tested foreign corporation and the look-through entity or between look-through entities generally also

are eliminated for purposes of both the

Income and the Asset Tests, as discussed

in Part IV.D of this Summary of Comments and Explanation of Revisions. See

§1.1297-2(c)(1)(ii), (c)(2)(ii), and (c)(3).

If the obligation is between look-through

February 1, 2021

entities that are not wholly owned by the

tested foreign corporation, a proportionate

part of the obligation and income from it

is eliminated. See id.

2. Definition of Look-Through Subsidiary

A subsidiary of a tested foreign corporation is treated as a look-through subsidiary if both an asset test and an income test

are satisfied. See §1.1297-2(g)(3). If only

one test is satisfied, the subsidiary is not

treated as a look-through subsidiary. See

generally id. The asset test is satisfied for

any measuring period (for example, one

quarter of a taxable year) if on the relevant measuring date (for example, the end

of a quarter) the tested foreign corporation

owns at least 25 percent of the value of the

stock of the subsidiary. See §1.1297-2(g)

(3)(i). The income test is satisfied if either

(i) the tested foreign corporation owns an

average of at least 25 percent of the value

of the subsidiary’s stock on the measuring

dates of an entire taxable year, or (ii) the

tested foreign corporation owns at least

25 percent of the value of the subsidiary’s

stock on a measuring date and the subsidiary’s gross income for the measuring period can be determined. See §1.1297-2(g)

(3)(ii). Consequently, if a tested foreign

corporation owns at least 25 percent of a

subsidiary’s stock for part but not all of a

taxable year, the subsidiary is treated as

a look-through subsidiary for that part of

the taxable year only if the tested foreign

corporation can determine the subsidiary’s gross income on the measuring dates

within that part of the taxable year. These

rules are intended to ensure that a subsidiary is not treated as a look-through subsidiary unless the tested foreign corporation

can determine the proportionate share of

the subsidiary’s assets and income that it

is treated as directly owning and deriving.

B. Look-through partnerships

1. Overview

The proposed regulations defined a

look-through partnership as a partnership

in which the tested foreign corporation

owned at least 25 percent in value. See

proposed §1.1297-1(c)(2)(i), (d)(3)(i), and

(f)(1). The preamble to the proposed regulations indicated that the look-through

February 1, 2021

partnership rules were drafted to apply

look-through treatment as provided in

section 1297(c) consistently to lower-tier

partnerships and lower-tier corporations.

See 84 FR 33120, at 33124. The preamble

stated that the difference between the 25

percent threshold for look-through partnerships in the proposed regulations and

the treatment of partnership income for

FPHCI purposes is warranted because of

the flexibility that entities have in their

characterization under §301.7701-3 and

because of the fact that treating a subsidiary as a partnership may not have U.S.

income tax consequences for a tested foreign corporation as it could for a CFC. See

id. The preamble also noted that this rule

ensured that the tested foreign corporation would have significant control over

the partnership activities, such that a partnership interest could represent an active

business interest. See id. The preamble requested comments on whether 25 percent

was the right threshold, whether different

rules should apply to general partnerships

and limited partnerships, and whether a

material participation test should apply.

The definition of look-through partnership in the final regulations is revised to

more closely align with the definition of

look-through subsidiary. Under the final

regulations, a look-through partnership is

a partnership that would be a look-through

subsidiary with respect to the tested foreign corporation if the partnership were

a corporation. See §1.1297-2(g)(4)(i)(A).

Accordingly, as noted by one comment,

the taxpayer-favorable rules of section

1297(c) will apply to look-through partnerships, for example by allowing attribution of the activities of other affiliates

in determining whether rental or royalty income of the partnership is treated

as passive or non-passive. In response

to other comments, additional changes

have been made to the definition of lookthrough partnership to allow look-through

treatment for certain minority interests

in partnerships. See §1.1297-2(g)(4)(i)

(B). These changes are discussed in Part

IV.B.2 of this Summary of Comments and

Explanation of Revisions.

The look-through partnership rules

were located in proposed §1.1297-1,

which provided general rules concerning

the Income and Asset Tests. Because lookthrough treatment for purposes of PFIC

520

testing is provided in section 1297(c) and

§1.1297-2 provides guidance on the application of section 1297(c), the rules in the

final regulations concerning look-through

partnerships are in §1.1297-2 along with

all of the other rules discussing lookthrough treatment. See §1.1297-2(b)(3)

and (g)(4).

2. Definition of Look-Through

Partnership

Under the proposed regulations, a

look-through partnership with respect to a

tested foreign corporation was defined as

a partnership if (i) for purposes of section

1297(a)(2), the tested foreign corporation

owned at least 25 percent of its value on

a measuring date and (ii) for purposes of

section 1297(a)(1), the tested foreign corporation owned at least 25 percent of its

value on the date on which income was received or accrued by the partnership. See

proposed §1.1297-1(f)(1). The proposed

regulations also provided that, if a tested

foreign corporation owns, directly or indirectly, less than 25 percent of the value of

a partnership, the corporation’s distributive share of the partnership’s income was

treated as passive income for purposes

of the Income Test and the corporation’s

interest in the partnership was treated as

a passive asset for purposes of the Asset

Test. See proposed §1.1297-1(c)(2)(ii) and

(d)(3)(ii).

Three comments were received addressing these rules. The comments supported the proposed regulations’ general

treatment of look-through partnerships

and addressed the determination of when

a partnership is treated as a look-through

partnership. Two comments recommended that the 25-percent threshold be eliminated so that look-through treatment

would apply to all partnerships regardless

of the ownership level by the tested foreign corporation. A third comment stated

that the proper approach to partnerships

in applying look-through rules raises difficult issues and made several alternative

recommendations.

The two comments recommending that

all partnerships be treated as look-through

partnerships noted that partnerships are

pass-through entities that are generally

treated as aggregates for many purposes throughout the Code and asserted that

Bulletin No. 2021–5

section 1297(c) implicitly indicates that

aggregate treatment was intended to apply to all partnerships because it provides

a 25-percent threshold only for corporations. The comments also stated that the

differences between corporate treatment

and partnership treatment have ramifications for many other parts of the Code,

such as subpart F, GILTI, and the anti-hybrid rules. The comments asserted that minority shareholders generally cannot compel an upper-tier foreign corporation to

make an election for a lower-tier foreign

corporation to be treated as a partnership

under §301.7701-3 and that it is unlikely

that a tested foreign corporation would

make a non-commercial investment in order to benefit minority shareholders.

The Treasury Department and the IRS

do not agree with these comments, other than the comment that partnerships

are treated as aggregates for many Code

purposes. Many of the legal entities potentially treated as look-through partnerships under section 1297 would have been

treated as corporations for U.S. federal income tax purposes when section 1297(c)

was enacted, because the enactment of

section 1297(c) preceded the promulgation of §301.7701-3 by approximately ten

years and before that time foreign corporate entities were generally classified as

corporations for U.S. federal income tax

purposes. The differences between corporate treatment and partnership treatment

referred to by the comments generally are

not relevant to foreign corporations that

are not subject to U.S. net income taxation

or to U.S. shareholders as to whom a foreign corporation is not treated as a CFC.

As stated in the preamble to the proposed

regulations, an election under §301.77013 to treat a foreign subsidiary of such a

foreign corporation as a partnership for

U.S. federal income tax purposes may

have no U.S. tax consequences other than

to affect the determination of whether the

foreign corporation is a PFIC.

The Treasury Department and the IRS

recognize that minority shareholders may

not be able to compel a foreign corporation to make a U.S. tax election or to

make particular investments. However, a

foreign corporation may cause a subsidiary to make an election to be treated as a

partnership for U.S. tax purposes or take

other steps in order to avoid classification

Bulletin No. 2021–5

as a PFIC in order to retain or attract U.S.

investors, since there are likely to be no

non-tax and no foreign tax consequences

to the election.

The two comments indicated that the

subpart F regime characterizes a partner’s

distributive share of partnership income

without regard to the partner’s level of

control or involvement for purposes of

determining subpart F income and recommended that the same approach apply

in these regulations. The final regulations

do not adopt this comment. The Treasury

Department and the IRS believe that the

difference in treatment between these

regulations and the subpart F regime is

warranted in light of the fact that Congress imposed a 25-percent threshold for

look-through treatment for subsidiaries in

section 1297 but not in subpart F, and that

consistency of treatment for look-through

subsidiaries and look-through partnerships in these regulations is consistent

with Congressional intent.

One comment recommended, as an alternative to automatic passive treatment

for less than 25-percent-owned interests,

that the distributive share of income from,

and the interest in, a less than 25-percent-owned partnership be characterized

as passive only if the necessary information cannot be obtained for purposes of

the Income Test and the Asset Test. The

Treasury Department and the IRS agree

that it may be difficult for a tested foreign

corporation to obtain adequate information from a subsidiary in which a tested

foreign corporation holds a less-than-25percent investment, and that if that is the

case, the investment should be treated as

passive. The Treasury Department and the

IRS have taken this comment into account

in the new rules described at the end of

this Part IV.B.2. The Treasury Department

and the IRS do not agree that a tested

foreign corporation that has less than a

25-percent-interest in an active partnership should be able to automatically treat

such partnership interest as active if such

information is available, for the reasons

already stated.

A third comment stated that the approach proposed in the proposed regulations has the advantage of certainty and

ease of administration because it provides

a relatively clear bright-line test and limits

the need to obtain information about the

521

assets and income of a lower-tier partnership that may be difficult for small partners to obtain. The comment also noted

that the proposed approach creates greater

equivalence between lower-tier entities

that have or have not elected to be treated

as pass-through entities, but observed that

the proposed regulations did not create

complete equivalence between such entities because the distributive share from a

related partnership was not subject to the

same rules as dividends from a related

corporation. The final regulations address

this concern by providing that the distributive share derived by a tested foreign

corporation from a related partnership is

subject to rules similar to such dividends.

See §1.1297-1(c)(4)(vii).

This comment also stated that a 25-percent threshold is not a good proxy for an

active business interest and is not consistent with long-standing market practice.

The comment recommended four alternatives for the threshold for partnership

look-through treatment. Under the first

alternative, the comment suggested that

the final regulations adopt a 25 percent

threshold similar to that of section 954(c)

(4). Under a second alternative, the comment suggested that the final regulations

not take into account elections under

§301.7701-3 for purposes of PFIC testing.

Under a third alternative, the comment

proposed that the final regulations treat

every pass-through entity as an aggregate

without regard to ownership threshold.

Under the fourth alternative, the comment

recommended that the final regulations

adopt a “material participation” approach

pursuant to which look-through with respect to a partnership applies if the tested

foreign corporation materially participates

in the underlying business of the partnership.

The Treasury Department and the IRS

recognize that although Congress has

mandated a 25-percent threshold in order

to treat a corporate subsidiary as a lookthrough entity, that threshold may not be

a good proxy for an active business interest. The Treasury Department and the

IRS considered whether the alternatives

suggested would better identify an active

partnership interest. The final regulations

do not adopt any of the alternatives suggested by the third comment but do adopt

an approach similar in concept to the

February 1, 2021

fourth of the alternatives. With respect to

the first and third alternatives, the Treasury

Department and the IRS have determined

that the 25-percent threshold should be the

same for lower-tier entities regardless of

whether they have elected pass-through

treatment for the reasons already discussed. With respect to the second alternative, the Treasury Department and the

IRS do not believe that it is appropriate in

this context to draw distinctions between

entities in the legal form of a partnership

and other entities treated as partnerships

for U.S. federal income tax purposes.

In regard to the fourth alternative, the

Treasury Department and the IRS agree

that if a tested foreign corporation is actively involved in the business of a partnership with active business operations,

look-through treatment may be appropriate, even if the tested foreign corporation

is a minority investor in the partnership,

so that the tested foreign corporation may

take into account the active assets and income of the partnership rather than treating the partnership investment as passive.

The Treasury Department and the IRS

considered a material participation test

but determined that the passive activity

loss rules of section 469 are not appropriate for a foreign corporate investor in

a partnership owned directly or indirectly

by a tested foreign corporation. The section 469 material participation rules focus

primarily on the activities of individuals.

See §1.469-5 and -5T. While section 469

also provides rules for partners that are

closely held corporations, those rules are

likely to be difficult to apply and to audit

in the PFIC context.

The Treasury Department and the IRS

also considered other participation and

attribution rules of the Code, including

proposed rules addressing when a corporate partner would be attributed the trade

or business assets and activities of a partnership for purposes of the active trade or

business requirement in section 355(b).

See 88 FR 26012 (REG-123365-03) (proposing a rule that a partner that owns a

meaningful interest in a partnership would

be attributed the trade or business assets

and activities of the partnership if the partner performs active and substantial management functions for the partnership with

respect to the trade or business assets or

activities (for example, by making deci-

February 1, 2021

sions regarding significant business issues

of the partnership and regularly participating in the overall supervision, direction,

and control of the employees performing

the operational functions for the partnership)). However, the Treasury Department

and the IRS determined that such a rule

would not be appropriate for purposes of

section 1297. As stated in a comment, the

disadvantage of participation-based tests

is that they are factual and potentially subjective, and therefore less administrable.

For example, the proposed section 355(b)

test described above would be difficult for

the IRS to audit in the case of a foreign

corporation that is not controlled by U.S.

shareholders. Moreover, if the “meaningful interest” requirement applied, lookthrough treatment might apply only to a

small number of partnerships that are not

already treated as look-through partnerships. The Treasury Department and the

IRS did not consider these approaches

to be more appropriate than applying the

rules of section 1297 at the partner level as

a means of testing whether an investment

in a partnership is an active business interest. Accordingly, the definition of lookthrough partnership is further altered to

include certain partnerships in which the

tested foreign corporation owns a minority interest if the tested foreign corporation

has sufficient active assets and income as

determined under the rules of section 1297

apart from the partnership. See §1.12972(g)(4)(i)(B).

Under the final regulations, a lookthrough partnership is defined as (i) a

partnership that would be a look-through

subsidiary if such partnership were a corporation—as discussed in Part IV.B.1 of

this Summary of Comments and Explanation of Revisions—or (ii) any other

partnership if the tested foreign corporation satisfies the active partner test. See

§1.1297-2(g)(4)(i). The active partner

test is satisfied if the tested foreign corporation would not be a PFIC if both the

Income and the Asset Test were applied

to it without including its interest in any

partnership that would not be a lookthrough subsidiary if such partnership

were a corporation. See §1.1297-2(g)(4)

(ii). If the tested foreign corporation has

no passive assets or income, even a very

small active business would allow the

interest to qualify as a look-through part-

522

nership under the active partner test. On

the other hand, qualifying under the active

partner test can only prevent a partnership interest from tainting an otherwise

non-PFIC corporation, rather than be

used affirmatively. Because the Treasury

Department and the IRS understand that

it may be difficult for minority investors

in partnerships to obtain the information

necessary to apply the Income and Asset

Tests taking into consideration the income

and assets of a look-through partnership,

the final regulations provide an election

out of the look-through partnership definition for partnerships that would not be

a look-through subsidiary if such partnership were a corporation. See §1.1297-2(g)

(4)(iii). The final regulations also provide

two new examples illustrating the active

partner test. See §1.1297-2(g)(4)(iv).

C. Overlap between section 1297(c) and

section 1298(b)(7)

The proposed regulations provided that

the look-through rule of section 1297(c)

does not apply to a domestic corporation

if the stock of the domestic corporation is

characterized under section 1298(b)(7) as

a non-passive asset that produces non-passive income. See proposed §1.1297-2(b)

(2)(iii). The preamble to the proposed

regulations noted that the Treasury Department and the IRS determined that

section 1298(b)(7) should generally take

precedence over section 1297(c) when

both rules would apply simultaneously

because section 1298(b)(7) contains the

more specific rule applicable to a tested

foreign corporation that owns a domestic

subsidiary.

Comments asserted that the legislative history concerning section 1297(c)

and section 1298(b)(7) does not support

the approach taken by proposed §1.12972(b)(2)(iii). These comments argued that

section 1298(b)(7) was intended to apply

only in circumstances in which income

and assets would be passive if section

1297(c) applied. According to the comments, Congress did not intend for one

section to take precedence over the other

because the legislative history does not

discuss whether section 1298(b)(7) is

supposed to take precedence over section

1297(c) or express any limitations on the

application of section 1297(c).

Bulletin No. 2021–5

Because section 1298(b)(7) contains

the more specific rule applicable to a tested foreign corporation that owns a domestic subsidiary, the Treasury Department

and the IRS have determined that the section 1298(b)(7) coordination rule is consistent with the relevant statutory provisions and results in appropriate treatment

with respect to look-through subsidiaries.

Accordingly, the final regulations do not

adopt these comments.

D. Elimination of certain assets and

income for purposes of applying section

1297(a)

The proposed regulations provided

that, for purposes of applying the Income

and Asset Tests, certain intercompany

payments of dividends and interest from a

look-through entity, and the related stock

and debt receivables, are eliminated. See

proposed §1.1297-2(c)(1) and (2). The

preamble to the proposed regulations indicated that the Treasury Department and

the IRS intended for the elimination of

such items to prevent double counting of

intercompany income and assets. In response to comments, the final regulations

revise the rules relating to intercompany

dividends and expand the elimination

rules to address intercompany rents and

royalties and to address distributions and

the distributive share of income from a

look-through partnership.

1. Treatment of Intercompany Dividends

Proposed §1.1297-2(c)(2) provided

that, for purposes of applying the Income

Test, intercompany payments of dividends

between a look-through subsidiary and a

tested foreign corporation are eliminated

to the extent the payment is attributable to

income of a look-through subsidiary that

was included in gross income by the tested

foreign corporation for purposes of determining its PFIC status.

A comment expressed concern that the

proposed regulation did not eliminate a

payment of a dividend by a look-through

subsidiary to a tested foreign corporation

that is made out of earnings and profits

not attributable to income of the subsidiary previously included in the gross income of the tested foreign corporation for

purposes of determining its PFIC status.

Bulletin No. 2021–5

One example of such a case would be a

dividend paid after a look-through subsidiary is acquired out of earnings and profits

accumulated before the tested foreign corporation’s acquisition of the look-through

subsidiary. Another example of such a dividend would be a dividend paid to a tested

foreign corporation from a subsidiary that

was a subsidiary but not a look-through

subsidiary when the relevant earnings and

profits were accumulated and the dividend

was paid but later became a look-through

subsidiary. The comment questioned

whether a dividend from pre-acquisition

earnings and profits represents true economic income of the tested foreign corporation, since the tested foreign corporation

“purchased” the pre-acquisition earnings

and profits, and observed that it could be

difficult for a tested foreign corporation

to determine what portion of a dividend

received is attributable to pre-acquisition

earnings and profits, particularly if the acquisition was not recent. As a result, the

tested foreign corporation might not in

practice be able to determine when it can

eliminate a dividend from a look-through

subsidiary from its gross income.

The proposed regulation eliminated

dividends from a look-through subsidiary

only to the extent attributable to gross income included by the tested foreign corporation. The comment recommended

that the final regulations remove the limitation. In the alternative, the comment requested that the final regulations provide

that dividends in an amount equal to current-year earnings would be deemed attributable to income included by the tested

foreign corporation and that dividends in

excess of that amount would be deemed to

be paid first from years in which the subsidiary was a look-through subsidiary and

treated as attributable to income included

by the tested foreign corporation during

that period. As an additional alternative,

the comment proposed that taxpayers

be allowed to determine the earnings to

which dividends were considered attributable in the case of an acquisition of the

look-through subsidiary based on the ratio

of pre-acquisition earnings to post-acquisition earnings over a limited period.

The Treasury Department and the IRS

agree that dividends should be treated as

paid out of current earnings and profits

and then out of accumulated earnings and

523

profits (beginning with the most recently

accumulated), in accordance with section

316, and the final regulations so provide.

See §1.1297-2(c)(2). However, the final

regulations do not adopt the comment’s

recommendation to treat all dividends

from a look-through subsidiary as eliminated from the tested foreign corporation’s gross income even if the dividend

is paid out of earnings and profits that are

attributable to gross income of the subsidiary that the tested foreign corporation

has not included in income. As explained

in the next two paragraphs, the rules regarding dividends paid out of earnings

not taken into account by a tested foreign

corporation must be coordinated with the

rules that apply to determine residual gain

when the stock of a look-through subsidiary is sold in order to avoid elimination of

income for purposes of the Income Test.

Under §1.1297-2(f), if a tested foreign corporation disposes of the stock of

a look-through subsidiary, the amount of

gain taken into account for purposes of

the Income Test generally is the total gain

recognized by the tested foreign corporation less unremitted earnings (residual

gain). Unremitted earnings are the excess

of income taken into account by the tested foreign corporation with respect to that

look-through subsidiary less dividends

from the subsidiary. The amount of gain

derived from the disposition of stock of a

look-through subsidiary and dividends received from the look-through subsidiary is

determined on a share-by-share basis under a reasonable method. such as the rules

under section 951 or 1248.

Thus, if a look-through subsidiary with

a value of $1000 earns $20 that is taken

into account by a tested foreign corporation

owner, any gain on a sale of the subsidiary’s

stock for $1020 will be reduced by $20 of

unremitted earnings. If the subsidiary pays

a $15 dividend before the sale, the receipt

of the dividend is disregarded for purposes

of the Income Test and a sale of the subsidiary’s stock for $1005 should give rise

to the same amount of residual gain. Thus,

the $20 will be taken into account for purposes of the Income Test and will not affect the amount of residual gain regardless

of whether a dividend is paid. By contrast,

if the look-through subsidiary pays a $15

dividend out of earnings that do not reflect

income taken into account by the tested

February 1, 2021

foreign corporation, the dividend would reduce the amount of gain on the sale of the

look-through subsidiary’s stock compared

to not paying a dividend because the dividend would reduce unremitted earnings

pursuant to §1.1297-2(f). Consequently,

if the payment of the dividend were disregarded as requested by the comment, the

$15 dividend would reduce potential future

gain but never give rise to corresponding

income to the tested foreign corporation for

purposes of the Income Test.

In order to prevent such a dividend from

reducing potential future gain on the sale

of the look-through subsidiary, it would be

necessary to reduce the basis of the stock

of the look-through subsidiary held by the

tested foreign corporation or make some

other adjustment to the taxation of gain

upon the disposition of the look-through

subsidiary’s stock. A basis reduction or

adjustment of that kind raises potentially

broader issues that were not addressed in

the proposed regulations. The Treasury Department and the IRS continue to study this

recommendation and additional guidance

on such elimination is proposed in the 2020

NPRM. See proposed §1.1297-2(c)(2).

2. Treatment of Intercompany Rents and

Royalties

The proposed regulations provided that

intercompany debt receivables and interest

are eliminated in proportion to the shareholder’s direct and indirect ownership

(by value) in the look-through subsidiary

with respect to a tested foreign corporation that owns less than 100 percent of a

look-through subsidiary. See proposed

§1.1297-2(c)(1) and (2). The preamble to

the proposed regulations explained that

this rule was based on the legislative history of the PFIC rules and was intended

to prevent duplication of passive assets

or passive income, for example if a wholly-owned look-through subsidiary with

entirely passive income paid a dividend to

the tested foreign corporation parent.

Comments supported the approach

taken in the proposed regulations with

regard to interest. A comment indicated

that payments of intercompany rents and

royalties raises similar concerns with respect to double counting. Accordingly, the

comment requested that, for purposes of

applying the Income Test and the Asset

February 1, 2021

Test, the final regulations extend the elimination rules to payments of intercompany

rents and royalties and any associated intangible assets in proportion to the tested

foreign corporation’s direct and indirect

ownership (by value) in the look-through

subsidiary or look-through partnership.

The Treasury Department and the IRS

agree with the comments, and §1.12972(c) accordingly extends the rules applicable to debt and interest to rents, royalties,

leases, and licenses.

The application of the elimination rule

to leases and licenses raises issues not

present with debt receivables. A lease or

license held by a look-through entity provides legal rights to use underlying property, such as a building or an intangible.

If the lease or license is disregarded by a

tested foreign corporation, it would not be

taken into account by the tested foreign

corporation in determining whether the

underlying property produces non-passive

income or is held for the production of

non-passive income. Moreover, while the

underlying property may be used as part

of an active business, it may be used as

part of the business of the lessee or licensee and not by the owner of the property.

Accordingly, the final regulations provide

that, for purposes of the Asset Test as applied to a tested foreign corporation, the

underlying property that is the subject of

the eliminated lease or license is characterized as a passive or non-passive asset

by taking into account the activities of

qualified affiliates of the tested foreign

corporation (as discussed in Part IV.E of

this Summary of Comments and Explanation of Revisions). A new example illustrates the expansion. See §1.1297-2(c)(4)

(v).

The final regulations also address more

precisely the calculations required in order to determine how much of an obligation and related income is eliminated if the

obligation runs between two look-through

entities that are not wholly-owned. The final regulations provide that the tested foreign corporation’s proportionate share of

a LTS obligation (as defined in §1.12972(c)(1)(ii)) or a TFC obligation (as defined

in §1.1297-2(c)(1)(ii)) is the value (or

adjusted basis) of the item multiplied by

the tested foreign corporation’s percentage ownership (by value) in each relevant

look-through subsidiary. See §1.1297-2(c)

524

(1)(ii). Examples 3 and 4 of §1.1297-2(c)

(4) illustrate that when an obligation runs

between two non-wholly-owned lookthrough entities, the percentage ownership

in each of those entities is taken into account. In Example 2, LTS2 has borrowed

$200x from LTS1. The tested foreign corporation owns 40 percent of LTS1’s stock

and 30 percent of LTS2’s stock. If the loan

had been made to LTS2’s shareholders,

on a pro rata basis, 30 percent of the loan

held by LTS1 ($60x) would be a TFC obligation and 70 percent of the loan held

by LTS1 ($140x) would be a third-party

obligation. The tested foreign corporation

would be treated for purposes of the Asset

Test as owning 40 percent of the TFC obligation, which would be eliminated. See

§1.1297-2(c)(1)(ii). The tested foreign

corporation also would be treated for purposes of the Asset Test as owning 40 percent of the hypothetical $140x third-party

loan, or $56x. Example 3 illustrates the

same principle.

3. Ownership Interests and Obligations of

a Look-Through Partnership

The final regulations provide that for

purposes of the Asset Test and the Income Test, the principles applicable to

the elimination of stock and obligations

of look-through subsidiaries and dividends, interest, rents and royalties paid by

look-through subsidiaries apply to lookthrough partnerships. See §1.1297-2(c)

(3). Since partnerships do not pay dividends, the regulations provide that those

principles apply to distributions and the

distributive share of income from a lookthrough partnership. See id. It is intended

that the same amount of assets and income

will be eliminated regardless of whether

the look-through entity or entities involved are look-through subsidiaries or

look-through partnerships that would be

look-through subsidiaries absent an election under §301.7701-3.

E. Attribution of activities of lookthrough subsidiaries and look-through

partnerships

1. Scope of Attribution

The proposed regulations provided

that, for purposes of section 1297, an item

Bulletin No. 2021–5

of rent or royalty income received or accrued by a tested foreign corporation (or

treated as received or accrued by the tested foreign corporation pursuant to section

1297(c)) that would otherwise be passive income if character were determined

based on the activities of the income-earning entity is not passive income if the item

would be excluded from FPHCI under

section 954(c)(2)(A) and §1.954-2(b)(6),

(c), and (d), determined by taking into account the activities performed by the officers and employees of the tested foreign

corporation, certain look-through subsidiaries, and certain partnerships in which

the tested foreign corporation or one of the

look-through subsidiaries is a partner. See

proposed §1.1297-2(e)(1).

One comment agreed that the activities

of the look-through subsidiary should be

taken into account to determine whether

an item of rent or royalty income of the

tested foreign corporation is passive or

non-passive and suggested that activity attribution be extended to apply to the section 954(h) and commodity producer tests.

The comment indicated that such treatment would be proper because financial

businesses generally segregate assets and

operations that are part of an integrated

business into different entities for non-tax

reasons. Because these final regulations

do not treat section 954(h) as applicable

for purposes of section 1297(b)(1), the

portion of the comment relating to section

954(h) is addressed in the preamble to the

2020 NPRM and not here. However, the

Treasury Department and the IRS agree

that it is appropriate to extend the activity attribution rules for purposes of certain

exceptions under section 954(c) that are

based on whether the entity is engaged in

the active conduct of a trade or business.

Accordingly, the final regulations extend

the activity attribution rules to income that

would be excluded from FPHCI under

section 954(c)(1)(B) (relating to property

transactions), (c)(1)(C) (relating to commodities), (c)(1)(D) (relating to foreign

currency gains), (c)(2)(A) (relating to

active rents and royalties), (c)(2)(B) (relating to export financing), and (c)(2)(C)

(relating to dealers). See §1.1297-2(e)(1).

Another comment noted that under the

rule in the proposed regulations, the income or assets of a look-through subsidiary classified as non-passive in the hands

Bulletin No. 2021–5

of a tested foreign corporation might

nevertheless be classified as passive in

the hands of the look-through subsidiary,

for example in the case where one lookthrough subsidiary held rental real estate

and another look-through subsidiary employed the employees who managed the

rental property. Under the rule in the proposed regulations the first look-through

subsidiary would be a PFIC and residual

gain with respect to the sale of the lookthrough subsidiary may be classified as

passive, even if the attribution of both the

property owned by the first subsidiary and

the activities of the employees of the second subsidiary caused the rental income

from the property to be treated as active

for a tested foreign corporation owner. To

mitigate this potential issue, the comment

suggested the final regulations provide

that such a look-through subsidiary be

treated as a non-PFIC with respect to that

tested foreign corporation under certain

circumstances. The Treasury Department

and the IRS have determined that the ultimate concerns raised by the comments

should largely be addressed by the modifications to the activity attribution rules

suggested by other comments and adopted in the final regulations, as discussed in

Part IV.E.2 of this Summary of Comments

and Explanation of Revisions. Those

modifications should generally result in

income and assets of a look-through subsidiary that are treated as non-passive in

the hands of a tested foreign corporation

also being treated as non-passive in the

hands of the look-through subsidiary, in

which case the look-through subsidiary

could be a non-PFIC and residual gain

on the sale of the look-through subsidiary

could be characterized as non-passive.

One comment recommended that rules

in the proposed regulations be modified to

apply the rules for active rents and royalties under section 954(c)(2)(A) as they

existed in 1986, as discussed in Part III.A

of this Summary of Comments and Explanation of Revisions, and if the regulations

were not modified in that manner the activity attribution rules should be revised to

take into account the “transition” rules in

the 2016 modifications to the active rents

and royalties rules. See TD 9792 (81 FR

76497) (adding the express requirement

to the active development tests in §1.9542(c)(1)(i) and (d)(1)(i) that the relevant

525

activities be performed by the lessor’s or

licensor’s own officers or staff of employees, and providing a transition rule that the

modified active development tests apply

only with respect to property manufactured, produced, developed, or created, or

in the case of acquired property, property

to which substantial value has been added, on or after September 1, 2015). The

2016 modifications are taken into account

through the cross-reference in §1.12971(c)(1)(i)(A) to section 954(c)(2)(A) (relating to active rents and royalties). The

Treasury Department and the IRS have

determined that no revisions to the PFIC

activity attribution rule are necessary, given that the PFIC activity attribution rules

clearly apply to take into account the activities of officers and employees of other

specified entities whether the rules under

section 954(c)(2)(A) apply as modified

(in the case of property manufactured,

produced, developed, or created, or in

the case of acquired property, property

to which substantial value has been added, on or after September 1, 2015) or the

rules under section 954(c)(2)(A) pre-modification apply (because no changes to the

property have occurred since September

1, 2015). Accordingly, the comment is not

adopted.

2. Ownership Threshold for Activity

Attribution

The proposed regulations provided

that, for purposes of the activity attribution rule described in Part IV.E.1 of this

Explanation of Comments and Summary

of Revisions, a tested foreign corporation may take into account the activities

performed only by those look-through

subsidiaries or look-through partnerships

with respect to which the tested foreign

corporation owns (directly or indirectly)

more than 50 percent by value. See proposed §1.1297-2(e)(1). The preamble to

the proposed regulations indicated that

the Treasury Department and the IRS determined that an ownership level of more

than 50-percent would prevent the activities of the look-through subsidiary or

look-through partnership from being attributed to an unrelated entity.

In response to a request for comments

in the preamble to the proposed regulations concerning the appropriate owner-

February 1, 2021

ship threshold for attribution of activities,

one comment recommended an affiliation

approach for the ownership threshold.

Under this approach, activities would

be attributed among members of the income-earning entity’s affiliated group, determined under principles of §1.904-4(b)

(2)(iii) modified to include partnerships

that are owned at least 50 percent by value

and corporations that are owned at least 50

percent by vote or value. For example, under this affiliation approach, the activities

of a group member could be attributed not

only “up” to a tested foreign corporation

that owned a sufficient amount of stock in

that group member (as would be the case

under the approach in the proposed regulations), but also “across” to a sister member that is a part of the affiliated group or

“down” to a subsidiary member that is a

part of the affiliated group.

Some comments noted that an approach

that takes into account voting rights in lieu

of value may be appropriate to take into

account instances where more than one

owner materially participates in the underlying activity. One of the comments

suggested that an ownership threshold of

at least 25 percent by vote would provide

the tested foreign corporation with sufficient control over the subsidiary for it to

be appropriate to attribute a portion of the

subsidiary’s activities to the tested foreign

corporation. Another comment recommended an ownership threshold of more

than 50 percent by vote or value by the

tested foreign corporation, with a requirement that the tested foreign corporation

materially participate in the same or complementary line of business of the activity-conducting subsidiary if it owns more

than 50 percent by vote but less than 50

percent by value of the activity conducting

subsidiary. In the alternative, the comment

suggested that the activities be attributed

in proportion to the ownership interest in

the activity-conducting subsidiary.

The Treasury Department and the

IRS disagree that satisfying a 25 percent threshold for ownership of an entity

is sufficient to conclude that the entity’s

business is sufficiently integrated with

that of a tested foreign corporation that

the entity’s activities should be taken

into account for purposes of determining

the character of income and assets of the

tested foreign corporation. However, the

February 1, 2021

Treasury Department and the IRS agree

with the comments that it is generally appropriate to expand the activity attribution

rule to attribute activities among members

of an affiliated group, determined by applying a more than 50 percent threshold

and by including partnerships and U.S.

affiliates in which corporate members of

the affiliated group satisfy such ownership

requirements. Accordingly, the final regulations so provide. See §1.1297-2(e)(1)

and (2) (defining qualified affiliates of the

affiliated group). However, the Treasury

Department and the IRS have determined

that because the rule applies for purposes

of section 1297(c), which focuses on ownership of at least 25 percent by value, the

threshold for inclusion in the group should

be determined by value. See §1.1297-2(e)

(2)(iv). Moreover, the parent of the affiliated group must also be foreign (a foreign corporation or partnership) in order

to apply the activity attribution rule. See

§1.1297-2(e)(2)(v). If the parent of the affiliated group were domestic (a U.S. corporation or partnership), then any qualified affiliate that is a foreign corporation

(including the tested foreign corporation)

would qualify as a controlled foreign corporation, and any U.S. investor with at

least a 10 percent ownership interest in

the tested foreign corporation would be

subject to the subpart F rules rather than

the PFIC rules under section 1297(d). Accordingly, an upstream foreign owner of

the tested foreign corporation and entities

that are held directly or indirectly by such

same upstream foreign owner as the tested foreign corporation may be considered

qualified affiliates, assuming the requisite

ownership percentage requirements are

met.

V. Comments and Revisions to Proposed

§1.1297-4 – Qualifying insurance

corporation

Section 1297(f) provides that a qualifying insurance corporation (“QIC”) is a

foreign corporation that (1) would be subject to tax under subchapter L if it were

a domestic corporation, and (2) either

(A) has applicable insurance liabilities

(“AIL”) constituting more than 25 percent

of its total assets on its applicable financial statement (“AFS”) (“the 25 percent

test”), or (B) meets an elective alternative

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facts and circumstances test which lowers

the AIL ratio to 10 percent (“alternative

facts and circumstances test”). Proposed

§1.1297-4 elaborated on these requirements accordingly.

A. 25 percent test

1. Applicable Insurance Liabilities

The 25 percent test in section 1297(f)

(1)(B) requires that the ratio of a foreign

corporation’s AIL to total assets exceed

25 percent. Section 1297(f)(3)(A) defines

AIL as loss and loss adjustment expenses (“LAE”) and reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance

risks and life and health insurance claims

with respect to contracts providing coverage for mortality or morbidity risks.

Proposed §1.1297-4(f)(2) provided

that with respect to any life or property

and casualty insurance business of a foreign corporation, AIL mean (1) occurred

losses for which the foreign corporation

has become liable but has not paid before

the end of the last annual reporting period

ending with or within the taxable year, including unpaid claims for death benefits,

annuity contracts, and health insurance

benefits; (2) unpaid expenses (including

reasonable estimates of anticipated expenses) of investigating and adjusted unpaid losses described in (1); and (3) the

aggregate amount of reserves (excluding

deficiency, contingency, or unearned premium reserves) held for future, unaccrued

health insurance claims and claims with

respect to contracts providing coverage

for mortality or morbidity risks, including

annuity benefits dependent upon the life

expectancy of one or more individuals.

Comments requested that the term “occurred losses” be changed because it is

not an industry standard term. Some comments suggested that the word “occurred”

be replaced with the word “incurred” or

“unpaid” and be clarified to explicitly include incurred but not reported (“IBNR”)

losses. Other comments suggested that the

term be defined as the term is used in the

Code, U.S. regulatory statements, or under U.S. generally accepted accounting

principles (“GAAP”) or international financial reporting standards (“IFRS”). Two

comments also requested clarification that

Bulletin No. 2021–5

unpaid LAE related to both paid and unpaid losses be included in the definition of

AIL.

The Treasury Department and the

IRS agree that further clarification of the

definition of AIL is necessary. While still

covering only losses that have occurred,

the final regulations clarify the definition

of AIL to adopt the comments which requested that AIL include incurred losses

(both reported and unreported) and unpaid

LAE on all incurred losses (whether the

losses are paid or unpaid).

Comments differed as to what items

should be included in the definition of

AIL. For example, several comments

suggested that AIL include insurance liabilities or loss reserves as reported on an

AFS (without further modification) while

other comments suggested that paid losses

and paid LAE be included as AIL (even

though they are not liabilities since they

have been paid and, as a result, do not appear on the AFS as liabilities).

A comment also requested that special

rules be created for financial guaranty

insurers and another comment requested

a special rule for mortgage guaranty insurers. The first comment recommended

that final regulations permit a financial

guaranty insurer to include in losses the

greater of two amounts: (1) the aggregate

amount of reserves (excluding deficiency, contingency, or unearned premium

reserves) held for future unaccrued insurance claims, or (2) the average of losses

incurred for policies over the previous ten

years of the life of the policy, whichever

is shorter. The second comment requested

that the 25 percent test be waived for a foreign corporation engaged in the business

of mortgage insurance and reinsurance if

at least 80 percent of its net written premiums are derived from mortgage guaranty

insurance (or reinsurance) and its gross

investment income is less than 50 percent

of its net written premiums as reported on

its AFS.

The final regulations do not adopt the

suggestion that paid losses or paid LAE

be treated as AIL nor the proposed special

rules for financial guaranty insurers and

mortgage guaranty insurers. These suggestions are contrary to the statute and the

intent of Congress. Section 1297(f) is limited to amounts that constitute liabilities,

whereas losses and LAE that have been

Bulletin No. 2021–5

paid are no longer liabilities and therefore do not qualify as AIL. Further, when

losses and LAE are paid, assets are also

reduced. It would not be appropriate to include loss and LAE amounts in the numerator of the 25 percent test (or alternative

facts and circumstances test), when the

corresponding assets are no longer reported on the AFS and included in the denominator. The statute also requires that liabilities include only insurance liabilities and

further excludes certain types of insurance

liabilities that may be included in a financial statement, such as unearned premium

reserves, contingency reserves, and deficiency reserves. See section 1297(f)(3)

(A); H.Rpt. No. 115-409, 115th Cong.1st

Sess., at 411; and Conference Rpt.No.115466, 115th Cong. 1st Sess., at 670 (“Unearned premium reserves with respect to

any type of risk are not treated as applicable insurance liabilities for purposes of

the provision.”). Therefore, §1.1297-4(f)

(2)(ii) provides that liabilities not within

the definition of AIL are not included in

the numerator of the 25 percent test (or

alternative facts and circumstances test)

and also specifies that amounts that are

not insurance liabilities (for example, liabilities related to non-insurance products

issued by an insurance company that may

be treated as debt, such as certain deposit

arrangements, structured settlements, and

guaranteed investment contracts or GICs)

are not AIL. The statute also does not contemplate averaging liabilities over a multiyear period because section 1297(f)(1)

(B) provides for an annual calculation by

looking to the foreign corporation’s AFS

“for the last year ending with or within the

taxable year.” Therefore, the final regulations do not include special rules for specialty insurers that would require multiyear averaging or disregard the liability

requirement.

Section 1297(f) contemplates that QIC

status is determined on an entity-by-entity basis. Therefore, §1.1297-4(f)(2)(i)(D)

(2) clarifies that the liabilities eligible to

be taken into account in determining AIL

include only the liabilities of the foreign

corporation whose QIC status is being

determined. For example, if a parent and

subsidiary both issue insurance contracts

to unrelated parties and the AFS is a

combined financial statement, the AIL of

parent and subsidiary must be separately

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determined and each of parent and subsidiary includes only the liabilities from the

contracts that it has issued (without regard

to the contracts issued by the other party).

This rule is consistent with §1.1297-4(f)

(2)(i)(D)(1) which provides the general

principle that no item may be taken into

account more than once.

2. Conformity Among Financial

Reporting Standards in Computing

Applicable Insurance Liabilities

Section 1297(f)(4) contemplates that a

foreign corporation can use GAAP, IFRS,

or the accounting standard used for the annual statement required to be filed with the

local regulator (if a statement prepared for

financial reporting purposes using GAAP

or IFRS is not available) as the starting

point to determine AIL. The annual statement required to be filed with the local

regulator may typically be prepared in

compliance with local statutory accounting standards. The Treasury Department

and IRS are aware that GAAP, IFRS, and

local statutory accounting sometimes have

different categories (and nomenclature)

and different methods of measuring losses

and reserves for insurance companies. The

final regulations define AIL more specifically so that only those liabilities that meet

the regulatory definition are included in

AIL irrespective of differences in nomenclature and methods that may be used by

different financial reporting standards.

It is anticipated that the starting point

for determining the amount of AIL will

be the AFS balance sheet. However, it

may be necessary in some circumstances

to disaggregate components of balance

sheet liabilities to determine the amount

of a company’s insurance liabilities that

meet the regulatory definition of AIL.

For example, the International Accounting Standards Board (“IASB”) issued a

new accounting standard called IFRS 17

for the accounting of insurance contracts

which was expected to become effective

January 1, 2021, and is now deferred to

be effective January 1, 2023. Some companies may have already adopted IFRS

17 for financial reporting purposes on an

optional basis. IFRS 17 generally does

not use the terms unpaid losses and LAE

or unearned premium reserve on its balance sheet. Instead, those amounts are

February 1, 2021

included in the overall insurance liabilities on the balance sheet and are required

to be separately identified in the notes,

as respectively, “liability for incurred

claims” and “liability for remaining coverage.” While they bear a different name,

they are intended to be substantially the

same in concept to claims reserves and

unearned premium reserves. Therefore, it

is expected that a foreign corporation using IFRS 17 only include those amounts

derived from the balance sheet that fall

within the final regulation’s definition

of AIL. Similarly, a foreign corporation

using IFRS 17 (or any other financial reporting standard) is expected to exclude

contingency reserves and deficiency reserves (in addition to unearned premium

reserves), as applicable, even when those

categories do not separately appear on

the balance sheet as a liability and are

subsumed within another reported line

item.

The Treasury Department and IRS recognize that IFRS 17 is a new accounting

standard and that questions may arise as

to how amounts relevant to the PFIC insurance exception are derived from an

IFRS 17 AFS. Similar questions may also

arise with respect to financial statements

prepared using GAAP and local statutory accounting, particularly as accounting

reporting standards evolve. The Treasury

Department and IRS request comments on

whether further guidance is necessary to

clarify how AILs are determined or make

further adjustments to ensure that similarly situated taxpayers are treated similarly

without regard to the financial reporting

standard adopted by the foreign corporation.

B. Alternative facts and circumstances

test

If a foreign corporation predominantly

engaged in an insurance business fails the

25 percent test solely due to runoff-related

or rating-related circumstances involving

its insurance business, and the ratio of

its applicable insurance liabilities to its

total assets is at least 10 percent, section

1297(f)(2) allows a United States person

that owns stock in the corporation to elect

to treat such stock as stock of a QIC. Proposed §1.1297-4(d) provided guidance regarding this election.

February 1, 2021

1. Predominantly Engaged in an

Insurance Business

Section 1297(b)(2)(B) provides that

passive income does not include income

derived in the active conduct of an insurance business by a QIC. Section 1297(f)(1)

(A) provides that a QIC must be a foreign

corporation which would be subject to tax

under subchapter L if such corporation

were a domestic corporation. Then, for

purposes of the alternative facts and circumstances test, section 1297(f)(2)(B)(i)

adds another requirement that the foreign

corporation be predominantly engaged in

an insurance business under regulations

provided by the Secretary based upon the

applicable facts and circumstances.

Proposed §1.1297-4(d)(2) provided

more specific guidance regarding the circumstances under which a foreign corporation is considered to be predominantly

engaged in an insurance business for

purposes of the alternative facts and circumstances test by setting forth a predominantly engaged test (separate from the active conduct test and the requirements of

subchapter L) by reference to the facts and

circumstances that tend to show (or not

show) that a foreign corporation is predominantly engaged in an insurance business based upon the factors set forth in

the legislative history. The proposed rule

provided that the determination is made

based on whether the particular facts and

circumstances of the foreign corporation

are comparable to commercial insurance

arrangements providing similar lines of

coverage to unrelated parties in arm’s

length transactions.

A comment pointed to a number of

ambiguities in the predominantly engaged

standard and asked for clarification. First,

it stated that it is not clear whether the proposed regulation’s predominantly engaged

test is in addition to the insurance company status test in subchapter L. Second,

it stated that it is unclear how non-arm’s

length insurance transactions are taken

into account when determining whether

more than half the business of the foreign

corporation is the issuing of insurance or

annuity contracts or the reinsuring of risks

underwritten by insurance companies and

how to compare related party transactions

to commercial insurance arrangements.

Third, it stated that it is unclear whether

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the list of facts and circumstances is an

exclusive set of factors.

In response to the comment, the final

regulations make clear that the predominantly engaged requirement in the alternative facts and circumstances test is in addition to the subchapter L requirement that

more than half the business of the foreign

corporation is the issuing of insurance or

annuity contracts or the reinsuring of risks

underwritten by insurance companies. It

also deletes the sentence regarding comparable commercial insurance arrangements

because the standard was unclear and instead replaces it with a statement that the

determination is made upon the character

of the business actually conducted in the

taxable year. Lastly, it clarifies that the list

of facts and circumstances is not exclusive

and can include other factors as may be

relevant to a specific situation.

2. Runoff-Related Circumstances

Proposed §1.1297-4(d)(3) provided

that “runoff-related circumstances” means

that the foreign corporation: (1) was actively engaged in the process of terminating its pre-existing, active insurance or

reinsurance underwriting operation pursuant to an adopted plan of liquidation or

termination of operations under the supervision of its applicable insurance regulatory body; (2) did not issue or enter into any

insurance, annuity, or reinsurance contract, other than a contractually obligated

renewal of an existing insurance contract

or a reinsurance contract pursuant to and

consistent with the plan of liquidation or

a termination of operations; and (3) made

payments during the annual reporting

period covered by the AFS to satisfy the

claims under insurance, annuity, or reinsurance contracts, and the payments cause

the corporation to fail to satisfy the 25 percent test.

A comment recommended that the final

regulations remove the requirement that

the runoff company have a plan of liquidation, remove the requirement that amounts

paid by the runoff company cause the corporation to fail to satisfy the 25 percent

test, and add a condition that the foreign

corporation has no current plan or intention to enter into any insurance, annuity,

or reinsurance contract other than in the

case of a contractually obligated renewal.

Bulletin No. 2021–5

The comment stated that there is no prevailing practice in the insurance industry

for a regulator to supervise a plan of liquidation or termination of a runoff company. The comment further stated that runoff

carriers may be part of a larger insurance

group, and that management of the runoff

business is not necessarily a prelude to liquidation but can be a way for the active

insurance businesses to shift their core

business segments and maximize their use

of capital. In addition, some companies

(known as “runoff specialists”) are in the

business of acquiring reserve liabilities to

profitably manage the settlement and payout of claims until all of the liabilities are

exhausted.

The Treasury Department and IRS have

considered these comments and believe

that the exception from the 25 percent test

should not be extended to runoff occurring

in the context of the ordinary course of an

ongoing business. The Conference Report

to the Act describes a company with runoff-related circumstances as “not taking

on new insurance business” and “using

its remaining assets to pay off claims with

respect to pre-existing insurance risks on

its books.” See H.R. Rep. No. 115-466,

at 671 (2017) (Conf. Rep.). The lower 10

percent threshold (which permits an insurance company to hold assets that are 1,000

percent of its AIL) should be limited to

extraordinary circumstances in which the

insurance company fails the 25 percent

test solely because it is in the process of

exiting the insurance business and is required to hold additional capital in excess

of the 400 percent of AIL permitted by the

25 percent test due to its business being

in runoff.

The final regulations delete, however,

the requirement that the runoff company

have a plan of liquidation and instead require that the company be in the process

of terminating its pre-existing, active conduct of an insurance business under the

supervision of its applicable insurance

regulatory body or any court-ordered receivership proceeding (liquidation, rehabilitation, or conservation), which covers

a broader array of circumstances than the

proposed regulation. See §1.1297-4(d)(3)

(i).

The final regulations retain the requirement in the proposed regulations

that the insurance company make claims

Bulletin No. 2021–5

payments during the annual reporting period. See §1.1297-4(d)(3)(iii). However,

in response to comments, the final regulations do not require such payments

to cause the insurance company’s ratio

of liabilities to assets to fail the 25 percent test and instead clarify in §1.12974(d)(3)(i) that the company must fail to

satisfy the 25 percent test because it is

required to hold additional assets due to

its business being in runoff. Finally, for

clarity and consistent with the comment’s

suggestion, §1.1297-4(d)(3)(ii) adds a

condition that the foreign corporation has

no plan or intention to enter into any insurance, annuity, or reinsurance contract

other than in the case of a contractually

obligated renewal.

3. Rating-Related Circumstances

Proposed §1.1297-4(d)(4) provided that “rating-related circumstances”

means that a foreign corporation’s failure

to satisfy the 25 percent test was a result

of specific requirements with respect to

its capital and surplus that a generally

recognized credit rating agency imposes

that the foreign corporation must comply with to maintain the minimum credit

rating required for it to be classified as

secure to write new insurance business

for the current year. This condition in

the proposed regulations was based upon

the premise that although the generally

recognized credit rating agencies (A.M.

Best, Fitch, Moody’s, and Standard and

Poor) may use separate rating codes, the

ratings could be classified into “secure”

and “vulnerable” categories, and that the

rating agencies require reporting entities

to maintain a minimum amount of capital

appropriate to support its overall business operations in consideration of its

size and risk profile.

Comments suggested that the proposed

regulation’s reference to “secure” be

changed. Some comments suggested that

the standard should be revised to reflect

only a rating agency’s requirements that

are “necessary” to write new business in

accordance with the foreign corporation’s

regulatory or board supervised business

plan. Another comment requested that the

term necessary be defined to mean that a

foreign corporation complies with the requirements of the credit rating agency to

529

maintain a rating equivalent to A- by A.M.

Best for reinsurers or BBB+ by Standard

& Poor’s for all other insurers.

The Treasury Department and IRS

agree that the use of the term “secure”

should be amended. Therefore, the final

regulations provide that the rating-related circumstances standard requires that

the 25 percent test is not met due to capital and surplus amounts that a generally

recognized credit rating agency considers

necessary for the foreign corporation to

obtain a public rating with respect to its

financial strength, and the foreign corporation maintains such capital and surplus

in order to obtain the minimum credit rating necessary for the current year by the

foreign corporation to be able to write the

business in its regulatory or board supervised business plan.

A comment also requested that the proposed regulations be revised to provide

that the rating-related circumstances standard not be an annual test. The comment

requested that once the foreign corporation satisfies the rating-related circumstances standard, the alternative facts and

circumstances test should not need to be

reapplied unless there is a change in circumstances. The final regulations do not

adopt this comment because the test for a

foreign corporation’s PFIC status and the

AIL tests are annual tests.

Several comments requested that additional categories of rating-related circumstances be included under which certain types of entities or businesses would

be treated as per se meeting the rating-related circumstances requirement. These

businesses include reinsurance that is

fully collateralized, mortgage insurance

and reinsurance, and financial guaranty

insurance. Another comment noted that

lines of business that require a higher

level of capital as compared to reserves

are those that cover risks that are low

frequency but high severity, such as catastrophic risk (for example, hurricanes

and earthquakes) and financial obligation

insurance such as mortgage and financial

guaranty insurance.

Comments noted that financial guaranty and mortgage guaranty insurers are

generally required to operate as monoline

businesses, such that the company does

not have the option to pool its financial

obligation risks with other types of risks

February 1, 2021

(whereas pooling of different types of

risks can reduce overall risk exposure,

and thus capital needs). Comments also

noted that the loss experience of mortgage and financial guaranty insurers is

closely tied to the economy as a whole,

such that insurance liabilities are relatively low when the economy is strong

but much higher in times of economic

crisis, and that credit rating agencies correspondingly expect such companies to

hold additional capital to protect policyholders due to the monoline nature and

volatility of the businesses.

With respect to mortgage insurers, the

Federal Housing Agency (FHA), in its role

as regulator of Fannie Mae and Freddie

Mac (government-sponsored entities who

purchase or guarantee a majority of U.S.

home mortgage loans), also prescribes

capital requirements that must be satisfied

by private mortgage insurers to be eligible

to provide mortgage insurance on loans

owned or guaranteed by Fannie Mae or

Freddie Mac. These guidelines were set

after the 2007-2008 financial crisis and

are designed to ensure that mortgage guaranty insurers maintain sufficient capital

to cover obligations in times of financial

distress, when defaults and foreclosures

increase. Rating agencies evaluate satisfaction of FHA guidelines when rating

mortgage guaranty insurers, and FHA and

rating agency capital standards geared

to ensuring capital adequacy in times of

crisis may result in a mortgage guaranty

insurer being required to hold an amount

of capital that causes its current insurance

liabilities to be less than 25 percent of its

assets in low loss years when the economy

is strong.

Financial guaranty insurance is a line of

insurance business in which an insurance

company guarantees scheduled payments

of interest and principal on a bond or other debt security in the event of issuer default. A comment explained that financial

guaranty insurance is unique in that the

policyholder is effectively paying for use

of the financial guaranty insurer’s credit

rating. For example, if a municipality insures its municipal bond obligations with

a financial guarantee insurer, the municipality can charge a lower interest rate on

its bond, because the obligation is guaranteed by the insurer’s high credit rating. A

very high credit rating is thus essential for

February 1, 2021

a financial guarantee insurer to write new

business. Further (and similar to mortgage

guaranty insurers) rating agency capital

standards for financial guaranty insurers

are geared to ensuring capital adequacy

in times of crisis and may require a higher level of capital to get the same rating

as an insurer with a different portfolio of

risks. The combination of enhanced rating

agency capital requirements and the need

for a very high credit rating to write new

business often results in a financial guaranty insurer being required to hold capital

such that its current insurance liabilities

are less than 25 percent of its assets in low

loss years.

The Treasury Department and IRS

considered these comments and the circumstances under which an insurance

company would need assets in excess of

400 percent of its insurance liabilities in

order to obtain the credit rating needed

to write new business. As described in

comments, companies that may require

a higher level of capital as compared

to insurance liabilities are companies

that provide primarily catastrophic loss

coverage and also monoline companies

providing mortgage or financial guaranty insurance that experience significant

losses on a low frequency but high severity basis. In low loss years, these types of

companies may have less than 25 percent

insurance liabilities to assets, but the additional assets may be viewed as necessary by rating agencies for the companies

to meet insurance obligations in high loss

years, and thus to receive the credit rating that the companies require to write

the business in their business plan. Thus,

the final regulations provide that the rating related circumstances exception is

only available to a foreign corporation if

it is a company that exclusively provides

mortgage insurance or if more than half

of the foreign corporation’s net written

premiums for the annual reporting period

(or the average of the net written premiums for the foreign corporation’s annual

reporting period and the two immediately preceding annual reporting periods)

are from insurance coverage against the

risk of loss from a catastrophic loss event

(that is, a low frequency but high severity

loss event). See §1.1297-4(d)(4)(i).

The final regulations also provide that

a financial guaranty insurance company

530

that fails the 25 percent test is deemed to

satisfy the rating-related circumstances

requirement. See §1.1297-4(d)(4)(ii). The

final regulations define a financial guaranty insurance company as an insurance

company whose sole business is to insure or reinsure only the type of business

written by (or that would be permitted to

be written by) a company licensed under, and compliant with, a U.S. state law,

modeled after the National Association of

Insurance Companies Financial Guaranty

Insurance Guideline, that specifically governs the licensing a

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