Exceptions to Passive Income Characterization for Certain Foreign Banks and Securities Dealers

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-0065-93]

RIN 1545-AS46

Exceptions to Passive Income Characterization for Certain Foreign

Banks and Securities Dealers

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document provides guidance concerning the application of

the exceptions to passive income contained in section 1296(b) for

foreign banks, securities dealers and brokers. This document affects

persons who own direct or indirect interests in certain foreign

corporations. This document also provides notice of a public hearing on

these proposed regulations.

DATES: Written comments must be received by August 10, 1995. Outlines

of oral comments to be presented at the public hearing scheduled for

August 31, 1995 at 10 a.m. must be received by August 10, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (INTL-0065-93), room

5228, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. In the alternative, submissions may be hand

delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R

(INTL-0065-93), Courier's Desk, Internal Revenue Building, 1111

Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Ramon

Camacho at (202) 622-3870; concerning submissions and the hearing, Ms.

Christina Vasquez, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

A passive foreign investment company (PFIC) is any foreign

corporation that satisfies either the income test or asset test in

section 1296(a) of the Internal Revenue Code (Code). Under the income

test, a foreign corporation is a PFIC if 75 percent or more of its

gross income for the year is passive income. Sec. 1296(a)(1).

Alternatively, a foreign corporation is a PFIC if 50 percent or more of

the average value of its assets for the taxable year produce passive

income or are held for the production of passive income. Sec.

1296(a)(2). Under section 1296(b)(1), passive income is foreign

personal holding company income as defined in section 954(c) of the

Code, and includes dividends, interest, certain rents and royalties,

and gain from certain property transactions, including gain from the

sale of assets that produce passive income.

Under section 1296(b)(2)(A), income earned in the active conduct of

a banking business by a foreign corporation licensed to do business as

a bank in the United States and, to the extent provided in regulations,

by other corporations engaged in the banking business is not passive.

Notice 89-81, 1989-2 CB 399, (Notice) described rules to be

incorporated into subsequent regulations that would expand this

exception to certain foreign banks not licensed to do a banking

business in the United States. The rules contained in Sec. 1.1296-4 of

the proposed regulations would implement section 1296(b)(2)(A) for

banking activities conducted by foreign corporations.

In 1993, Congress added section 1296(b)(3)(A) to the Code,

effective for taxable years beginning after September 30, 1993. See

Omnibus Budget Reconciliation Act of 1993 (1993 Act), Pub. L. 103-66,

section 13231(d), 107 Stat. 312, 499. The provision treats as

nonpassive any income derived in the active conduct of a securities

business by a controlled foreign corporation (CFC) if the CFC is a U.S.

registered dealer or broker and, to the extent provided in regulations,

a CFC not so registered. The rules contained in Sec. 1.1296-6 would

implement section 1296(b)(3)(A).

Section 956A, added by the 1993 Act, requires each U.S. shareholder

of a CFC to include in income its pro rata share of the CFC's excess

passive assets. Under section 956A(c)(2), a passive asset is any asset

that produces passive income as defined in section 1296(b). An asset

that generates nonpassive income under Sec. 1.1296-4 or Sec. 1.1296-6

of the proposed regulations will be nonpassive for purposes of section

956A.

Explanation of Provisions

I. Description of Proposed Rules for Foreign Banks

A. General Rule

Section 1.1296-4(a) of the proposed regulations provides generally

that, for purposes of section 1296(a)(1), passive income does not

include banking income earned by an active bank or by a qualified

affiliate of such a bank. For this purpose, an active bank is either a

corporation that possesses a license issued under federal or state law

to do business as a bank in the United States, or a foreign corporation

that meets the licensing, deposit-taking, and lending requirements of

paragraphs (c), (d), and (e), respectively, of Sec. 1.1296-4.

The proposed rules generally adopt the deposit, lending, and

licensing standards contained in the Notice. These standards are

consistent with the provisions of the Code that define a bank as an

institution that accepts deposits from and makes loans to the public

and is licensed under state or federal law to conduct banking

activities. See e.g., sec. 581. The IRS and Treasury believe that

Congress intended [[Page 20923]] to grant the banking exception only to

corporations that conform to a traditional U.S. banking model.

However, the proposed rules liberalize the approach taken in the

Notice in several ways. Most significantly, the proposed rules adopt

subjective tests to measure whether the corporation meets the deposit-

taking and lending requirements. The IRS and Treasury rejected reliance

on objective tests such as those in the Notice after learning, through

several ruling requests pursuant to the Notice, that objective

standards may cause legitimate banks to be treated as nonbanks.

Because of the rigidity of the objective tests, the Notice

permitted the IRS to rule in rare and unusual circumstances that a

foreign corporation was an active bank even though it failed to satisfy

the requirements of the Notice. The proposed regulations do not adopt

this procedure because the IRS and Treasury believe that the enhanced

flexibility of the proposed rules should permit all foreign

corporations actively conducting a licensed banking business (whether

directly or through affiliates) to qualify for the bank exception.

B. Licensing Requirement

A foreign corporation that is not licensed in the United States

satisfies the licensing requirements of Sec. 1.1296-4(c) if it is

licensed or authorized to accept deposits from residents of the country

in which it is chartered or incorporated, and to conduct, in such

country, any of the banking activities described in the proposed

regulations. However, a corporation fails this licensing test if one of

the principal purposes for its obtaining a license was compliance with

the requirements of this section.

The IRS and Treasury believe that being licensed as a bank by a

bank regulatory authority is strong evidence that a corporation is a

bank. The proposed regulations therefore adopt a licensing test to

distinguish banks from investment funds.

C. Deposit-Taking Test

A foreign corporation satisfies the deposit-taking test of

Sec. 1.1296-4(d) if it regularly accepts deposits in the ordinary

course of its trade or business from customers who are residents of the

country in which it is licensed or authorized. In addition, the amount

of deposits shown on the corporation's balance sheet must be

substantial. Section 1.1296-4(d)(3) provides that whether the amount of

deposits on a corporation's balance sheet is substantial depends on all

the facts and circumstances, including whether the capital structure

and funding of the bank as a whole are similar to that of comparable

banking institutions engaged in the same types of activities and

subject to regulation by the same banking authorities.

The proposed regulations adopt this deposit-taking test in part to

distinguish banks from finance companies, which do not accept deposits.

This distinction between finance companies and banks is required by

Congress. H.R. Conf. Rep. No. 213, 103d Cong., 1st Sess. 641 (1993)

(noting that the banking, insurance, and securities exemptions ``do not

apply to income derived in the conduct of financing and credit services

businesses''). Although the IRS and Treasury believe that deposit-

taking is a key attribute of all active banks, they also recognize that

subjective tests will better accommodate the various types of banks

that have developed as a result of different banking systems and

regulatory frameworks.

The proposed regulations introduce flexibility to the deposit-

taking requirements in several ways. First, the requirement that the

amount of deposits be substantial is more flexible than the Notice

requirement that deposits constitute at least 50 percent of the total

liabilities of the bank. The IRS and Treasury recognize that a bank's

funding preferences may be affected by market conditions and regulatory

requirements and believes that an institution may be properly treated

as an active bank even if deposits do not constitute the institution's

primary source of funding.

Second, unlike the Notice, the proposed regulations do not include

any special rules for interbank deposits but treat them like any other

deposit, regardless of whether they are received from persons who are

members of a related group as defined in Sec. 1.1296-4(i)(4). The IRS

and Treasury believe this change is appropriate because the acceptance

of interbank deposits from related or unrelated persons on an arm's

length basis is a banking activity normally engaged in by banks. In

addition, the impact of a rule that distinguishes between interbank

deposits received from related persons and those received from

unrelated persons is diminished where deposit-taking activity is not

measured with a bright-line test.

Finally, the proposed rules change the Notice requirement that a

corporation must hold deposits from at least 1,000 persons who are bona

fide residents of the country that issued the corporation's banking

license because this requirement proved troublesome for certain private

banks with clientele from several countries. The requirement was

intended to address cases where a bank is licensed by a country but not

allowed to accept deposits from its residents. In the IRS and

Treasury's view, such an entity should not be treated as an active bank

for purposes of section 1296 because it is not accorded full bank

status by the bank authorities that issued its banking license.

However, the IRS and Treasury believe that a bright-line deposit

standard is not necessary to address this concern. Instead, the

proposed regulations require that a corporation regularly accept

deposits from residents of the country in which it is licensed.

D. Lending Test

A foreign corporation satisfies the lending test of Sec. 1.1296-

4(e) if it regularly makes loans to customers in the ordinary course of

its trade or business. This is a change from the Notice's requirement

that loans to unrelated persons make up more than 50 percent of the

corporation's loan portfolio. The lending test is necessary to

distinguish banks, which extend credit to customers, from corporations

that merely invest. However, such a distinction can be drawn without

relying on a bright-line standard such as that contained in the Notice.

In order to distinguish loans from investments for purposes of

these rules, the proposed regulations provide that a note, bond,

debenture or other evidence of indebtedness is a loan only if it is

received by the corporation on an extension of credit made pursuant to

a loan agreement entered into in the ordinary course of the

corporation's banking business. Debt instruments treated as securities

for purposes of the corporation's financial statements generally are

not loans.

E. Banking Income and Activities

Section 1.1296-4(f)(1) provides that banking income is gross income

derived from the active conduct of any banking activity as defined in

Sec. 1.1296-4(f)(2). These activities include all of the activities

treated as banking activities in the Notice, with no material changes,

except that finance leasing is included as a banking activity.

The proposed regulations do not adopt the Notice's rule that all of

the U.S. effectively connected income earned by a foreign corporation

in the active conduct of a trade or business pursuant to a U.S. bank

license automatically is nonpassive. One effect of this rule was that

effectively connected income earned by a U.S.- licensed bank from

transactions with related parties would have been banking income, while

income earned by non- [[Page 20924]] U.S.-licensed banks from similar

related-party transactions would not have been banking income. Because

the proposed regulations generally do not differentiate between related

party and non-related party transactions in the same way as the Notice,

the only effect of the rule would have been to treat, in the case of

U.S. licensed banks only, as banking income the income earned on

transactions with related parties who are not customers and income

earned from activities (such as securities activities) that are not

banking activities described in Sec. 1.1296-4(f). The IRS and Treasury

believe that the standards for determining whether income is derived in

the active conduct of a banking business should be the same for all

corporations that are either active banks or qualified bank affiliates.

The IRS and Treasury are aware that many bank activities may also

be considered securities activities. Under the proposed regulations, an

entity that performs an activity that is both a banking activity and a

securities activity must satisfy only the requirements of the bank

rules to treat income from such activity as nonpassive. For example, an

entity that derives income from dealing in foreign exchange may treat

such income as nonpassive if it is an active bank (or a qualified bank

affiliate) even though it is not a controlled foreign corporation.

Dealing in securities, however, is not included as both a banking

activity and a securities activity. The IRS and Treasury believe that

Congress intended that income from dealing in securities should be

nonpassive only if it is earned by a controlled foreign corporation

that actively conducts a securities business and meets the other

requirements of section 1296(b)(3)(A).

The IRS and Treasury have become aware that certain developing

country economies impose high deposit reserve requirements as a tool

for implementing monetary policy. Because the central banks of these

countries require the maintenance of such reserves as a prerequisite to

conducting a banking business, the earnings on such assets, if any,

should appropriately be excluded from passive income.

F. Customer Relationship

Under the proposed regulations, a bank satisfies the deposit and

lending tests only if it carries on such activities with customers.

Moreover, only the income from its banking activities (and those of its

qualified bank affiliates) conducted with, or for, customers will

produce nonpassive income. This is a change from the Notice

requirement, under which activities qualified only if they were

conducted with unrelated parties. Under the proposed regulations, a

customer may be any person, related or unrelated, if that person has a

customer relationship with the bank. Whether such a relationship exists

depends on all the facts and circumstances. However, persons who are

related to, or who are shareholders, officers, directors, or other

employees of, the corporation will not be treated as customers of the

corporation if one of the principal purposes for the corporation's

transacting business with such persons was to qualify the corporation

as an active bank or qualified bank affiliate.

G. Affiliates of Active Banks

The IRS and Treasury recognize that many active banks conduct one

or more banking activities through separately incorporated affiliates

that may not individually qualify as active banks. Accordingly, the

proposed regulations provide rules under which income from banking

activities may be treated as nonpassive if earned by a corporation that

does not qualify as an active bank but is a member of a related group

of which an active bank is also a member. However, such income is

nonpassive only for purposes of determining whether any member of the

related group is a passive foreign investment company or for purposes

of applying the excess passive asset rules of section 956A(c)(2)(A). In

addition, such income remains passive with respect to persons who own

stock in the affiliate but who are not members of the related group of

which the affiliate is a member.

For purposes of these rules, a related group is any group of

persons related within the meaning of section 954(d)(3), substituting

person for controlled foreign corporation. This definition is a

departure from the affiliated group definition of the Notice because it

permits noncorporate entities (such as partnerships) to count as

members of the group for purposes of satisfying the groupwide gross

income test.

Section 1.1296-4(i)(2) requires the bank affiliate to generate more

than 60 percent of its income from banking, insurance and securities

activities (but not other financial services). For purposes of this

test, the look-through rules of sections 1296(c) and 1296(b)(2)(C) do

not apply. This requirement ensures that a bank affiliate's eligibility

for the bank exception depends upon the business activities conducted

directly by the affiliate, and is not influenced by activities

conducted by related persons. However, a bank affiliate may

nevertheless apply sections 1296(c) and 1296(b)(2)(A) to determine

whether it is a PFIC under the income or asset tests of section

1296(a).

In addition, the related group must meet two gross income tests for

the exception to apply. First, under Sec. 1.1296-4(i)(3)(i), income

from banking activities derived by active banks must constitute at

least 30 percent of the financial services income earned by group

members. Second, under Sec. 1.1296-4(i)(3)(ii), income earned by group

members from banking activities, securities activities, and insurance

activities must constitute at least 70 percent of the financial

services income earned by group members that are financial services

entities. The regulations adopt the definition of financial services

income contained in Sec. 1.904-4(e), which includes only income earned

by financial services entities.

These affiliate rules are structurally similar to the affiliate

rules contained in the Notice, but have been modified in several

respects to respond to taxpayer comments. For example, the 80 percent

stock ownership threshold of the Notice caused many corporations to be

treated as PFICs solely because the gross income of subsidiaries in

which the group owned less than an 80 percent interest was excluded for

purposes of the Notice's gross income tests, even though the group had

voting control of such subsidiaries. The adoption of a lower 50 percent

ownership threshold for group membership in the proposed regulations

recognizes that international groups are not organized to meet the 80

percent threshold required for consolidation under U.S. tax law.

In addition, the gross income tests were changed in several ways to

deal with problems encountered by diversified affiliated groups. First,

the denominators of the fractions now include only financial services

income, which by its terms includes only income earned by financial

services entities. This change prevents foreign corporations that are

part of a banking group from being disqualified solely because the

group is a subgroup of a larger group that does not perform solely

financial services.

Second, the numerator of the fraction for the groupwide gross

income test now includes gross income from securities and insurance

activities in addition to banking activities. This change prevents a

foreign corporation engaged in banking activities that is part of a

banking subgroup from being disqualified solely because it is part of a

larger group that provides a broad range of financial services.

[[Page 20925]]

Finally, the proposed rules drop the Notice requirement that an

active bank be a group member for 5 years before its income may count

towards satisfaction of the gross income tests. Since PFIC status is

determined annually, the IRS and Treasury believe that whether a group

is a banking group should depend only on its status during the current

taxable year.

H. Income From Nonbanking Activities

As in the Notice, Sec. 1.1296-4(j) of the proposed regulations

provides that income derived from the conduct of activities other than

banking activities described in Sec. 1.1296-4(f)(2) and income from

assets held for the conduct of such activities are nonpassive only to

the extent provided in section 1296.

J. Effective Date

Section 1.1296-4 is proposed to be effective for all taxable years

beginning after December 31, 1994. However, taxpayers may apply

Sec. 1.1296-4 to a taxable year beginning after December 31, 1986, but

must consistently apply Sec. 1.1296-4 to such taxable year and all

subsequent years. While application of Sec. 1.1296-4 to a year

beginning after December 31, 1986, cannot affect the tax liability of a

taxpayer for any closed taxable year, a taxpayer may apply Sec. 1.1296-

4 to a closed taxable year for the purpose of determining whether a

foreign corporation is a PFIC in calculating the taxpayer's liability

for an open taxable year.

II. Exception for Income Earned in a Securities Business

A. General Rule

Section 1.1296-6(a) of the proposed regulations provides generally

that securities income earned by an active securities dealer, active

securities broker or qualified securities affiliate is nonpassive. As

required by section 1296(b)(3)(C), the rules apply only for purposes of

determining whether a controlled foreign corporation (as defined in

section 957(a)) is a PFIC with respect to its United States

shareholders (as defined in section 951(b)), or for purposes of

determining whether an asset is passive under section 956A(c)(2).

B. Active Securities Dealer and Active Securities Broker

Under Sec. 1.1296-6(b)(1), an active dealer or broker is a dealer

or broker that meets certain licensing requirements.

Section 1.1296-6(c) defines a securities dealer as a dealer in

securities within the meaning of section 475(c)(1). Under Sec. 1.1296-

6(d), a securities broker is a foreign corporation that stands ready to

effect transactions in securities and other financial instruments for

the account of customers in the ordinary course of its trade or

business during the taxable year. A securities dealer or broker is

licensed under Sec. 1.1296-6(b) if it possesses a U.S. license to do

business as a securities dealer or broker in the United States or if it

is licensed or authorized in the country in which it is chartered or

incorporated to conduct one or more securities activities described in

Sec. 1.1296-6(e)(2) with residents of that country. The conduct of such

activities must be subject to bona fide regulation, including

appropriate reporting, monitoring and prudential requirements, by a

securities regulatory authority that regularly enforces compliance with

such standards.

C. Securities Income & Securities Activities

Section 1.1296-6(e)(1) provides generally that securities income

means the gross income derived from the active conduct of any

securities activity that constitutes a trade or business. The list of

securities activities contained in Sec. 1.1296-6(e)(2) generally is

consistent with the legislative history to section 1296(b)(3)(A). See

H.R. Rep. No. 111, 103d Cong., 1st Sess. 704 (1993).

Section 1.1296-6(e)(2)(iv) includes as an additional securities

activity the maintenance of a capital deposit required under foreign

law as a prerequisite to acting as a broker in that jurisdiction.

Without this rule, a broker that is not also a dealer could be a PFIC

under section 1296(a)(2) even though the majority of its income is

commission income. This rule applies only if significant restrictions

exist on the use of its capital. Thus, working capital will not qualify

as a deposit for purposes of this rule.

In general, only income from transactions entered into with, or on

behalf of, persons with whom the corporation has a dealer-customer

relationship may be treated as nonpassive. Section 1.1296-6(g) adopts

without change the definition of dealer-customer relationship contained

in the bank rules.

Under Sec. 1.1296-6(h) of the proposed regulations, income and gain

from a security identified as held for investment under section

475(b)(1)(A) or which is not held for sale within the meaning of

section 475(b)(1)(B) is passive. Because the identification rules of

sections 475(b) and 1.475(b)-1T and 1.475(b)-2T apply, the rules

governing identification of inventory securities in Notice 88-22, 1988-

1 CB 489 and Notice 89-81, 1989-2 CB 399 do not apply with respect to

taxable years beginning after September 30, 1993. However, the

inventory identification rules of Notice 89-81 and Notice 88-22 will

continue to apply for taxable years beginning before October 1, 1993.

D. Matched Book Income

Section 1.1296-6(i) of the proposed regulations provides special

rules for determining a securities dealer's income from certain matched

transactions. These rules are adopted in order to eliminate a potential

opportunity for abuse that arises from the manner in which a matched

book repo business is conducted by securities dealers.

A matched transaction is defined as a sale and repurchase agreement

with respect to the same security, entered into by the controlled

foreign corporation in the active conduct of its trade or business and

properly treated as offsetting agreements in a matched book. In a

typical repurchase agreement a taxpayer sells a security and, at the

same time, agrees to repurchase an identical security from the

purchaser at a price in excess of the taxpayer's sales price. In a

reverse repurchase agreement, a taxpayer purchases a security and

concurrently agrees to sell an identical security to the seller at a

price in excess of the taxpayer's purchase price. A taxpayer who keeps

a matched book generally enters into offsetting repurchase and reverse

repurchase agreements involving identical securities. Such taxpayers

act as intermediaries by matching persons who need cash for a short

period with those who need securities for the same period.

Under the proposed regulations, securities income includes only the

net (not gross) income from matched transactions. Without the proposed

regulation's netting rule, related groups that are predominantly

engaged in passive activities could easily meet the gross income tests

contained in the qualified affiliate rules because a CFC conducting a

matched book business will earn large amounts of gross income, even

though net economic income from matched book activities is

comparatively small.

E. Affiliates of Dealers or Brokers

Like banks, securities dealers and brokers frequently operate

through separately incorporated subsidiaries that may not qualify

independently as active securities dealers or brokers but which form

part of an integrated securities business conducted by an active dealer

or broker. Accordingly, the proposed regulations contain rules that

extend the [[Page 20926]] securities dealer/broker exception to certain

qualified affiliates of active securities dealers or brokers. These

rules generally mirror the qualified bank affiliate rules contained in

Sec. 1.1296-4(i), except that they extend the securities dealer/broker

exception only to qualified securities affiliates that are CFCs, as

required by section 1296(b)(3)(A).

F. Income From Nonsecurities Activities

Section 1.1296-6(k) of the proposed regulations provides that

income derived from the conduct of activities other than securities

activities described in Sec. 1.1296-6(e)(2) and income from assets held

for the conduct of such activities are nonpassive only to the extent

provided in section 1296.

G. Effective Date

The rules contained in Sec. 1.1296-6 are proposed to be effective

for taxable years beginning after September 30, 1993.

III. Look-Through Rules

The proposed regulations do not contain guidance regarding the

look-through rules of sections 1296(c) and 1296(b)(2)(C) or the

grouping rules of section 956A(d). In general, the proposed regulations

also do not address whether, and to what extent, look-through

principles may apply to characterize income from a partnership as

nonpassive and an interest in a partnership as a nonpassive asset,

except to the extent that section 475 may treat a partnership as a

securities dealer. Because these issues are not unique to financial

institutions, the IRS and Treasury will address them in future

regulations of more general application. The IRS and Treasury solicit

comments on the proper scope and application of look-through and

grouping concepts to banks, securities dealers and securities brokers.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for August 31, 1995, at 10

a.m., in the Internal Revenue Service Auditorium, 7400 corridor.

Because of access restrictions, visitors will not be admitted beyond

the Internal Revenue Building lobby more than 15 minutes before the

hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments and an outline of the topics to be discussed

and the time to be devoted to each topic (signed original and eight (8)

copies) by August 10, 1995.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Ramon Camacho, Office

of the Associate Chief Counsel (International). However, other

personnel from the IRS and Treasury Department participated in their

development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

removing the entry for Sections 1.1291-10T, 1.1294-1T, 1.1295-1T, and

1.1297-3T and adding entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.1291-10T also issued under 26 U.S.C. 1291(d)(2).

Section 1.1294-1T also issued under 26 U.S.C. 1294.

Section 1.1295-1T also issued under 26 U.S.C. 1295.

Section 1.1296-4 also issued under 26 U.S.C. 1296(b)(2)(A).

Section 1.1296-6 also issued under 26 U.S.C. 1296(b)(3)(A).

Section 1.1297-3T also issued under 26 U.S.C. 1297(b)(1). * * *

Sec. 1.1291-0T [Redesignated as Sec. 1.1291-0]

Par. 2. Section 1.1291-0T is redesignated as Sec. 1.1291-0.

Par. 3. Newly designated Sec. 1.1291-0 is amended as follows:

1. The section heading for newly designated Sec. 1.1291-0 is

revised.

2. The introductory language for newly designated Sec. 1.1291-0 is

revised.

3. Entries for Secs. 1.1296-4 and 1.1296-6 are added in numerical

order.

The revisions and additions read as follows:

Sec. 1.1291-0 Passive foreign investment companies--table of contents.

This section lists headings under sections 1291, 1294, 1296 and

1297 of the Internal Revenue Code.

* * * * *

Sec. 1.1296-4 Characterization of certain banking income of

foreign banks as nonpassive.

(a) General rule.

(b) Active bank.

(1) U.S. licensed banks.

(2) Other foreign banks.

(c) Licensing requirements.

(d) Deposit-taking requirements.

(1) General rule.

(2) Deposit.

(3) Substantiality of deposits.

(e) Lending activities test.

(f) Banking income.

(1) General rule.

(2) Banking activities.

(g) Certain restricted reserves.

(h) Customer relationship.

(i) Income earned by qualified bank affiliates.

(1) General rule.

(2) Affiliate income requirement.

(3) Group income requirements.

(4) Related group.

(j) Income from nonbank activities.

(k) Effective date.

Sec. 1.1296-6 Characterization of certain securities income.

(a) General rule.

(b) Active dealer or broker.

(1) General rule.

(2) U.S. licensed dealers and brokers.

(3) Other dealers and brokers.

(i) General rule.

(ii) Licensing requirements.

(c) Securities dealer.

(d) Securities broker.

(e) Securities income.

(1) General rule.

(2) Securities activities.

(f) Certain deposits of capital.

(g) Dealer-customer relationship.

(h) Investment income. [[Page 20927]]

(i) Calculation of gross income from a matched book.

(j) Income earned by qualified securities affiliates.

(1) General rule.

(2) Affiliate income requirement.

(3) Group income requirements.

(4) Related group.

(5) Example.

(k) Income from nonsecurities activities.

(l) Effective date.

* * * * *

Par. 4. Section 1.1296-4 is added to read as follows:

Sec. 1.1296-4 Characterization of certain banking income of foreign

banks as nonpassive.

(a) General rule. For purposes of section 1296, banking income

earned by an active bank, as defined in either paragraph (b) (1) or (2)

of this section, or by a qualified bank affiliate, as defined in

paragraph (i) of this section, is nonpassive income.

(b) Active bank--(1) U.S. licensed banks. A corporation (whether

domestic or foreign) is an active bank if it is licensed by federal or

state bank regulatory authorities to do business as a bank in the

United States. A foreign corporation will not satisfy the requirements

of this paragraph (b)(1) if, under its federal or state license or

licenses, the foreign corporation is permitted to maintain only an

office, such as a representative office, that is prohibited by federal

or state law from taking deposits or making loans.

(2) Other foreign banks. A foreign corporation is an active bank if

it meets the licensing requirement of paragraph (c) of this section and

it actively conducts, within the meaning of Sec. 1.367(a)-2T(b)(3), a

banking business that is a trade or business within the meaning of

Sec. 1.367(a)-2T(b)(2). In order for the business conducted by a

foreign corporation to be considered a banking business, the foreign

corporation must also meet the deposit-taking requirements of paragraph

(d) of this section and the lending requirements of paragraph (e) of

this section.

(c) Licensing requirements. To be an active bank under paragraph

(b)(2) of this section, a foreign corporation must be licensed or

authorized to accept deposits from residents of the country in which it

is chartered or incorporated and to conduct, in that country, one or

more of the banking activities described in paragraph (f)(2) of this

section. However, in no case will a foreign corporation satisfy the

requirements of this paragraph (c) if one of the principal purposes for

its obtaining a license or authorization was to satisfy the

requirements of this section.

(d) Deposit-taking requirements--(1) General rule. To be an active

bank under paragraph (b)(2) of this section--

(i) A foreign corporation must, in the ordinary course of the

corporation's trade or business, regularly accept deposits from

customers who are residents of the country in which it is licensed or

authorized; and

(ii) The amount of deposits shown on the corporation's balance

sheet must be substantial.

(2) Deposit. Whether a liability constitutes a deposit for purposes

of this paragraph (d) is determined by reference to the characteristics

of the relevant instrument and does not depend solely on whether the

instrument is designated as a deposit.

(3) Substantiality of deposits. Whether the amount of deposits

(including interbank deposits) shown on a corporation's balance sheet

is substantial depends on all the facts and circumstances, including

whether the corporation's capital structure and funding sources as a

whole are similar to that of banking institutions engaged in the same

types of activities and subject to the jurisdiction of the same bank

regulatory authorities.

(e) Lending activities test. To be an active bank under paragraph

(b)(2) of this section, a corporation must regularly make loans to

customers in the ordinary course of its trade or business. A note,

bond, debenture or other evidence of indebtedness will be treated as a

loan for purposes of this section only if the debt instrument is

received by the corporation on an extension of credit made pursuant to

a loan agreement entered into in the ordinary course of the

corporation's banking business. Such debt instruments generally will

not be considered loans for purposes of this section if the instruments

are not treated as loans (but are classified as securities or other

investment assets, for example) for purposes of the foreign

corporation's financial statements.

(f) Banking income--(1) General rule. Banking income is the gross

income derived from the active conduct (within the meaning of

Sec. 1.367(a)-2T(b)(3)) of any banking activity described in paragraph

(f)(2) of this section.

(2) Banking activities. For purposes of this section, the following

are banking activities--

(i) Lending activities described in paragraph (e) of this section;

(ii) Factoring evidences of indebtedness for customers;

(iii) Purchasing, selling, discounting, or negotiating for

customers notes, drafts, checks, bills of exchange, acceptances, or

other evidences of indebtedness;

(iv) Issuing letters of credit and negotiating drafts drawn

thereunder for customers;

(v) Performing trust services, including activities as a fiduciary,

agent or custodian, for customers, provided such trust activities are

not performed in connection with services provided by a dealer in

stock, securities or similar financial instruments;

(vi) Arranging foreign exchange transactions (including any section

988 transaction within the meaning of section 988(c)(1)) for, or

engaging in foreign exchange transactions with, customers;

(vii) Arranging interest rate or currency futures, forwards,

options or notional principal contracts for, or entering into such

transactions with, customers;

(viii) Underwriting issues of stock, debt instruments or other

securities under best efforts or firm commitment agreements for

customers;

(ix) Engaging in finance leases, as defined in Sec. 1.904-

4(e)(2)(i)(V);

(x) Providing charge and credit card services for customers or

factoring receivables obtained in the course of providing such

services;

(xi) Providing traveler's check and money order services for

customers;

(xii) Providing correspondent bank services for customers;

(xiii) Providing paying agency and collection agency services for

customers;

(xiv) Maintaining restricted reserves (including money or

securities) as described in paragraph (g) of this section; and

(xv) Any other activity that the Commissioner determines, through a

revenue ruling or other formal published guidance (see

Sec. 601.601(d)(2) of this chapter), to be a banking activity generally

conducted by active banks in the ordinary course of their banking

business.

(g) Certain restricted reserves. A deposit of assets in a reserve

is, for purposes of this section, a banking activity if the deposit is

maintained in a segregated account in order to satisfy a capital or

reserve requirement under the laws of a jurisdiction in which the

corporation actively conducts (within the meaning of Sec. 1.367(a)-

2T(b)(3)) a banking business that is a trade or business (within the

meaning of Sec. 1.367(a)-2T(b)(2)). A deposit of assets into a reserve

qualifies under this paragraph (g) if and only to the extent that the

assets are not available for use in connection with the corporation's

banking business because of significant [[Page 20928]] regulatory

restrictions on the investment of such assets. This paragraph (g) does

not apply to ordinary working capital, which is available for

unrestricted use.

(h) Customer relationship. Whether a customer relationship exists

is determined by reference to all the facts and circumstances. Such a

relationship does not exist with respect to transactions between

members of a related group, as defined in paragraph (i)(4) of this

section, or transactions with any shareholders, officers, directors or

other employees of any person that would otherwise be treated as an

active bank or qualified bank affiliate if one of the principal

purposes for such transactions was to satisfy the requirements of this

section.

(i) Income earned by qualified bank affiliates--(1) General rule. A

foreign corporation that is not an active bank but which derives

banking income, as defined in paragraph (f)(1) of this section, is a

qualified bank affiliate for purposes of this section if such

corporation meets the requirements of paragraph (i)(2) of this section

and the related group of which it is a member meets the requirements of

paragraph (i)(3) of this section. Banking income earned by a qualified

bank affiliate is nonpassive only for purposes of determining whether

any member of the related group is a passive foreign investment company

or holds stock in a passive foreign investment company or for purposes

of applying section 956A(c)(2)(A). However, banking income of a

qualified bank affiliate remains passive with respect to persons who

own stock in that affiliate but who are not members of the related

group of which the affiliate is a member.

(2) Affiliate income requirement. To be a qualified bank affiliate,

at least 60 percent of the foreign corporation's total gross income for

the taxable year must be banking income, securities income, as defined

in Sec. 1.1296-6(e)(1), or gross income described in section

1296(b)(2)(B) (relating to insurance activities). For purposes of

applying this paragraph (i)(2), the look-through rules of sections

1296(b)(2)(C) and 1296(c) do not apply.

(3) Group income requirements. The related group qualifies under

this paragraph (i) if--

(i) At least 30 percent of the aggregate gross financial services

income, as defined in Sec. 1.904-4(e)(1), earned during the taxable

year by members of the related group is banking income earned by active

banks who are members of the related group during the current taxable

year; and

(ii) At least 70 percent of the aggregate gross financial services

income earned during the taxable year by members of the related group

is banking income, securities income, or gross income described in

section 1296(b)(2)(B)(relating to insurance activities).

(4) Related group. The related group is the group of persons

consisting of the entity being tested under this paragraph (i) and all

entities that are related within the meaning of section 954(d)(3) to

such entity, substituting ``person'' for ``controlled foreign

corporation'' each time the latter term appears.

(j) Income from nonbank activities. Income derived from the conduct

of activities other than banking activities described in paragraph

(f)(2) of this section and income from assets held for the conduct of

such other activities are nonpassive only to the extent otherwise

provided in section 1296.

(k) Effective date. This section is effective for taxable years

beginning after December 31, 1994. However, taxpayers may apply this

section to a taxable year beginning after December 31, 1986, but must

consistently apply this section to such taxable year and all subsequent

years.

Par. 5. Section 1.1296-6 is added to read as follows:

Sec. 1.1296-6 Characterization of certain securities income.

(a) General rule. For purposes of section 1296, securities income

earned by an active dealer or active broker, as defined in paragraph

(b) of this section, or a qualified securities affiliate, as defined in

paragraph (j) of this section, is nonpassive income. This section

applies only for purposes of determining whether a controlled foreign

corporation, as defined in section 957(a), is a passive foreign

investment company with respect to its United States shareholders as

defined in section 951(b), or for the purpose of determining whether an

asset is passive under section 956A(c)(2)(A).

(b) Active dealer or broker--(1) General rule. A securities dealer,

as defined in paragraph (c) of this section, or a securities broker, as

defined in paragraph (d) of this section, is an active dealer or an

active broker for purposes of this section if it meets the requirements

of either paragraph (b) (2) or (3) of this section.

(2) U.S. licensed dealers and brokers. A securities dealer or

securities broker (whether foreign or domestic) is an active dealer or

an active broker if it is registered as a securities dealer or broker

under section 15(a) of the Securities Exchange Act of 1934 or is

registered as a Government securities dealer or broker under section

15C(a) of such Act.

(3) Other dealers and brokers--(i) General rule. A securities

dealer or a securities broker is an active dealer or an active broker

if it meets the licensing requirements of paragraph (b)(3)(ii) of this

section and actively conducts, within the meaning of Sec. 1.367(a)-

2T(b)(3), one or more securities activities, as defined in paragraph

(e)(2) of this section, as a trade or business within the meaning of

Sec. 1.367(a)-2T(b)(2).

(ii) Licensing requirements. To be an active dealer or an active

broker under paragraph (b)(3) of this section, a securities dealer or

securities broker must be licensed or authorized in the country in

which it is chartered, incorporated or organized to conduct one or more

of the securities activities described in paragraph (e)(2) of this

section with residents of that country. The conduct of such activities

must be subject to bona fide regulation, including appropriate

reporting, monitoring and prudential (including capital adequacy)

requirements, by a securities regulatory authority in that country that

regularly enforces compliance with such requirements and prudential

standards.

(c) Securities dealer. For purposes of this section, a securities

dealer is a dealer (whether foreign or domestic) in securities within

the meaning of section 475(c)(1).

(d) Securities broker. For purposes of this section, a securities

broker is a corporation (whether domestic or foreign) that, during its

taxable year, stands ready, in the ordinary course of its trade or

business, to effect transactions in securities and other financial

instruments for the account of customers, including the arrangement of

loans of securities owned by customers.

(e) Securities income--(1) General rule. Securities income means

the gross income (except as provided in paragraph (i) of this section)

derived from the active conduct (within the meaning of Sec. 1.367(a)-

2T(b)(3)) of any securities activity described in paragraph (e)(2) of

this section.

(2) Securities activities. For purposes of this section, the

following are securities activities--

(i) Purchasing or selling stock, debt instruments, interest rate or

currency futures or other securities or derivative financial products

(including notional principal contracts) from or to customers and

holding stock, debt instruments and other securities as inventory for

sale to customers, unless the relevant securities or derivative

financial products (including notional [[Page 20929]] principal

contracts) are not held in a dealer capacity;

(ii) Effecting transactions in securities for customers as a

securities broker;

(iii) Arranging futures, forwards, options, or notional principal

contracts for, or entering into such transactions with, customers;

(iv) Arranging foreign exchange transactions (including any section

988 transaction within the meaning of section 988(c)(1)) for, or

engaging in foreign exchange transactions with, customers;

(v) Underwriting issues of stocks, debt instruments, or other

securities under best efforts or firm commitment agreements with

customers;

(vi) Purchasing, selling, discounting, or negotiating for customers

on a regular basis notes, drafts, checks, bills of exchange,

acceptances or other evidences of indebtedness;

(vii) Borrowing or lending stocks or securities for customers;

(viii) Engaging in securities repurchase or reverse repurchase

transactions with customers;

(ix) Engaging in hedging activities directly related to another

securities activity described in this paragraph (e)(2);

(x) Repackaging mortgages and other financial assets into

securities and servicing activities with respect to such financial

assets (including the accrual of interest incidental to such

activities);

(xi) Engaging in financing activities typically provided by an

investment bank, such as--

(A) Project financing provided in connection with, for example,

construction projects;

(B) Structured finance, including the extension of a loan and the

sale of participations or interests in the loan to other financial

institutions or investors; and

(C) Leasing activities to the extent incidental to financing

activities described in this paragraph (e)(2)(xi) or to advisory

services described in paragraph (e)(2)(xii) of this section;

(xii) Providing financial or investment advisory services,

investment management services, fiduciary services, trust services or

custodial services;

(xiii) Providing margin or any other financing for a customer

secured by securities or money market instruments, including repurchase

agreements, or providing financing in connection with any of the

activities listed in paragraphs (e)(2)(i) through (e)(2)(xii) of this

section;

(xiv) Maintaining deposits of capital (including money or

securities) described in paragraph (f) of this section; and

(xv) Any other activity that the Commissioner determines, through a

revenue ruling or other formal published guidance, to be a securities

activity generally conducted by active dealers or active brokers in the

ordinary course of their securities business.

(f) Certain deposits of capital. A deposit of capital is, for

purposes of this section, a securities activity if the deposit is

maintained in a segregated account in order to satisfy a capital

requirement for registration as a securities broker or dealer under the

laws of a jurisdiction in which the broker or dealer actively conducts

(within the meaning of Sec. 1.367(a)-2T(b)(3)) a trade or business

(within the meaning of Sec. 1.367(a)-2T(b)(2)) as a securities broker

or dealer. A deposit of capital qualifies under this paragraph (f) if

and only to the extent that the assets are not available for use in

connection with the controlled foreign corporation's activities as a

securities broker or dealer because of significant regulatory

restrictions on the investment of such assets. This paragraph (f) does

not apply to ordinary working capital, which is available for

unrestricted use.

(g) Dealer-customer relationship. Whether a dealer-customer

relationship exists is determined by reference to all the facts and

circumstances. Such a relationship does not exist with respect to

transactions between members of a related group, as defined in

paragraph (j)(4) of this section, or transactions with any

shareholders, officers, directors or other employees of any person that

would otherwise be treated as an active dealer, active broker or

qualified securities affiliate if one of the principal purposes for

such transactions was to satisfy the requirements of this section.

(h) Investment income. Income earned on any securities held for

investment within the meaning of section 475(b)(1)(A) or not held for

sale within the meaning of section 475(b)(1)(B), is passive for

purposes of sections 1296(a)(1), 1296(a)(2) and 956A(c)(2)(A).

(i) Calculation of gross income from a matched book. Securities

income includes only the net (not gross) income from matched

transactions. For purposes of this section, a matched transaction is a

sale and repurchase agreement with respect to the same security

properly treated as offsetting agreements in a matched book.

(j) Income earned by qualified securities affiliates--(1) General

rule. A foreign corporation that is not an active dealer or an active

broker but which derives securities income described in paragraph

(e)(1) of this section is a qualified securities affiliate for purposes

of this section if such corporation meets the requirements of paragraph

(j)(2) of this section and is a member of a related group that meets

the requirements of paragraph (j)(3) of this section. Securities income

earned by a qualified securities affiliate is nonpassive only for

purposes of determining whether any member of the related group is a

passive foreign investment company or holds stock in a passive foreign

investment company or for purposes of applying section 956A(c)(2)(A).

However, securities income of a qualified securities affiliate remains

passive with respect to persons who own stock in that affiliate but who

are not members of the related group of which the affiliate is a

member.

(2) Affiliate income requirement. To be a qualified securities

affiliate, at least 60 percent of the foreign corporation's total gross

income for the taxable year must be banking income, as defined in

Sec. 1.1296-4(f)(1), securities income, as defined in paragraph (e)(1)

of this section, or gross income described in section 1296(b)(2)(B)

(relating to insurance activities). For purposes of this paragraph

(j)(2), the look-through rules of sections 1296(b)(2)(C) and 1296(c) do

not apply.

(3) Group income requirements. The related group qualifies under

this paragraph (j) if--

(i) At least 30 percent of the aggregate gross financial services

income, as defined in Sec. 1.904-4(e)(1), earned during the taxable

year by members of the related group is securities income earned by

active dealers or active brokers who are members of the related group

during the current taxable year; and

(ii) At least 70 percent of the aggregate gross financial services

income earned during the taxable year by members of the related group

is banking income, securities income, or gross income described in

section 1296(b)(2)(B) (relating to insurance activities).

(4) Related group. The related group is the group of persons

consisting of the entity being tested under this paragraph (j) and all

entities that are related within the meaning of section 954(d)(3) to

such entity, substituting ``person'' for ``controlled foreign

corporation'' each time the latter term appears.

(5) Example. The following example illustrates the rules of this

paragraph (j).

Example. (i) Facts. SD is a country Y corporation that owns 85

percent of the stock of M, a country Z corporation. A, a U.S.

person, owns the remaining 15 percent of the stock of M. B, C, and

D, all unrelated U.S. persons, own 5, 15, and 36 percent,

respectively, of the stock of SD. The rest of SD's stock is publicly

held. SD is a securities dealer within the meaning of section

[[Page 20930]] 475(c)(1) and satisfies the licensing requirements of

paragraph (b)(3)(ii) of this section. Because M's sole activity is

conducting a matched book repo business, M is not a securities

dealer within the meaning of section 475. For its taxable year

ending December 31, 1994, SD earns $100 of gross income from trading

profits and interest and dividends on inventory. For its taxable

year ending December 31, 1994, M earns $50 of net interest income

from its matched book repo business. SD and M earn no other income.

All of SD and M's assets are held in connection with their

securities businesses and none has been identified as having been

held for investment.

(ii) Securities income earned by SD. SD is an active dealer

under paragraph (b) of this section because it is a securities

dealer under section 475 and satisfies the licensing requirements of

paragraph (b)(3)(ii) of this section. Therefore, because SD is a

controlled foreign corporation, SD's securities income is nonpassive

under paragraph (a) of this section.

(iii) Securities income earned by M. (A) SD and M are financial

services entities that are the only members of a related group as

defined in paragraph (j)(4) of this section. The percentage of the

SD-M related group's financial services income that is securities

income earned by active dealers (SD), is 66.66 percent (($100/$150)

X 100). The percentage of the SD-M related group's financial

services income that is securities income, banking income (as

defined in Sec. 1.1296-4(f)), or insurance income (as defined in

section 1296(b)(2)(B)) is 100 percent (($150/$150) x 100). In

addition, the percentage of M's income that is securities income is

100 percent (($50/$50) x 100).

(B) M is a qualified securities affiliate because the gross

income tests of paragraphs (j)(2) and (3) of this section are

satisfied. Accordingly, because M is a controlled foreign

corporation, M's securities income is nonpassive for purposes of

determining whether C or D own an interest in a PFIC (whether SD or

M). M is thus not a PFIC with respect to C or D because it does not

meet the income or asset tests of section 1296(a). SD also is not a

PFIC with respect to C or D because it does not meet the income or

assets tests of section 1296(a), after applying the look-through

rule of section 1296(c).

(C) However, because B owns less than 10 percent of the stock of

SD, and is therefore not a United States shareholder with respect to

SD under section 951(b), M's interest income is passive (even though

it is securities income) for purposes of determining whether B's

indirect interest in M is an interest in a PFIC. Moreover, M's

interest income is passive for purposes of determining whether A

owns an interest in a PFIC. As a result, M meets the income and

asset tests of section 1296(a) and is therefore a PFIC with respect

to A and B.

(k) Income from nonsecurities activities. Income derived from the

conduct of activities other than securities activities described in

paragraph (e)(2) of this section and income from assets held for the

conduct of such other activities are nonpassive only to the extent

otherwise provided in section 1296.

(l) Effective date. This section is effective for taxable years

beginning after September 30, 1993.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95-10174 Filed 4-27-95; 8:45 am]

BILLING CODE 4830-01-U