Qualified Electing Fund Elections

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-209040-88]

RIN 1545-AM41

Qualified Electing Fund Elections

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations permitting certain

shareholders to make a special election under section 1295, in lieu of

the election currently provided for under that section, with respect to

certain preferred shares of a passive foreign investment company

(PFIC). A shareholder that makes a special election must account for

dividend income on the shares subject to the special election under

special income inclusion rules, rather than under the general income

inclusion rules of section 1293. This document also provides notice of

a public hearing on these proposed regulations.

DATES: Written comments must be received by March 24, 1997. Requests to

speak and outlines of oral comments to be discussed at the public

hearing scheduled for May 8, 1997, at 10:00 a.m. must be received by

April 17, 1997.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209040-88), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered between the

hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209040-88), Courier's

Desk, Internal Revenue Service, 1111 Constitution Avenue, NW.,

Washington, DC. Alternatively, taxpayers may submit comments

electronically via the Internet by selecting the ``Tax Regs'' option on

the IRS Home Page, or by submitting comments directly to the IRS

Internet site at http://www.irs.ustreas.gov/prod/tax__regs/

comments.html. The public hearing will be held in room 3313, Internal

Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Judith

Cavell Cohen, (202) 622-3880; concerning submissions and the hearing,

Evangelista Lee, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. 3507(d)). Comments on the collection of information should be

sent to the Office of Management and Budget, Attn: Desk Officer for the

Department of the Treasury, Office of

[[Page 67753]]

Information and Regulatory Affairs, Washington, DC 20503, with copies

to the Internal Revenue Service, Attn: IRS Reports Clearance Officer,

T:FP, Washington, DC 20224. Comments on the collection of information

should be received by February 24, 1997. Comments are specifically

requested concerning:

Whether the proposed collection of information is necessary for the

proper performance of the functions of the Internal Revenue Service,

including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed

collection of information (see below);

How the quality, utility, and clarity of the information to be

collected may be enhanced;

How the burden of complying with the proposed collection of

information may be minimized, including through the application of

automated collection techniques or other forms of information

technology; and

Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of services to provide information.

The collection of information in this proposed regulation is in

proposed regulation Sec. 1.1295-2(c)(3) and proposed regulation

Sec. 1.1295-2(e) and (f). This information will notify the Commissioner

that certain shareholders have made the special election. In addition,

this information will enable the IRS to determine if a shareholder

qualifies for the special election and is satisfying the income

inclusion requirements of proposed regulation Sec. 1.1293-2. The

collection of information is mandatory. The likely respondents are

individuals, businesses, and other for-profit organizations.

Estimated total annual reporting/recordkeeping burden: 600 hours.

The estimated annual burden per respondent varies from 21 minutes to

8.3 hours, depending on individual circumstances, with an estimated

average of 35 minutes.

Estimated number of respondents: 1030.

Estimated annual frequency of responses: On occasion.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number assigned by the Office of

Management and Budget.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

This document contains proposed Income Tax Regulations (26 CFR part

1) under sections 1293 and 1295 of the Internal Revenue Code. Sections

1293 and 1295 were added by the Tax Reform Act of 1986 (the Act) and

were amended by the Technical and Miscellaneous Revenue Act of 1988

(TAMRA). The sections, as amended, were effective for taxable years of

foreign corporations beginning after December 31, 1986. Section 1293

also was amended by the Omnibus Reconciliation Act of 1993 (OBRA).

Guidance for making the section 1295 election was provided in proposed

regulation Sec. 1.1295-1 and Notice 88-125, 1988-2 C.B. 535. Guidance

regarding the annual income inclusion rule for shareholders making a

section 1295 election was provided in proposed regulation Sec. 1.1293-

1.

Explanation of Provisions

Special Preferred Section 1295 Election

1. Introduction

The passive foreign investment company (PFIC) rules of the Code are

designed to eliminate potential tax deferral opportunities associated

with equity investments by United States persons in foreign

corporations that have substantial levels of passive income or assets.

The PFIC rules eliminate tax deferral opportunities by applying the

section 1291 interest charge regime to PFIC shareholders that fail to

make a section 1295 annual income inclusion election (section 1295

election). In general, the section 1291 interest charge regime applies

to the ``extraordinary'' portion of any distribution received by the

shareholder, and any gain recognized on a disposition of shares.

The PFIC rules apply to investments in both common and preferred

shares of a PFIC. Preferred shares, unlike common shares, generally

provide for limited dividend and liquidation or redemption rights, and

thus do not participate significantly in corporate growth. Accordingly,

preferred shares of a PFIC generally do not afford U.S. investors with

the same potential for U.S. tax deferral as common shares of a PFIC.

Preferred shareholders, like common shareholders, may make the

section 1295 election to avoid the interest charge regime of section

1291. Shareholders that make the section 1295 election are required

under section 1293 to include in income annually, as ordinary income,

their pro rata share of the PFIC's ordinary earnings and, as long-term

capital gain, their pro rata share of the PFIC's net capital gain for

the year. In order to determine their pro rata share of ordinary

earnings and net capital gain, shareholders that have made a section

1295 election must obtain certain U.S. tax accounting information from

the PFIC regarding the PFIC's earnings. If this information is not

available, the shareholders cannot make the section 1295 election. If

the requisite information is available, the annual information

reporting and collection requirements associated with the section 1295

election may render the election impractical for smaller investors.

Because preferred shares often do not afford investors with significant

tax-deferral opportunity, commenters have suggested that the current

section 1295 election regime should be simplified for certain types of

preferred shares.

The proposed regulations adopt a special section 1295 election

regime that would require holders of certain preferred shares of a PFIC

that elect to be subject to the regime to accrue annually ordinary

dividend income with respect to the preferred shares regardless of the

holder's pro rata share of ordinary earnings or net capital gain of the

PFIC for the year. Because shareholders would accrue income regardless

of the earnings and net capital gain of the PFIC, shareholders that

elect to be subject to the regime would not have to report and collect

any U.S. tax accounting information regarding the PFIC in order to make

the special section 1295 election.

The proposed regulations are issued under two sections of the Code.

Section 1.1295-2 of the proposed regulations provides rules for making

a QEF election under the special proposed section 1295 election regime

(special preferred QEF election). Section 1.1293-2 describes the annual

income inclusion rules for shareholders that have made the special

preferred QEF election.

The proposed regulations would apply only with respect to

qualifying preferred shares issued after the date the proposed

regulations are finalized.

2. Rules for Making the Special Preferred QEF Election

Under proposed regulation Sec. 1.1295-2(a), the special preferred

QEF election may be made in lieu of the section 1295 election described

in proposed regulation Sec. 1.1295-1 and Notice 88-125, 1988-2 C.B. 535

(regular section 1295 election), with respect to certain types of

preferred shares (qualified

[[Page 67754]]

preferred shares) by certain holders satisfying prescribed ownership

requirements.

The special preferred QEF election may only be made with respect to

qualified preferred shares as defined in proposed regulation

Sec. 1.1295-2(b). To ensure that the special preferred QEF election

cannot be used for tax avoidance purposes and to reduce complexity, the

proposed regulations define qualified preferred shares narrowly to

include only a limited class of preferred shares likely to be marketed

to U.S. retail investors. Although the definition of qualified

preferred shares includes both cumulative and non-cumulative preferred

shares, the definition excludes various types of preferred shares,

including preferred shares denominated in a foreign currency and

preferred shares issued at a significant discount to their liquidation

or redemption amounts. The PFIC issuing the preferred shares must

represent that it intends to pay dividends currently. Proposed

regulation Sec. 1.1295-2(b) provides additional restrictions with

respect to preferred shares acquired in secondary market transactions.

Proposed regulation Sec. 1.1295-2(c) describes shareholders who may

make the election. Under proposed regulation Sec. 1.1295-2(c)(1), any

United States person that acquires qualified preferred shares for cash

or in certain nonrecognition transactions and that holds such shares

directly may make the election. United States persons that are pass-

through entities, including partnerships, S corporations, trusts and

estates, may qualify as shareholders.

The special preferred QEF election regime is narrowly targeted to

eliminate certain of the information reporting and collection

requirements associated with the existing section 1295 election and

annual inclusion rules for U.S. retail investors in preferred shares of

PFICs. Treasury and the Service believe that the special preferred QEF

election regime should only apply with respect to foreign corporations

that are not expected to be in a position to provide U.S. tax

accounting information to shareholders. Accordingly, proposed

regulation Sec. 1.1295-2(c)(2) provides that the special preferred QEF

election does not apply to holders of preferred shares in a PFIC that

is a controlled foreign corporation. Further, proposed regulation

Sec. 1.1295-2(c)(3) provides that the special preferred QEF election

does not apply to holders that own 5 percent or more of the vote or

value of any class of shares of the PFIC. Holders of five percent or

more of the vote or value of any class of shares generally are not the

type of retail investor that the proposed regulations are designed to

assist. Such holders may only make the section 1295 election provided

under current rules.

Proposed regulation Sec. 1.1295-2(c)(3) requires the corporation to

provide to electing shareholders a statement, directly or in a

disclosure document generally available to all U.S. shareholders,

either that it is or that it reasonably believes that it is a PFIC and

that it is not a controlled foreign corporation. Shareholders that fail

to receive such a statement are not permitted to make a special

preferred QEF election.

Proposed regulation Sec. 1.1295-2(d) describes the effect of the

special preferred QEF election. Proposed regulation Sec. 1.1295-2(d)(1)

provides that shares subject to a special preferred QEF election will

be treated as shares of a pedigreed QEF (as defined in proposed

regulation Sec. 1.1291-1(b)(2)(ii)) for all taxable years of the

foreign corporation that are included wholly or partly in the

shareholder's holding period of the shares. Under the proposed

regulations, the election will apply to all qualified preferred shares

of a foreign corporation owned directly by the shareholder that are

acquired in the taxable year with respect to which the election is

made. Although a special preferred QEF election will not apply

automatically to qualified preferred shares acquired in subsequent

taxable years of a shareholder, the proposed regulations permit the

shareholder to make separate special preferred QEF elections with

respect to qualified preferred shares acquired in later years.

Proposed regulation Sec. 1.1295-2(d)(2) provides that the special

preferred QEF election regime applies whether or not the foreign

corporation is a PFIC in any year subsequent to the year of the

election. Accordingly, shareholders that make the special preferred QEF

election must make annual Sec. 1.1293-2 income inclusions, as provided

in proposed regulation Sec. 1.1295-2(d)(3), even if the foreign

corporation does not qualify as a PFIC for a particular year.

Proposed regulation Sec. 1.1295-2(e) specifies the time and manner

of making the special preferred QEF election. In order to make the

special preferred QEF election, a shareholder files Form 8621 (Return

by a Shareholder of a Passive Foreign Investment Company or Qualified

Electing Fund), for the taxable year of the election, checking the

appropriate box in Form 8621, Part I, for making the section 1295

election, and indicating in the margin of Part I that the shareholder

is making a special preferred QEF election with respect to certain

specified shares. In addition, the shareholder must attach to Form 8621

a brief statement containing the information and representations

contained in proposed regulation Sec. 1.1295-2(e)(2)(ii). Under

proposed regulation Sec. 1.1295-2(f), in subsequent years, the

shareholder must file Form 8621 with respect to the foreign corporation

but need not attach any statement to the form. For all taxable years

covered by the election, the shareholder must report on Line 6a of Part

II of Form 8621 the amount includible under proposed regulation

Sec. 1.1293-2 with respect to qualified preferred shares subject to a

special preferred QEF election.

Proposed regulation Sec. 1.1293-2(g) states that a sale, exchange

or other disposition of shares subject to a special preferred QEF

election terminates the election with respect to those shares. Also,

the Commissioner may terminate or invalidate an election if a

shareholder fails to satisfy the initial or ongoing requirements of the

election. For example, the Commissioner may terminate or invalidate a

special preferred QEF election if the shareholder owns five percent or

more of the vote or value of any class of shares of the PFIC at any

time during the period that the shareholder owns qualified preferred

shares subject to the election. A shareholder may not itself terminate

a special preferred QEF election.

3. Annual Inclusion Rules for Electing Shareholders.

Under proposed regulation Sec. 1.1293-2(a), a shareholder that has

made a special preferred QEF election must make annual income

inclusions with respect to qualified preferred shares subject to the

election. Unlike the annual income inclusions provided under section

1293 and proposed regulation Sec. 1.1293-1, the annual inclusions under

the special preferred QEF election regime are determined without regard

to the shareholder's pro rata share of the foreign corporation's

ordinary earnings or net capital gains.

Proposed regulation Sec. 1.1293-2(b) provides rules for determining

the amount that a shareholder must include in income annually under the

special preferred QEF election regime. Under the proposed regulations,

this annual amount consists of two components. The first component is

an annual inclusion amount based on a ratable daily portion of dividend

income that accrues on the qualified preferred shares (annual dividend

amount). This ratable inclusion rule for the annual dividend amount is

analogous to the rule for inclusion of income with respect to

[[Page 67755]]

periodic payments on notional principal contracts under Sec. 1.446-3.

The second component of the preferred QEF amount arises only in respect

of fixed term preferred shares, as described proposed regulation

Sec. 1.1295-2(b)(vii), acquired in a secondary market transaction, and

is calculated based on the ratable inclusion of the excess, if any, of

the redemption price of the shares over the acquisition cost of the

shares (preferred discount amount). This ratable inclusion rule for the

preferred discount amount is analogous to the rule for the ratable

inclusion of market discount on certain debt under section 1276(b)(1).

The Service and Treasury solicit comments regarding the income

inclusion rules of the proposed regulations, including comments as to

whether foreign corporations and their agents could effectively assist

holders in complying with the income inclusion rules applicable to

preferred discount.

Proposed regulation Sec. 1.1293-2(c) provides certain special rules

regarding the annual income inclusion required under proposed

regulation Sec. 1.1293-2(a). Under Sec. 1.1293-2(c)(1), annual amounts

are included in income by shareholders irrespective of the PFIC's

earnings and profits. In this regard, the special preferred QEF

election differs from the regular section 1295 election in that

shareholders making the special preferred QEF election must accrue the

annual amount as ordinary income even if the amount exceeds the

shareholder's pro rata share of the foreign corporation's earnings and

profits. Proposed regulation Sec. 1.1293-2(c)(3) requires the

shareholder to include the annual dividend amount as ordinary income

regardless of whether any portion of the PFIC's earnings for the year

represents net capital gain. Proposed regulation Sec. 1.1293-2(c)(4)

provides rules for the tax-free distribution of previously taxed

amounts. Proposed regulation Sec. 1.1293-2(c)(5) provides certain basis

adjustment rules similar to the basis adjustment rule of section

1293(d). Finally, proposed regulation Sec. 1.1293-2(c)(6) provides

rules intended to limit the effect of a special preferred QEF election

to the shareholder making the election. Accordingly, a special

preferred QEF election will not affect the foreign corporation's

calculation of its earnings and profits, and will have no consequences

for shareholders that have not made a special preferred QEF election.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in Executive Order

12866. Therefore, a regulatory assessment is not required. It is hereby

certified that these regulations do not have a significant economic

impact on a substantial number of small entities. This certification is

based on the fact that these regulations represent a wholly elective

simpler alternative to the section 1295 election described in

Sec. 1.1295-1 and Notice 88-125, 1988-2 C.B. 535, and impose a lighter

collection of information burden. Further, the requirement that

electing shareholders indicate their special election on Form 8621

annually and attach a statement, providing certain information in the

first year of the election only, is minimal and will not impose a

significant economic impact on electing shareholders. Therefore, a

Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5

U.S.C. chapter 6) 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 May 8, 1997, at 10:00 a.m.

in room 3313, Internal Revenue Building, 1111 Constitution Avenue, NW.,

Washington DC. 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 by March 24, 1997, and submit an outline of the

topics to be discussed and the time to be devoted to each topic (signed

original and eight (8) copies) by April 17, 1997.

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

comments.

An agenda showing the schedule of 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 Judith Cavell Cohen of

the Office of 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 adding

an entry in numerical order to read as follows:

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

Section 1.1293-2 also issued under 26 U.S.C. 1297(f).

Section 1.1295-2 also issued under 26 U.S.C. 1297(f). * * *

Par. 2. Section 1.1293-2 is added to read as follows:

Sec. 1.1293-2 Special Inclusion Rules for Special Preferred QEF

Election.

(a) In general. A shareholder (including a shareholder that is a

pass-through entity, as described in Sec. 1.1295-2(c)(1)) that makes a

special preferred QEF election under Sec. 1.1295-2 must, regardless of

the shareholder's method of accounting, include in income in respect of

each share subject to the election, an annual amount (preferred QEF

amount) determined according to the rules of paragraph (b) of this

section. A shareholder that makes a special preferred QEF election must

include the preferred QEF amount in income under this section for each

year in which the taxpayer continues to hold a share that is subject to

the election. The rules of this section apply in lieu of the general

rules of section 1293 and Sec. 1.1293-1.\1\

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\1\ This proposed regulation was published on April 1, 1992, at

57 FR 11024.

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(b) Preferred QEF amount--(1) In general. The preferred QEF amount

for any share subject to a special preferred QEF election is the sum of

the ratable daily portion of each periodic dividend amount (as

described in paragraph (b)(2) of this section) on the share for the

taxable year of the shareholder to which that portion relates, plus the

preferred discount amount (as defined below), if any, for the taxable

year. For purposes of this section, the preferred discount amount for a

taxable year is the amount that bears the same ratio to the total

amount of preferred discount (as described in Sec. 1.1295-2(b)(2)(i))

on the share as the number of days that the taxpayer held the share in

the taxable

[[Page 67756]]

year bears to the number of days after the date the taxpayer acquired

the share and up to (and including) the share's redemption date as

established under the principles of Sec. 1.305-5(b). Notwithstanding

the preceding sentence, the preferred discount amount for a taxable

year is zero if the preferred discount on the share at the time of its

acquisition by the shareholder was less than an amount equal to \1/4\

of 1 percent of the redemption price of the stock, multiplied by the

number of complete years from the date of acquisition of the stock to

the redemption date of the stock.

(2) Periodic dividend amount. A periodic dividend amount is the

amount payable with respect to a share, whether on a cumulative or

noncumulative basis, for a period (wholly or partly within the

shareholder's taxable year) for which dividends on the share are

calculated based upon the redemption or liquidation price of the share

multiplied by a fixed percentage rate.

(c) Special rules of application--(1) Earnings and profits

disregarded. The amounts to be included in income pursuant to this

section are determined without regard to the earnings and profits of

the foreign corporation with respect to which the special preferred QEF

election applies.

(2) Year of inclusion. The shareholder includes the preferred QEF

amount in its taxable year without regard to the taxable year of the

foreign corporation with respect to which the special preferred QEF

election applies.

(3) Character of inclusions. The shareholder includes all preferred

QEF amounts in income as ordinary earnings.

(4) Treatment of distributions. Distributions received by a

shareholder on shares subject to a special preferred QEF election that

are paid out of earnings and profits of the foreign corporation are not

included in gross income of the shareholder to the extent the

distributions do not exceed the preferred QEF amounts (other than any

portion of preferred QEF amounts consisting of preferred discount

amounts) previously includible in income pursuant to this section.

These distributions will, however, be treated as dividends for all

other purposes of the Code and regulations. Amounts distributed to a

shareholder with respect to shares subject to a special preferred QEF

election that exceed amounts previously included in income under this

section with respect to such shares are treated for all purposes of the

Code and regulations as a distribution of property subject to the rules

of section 301.

(5) Basis adjustment rules. The adjusted basis of a shareholder in

shares that are subject to a special preferred QEF election shall be--

(i) Increased by any amount that is included in the gross income of

the shareholder under paragraph (a) of this section; and

(ii) Decreased by any dividends (not to exceed the amount included

in gross income under paragraph (a) of this section) actually paid to

the shareholder in respect of such shares.

(6) Effect limited to electing shareholder. This section does not

apply to the foreign corporation with respect to which a special

preferred QEF election applies. Accordingly, the provisions of this

section will not affect the foreign corporation's calculation of its

earnings and profits for any purpose of the Code or regulations. In

addition, the rules of this section apply only for purposes of

determining the tax consequences for holders of shares subject to the

election. Thus, the election shall have no effect on the application of

the Code or regulations with respect to the tax consequences of the

ownership of shares that are not subject to the election, including for

purposes of determining whether any distributions from the foreign

corporation with respect to such shares should be treated as having

been included in the income of any United States person pursuant to

section 1293(c) or section 959.

(d) Examples. The following examples illustrate the rules of

paragraphs (a), (b) and (c) of this section. Although these examples

assume a 30-day month, 360-day year, any reasonable counting method may

be used to compute the length of accrual periods. For purposes of

simplicity, the relevant amounts as stated are rounded to two decimal

places. However, the computations do not reflect any such rounding

convention. The examples are as follows:

Example 1. Preferred QEF amount--(i) Facts. (A) On May 1, 1998,

A, an individual who files his returns on a calendar year basis,

purchased for $10,000 in a single secondary market transaction 100

shares of nonconvertible Class A $100 par value preferred stock (the

Class A Stock) of FC, a foreign corporation with a taxable year

ending on March 31.

(B) The terms of the Class A Stock provide for a mandatory

redemption of the Class A Stock by the issuer at par on June 1,

2012. The Class A Stock is not redeemable pursuant to an issuer call

or holder put on any other date. Each share of Class A Stock

provides for a semi-annual cumulative distribution payable in

dollars on June 1 and December 1 equal to one-half the product of

the par value of the Class A Stock and the applicable annual dollar

LIBOR in effect on the distribution date immediately prior to the

relevant distribution date. The shares of the Class A stock are

qualified preferred shares in the hands of A. A purchases no other

qualified preferred shares of FC during its 1998 or 1999 taxable

years.

(C) A made a special preferred QEF election for A's taxable year

ended December 31, 1998, which applies to the Class A Stock acquired

by A on May 1, 1998. FC is a PFIC under section 1296 for its taxable

year ending March 31, 1999, but FC is not a PFIC for its taxable

year ending March 31, 2000. FC paid no current dividends on June 1,

1998, and December 1, 1998, paid the June 1, 1999, dividend

currently on June 1, 1999, together with accumulated distributions

from June 1, 1998, and December 1, 1998, and paid the December 1,

1999, dividend currently on December 1, 1999. The applicable annual

LIBOR is 8 percent on December 1, 1997, 7 percent on June 1, 1998, 9

percent on December 1, 1998, 10 percent on June 1, 1999, and 9

percent on December 1, 1999. FC had sufficient earnings and profits,

within the meaning of section 312, for its taxable year ending on

March 31, 2000, so that actual distributions to all shareholders of

Class A Stock in that year were treated as paid out of earnings and

profits of FC.

(ii) Tax consequences to A for A's taxable year ending December

31, 1998. As required under paragraph (a) of this section, A must

include in gross income for its 1998 taxable year the 1998 preferred

QEF amount. The preferred QEF amount, as determined under paragraph

(b) of this section, for A's 1998 taxable year is the ratable

portion of each periodic dividend amount for that year. For 1998,

there are three periodic dividend amounts: The periodic dividend

amount for the period from December 1, 1997, to June 1, 1998

(periodic dividend amount 1), the periodic dividend amount for the

period from June 1, 1998, to December 1, 1998 (periodic dividend

amount 2), and the periodic dividend amount for the period from

December 1, 1998, to June 1, 1999 (periodic dividend amount 3).

Periodic dividend amount 1 in respect of each share owned by A is $4

(1/2 multiplied by the applicable annual LIBOR of 8 percent set on

December 1, 1997, multiplied by the $100 amount payable on

redemption). Because A acquired the shares on May 1, 1998, A's

ratable portion of periodic dividend amount 1 for 1998 is

approximately $.67 (30/180 multiplied by $4) per share. Periodic

dividend amount 2 in respect of each share owned by A is $3.50 (1/2

multiplied by the applicable annual LIBOR of 7 percent set on June

1, 1998, multiplied by $100). Because A owned the shares for the

entire period associated with periodic dividend amount 2, A's

ratable portion of periodic dividend amount 2 for 1998 is the full

$3.50 per share. Periodic dividend amount 3 in respect of each share

owned by A is $4.50 (1/2 multiplied by the applicable annual LIBOR

of 9 percent set on December 1, 1998, multiplied by $100). Because

the portion of 1998 associated with periodic dividend amount 3 is

only the month of December, 1998, A's ratable portion of periodic

dividend amount 3 for 1998 is approximately

[[Page 67757]]

$.75 (30/180 multiplied by $4.50). Accordingly, A s preferred QEF

amount for 1998 is approximately $4.92 ($.67 + $3.5 + $.75) per

share. A must include approximately $492 (approximately $4.92 per

share, multiplied by 100 shares) in income as ordinary earnings for

its 1998 tax year even though FC paid no actual dividend to

shareholders of Class A Stock for the period in 1998 during which A

held the Class A Stock.

(iii) Tax consequences to A for A's taxable year ending December

31, 1999. As required under paragraph (a) of this section, A

includes in gross income for its 1999 taxable year its preferred QEF

amount for 1999. The preferred QEF amount, as determined under

paragraph (b) of this section, for A's 1999 taxable year is the

ratable portion of each periodic dividend amount for that year. For

1999, there are three periodic dividend amounts: The periodic

dividend amount for the period from December 1, 1998, to June 1,

1999 (periodic dividend amount 1), the periodic dividend amount for

the period from June 1, 1999, to December 1, 1999 (periodic dividend

amount 2), and the periodic dividend amount for the period from

December 1, 1999, to June 1, 2000 (periodic dividend amount 3).

Periodic dividend amount 1 in respect of each share owned by A is

$4.50 (1/2 multiplied by the applicable annual LIBOR of 9 percent

set on December 1, 1998, multiplied by $100). Because A held each

share of Class A Stock for five months in 1999 for the period

associated with periodic dividend amount 1, A's ratable portion of

periodic dividend amount 1 for 1999 is approximately $3.75 (150/180

multiplied by $4.50). Periodic dividend amount 2 in respect of each

share owned by A is $5 (1/2 multiplied by the applicable annual

LIBOR of 10 percent set on June 1, 1999, multiplied by $100).

Because A owned the share for the entire period associated with

periodic dividend amount 2, A's ratable portion of periodic dividend

amount 2 for 1999 is the full $5. Periodic dividend amount 3 in

respect of each share owned by A is $4.50 (1/2 multiplied by the

applicable annual LIBOR of 9 percent set on December 1, 1999,

multiplied by $100). Because A held each share of Class A Stock for

one month in 1999 for the period associated with periodic dividend

amount 3, A's ratable portion of periodic dividend amount 3 for 1999

is approximately $.75 (30/180 multiplied by $4.50). Accordingly, A's

preferred QEF amount for 1998 is approximately $9.50 ($3.75 + $5 +

$.75). A must include approximately $950 ($9.50 per share,

multiplied by 100 shares) in income as ordinary income for its 1999

taxable year even though FC was not a PFIC for FC's taxable year

ending in 2000. The current distributions and arrearages actually

paid to A with respect to the Class A Stock are not includible in

income by A under paragraph (c)(4) of this section because they

constitute amounts previously included in income.

Example 2. Preferred Discount--(i) Facts. The facts are the same

as in Example 1 except that A acquired the 100 shares of Class A

Stock for $9000.

(ii) Tax Consequences to A for A s taxable year ending December

31, 1998. (A) Because the Class A Stock is fixed term preferred

stock (as described in Sec. 1.1295-2(b)(1)(vii)) and A acquired each

share of the Class A stock with $10 of preferred discount, as

described in Sec. 1.1295-2(b)(2), A's preferred QEF amount to be

included by A for the taxable year consists of the sum of the

ratable daily portion of each periodic dividend amount, as

calculated in paragraph (d)(ii) of Example 1 of this section, plus

the preferred discount amount described in paragraph (b)(1) of this

section.

(B) The preferred discount amount with respect to each share is

approximately $.47 ($10 multiplied by 240 days/5070 days to

maturity). A must include approximately $47 ($.47 per share,

multiplied by 100 shares), together with the amount calculated in

paragraph (d)(ii) of Example 1 of this section, in income as

ordinary earnings for its 1998 tax year even though FC paid no

actual dividend to shareholders of Class A Shares for the period in

1998 during which A held the Class A Stock.

(iii) Tax consequences to A for A's taxable year ending December

31, 1999. The portion of the preferred discount on each share

includible under paragraph (a) of this section is approximately $.71

($10 multiplied by 360 days/5070 days to maturity). A must include

this amount, together with the amount calculated in paragraph

(d)(iii) of Example 1 of this section, in income as ordinary

earnings for its 1999 tax year even though FC was not a PFIC for

FC's taxable year ending in 2000. The current distributions and

arrearages actually paid to A in 1999 with respect to the Class A

Stock are not includible in income by A under paragraph (c)(4) of

this section, because they constitute amounts previously included in

income.

(e) Effective date. The rules under this section apply with respect

to qualified preferred stock subject to a special preferred QEF

election made after the date that is 30 days after the date of

publication of this document as a final regulation.

Par. 3. Section 1.1295-2 is added to read as follows:

Sec. 1.1295-2 Special Preferred QEF Election.

(a) In general. This section provides rules permitting certain

shareholders to make a special election under section 1295 (special

preferred QEF election) in lieu of the election described in

Sec. 1.1295-1 \2\ and Notice 88-125, 1988-2 C.B. 535 (see

Sec. 601.601(d)(2)(ii)(b) of this chapter), with respect to certain

preferred shares (qualified preferred shares) of a foreign corporation

that certifies either that it is a PFIC (as defined in Sec. 1.1291-

1(b)(1)(i)) \3\ or that it reasonably believes that it is a PFIC. In

order to make a special preferred QEF election, a shareholder must

satisfy the stock ownership requirement of paragraph (c)(2) of this

section. A special preferred QEF election of a shareholder applies only

to those qualified preferred shares acquired and held directly by the

shareholder in the taxable year of the shareholder for which the

election is made. A shareholder making a special preferred QEF election

must account for dividend income on shares subject to the election

under the special income inclusion rules described in Sec. 1.1293-2,

rather than under the general income inclusion rules of section 1293

and Sec. 1.1293-1. In addition, for purposes of determining the tax

consequences of owning shares subject to the special preferred QEF

election, an electing shareholder must treat the foreign corporation as

a PFIC for the entire period during which the shareholder continues to

hold any of such shares. Paragraph (b) of this section defines

qualified preferred share. Paragraph (c) of this section provides rules

for determining who may make the special preferred QEF election.

Paragraph (d) of this section provides rules concerning the effect of

the election. Paragraph (e) of this section provides rules for the time

and manner of making the election. Paragraph (f) of this section sets

forth the annual reporting requirement for the election. Paragraph (g)

of this section provides rules concerning the possible termination or

invalidation of the election. For the applicability date of this

section, see paragraph (h) of this section.

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\2\ This proposed regulation was published on April 1, 1992, at

57 FR 11024.

\3\ This proposed regulation was published on April 1, 1992, at

57 FR 11024.

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(b) Qualified preferred share defined--(1) In general. For purposes

of this section, a share of a foreign corporation is a qualified

preferred share only if--

(i) The share was originally issued for cash or in exchange for

qualified preferred shares of the foreign corporation in a transaction

to which section 354(a)(1) applied;

(ii) If the share were to constitute a debt obligation, the share

would be in registered form within the meaning of Sec. 5f.103-1(c) of

this chapter;

(iii) All amounts payable with respect to the share are denominated

in U.S. dollars and are not determined by reference to the value of a

currency other than the U.S. dollar;

(iv) The share is limited and preferred as to dividends and does

not participate in corporate growth to any significant extent within

the meaning of section 1504(a)(4)(B);

(v) The share has a fixed redemption or liquidation price;

(vi) The share provides for cumulative or noncumulative dividend

rights that are limited to an annual (or shorter period) amount

computed by

[[Page 67758]]

multiplying either the redemption or liquidation price of the share by

a specified index described in Sec. 1.446-3(c)(2)(i), (iii), or (iv)

(specified index), or by a specified index periodically re-established

pursuant to an auction reset mechanism, set in advance of the period

with respect to which the specified index applies;

(vii) If the share may be redeemed under circumstances described in

Sec. 1.305-5(b) such that redemption premium (as described in

Sec. 1.305-5(b)) could be treated under section 305(c) as a

constructive distribution (fixed term preferred stock), the share was

not issued with redemption premium exceeding the de minimis amount

described in section 305(c)(1) and Sec. 1.305-5(b)(1);

(viii) If the share may not be redeemed under circumstances

described in Sec. 1.305-5(b) such that redemption premium would not be

treated under section 305 as a constructive distribution (perpetual

preferred stock), the share does not provide shareholders with the

right to receive an amount upon liquidation or redemption that exceeds

the issue price of the share (as determined under the principles of

section 1273(b)) by an amount in excess of 5 percent of such

liquidation or redemption amount;

(ix) If redeemable, the share is redeemable only in whole and not

in part and is not subject to mandatory redemption within five years of

the issue date of the share. Further, the share is not subject to a

holder put or issuer call that, based on all the facts and

circumstances as of the issue date of the share, is more likely than

not to be exercised at a time within five years of the issue date;

(x) If convertible, the share is not convertible into a share other

than a share meeting all the conditions set forth in paragraphs

(b)(1)(i) through (b)(1)(ix) of this section; and

(xi) The issuer of the share has indicated in an offering document

relating to the original issuance of the share or in a written

statement available to U.S. holders that the issuer has no current

intention or belief that it will not pay dividends on the share on a

current basis and that the share meets the conditions set forth in

paragraphs (b)(1)(i) through (b)(1)(x) of this section and this

paragraph (b)(1)(xi).

(2) Special rules for shares acquired in secondary market

transactions--(i) Fixed term preferred stock. A share of fixed term

preferred stock (as described in paragraph (b)(1)(vii) of this section)

that satisfies the conditions set forth in paragraph (b)(1) of this

section and that is acquired in a transaction other than in connection

with the initial issuance of the share (a secondary market

transaction), shall constitute a qualified preferred share with respect

to a shareholder, but only if the shareholder acquires the share for

cash and the share has preferred discount (as defined below) that is

less than or equal to an amount equal to 1 percent of the redemption

price, multiplied by the number of complete years from the date of

acquisition of the share to the redemption date as established under

the principles of Sec. 1.305-5(b). Sales of shares to bond houses,

brokers, or similar persons or organizations acting in the capacity as

underwriters, placement agents, or wholesalers are ignored for purposes

of determining whether a share is acquired in connection with the

initial issuance of the share. For purposes of this section, the

preferred discount for a share is the excess of the redemption price of

the share payable on the redemption date over the shareholder's

acquisition cost for the share.

(ii) Perpetual preferred stock. A share of perpetual preferred

stock, within the meaning of paragraph (b)(1)(viii) of this section,

that satisfies the conditions set forth in paragraph (b)(1) of this

section and that is acquired in a secondary market transaction, shall

constitute a qualified preferred share with respect to the shareholder,

but only if the shareholder acquires the share for cash and the amount

payable upon liquidation of the share exceeds the shareholder's

acquisition cost for the share by an amount less than or equal to 10

percent of such liquidation amount.

(iii) Examples. The following examples illustrate the rules of this

paragraph (b)(2).

Example 1--(i) Facts. On May 1, 1998, A, an individual who files

her return on a calendar year basis, purchases for $9000 cash in a

single secondary market transaction (as defined in paragraph

(b)(2)(i) of this section) 100 shares of nonconvertible Class A $100

par value preferred stock (Class A Stock) of FC, a foreign

corporation with a taxable year ending March 31. The terms of the

Class A Stock satisfy all the conditions described in paragraph

(b)(1) of this section and provide for a mandatory redemption of the

Class A Stock by the issuer in U.S. dollars at par on June 1, 2012.

The Class A Stock is not redeemable pursuant to an issuer call or

holder put on any other date.

(ii) Analysis. In order for A to make a special preferred QEF

election with respect to the Class A Stock acquired by A, the Class

A Stock acquired must constitute qualified preferred shares.

Although the Class A Stock meets the requirements for qualified

preferred shares set forth in paragraph (b)(1) of this section, the

stock also must satisfy the requirements described in paragraph

(b)(2) because A acquired the stock in a secondary market

transaction. Because the terms of the Class A Stock provide that the

stock will be redeemed by the issuer on June 1, 2012, the stock

constitutes fixed term preferred stock within the meaning of

paragraph (b)(1)(vii) of this section. A purchased the Class A Stock

for $90 per share, representing a $10 discount ($100 June 1, 2012,

per share redemption price less $90 acquisition cost). Because this

$10 discount, which constitutes preferred discount within the

meaning of paragraph (b)(2)(i) of this section, is less than $14 (1

percent of the redemption price multiplied by 14 (the number of

complete years until the mandatory redemption date)), the Class A

Stock acquired by A satisfies the conditions of paragraph (b)(2)(i)

of this section and therefore constitutes qualified preferred

shares.

Example 2--(i) Facts. The facts are the same as in Example 1,

except that A acquires the 100 shares of Class A Stock for $8000.

(ii) Analysis. In this case, A purchased the Class A Stock for

$80 per share, representing a $20 discount ($100 June 1, 2012,

redemption price less $80 acquisition cost). Because this $20 of

preferred discount is greater than $14 (1 percent of the redemption

price multiplied by 14 (the number of complete years until the

mandatory redemption date)), the Class A Stock fails to satisfy the

conditions of paragraph (b)(2)(i) of this section and therefore

fails to qualify as qualified preferred shares.

(c) Who may make the election--(1) In general. A U.S. person that

acquires qualified preferred shares for cash or in a nonrecognition

transaction described in Sec. 1.1291-6(a) \4\ (nonrecognition

transaction) and that holds such shares directly may make a special

preferred QEF election, provided that, in the case of shares acquired

in a nonrecognition transaction, either the qualified preferred shares

are treated as stock of a pedigreed QEF, as defined in Sec. 1.1291-

1(b)(2)(ii), immediately prior to the nonrecognition transaction, or

the gain, if any, realized on the transaction would be recognized under

Sec. 1.1291- 6(b) with respect to the nonrecognition transaction. A

special preferred QEF election will not apply to any shares with

respect to which the electing shareholder is an indirect shareholder,

within the meaning of Sec. 1.1291-1(b)(8). Solely for purposes of this

section, partnerships, S corporations, trusts and estates (pass-through

entities) that directly own qualified preferred shares are treated as

shareholders that may make a special preferred QEF election. A

shareholder may not make a special preferred QEF election if at any

time the shareholder made a section 1295 election (other than a special

preferred QEF election) with respect to the foreign corporation. A

shareholder may not

[[Page 67759]]

make a special preferred QEF election unless the shareholder satisfies

the stock ownership requirements set forth in paragraph (c)(2) of this

section, and the shareholder receives from the foreign corporation the

statement described in paragraph (c)(3) of this section.

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\4\ This proposed regulation was published on April 1, 1992, at

57 FR 11024.

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(2) Ownership requirement. A holder of qualified preferred shares

of a foreign corporation may make a special preferred QEF election only

if, at all times during the taxable year of the shareholder, the

shareholder does not own, directly, indirectly, or constructively,

within the meaning of section 958, five percent or more of the vote or

value of any class of stock of the foreign corporation. The five

percent vote or value limitation must be satisfied for each taxable

year of the shareholder during which the shareholder continues to hold

shares subject to the special preferred QEF election.

(3) Statement from corporation. A shareholder may make the special

preferred QEF election only if the foreign corporation has provided a

written statement relating to the taxable year of the corporation that

ends with or within the taxable year of the shareholder for which the

election is made certifying either that the foreign corporation is, or

that it reasonably believes that it is, a PFIC, and that it is not a

controlled foreign corporation within the meaning of section 957(a) for

such taxable year of the corporation. The statement must be provided

directly to the electing shareholder or in a disclosure or other

document generally available to all U.S. holders. Electing shareholders

must retain a copy of the statement for their records.

(d) Effect of election--(1) In general. Unless terminated or

invalidated pursuant to paragraph (g) of this section, shares subject

to a special preferred QEF election will be treated as shares of a

pedigreed QEF (as defined in Sec. 1.1291-1(b)(2)(ii)) for all taxable

years of the foreign corporation that are included wholly or partly in

the shareholder's holding period of the shares. A special preferred QEF

election applies to all qualified preferred shares owned directly by

the shareholder that are acquired in the taxable year of the election.

Separate special preferred QEF elections may be made for qualified

preferred shares acquired in other taxable years of the taxpayer. A

special preferred QEF election is personal to the shareholder that made

the election and does not apply to a transferee of the shares. A

shareholder that has made a special preferred QEF election may not

make, with respect to the foreign corporation, any other election

permitted under sections 1291 through 1297 and the regulations under

those sections, including a section 1295 election as described in

Sec. 1.1295-1 and Notice 88-125, 1988-2 C.B. 535 (see

Sec. 601.601(d)(2)(ii)(b) of this chapter), for any period during which

the special preferred QEF election remains in effect with respect to

any shares of the shareholder.

(2) Continued PFIC Characterization. By making the special

preferred QEF election, the shareholder agrees to treat the foreign

corporation as a PFIC with respect to qualified preferred shares

subject to the election at all times during its holding period for such

shares, without regard to whether the foreign corporation is a PFIC for

any taxable year of the foreign corporation during which the preferred

QEF election remains in effect.

(3) Section 1293 inclusions. For each taxable year of the

shareholder to which an election under this section applies, the

shareholder must include in income the preferred QEF amount, as defined

in Sec. 1.1293-2, in the manner and under the rules provided in that

section.

(e) Time for and manner of making the special preferred QEF

election--(1) Time for making the election. A special preferred QEF

election must be made on or before the due date, as extended, for

filing the shareholder's return for the taxable year during which the

shareholder acquired the qualified preferred shares for which the

election is being made. A special preferred QEF election may not be

made for those shares at any other time pursuant to any other provision

of the Code or regulations.

(2) Manner of making the election--(i) In general. A shareholder

makes the special preferred QEF election under this section for all

qualified preferred shares of a foreign corporation acquired during the

shareholder's taxable year by checking the appropriate box in Form 8621

(Return by a Shareholder of a Passive Foreign Investment Company or

Qualified Electing Fund), Part I, for making the section 1295 election,

and indicating in the margin of Part I that the shareholder is making a

special preferred QEF election with respect to certain specified

shares. The shareholder also must report the preferred QEF amount for

the taxable year of the election on Line 6a of Part II of Form 8621. In

addition, the shareholder must attach to Form 8621 the statement

(preferred QEF statement) described in paragraph (e)(2)(ii) of this

section, signed by the shareholder under penalties of perjury, stating

that the information and representations provided in the preferred QEF

statement are true, correct, and complete to the best of the

shareholder's knowledge and belief.

(ii) Preferred QEF statement contents. The preferred QEF statement

must include the following information and representations:

(A) The first taxable year of the shareholder for which the special

preferred QEF election is made;

(B) The number of shares subject to the election, their acquisition

date(s) and acquisition price(s), and the class designation(s) of the

shares;

(C) A representation by the shareholder that it did not at any time

during its taxable year own directly, indirectly, or constructively,

within the meaning of section 958, five percent or more of the vote or

value of any class of stock of the foreign corporation with respect to

which the election applies;

(D) A representation by the shareholder that it has obtained the

written statement described in paragraph (c)(3) of this section; and

(E) A representation by the shareholder that it has never made a

section 1295 election other than a special preferred QEF election with

respect to the foreign corporation.

(f) Annual reporting requirement. For each taxable year of a

shareholder during which the shareholder holds shares of a foreign

corporation subject to one or more special preferred QEF elections, the

shareholder must file Form 8621 with respect to the foreign corporation

regardless of whether the foreign corporation is or is not a PFIC under

section 1296 during any portion of the taxable year. The shareholder

must indicate in the margin of Part I of Form 8621 the number of

special preferred QEF elections of the shareholder that remain in

effect with respect to the foreign corporation. In addition, the

shareholder must report, on Line 6a of Part II of Form 8621, the

aggregate of the preferred QEF amounts for all relevant special

preferred QEF elections in effect for the taxable year.

(g) Termination or invalidation of election--(1) In general. A

sale, exchange or other disposition of a share that is subject to a

special preferred QEF election will terminate the special preferred QEF

election with respect to that share. In addition, the Commissioner may,

in the Commissioner's discretion, terminate or invalidate a special

preferred QEF election if a shareholder that made the election fails to

satisfy the initial or ongoing requirements of the election. Once made,

a special preferred QEF election may not be terminated or invalidated

by the shareholder.

[[Page 67760]]

(2) Effect of termination or invalidation. Termination of a special

preferred QEF election by the Commissioner will be effective on the

first day of the shareholder's first taxable year following the last

taxable year of the shareholder for which the requirements of the

election are satisfied. For purposes of sections 1291 through 1297 and

the regulations thereunder, the holding period of qualified preferred

shares subject to an election that has been terminated will be treated

as beginning on the effective date of the termination. A shareholder

that has made an election that is invalidated by the Commissioner will

be treated for purposes of sections 1291 through 1297 and the

regulations thereunder as if the shareholder never made the election.

(h) Effective date. An election under this section may only be made

with respect to qualified preferred shares that are issued after the

date that is 30 days after the date of publication of this document as

a final regulation.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 96-32247 Filed 12-23-96; 8:45 am]

BILLING CODE 4830-01-U