New Tax Regualtions Clarify PFIC Antiabuse Rules And Safe Harbors

New regulations issued under sections 1291, 1297, and 1298 clarify whether a foreign corporation is treated as a passive foreign investment company and whether a U.S. person that indirectly owns stock in a PFIC is treated as a shareholder.

Final regs issued January 15 (and corrected March 5 and March 10) retained the basic approach and structure of proposed regs issued July 11, 2019. Section 1.1298-4 of the final regs clarifies treatment of a tested foreign corporation’s 25-percent-owned domestic subsidiary and includes an antiabuse rule for taxpayers that house passive assets in domestic corporations in order to avoid PFIC status.

Proposed regs also issued January 15 (not yet finalized) contain additional guidance on reg. section 1.1298-4(e) that provide safe harbors limiting application of the antiabuse rule in the final regs.

Passive Foreign Investment Companies

PFICs are defined and taxed under sections 1291–1298. If a foreign corporation meets the definition of a PFIC, its U.S. shareholders must pay tax and interest on income from PFIC distributions or gain from PFIC stock dispositions as if it were distributed ratably on each day of the shareholders’ holding period.

PFICs are generally foreign corporations with at least 75% passive income or at least 50% of total assets generating passive income.

The PFIC regime was enacted in 1986 to eliminate tax deferral on passive earnings of foreign corporations, whether or not closely held. Without a qualified electing fund election, PFIC status can discourage distributions. Under the PFIC code provisions:

• section 1291 imposes an interest charge on a PFIC’s tax deferral;
• section 1293 addresses taxation on income of QEFs;
• section 1294 provides an election to extend time for payment of tax on undistributed earnings;
• section 1295 contains guidance on QEFs;
• section 1296 contains a mark-to-market election for PFIC stock;
• section 1297 defines PFIC; and
• section 1298 contains an assortment of special PFIC rules.

The new regs amend existing regs and add new ones that:

• clarify ownership attribution rules in reg. section 1.1291-1(b) that treat U.S. persons as shareholders of PFICs;
• clarify the definition of a PFIC in reg. section 1.1297-1;
• provide rules related to look-through subsidiaries and partnerships in reg. section 1.1297-2;
• clarify treatment of qualifying insurance corporations in reg. section 1.1297-4;
• clarify the exception to passive income treatment for active insurance income in reg. section 1.1297-5 and -6;
• provide guidance on the change of business exception to PFIC status in reg. section 1.1298-2; and
• provide guidance on treatment of foreign corporations owning stock in 25-percent-owned domestic corporations in reg. section 1.1298-4.

A PFIC is defined in section 1297(a)(1) and (2) as a foreign corporation that meets either an income or an asset test as follows:

• 75% or more of the corporation’s gross income for the tax year is passive; or
• at least 50% of the corporation’s assets (as determined under section 1297(e)) produce (or are held to produce) passive income during the tax year.

Section 1298he new final and proposed regs that clarify treatment of 15-percent-owned domestic corporations accompany section 1298, which contains an assortment of special rules that address PFIC-related questions. Section 1298(a)–(g) is summarized below.

Section 1298(a)(1)–(5) contains rules for attribution of stock ownership:

• to U.S. persons;
• from corporations to their shareholders;
• from passthrough entities to their owners;
• to stock option holders; and
• successively between taxpayers.

Section 1298(b)(1)–(8) (called “other special rules”) contains eight rules of varying complexity that address a wide variety of subjects:

• Section 1298(b)(1) provides that a stock ownership attribution determination is made at any time during the taxpayer’s holding period when the tested foreign corporation was a PFIC (and not a QEF).
• Section 1298(b)(2) provides that corporations will not be treated as PFIC’s during their start-up years.
• Section 1298(b)(3) provides that corporations changing businesses will not be treated as PFICs.
• Section 1298(b)(4) provides that separate classes of stock (or other interests) in a corporation are to be treated as interests in separate corporations.
• Section 1298(b)(5) applies when a U.S. person is attributed ownership of stock in a PFIC under section 1298(a) and requires disposition of the PFIC stock or distribution by the PFIC to be treated as a disposition by or distribution to the U.S. person and treated in the same manner as previously taxed income.
• Section 1298(b)(6) requires a taxpayer who uses PFIC stock as security for a loan to be treated as having disposed of the stock.
• Section 1298(b)(7) (the subject of this article) allows foreign corporations that are subject to the section 531 accumulated earnings tax and that own stock in 25-percent-owned domestic corporations to treat stock owned by the domestic corporation as a non-passive asset and related income inclusions as non-passive income.
• Section 1298(b)(8) requires subpart F income inclusions under section 951(a)(1)(B) (earnings invested in U.S. property) to be treated as distributions received by the shareholder.

Section 1298(c)(1)–(3) provides three rules that apply to PFIC stock held by a pooled income fund (as defined in section 642(c)(5)) when the fund’s governing instrument allows no gain from a disposition of the PFIC stock to be allocated to fund income:

• section 1291 does not apply to any gain on a disposition of the stock by the fund if (without regard to section 1291) section 642(c)(3) allows a deduction for the gain;
• section 1293 does not apply to the PFIC stock; and
• in determining whether section 1291 applies to any PFIC distribution, section 1291(d) does not apply.

Section 1298(d)(1)–(3) requires any tangible personal property leased to a foreign corporation for at least 12 months to be treated as an asset actually held by the corporation and the unamortized portion of the present value of the lease payments to be taken into account for the section 1297(a)(2) asset test.

Section 1298(e)(1)–(3) allows the adjusted basis of a controlled foreign corporation’s total assets to be increased by any research or experimental expense (within the meaning of section 174) paid by the CFC during the year and the preceding two years (minus reimbursement received), or by 300% of any licensing payments made by the CFC during the year for the use of intangible property in an active trade or business.

Section 1298(f) requires each U.S. person that is a shareholder of a PFIC to file an annual report, and section 1298(g) calls for regs necessary or appropriate to carry out the purposes of the PFIC rules.

This article addresses the treatment of 25-percent-owned domestic corporations in section 1298(b)(7) under section 1.1298-4 final and proposed regs. A previous article addressed the exception to PFIC status for tested foreign corporations changing businesses in section 1298(b)(3) and reg. section 1.1298-2 (Tax Notes Int’l, Sept. 20, 2021, p. 1547).

25-Percent-Owned Domestic Corporations

Section 1298(b)(7) addresses treatment of tested foreign corporations that own stock in 25-percent-owned domestic corporations.

Section 1298(b)(7)(A) applies when a tested foreign corporation:

• is subject to the accumulated earnings tax imposed by section 531 (or waives a benefit under a treaty that would prevent the imposition of the tax); and
• owns at least 25% (by fair market value) of the stock of a domestic corporation.

To determine whether the foreign parent corporation is a PFIC, any qualified stock held by the 25-percent-owned domestic subsidiary corporation is treated as an asset that does not produce passive income (and is not held for the production of passive income), and any amount included in gross income in relation to the qualified stock is not treated as passive income.

Section 1298(b)(7)(B) defines qualified stock as stock in a domestic C corporation that is not a regulated investment company or real estate investment trust.

Final Reg. Section 1.1298-4Reg. section 1.1298-4(a)–(f) supplements the rules in section 1298(b)(7). Reg. section 1.1298-4(a) contains a useful overview that describes the section as providing rules under section 1298(b)(7) that apply to foreign corporations that own stock in 25-percent-owned domestic corporations for determining whether a foreign corporation is a PFIC. The guidance:

• provides a general non-passive income and assets rule;
• provides rules concerning ownership of 25-percent-owned domestic corporations or qualified stock through partnerships;
• provides rules for determining whether a foreign corporation is subject to the tax imposed by section 531 and for waiving treaty benefits that would prevent the imposition of the tax;
• provides an antiabuse rule; and
• lays out applicability dates.

Reg. section 1.1298-4(b)(1) repeats the general rule in section 1298(b)(7)(A) that applies when a tested foreign corporation:

• is subject to the section 531 tax (or waives a treaty benefit that would otherwise prevent the tax); and
• owns (directly or indirectly under reg. section 1.1298-4(c)) at least 25 percent (by FMV) of the stock of a domestic corporation.

When those two circumstances are present, the general rule allows taxpayers determining whether the foreign corporation is a PFIC to treat any qualified stock held (directly or indirectly) by the 25-percent-owned domestic corporation as a non-passive asset and any amount included in gross income related to the qualified stock as non-passive income.

Reg. section 1.1298-4(b)(2) repeats the definition of qualified stock in section 1298(b)(7)(B). Qualified stock means any stock in a C corporation that is a domestic corporation and that is not a RIC or a REIT. The regs refer to the corporation owned by the 25-percent-owned domestic subsidiary as a “second-tier domestic corporation.”

Reg. section 1.1298-4(c) addresses indirect ownership of stock through partnerships. The indirect ownership rules vary depending on whether the partner of the partnership is a tested foreign corporation or a domestic corporation.

When a tested foreign corporation is the partner, it is considered to own its proportionate share of any stock of a domestic corporation held by the partnership.

When a domestic corporation is the partner, it is considered to own its proportionate share of only qualified stock held by the partnership.

An upper-tier partnership’s attributable share of the stock of a domestic corporation or of qualified stock held by a lower-tier partnership is treated as held by the upper-tier partnership for applying the rule in reg. section 1.1298-4(c).

Reg. section 1.1298-4(d)(1) and (2) addresses the section 531 tax and the waiver of treaty benefits. Under reg. section 1.1298-4(d)(1), a tested foreign corporation is considered subject to the section 531 tax regardless of whether the tax is imposed on the corporation and whether the requirements of reg. section 1.532-1(c) are met.

Under reg. section 1.1297-4(d)(2)(i), a tested foreign corporation that files (or is required to file) a federal income tax return waives the benefit under a treaty that would otherwise prevent the imposition of the section 531 tax by attaching a statement to its original or amended return for the year section 1298(b)(7) and reg. section 1.1298-4(b)(1) are applied or any prior year.

The statement must say that the tested foreign corporation irrevocably waives treaty protection against the imposition of the section 531 tax, effective for all prior, current, and future tax years. This assumes the tax year for which the return is filed and all subsequent tax years are not closed by the period of limitations on assessments in section 6501.

Under reg. section 1.1298-4(d)(2)(ii)(A) and (B), a tested foreign corporation that is not required to file a federal income tax return waives the treaty benefit by adopting a resolution or making a statement to that effect on or before a date no later than nine months following the close of the year for which section 1298(b)(7) and reg. section 1.1298-4(b)(1) are applied.

The tested foreign corporation must adopt a resolution (or similar governance document) that confirms it has irrevocably waived any treaty protection against the imposition of the section 531 tax, effective for all prior, current, and future tax years, and maintain a copy of the resolution (or other governance document) in its records.

If the tested foreign corporation is publicly traded (as described in section 1297(e)(3)), it may include in its public filings a statement that it irrevocably waives treaty protection against the imposition of the section 531 tax, effective for all prior, current, and future tax years.

Reg. section 1.1298-4(e)(1) contains an antiabuse rule that operates as an exception to the non-passive treatment of qualified stock and related income inclusions in section 1298(b)(7).

Non-passive treatment of qualified stock and related income inclusions do not apply to qualified stock in a second-tier domestic corporation owned by a 25-percent-owned domestic corporation if holding passive assets through the second-tier domestic corporation to avoid classification of the tested foreign corporation as a PFIC is a principal purpose for:

• for forming, acquiring, or holding the stock of the 25-percent-owned domestic corporation or the second-tier domestic corporation; or
• for capitalizing or otherwise funding the second-tier domestic corporation.

Reg. section 1.1298-4(e)(2) and (3) are reserved in the final regs. The 2021 proposed regs, however, provide two safe harbors and examples in those sections for taxpayers that wish to avoid application of the antiabuse rule in final reg. section 1.1298-4(e)(1).

Prop. Reg. Section 1.1298-4(e)(2) and (3)Prop. reg. section 1.1298-4(e (2) and (3) contains two safe harbors and four examples, respectively.

Prop. reg. section 1.1298-4(e)(2) provides that the antiabuse exception in reg. section 1.1298-4(e)(1) will not apply if either of two safe harbors in prop. reg. section 1.1298-4(e)(2)(i) or (e)(2)(ii) applies. Those provisions contain safe harbors for active businesses, changing businesses, and new businesses.

Under prop. reg. section 1.1298-4(e)(2)(i)(A)-(C), the exception to non-passive treatment will not apply if the FMV of the second-tier domestic corporation’s assets used or held for use in a U.S. active trade or business is more than 80% of the corporation’s gross asset FMV.

The FMV of the second-tier domestic corporation’s assets takes into account its pro rata share of its domestic subsidiary qualified affiliates’ asset FMVs (and does not take into account the stock of the affiliates).

Prop. reg. section 1.1298-4(e)(2)(i)(B) defines domestic subsidiary qualified affiliate to mean each member of the affiliated group determined by treating the second-tier domestic corporation as the common parent. Affiliated group is defined in section 1504(a) as modified by reducing the ownership threshold from at least 80% to more than 50%.

To determine whether an active trade or business exists, and whether assets are used in an active trade or business, prop. reg. section 1.1298-4(e)(2)(i)(D) directs taxpayers to reg. section 1.367(a)-2(d)(2), (3), and (5).

However, officers and employees of related entities as provided in reg. section 1.367(a)-2(d)(3) include only the officers and employees of related domestic entities within the meaning of section 267(b) or 707(b)(1) (generally requiring a more than 50% ownership threshold).

Prop. reg. section 1.1298-4(e)(2)(ii)(A)-(D) has a safe harbor for businesses undergoing change and for new businesses. The antiabuse rule does not apply if the second-tier domestic corporation engages in an active U.S. trade or business that satisfies the 80% threshold in prop. reg. section 1.1298-4(e)(2)(i) by the end of the transition period following the testing date.

The testing date is the last day of the month in which either:

• the second-tier domestic corporation is created or organized or is acquired, directly or indirectly, by the tested foreign corporation; or
• a second-tier domestic corporation that previously satisfied prop. reg. section 1.1298-4(e)(2)(i) disposes of substantially all assets used or held for use in its active U.S. trade or business to a person that is not related within the meaning of section 267(b) or 707(b)(1).

The transition period is 36 months from the testing date.

The safe harbor in prop. reg. section 1.1298-4(e)(2)(ii) does not apply for any tested foreign corporation year (including previous years) if the second-tier domestic corporation does not engage in an active U.S. trade or business that satisfies prop. reg. section 1.1298-4(e)(2)(i) by the end of the transition period following a testing date.

Examples

Prop. reg. section 1.1298-4(e)(3) has four examples that illustrate the safe harbor rules in prop. reg. section 1.1298-4(e)(2).

All four examples assume that a tested foreign corporation (TFC) is a foreign corporation that is not a CFC (within the meaning of section 957(a)) and is subject to the section 531 tax.

Subsidiaries USS1 and USS2 are domestic corporations for TFC’s entire tax year. TFC owns 100 percent of the stock of USS1 (a 25-percent-owned domestic subsidiary), and USS1 owns 100 percent of the stock of USS2 (a second-tier domestic subsidiary).

Example 1 illustrates the safe harbor in prop. reg. section 1.1298-4(e)(2)(i) that does not involve a new or changing business. It assumes that USS2 operates an active U.S. trade or business within the meaning of reg. section 1.367(a)-2(d)(2), (3), and (5). Throughout TFC’s year 1, the USS2’s total asset FMV is $100, and the FMV of USS2’s assets used or held for use in its active U.S. trade or business is $20.

USS2 was not created, organized, or acquired within the preceding 36 months and has not disposed of a U.S. active trade or business within the preceding 36 months — so there is no testing date or transition period analysis.

The safe harbor in prop. reg. section 1.1298-4(e)(2)(i) does not apply in year 1 even though USS2 is engaged in an active U.S. trade or business because only 20% ($20/$100) of its assets are used or held for use in an active U.S. trade or business within the meaning of reg. section 1.367(a)-2(d)(2), (3), and (5).

This amount is not more than 80% of USS2’s total gross asset FMV, as required by prop. reg. section 1.1298-4(e)(2)(i).

Accordingly, the general antiabuse rule in reg. section 1.1298-4(e)(1) will apply if the principal purpose for holding passive assets through USS2 (the second-tier domestic corporation) is to avoid classification of TFC as a PFIC.

Example 2 illustrates the domestic subsidiary qualified affiliate look-through rules. It assumes the same facts as in example 1 except that USS2 wholly owns domestic subsidiary USS3. Throughout TFC’s tax year 1, the FMV of USS3’s assets is $400, and USS3 uses 100% of its assets in an active U.S. trade or business within the meaning of reg. section 1.367(a)-2(d)(2), (3), and (5).

Because USS3 is a domestic subsidiary qualified affiliate of USS2, USS2’s pro rata share of USS3’s assets is taken into account to determine whether USS2 satisfies the 80% safe harbor. Accordingly, USS2 takes into account its $400 pro rata share of USS3’s assets in addition to the $100 of its own assets.

USS2 is treated as owning $500 total assets, with $420/$500, or 84%, of the total assets treated as used or held for use in an active U.S. trade or business. Therefore, the safe harbor in prop. reg. section 1.1298-4(e)(2)(i) applies in year 1, and the general antiabuse rule in reg. section 1.1298-4(e)(1) does not apply.

Example 3 illustrates the change of business safe harbor. It assumes that USS2 uses 100% of its assets in an active U.S. trade or business throughout year 1 and thus satisfies prop. reg. section 1.1298-4(e)(2)(i) in year 1.

On the first day of year 2, USS2 disposes of all assets for cash. On the seventh day of year 5 (or before the end of the first month), USS2 invests the cash in assets that it immediately begins to use in an active U.S. trade or business.

Because USS2, the second-tier domestic corporation, engages in an active U.S. trade or business by the end of the 36-month transition period that began after the testing date (the last day of the first month of year 2) in which it disposed of its entire active U.S. trade or business, the safe harbor in prop. reg. section1.1298-4(e)(2)(ii) applies in years 2, 3, and 4. The general antiabuse rule in reg. section 1.1298-4(e)(1) does not apply.

Example 4 assumes the same facts as in example 3, except that at the end of the first month of year 5, USS2 is still in negotiations to purchase assets to be used in an active U.S. trade or business. USS2 does not complete the asset purchase until the third month of year 5.

The safe harbor in prop. reg. section 1.1298-4(e)(2)(ii) does not apply for year 2, 3, or 4 because USS2 (the second-tier domestic corporation) did not engage in an active U.S. trade or business that satisfied prop. reg. section 1.1298-4(e)(2)(i) by the end of the 36-month transition period that began on the testing date, which was the end of the first month in year 2 when USS2 sold its prior active trade or business.

Accordingly, the general antiabuse rule in reg. section 1.1298-4(e)(1) will apply if there is a principal purpose to hold passive assets through USS2 (the second-tier domestic corporation) to avoid classification of TFC (the tested foreign corporation) as a PFIC.

Applicability Dates

Reg. section 1.1298-4(f) provides that the final regs apply to shareholder tax years beginning on or after January 14, 2021.

However, a shareholder may choose to apply the rules for any open year beginning before that date as long as it consistently applies this section and reg. sections 1.1297-1 and -2, 1.1298-2, and 1.1291-1(b)(8)(iv) and (b)(8)(v)(A)–(D) for the earlier year and all subsequent years (except that consistent treatment is not required under reg. section 1.1297-1(c)(1)(i)(A)).

Prop. reg. section 1.1298-4(f) provides that prop. reg. section 1.1298-4(e)(2) and (3) applies to shareholder years beginning on or after the date the regs are filed as final regs in the Federal Register.

A shareholder may choose to apply the rules for any open year beginning before that date without regard to whether the rules are applied consistently, provided that once applied, each rule must be applied for the earlier year and all subsequent years.

Preambles

The preambles to the 2021 final and proposed regs provide additional insight into the rationale and operation of the rules in final and prop. reg. section 1.1298-4.

Final Regs’ Preamble

Section 1298(b)(7) provides a special characterization rule that applies when a tested foreign corporation owns at least 25% of the FMV of the stock of a domestic corporation and is subject to the accumulated earnings tax under section 531 (or waives any benefit under a treaty that would otherwise prevent imposition of the tax).

In that case, section 1298(b)(7) treats any qualified stock held by the domestic corporation as a non-passive asset and the related income as non-passive income.

Section 1298(a)(2) and (b)(7)The 2019 proposed regs disregarded the section 1298(b)(7) non-passive characterization rules when applying the stock ownership attribution rules in section 1298(a)(2).

Prop. reg. section 1.1298-4(e) provided that section 1298(b)(7) does not apply to determine whether a tested foreign corporation is a PFIC for section 1298(a)(2) purposes.

Section 1298(a)(2) attributes ownership of stock owned by a PFIC to the PFIC’s shareholders more broadly than stock owned by a corporation that is not a PFIC. 

Section 1298(a)(2) generally provides that if a person owns 50% or more of a corporation’s stock FMV, that person is considered to own a proportionate share of any stock owned by the corporation. However, a shareholder of a PFIC is treated as owning stock owned by the PFIC without regard to the 50% limitation.

Several commentators recommended that the final regs eliminate the rules in reg. sections 1.1291-1(b)(8)(ii)(B) and 1.1298-4(e) for several reasons:

• Congress intended for stock that is treated as non-passive under section 1298(b)(7) to be characterized as non-passive for all purposes, including section 1298(a)(2) ownership attribution.
• The statutory text of section 1298(a)(2)(B) already excludes application of section 1297(d) (excepting U.S. shareholders of CFCs from the PFIC regime), and therefore any additional exclusion from section 1298(a)(2) (like section 1298(b)(7)) is precluded.
• Legislative history suggests that Congress intended for section 1298(b)(7) to encourage investments in domestic corporations.
• The attribution rules would be burdensome to minority shareholders that would not be able to obtain information on lower-tier PFICs to comply with the PFIC rules.
• Congress acknowledged the lack of control that minority investors have in parent companies by providing the 50% threshold in section 1298(a)(2).

Treasury and the IRS determined that it is appropriate for section 1298(b)(7) generally to apply for the ownership attribution rules of section 1298(a) if adequate measures are taken to prevent taxpayers from holding primarily passive assets in domestic subsidiaries to avoid PFIC classification.

The application of the domestic subsidiary antiabuse rule is sufficient to address concerns about abusive planning related to section 1298(b)(7) without a need for the domestic subsidiary attribution rules. Therefore, the domestic subsidiary attribution rules in prop. reg. section 1.1298-4(e) are eliminated in the final regs.

Antiabus45e Rules

Two antiabuse rules in the 2019 proposed regs provide that section 1298(b)(7) does not apply if:

• the tested foreign corporation would be a PFIC if the qualified stock held by the 25-percent-owned domestic corporation or any related income inclusions are disregarded; or
• a principal purpose for the tested foreign corporation’s formation or acquisition of the 25-percent-owned domestic corporation is to avoid classification of the tested foreign corporation as a PFIC.

Disregarding Qualified Stock

Treasury and the IRS believe that a taxpayer should not be permitted to use the domestic subsidiary rule in section 1298(b)(7) to avoid the PFIC rules by indirectly holding predominantly passive assets through a two-tiered chain of domestic subsidiaries.

Several comments requested withdrawing the antiabuse rule in the proposed regs that disregards qualified stock. Congress was aware of the potential for taxpayers to rely on section 1298(b)(7) to avoid PFIC status by treating otherwise passive investments as non-passive, and it intended for the accumulated earnings tax to mitigate potential abuse.

The accumulated earnings tax on tested foreign corporations, the U.S. corporate tax on domestic subsidiaries, and the U.S. withholding tax on distributions to tested foreign corporations already discourage tested foreign corporations from artificially overweighting their investment assets held through domestic subsidiaries.

The rule that disregards qualified stock creates a hypothetical PFIC test that supersedes the statute when it causes a tested foreign corporation to be a PFIC when the domestic subsidiary rule in section 1298(b)(7) would otherwise cause the tested foreign corporation to not be a PFIC.

Treasury and the IRS determined that disregarding qualified stock is unnecessary to address abuse concerns. The final regs that tailor the scope of the principal-purpose antiabuse rule target those concerns more effectively. Accordingly, the qualified stock antiabuse rule in the 2019 proposed regs is withdrawn.

Principal-Purpose Antiabuse Rule

Under a principal-purpose antiabuse rule in the proposed regs, a principal purpose was deemed to exist when the 25-percent-owned domestic corporation was not engaged in an active U.S. trade or business.

Commentators asserted that this principal-purpose antiabuse rule was overbroad and should be more narrowly drawn or eliminated for several reasons, including:

• Congress contemplated that taxpayers would plan into section 1298(b)(7) and intended for the accumulated earnings tax to be the sole limitation on its applicability;
• the principal-purpose antiabuse rule was inconsistent with two private letter rulings that endorsed the use of domestic subsidiaries to manage PFIC status;
• the 25-percent-owned domestic corporation is likely to be a holding company without any active trade or business, and therefore the tested foreign corporation would likely be deemed to have a principal purpose of avoiding PFIC classification;
• the standard for deeming a principal purpose of avoiding PFIC status to exist is misguided because a corporation need not be engaged in an active trade or business to generate non-passive income; and
• the principal-purpose antiabuse rule would disallow planning to manage the PFIC risks of start-up companies and active companies undergoing transition.

Treasury and the IRS determined that the final regs should retain a principal-purpose antiabuse rule to prevent holding passive assets through a two-tiered chain of domestic subsidiaries to allow foreign affiliates that hold passive assets to avoid the PFIC rules.

Absent an antiabuse rule, a two-tiered chain of domestic subsidiaries could be used to shield U.S. investors in a tested foreign corporation from the application of the PFIC rules, despite having substantial amounts of passive assets held by the tested foreign corporation or its foreign subsidiaries.

Treasury and the IRS concluded that a principal-purpose antiabuse rule is consistent with section 1298 and the broad regulatory authority under section 1298(g).

The legislative history of section 1298(b)(7) envisions that U.S. shareholders that hold passive assets through a U.S. corporate structure, rather than in a foreign corporation, to avoid the PFIC regime should be subject to tax treatment essentially equivalent to shareholders of a PFIC.

While Congress intended that the accumulated earnings tax serve this function, Treasury and the IRS have determined that this tax alone is not sufficient to curtail abuse because it is rarely applied in practice.

The U.S. net income tax on income from passive assets held by a domestic subsidiary is also not a sufficient disincentive to hold those assets in a domestic subsidiary. The passive assets may generate a small amount of income, or the domestic subsidiary may be leveraged so that its net income subject to tax is less than the gross income that would have been taken into account under the PFIC rules if the assets were held by a foreign affiliate.

Section 1298(g) provides authority to prevent abuse of the PFIC rules, and the principal-purpose antiabuse rule is not inconsistent with the private letter rulings. However, it is appropriate to tailor the scope of the principal-purpose antiabuse rule more closely to the potential abuses of greatest concern.

Accordingly, the principal-purpose antiabuse rule in the final regs is modified to strike the appropriate balance between preventing taxpayers from inappropriately applying section 1298(b)(7) to avoid the PFIC rules and allowing taxpayers to manage the PFIC risks of start-up companies and active companies undergoing business transitions.

Under the principal-purpose antiabuse rule in section 1.1298-4(e)(1) of the final regs, section 1298(b)(7) does not apply if either:

• a principal purpose for forming, acquiring, or holding stock of either domestic corporation was to avoid PFIC classification; or
• a principal purpose of capitalizing or otherwise funding the second-tier domestic corporation is to hold passive assets through the corporation to avoid PFIC classification.

Unlike the 2019 proposed regs that applied the principal-purpose antiabuse rule only at the level of the upper-tier domestic corporation, the final regs apply the rule at both domestic corporation levels. Because a two-tiered domestic structure can be planned into at either tier level in the structure, the first prong of the antiabuse rule — which targets corporate formations, acquisitions, or stock holding — applies at both levels.

On the other hand, the second prong of the antiabuse rule — which targets capitalizing or funding — applies at the level of the second-tier domestic subsidiary because the benefit of section 1298(b)(7) applies only to assets held at that level.

Treasury and the IRS continue to study narrowing the principal-purpose antiabuse test to address concerns about temporarily holding passive assets in a U.S. corporate structure for valid business reasons. Moreover, safe harbors to address those concerns are provided in the 2021 proposed regs in section 1.1298-4(e)(2) and (e)(3).

Proposed Regs’ Preamble

Section 1298(b)(7) provides that qualified stock in a domestic C corporation owned by a tested foreign corporation through a 25-percent-owned domestic corporation is treated as an asset generating non-passive income for section 1297(a) if the tested foreign corporation is subject to the accumulated earnings tax or waives any treaty protections against the imposition of the accumulated earnings tax.

Section 1298(b)(7) provides a special non-passive characterization rule that applies when:

• a tested foreign corporation owns at least 25 percent of the FMV of the stock of a domestic corporation;
• the 25-percent-owned domestic corporation owns qualified stock in another domestic corporation; and
• the tested foreign corporation is subject to the accumulated earnings tax under section 531 (or waives any benefit under a treaty that would otherwise prevent imposition of the tax).

In that case, section 1298(b)(7) treats the stock of the second-tier domestic corporation held by the 25-percent-owned domestic corporation as a non-passive asset and the related income as non-passive income.

The 2019 proposed regs provide that section 1298(b)(7) does not apply if a principal purpose for the tested foreign corporation’s formation or acquisition of the 25-percent-owned domestic corporation is to avoid classification of the tested foreign corporation as a PFIC. A modified version of the principal-purpose antiabuse rule is adopted in section 1.1298-4(e)(1) of the final regs.

Section 1.1298-4(e)(2)(i) and (ii) of the 2021 proposed regs provides two safe harbors from the principal-purpose antiabuse rule in section 1.1298-4(e)(1) of the final regs. Treasury and the IRS request comments on the safe harbors.

Under the first safe harbor, the antiabuse rule will not apply if more than 80% of the asset FMV of the second-tier domestic corporation is used in an active U.S. trade or business as determined under modified section 367 rules (see prop. reg. section1.1298-4(e)(2)(i)). To apply the safe harbor, the assets of the second-tier domestic subsidiary’s qualified affiliates (as defined in prop. reg. section 1.1298-4(e)(2)(i)(B)) are also considered in determining whether 80 percent of the second-tier domestic corporation’s assets are used in a U.S. trade or business (see prop. reg. section1.1298-4(e)(2)(i)(A)).

The 2021 proposed regs provide a second safe harbor in reg. section 1.1298-4(e)(2)(ii) for active companies undergoing transition and start-up companies. Under this safe harbor, the antiabuse rule will not apply if the second-tier domestic corporation engages in an active U.S. trade or business that satisfies the 80 percent threshold in the first safe harbor by the end of the transition period following the testing date.

Prop. reg. section 1.1298-4(e)(2)(ii)(B) defines testing date as the last day of the month in which either:

• the second-tier domestic corporation is created, organized, or acquired (the start-up testing date); or
• a second-tier domestic corporation that previously satisfied the first safe harbor disposes of substantially all its active U.S. trade or business (the change of business testing date).

Prop. reg. section 1.1298-4(e)(2)(ii)(C) provides that the transition period is 36 months after a testing date. If the requirements of the business transition and start-up safe harbor are not satisfied within the transition period, the benefit of the safe harbor is lost retroactively for the entire period in which the safe harbor was claimed (see prop. reg. section 1.1298-4(e)(2)(ii)(D)).

In these instances, the general antiabuse rule in reg. section 1.1298-4(e)(1) will be applied to the tested foreign corporation to determine whether a principal purpose to avoid PFIC classification existed for the preceding years, which would be within the normal three-year statute of limitations on assessments under section 6501.