The alternative investment industry welcomed final regulations recently published by the IRS and the Treasury Department to minimize the reporting burden for certain investors in passive foreign investment companies (PFICs).
The PFIC regime is a set of anti-abuse rules intended to eliminate the benefits of tax deferral by U.S. persons who invest in certain offshore corporations that satisfy either an asset or an income test. The income test is met if a minimum of 75 percent of the foreign corporation’s gross income is passive income. The asset test is met if a minimum of 50 percent of the foreign corporation’s assets are assets that produce, or are held to produce, passive income. The rules are effective as of December 28, 2016, are intended to provide clarity and minimize reporting where the IRS deemed it unnecessary. Please note that this article is not an exhaustive analysis of the final regulations but is intended to focus on the impact these final regulations will have on the alternative investment industry.
The final regulations codify prior IRS guidance related to the definition of a shareholder of a PFIC. Specifically, owners of an interest in a PFIC that is held through a tax-exempt entity are removed from the definition of PFIC shareholders. Therefore, for example, neither beneficiaries of pension funds nor owners of an IRA should be treated as shareholders of a PFIC if the pension or IRA is invested in an offshore feeder fund (blocker) that is formed as a foreign corporation. This clarified definition should be a welcome relief to a significant portion of alternative investors who are now exempt from filing Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
The final regulations adopt a “non-duplication” rule designed to ensure that the same shares of a PFIC are not attributed to multiple U.S. persons. To illustrate, the preamble to the final regulations addresses a tiered structure where a U.S. person wholly owns a domestic U.S. corporation that in turn owns a majority interest in a foreign (non-PFIC) corporation. Additionally, the U.S. person directly owns the minority interest in the aforementioned non-PFIC foreign corporation. The foreign corporation in turn holds 100 percent of all the shares of a lower-tier PFIC. Prior to these final regulations, the existing regulations could have been interpreted to attribute ownership of 100 percent of the non-PFIC’s shares to the U.S. person, resulting in duplicate ownership of the 51 percent ownership held by the domestic corporation. Under the prior rules, both the U.S. owner and the domestic corporation could have been treated as majority owners of the PFIC and required to file Form 8621.
The non-duplication rule has the effect of disregarding attributable ownership in a tiered structure. Therefore, a U.S. person should no longer be treated as the owner of PFIC shares that are directly or indirectly owned by another U.S. person (including a U.S. corporation). While this rule may have limited application to hedge fund structures, it may be more relevant in private equity deals that include multiple tiers.
The final regulations also include certain classes of PFIC shareholders that would no longer have to file Form 8621. Notably this group includes the following:
The final regulations codify the Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations reporting exemption for filers who qualify under the constructive ownership exception. These final regulations adopt prior guidance that exempt such taxpayers from filing if they include a statement detailing certain identifying information of the filer upon whose reporting they rely.
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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.
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