The IRS on Jan. 24, 2022, released concurrent final regulations (T.D. 9960) and proposed regulations (REG-118250-20) that provide new rules that treat domestic partnerships and S corporations as an aggregate of their partners or shareholders rather than as entities with respect to investments in certain foreign corporations.
The new regulations follow previously proposed regulations from June 2019 (REG-101828-19) that were issued in conjunction with rules that included a similar aggregate treatment with respect to the global intangible low-taxed income (GILTI) regime.
The final regulations look to provide pass-through entities consistent treatment between GILTI and Subpart F, and the proposed regulations would extend that consistency to passive foreign investment companies (PFICs), among other international tax provisions.
The guidance represents a continued shift in approach. Since 1962, domestic partnerships have been treated as separate entities when determining an investor’s Subpart F inclusion. However, the continued shift of IRS guidance towards the aggregate approach in these rules will significantly impact nearly all pass-through entities with investments in foreign corporations. This change will bring new challenges—including increased compliance and complexity at the partner level, the need to re-think old structures, and the ability to plan for investments in foreign corporations in new ways.
Final regs address foreign stock ownership
The final regulations are largely consistent with the 2019 proposed regulations but contain some important clarifications—including clarifying the scope of when the aggregate treatment should be applied in the case of a domestic partnership.
The 2019 proposed regulations provided that, except for certain specifically enumerated reasons, the aggregate treatment would be applied “for purposes of Section 951 and Section 951A, and for purposes of any other provision that applies by reference to Section 951 or Section 951A.” The final regulations, however, replace “any other provision that applies by reference” to Section 951 or Section 951A with “any provision that specifically applies by reference” to Section 951 or Section 951A. The preamble explains that the word “specifically” is intended to clarify that the rule only applies to the particular provision within a code section or regulation that applies specifically by reference to Sections 951, 951A or 956(a). In addition, Section 956(a) was also added to the scope such that the final regulation requires aggregate treatment with respect to inclusions under Sections 951 (Subpart F), 951A (GILTI) and 956(a) (investments in U.S. property).
Under the regulations, aggregate treatment does not apply for purposes of determining whether any U.S. person is a U.S. shareholder or whether a foreign corporation is a controlled foreign corporation (CFC). The final regulations also address the determination of a CFC’s “controlling domestic shareholders” when the CFC is owned by a domestic partnership. Consistent with the 2019 proposed regulations, aggregate treatment is not extended to the determination of the controlling domestic shareholders of a CFC owned through a partnership under Section 964. However, the preamble provides that Treasury and the IRS believe that aggregate treatment should apply to domestic partnerships for purposes of determining the controlling domestic shareholders of a CFC under Section 964. As a result, this provision is revised in the 2022 proposed regulations (discussed further below). The preamble to the regulations also largely defers to future, or concurrently issued, proposed guidance on the treatment of PFICs, related party insurance income, previously taxed earnings and profits (PTEP), and related basis issues.
Grant Thornton Insight:
Application of this rule may eliminate Subpart F inclusions, GILTI inclusions—which already occurred under the 2019 final GILTI regulations—and Section 956 inclusions for partners or shareholders that own less than 10% in a CFC indirectly through a domestic partnership or S corporation. For example, assume a U.S. individual owns 5% and a domestic corporation owns 95% of a domestic partnership that, in turn, owns 100% of a CFC. Because the individual indirectly owns less than 10% in the CFC, the individual is not a U.S. shareholder and thus does not have an income inclusion under Section 951 or Section 956, or a pro rata share of any amount for purposes of Section 951A.
New proposed regulation would address PFICs
The existing PFIC regulations applied a mix of the aggregate and entity approaches. For example, aggregate treatment applied to PFICs subject to Section 1291, while the entity treatment applied to PFICs for which a partnership made a qualified electing fund (QEF) election. The 2022 proposed regulations would require domestic partnerships and S corporations to apply the aggregate approach to many other areas of the PFIC rules beyond Section 1291. Aggregate treatment would apply for purpose of making the QEF election, mark-to-market (MTM) election, the PFIC purging elections, the CFC/PFIC overlap rule, and for filing Forms 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
The proposed regulations modify the definition of “shareholder” under Treas. Reg. sec. 1.1291-1(b)(7) by excluding pass-through entities. Therefore, domestic pass-through entities are not considered shareholders for purposes of making certain elections (e.g., QEF, MTM and purging elections), as well as the requirements to file information returns with respect to the PFICs. Instead, each electing partner or shareholder would include its pro rata share of QEF inclusion or MTM gain or loss as if the stock was held directly, and not as a share of the pass-through entity’s income. Under the aggregate approach, in order to assist the pass-through entity with information reporting and basis tracking, each electing partner or shareholder must notify the pass-through filer of its election. In the preamble, the IRS requests comments on whether final regulations should also permit-pass-through entities to make QEF or MTM elections on behalf of partners.
Domestic pass-through entities would no longer be required to file Form 8621. Instead, domestic partnerships and S corporations that own PFICs would provide information to their partners and shareholders on Schedules K-3 to allow the partners and shareholders to complete Forms 8621.
Grant Thornton Insight:
The IRS indicated that new Schedules K-2 and K-3 reporting should facilitate the ultimate pass-through owners’ ability to comply. Although this may be true, this change could result in a massive increase in information reporting at the ultimate partner/shareholder level. For example, a typical investment fund may have hundreds of partners—many of which may be pass-through partners—potentially exponentially increasing the number of ultimate partners subject to reporting. Currently, if the lowest domestic fund invests in a PFIC and makes a QEF election, the partnership would file Form 8621, but the ultimate partners would not be obligated to do so. Instead, the partners would only need to include the QEF income provided on their Schedule K-1. Under the 2022 proposed regulations, the partnership would be excused from filing Form 8621 and making the QEF election, and instead the hundreds, if not thousands, of ultimate partners would need to file Forms 8621 and make their own required QEF elections.
A foreign corporation that is both a CFC and a PFIC is not considered to be a PFIC with respect to a shareholder during the shareholder’s “qualified portion” of its holding period (the ‘‘CFC overlap rule’’). The term ‘‘qualified portion’’ generally means the portion of the shareholder’s holding period during which the shareholder is a U.S. shareholder with respect to the PFIC and during which the PFIC is also a CFC. Generally, this means that the PFIC regime should not apply to a U.S. person that is subject to the Subpart F rules. The proposed regulations confirm that the term “qualified portion” (for purposes of the CFC overlap rule) does not include any portion of the domestic partner or S corporation shareholder’s holding period during which the partner or shareholder was not a U.S. shareholder with respect to the CFC that is also a PFIC.
Additional international tax issues
In addition to the various PFIC provisions, the proposed rules also provide other guidance, including rules proposing to:
- Apply the aggregate approach for purposes of determining the controlling domestic shareholder(s) of a foreign corporation under Treas. Reg. sec. 1.964-1(c)
- Implement the transitional rules described in Notice 2020-69, which allows an S corporation to apply the entity approach for limited purposes
- Provide that Treas. Reg. sec. 1.1411-10(g) elections are no longer permitted to be made by the domestic pass-through entities, but instead should be made only by an individual, estate, or trust that holds the CFC or QEF indirectly through the domestic pass-through entity.
Applicability dates
The final regulations are effective for tax years beginning after Jan. 25, 2022—however, taxpayers are permitted to apply the regulations to periods beginning after Dec. 31, 2017, as long as taxpayers meet pertinent consistency requirements.
The 2022 proposed regulations generally are proposed to apply to tax years beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register. Special applicability dates apply for certain rules (e.g., rules that implement pre-existing notices).
Next Steps
Consistent with the aggregate approach adopted in the final GILTI regulations, the final Section 958 regulations eliminate deemed income inclusions for partners that own less than 10% in a CFC indirectly through a domestic partnership. However, in such a case, partners may become subject to the PFIC rules. In addition, the proposed regulations would significantly increase the compliance burden related to PFIC investments by shifting the reporting requirements up to the ultimate partners or shareholders.
The proposed regulations would expand the aggregate approach in an attempt to be consistent across applicable international provisions. However, in many cases, administrability could be sacrificed in exchange for consistent application of the aggregate approach. Pass-through entities and their related investors should take the opportunity to assess how the proposed regulations may affect their specific structure.
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