Final & Proposed Regulations for Domestic Pass-through Entities: Section 958 and PFICs
On January 24, 2022, the IRS issued final regulations (RIN-1545-BP79, TD 9960) under Section 958 regarding the treatment of domestic partnerships for purposes of determining amounts included in the gross income of their partners with respect to foreign corporations (958 Final Regulations).
Also, on January 24, 2022, the IRS issued proposed regulations (REG-118250-20), which provide guidance on passive foreign investment companies (PFICs) and controlled foreign corporations (CFCs) held by domestic partnerships and S corporations (PFIC Proposed Regulations).
Both sets of regulations were published in the Federal Register on January 25, 2022.
In these final and proposed regulations, the IRS made a clear shift toward treating partnerships as aggregates of their individual partners, according to which partners are deemed to own the assets rather than the partnership being considered as an entity separate from the partners. The result is that partners count their shares of the partnership’s foreign income in their own gross incomes. This change will result in increased compliance and reporting requirements for individual partners and S corporation shareholders.
This True Insight will cover both sets of regulations as well as issues related to partnership reporting requirements for Schedules K-2 and K-3, which were revised by the IRS in 2021. Taxpayers should review these new regulations with respect to their direct and indirect foreign investments because current structures may be affected.
Section 958: Determination of Stock Ownership in Foreign Corporations by US Partnerships
The 958 Final Regulations treat a domestic partnership as an aggregate of its partners for purposes of computing income inclusions under Section 951 (subpart F income) and 951A (global intangible low-taxed income, GILTI) as well as other provisions that specifically apply by reference to Sections 951 and 951A.
The 958 Final Regulations treat partnerships as aggregates of their partners, rather than entities separate from the partners, when calculating foreign income such as subpart F income or GILTI. Thus, the partners themselves are deemed to own the partnership’s assets and run its operations, and they count their shares of the partnership’s offshore income as part of their own gross income.
The new guidance finalizes portions of the proposed regulations that were issued in June 2019 (2019 Proposed Regulations) (REG-101828-19). The domestic partnership rules were addressed in these proposed regulations along with rules related to a “high-tax exclusion” that allowed companies to opt out of GILTI on foreign income on which they had already paid offshore taxes over a certain rate. After the 2019 Proposed Regulations were published, the two issues were separated, and final regulations on the high-tax exclusion were issued in 2020 (RIN-1545-BP15).
The 958 Final Regulations also address a variety of topics regarding the application of the aggregate approach as related to Section 956, controlling domestic shareholders, and application of Section 1248.
The new guidance also clarifies certain issues with respect to which the aggregate approach does not apply.
2019 Proposed Regulations and Final GILTI Regulations
On June 21, 2019, the IRS published final 951A regulations (Final 951A regulations) (TD 9866) providing guidance with respect to the treatment of domestic partnerships that own stock in controlled foreign corporations (CFCs) for purposes of Section 951A that generally treat a domestic partnership as an aggregate of all of its partners for purposes of computing income inclusions under Section 951A (and other provisions that apply by reference to Section 951A). The Final 951A regulations shifted away from the hybrid approach to domestic partnerships that was first proposed in 2018 with respect to Section 951A.
Along with those final regulations, the IRS published the 2019 Proposed Regulations under Sections 951, 951A, 954, 956, 958, and 1502. Consistent with the approach adopted in the Final 951A Regulations, the 2019 Proposed Regulations generally extended the treatment of domestic partnerships as aggregates of their partners for purposes of determining income inclusions under Section 951 and for purposes of provisions that apply by reference to Section 951.
The 958 Final Regulations finalize the portion of the 2019 Proposed Regulations that generally treat domestic partnerships as aggregates of their partners for purposes of determining income inclusions under Section 951 and for purposes of provisions that apply specifically by reference to Section 951.
The 958 Final Regulations do not specifically address the treatment of S corporations, but they are statutorily treated as partnerships for subpart F purposes so aggregate treatment will apply for purposes of Sections 951, 951A, and 956(a).
Section 956 Application
The 958 Final Regulations clarify that aggregate treatment of domestic partnerships applies for purposes of Section 956(a) to ensure that a US shareholder partner determines a Section 956 inclusion amount with respect to CFCs owned through a domestic partnership as part of the US shareholder partner’s subpart F inclusion. Aggregate treatment does not apply, however, for purposes of Sections 956(c) (the definition of US property) or 956(d) (the treatment of pledges and guarantees), in which case Treasury and the IRS state that treating a domestic partnership as an entity separate from its partners in those cases is more appropriate from a policy perspective.
Certain existing final regulations including Regs. §§1.956-1(a)(2)(i), (iii), and (a)(3)(iv) treat domestic partnerships as entities separate from their partners for purposes for Section 956. The 958 Final Regulations removed these provisions because they are inconsistent with the aggregate approach.
Controlling Domestic Shareholders
The controlling domestic shareholders of a CFC are defined as the US shareholders that, in the aggregate, own more than 50% of the total combined voting power of all classes of stock of the CFC entitled to vote and that undertake to act on the CFC’s behalf. If the ownership requirement is not met, the controlling domestic shareholders of the CFC are all of the US shareholders that own stock in the CFC.
The 958 Final Regulations do not apply aggregate treatment for determining the controlling domestic shareholders of a CFC. The PFIC Proposed Regulations, however, include a revision of Section 1.958-1(d)(2) to provide that aggregate treatment applies for purposes of determining the controlling domestic shareholders of a CFC. See the discussion below for more detail on this issue.
Issues not addressed with respect to aggregate treatment by the 958 Final Regulations
The 958 Final Regulations do not address the issue of aggregate treatment for a domestic partnership for purposes of:
- Determining US shareholder and CFC status under Sections 951(b) and 957(a)
- Applying Section 956(c) and (d)
- Applying Section 1248
Section 1248: Future guidance may address the application of Section 1248 to transactions involving a domestic partnership’s sale of CFC stock. In the interim, foreign partnerships continue to be treated as aggregates and domestic partnerships as entities for Section 1248 purposes. The 958 Final Regulations do, however, clarify that the aggregate approach set forth in Section 1.958-1(d)(1) does not apply for purposes of Section 1248. The new guidance does not affect the application of Section 1.1248-1(a)(4), which treats the partners in a foreign partnership that sells or exchanges stock of a corporation as selling or exchanging their proportionate share of the stock of such corporation.
IRS Corrections to the 958 Final Regulations
On February 18, 2022, the IRS issued corrections to the 958 Final Regulations. The corrections were effective on January 25, 2022. The IRS issued additional corrections to these final regulations on March 10, 2022, which were applicable on February 22, 2022.
Reaction of Tax Professionals to the 958 Final Regulations
In reaction to the 958 Final Regulations, tax professionals have suggested that the new rules could create compliance challenges for taxpayers. The shift to an “aggregate approach” means that partners will have to assume new compliance and filing burdens. Large partnerships may be able to handle that for partners, but many individual investors will be required to comply on their own with the rules. In addition, there may be withholding issues which will require proper procedures to align with the new guidance.
Effective Dates for the 958 Final Regulations
The 958 Final Regulations apply to tax years of foreign corporations that begin on or after January 25, 2022, and to tax years of US persons in which or with which such tax years of foreign corporations end. A domestic partnership may apply the 958 Final Regulations to tax years of a foreign corporation beginning after December 31, 2017, subject to certain requirements including that the rules are applied consistently with respect to all foreign corporations whose stock the domestic partnerships own.
Passive Foreign Investment Companies (PFICs): Ownership of Shares by US Partnerships
The PFIC Proposed Regulations are the latest guidance package to treat domestic partnerships as an aggregate of their partners, rather than as separate entities, for offshore income. The new guidance expands the aggregate approach to PFICs by concluding that individual partners and S corporation shareholders will make their own tax decisions, including whether to treat certain earnings as capital gains rather than ordinary income.
The PFIC Proposed Regulations address the treatment of PFICs held by domestic partnerships and S corporations, as well as other PFIC-and CFC-related issues. A non-US corporation will generally be treated as a PFIC if at least 50% of its assets constitute passive assets (including shares, cash, certain intellectual property) or if at least 75% of its gross income is generated from passive sources (including dividends, interest, capital gains, and royalties).
US shareholders of a PFIC are subject to a punitive US tax regime that includes default excess distribution rules. US shareholders will generally be subject to ordinary income tax rates (i.e., no reduced capital gains tax rate) and substantial interest charges upon any distributions from the PFIC or a disposition of PFIC shares. Relief from the punitive PFIC rules may be available if the US shareholder makes a timely “qualified electing fund” (QEF) or “mark-to-market” (MTM) election with respect to the PFIC investment.
In the case of a QEF election, the US shareholder would be taxed on undistributed PFIC income as it is earned on a current basis. The QEF election must be made in the taxable year when the PFIC investment is first acquired by the US shareholder or the non-US corporation first becomes a PFIC. In the case of an MTM election, the US shareholder would recognize any unrealized gain in the PFIC shares on an annual basis as ordinary income by effectively marking the investment to market each year. Only PFICs that are marketable securities are eligible for the MTM election.
Under current PFIC rules, a domestic partnership or S corporation holding a PFIC generally is responsible for reporting, elections, and inclusions related to that PFIC. A US person owning an interest in a PFIC indirectly through a domestic partnership or S corporation generally takes into account QEF inclusions or MTM amounts under rules applicable to income inclusions from such domestic partnership or S corporation. The US person generally is not responsible for directly reporting ownership in, making elections with respect to, or including amounts from a PFIC held through a domestic intermediary entity for which a QEF or MTM election has been made.
The New PFIC Proposed Regulations
The PFIC Proposed Regulations generally adopt an aggregate approach that requires reporting, elections, and inclusions at the partner or shareholder level rather than at the domestic partnership or S corporation level, which has been the historical method. They would treat partners or S corporation shareholders, instead of the partnership or S corporation, as PFIC shareholders for the following:
- Making QEF, MTM, or purging elections;
- Recognizing QEF or MTM income;
- Applying the CFC overlap rule; and
- Filing Forms 8621, PFIC information returns.
The new proposed regulations also provide guidance regarding:
- The determination of the controlling domestic shareholders of foreign corporations;
- The treatment of S corporations with accumulated E&P; and
- The determination and inclusion of related-person insurance income (RPII).
The Preamble to the PFIC Proposed Regulations explains the adoption of the aggregate approach by noting that the aggregate treatment approach has already been adopted in other areas of the tax code including when determining a partner’s inclusion of global intangible low-taxed income (GILTI). It also notes that this approach represents:
- Consistency with the general treatment of partnerships across the PFIC regime;
- Alignment of the rules governing these elections with the treatment of domestic partnerships and S corporations for purposes of the CFC overlap rule, and
- The fact that partners and shareholders of domestic partnerships and S corporations, respectively, are the persons most affected by such elections and should therefore make decisions on whether to make the elections.
Under the PFIC Proposed Regulations, a partner or S corporation shareholder (rather than the entity as a whole) can choose to treat the PFIC as a QEF. Under rules for a QEF, a shareholder can treat certain share distributions as capital gains rather than ordinary income for tax purposes. Treasury states in the Preamble that aggregate treatment for the QEF election is consistent with the general treatment of partnerships under the PFIC regime.
In addition to applying the aggregate treatment for QEFs, the proposed guidance also takes the same approach to making a MTM election for a PFIC. Thus, partners and shareholders would decide whether to make the election and treat certain gains as ordinary income.
The election by a partner or shareholder would apply to all PFIC stock held by the electing partner or shareholder, including stock that is not held through the partnership or S corporation. The electing partner or shareholder would be required to notify the partnership of S corporation of its election and account for its pro rata share of ordinary earnings and net capital gain attributable to QEF.
If a shareholder transfers PFIC stocks subject to a QEF election to a pass-through entity in which it holds an interest, the transferor would continue to have QEF inclusions. PFIC elections made by a domestic partnership or S corporation under the existing rules with respect to any taxable years of PFICs that end on or before the date on which the PFIC Proposed Regulations become final will be respected and will apply to all relevant US partners and S corporation shareholders as of that date.
With respect to MTM elections, the electing partner or shareholder would determine its own MTM gain or loss rather than recognizing their distributive share of the domestic partnership’s or S corporation’s MTM gain or loss. MTM gain or loss would be determined based on the electing partner’s or shareholder’s taxable year, not the pass-through entity’s taxable year.
The electing partner or shareholder would be required to notify the partnership or S corporation of its election. Pre-existing MTM elections made by a domestic partnership or S corporation would continue for any partner or S corporation shareholder that owns an interest in the PFIC through the pass-through entity on the date the PFIC Proposed Regulations are finalized.
PFIC purging elections would be made by the partner or S corporation shareholder.
Subpart F Rules – Controlling Domestic Shareholders
As noted above, the 958 Final Regulations do not apply aggregate treatment for purposes of determining controlling domestic shareholders of foreign corporations. The IRS and Treasury do include aggregate treatment for this purpose in the PFIC Proposed Regulations, which aligns with their conclusion that domestic partnerships should be treated as aggregates for purposes of determining whether a US shareholder is a controlling domestic shareholder of a CFC.
Thus, domestic partnerships and S corporations are treated as aggregates of their partners and shareholders for purposes of determining the controlling domestic shareholders of foreign corporations. CFC elections that are made by controlled domestic shareholders would be made by partners or shareholders rather than by domestic partnerships or S corporations.
This aggregate treatment approach was included in the PFIC Proposed Regulations in order to give taxpayers an opportunity to comment.
S corporations with accumulated E&P: The PFIC Proposed Regulations include the S corporation transition approach, which was included in Notice 2020-69 with respect to aggregate treatment of S corporations for purposes of GILTI inclusion, but they do not extend the approach to all S corporations regardless of accumulated E&P.
CFC Overlap Rule: Under the CFC overlap rule in Section 1297(d), if a PFIC is also a CFC, US shareholders of the CFC generally will not be subject to the PFIC rules. This rule is intended to prevent double taxation of a US shareholder’s pro rata share of a foreign corporation’s income under both subpart F and the PFIC rules. Section 1297(d) provides that a corporation is not treated as a PFIC with respect to a shareholder during the “qualified portion” of the shareholder’s holding period with respect to stock in the corporation. The PFIC Proposed Regulations provide that, for purposes of the CFC overlap rule, the term “qualified portion” does not include any portion of a domestic partner or S corporation shareholder’s holding period during which such partner or shareholder was not a US shareholder, within the meaning of Section 951(b), with respect to the PFIC/CFC. The new guidance explains that the purpose of this rule is to prevent a domestic partner or S corporation shareholder that is not an indirect US shareholder of the CFC/PFIC from relying on the CFC overlap rule applied at the domestic partnership level to avoid the PFIC regime. The new guidance does include a transition rule to certain indirect owners who may no longer be able to utilize the CFC overlap rule.
Hybrid Approach for Certain Pass-through Entities: The PFIC Proposed Regulations adopt the rules from Notice 2019-46 that would permit domestic partnerships and S corporations to apply the hybrid approach of the 2018 proposed GILTI regulations (REG-104390-18) for taxable years ending before June 22, 2019, and exempt such entities from certain penalties.
Related-person insurance income (RPII): The PFIC Proposed Regulations make several changes to related-person insurance income (RPII) and related rules, including the application of the aggregate approach in some cases and the entity approach in others. They also include the new concept of a “related insured” in defining RPII, and an anti-abuse rule is included covering certain cross-insurance arrangements.
Form 8621 Information Reporting
Partners and S corporation shareholders would be required to file a Form 8621 information return. Domestic partnerships and S corporations would no longer be required to file the Form 8621.
The PFIC Proposed Regulations generally apply for tax years of shareholders beginning on or after the date of the filing publication of these regulations as final in the Federal Register.
IRS Request for Comments – Administrability Concerns
The IRS has invited comments on a number of issues by April 25, 2022. Businesses are advised to review the PFIC Proposed Regulations to determine whether the guidance would affect the PFIC status of their direct and indirect investments and then to respond with comments if they are warranted.
The Preamble acknowledges that the proposed partner and shareholder elections may cause administration problems including increased compliance burdens and limited access to information especially in the case of large investment partnerships. Thus, Treasury and the IRS have requested comments on potential mechanisms by which a partnership or S corporation could be delegated the requisite authority to continue to make the elections on behalf of their owners. The request for comments notes these issues:
- The legal mechanism by which these entities would be delegated the ability to make such elections;
- Whether these elections would be binding on all partners or shareholders; and
- The timing, filing, and notification requirements that should apply to such elections.
In a recent webcast hosted by the International Tax Institute, Edward Tracy of the IRS Office of Associate Chief Counsel stated that the IRS understands that domestic partnerships with stock in PFICs are facing serious administrative issues under the PFIC Proposed Regulations, which is demonstrated by the fact that the request for comments is more detailed than is generally included in proposed guidance. For example, he described a case where one partner wants to make a QEF election and another partner does not, or another partner wants to make an MTM election that imposes an annual tax on the stock as if it were sold at fair market value.
Partnership Reporting Requirements: Schedule K-2 and K-3 Reporting Relief
New Schedules K-2 and K-3 for partnerships and other pass-through entities with foreign interests were finalized by the IRS in 2021. The new schedules require more explicit detail about the partnership’s international activity that was only implicitly required in prior years (box 16 of schedule K-1 previously required disclosing foreign transactions, but it was unclear about the specific information that must be reported which led to widespread inconsistencies in those disclosures). They require any pass-through entity with foreign investors or other international activity to report that information on the new forms. Schedule K-2 reports the partnership’s total amount of any international taxable income, credits, or deductions and Schedule K-3 covers the partner’s share of that international activity.
For tax years beginning in 2021, the new Schedules K-2 and K-3 are required for most pass-through entities with foreign investors or international activity. The Preamble to the PFIC Proposed Regulations states that the new Schedule K-2 and K-3 reporting is expected to facilitate a partner’s ability to make a QEF election.
The instructions of Part VII of Schedules K-2 and K-3 currently include a filing exception for a domestic partnership or S corporation which made a QEF, MTM, or qualified investment company (QIC) election with respect to a PFIC. A question exists as to whether this exception will continue to be available if the PFIC Proposed Regulations become final due to the shift of reporting responsibilities to the partner or shareholder level.
On February 16, 2022, the IRS clarified Schedule K-2 and K-3 reporting relief for certain partnerships by adding details on the requirements for a partnership to be eligible for a filing exemption for the new schedules for 2021.
The IRS issued a list of answers to FAQs for the new Schedules K-2 and K-3, which require partnerships and S corporations to report their foreign income in much greater detail. Specifically, the IRS said that it would not require partnerships and S corporations without any foreign activity or foreign partners to file the new schedules for the 2021 tax year. The IRS news release announcing the relief for tax year 2021 include four conditions that must be met in order to qualify for the transition relief.
In an updated FAQ, the IRS said that partnerships with direct partners that are foreign estates and trusts, as well as foreign corporations, individuals or partnerships, would not qualify for the relief. The FAQ also specified that disqualifying foreign activity includes having foreign taxes paid or accrued, or assets that generate foreign source income.
For taxpayers who may be affected by either the 958 Final Regulations or the PFIC Proposed Regulations, review of this new guidance should be undertaken now since current investments may be affected as well as tax filings for the tax year 2021. In addition, taxpayers may wish to respond to the IRS request for comments in order to register their input on the PFIC Proposed Regulations and specifically, the compliance issues.
If you have questions about any of the information in this True Insight, please contact a member of your TPC engagement team.