[Federal Register Volume 60, Number 82 (Friday, April 28, 1995)]
[Proposed Rules]
[Pages 20922-20930]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-10174]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[INTL-0065-93]
RIN 1545-AS46
Exceptions to Passive Income Characterization for Certain Foreign
Banks and Securities Dealers
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document provides guidance concerning the application of
the exceptions to passive income contained in section 1296(b) for
foreign banks, securities dealers and brokers. This document affects
persons who own direct or indirect interests in certain foreign
corporations. This document also provides notice of a public hearing on
these proposed regulations.
DATES: Written comments must be received by August 10, 1995. Outlines
of oral comments to be presented at the public hearing scheduled for
August 31, 1995 at 10 a.m. must be received by August 10, 1995.
ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (INTL-0065-93), room
5228, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. In the alternative, submissions may be hand
delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R
(INTL-0065-93), Courier's Desk, Internal Revenue Building, 1111
Constitution Avenue NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Ramon
Camacho at (202) 622-3870; concerning submissions and the hearing, Ms.
Christina Vasquez, (202) 622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
A passive foreign investment company (PFIC) is any foreign
corporation that satisfies either the income test or asset test in
section 1296(a) of the Internal Revenue Code (Code). Under the income
test, a foreign corporation is a PFIC if 75 percent or more of its
gross income for the year is passive income. Sec. 1296(a)(1).
Alternatively, a foreign corporation is a PFIC if 50 percent or more of
the average value of its assets for the taxable year produce passive
income or are held for the production of passive income. Sec.
1296(a)(2). Under section 1296(b)(1), passive income is foreign
personal holding company income as defined in section 954(c) of the
Code, and includes dividends, interest, certain rents and royalties,
and gain from certain property transactions, including gain from the
sale of assets that produce passive income.
Under section 1296(b)(2)(A), income earned in the active conduct of
a banking business by a foreign corporation licensed to do business as
a bank in the United States and, to the extent provided in regulations,
by other corporations engaged in the banking business is not passive.
Notice 89-81, 1989-2 CB 399, (Notice) described rules to be
incorporated into subsequent regulations that would expand this
exception to certain foreign banks not licensed to do a banking
business in the United States. The rules contained in Sec. 1.1296-4 of
the proposed regulations would implement section 1296(b)(2)(A) for
banking activities conducted by foreign corporations.
In 1993, Congress added section 1296(b)(3)(A) to the Code,
effective for taxable years beginning after September 30, 1993. See
Omnibus Budget Reconciliation Act of 1993 (1993 Act), Pub. L. 103-66,
section 13231(d), 107 Stat. 312, 499. The provision treats as
nonpassive any income derived in the active conduct of a securities
business by a controlled foreign corporation (CFC) if the CFC is a U.S.
registered dealer or broker and, to the extent provided in regulations,
a CFC not so registered. The rules contained in Sec. 1.1296-6 would
implement section 1296(b)(3)(A).
Section 956A, added by the 1993 Act, requires each U.S. shareholder
of a CFC to include in income its pro rata share of the CFC's excess
passive assets. Under section 956A(c)(2), a passive asset is any asset
that produces passive income as defined in section 1296(b). An asset
that generates nonpassive income under Sec. 1.1296-4 or Sec. 1.1296-6
of the proposed regulations will be nonpassive for purposes of section
956A.
Explanation of Provisions
I. Description of Proposed Rules for Foreign Banks
A. General Rule
Section 1.1296-4(a) of the proposed regulations provides generally
that, for purposes of section 1296(a)(1), passive income does not
include banking income earned by an active bank or by a qualified
affiliate of such a bank. For this purpose, an active bank is either a
corporation that possesses a license issued under federal or state law
to do business as a bank in the United States, or a foreign corporation
that meets the licensing, deposit-taking, and lending requirements of
paragraphs (c), (d), and (e), respectively, of Sec. 1.1296-4.
The proposed rules generally adopt the deposit, lending, and
licensing standards contained in the Notice. These standards are
consistent with the provisions of the Code that define a bank as an
institution that accepts deposits from and makes loans to the public
and is licensed under state or federal law to conduct banking
activities. See e.g., sec. 581. The IRS and Treasury believe that
Congress intended [[Page 20923]] to grant the banking exception only to
corporations that conform to a traditional U.S. banking model.
However, the proposed rules liberalize the approach taken in the
Notice in several ways. Most significantly, the proposed rules adopt
subjective tests to measure whether the corporation meets the deposit-
taking and lending requirements. The IRS and Treasury rejected reliance
on objective tests such as those in the Notice after learning, through
several ruling requests pursuant to the Notice, that objective
standards may cause legitimate banks to be treated as nonbanks.
Because of the rigidity of the objective tests, the Notice
permitted the IRS to rule in rare and unusual circumstances that a
foreign corporation was an active bank even though it failed to satisfy
the requirements of the Notice. The proposed regulations do not adopt
this procedure because the IRS and Treasury believe that the enhanced
flexibility of the proposed rules should permit all foreign
corporations actively conducting a licensed banking business (whether
directly or through affiliates) to qualify for the bank exception.
B. Licensing Requirement
A foreign corporation that is not licensed in the United States
satisfies the licensing requirements of Sec. 1.1296-4(c) if it is
licensed or authorized to accept deposits from residents of the country
in which it is chartered or incorporated, and to conduct, in such
country, any of the banking activities described in the proposed
regulations. However, a corporation fails this licensing test if one of
the principal purposes for its obtaining a license was compliance with
the requirements of this section.
The IRS and Treasury believe that being licensed as a bank by a
bank regulatory authority is strong evidence that a corporation is a
bank. The proposed regulations therefore adopt a licensing test to
distinguish banks from investment funds.
C. Deposit-Taking Test
A foreign corporation satisfies the deposit-taking test of
Sec. 1.1296-4(d) if it regularly accepts deposits in the ordinary
course of its trade or business from customers who are residents of the
country in which it is licensed or authorized. In addition, the amount
of deposits shown on the corporation's balance sheet must be
substantial. Section 1.1296-4(d)(3) provides that whether the amount of
deposits on a corporation's balance sheet is substantial depends on all
the facts and circumstances, including whether the capital structure
and funding of the bank as a whole are similar to that of comparable
banking institutions engaged in the same types of activities and
subject to regulation by the same banking authorities.
The proposed regulations adopt this deposit-taking test in part to
distinguish banks from finance companies, which do not accept deposits.
This distinction between finance companies and banks is required by
Congress. H.R. Conf. Rep. No. 213, 103d Cong., 1st Sess. 641 (1993)
(noting that the banking, insurance, and securities exemptions ``do not
apply to income derived in the conduct of financing and credit services
businesses''). Although the IRS and Treasury believe that deposit-
taking is a key attribute of all active banks, they also recognize that
subjective tests will better accommodate the various types of banks
that have developed as a result of different banking systems and
regulatory frameworks.
The proposed regulations introduce flexibility to the deposit-
taking requirements in several ways. First, the requirement that the
amount of deposits be substantial is more flexible than the Notice
requirement that deposits constitute at least 50 percent of the total
liabilities of the bank. The IRS and Treasury recognize that a bank's
funding preferences may be affected by market conditions and regulatory
requirements and believes that an institution may be properly treated
as an active bank even if deposits do not constitute the institution's
primary source of funding.
Second, unlike the Notice, the proposed regulations do not include
any special rules for interbank deposits but treat them like any other
deposit, regardless of whether they are received from persons who are
members of a related group as defined in Sec. 1.1296-4(i)(4). The IRS
and Treasury believe this change is appropriate because the acceptance
of interbank deposits from related or unrelated persons on an arm's
length basis is a banking activity normally engaged in by banks. In
addition, the impact of a rule that distinguishes between interbank
deposits received from related persons and those received from
unrelated persons is diminished where deposit-taking activity is not
measured with a bright-line test.
Finally, the proposed rules change the Notice requirement that a
corporation must hold deposits from at least 1,000 persons who are bona
fide residents of the country that issued the corporation's banking
license because this requirement proved troublesome for certain private
banks with clientele from several countries. The requirement was
intended to address cases where a bank is licensed by a country but not
allowed to accept deposits from its residents. In the IRS and
Treasury's view, such an entity should not be treated as an active bank
for purposes of section 1296 because it is not accorded full bank
status by the bank authorities that issued its banking license.
However, the IRS and Treasury believe that a bright-line deposit
standard is not necessary to address this concern. Instead, the
proposed regulations require that a corporation regularly accept
deposits from residents of the country in which it is licensed.
D. Lending Test
A foreign corporation satisfies the lending test of Sec. 1.1296-
4(e) if it regularly makes loans to customers in the ordinary course of
its trade or business. This is a change from the Notice's requirement
that loans to unrelated persons make up more than 50 percent of the
corporation's loan portfolio. The lending test is necessary to
distinguish banks, which extend credit to customers, from corporations
that merely invest. However, such a distinction can be drawn without
relying on a bright-line standard such as that contained in the Notice.
In order to distinguish loans from investments for purposes of
these rules, the proposed regulations provide that a note, bond,
debenture or other evidence of indebtedness is a loan only if it is
received by the corporation on an extension of credit made pursuant to
a loan agreement entered into in the ordinary course of the
corporation's banking business. Debt instruments treated as securities
for purposes of the corporation's financial statements generally are
not loans.
E. Banking Income and Activities
Section 1.1296-4(f)(1) provides that banking income is gross income
derived from the active conduct of any banking activity as defined in
Sec. 1.1296-4(f)(2). These activities include all of the activities
treated as banking activities in the Notice, with no material changes,
except that finance leasing is included as a banking activity.
The proposed regulations do not adopt the Notice's rule that all of
the U.S. effectively connected income earned by a foreign corporation
in the active conduct of a trade or business pursuant to a U.S. bank
license automatically is nonpassive. One effect of this rule was that
effectively connected income earned by a U.S.- licensed bank from
transactions with related parties would have been banking income, while
income earned by non- [[Page 20924]] U.S.-licensed banks from similar
related-party transactions would not have been banking income. Because
the proposed regulations generally do not differentiate between related
party and non-related party transactions in the same way as the Notice,
the only effect of the rule would have been to treat, in the case of
U.S. licensed banks only, as banking income the income earned on
transactions with related parties who are not customers and income
earned from activities (such as securities activities) that are not
banking activities described in Sec. 1.1296-4(f). The IRS and Treasury
believe that the standards for determining whether income is derived in
the active conduct of a banking business should be the same for all
corporations that are either active banks or qualified bank affiliates.
The IRS and Treasury are aware that many bank activities may also
be considered securities activities. Under the proposed regulations, an
entity that performs an activity that is both a banking activity and a
securities activity must satisfy only the requirements of the bank
rules to treat income from such activity as nonpassive. For example, an
entity that derives income from dealing in foreign exchange may treat
such income as nonpassive if it is an active bank (or a qualified bank
affiliate) even though it is not a controlled foreign corporation.
Dealing in securities, however, is not included as both a banking
activity and a securities activity. The IRS and Treasury believe that
Congress intended that income from dealing in securities should be
nonpassive only if it is earned by a controlled foreign corporation
that actively conducts a securities business and meets the other
requirements of section 1296(b)(3)(A).
The IRS and Treasury have become aware that certain developing
country economies impose high deposit reserve requirements as a tool
for implementing monetary policy. Because the central banks of these
countries require the maintenance of such reserves as a prerequisite to
conducting a banking business, the earnings on such assets, if any,
should appropriately be excluded from passive income.
F. Customer Relationship
Under the proposed regulations, a bank satisfies the deposit and
lending tests only if it carries on such activities with customers.
Moreover, only the income from its banking activities (and those of its
qualified bank affiliates) conducted with, or for, customers will
produce nonpassive income. This is a change from the Notice
requirement, under which activities qualified only if they were
conducted with unrelated parties. Under the proposed regulations, a
customer may be any person, related or unrelated, if that person has a
customer relationship with the bank. Whether such a relationship exists
depends on all the facts and circumstances. However, persons who are
related to, or who are shareholders, officers, directors, or other
employees of, the corporation will not be treated as customers of the
corporation if one of the principal purposes for the corporation's
transacting business with such persons was to qualify the corporation
as an active bank or qualified bank affiliate.
G. Affiliates of Active Banks
The IRS and Treasury recognize that many active banks conduct one
or more banking activities through separately incorporated affiliates
that may not individually qualify as active banks. Accordingly, the
proposed regulations provide rules under which income from banking
activities may be treated as nonpassive if earned by a corporation that
does not qualify as an active bank but is a member of a related group
of which an active bank is also a member. However, such income is
nonpassive only for purposes of determining whether any member of the
related group is a passive foreign investment company or for purposes
of applying the excess passive asset rules of section 956A(c)(2)(A). In
addition, such income remains passive with respect to persons who own
stock in the affiliate but who are not members of the related group of
which the affiliate is a member.
For purposes of these rules, a related group is any group of
persons related within the meaning of section 954(d)(3), substituting
person for controlled foreign corporation. This definition is a
departure from the affiliated group definition of the Notice because it
permits noncorporate entities (such as partnerships) to count as
members of the group for purposes of satisfying the groupwide gross
income test.
Section 1.1296-4(i)(2) requires the bank affiliate to generate more
than 60 percent of its income from banking, insurance and securities
activities (but not other financial services). For purposes of this
test, the look-through rules of sections 1296(c) and 1296(b)(2)(C) do
not apply. This requirement ensures that a bank affiliate's eligibility
for the bank exception depends upon the business activities conducted
directly by the affiliate, and is not influenced by activities
conducted by related persons. However, a bank affiliate may
nevertheless apply sections 1296(c) and 1296(b)(2)(A) to determine
whether it is a PFIC under the income or asset tests of section
1296(a).
In addition, the related group must meet two gross income tests for
the exception to apply. First, under Sec. 1.1296-4(i)(3)(i), income
from banking activities derived by active banks must constitute at
least 30 percent of the financial services income earned by group
members. Second, under Sec. 1.1296-4(i)(3)(ii), income earned by group
members from banking activities, securities activities, and insurance
activities must constitute at least 70 percent of the financial
services income earned by group members that are financial services
entities. The regulations adopt the definition of financial services
income contained in Sec. 1.904-4(e), which includes only income earned
by financial services entities.
These affiliate rules are structurally similar to the affiliate
rules contained in the Notice, but have been modified in several
respects to respond to taxpayer comments. For example, the 80 percent
stock ownership threshold of the Notice caused many corporations to be
treated as PFICs solely because the gross income of subsidiaries in
which the group owned less than an 80 percent interest was excluded for
purposes of the Notice's gross income tests, even though the group had
voting control of such subsidiaries. The adoption of a lower 50 percent
ownership threshold for group membership in the proposed regulations
recognizes that international groups are not organized to meet the 80
percent threshold required for consolidation under U.S. tax law.
In addition, the gross income tests were changed in several ways to
deal with problems encountered by diversified affiliated groups. First,
the denominators of the fractions now include only financial services
income, which by its terms includes only income earned by financial
services entities. This change prevents foreign corporations that are
part of a banking group from being disqualified solely because the
group is a subgroup of a larger group that does not perform solely
financial services.
Second, the numerator of the fraction for the groupwide gross
income test now includes gross income from securities and insurance
activities in addition to banking activities. This change prevents a
foreign corporation engaged in banking activities that is part of a
banking subgroup from being disqualified solely because it is part of a
larger group that provides a broad range of financial services.
[[Page 20925]]
Finally, the proposed rules drop the Notice requirement that an
active bank be a group member for 5 years before its income may count
towards satisfaction of the gross income tests. Since PFIC status is
determined annually, the IRS and Treasury believe that whether a group
is a banking group should depend only on its status during the current
taxable year.
H. Income From Nonbanking Activities
As in the Notice, Sec. 1.1296-4(j) of the proposed regulations
provides that income derived from the conduct of activities other than
banking activities described in Sec. 1.1296-4(f)(2) and income from
assets held for the conduct of such activities are nonpassive only to
the extent provided in section 1296.
J. Effective Date
Section 1.1296-4 is proposed to be effective for all taxable years
beginning after December 31, 1994. However, taxpayers may apply
Sec. 1.1296-4 to a taxable year beginning after December 31, 1986, but
must consistently apply Sec. 1.1296-4 to such taxable year and all
subsequent years. While application of Sec. 1.1296-4 to a year
beginning after December 31, 1986, cannot affect the tax liability of a
taxpayer for any closed taxable year, a taxpayer may apply Sec. 1.1296-
4 to a closed taxable year for the purpose of determining whether a
foreign corporation is a PFIC in calculating the taxpayer's liability
for an open taxable year.
II. Exception for Income Earned in a Securities Business
A. General Rule
Section 1.1296-6(a) of the proposed regulations provides generally
that securities income earned by an active securities dealer, active
securities broker or qualified securities affiliate is nonpassive. As
required by section 1296(b)(3)(C), the rules apply only for purposes of
determining whether a controlled foreign corporation (as defined in
section 957(a)) is a PFIC with respect to its United States
shareholders (as defined in section 951(b)), or for purposes of
determining whether an asset is passive under section 956A(c)(2).
B. Active Securities Dealer and Active Securities Broker
Under Sec. 1.1296-6(b)(1), an active dealer or broker is a dealer
or broker that meets certain licensing requirements.
Section 1.1296-6(c) defines a securities dealer as a dealer in
securities within the meaning of section 475(c)(1). Under Sec. 1.1296-
6(d), a securities broker is a foreign corporation that stands ready to
effect transactions in securities and other financial instruments for
the account of customers in the ordinary course of its trade or
business during the taxable year. A securities dealer or broker is
licensed under Sec. 1.1296-6(b) if it possesses a U.S. license to do
business as a securities dealer or broker in the United States or if it
is licensed or authorized in the country in which it is chartered or
incorporated to conduct one or more securities activities described in
Sec. 1.1296-6(e)(2) with residents of that country. The conduct of such
activities must be subject to bona fide regulation, including
appropriate reporting, monitoring and prudential requirements, by a
securities regulatory authority that regularly enforces compliance with
such standards.
C. Securities Income & Securities Activities
Section 1.1296-6(e)(1) provides generally that securities income
means the gross income derived from the active conduct of any
securities activity that constitutes a trade or business. The list of
securities activities contained in Sec. 1.1296-6(e)(2) generally is
consistent with the legislative history to section 1296(b)(3)(A). See
H.R. Rep. No. 111, 103d Cong., 1st Sess. 704 (1993).
Section 1.1296-6(e)(2)(iv) includes as an additional securities
activity the maintenance of a capital deposit required under foreign
law as a prerequisite to acting as a broker in that jurisdiction.
Without this rule, a broker that is not also a dealer could be a PFIC
under section 1296(a)(2) even though the majority of its income is
commission income. This rule applies only if significant restrictions
exist on the use of its capital. Thus, working capital will not qualify
as a deposit for purposes of this rule.
In general, only income from transactions entered into with, or on
behalf of, persons with whom the corporation has a dealer-customer
relationship may be treated as nonpassive. Section 1.1296-6(g) adopts
without change the definition of dealer-customer relationship contained
in the bank rules.
Under Sec. 1.1296-6(h) of the proposed regulations, income and gain
from a security identified as held for investment under section
475(b)(1)(A) or which is not held for sale within the meaning of
section 475(b)(1)(B) is passive. Because the identification rules of
sections 475(b) and 1.475(b)-1T and 1.475(b)-2T apply, the rules
governing identification of inventory securities in Notice 88-22, 1988-
1 CB 489 and Notice 89-81, 1989-2 CB 399 do not apply with respect to
taxable years beginning after September 30, 1993. However, the
inventory identification rules of Notice 89-81 and Notice 88-22 will
continue to apply for taxable years beginning before October 1, 1993.
D. Matched Book Income
Section 1.1296-6(i) of the proposed regulations provides special
rules for determining a securities dealer's income from certain matched
transactions. These rules are adopted in order to eliminate a potential
opportunity for abuse that arises from the manner in which a matched
book repo business is conducted by securities dealers.
A matched transaction is defined as a sale and repurchase agreement
with respect to the same security, entered into by the controlled
foreign corporation in the active conduct of its trade or business and
properly treated as offsetting agreements in a matched book. In a
typical repurchase agreement a taxpayer sells a security and, at the
same time, agrees to repurchase an identical security from the
purchaser at a price in excess of the taxpayer's sales price. In a
reverse repurchase agreement, a taxpayer purchases a security and
concurrently agrees to sell an identical security to the seller at a
price in excess of the taxpayer's purchase price. A taxpayer who keeps
a matched book generally enters into offsetting repurchase and reverse
repurchase agreements involving identical securities. Such taxpayers
act as intermediaries by matching persons who need cash for a short
period with those who need securities for the same period.
Under the proposed regulations, securities income includes only the
net (not gross) income from matched transactions. Without the proposed
regulation's netting rule, related groups that are predominantly
engaged in passive activities could easily meet the gross income tests
contained in the qualified affiliate rules because a CFC conducting a
matched book business will earn large amounts of gross income, even
though net economic income from matched book activities is
comparatively small.
E. Affiliates of Dealers or Brokers
Like banks, securities dealers and brokers frequently operate
through separately incorporated subsidiaries that may not qualify
independently as active securities dealers or brokers but which form
part of an integrated securities business conducted by an active dealer
or broker. Accordingly, the proposed regulations contain rules that
extend the [[Page 20926]] securities dealer/broker exception to certain
qualified affiliates of active securities dealers or brokers. These
rules generally mirror the qualified bank affiliate rules contained in
Sec. 1.1296-4(i), except that they extend the securities dealer/broker
exception only to qualified securities affiliates that are CFCs, as
required by section 1296(b)(3)(A).
F. Income From Nonsecurities Activities
Section 1.1296-6(k) of the proposed regulations provides that
income derived from the conduct of activities other than securities
activities described in Sec. 1.1296-6(e)(2) and income from assets held
for the conduct of such activities are nonpassive only to the extent
provided in section 1296.
G. Effective Date
The rules contained in Sec. 1.1296-6 are proposed to be effective
for taxable years beginning after September 30, 1993.
III. Look-Through Rules
The proposed regulations do not contain guidance regarding the
look-through rules of sections 1296(c) and 1296(b)(2)(C) or the
grouping rules of section 956A(d). In general, the proposed regulations
also do not address whether, and to what extent, look-through
principles may apply to characterize income from a partnership as
nonpassive and an interest in a partnership as a nonpassive asset,
except to the extent that section 475 may treat a partnership as a
securities dealer. Because these issues are not unique to financial
institutions, the IRS and Treasury will address them in future
regulations of more general application. The IRS and Treasury solicit
comments on the proper scope and application of look-through and
grouping concepts to banks, securities dealers and securities brokers.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866. Therefore,
a regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do
not apply to these regulations, and, therefore, a Regulatory
Flexibility Analysis 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 August 31, 1995, at 10
a.m., in the Internal Revenue Service Auditorium, 7400 corridor.
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 and an outline of the topics to be discussed
and the time to be devoted to each topic (signed original and eight (8)
copies) by August 10, 1995.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the 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 Ramon Camacho, Office
of the 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
removing the entry for Sections 1.1291-10T, 1.1294-1T, 1.1295-1T, and
1.1297-3T and adding entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.1291-10T also issued under 26 U.S.C. 1291(d)(2).
Section 1.1294-1T also issued under 26 U.S.C. 1294.
Section 1.1295-1T also issued under 26 U.S.C. 1295.
Section 1.1296-4 also issued under 26 U.S.C. 1296(b)(2)(A).
Section 1.1296-6 also issued under 26 U.S.C. 1296(b)(3)(A).
Section 1.1297-3T also issued under 26 U.S.C. 1297(b)(1). * * *
Sec. 1.1291-0T [Redesignated as Sec. 1.1291-0]
Par. 2. Section 1.1291-0T is redesignated as Sec. 1.1291-0.
Par. 3. Newly designated Sec. 1.1291-0 is amended as follows:
1. The section heading for newly designated Sec. 1.1291-0 is
revised.
2. The introductory language for newly designated Sec. 1.1291-0 is
revised.
3. Entries for Secs. 1.1296-4 and 1.1296-6 are added in numerical
order.
The revisions and additions read as follows:
Sec. 1.1291-0 Passive foreign investment companies--table of contents.
This section lists headings under sections 1291, 1294, 1296 and
1297 of the Internal Revenue Code.
* * * * *
Sec. 1.1296-4 Characterization of certain banking income of
foreign banks as nonpassive.
(a) General rule.
(b) Active bank.
(1) U.S. licensed banks.
(2) Other foreign banks.
(c) Licensing requirements.
(d) Deposit-taking requirements.
(1) General rule.
(2) Deposit.
(3) Substantiality of deposits.
(e) Lending activities test.
(f) Banking income.
(1) General rule.
(2) Banking activities.
(g) Certain restricted reserves.
(h) Customer relationship.
(i) Income earned by qualified bank affiliates.
(1) General rule.
(2) Affiliate income requirement.
(3) Group income requirements.
(4) Related group.
(j) Income from nonbank activities.
(k) Effective date.
Sec. 1.1296-6 Characterization of certain securities income.
(a) General rule.
(b) Active dealer or broker.
(1) General rule.
(2) U.S. licensed dealers and brokers.
(3) Other dealers and brokers.
(i) General rule.
(ii) Licensing requirements.
(c) Securities dealer.
(d) Securities broker.
(e) Securities income.
(1) General rule.
(2) Securities activities.
(f) Certain deposits of capital.
(g) Dealer-customer relationship.
(h) Investment income. [[Page 20927]]
(i) Calculation of gross income from a matched book.
(j) Income earned by qualified securities affiliates.
(1) General rule.
(2) Affiliate income requirement.
(3) Group income requirements.
(4) Related group.
(5) Example.
(k) Income from nonsecurities activities.
(l) Effective date.
* * * * *
Par. 4. Section 1.1296-4 is added to read as follows:
Sec. 1.1296-4 Characterization of certain banking income of foreign
banks as nonpassive.
(a) General rule. For purposes of section 1296, banking income
earned by an active bank, as defined in either paragraph (b) (1) or (2)
of this section, or by a qualified bank affiliate, as defined in
paragraph (i) of this section, is nonpassive income.
(b) Active bank--(1) U.S. licensed banks. A corporation (whether
domestic or foreign) is an active bank if it is licensed by federal or
state bank regulatory authorities to do business as a bank in the
United States. A foreign corporation will not satisfy the requirements
of this paragraph (b)(1) if, under its federal or state license or
licenses, the foreign corporation is permitted to maintain only an
office, such as a representative office, that is prohibited by federal
or state law from taking deposits or making loans.
(2) Other foreign banks. A foreign corporation is an active bank if
it meets the licensing requirement of paragraph (c) of this section and
it actively conducts, within the meaning of Sec. 1.367(a)-2T(b)(3), a
banking business that is a trade or business within the meaning of
Sec. 1.367(a)-2T(b)(2). In order for the business conducted by a
foreign corporation to be considered a banking business, the foreign
corporation must also meet the deposit-taking requirements of paragraph
(d) of this section and the lending requirements of paragraph (e) of
this section.
(c) Licensing requirements. To be an active bank under paragraph
(b)(2) of this section, a foreign corporation must be licensed or
authorized to accept deposits from residents of the country in which it
is chartered or incorporated and to conduct, in that country, one or
more of the banking activities described in paragraph (f)(2) of this
section. However, in no case will a foreign corporation satisfy the
requirements of this paragraph (c) if one of the principal purposes for
its obtaining a license or authorization was to satisfy the
requirements of this section.
(d) Deposit-taking requirements--(1) General rule. To be an active
bank under paragraph (b)(2) of this section--
(i) A foreign corporation must, in the ordinary course of the
corporation's trade or business, regularly accept deposits from
customers who are residents of the country in which it is licensed or
authorized; and
(ii) The amount of deposits shown on the corporation's balance
sheet must be substantial.
(2) Deposit. Whether a liability constitutes a deposit for purposes
of this paragraph (d) is determined by reference to the characteristics
of the relevant instrument and does not depend solely on whether the
instrument is designated as a deposit.
(3) Substantiality of deposits. Whether the amount of deposits
(including interbank deposits) shown on a corporation's balance sheet
is substantial depends on all the facts and circumstances, including
whether the corporation's capital structure and funding sources as a
whole are similar to that of banking institutions engaged in the same
types of activities and subject to the jurisdiction of the same bank
regulatory authorities.
(e) Lending activities test. To be an active bank under paragraph
(b)(2) of this section, a corporation must regularly make loans to
customers in the ordinary course of its trade or business. A note,
bond, debenture or other evidence of indebtedness will be treated as a
loan for purposes of this section only if the debt instrument is
received by the corporation on an extension of credit made pursuant to
a loan agreement entered into in the ordinary course of the
corporation's banking business. Such debt instruments generally will
not be considered loans for purposes of this section if the instruments
are not treated as loans (but are classified as securities or other
investment assets, for example) for purposes of the foreign
corporation's financial statements.
(f) Banking income--(1) General rule. Banking income is the gross
income derived from the active conduct (within the meaning of
Sec. 1.367(a)-2T(b)(3)) of any banking activity described in paragraph
(f)(2) of this section.
(2) Banking activities. For purposes of this section, the following
are banking activities--
(i) Lending activities described in paragraph (e) of this section;
(ii) Factoring evidences of indebtedness for customers;
(iii) Purchasing, selling, discounting, or negotiating for
customers notes, drafts, checks, bills of exchange, acceptances, or
other evidences of indebtedness;
(iv) Issuing letters of credit and negotiating drafts drawn
thereunder for customers;
(v) Performing trust services, including activities as a fiduciary,
agent or custodian, for customers, provided such trust activities are
not performed in connection with services provided by a dealer in
stock, securities or similar financial instruments;
(vi) Arranging foreign exchange transactions (including any section
988 transaction within the meaning of section 988(c)(1)) for, or
engaging in foreign exchange transactions with, customers;
(vii) Arranging interest rate or currency futures, forwards,
options or notional principal contracts for, or entering into such
transactions with, customers;
(viii) Underwriting issues of stock, debt instruments or other
securities under best efforts or firm commitment agreements for
customers;
(ix) Engaging in finance leases, as defined in Sec. 1.904-
4(e)(2)(i)(V);
(x) Providing charge and credit card services for customers or
factoring receivables obtained in the course of providing such
services;
(xi) Providing traveler's check and money order services for
customers;
(xii) Providing correspondent bank services for customers;
(xiii) Providing paying agency and collection agency services for
customers;
(xiv) Maintaining restricted reserves (including money or
securities) as described in paragraph (g) of this section; and
(xv) Any other activity that the Commissioner determines, through a
revenue ruling or other formal published guidance (see
Sec. 601.601(d)(2) of this chapter), to be a banking activity generally
conducted by active banks in the ordinary course of their banking
business.
(g) Certain restricted reserves. A deposit of assets in a reserve
is, for purposes of this section, a banking activity if the deposit is
maintained in a segregated account in order to satisfy a capital or
reserve requirement under the laws of a jurisdiction in which the
corporation actively conducts (within the meaning of Sec. 1.367(a)-
2T(b)(3)) a banking business that is a trade or business (within the
meaning of Sec. 1.367(a)-2T(b)(2)). A deposit of assets into a reserve
qualifies under this paragraph (g) if and only to the extent that the
assets are not available for use in connection with the corporation's
banking business because of significant [[Page 20928]] regulatory
restrictions on the investment of such assets. This paragraph (g) does
not apply to ordinary working capital, which is available for
unrestricted use.
(h) Customer relationship. Whether a customer relationship exists
is determined by reference to all the facts and circumstances. Such a
relationship does not exist with respect to transactions between
members of a related group, as defined in paragraph (i)(4) of this
section, or transactions with any shareholders, officers, directors or
other employees of any person that would otherwise be treated as an
active bank or qualified bank affiliate if one of the principal
purposes for such transactions was to satisfy the requirements of this
section.
(i) Income earned by qualified bank affiliates--(1) General rule. A
foreign corporation that is not an active bank but which derives
banking income, as defined in paragraph (f)(1) of this section, is a
qualified bank affiliate for purposes of this section if such
corporation meets the requirements of paragraph (i)(2) of this section
and the related group of which it is a member meets the requirements of
paragraph (i)(3) of this section. Banking income earned by a qualified
bank affiliate is nonpassive only for purposes of determining whether
any member of the related group is a passive foreign investment company
or holds stock in a passive foreign investment company or for purposes
of applying section 956A(c)(2)(A). However, banking income of a
qualified bank affiliate remains passive with respect to persons who
own stock in that affiliate but who are not members of the related
group of which the affiliate is a member.
(2) Affiliate income requirement. To be a qualified bank affiliate,
at least 60 percent of the foreign corporation's total gross income for
the taxable year must be banking income, securities income, as defined
in Sec. 1.1296-6(e)(1), or gross income described in section
1296(b)(2)(B) (relating to insurance activities). For purposes of
applying this paragraph (i)(2), the look-through rules of sections
1296(b)(2)(C) and 1296(c) do not apply.
(3) Group income requirements. The related group qualifies under
this paragraph (i) if--
(i) At least 30 percent of the aggregate gross financial services
income, as defined in Sec. 1.904-4(e)(1), earned during the taxable
year by members of the related group is banking income earned by active
banks who are members of the related group during the current taxable
year; and
(ii) At least 70 percent of the aggregate gross financial services
income earned during the taxable year by members of the related group
is banking income, securities income, or gross income described in
section 1296(b)(2)(B)(relating to insurance activities).
(4) Related group. The related group is the group of persons
consisting of the entity being tested under this paragraph (i) and all
entities that are related within the meaning of section 954(d)(3) to
such entity, substituting ``person'' for ``controlled foreign
corporation'' each time the latter term appears.
(j) Income from nonbank activities. Income derived from the conduct
of activities other than banking activities described in paragraph
(f)(2) of this section and income from assets held for the conduct of
such other activities are nonpassive only to the extent otherwise
provided in section 1296.
(k) Effective date. This section is effective for taxable years
beginning after December 31, 1994. However, taxpayers may apply this
section to a taxable year beginning after December 31, 1986, but must
consistently apply this section to such taxable year and all subsequent
years.
Par. 5. Section 1.1296-6 is added to read as follows:
Sec. 1.1296-6 Characterization of certain securities income.
(a) General rule. For purposes of section 1296, securities income
earned by an active dealer or active broker, as defined in paragraph
(b) of this section, or a qualified securities affiliate, as defined in
paragraph (j) of this section, is nonpassive income. This section
applies only for purposes of determining whether a controlled foreign
corporation, as defined in section 957(a), is a passive foreign
investment company with respect to its United States shareholders as
defined in section 951(b), or for the purpose of determining whether an
asset is passive under section 956A(c)(2)(A).
(b) Active dealer or broker--(1) General rule. A securities dealer,
as defined in paragraph (c) of this section, or a securities broker, as
defined in paragraph (d) of this section, is an active dealer or an
active broker for purposes of this section if it meets the requirements
of either paragraph (b) (2) or (3) of this section.
(2) U.S. licensed dealers and brokers. A securities dealer or
securities broker (whether foreign or domestic) is an active dealer or
an active broker if it is registered as a securities dealer or broker
under section 15(a) of the Securities Exchange Act of 1934 or is
registered as a Government securities dealer or broker under section
15C(a) of such Act.
(3) Other dealers and brokers--(i) General rule. A securities
dealer or a securities broker is an active dealer or an active broker
if it meets the licensing requirements of paragraph (b)(3)(ii) of this
section and actively conducts, within the meaning of Sec. 1.367(a)-
2T(b)(3), one or more securities activities, as defined in paragraph
(e)(2) of this section, as a trade or business within the meaning of
Sec. 1.367(a)-2T(b)(2).
(ii) Licensing requirements. To be an active dealer or an active
broker under paragraph (b)(3) of this section, a securities dealer or
securities broker must be licensed or authorized in the country in
which it is chartered, incorporated or organized to conduct one or more
of the securities activities described in paragraph (e)(2) of this
section with residents of that country. The conduct of such activities
must be subject to bona fide regulation, including appropriate
reporting, monitoring and prudential (including capital adequacy)
requirements, by a securities regulatory authority in that country that
regularly enforces compliance with such requirements and prudential
standards.
(c) Securities dealer. For purposes of this section, a securities
dealer is a dealer (whether foreign or domestic) in securities within
the meaning of section 475(c)(1).
(d) Securities broker. For purposes of this section, a securities
broker is a corporation (whether domestic or foreign) that, during its
taxable year, stands ready, in the ordinary course of its trade or
business, to effect transactions in securities and other financial
instruments for the account of customers, including the arrangement of
loans of securities owned by customers.
(e) Securities income--(1) General rule. Securities income means
the gross income (except as provided in paragraph (i) of this section)
derived from the active conduct (within the meaning of Sec. 1.367(a)-
2T(b)(3)) of any securities activity described in paragraph (e)(2) of
this section.
(2) Securities activities. For purposes of this section, the
following are securities activities--
(i) Purchasing or selling stock, debt instruments, interest rate or
currency futures or other securities or derivative financial products
(including notional principal contracts) from or to customers and
holding stock, debt instruments and other securities as inventory for
sale to customers, unless the relevant securities or derivative
financial products (including notional [[Page 20929]] principal
contracts) are not held in a dealer capacity;
(ii) Effecting transactions in securities for customers as a
securities broker;
(iii) Arranging futures, forwards, options, or notional principal
contracts for, or entering into such transactions with, customers;
(iv) Arranging foreign exchange transactions (including any section
988 transaction within the meaning of section 988(c)(1)) for, or
engaging in foreign exchange transactions with, customers;
(v) Underwriting issues of stocks, debt instruments, or other
securities under best efforts or firm commitment agreements with
customers;
(vi) Purchasing, selling, discounting, or negotiating for customers
on a regular basis notes, drafts, checks, bills of exchange,
acceptances or other evidences of indebtedness;
(vii) Borrowing or lending stocks or securities for customers;
(viii) Engaging in securities repurchase or reverse repurchase
transactions with customers;
(ix) Engaging in hedging activities directly related to another
securities activity described in this paragraph (e)(2);
(x) Repackaging mortgages and other financial assets into
securities and servicing activities with respect to such financial
assets (including the accrual of interest incidental to such
activities);
(xi) Engaging in financing activities typically provided by an
investment bank, such as--
(A) Project financing provided in connection with, for example,
construction projects;
(B) Structured finance, including the extension of a loan and the
sale of participations or interests in the loan to other financial
institutions or investors; and
(C) Leasing activities to the extent incidental to financing
activities described in this paragraph (e)(2)(xi) or to advisory
services described in paragraph (e)(2)(xii) of this section;
(xii) Providing financial or investment advisory services,
investment management services, fiduciary services, trust services or
custodial services;
(xiii) Providing margin or any other financing for a customer
secured by securities or money market instruments, including repurchase
agreements, or providing financing in connection with any of the
activities listed in paragraphs (e)(2)(i) through (e)(2)(xii) of this
section;
(xiv) Maintaining deposits of capital (including money or
securities) described in paragraph (f) of this section; and
(xv) Any other activity that the Commissioner determines, through a
revenue ruling or other formal published guidance, to be a securities
activity generally conducted by active dealers or active brokers in the
ordinary course of their securities business.
(f) Certain deposits of capital. A deposit of capital is, for
purposes of this section, a securities activity if the deposit is
maintained in a segregated account in order to satisfy a capital
requirement for registration as a securities broker or dealer under the
laws of a jurisdiction in which the broker or dealer actively conducts
(within the meaning of Sec. 1.367(a)-2T(b)(3)) a trade or business
(within the meaning of Sec. 1.367(a)-2T(b)(2)) as a securities broker
or dealer. A deposit of capital qualifies under this paragraph (f) if
and only to the extent that the assets are not available for use in
connection with the controlled foreign corporation's activities as a
securities broker or dealer because of significant regulatory
restrictions on the investment of such assets. This paragraph (f) does
not apply to ordinary working capital, which is available for
unrestricted use.
(g) Dealer-customer relationship. Whether a dealer-customer
relationship exists is determined by reference to all the facts and
circumstances. Such a relationship does not exist with respect to
transactions between members of a related group, as defined in
paragraph (j)(4) of this section, or transactions with any
shareholders, officers, directors or other employees of any person that
would otherwise be treated as an active dealer, active broker or
qualified securities affiliate if one of the principal purposes for
such transactions was to satisfy the requirements of this section.
(h) Investment income. Income earned on any securities held for
investment within the meaning of section 475(b)(1)(A) or not held for
sale within the meaning of section 475(b)(1)(B), is passive for
purposes of sections 1296(a)(1), 1296(a)(2) and 956A(c)(2)(A).
(i) Calculation of gross income from a matched book. Securities
income includes only the net (not gross) income from matched
transactions. For purposes of this section, a matched transaction is a
sale and repurchase agreement with respect to the same security
properly treated as offsetting agreements in a matched book.
(j) Income earned by qualified securities affiliates--(1) General
rule. A foreign corporation that is not an active dealer or an active
broker but which derives securities income described in paragraph
(e)(1) of this section is a qualified securities affiliate for purposes
of this section if such corporation meets the requirements of paragraph
(j)(2) of this section and is a member of a related group that meets
the requirements of paragraph (j)(3) of this section. Securities income
earned by a qualified securities affiliate is nonpassive only for
purposes of determining whether any member of the related group is a
passive foreign investment company or holds stock in a passive foreign
investment company or for purposes of applying section 956A(c)(2)(A).
However, securities income of a qualified securities affiliate remains
passive with respect to persons who own stock in that affiliate but who
are not members of the related group of which the affiliate is a
member.
(2) Affiliate income requirement. To be a qualified securities
affiliate, at least 60 percent of the foreign corporation's total gross
income for the taxable year must be banking income, as defined in
Sec. 1.1296-4(f)(1), securities income, as defined in paragraph (e)(1)
of this section, or gross income described in section 1296(b)(2)(B)
(relating to insurance activities). For purposes of this paragraph
(j)(2), the look-through rules of sections 1296(b)(2)(C) and 1296(c) do
not apply.
(3) Group income requirements. The related group qualifies under
this paragraph (j) if--
(i) At least 30 percent of the aggregate gross financial services
income, as defined in Sec. 1.904-4(e)(1), earned during the taxable
year by members of the related group is securities income earned by
active dealers or active brokers who are members of the related group
during the current taxable year; and
(ii) At least 70 percent of the aggregate gross financial services
income earned during the taxable year by members of the related group
is banking income, securities income, or gross income described in
section 1296(b)(2)(B) (relating to insurance activities).
(4) Related group. The related group is the group of persons
consisting of the entity being tested under this paragraph (j) and all
entities that are related within the meaning of section 954(d)(3) to
such entity, substituting ``person'' for ``controlled foreign
corporation'' each time the latter term appears.
(5) Example. The following example illustrates the rules of this
paragraph (j).
Example. (i) Facts. SD is a country Y corporation that owns 85
percent of the stock of M, a country Z corporation. A, a U.S.
person, owns the remaining 15 percent of the stock of M. B, C, and
D, all unrelated U.S. persons, own 5, 15, and 36 percent,
respectively, of the stock of SD. The rest of SD's stock is publicly
held. SD is a securities dealer within the meaning of section
[[Page 20930]] 475(c)(1) and satisfies the licensing requirements of
paragraph (b)(3)(ii) of this section. Because M's sole activity is
conducting a matched book repo business, M is not a securities
dealer within the meaning of section 475. For its taxable year
ending December 31, 1994, SD earns $100 of gross income from trading
profits and interest and dividends on inventory. For its taxable
year ending December 31, 1994, M earns $50 of net interest income
from its matched book repo business. SD and M earn no other income.
All of SD and M's assets are held in connection with their
securities businesses and none has been identified as having been
held for investment.
(ii) Securities income earned by SD. SD is an active dealer
under paragraph (b) of this section because it is a securities
dealer under section 475 and satisfies the licensing requirements of
paragraph (b)(3)(ii) of this section. Therefore, because SD is a
controlled foreign corporation, SD's securities income is nonpassive
under paragraph (a) of this section.
(iii) Securities income earned by M. (A) SD and M are financial
services entities that are the only members of a related group as
defined in paragraph (j)(4) of this section. The percentage of the
SD-M related group's financial services income that is securities
income earned by active dealers (SD), is 66.66 percent (($100/$150)
X 100). The percentage of the SD-M related group's financial
services income that is securities income, banking income (as
defined in Sec. 1.1296-4(f)), or insurance income (as defined in
section 1296(b)(2)(B)) is 100 percent (($150/$150) x 100). In
addition, the percentage of M's income that is securities income is
100 percent (($50/$50) x 100).
(B) M is a qualified securities affiliate because the gross
income tests of paragraphs (j)(2) and (3) of this section are
satisfied. Accordingly, because M is a controlled foreign
corporation, M's securities income is nonpassive for purposes of
determining whether C or D own an interest in a PFIC (whether SD or
M). M is thus not a PFIC with respect to C or D because it does not
meet the income or asset tests of section 1296(a). SD also is not a
PFIC with respect to C or D because it does not meet the income or
assets tests of section 1296(a), after applying the look-through
rule of section 1296(c).
(C) However, because B owns less than 10 percent of the stock of
SD, and is therefore not a United States shareholder with respect to
SD under section 951(b), M's interest income is passive (even though
it is securities income) for purposes of determining whether B's
indirect interest in M is an interest in a PFIC. Moreover, M's
interest income is passive for purposes of determining whether A
owns an interest in a PFIC. As a result, M meets the income and
asset tests of section 1296(a) and is therefore a PFIC with respect
to A and B.
(k) Income from nonsecurities activities. Income derived from the
conduct of activities other than securities activities described in
paragraph (e)(2) of this section and income from assets held for the
conduct of such other activities are nonpassive only to the extent
otherwise provided in section 1296.
(l) Effective date. This section is effective for taxable years
beginning after September 30, 1993.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-10174 Filed 4-27-95; 8:45 am]
BILLING CODE 4830-01-U