[Federal Register Volume 86, Number 10 (Friday, January 15, 2021)]
[Rules and Regulations]
[Pages 4516-4579]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-27009]



[[Page 4515]]

Vol. 86

Friday,

No. 10

January 15, 2021

Part V





Department of the Treasury





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Internal Revenue Services





26 CFR Part 1





Guidance on Passive Foreign Investment Companies; Final Rule

  Federal Register / Vol. 86, No. 10 / Friday, January 15, 2021 / Rules 
and Regulations  

[[Page 4516]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9936]
RIN 1545-BO59


Guidance on Passive Foreign Investment Companies

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations regarding the 
determination of whether a foreign corporation is treated as a passive 
foreign investment company (``PFIC'') for purposes of the Internal 
Revenue Code (``Code''), and the application and scope of certain rules 
that determine whether a United States person that indirectly holds 
stock in a PFIC is treated as a shareholder of the PFIC. The 
regulations affect United States persons with direct or indirect 
ownership interests in certain foreign corporations.

DATES: 
    Effective date: These regulations are effective on January 14, 
2021.
    Applicability dates: For dates of applicability see Sec. Sec.  
1.1291-1(j), 1.1297-1(g), 1.1297-2(h), 1.1297-4(g), 1.1297-6(f), 
1.1298-2(g), and 1.1298-4(f).

FOR FURTHER INFORMATION CONTACT: Concerning the regulations Sec. Sec.  
1.1291-0 and 1.1291-1, 1.1297-0 through 1.1297-2, 1.1298-0, 1.1298-2, 
and 1.1298-4, Christina G. Daniels at (202) 317-6934; concerning the 
regulations Sec. Sec.  1.1297-4 and 1.1297-6, Josephine Firehock at 
(202) 317-4932 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    On July 11, 2019, the Department of the Treasury (``Treasury 
Department'') and the IRS published proposed regulations (REG-105474-
18) under sections 1291, 1297, and 1298 in the Federal Register (84 FR 
33120) (the ``proposed regulations'' or ``2019 proposed regulations''). 
All written comments received in response to the proposed regulations 
are available at www.regulations.gov or upon request. A public hearing 
on the proposed regulations was scheduled for December 9, 2019, but it 
was not held because there were no requests to speak. Terms used but 
not defined in this preamble have the meaning provided in these final 
regulations.
    In addition, on October 2, 2019, the Treasury Department and the 
IRS published proposed regulations (REG-104223-18) relating to the 
repeal of section 958(b)(4) by the Tax Cuts and Jobs Act, Public Law 
115-97, 131 Stat. 2054 (2017) (the ``Act'') in the Federal Register (84 
FR 52398) (the ``section 958 proposed regulations''). As in effect 
before its repeal, section 958(b)(4) provided that section 
318(a)(3)(A), (B), and (C) (providing for downward attribution) was not 
to be applied so as to consider a United States person (as defined in 
section 7701(a)(30)) as owning stock owned by a person who is not a 
United States person (a ``foreign person''). After the Act repealed 
section 958(b)(4), stock of a foreign corporation owned by a foreign 
person could be attributed to a United States person under section 
318(a)(3) for various purposes, including for purposes of determining 
whether the foreign corporation is a controlled foreign corporation 
within the meaning of section 957 (``CFC''). The section 958 proposed 
regulations generally made modifications to ensure that the operation 
of certain rules outside of subpart F of part III of subchapter N of 
chapter 1 of subtitle A of the Code (``subpart F'') are consistent with 
their application before the Act's repeal of section 958(b)(4). A 
public hearing on these regulations was not held because there were no 
requests to speak. This rulemaking finalizes the portion of the section 
958 proposed regulations under section 1297 regarding the treatment of 
foreign corporations for purposes of section 1297(e).\1\ See Part 
III.D.1 of the Summary of Comments and Explanation of Revisions 
section.
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    \1\ The other portions of the section 958 proposed regulations 
were finalized at 85 FR 59428.
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    A notice of proposed rulemaking published in the Proposed Rules 
section of this issue of the Federal Register (REG-111950-20) (the 
``2020 NPRM'') provides additional guidance on the treatment of income 
and assets of a foreign corporation for purposes of the PFIC rules and 
on the exception from passive income under section 1297(b)(2)(B) 
(``PFIC insurance exception'').

Summary of Comments and Explanation of Revisions

I. Overview

    The final regulations retain the basic approach and structure of 
the proposed regulations, with certain revisions. This Summary of 
Comments and Explanation of Revisions section discusses those revisions 
as well as comments received in response to the solicitation of 
comments in the notice of proposed rulemaking. Comments outside the 
scope of this rulemaking are generally not addressed but may be 
considered in connection with the potential issuance of future 
guidance.

II. Comments and Revisions to Proposed Sec.  1.1291-1--Taxation of U.S. 
Persons That Are Shareholders of Section 1291 Funds

    Section 1298(a) provides attribution rules that apply to the extent 
the effect is to treat stock of a PFIC as owned by a United States 
person. These rules apply when a United States person directly or 
indirectly owns an interest in a PFIC, a partnership, an estate or a 
trust, or when a United States person directly or indirectly owns 50 
percent or more in value of the stock of a corporation that is not a 
PFIC. In such cases, the attribution rules of section 1298(a) may apply 
to treat the United States person as owning shares of a PFIC owned 
directly or indirectly by such an entity. Stock considered to be owned 
by a person by reason of any of the foregoing rules is treated as 
actually owned by that person for purposes of the further application 
of those rules (the ``successive application rule''). Except as 
provided in regulations, the attribution rules do not apply to treat 
stock owned or treated as owned by a United States person as owned by 
any other person. The current rules in Sec.  1.1291-1(b)(8) are 
consistent with these statutory provisions.

A. Attribution of Ownership Through a Partnership, S Corporation, 
Estate or Trust

    Proposed Sec.  1.1291-1(b)(8)(iii) provided that an owner of an 
interest in a partnership, S corporation, estate or trust (a ``pass-
through entity'') would be treated as owning stock owned by the pass-
through entity only if the pass-through owner owns 50 percent or more 
of the pass-through entity. Examples in the proposed regulations 
illustrated the operation of this rule in cases where a United States 
person owns 50 percent, in one case, or 40 percent, in another case, of 
a foreign partnership. The preamble to the proposed regulations 
indicated that the proposed rule was intended to ensure that the 
attribution rules apply consistently whether a United States person 
owns stock of a non-PFIC foreign corporation indirectly through a 
partnership or directly.
    The only comment received on this proposed rule agreed with the 
results of the first example but recommended that a different approach 
be taken with respect to attribution through partnerships. The comment 
responded to the statement in the preamble that the proposed 
regulations would have results consistent with an aggregate approach to

[[Page 4517]]

partnerships by noting that in certain circumstances the proposed rule 
would deviate from a true aggregation approach. It posited an example 
in which application of the rule in the proposed regulations would 
prevent a United States person from being treated as owning stock of a 
PFIC owned by a non-PFIC corporation, even though the United States 
person directly and indirectly owned, in the aggregate, more than 50 
percent of the stock of the non-PFIC corporation and argued that this 
result was inappropriate. Accordingly, the comment suggested that the 
final regulations, instead of adopting the rule included in the 
proposed regulations, adopt a rule that uses an aggregation approach to 
attribution through partnerships.
    The Treasury Department and the IRS agree with the comment that the 
rule in the proposed regulations could have inappropriate results, and 
that a partner in a partnership should be treated as indirectly owning 
the same number of shares of a non-PFIC corporation owned by the 
partnership as if the partner held those shares directly. Accordingly, 
the final regulations do not adopt the rules in the proposed 
regulations to amend the rules of Sec.  1.1291-1(b)(8)(iii), relating 
to pass-through entities (partnerships, S corporations, estates and 
nongrantor trusts).

B. Application of ``top-down'' Approach

    The preamble to the proposed regulations indicated that proposed 
Sec.  1.1291-1(b)(8)(iii) was intended to apply the attribution rules 
to a tiered ownership structure involving a pass-through entity on a 
``top-down'' basis, by starting with a United States person and 
determining what stock is considered owned at each successive lower 
tier on a proportionate basis. The preamble requested comments as to 
whether the ``top-down'' approach should be extended to attribution 
through corporations.
    The only comment received on the issue indicated that the ``top-
down'' approach should not be so extended, on the grounds that the 
successive application rule of section 1298(a)(5) requires a ``bottom-
up'' approach (that is, applying the attribution rules to a tiered 
ownership structure by starting with the lowest-tier entity and 
determining which persons are treated as owning stock of that entity at 
each successive higher tier on a proportionate basis) for corporate 
structures. The comment acknowledged that this would result in 
inconsistency in attribution of ownership between stock of a PFIC held 
through a partnership (which, in many cases, may be a foreign corporate 
entity treated as a partnership for U.S. federal income tax purposes as 
the result of a check-the-box election) and stock of a PFIC held 
through a corporation.
    The Treasury Department and the IRS have determined that the same 
approach should apply to attribution through a pass-through entity, a 
PFIC or a 50 percent-owned non-PFIC corporation. In each case, the 
statutory language provides that an owner of an interest in such an 
entity is treated as owning its proportionate share of stock owned by 
the entity. The same approach to attribution therefore should apply 
regardless of which entity a United States person holds an interest in.
    The successive application rule of section 1298(a)(5) can be 
applied either under a ``top-down'' or ``bottom-up'' approach. While 
both approaches to attribution may treat a United States person as 
owning an amount of stock of a PFIC that is less than that person's 
economic interest in the PFIC, a ``top-down'' approach takes into 
account both the direct and indirect ownership of stock of a 
corporation by the same person while the bottom-up approach may not do 
so. For example, assume that U.S. individual A owns 49 percent of the 
partnership interests in a partnership that owns 95 percent of the 
stock of a tested foreign corporation. The tested foreign corporation 
is not a PFIC but owns all of the single class of stock of a PFIC. 
Individual A also owns the remaining 5 percent of the tested foreign 
corporation's stock directly. Under a ``top-down'' approach, individual 
A is deemed to hold 46.55 percent of the tested foreign corporation's 
stock through the partnership and owns 5 percent of the tested foreign 
corporation's stock directly. Therefore, individual A is treated as 
owning 51.55 percent of the tested foreign corporation's stock and 
51.55 percent of the PFIC stock. Under a ``bottom-up'' approach, the 
tested foreign corporation owns all of the PFIC stock; the partnership 
owns 95 percent of the tested foreign corporation's stock and therefore 
is treated as owning 95 percent of the PFIC stock; and individual A is 
treated as owning 49 percent of what the partnership owns, or 46.55 
percent of the PFIC stock. In this example, the ``top-down'' approach 
treats individual A as owning its economic share of the PFIC's stock, 
while the ``bottom-up'' approach may not take into account the PFIC 
stock that is owned through the 5 percent of the tested foreign 
corporation's stock that individual A owns directly. Accordingly, the 
final regulations apply a ``top-down'' approach to the attribution of 
ownership through all tiered ownership structures.
    The final regulations also include a new rule addressing the 
application of the successive application rule to tiered ownership 
structures. The new rule specifically provides for a top-down approach 
to attribution of ownership. See Sec.  1.1291-1(b)(8)(iv). The examples 
in the existing and proposed regulations have been revised to clarify 
how the top-down approach applies to those examples. See Sec.  1.1291-
1(b)(8)(v). A new example is added to illustrate the operation of the 
successive application rule in a fact pattern in which a United States 
person owns stock of a foreign corporation both directly and indirectly 
through a partnership. See Sec.  1.1291-1(b)(8)(v)(D).

C. Ownership Attribution Through Nongrantor Trusts

    A comment requested that the final regulations provide additional 
guidance on attributing PFIC stock held by a nongrantor trust to the 
beneficiaries of the trust, suggesting that determining ownership by 
U.S. beneficiaries of PFIC stock held directly or indirectly by a 
nongrantor trust warrants more specificity than determining ownership 
in PFIC stock held directly or indirectly by other pass-through 
entities.
    Section 1298(a)(3) and Sec.  1.1291-1(b)(8)(iii)(C) provide that 
each beneficiary is considered to own a proportionate amount of stock 
held by a foreign or domestic estate or nongrantor trust. Section 
1.1291-1(b)(8)(i) provides that the determination of a person's 
indirect ownership is made on the basis of all the facts and 
circumstances of each case and that the substance rather than the form 
of the ownership is controlling, taking into account the purposes of 
sections 1291 through 1298.
    On December 31, 2013, the Treasury Department and the IRS published 
final and temporary regulations under several Code sections including 
section 1291 (78 FR 79602, as corrected at 79 FR 26836) (``2013 
temporary and final regulations''). The preamble to those regulations 
provided that pending further guidance, beneficiaries of estates and 
nongrantor trusts that hold PFIC stock subject to the section 1291 
regime should use a reasonable method to determine their ownership 
interests in the PFIC. The preamble to those regulations also provided 
that section 1291 and the principles of subchapter J must be applied in 
a reasonable manner with respect to estates and trusts, and 
beneficiaries thereof, to preserve or trigger the tax and interest 
charge rules under section 1291. Accordingly, the

[[Page 4518]]

preamble provided that the estate or trust, or the beneficiary thereof, 
must take excess distributions into account under section 1291 in a 
reasonable manner, consistent with the general operating rules of 
subchapter J and that it would be unreasonable for the shareholders of 
the section 1291 fund to take the position that neither the 
beneficiaries nor the estate or trust are subject to the tax and 
interest charge rules under section 1291.
    The Treasury Department and the IRS remain aware of the need for 
guidance regarding both the ownership attribution rules and the 
interaction of the rules in subchapter J with the PFIC rules. The 
Treasury Department and the IRS are also aware that in some cases, the 
application of the PFIC attribution rules may impose tax on U.S. 
beneficiaries of foreign trusts that never receive the related 
distributions. The Treasury Department and the IRS believe that further 
guidance with respect to the identification of indirect shareholders in 
such circumstances requires coordination of the PFIC rules with the 
rules of subchapter J, which is beyond the scope of this regulation 
project. Pending the issuance of further guidance, taxpayers should 
continue to apply these rules in a reasonable manner as expressed in 
the preamble to the 2013 temporary and final regulations.

III. Comments and Revisions to Proposed Sec.  1.1297-1--Definition of 
Passive Foreign Investment Company

    Proposed Sec.  1.1297-1 provided general rules and definitions 
under section 1297 including general rules concerning the application 
of the income test of section 1297(a)(1) (``Income Test'') and the 
asset test of section 1297(a)(2) (``Asset Test''), clarification on the 
scope of the section 1297(b)(1) cross-reference to section 954(c) for 
purposes of defining passive income, and general rules that address 
certain computational and characterization issues that arise in 
applying the Asset Test.

A. Definition of Passive Income

1. In General
    Section 1297(b)(1) defines passive income, for purposes of the PFIC 
rules, as income of a kind that would be foreign personal holding 
company income (``FPHCI'') under section 954(c), and proposed Sec.  
1.1297-1(c)(1)(i) provided accordingly that passive income means income 
of a kind that would be FPHCI under section 954(c)(1). A comment 
suggested that the cross-reference to section 954(c)(1) should 
incorporate only those provisions of section 954(c) (and the 
regulations thereunder) that were in effect in 1986 when section 1297 
was enacted and not, for example, section 954(c)(1)(H), relating to 
income from personal services contracts, or recent revisions to the 
regulatory rules for active rents and royalties under section 
954(c)(2)(C). The Treasury Department and the IRS disagree, and believe 
that, in view of the original purpose of referencing section 954(c), 
section 1297 incorporates the law in respect of the referenced 
provisions--both statutory and regulatory--when it is applied. Compare 
section 951A(d)(3).\2\ Therefore, the final regulations do not adopt 
this comment.
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    \2\ As enacted, section 951A(d) contains two paragraphs 
designated as paragraph (3). The section 951A(d)(3) referenced in 
this preamble relates to the paragraph on determination of the 
adjusted basis in property for purposes of calculating QBAI.
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2. PFIC/CFC Overlap Rule and RPII Income
    Section 1297(d) provides that, for PFIC purposes, a corporation 
shall not be treated as a PFIC with respect to a shareholder during the 
qualified portion of such shareholder's holding period with respect to 
stock in such corporation during which time the corporation is a CFC 
(``PFIC/CFC overlap rule''). The qualified portion of a shareholder's 
holding period generally is the period during which the shareholder is 
a United States shareholder (``U.S. shareholder''), as defined in 
section 951(b). Section 951(b) defines a U.S. shareholder, for purposes 
of the Code, as a U.S. person that owns 10 percent or more of the 
voting power or value of a foreign corporation. Section 957(a) provides 
that, for purposes of the Code, a CFC means any foreign corporation 
more than 50 percent owned (by vote or value, taking into account 
section 958(b) constructive ownership rules) by U.S. shareholders on 
any day during the taxable year of the foreign corporation.
    In certain circumstances, the subpart F insurance rules lower the 
CFC ownership threshold requirements used to determine CFC status and 
eliminate the 10 percent vote or value test for determining U.S. 
shareholder status that are otherwise applicable for purposes of the 
Code. Under section 957(b), a special definition of a CFC applies and 
lowers the more than 50 percent ownership rule to a more than 25 
percent ownership rule for taking into account section 953(a) insurance 
income, but only if the foreign corporation's gross amount of premiums 
or other consideration in respect of reinsurance or the issuing of 
insurance or annuity contracts not described in section 953(e)(2) 
exceeds 75 percent of the gross amount of all premiums or other 
consideration in respect of all risks. Also, under section 
953(c)(1)(B), for purposes of taking into account related party 
insurance income (``RPII'') as defined in section 953(c)(2), the CFC 
ownership requirement is reduced to a ``25 percent or more'' 
requirement. In addition, for purposes of determining RPII, the 10 
percent of vote or value test for determining U.S. shareholder status 
is eliminated. See section 953(c)(1)(A). Instead, for RPII purposes, a 
U.S. shareholder means any U.S. person that directly or indirectly owns 
any of the stock of the foreign corporation at any time during the 
foreign corporation's taxable year. See section 953(c)(1)(A). 
Constructive ownership under section 958(b) is not taken into account 
for this purpose.
    A comment requested that the proposed regulations be modified to 
provide an exception to the PFIC rules for all U.S. shareholders 
(meaning without regard to the 10 percent vote or value test in section 
951(b)) of all CFCs (including those that satisfy the 25 percent 
threshold applicable solely for the subpart F purposes described 
above). The final regulations do not adopt this comment. Consideration 
of the scope of the PFIC/CFC overlap rule, including the interaction 
with the RPII rules, is beyond the scope of this rulemaking. The 
Treasury Department and the IRS continue to study the interaction of 
these provisions and if necessary, will provide guidance in the future.

B. Exceptions From Passive Income

1. Application of Active Banking and Active Insurance Exceptions
    Proposed Sec.  1.1297-1(c)(1)(i)(A) provided that section 954(h), 
which excludes from FPHCI income derived by a CFC in the active conduct 
of a banking or financing business from customers outside of the United 
States, applied for purposes of determining PFIC status. The proposed 
regulations also provided that section 954(i), which excludes from 
FPHCI certain income derived in the active conduct of an insurance 
business, did not apply for purposes of determining PFIC status. See 
proposed Sec.  1.1297-1(c)(1)(i)(B). Several comments approved of the 
application of section 954(h) to the determination of whether income is 
treated as passive for purposes of section 1297. One comment noted 
that, in the case of tested foreign corporations with look-through 
subsidiaries that are domestic corporations, section 
954(h)(3)(A)(ii)(I)

[[Page 4519]]

would result in the section 954(h) exception being inapplicable to 
active financing income earned by these subsidiaries from transactions 
with local customers, even though it would otherwise be of a type that 
would not be passive. The comment suggested that section 954(h) should 
be applied in the PFIC context by treating income as qualified banking 
or financing income even if the income is derived from transactions 
with customers in the United States. Several comments recommended that 
the section 954(h) exception continue to apply in the PFIC context in 
the event that final regulations implementing the active banking 
exception in section 1297(b)(2)(A) are adopted. Comments also requested 
that the final regulations apply the section 954(i) insurance exception 
for purposes of determining PFIC status of an insurance company in a 
parallel manner as section 954(h).
    In response to these comments, the Treasury Department and the IRS 
have further studied sections 954 and 1297 and their legislative 
history. As described in more detail in the remainder of this Part 
III.B.1 of this Summary of Comments and Explanation of Revisions 
section, the Treasury Department and the IRS have determined that 
sections 954(h) and (i) do not apply for purposes of section 1297(b) 
absent regulations and that the appropriate statutory authority for any 
such regulations is section 1297(b)(2) rather than section 1297(b)(1). 
The Treasury Department and the IRS have further concluded that section 
954(i) does not apply for purposes of section 1297(b)(2)(B), and that 
certain principles of section 954(h) should be applied for purposes of 
section 1297(b)(2)(A) but that a different approach is warranted with 
respect to section 954(h) than the approach taken in the proposed 
regulations. Accordingly, the 2020 NPRM proposes rules that would treat 
qualifying income of certain taxpayers that satisfy the requirements of 
section 954(h) as income derived in the active conduct of a banking 
business within the meaning of section 1297(b)(2). See proposed Sec.  
1.1297-1(c)(2).
    As previously discussed, section 1297(b)(1) provides that, except 
as otherwise provided in section 1297(b)(2), passive income means any 
income of a kind that would be FPHCI as defined in section 954(c). The 
definitions of the categories of FPHCI listed in section 954(c) 
describe types of gross income, for example interest, dividends, gains 
from the sale of property and foreign currency gains, as well as 
exceptions to those definitions. While these definitions and exceptions 
in some places refer to CFCs, the definitions and exceptions themselves 
do not require that a foreign corporation be a CFC. By contrast, 
although sections 954(h) and (i) apply ``for purposes of section 
954(c)(1),'' those provisions explicitly require that a foreign 
corporation be a CFC to qualify for an exception to FPHCI. Section 
954(h) applies only to eligible CFCs, as defined in section 954(h)(2), 
and section 954(i) applies only to qualifying insurance company CFCs, 
as defined in section 953(e)(3). Accordingly, sections 954(h) and (i) 
do not apply for purposes of section 1297(b)(1) unless a tested foreign 
corporation is treated pursuant to regulations as a CFC for that 
purpose or otherwise qualifies as a CFC. See proposed Sec.  1.1297-
1(c)(1)(i)(D) of the 2019 proposed regulations (treating a tested 
foreign corporation as a CFC for purposes of applying section 954(h)).
    The Treasury Department and the IRS have further determined that 
any regulations treating sections 954(h) and (i) as applicable for 
purposes of section 1297(b) should be issued under section 1297(b)(2) 
and not under section 1297(b)(1). As originally enacted, section 
1297(b)(1) provided a rule of general application, and section 
1297(b)(2) provided a limited set of exceptions to section 1297(b)(1). 
While the list of exceptions in section 1297(b)(2) has changed from 
time to time, that statutory scheme remains intact today. Section 
1297(b)(2) provides exceptions for income derived in the active conduct 
of a banking or insurance business, subject to various conditions. If 
section 954(h) or (i) were treated as applicable for purposes of 
section 1297(b)(1), section 1297(b)(2)(A) and (B) would provide 
duplicative exceptions for banking or insurance income, respectively. 
Moreover, interpreting section 1297(b)(1) in this manner would have the 
effect of narrowing the scope of the exceptions provided by section 
1297(b)(2), because the income of some foreign banks or insurance 
companies would already be treated as non-passive under section 
1297(b)(1). No explicit action by Congress authorizes the narrowing of 
section 1297(b)(2) in this manner. The legislative history of the 
enactment of section 954(h) (as a temporary rule relating to both 
banking and insurance income) in 1997 and the enactment of sections 
954(h) and (i) in 1998 are void of any indication that Congress 
intended such an interpretation of section 1297(b)(1).\3\ The 
legislative history provides further evidence that section 954(h) was 
not intended to apply for purposes of section 1297(b)(1); the 
conference report states that ``the conferees intend that a corporation 
will be considered to be engaged in the active conduct of a banking . . 
. business if the corporation would be treated as so engaged under the 
regulations proposed under'' section 1297(b)(2).\4\ Incorporating this 
standard into section 1297(b)(1) would limit the scope of section 
1297(b)(2). Accordingly, given the specialized nature of these 
exceptions within the subpart F regime, the Treasury Department and the 
IRS have determined that it is inappropriate to apply them in defining 
the types of income that are ``of a kind'' described in section 954(c) 
(that is, FPHCI) for purposes of section 1297(b)(1).
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    \3\ See H.R. Rep. No. 220, 105th Cong. 1st Sess. 623-28 (July 
30, 1997) (discussing adoption of section 1297(d) CFC overlap rule 
and section 1296 mark-to-market rule; no discussion of 
contemporaneous adoption of section 954(h)); id. at 639-45 
(discussing adoption of active financing income (section 954(h)) 
rule; no suggestion that rules apply for PFIC purposes).
    \4\ Id. at 642; see also H.R. Rep. No. 105-825, at 1555 (Oct. 
19, 1998) (Conf. Rep.) (``[I]n this regard, a corporation is 
considered to be engaged in the active conduct of a banking or 
securities business if the corporation would be treated as so 
engaged under the regulations proposed under prior law section 
1296(b) (as in effect prior to the enactment of the Taxpayer Relief 
Act of 1997)'').
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    In addition, as explained in the preamble to the 2019 proposed 
regulations, the Treasury Department and the IRS have determined that 
because the recent changes to section 1297(b)(2)(B) require that income 
eligible for the exception be earned by a qualifying insurance 
corporation, section 954(i) should not apply in addition to the newly 
modified exception in section 1297(b)(2)(B). See 84 FR 33120, at 33123. 
Therefore, the final regulations do not adopt the comments requesting 
that the section 954(i) exception apply for purposes of determining 
PFIC status. As a result, section 954(i) remains listed in Sec.  
1.1297-1(c)(1)(i)(B) as one of the exceptions in section 954 that is 
not applied in the PFIC context.
    Section 954(h) has been removed from the list of exceptions that 
are applied to PFICs with respect to section 1297(b)(1). See Sec.  
1.1297-1(c)(1)(i)(A). Despite the conclusion that it is inappropriate 
to incorporate section 954(h) as an exception to the definition of 
passive income under section 1297(b)(1), the Treasury Department and 
the IRS have considered whether principles of section 954(h) could 
apply in the context of the rules of section 1297(b)(2)(A). Section 
1297(b)(2)(A) provides that passive income does not include any income 
derived in the

[[Page 4520]]

active conduct of a banking business by an institution licensed to do 
business as a bank in the United States (or, to the extent provided in 
regulations, by any other corporation). Pursuant to this grant of 
regulatory authority, the 2020 NPRM proposes an active banking 
exception that incorporates certain principles of section 954(h) in 
defining other corporations that are eligible to apply this exception 
in addition to U.S. licensed banks. See proposed Sec.  1.1297-1(c)(2). 
The preamble to the 2020 NPRM discusses comments that address issues 
relating to the potential application of section 954(h) in the PFIC 
context.
2. Treatment of Gains From Certain Transactions
    Proposed Sec.  1.1297-1(c)(1)(ii) provided that for purposes of the 
Income Test, categories of income under section 954(c) that are 
determined by netting gains against losses are taken into account by a 
corporation on that net basis. However, under the proposed regulations, 
the net amount of income in each category of FPHCI was calculated 
separately for each relevant corporation, such that net gains or losses 
of a look-through subsidiary may not be netted against net losses or 
gains of another look-through subsidiary or of a tested foreign 
corporation. See proposed Sec.  1.1297-1(c)(1)(ii).
    One comment recommended that the final regulations not adopt the 
separate entity approach in proposed Sec.  1.1297-1(c)(1)(ii) and, 
instead, permit a tested foreign corporation to net its gains and 
losses with those of its directly or indirectly owned look-through 
subsidiaries and its directly or indirectly owned partnerships. The 
comment noted that the separate entity approach could result in an 
overstatement of FPHCI of an integrated business that is conducted 
through multiple subsidiaries.
    The Treasury Department and the IRS have determined that the 
integrated treatment proposed by the comment with respect to look-
through subsidiaries and look-through partnerships is consistent with 
the statutory language treating the owner of a look-through subsidiary 
as receiving directly its proportionate share of the income of the 
subsidiary, and with the policies underlying section 1297(c). 
Accordingly, Sec.  1.1297-1(c)(1)(ii) provides that the net gains or 
income for a category of FPHCI that is determined by netting gains 
against losses are determined at the level of a tested foreign 
corporation taking into account individual items of the tested foreign 
corporation and its look-through subsidiaries and look-through 
partnerships. Because these regulations do not adopt an overall look-
through approach with respect to all partnerships, netting is not 
provided with respect to gains and losses derived from partnerships 
that are not look-through partnerships. For example, netting does not 
apply to gains and losses that are part of a tested foreign 
corporation's distributive share from a partnership that is a related 
person within the meaning of section 954(d)(3) but not a look-through 
partnership.
3. Treatment of Effectively Connected Income and Income Attributable to 
U.S. Permanent Establishments
    Section 952(b) excludes from subpart F income the U.S. source 
income of a CFC that is effectively connected with the conduct by such 
CFC of a trade or business in the United States (``effectively 
connected income''). Comments noted that the proposed regulations did 
not address the treatment of effectively connected income, or the 
assets held to produce such income, of a foreign corporation or the 
treatment of income that is attributable to a U.S. permanent 
establishment, or the assets held to produce such income. The comments 
noted that section 952(b) can exclude from subpart F income amounts 
that are FPHCI in order to prevent such amounts from being double-
taxed, once directly to the foreign corporation, and a second time to 
United States shareholders of the foreign corporation, and stated that 
the PFIC rules should not discriminate against income earned through a 
U.S. branch rather than through a domestic subsidiary that may qualify 
for the special rules of section 1298(b)(7). These comments suggested 
that the final regulations either characterize such income, and the 
assets held to produce such income, as non-passive or not include such 
income for purposes of the Income and Asset Tests.
    As noted in Part III.B.1 of this Summary of Comments and 
Explanation of Revisions, the determination of whether amounts should 
be taken into account for purposes of the Income Test or the Asset Test 
is based on whether income would be FPHCI under section 954(c), not 
whether the income is treated as subpart F income. The PFIC rules 
address whether income is passive, which is a different question from 
whether it should be treated as subpart F income. Section 1298(b)(7) 
does not provide non-passive treatment for all income of domestic 
subsidiaries, but rather only for income of domestic subsidiaries that 
meet specified requirements, indicating that Congress did not consider 
it appropriate to exclude all income of domestic subsidiaries that are 
subject to U.S. net income taxation from passive income treatment. As a 
corollary, the limited scope of section 1298(b)(7) implies that a broad 
exception for effectively connected income is not warranted. 
Furthermore, section 1293(g)(1)(B)(ii) provides authority to exclude 
effectively connected income of a PFIC that is subject to U.S. net 
income taxation from inclusion in the hands of a shareholder of the 
PFIC that has made a qualified electing fund election, indicating that 
effectively connected income is otherwise treated as income of a tested 
foreign corporation for PFIC purposes.
    The Treasury Department and the IRS have determined that an 
exclusion of effectively connected income (and income attributable to a 
U.S. permanent establishment) from passive income would be inconsistent 
with the statutory definition of passive income in section 1297(b)(1), 
with the limited application of section 1298(b)(7) and with the 
exclusion provided by section 1293(g)(1)(B)(ii), and that the treatment 
of effectively connected income (and income attributable to a U.S. 
permanent establishment) is contemplated and appropriately addressed by 
the existing PFIC rules. Consequently, the final regulations do not 
adopt the suggestions in these comments.

C. Income Subject to the Related Person Look-Through Rule

    Section 1297(b)(2)(C) characterizes dividends, interest, rents, and 
royalties received or accrued from a related person as non-passive 
income to the extent those amounts are properly allocable to income of 
such related person that is not passive. Proposed Sec.  1.1297-1(c)(3) 
provided additional guidance on the application of the section 
1297(b)(2)(C) related person exception for dividends, interest, rents, 
and royalties. In response to comments, changes have been made to these 
regulations and additional guidance has been provided.
    Under the final regulations, for purposes of the Asset Test and 
Income Test, corporations and partnerships owned in whole or part by a 
tested foreign corporation are generally classified into one or more of 
three categories. Lower-tier entities generally are treated as one or 
more of (i) a look-through subsidiary or look-through partnership (a 
``look-through entity''), (ii) a related person or (iii) an entity that 
is neither a look-through entity nor a related person. The rules for 
look-through entities are discussed in Part IV of this Summary of 
Comments and Explanation of Revisions. Dividends

[[Page 4521]]

and the distributive share of income from a lower-tier entity that is 
neither a look-through entity nor a related person generally are 
treated as passive income, regardless of whether the income of the 
lower-tier entity is active or passive in its hands. See Sec.  1.1297-
1(c)(3). Similarly, ownership interests in such entities are treated as 
passive assets. See Sec.  1.1297-1(d)(4).
    For purposes of section 1297(b)(2)(C), the term related person has 
the meaning provided by section 954(d)(3). See section 1297(b)(2) and 
Sec.  1.1297-1(f)(8). Because the ownership threshold required for an 
entity to be treated as a related person is higher than the ownership 
threshold required for an entity to be treated as a look-through 
entity, there may be many entities that qualify as both or solely as 
look-through entities. However, because section 954(d)(3) has broader 
attribution rules than the rules that apply for purposes of determining 
look-through entity classification, there may be entities that are 
treated as related persons with respect to a tested foreign corporation 
but not as look-through entities with respect to that tested foreign 
corporation.
    For purposes of section 1297(b)(2)(C), interest, dividends, rents 
or royalties actually received or accrued by a tested foreign 
corporation are considered received or accrued from a related person 
only if the payor of the interest, dividend, rent or royalty is a 
related person with respect to the tested foreign corporation. In the 
case of income received or accrued from a look-through entity, the 
rules that eliminate intercompany income described in Part IV.D of this 
Summary of Comments and Explanation of Revisions apply before the rules 
applicable to income received or accrued from a related person. See 
Sec.  1.1297-1(c)(4)(ii). Consequently, the rules of Sec.  1.1297-
1(c)(4) apply to dividends, interest, rents, and royalties received or 
accrued from a look-through entity only if those amounts are treated as 
regarded after application of the intercompany income rules. These 
rules also apply to income from a related person that is received or 
accrued by a look-through entity. The determination of whether income 
received or accrued by a look-through entity is treated as received 
from a related person is made at the level of the look-through entity, 
both for purposes of determining whether the look-through entity is a 
PFIC, if relevant, and for purposes of determining whether an upper-
tier tested foreign corporation is a PFIC. See Sec.  1.1297-2(d).
    If a partnership is a related person (that is not a look-through 
entity) with respect to a tested foreign corporation or look-through 
entity, and therefore subject to these rules, the tested foreign 
corporation's or look-through entity's distributive share of income 
from the partnership is treated as passive or non-passive in whole or 
part based on the activities of the partnership, and the partnership 
interest is correspondingly treated as passive or non-passive in whole 
or part. See Sec.  1.1297-1(c)(4)(vii), (d)(3)(i), and (d)(4). An asset 
that gives rise to income that is treated as in part passive and in 
part non-passive pursuant to these rules is subject to the rules that 
apply to dual-character assets. See Sec.  1.1297-1(d)(3)(i).
1. Treatment of Interest
    The proposed regulations provided that, for purposes of the section 
1297(b)(2)(C) exception, interest is properly allocable to income of 
the related person that is not passive income based on the relative 
portion of the related person's income for its taxable year that ends 
in or with the taxable year of the recipient that is not passive 
income. See proposed Sec.  1.1297-1(c)(3)(i). Comments generally 
supported the pro rata approach taken in the proposed regulations. One 
comment noted that the final regulations should clarify that the 
allocation is based on the ratio of gross non-passive income to gross 
total income. Another comment that supported the pro rata approach in 
the proposed regulations recommended that the final regulations address 
situations in which the related person does not have income during the 
taxable year of the payment. In such a case, this comment suggested 
that the final regulations apply the principles of Sec.  1.861-9T, 
which provides rules for allocating and apportioning interest expense, 
to determine whether the interest payments are allocated to passive or 
non-passive income of the related person. The comment also requested 
that the approach using the principles of Sec.  1.861-9T to allocate 
interest when the related person does not have gross income be made 
available as an alternative method at the election of the tested 
foreign corporation.
    As suggested by the first comment, the final regulations clarify 
that the ratio for allocating interest to income is based on gross 
income. See Sec.  1.1297-1(c)(4)(iii). Similar clarifications are made 
for the rule for rents and royalties. See Sec.  1.1297-1(c)(4)(v). The 
Treasury Department and the IRS have determined that the pro rata 
approach provided in the proposed regulations is the most 
straightforward and consistent with the purposes of the section 
1297(b)(2)(C) exception if the related person has gross income in the 
taxable year, and accordingly, the final regulations do not provide a 
generally applicable election to apply the principles of Sec.  1.861-9T 
in lieu of the general rule. See Sec.  1.1297-1(c)(4)(iii).
    It is anticipated that it will rarely be the case that a related 
person will not have gross income, because gross income for most 
taxpayers is determined without taking expenses into account. However, 
in the case of taxpayers that determine gross income after taking 
operating expenses into account, it is possible that a taxpayer will 
not have gross income for a taxable year. In such a case, the Treasury 
Department and the IRS agree that the principles of Sec.  1.861-9T may 
properly apply for a year in which the related person does not have 
gross income, because Sec.  1.861-9T is a general rule--the default 
rule in the absence of a more specific rule--relating to the allocation 
of interest expense. Alternatively, because section 1297(b)(2)(C) 
characterizes interest received or accrued from a related person as 
non-passive income to the extent it is properly allocable to non-
passive income of the related person, it may also be appropriate for 
interest received or accrued by the tested foreign corporation to be 
allocated entirely to passive income in such a case, and that treatment 
may be simpler for a tested foreign corporation to determine. 
Accordingly, the final regulations provide that for a year in which the 
related person does not have gross income, a tested foreign corporation 
may use the principles of Sec.  1.861-9 through -13T, applied in a 
reasonable and consistent manner taking into account the general 
operation of the PFIC rules and the purpose of section 1297(b)(2)(C) in 
order to allocate interest received or accrued from the related person 
between passive and non-passive income. Alternatively, at a tested 
foreign corporation's election, it may treat the interest income 
entirely as passive income.
2. Treatment of Dividends
    The proposed regulations provided that, for purposes of the section 
1297(b)(2)(C) exception, dividends are treated as properly allocable to 
income of the related person that is not passive income based on the 
portion of the related payor's current earnings and profits (``E&P'') 
for the taxable year that ends in or with the taxable year of the 
recipient that is attributable to non-passive income. See proposed 
Sec.  1.1297-1(c)(3)(ii).

[[Page 4522]]

    A comment observed that foreign corporations often do not maintain 
E&P based on U.S. tax principles. The comment recommended that 
dividends be treated as allocated between passive and non-passive 
amounts based on the ratio of passive to non-passive gross income.
    Two comments requested that proposed Sec.  1.1297-1(c)(3)(ii) be 
modified to allocate dividend income based on both current and 
accumulated E&P of the related payor to which the dividend income is 
attributable, in accordance with the principles of section 316. A third 
comment observed that there are administrative benefits to 
characterizing dividends by reference to current E&P, because it may be 
easier to obtain relevant information for current E&P and because the 
nature of a company's activities may change. This comment further 
requested that dividends be determined by reference to gross income 
over a reasonable look-back period such as three to five years, rather 
than by reference to E&P under section 316 principles, in order to 
reflect the economic reality of the corporation's activities and to 
avoid undue emphasis on the timing of the dividends. The comment 
suggested as an alternative that this method might apply only if the 
related payor does not maintain E&P using U.S. tax principles, while if 
the related party does maintain E&P based on U.S. tax principles, then, 
to the extent of current E&P, dividends would be characterized based on 
the portion of the related payor's current-year E&P that is 
attributable to non-passive income, and the remaining amount would be 
characterized based on the relative portion of accumulated E&P that is 
attributable to non-passive income. The comment suggested that the 
ratio for accumulated E&P could be based on accumulated E&P for the 
period in which the related payor was a related person under section 
954(d)(3).
    Another comment suggested that the difficulty in obtaining 
information necessary to determine the character of accumulated E&P 
with respect to foreign corporations could be addressed by allowing 
taxpayers to use reasonable methods to determine the character of 
accumulated E&P and proposed that characterizing the accumulated E&P 
based on the current year's E&P be considered a reasonable method.
    The Treasury Department and the IRS agree that dividends from 
related parties should be allocated between passive and non-passive E&P 
based on the principles of section 316, which apply generally for 
purposes of the U.S. international tax rules. Accordingly, the final 
regulations adopt the recommendation to characterize dividends in 
accordance with first current and then accumulated E&P of the related 
payor to which the dividend income is attributable. See Sec.  1.1297-
1(c)(4)(iv)(A). In order to address concerns that foreign corporations 
that are not CFCs may not maintain E&P based on U.S. tax principles, 
taxpayers are permitted to allocate E&P in proportion to the ratio of 
passive gross income to non-passive gross income for the relevant 
period. See Sec.  1.1297-1(c)(4)(iv)(B).
    The Treasury Department and the IRS also agree with the premise of 
all of the comments that if dividends are paid out of E&P other than 
current E&P, either because there is no current E&P or because the 
amount of the dividends exceeds the current E&P, it would be 
appropriate to take into account the character of the income supporting 
the dividend. The final regulations provide that dividends paid out of 
accumulated E&P are allocated between passive and non-passive E&P under 
the same rules that apply with respect to dividends paid out of current 
E&P. See Sec.  1.1297-1(c)(4)(iv)(C).
    The Treasury Department and the IRS understand that it may be 
difficult for shareholders to determine the character of accumulated 
E&P with respect to foreign corporations, particularly for E&P from 
pre-acquisition periods. The suggestion of referring to a look-back 
period of several years is consistent with the rule for characterizing 
stock, discussed in Part III.D.4 of this Summary of Comments and 
Explanation of Revisions, which is intended to effectively treat stock 
as, in whole or part, held for the production of non-passive income if 
dividends received with respect to it within a three-year period 
constitute non-passive income due to the application of section 
1297(b)(2)(C). Accordingly, the final regulations permit taxpayers to 
use the default approach, consistent with general U.S. federal income 
tax principles, of allocating dividends paid out of accumulated E&P 
based on the ratio of passive to non-passive E&P for each prior year 
(beginning with the most recently accumulated), or to use one of two 
administratively simpler alternatives. See id. The first alternative is 
to allocate dividends paid out of accumulated E&P based on the ratio of 
passive to non-passive E&P that is attributable to E&P accumulated in 
the years in which the payor was related to the recipient. If the payor 
has been related to the recipient for more than three years, a second 
alternative is available, which is to allocate dividends paid out of 
accumulated E&P based on the ratio of passive to non-passive E&P that 
is attributable to E&P accumulated during a look-back period of the 
three years before the current taxable year. See id.

D. Asset Test

1. Section 958 Proposed Regulations
    Shareholders of a foreign corporation that became a CFC as a result 
of the repeal of section 958(b)(4) would have to apply the Asset Test 
based on the adjusted basis of the foreign corporation's assets under 
section 1297(e). The section 958 proposed regulations modified the 
definition of a CFC for purposes of section 1297(e) to disregard 
downward attribution from foreign persons. See proposed Sec.  1.1297-
1(d)(1)(iii)(A). No comments were received with respect to this rule in 
the section 958 proposed regulations. Accordingly, the rule is 
finalized without modification. See Sec.  1.1297-1(d)(1)(v)(B)(2).
2. Determination of Average Amount of Assets Based on Value or Adjusted 
Basis
    Section 1297(e) provides that the assets of a tested foreign 
corporation are to be measured based on (i) value, pursuant to section 
1297(e)(1), if it is a publicly traded corporation for the taxable 
year, or if section 1297(e)(2) does not apply to it for the taxable 
year; or (ii) adjusted basis, pursuant to section 1297(e)(2), if it is 
a CFC or elects the application of section 1297(e)(2). These statutory 
provisions create a hierarchy for determining the method for measuring 
the assets of a tested foreign corporation, as follows: (a) First by 
value, if the tested foreign corporation is a publicly traded 
corporation for the taxable year; (b) second by adjusted basis, if the 
tested foreign corporation is not a publicly traded corporation and is 
a CFC; and (c) third by value, or at the election of the tested foreign 
corporation, by adjusted basis, in other cases. The Treasury Department 
and the IRS understand that taxpayers typically prefer to use value to 
measure assets of a tested foreign corporation.
    The proposed regulations provided that, for purposes of the Asset 
Test, companies that were publicly traded for only part of the year 
were required to measure assets on the basis of value for the entire 
year if the corporation was publicly traded on the majority of days 
during the year or if section 1297(e)(2) did not apply to the 
corporation on the majority of days of the year. If the tested foreign 
corporation was not publicly traded on the majority of days during the 
year, the tested foreign corporation was required to use adjusted basis 
to

[[Page 4523]]

measure assets if it was a CFC or if an election to use adjusted basis 
was made under section 1297(e)(2)(B). See proposed Sec.  1.1297-
1(d)(1)(v). The majority of days rule in the proposed regulations would 
have required a tested foreign corporation that was a CFC and whose 
shares were publicly traded for less than the majority of days during 
the year to use adjusted basis to measure its assets for that taxable 
year because the corporation would not have been treated as a publicly 
traded corporation. The requirement to use adjusted basis might apply, 
for example, to a foreign corporation treated as a CFC that issues 
publicly traded shares in an initial public offering in the second half 
of the year.
    A comment requested that the proposed regulations be modified to 
provide that the Asset Test be applied based on value if shares of the 
tested foreign corporation were publicly traded at any time during the 
taxable year. The comment asserted that the use of value more 
appropriately reflects the purposes of the PFIC rules in general, and 
that the statute requires only non-publicly traded CFCs to use basis 
for purposes of the Asset Test and otherwise allows a tested foreign 
corporation to apply the Asset Test based on value. The comment also 
noted that, due to the repeal of section 958(b)(4), there may be more 
tested foreign corporations that are CFCs. In such cases, less-than-10-
percent shareholders of those tested foreign corporations would be 
required to use basis rather than value in determining PFIC status. The 
comment requested relief from this result. The comment further noted 
that publicly traded corporations required to use basis would not be 
able to take into account goodwill and other self-created business 
intangibles for purposes of the Asset Test because such items often do 
not have tax basis.
    The Treasury Department and the IRS agree with the concerns 
expressed by the comment regarding the effects of the repeal of section 
958(b)(4). As discussed in Part III.D.1 of this Summary of Comments and 
Explanation of Revisions, this rulemaking finalizes the portion of the 
section 958 proposed regulations concerning the definition of the term 
CFC for purposes of the Asset Test, which accordingly allows use of the 
value method of measuring assets to the extent permissible under the 
statute. See Sec.  1.1297-1(d)(1)(v)(B)(2) (treating foreign 
corporations that are CFCs solely due to the repeal of section 
958(b)(4) as not CFCs for purposes of section 1297(e)). The Treasury 
Department and the IRS believe that this change may alleviate much of 
the concern expressed about the proposed rule because the change makes 
it less likely that a tested foreign corporation will be treated as a 
CFC that is required to use adjusted basis to measure its assets.
    The Treasury Department and the IRS also agree that section 1297(e) 
favors the use of value as a method to measure assets and that the use 
of value aligns with the objective of the PFIC rules. As a result, the 
final regulations expand the definition of publicly traded corporation 
for purposes of section 1297(e) to include more circumstances in which 
a tested foreign corporation is treated as a publicly traded foreign 
corporation. See Sec.  1.1297-1(f)(7). However, the Treasury Department 
and the IRS believe that it would be inappropriate to require a 
corporation to use value for purposes of the Asset Test if it was 
publicly traded for a de minimis period during its taxable year. 
Accordingly, the final regulations provide that a publicly traded 
corporation, which is defined as a corporation that has been publicly 
traded in more than de minimis amounts for at least twenty trading days 
(approximately one month) during a taxable year, is required to apply 
the Asset Test based on value. See Sec.  1.1297-1(d)(1)(v)(A) and 
(f)(7). Pursuant to section 1297(e), a tested foreign corporation that 
does not qualify as a publicly traded foreign corporation may use value 
to measure assets as long as it is not a non-publicly traded CFC, but 
it is not required to do so.
    The comment also requested clarification on the application of 
section 1297(e) in the case of tiers of tested foreign corporations. 
The comment recommended the final regulations provide that, for 
purposes of applying the Asset Test, a publicly traded tested foreign 
corporation should measure all of its assets--including the assets of 
its non-publicly traded look-through subsidiaries--based on value. The 
Treasury Department and the IRS generally agree with the premise of 
this comment, except in cases where section 1297(e) requires a 
different treatment for the assets of subsidiaries (as discussed in the 
next paragraph). For the avoidance of doubt, the final regulations 
include cross-references to Sec.  1.1297-2(b)(2)(i) (which provides the 
rule that a tested foreign corporation is deemed to directly own the 
assets of the look-through subsidiary) in the final section 1297(e) 
rules. See Sec.  1.1297-1(d)(1)(i) and (d)(1)(v)(A).
    The comment also observed that, unlike the typical situation where 
a publicly traded tested foreign corporation would measure all of its 
assets (including the assets of its non-publicly traded look-through 
subsidiaries) based on value in accordance with section 1297(e)(1)(A), 
it is questionable whether a CFC that is a non-publicly traded 
subsidiary of a publicly traded parent corporation could also use 
value, rather than basis, for purposes of testing its own PFIC status. 
The comment noted that such a subsidiary might be a CFC as a result of 
the repeal of section 958(b)(4). As discussed in Part III.D.1 of this 
Summary of Comments and Explanation of Revisions, Sec.  1.1297-
1(d)(1)(v)(B)(2), which provides that foreign corporations that are 
CFCs solely due to the repeal of section 958(b)(4) are not treated as 
such for purposes of section 1297(e), mitigates this concern. Further, 
if a lower-tier tested foreign corporation is a CFC that is not 
publicly traded, section 1297(e)(2)(A) requires that adjusted basis be 
used as the method for measuring its assets. Therefore, the final 
regulations clarify that a lower-tier tested foreign corporation that 
is a non-publicly traded CFC must use adjusted basis and not value to 
measure its assets, regardless of whether it is owned by a publicly 
traded foreign corporation.
    In order to clarify the application of the statutory hierarchy for 
measuring a tested foreign corporation's assets more generally, 
including with respect to lower-tier tested foreign corporations, Sec.  
1.1297-1(d)(1)(v) has been revised. The regulation provides a hierarchy 
that generally applies to every tested foreign corporation, regardless 
of whether it is an upper-tier or lower-tier tested foreign 
corporation. Pursuant to section 1297(e) and this hierarchy, (i) a 
publicly traded foreign corporation (as defined in Sec.  1.1297-
1(f)(7)) must use value to measure its assets, (ii) a non-publicly 
traded CFC must use basis to measure its assets, unless the CFC becomes 
a publicly traded foreign corporation (as defined in Sec.  1.1297-
1(f)(7)) during a taxable year, and (iii) any other tested foreign 
corporation would use value to measure its assets unless an election is 
made to use adjusted basis, except if it is a lower-tier subsidiary in 
which case additional rules apply. See Sec.  1.1297-1(d)(1)(v)(A), (B), 
and (C)(1). Section 1.1297-1(d)(1)(iii) clarifies that the election to 
use adjusted basis may be made by the tested foreign corporation or its 
shareholders.
    Revised Sec.  1.1297-1(d)(1)(v) provides specific rules for 
measuring the assets of lower-tier subsidiaries, which in the usual 
case are expected to be look-through subsidiaries. These rules follow 
the same hierarchy described in the prior paragraph, except that the 
method used to measure the assets of a lower-tier subsidiary may be 
determined either by the status of the lower-tier subsidiary

[[Page 4524]]

if it is a publicly traded foreign corporation or a non-publicly traded 
CFC, or by the status of a tested foreign corporation that directly or 
indirectly owns all or part of the shares of the lower-tier subsidiary 
(a parent foreign corporation), if the parent foreign corporation has 
one of those statuses. See Sec.  1.1297-1(d)(1)(v)(C)(2).
    As a general matter, the method used by a parent foreign 
corporation to measure its assets also must be used to measure the 
assets of a lower-tier foreign corporation owned in whole or part by 
that parent foreign corporation. This rule applies both for purposes of 
determining whether the parent foreign corporation is a PFIC and for 
purposes of determining whether the lower-tier foreign corporation is a 
PFIC. If a tested foreign corporation indirectly owns a lower-tier 
subsidiary through one or more other foreign corporations, the status 
of the parent foreign corporation in that chain of corporations that 
has the highest status in the hierarchy described above governs. See 
Sec.  1.1297-1(d)(1)(v)(C)(2)(iii).
    This general consistency rule does not apply, however, if the 
lower-tier foreign corporation has a status for which section 1297(e) 
mandates a method for measuring assets (that is, it is a publicly 
traded foreign corporation or non-publicly traded CFC). In such a case, 
the statutorily mandated method applies to measure the lower-tier 
foreign corporation's assets, both for purposes of determining whether 
the parent foreign corporation is a PFIC and for purposes of 
determining whether the lower-tier foreign corporation is a PFIC. For 
example, if a tested foreign corporation is a publicly traded foreign 
corporation, then both its assets and the assets of its lower-tier 
subsidiaries must be measured on the basis of value, unless a lower-
tier subsidiary is a non-publicly traded CFC, in which case the assets 
of that subsidiary must be measured using adjusted basis. Similarly, if 
a tested foreign corporation is a non-publicly traded CFC, then both 
its assets and the assets of its lower-tier subsidiaries must be 
measured using adjusted basis, unless a lower-tier subsidiary is a 
publicly traded foreign corporation, in which case the assets of that 
subsidiary must be measured using value. See Sec.  1.1297-
1(d)(1)(v)(C)(2)(i) and (ii). If a lower-tier tested foreign 
corporation does not have a status for which section 1297(e) mandates a 
method for measuring assets, and it is a subsidiary of more than one 
parent foreign corporation, then U.S. shareholders of the two different 
parent corporations may be required to use different methods to measure 
the assets of the lower-tier foreign corporation based on the method 
used for each respective parent foreign corporation. See the last 
sentence of Sec.  1.1297-1(d)(1)(v)(C)(2)(iii) and Sec.  1.1297-
1(d)(1)(v)(E)(3) (Example 3).
    The Treasury Department and the IRS recognize that section 
1297(e)(1) requires in many cases that a valuation must be performed 
for assets of an operating company for which no publicly available 
valuation is available, apart from information provided in financial 
statements prepared under widely-used financial reporting standards, 
and that ascertaining such a valuation creates a compliance burden. The 
Treasury Department and the IRS are studying whether to provide rules 
permitting taxpayers to rely on financial statement information in 
appropriate cases, and the final regulations reserve on this issue. See 
Sec.  1.1297-1(d)(1)(v)(D). The 2020 NPRM proposes a rule to address 
this issue and solicits comments on the proposed rule. See proposed 
Sec.  1.1297-1(d)(1)(v)(D).
3. Treatment of Working Capital for Purposes of Asset Test
    The proposed regulations did not address the treatment of working 
capital for purposes of the Asset Test. Notice 88-22, 1988-1 C.B. 489 
(``Notice 88-22'') provides that cash and other current assets readily 
convertible into cash, including assets that may be characterized as 
the working capital of an active business, are treated as passive 
assets for purposes of the Asset Test. Notice 88-22 indicated that 
passive treatment is warranted because working capital produces passive 
income (interest income).
    A comment on the proposed regulations asserted that the approach 
taken in Notice 88-22 with respect to working capital undermines the 
purpose of the PFIC regime to distinguish between investments in 
passive assets and investments in active businesses. The comment 
requested that the final regulations adopt an approach, similar to the 
treatment of dual-character assets, pursuant to which working capital 
would be bifurcated between passive and non-passive assets in 
proportion to the relative amount of gross income that is passive or 
non-passive.
    The Treasury Department and the IRS continue to study the 
appropriate treatment of working capital, and the final regulations 
reserve on this issue. See Sec.  1.1297-1(d)(2). The 2020 NPRM proposes 
a limited exception to the treatment of working capital to take into 
account the short-term cash needs of operating companies. See proposed 
Sec.  1.1297-1(d)(2).
4. Assets That Produce Income Subject to the Related Person Look-
Through Rule
    The proposed regulations defined the term passive asset, consistent 
with section 1297(a), as an asset that produces passive income, or 
which is held for the production of passive income, taking into account 
the rules in proposed Sec.  1.1297-1(c), which defined passive income, 
and proposed Sec.  1.1297-1(d), which provided rules for the 
application of the Asset Test. See proposed Sec.  1.1297-1(f)(6). The 
proposed regulations also provided that an asset that produces both 
passive income and non-passive income during a taxable year is treated 
as two assets, one of which is passive and one of which is non-passive, 
with the value (or adjusted basis) of the asset being allocated between 
the passive asset and non-passive asset in proportion to the relative 
amounts of passive and non-passive income produced by the asset during 
the taxable year. See proposed Sec.  1.1297-1(d)(2)(i).
    A number of comments expressed concern that the proposed 
regulations did not provide a general rule to characterize assets--in 
particular shares of stock--that give rise to income subject to the 
related person look-through rule of section 1297(b)(2)(C), discussed in 
Part III.C of this Summary of Comments and Explanation of Revisions. 
The comments suggested that the final regulations include a rule that 
treats assets that give rise to income subject to section 1297(b)(2)(C) 
as a passive or non-passive asset to the extent the income that is 
received with respect to such asset is treated as passive or non-
passive by the tested foreign corporation. The Treasury Department and 
the IRS agree that it is consistent with the statutory language and 
intent of section 1297(a)(2) to treat assets that give rise to both 
passive and non-passive income as partly passive and partly non-
passive. The Treasury Department and the IRS believe that it was clear 
under proposed Sec.  1.1297-1(d)(2)(i) and (f)(6) that assets that 
produced income subject to the related person look-through rule of 
section 1297(b)(2)(C) were treated as non-passive in proportion to the 
non-passive income produced by the asset, subject to the special rules 
in Sec.  1.1297-1(d). However, for the avoidance of doubt, the final 
regulations provide an explicit cross-reference to section 
1297(b)(2)(C) to clarify that assets that produce income subject to the 
related person look-through rule are subject to the general and special 
rules with respect to treatment of assets under Sec.  1.1297-1(d),

[[Page 4525]]

for example related party stock, loans, leases or licenses that produce 
dividends, interest, rent or royalties that are treated as passive and 
non-passive under section 1297(b)(2)(C). See Sec.  1.1297-1(d)(3)(i). 
Accordingly, assets that give rise to income subject to section 
1297(b)(2)(C) generally are treated as a passive or non-passive asset 
to the extent the income that is received with respect to such asset is 
treated as passive or non-passive by the tested foreign corporation.
    The proposed regulations also provided that stock of a related 
person with respect to which no dividends are received or accrued 
during a taxable year but that previously generated dividends that were 
characterized as non-passive income, in whole or in part, under section 
1297(b)(2)(C) is characterized based on the dividends received or 
accrued with respect thereto for the prior two years. See proposed 
Sec.  1.1297-1(d)(2)(iii).
    Comments noted that there may be instances in which the related 
person has not paid dividends in more than two years. One comment 
suggested that, in this instance, stock be apportioned in proportion to 
the average percentage of the dividends that were characterized as 
passive and non-passive in the last two years in which the related 
person paid dividends. If the related person never paid a dividend that 
was excluded under section 1297(b)(2)(C), the comment recommended that 
the stock be characterized based on the earnings during the last two 
years in which the related person generated earnings or, if the related 
person has never generated earnings, based on the earnings that are 
reasonably expected to be generated in the future. Another comment 
requested that proposed Sec.  1.1297-1(d)(2)(iii) be replaced with a 
general rule with respect to stock of a related party that would 
characterize the stock based on whether the stock is expected to 
generate passive income. The comment asserted that this rule would 
allow for taxpayers to use reasonable methods to determine if the stock 
is expected to generate passive income.
    One comment argued that, for purposes of characterizing stock that 
does not generate dividends in the current year, a look-back period of 
two years would be appropriate if the final regulations adopt an 
approach that characterizes the stock based on the character of 
hypothetical dividends and uses the proportionate amount of non-passive 
gross income over the look-back period to determine the character of 
the dividends. If such an approach is not adopted, the comment 
recommended that, instead of a look-back period of two years, the stock 
could be characterized based on dividends paid during the preceding 
five years or, if shorter, the period during which the subsidiary was a 
related person under section 954(d)(3).
    Proposed Sec.  1.1297-1(d)(2)(iii) was premised on the 
understanding that stock that has recently generated dividends that 
are, in whole or in part, non-passive under the related person look-
through rule can be understood to be held for the production of non-
passive income. If, however, the stock has not recently generated 
dividends, it is more appropriate to treat the stock as held for the 
production of gains upon disposition, which would generally be passive 
income. Accordingly, the Treasury Department and the IRS have 
determined that it would not be appropriate to allow stock to be 
treated as a non-passive asset on the basis of speculation that 
dividends might be received with respect to the stock and that such 
dividends could be non-passive under section 1297(b)(2)(C) as most of 
the comments' recommendations would provide. Moreover, the changes to 
the rules for determining the passive or non-passive character of 
dividends, discussed in Part III.C.2 of this Summary of Comments and 
Explanation of Revisions, also take into account the actual history of 
the stock and allow taxpayers to treat the most recent prior years as 
most relevant in determining the character of the stock. Thus, the 
final regulations do not adopt these comments and, instead, the final 
regulations provide that stock that did not produce dividends within 
the current taxable year or within either of the preceding two taxable 
years is characterized as a passive asset. See Sec.  1.1297-
1(d)(3)(iii); but see section 1297(c) and Sec.  1.1297-2(c)(1)(i) 
(eliminating stock of look-through subsidiaries for purposes of the 
Asset Test).

E. Stapled Entities

    Proposed Sec.  1.1297-1(e) provided that, for purposes of 
determining whether any stapled entity (as defined in section 
269B(c)(2)) is a PFIC, all entities that are stapled entities with 
respect to each other are treated as one entity. A comment suggested 
that the definition of stapled entities provided in section 269B(c)(2) 
and Sec.  1.269B-1 could be overbroad and thus lead to planning 
opportunities for purposes of PFIC testing. Therefore, the comment 
recommended that the final regulations provide a more restrictive 
definition for stapled entities so that, for purposes of PFIC testing, 
single-entity treatment would be limited to situations in which nearly 
100 percent of the outstanding equity interests in both entities are 
stapled to each other. Alternatively, the comment suggested, the 
Treasury Department and the IRS could issue rules applicable to the 
holders of stapled interests clarifying the application of the anti-
abuse rule in section 1298(b)(4) (which would treat separate classes of 
stock (or other interests) in a corporation as interests in separate 
corporations, pursuant to regulations, where necessary to carry out the 
purposes of the PFIC regime) to such stapled interests by providing 
that the rule would apply only if unusual features exist and the 
arrangement would allow avoidance of the PFIC rules. The comment also 
highlighted the inappropriateness of potentially applying the rule in 
proposed Sec.  1.1297-1(e) to treat a shareholder of an entity that 
would not be a PFIC, but for the rule, as the shareholder of a PFIC.
    Another comment requested clarification on the extent to which 
stapled entities that were treated as a single entity for purposes of 
PFIC testing would be treated as a single entity with respect to other 
provisions in the PFIC regime. In particular, the comment requested 
that the final regulations indicate whether the stapled entities are 
treated as one PFIC for purposes of including income under the PFIC 
regime and for purposes of making an election with respect to income 
inclusions under the PFIC regime. Like the first comment, it also 
requested guidance when not all interests are stapled.
    The Treasury Department and the IRS have determined that it is 
appropriate to apply the single entity treatment of proposed Sec.  
1.1297-1(e) even when not all interests in the stapled entities are 
stapled because section 269B(c)(2) applies only when controlling 
interests in the stapled entities are stapled, but that the application 
of the rule should be limited to apply only to U.S. persons that hold 
stapled interests and should not affect U.S. persons that directly or 
indirectly own only one of the stapled entities. Accordingly, the rule 
in proposed Sec.  1.1297-1(e) is modified to apply only if a U.S. 
person that would be a shareholder of the stapled entities owns stock 
in all entities that are stapled entities with respect to each other. 
In this case, the stapled entities are treated as an interest in a 
single entity for all purposes of the PFIC rules, which may have the 
effect of causing a stapled entity that would not be a PFIC on a stand-
alone basis to be treated as a PFIC when stapled, or the reverse. See 
Sec.  1.1297-1(e). Given these modifications to the rule and the fact 
that the

[[Page 4526]]

definition of stapled entities in section 269B(c)(2) already limits 
stapling to situations in which more than 50 percent in the value of 
the beneficial ownership in each of the entities consists of stapled 
interests, the Treasury Department and the IRS have determined that it 
is not necessary at this time to provide guidance on the application of 
section 1298(b)(4) or to further limit the interests that can be 
stapled.

IV. Comments and Revisions to Proposed Sec.  1.1297-2--Special Rules 
Regarding Look-Through Subsidiaries and Look-Through Partnerships

    Proposed Sec.  1.1297-2 provided guidance on the application of the 
look-through rule of section 1297(c) for purposes of the Income Test 
and the Asset Test.

A. Overview

1. Treatment of Income and Assets
    Under the final regulations, a tested foreign corporation is 
treated as directly owning the assets of, and directly deriving the 
gross income of, a look-through subsidiary or look-through partnership. 
See Sec.  1.1297-2(b)(2) and (b)(3). The tested foreign corporation 
disregards the equity interest in the look-through entity for purposes 
of the Asset Test. See Sec.  1.1297-2(c)(1)(i) and (c)(3). As discussed 
in more detail in Part IV.D of this Summary of Comments and Explanation 
of Revisions, dividends from a lower-tier subsidiary and distributions 
and the distributive share of income from a lower-tier partnership 
generally are treated as if they did not exist (``eliminated'') for 
purposes of the Income Test. See Sec.  1.1297-2(c)(2)(i) and (c)(3).
    For Income Test purposes, the proposed regulations provided that 
the disposition of the stock of a look-through subsidiary is treated as 
the disposition of stock and provided rules for the calculation of 
gain. See proposed Sec.  1.1297-2(f)(1). The final regulations also 
include rules addressing the disposition of partnership interests in a 
look-through partnership, which are similar in concept to the rules 
that apply to the disposition of stock of a look-through subsidiary, 
and rules addressing the disposition of partnership interests in a 
partnership described in section 954(c)(4)(B). See Sec.  1.1297-
2(f)(4). Where both rules could potentially apply, the disposition is 
subject to the rules of section 954(c)(4). See Sec.  1.1297-2(f)(4)(i) 
and (ii). Consequently, it is anticipated that the sale of interests in 
a partnership that a tested foreign corporation owns at least 25 
percent of by value generally will be subject to section 954(c)(4), and 
therefore will be treated as a disposition of assets rather than a 
disposition of the partnership interest, while the sale of interests in 
a partnership that a tested foreign corporation owns less than 25 
percent of by value may or may not be subject to section 954(c)(4) in 
light of the different 25-percent ownership test in that statutory 
provision. The effect on the determination of gain under section 
954(c)(4) of partnership earnings that have been included in income by 
the tested foreign corporation but not distributed is beyond the scope 
of these regulations.
    Payments of interest, rent and royalties, and the related debt 
obligation, lease or license, between the tested foreign corporation 
and the look-through entity or between look-through entities generally 
also are eliminated for purposes of both the Income and the Asset 
Tests, as discussed in Part IV.D of this Summary of Comments and 
Explanation of Revisions. See Sec.  1.1297-2(c)(1)(ii), (c)(2)(ii), and 
(c)(3). If the obligation is between look-through entities that are not 
wholly owned by the tested foreign corporation, a proportionate part of 
the obligation and income from it is eliminated. See id.
2. Definition of Look-Through Subsidiary
    A subsidiary of a tested foreign corporation is treated as a look-
through subsidiary if both an asset test and an income test are 
satisfied. See Sec.  1.1297-2(g)(3). If only one test is satisfied, the 
subsidiary is not treated as a look-through subsidiary. See generally 
id. The asset test is satisfied for any measuring period (for example, 
one quarter of a taxable year) if on the relevant measuring date (for 
example, the end of a quarter) the tested foreign corporation owns at 
least 25 percent of the value of the stock of the subsidiary. See Sec.  
1.1297-2(g)(3)(i). The income test is satisfied if either (i) the 
tested foreign corporation owns an average of at least 25 percent of 
the value of the subsidiary's stock on the measuring dates of an entire 
taxable year, or (ii) the tested foreign corporation owns at least 25 
percent of the value of the subsidiary's stock on a measuring date and 
the subsidiary's gross income for the measuring period can be 
determined. See Sec.  1.1297-2(g)(3)(ii). Consequently, if a tested 
foreign corporation owns at least 25 percent of a subsidiary's stock 
for part but not all of a taxable year, the subsidiary is treated as a 
look-through subsidiary for that part of the taxable year only if the 
tested foreign corporation can determine the subsidiary's gross income 
on the measuring dates within that part of the taxable year. These 
rules are intended to ensure that a subsidiary is not treated as a 
look-through subsidiary unless the tested foreign corporation can 
determine the proportionate share of the subsidiary's assets and income 
that it is treated as directly owning and deriving.

B. Look-Through Partnerships

1. Overview
    The proposed regulations defined a look-through partnership as a 
partnership in which the tested foreign corporation owned at least 25 
percent in value. See proposed Sec.  1.1297-1(c)(2)(i), (d)(3)(i), and 
(f)(1). The preamble to the proposed regulations indicated that the 
look-through partnership rules were drafted to apply look-through 
treatment as provided in section 1297(c) consistently to lower-tier 
partnerships and lower-tier corporations. See 84 FR 33120, at 33124. 
The preamble stated that the difference between the 25 percent 
threshold for look-through partnerships in the proposed regulations and 
the treatment of partnership income for FPHCI purposes is warranted 
because of the flexibility that entities have in their characterization 
under Sec.  301.7701-3 and because of the fact that treating a 
subsidiary as a partnership may not have U.S. income tax consequences 
for a tested foreign corporation as it could for a CFC. See id. The 
preamble also noted that this rule ensured that the tested foreign 
corporation would have significant control over the partnership 
activities, such that a partnership interest could represent an active 
business interest. See id. The preamble requested comments on whether 
25 percent was the right threshold, whether different rules should 
apply to general partnerships and limited partnerships, and whether a 
material participation test should apply.
    The definition of look-through partnership in the final regulations 
is revised to more closely align with the definition of look-through 
subsidiary. Under the final regulations, a look-through partnership is 
a partnership that would be a look-through subsidiary with respect to 
the tested foreign corporation if the partnership were a corporation. 
See Sec.  1.1297-2(g)(4)(i)(A). Accordingly, as noted by one comment, 
the taxpayer-favorable rules of section 1297(c) will apply to look-
through partnerships, for example by allowing attribution of the 
activities of other affiliates in determining whether rental or royalty 
income of the partnership is treated as passive or non-passive. In

[[Page 4527]]

response to other comments, additional changes have been made to the 
definition of look-through partnership to allow look-through treatment 
for certain minority interests in partnerships. See Sec.  1.1297-
2(g)(4)(i)(B). These changes are discussed in Part IV.B.2 of this 
Summary of Comments and Explanation of Revisions.
    The look-through partnership rules were located in proposed Sec.  
1.1297-1, which provided general rules concerning the Income and Asset 
Tests. Because look-through treatment for purposes of PFIC testing is 
provided in section 1297(c) and Sec.  1.1297-2 provides guidance on the 
application of section 1297(c), the rules in the final regulations 
concerning look-through partnerships are in Sec.  1.1297-2 along with 
all of the other rules discussing look-through treatment. See Sec.  
1.1297-2(b)(3) and (g)(4).
2. Definition of Look-Through Partnership
    Under the proposed regulations, a look-through partnership with 
respect to a tested foreign corporation was defined as a partnership if 
(i) for purposes of section 1297(a)(2), the tested foreign corporation 
owned at least 25 percent of its value on a measuring date and (ii) for 
purposes of section 1297(a)(1), the tested foreign corporation owned at 
least 25 percent of its value on the date on which income was received 
or accrued by the partnership. See proposed Sec.  1.1297-1(f)(1). The 
proposed regulations also provided that, if a tested foreign 
corporation owns, directly or indirectly, less than 25 percent of the 
value of a partnership, the corporation's distributive share of the 
partnership's income was treated as passive income for purposes of the 
Income Test and the corporation's interest in the partnership was 
treated as a passive asset for purposes of the Asset Test. See proposed 
Sec.  1.1297-1(c)(2)(ii) and (d)(3)(ii).
    Three comments were received addressing these rules. The comments 
supported the proposed regulations' general treatment of look-through 
partnerships and addressed the determination of when a partnership is 
treated as a look-through partnership. Two comments recommended that 
the 25-percent threshold be eliminated so that look-through treatment 
would apply to all partnerships regardless of the ownership level by 
the tested foreign corporation. A third comment stated that the proper 
approach to partnerships in applying look-through rules raises 
difficult issues and made several alternative recommendations.
    The two comments recommending that all partnerships be treated as 
look-through partnerships noted that partnerships are pass-through 
entities that are generally treated as aggregates for many purposes 
throughout the Code and asserted that section 1297(c) implicitly 
indicates that aggregate treatment was intended to apply to all 
partnerships because it provides a 25-percent threshold only for 
corporations. The comments also stated that the differences between 
corporate treatment and partnership treatment have ramifications for 
many other parts of the Code, such as subpart F, GILTI, and the anti-
hybrid rules. The comments asserted that minority shareholders 
generally cannot compel an upper-tier foreign corporation to make an 
election for a lower-tier foreign corporation to be treated as a 
partnership under Sec.  301.7701-3 and that it is unlikely that a 
tested foreign corporation would make a non-commercial investment in 
order to benefit minority shareholders.
    The Treasury Department and the IRS do not agree with these 
comments, other than the comment that partnerships are treated as 
aggregates for many Code purposes. Many of the legal entities 
potentially treated as look-through partnerships under section 1297 
would have been treated as corporations for U.S. federal income tax 
purposes when section 1297(c) was enacted, because the enactment of 
section 1297(c) preceded the promulgation of Sec.  301.7701-3 by 
approximately ten years and before that time foreign corporate entities 
were generally classified as corporations for U.S. federal income tax 
purposes. The differences between corporate treatment and partnership 
treatment referred to by the comments generally are not relevant to 
foreign corporations that are not subject to U.S. net income taxation 
or to U.S. shareholders as to whom a foreign corporation is not treated 
as a CFC. As stated in the preamble to the proposed regulations, an 
election under Sec.  301.7701-3 to treat a foreign subsidiary of such a 
foreign corporation as a partnership for U.S. federal income tax 
purposes may have no U.S. tax consequences other than to affect the 
determination of whether the foreign corporation is a PFIC.
    The Treasury Department and the IRS recognize that minority 
shareholders may not be able to compel a foreign corporation to make a 
U.S. tax election or to make particular investments. However, a foreign 
corporation may cause a subsidiary to make an election to be treated as 
a partnership for U.S. tax purposes or take other steps in order to 
avoid classification as a PFIC in order to retain or attract U.S. 
investors, since there are likely to be no non-tax and no foreign tax 
consequences to the election.
    The two comments indicated that the subpart F regime characterizes 
a partner's distributive share of partnership income without regard to 
the partner's level of control or involvement for purposes of 
determining subpart F income and recommended that the same approach 
apply in these regulations. The final regulations do not adopt this 
comment. The Treasury Department and the IRS believe that the 
difference in treatment between these regulations and the subpart F 
regime is warranted in light of the fact that Congress imposed a 25-
percent threshold for look-through treatment for subsidiaries in 
section 1297 but not in subpart F, and that consistency of treatment 
for look-through subsidiaries and look-through partnerships in these 
regulations is consistent with Congressional intent.
    One comment recommended, as an alternative to automatic passive 
treatment for less than 25-percent-owned interests, that the 
distributive share of income from, and the interest in, a less than 25-
percent-owned partnership be characterized as passive only if the 
necessary information cannot be obtained for purposes of the Income 
Test and the Asset Test. The Treasury Department and the IRS agree that 
it may be difficult for a tested foreign corporation to obtain adequate 
information from a subsidiary in which a tested foreign corporation 
holds a less-than-25-percent investment, and that if that is the case, 
the investment should be treated as passive. The Treasury Department 
and the IRS have taken this comment into account in the new rules 
described at the end of this Part IV.B.2. The Treasury Department and 
the IRS do not agree that a tested foreign corporation that has less 
than a 25-percent-interest in an active partnership should be able to 
automatically treat such partnership interest as active if such 
information is available, for the reasons already stated.
    A third comment stated that the approach proposed in the proposed 
regulations has the advantage of certainty and ease of administration 
because it provides a relatively clear bright-line test and limits the 
need to obtain information about the assets and income of a lower-tier 
partnership that may be difficult for small partners to obtain. The 
comment also noted that the proposed approach creates greater 
equivalence between lower-tier entities that have or have not elected 
to be treated as pass-through entities, but observed that the proposed 
regulations

[[Page 4528]]

did not create complete equivalence between such entities because the 
distributive share from a related partnership was not subject to the 
same rules as dividends from a related corporation. The final 
regulations address this concern by providing that the distributive 
share derived by a tested foreign corporation from a related 
partnership is subject to rules similar to such dividends. See Sec.  
1.1297-1(c)(4)(vii).
    This comment also stated that a 25-percent threshold is not a good 
proxy for an active business interest and is not consistent with long-
standing market practice. The comment recommended four alternatives for 
the threshold for partnership look-through treatment. Under the first 
alternative, the comment suggested that the final regulations adopt a 
25 percent threshold similar to that of section 954(c)(4). Under a 
second alternative, the comment suggested that the final regulations 
not take into account elections under Sec.  301.7701-3 for purposes of 
PFIC testing. Under a third alternative, the comment proposed that the 
final regulations treat every pass-through entity as an aggregate 
without regard to ownership threshold. Under the fourth alternative, 
the comment recommended that the final regulations adopt a ``material 
participation'' approach pursuant to which look-through with respect to 
a partnership applies if the tested foreign corporation materially 
participates in the underlying business of the partnership.
    The Treasury Department and the IRS recognize that although 
Congress has mandated a 25-percent threshold in order to treat a 
corporate subsidiary as a look-through entity, that threshold may not 
be a good proxy for an active business interest. The Treasury 
Department and the IRS considered whether the alternatives suggested 
would better identify an active partnership interest. The final 
regulations do not adopt any of the alternatives suggested by the third 
comment but do adopt an approach similar in concept to the fourth of 
the alternatives. With respect to the first and third alternatives, the 
Treasury Department and the IRS have determined that the 25-percent 
threshold should be the same for lower-tier entities regardless of 
whether they have elected pass-through treatment for the reasons 
already discussed. With respect to the second alternative, the Treasury 
Department and the IRS do not believe that it is appropriate in this 
context to draw distinctions between entities in the legal form of a 
partnership and other entities treated as partnerships for U.S. federal 
income tax purposes.
    In regard to the fourth alternative, the Treasury Department and 
the IRS agree that if a tested foreign corporation is actively involved 
in the business of a partnership with active business operations, look-
through treatment may be appropriate, even if the tested foreign 
corporation is a minority investor in the partnership, so that the 
tested foreign corporation may take into account the active assets and 
income of the partnership rather than treating the partnership 
investment as passive. The Treasury Department and the IRS considered a 
material participation test but determined that the passive activity 
loss rules of section 469 are not appropriate for a foreign corporate 
investor in a partnership owned directly or indirectly by a tested 
foreign corporation. The section 469 material participation rules focus 
primarily on the activities of individuals. See Sec.  1.469-5 and -5T. 
While section 469 also provides rules for partners that are closely 
held corporations, those rules are likely to be difficult to apply and 
to audit in the PFIC context.
    The Treasury Department and the IRS also considered other 
participation and attribution rules of the Code, including proposed 
rules addressing when a corporate partner would be attributed the trade 
or business assets and activities of a partnership for purposes of the 
active trade or business requirement in section 355(b). See 88 FR 26012 
(REG-123365-03) (proposing a rule that a partner that owns a meaningful 
interest in a partnership would be attributed the trade or business 
assets and activities of the partnership if the partner performs active 
and substantial management functions for the partnership with respect 
to the trade or business assets or activities (for example, by making 
decisions regarding significant business issues of the partnership and 
regularly participating in the overall supervision, direction, and 
control of the employees performing the operational functions for the 
partnership)). However, the Treasury Department and the IRS determined 
that such a rule would not be appropriate for purposes of section 1297. 
As stated in a comment, the disadvantage of participation-based tests 
is that they are factual and potentially subjective, and therefore less 
administrable. For example, the proposed section 355(b) test described 
above would be difficult for the IRS to audit in the case of a foreign 
corporation that is not controlled by U.S. shareholders. Moreover, if 
the ``meaningful interest'' requirement applied, look-through treatment 
might apply only to a small number of partnerships that are not already 
treated as look-through partnerships. The Treasury Department and the 
IRS did not consider these approaches to be more appropriate than 
applying the rules of section 1297 at the partner level as a means of 
testing whether an investment in a partnership is an active business 
interest. Accordingly, the definition of look-through partnership is 
further altered to include certain partnerships in which the tested 
foreign corporation owns a minority interest if the tested foreign 
corporation has sufficient active assets and income as determined under 
the rules of section 1297 apart from the partnership. See Sec.  1.1297-
2(g)(4)(i)(B).
    Under the final regulations, a look-through partnership is defined 
as (i) a partnership that would be a look-through subsidiary if such 
partnership were a corporation--as discussed in Part IV.B.1 of this 
Summary of Comments and Explanation of Revisions--or (ii) any other 
partnership if the tested foreign corporation satisfies the active 
partner test. See Sec.  1.1297-2(g)(4)(i). The active partner test is 
satisfied if the tested foreign corporation would not be a PFIC if both 
the Income and the Asset Test were applied to it without including its 
interest in any partnership that would not be a look-through subsidiary 
if such partnership were a corporation. See Sec.  1.1297-2(g)(4)(ii). 
If the tested foreign corporation has no passive assets or income, even 
a very small active business would allow the interest to qualify as a 
look-through partnership under the active partner test. On the other 
hand, qualifying under the active partner test can only prevent a 
partnership interest from tainting an otherwise non-PFIC corporation, 
rather than be used affirmatively. Because the Treasury Department and 
the IRS understand that it may be difficult for minority investors in 
partnerships to obtain the information necessary to apply the Income 
and Asset Tests taking into consideration the income and assets of a 
look-through partnership, the final regulations provide an election out 
of the look-through partnership definition for partnerships that would 
not be a look-through subsidiary if such partnership were a 
corporation. See Sec.  1.1297-2(g)(4)(iii). The final regulations also 
provide two new examples illustrating the active partner test. See 
Sec.  1.1297-2(g)(4)(iv).

[[Page 4529]]

C. Overlap Between Section 1297(c) and Section 1298(b)(7)

    The proposed regulations provided that the look-through rule of 
section 1297(c) does not apply to a domestic corporation if the stock 
of the domestic corporation is characterized under section 1298(b)(7) 
as a non-passive asset that produces non-passive income. See proposed 
Sec.  1.1297-2(b)(2)(iii). The preamble to the proposed regulations 
noted that the Treasury Department and the IRS determined that section 
1298(b)(7) should generally take precedence over section 1297(c) when 
both rules would apply simultaneously because section 1298(b)(7) 
contains the more specific rule applicable to a tested foreign 
corporation that owns a domestic subsidiary.
    Comments asserted that the legislative history concerning section 
1297(c) and section 1298(b)(7) does not support the approach taken by 
proposed Sec.  1.1297-2(b)(2)(iii). These comments argued that section 
1298(b)(7) was intended to apply only in circumstances in which income 
and assets would be passive if section 1297(c) applied. According to 
the comments, Congress did not intend for one section to take 
precedence over the other because the legislative history does not 
discuss whether section 1298(b)(7) is supposed to take precedence over 
section 1297(c) or express any limitations on the application of 
section 1297(c).
    Because section 1298(b)(7) contains the more specific rule 
applicable to a tested foreign corporation that owns a domestic 
subsidiary, the Treasury Department and the IRS have determined that 
the section 1298(b)(7) coordination rule is consistent with the 
relevant statutory provisions and results in appropriate treatment with 
respect to look-through subsidiaries. Accordingly, the final 
regulations do not adopt these comments.

D. Elimination of Certain Assets and Income for Purposes of Applying 
Section 1297(a)

    The proposed regulations provided that, for purposes of applying 
the Income and Asset Tests, certain intercompany payments of dividends 
and interest from a look-through entity, and the related stock and debt 
receivables, are eliminated. See proposed Sec.  1.1297-2(c)(1) and (2). 
The preamble to the proposed regulations indicated that the Treasury 
Department and the IRS intended for the elimination of such items to 
prevent double counting of intercompany income and assets. In response 
to comments, the final regulations revise the rules relating to 
intercompany dividends and expand the elimination rules to address 
intercompany rents and royalties and to address distributions and the 
distributive share of income from a look-through partnership.
1. Treatment of Intercompany Dividends
    Proposed Sec.  1.1297-2(c)(2) provided that, for purposes of 
applying the Income Test, intercompany payments of dividends between a 
look-through subsidiary and a tested foreign corporation are eliminated 
to the extent the payment is attributable to income of a look-through 
subsidiary that was included in gross income by the tested foreign 
corporation for purposes of determining its PFIC status.
    A comment expressed concern that the proposed regulation did not 
eliminate a payment of a dividend by a look-through subsidiary to a 
tested foreign corporation that is made out of earnings and profits not 
attributable to income of the subsidiary previously included in the 
gross income of the tested foreign corporation for purposes of 
determining its PFIC status. One example of such a case would be a 
dividend paid after a look-through subsidiary is acquired out of 
earnings and profits accumulated before the tested foreign 
corporation's acquisition of the look-through subsidiary. Another 
example of such a dividend would be a dividend paid to a tested foreign 
corporation from a subsidiary that was a subsidiary but not a look-
through subsidiary when the relevant earnings and profits were 
accumulated and the dividend was paid but later became a look-through 
subsidiary. The comment questioned whether a dividend from pre-
acquisition earnings and profits represents true economic income of the 
tested foreign corporation, since the tested foreign corporation 
``purchased'' the pre-acquisition earnings and profits, and observed 
that it could be difficult for a tested foreign corporation to 
determine what portion of a dividend received is attributable to pre-
acquisition earnings and profits, particularly if the acquisition was 
not recent. As a result, the tested foreign corporation might not in 
practice be able to determine when it can eliminate a dividend from a 
look-through subsidiary from its gross income.
    The proposed regulation eliminated dividends from a look-through 
subsidiary only to the extent attributable to gross income included by 
the tested foreign corporation. The comment recommended that the final 
regulations remove the limitation. In the alternative, the comment 
requested that the final regulations provide that dividends in an 
amount equal to current-year earnings would be deemed attributable to 
income included by the tested foreign corporation and that dividends in 
excess of that amount would be deemed to be paid first from years in 
which the subsidiary was a look-through subsidiary and treated as 
attributable to income included by the tested foreign corporation 
during that period. As an additional alternative, the comment proposed 
that taxpayers be allowed to determine the earnings to which dividends 
were considered attributable in the case of an acquisition of the look-
through subsidiary based on the ratio of pre-acquisition earnings to 
post-acquisition earnings over a limited period.
    The Treasury Department and the IRS agree that dividends should be 
treated as paid out of current earnings and profits and then out of 
accumulated earnings and profits (beginning with the most recently 
accumulated), in accordance with section 316, and the final regulations 
so provide. See Sec.  1.1297-2(c)(2). However, the final regulations do 
not adopt the comment's recommendation to treat all dividends from a 
look-through subsidiary as eliminated from the tested foreign 
corporation's gross income even if the dividend is paid out of earnings 
and profits that are attributable to gross income of the subsidiary 
that the tested foreign corporation has not included in income. As 
explained in the next two paragraphs, the rules regarding dividends 
paid out of earnings not taken into account by a tested foreign 
corporation must be coordinated with the rules that apply to determine 
residual gain when the stock of a look-through subsidiary is sold in 
order to avoid elimination of income for purposes of the Income Test.
    Under Sec.  1.1297-2(f), if a tested foreign corporation disposes 
of the stock of a look-through subsidiary, the amount of gain taken 
into account for purposes of the Income Test generally is the total 
gain recognized by the tested foreign corporation less unremitted 
earnings (residual gain). Unremitted earnings are the excess of income 
taken into account by the tested foreign corporation with respect to 
that look-through subsidiary less dividends from the subsidiary. The 
amount of gain derived from the disposition of stock of a look-through 
subsidiary and dividends received from the look-through subsidiary is 
determined on a share-by-share basis under a reasonable method, such as 
the rules under section 951 or 1248.
    Thus, if a look-through subsidiary with a value of $1000 earns $20 
that is taken into account by a tested foreign

[[Page 4530]]

corporation owner, any gain on a sale of the subsidiary's stock for 
$1020 will be reduced by $20 of unremitted earnings. If the subsidiary 
pays a $15 dividend before the sale, the receipt of the dividend is 
disregarded for purposes of the Income Test and a sale of the 
subsidiary's stock for $1005 should give rise to the same amount of 
residual gain. Thus, the $20 will be taken into account for purposes of 
the Income Test and will not affect the amount of residual gain 
regardless of whether a dividend is paid. By contrast, if the look-
through subsidiary pays a $15 dividend out of earnings that do not 
reflect income taken into account by the tested foreign corporation, 
the dividend would reduce the amount of gain on the sale of the look-
through subsidiary's stock compared to not paying a dividend because 
the dividend would reduce unremitted earnings pursuant to Sec.  1.1297-
2(f). Consequently, if the payment of the dividend were disregarded as 
requested by the comment, the $15 dividend would reduce potential 
future gain but never give rise to corresponding income to the tested 
foreign corporation for purposes of the Income Test.
    In order to prevent such a dividend from reducing potential future 
gain on the sale of the look-through subsidiary, it would be necessary 
to reduce the basis of the stock of the look-through subsidiary held by 
the tested foreign corporation or make some other adjustment to the 
taxation of gain upon the disposition of the look-through subsidiary's 
stock. A basis reduction or adjustment of that kind raises potentially 
broader issues that were not addressed in the proposed regulations. The 
Treasury Department and the IRS continue to study this recommendation 
and additional guidance on such elimination is proposed in the 2020 
NPRM. See proposed Sec.  1.1297-2(c)(2).
2. Treatment of Intercompany Rents and Royalties
    The proposed regulations provided that intercompany debt 
receivables and interest are eliminated in proportion to the 
shareholder's direct and indirect ownership (by value) in the look-
through subsidiary with respect to a tested foreign corporation that 
owns less than 100 percent of a look-through subsidiary. See proposed 
Sec.  1.1297-2(c)(1) and (2). The preamble to the proposed regulations 
explained that this rule was based on the legislative history of the 
PFIC rules and was intended to prevent duplication of passive assets or 
passive income, for example if a wholly-owned look-through subsidiary 
with entirely passive income paid a dividend to the tested foreign 
corporation parent.
    Comments supported the approach taken in the proposed regulations 
with regard to interest. A comment indicated that payments of 
intercompany rents and royalties raises similar concerns with respect 
to double counting. Accordingly, the comment requested that, for 
purposes of applying the Income Test and the Asset Test, the final 
regulations extend the elimination rules to payments of intercompany 
rents and royalties and any associated intangible assets in proportion 
to the tested foreign corporation's direct and indirect ownership (by 
value) in the look-through subsidiary or look-through partnership. The 
Treasury Department and the IRS agree with the comments, and Sec.  
1.1297-2(c) accordingly extends the rules applicable to debt and 
interest to rents, royalties, leases, and licenses.
    The application of the elimination rule to leases and licenses 
raises issues not present with debt receivables. A lease or license 
held by a look-through entity provides legal rights to use underlying 
property, such as a building or an intangible. If the lease or license 
is disregarded by a tested foreign corporation, it would not be taken 
into account by the tested foreign corporation in determining whether 
the underlying property produces non-passive income or is held for the 
production of non-passive income. Moreover, while the underlying 
property may be used as part of an active business, it may be used as 
part of the business of the lessee or licensee and not by the owner of 
the property. Accordingly, the final regulations provide that, for 
purposes of the Asset Test as applied to a tested foreign corporation, 
the underlying property that is the subject of the eliminated lease or 
license is characterized as a passive or non-passive asset by taking 
into account the activities of qualified affiliates of the tested 
foreign corporation (as discussed in Part IV.E of this Summary of 
Comments and Explanation of Revisions). A new example illustrates the 
expansion. See Sec.  1.1297-2(c)(4)(v).
    The final regulations also address more precisely the calculations 
required in order to determine how much of an obligation and related 
income is eliminated if the obligation runs between two look-through 
entities that are not wholly-owned. The final regulations provide that 
the tested foreign corporation's proportionate share of a LTS 
obligation (as defined in Sec.  1.1297-2(c)(1)(ii)) or a TFC obligation 
(as defined in Sec.  1.1297-2(c)(1)(ii)) is the value (or adjusted 
basis) of the item multiplied by the tested foreign corporation's 
percentage ownership (by value) in each relevant look-through 
subsidiary. See Sec.  1.1297-2(c)(1)(ii). Examples 3 and 4 of Sec.  
1.1297-2(c)(4) illustrate that when an obligation runs between two non-
wholly-owned look-through entities, the percentage ownership in each of 
those entities is taken into account. In Example 2, LTS2 has borrowed 
$200x from LTS1. The tested foreign corporation owns 40 percent of 
LTS1's stock and 30 percent of LTS2's stock. If the loan had been made 
to LTS2's shareholders, on a pro rata basis, 30 percent of the loan 
held by LTS1 ($60x) would be a TFC obligation and 70 percent of the 
loan held by LTS1 ($140x) would be a third-party obligation. The tested 
foreign corporation would be treated for purposes of the Asset Test as 
owning 40 percent of the TFC obligation, which would be eliminated. See 
Sec.  1.1297-2(c)(1)(ii). The tested foreign corporation also would be 
treated for purposes of the Asset Test as owning 40 percent of the 
hypothetical $140x third-party loan, or $56x. Example 3 illustrates the 
same principle.
3. Ownership Interests and Obligations of a Look-Through Partnership
    The final regulations provide that for purposes of the Asset Test 
and the Income Test, the principles applicable to the elimination of 
stock and obligations of look-through subsidiaries and dividends, 
interest, rents and royalties paid by look-through subsidiaries apply 
to look-through partnerships. See Sec.  1.1297-2(c)(3). Since 
partnerships do not pay dividends, the regulations provide that those 
principles apply to distributions and the distributive share of income 
from a look-through partnership. See id. It is intended that the same 
amount of assets and income will be eliminated regardless of whether 
the look-through entity or entities involved are look-through 
subsidiaries or look-through partnerships that would be look-through 
subsidiaries absent an election under Sec.  301.7701-3.

E. Attribution of Activities of Look-Through Subsidiaries and Look-
Through Partnerships

1. Scope of Attribution
    The proposed regulations provided that, for purposes of section 
1297, an item of rent or royalty income received or accrued by a tested 
foreign corporation (or treated as received or accrued by the tested 
foreign corporation pursuant to section 1297(c)) that would otherwise 
be passive income

[[Page 4531]]

if character were determined based on the activities of the income-
earning entity is not passive income if the item would be excluded from 
FPHCI under section 954(c)(2)(A) and Sec.  1.954-2(b)(6), (c), and (d), 
determined by taking into account the activities performed by the 
officers and employees of the tested foreign corporation, certain look-
through subsidiaries, and certain partnerships in which the tested 
foreign corporation or one of the look-through subsidiaries is a 
partner. See proposed Sec.  1.1297-2(e)(1).
    One comment agreed that the activities of the look-through 
subsidiary should be taken into account to determine whether an item of 
rent or royalty income of the tested foreign corporation is passive or 
non-passive and suggested that activity attribution be extended to 
apply to the section 954(h) and commodity producer tests. The comment 
indicated that such treatment would be proper because financial 
businesses generally segregate assets and operations that are part of 
an integrated business into different entities for non-tax reasons. 
Because these final regulations do not treat section 954(h) as 
applicable for purposes of section 1297(b)(1), the portion of the 
comment relating to section 954(h) is addressed in the preamble to the 
2020 NPRM and not here. However, the Treasury Department and the IRS 
agree that it is appropriate to extend the activity attribution rules 
for purposes of certain exceptions under section 954(c) that are based 
on whether the entity is engaged in the active conduct of a trade or 
business. Accordingly, the final regulations extend the activity 
attribution rules to income that would be excluded from FPHCI under 
section 954(c)(1)(B) (relating to property transactions), (c)(1)(C) 
(relating to commodities), (c)(1)(D) (relating to foreign currency 
gains), (c)(2)(A) (relating to active rents and royalties), (c)(2)(B) 
(relating to export financing), and (c)(2)(C) (relating to dealers). 
See Sec.  1.1297-2(e)(1).
    Another comment noted that under the rule in the proposed 
regulations, the income or assets of a look-through subsidiary 
classified as non-passive in the hands of a tested foreign corporation 
might nevertheless be classified as passive in the hands of the look-
through subsidiary, for example in the case where one look-through 
subsidiary held rental real estate and another look-through subsidiary 
employed the employees who managed the rental property. Under the rule 
in the proposed regulations the first look-through subsidiary would be 
a PFIC and residual gain with respect to the sale of the look-through 
subsidiary may be classified as passive, even if the attribution of 
both the property owned by the first subsidiary and the activities of 
the employees of the second subsidiary caused the rental income from 
the property to be treated as active for a tested foreign corporation 
owner. To mitigate this potential issue, the comment suggested the 
final regulations provide that such a look-through subsidiary be 
treated as a non-PFIC with respect to that tested foreign corporation 
under certain circumstances. The Treasury Department and the IRS have 
determined that the ultimate concerns raised by the comments should 
largely be addressed by the modifications to the activity attribution 
rules suggested by other comments and adopted in the final regulations, 
as discussed in Part IV.E.2 of this Summary of Comments and Explanation 
of Revisions. Those modifications should generally result in income and 
assets of a look-through subsidiary that are treated as non-passive in 
the hands of a tested foreign corporation also being treated as non-
passive in the hands of the look-through subsidiary, in which case the 
look-through subsidiary could be a non-PFIC and residual gain on the 
sale of the look-through subsidiary could be characterized as non-
passive.
    One comment recommended that rules in the proposed regulations be 
modified to apply the rules for active rents and royalties under 
section 954(c)(2)(A) as they existed in 1986, as discussed in Part 
III.A of this Summary of Comments and Explanation of Revisions, and if 
the regulations were not modified in that manner the activity 
attribution rules should be revised to take into account the 
``transition'' rules in the 2016 modifications to the active rents and 
royalties rules. See TD 9792 (81 FR 76497) (adding the express 
requirement to the active development tests in Sec.  1.954-2(c)(1)(i) 
and (d)(1)(i) that the relevant activities be performed by the lessor's 
or licensor's own officers or staff of employees, and providing a 
transition rule that the modified active development tests apply only 
with respect to property manufactured, produced, developed, or created, 
or in the case of acquired property, property to which substantial 
value has been added, on or after September 1, 2015). The 2016 
modifications are taken into account through the cross-reference in 
Sec.  1.1297-1(c)(1)(i)(A) to section 954(c)(2)(A) (relating to active 
rents and royalties). The Treasury Department and the IRS have 
determined that no revisions to the PFIC activity attribution rule are 
necessary, given that the PFIC activity attribution rules clearly apply 
to take into account the activities of officers and employees of other 
specified entities whether the rules under section 954(c)(2)(A) apply 
as modified (in the case of property manufactured, produced, developed, 
or created, or in the case of acquired property, property to which 
substantial value has been added, on or after September 1, 2015) or the 
rules under section 954(c)(2)(A) pre-modification apply (because no 
changes to the property have occurred since September 1, 2015). 
Accordingly, the comment is not adopted.
2. Ownership Threshold for Activity Attribution
    The proposed regulations provided that, for purposes of the 
activity attribution rule described in Part IV.E.1 of this Explanation 
of Comments and Summary of Revisions, a tested foreign corporation may 
take into account the activities performed only by those look-through 
subsidiaries or look-through partnerships with respect to which the 
tested foreign corporation owns (directly or indirectly) more than 50 
percent by value. See proposed Sec.  1.1297-2(e)(1). The preamble to 
the proposed regulations indicated that the Treasury Department and the 
IRS determined that an ownership level of more than 50-percent would 
prevent the activities of the look-through subsidiary or look-through 
partnership from being attributed to an unrelated entity.
    In response to a request for comments in the preamble to the 
proposed regulations concerning the appropriate ownership threshold for 
attribution of activities, one comment recommended an affiliation 
approach for the ownership threshold. Under this approach, activities 
would be attributed among members of the income-earning entity's 
affiliated group, determined under principles of Sec.  1.904-
4(b)(2)(iii) modified to include partnerships that are owned at least 
50 percent by value and corporations that are owned at least 50 percent 
by vote or value. For example, under this affiliation approach, the 
activities of a group member could be attributed not only ``up'' to a 
tested foreign corporation that owned a sufficient amount of stock in 
that group member (as would be the case under the approach in the 
proposed regulations), but also ``across'' to a sister member that is a 
part of the affiliated group or ``down'' to a subsidiary member that is 
a part of the affiliated group.
    Some comments noted that an approach that takes into account voting 
rights in lieu of value may be

[[Page 4532]]

appropriate to take into account instances where more than one owner 
materially participates in the underlying activity. One of the comments 
suggested that an ownership threshold of at least 25 percent by vote 
would provide the tested foreign corporation with sufficient control 
over the subsidiary for it to be appropriate to attribute a portion of 
the subsidiary's activities to the tested foreign corporation. Another 
comment recommended an ownership threshold of more than 50 percent by 
vote or value by the tested foreign corporation, with a requirement 
that the tested foreign corporation materially participate in the same 
or complementary line of business of the activity-conducting subsidiary 
if it owns more than 50 percent by vote but less than 50 percent by 
value of the activity conducting subsidiary. In the alternative, the 
comment suggested that the activities be attributed in proportion to 
the ownership interest in the activity-conducting subsidiary.
    The Treasury Department and the IRS disagree that satisfying a 25 
percent threshold for ownership of an entity is sufficient to conclude 
that the entity's business is sufficiently integrated with that of a 
tested foreign corporation that the entity's activities should be taken 
into account for purposes of determining the character of income and 
assets of the tested foreign corporation. However, the Treasury 
Department and the IRS agree with the comments that it is generally 
appropriate to expand the activity attribution rule to attribute 
activities among members of an affiliated group, determined by applying 
a more than 50 percent threshold and by including partnerships and U.S. 
affiliates in which corporate members of the affiliated group satisfy 
such ownership requirements. Accordingly, the final regulations so 
provide. See Sec.  1.1297-2(e)(1) and (2) (defining qualified 
affiliates of the affiliated group). However, the Treasury Department 
and the IRS have determined that because the rule applies for purposes 
of section 1297(c), which focuses on ownership of at least 25 percent 
by value, the threshold for inclusion in the group should be determined 
by value. See Sec.  1.1297-2(e)(2)(iv). Moreover, the parent of the 
affiliated group must also be foreign (a foreign corporation or 
partnership) in order to apply the activity attribution rule. See Sec.  
1.1297-2(e)(2)(v). If the parent of the affiliated group were domestic 
(a U.S. corporation or partnership), then any qualified affiliate that 
is a foreign corporation (including the tested foreign corporation) 
would qualify as a controlled foreign corporation, and any U.S. 
investor with at least a 10 percent ownership interest in the tested 
foreign corporation would be subject to the subpart F rules rather than 
the PFIC rules under section 1297(d). Accordingly, an upstream foreign 
owner of the tested foreign corporation and entities that are held 
directly or indirectly by such same upstream foreign owner as the 
tested foreign corporation may be considered qualified affiliates, 
assuming the requisite ownership percentage requirements are met.

V. Comments and Revisions to Proposed Sec.  1.1297-4--Qualifying 
Insurance Corporation

    Section 1297(f) provides that a qualifying insurance corporation 
(``QIC'') is a foreign corporation that (1) would be subject to tax 
under subchapter L if it were a domestic corporation, and (2) either 
(A) has applicable insurance liabilities (``AIL'') constituting more 
than 25 percent of its total assets on its applicable financial 
statement (``AFS'') (``the 25 percent test''), or (B) meets an elective 
alternative facts and circumstances test which lowers the AIL ratio to 
10 percent (``alternative facts and circumstances test''). Proposed 
Sec.  1.1297-4 elaborated on these requirements accordingly.

A. 25 Percent Test

1. Applicable Insurance Liabilities
    The 25 percent test in section 1297(f)(1)(B) requires that the 
ratio of a foreign corporation's AIL to total assets exceed 25 percent. 
Section 1297(f)(3)(A) defines AIL as loss and loss adjustment expenses 
(``LAE'') and reserves (other than deficiency, contingency, or unearned 
premium reserves) for life and health insurance risks and life and 
health insurance claims with respect to contracts providing coverage 
for mortality or morbidity risks.
    Proposed Sec.  1.1297-4(f)(2) provided that with respect to any 
life or property and casualty insurance business of a foreign 
corporation, AIL mean (1) occurred losses for which the foreign 
corporation has become liable but has not paid before the end of the 
last annual reporting period ending with or within the taxable year, 
including unpaid claims for death benefits, annuity contracts, and 
health insurance benefits; (2) unpaid expenses (including reasonable 
estimates of anticipated expenses) of investigating and adjusted unpaid 
losses described in (1); and (3) the aggregate amount of reserves 
(excluding deficiency, contingency, or unearned premium reserves) held 
for future, unaccrued health insurance claims and claims with respect 
to contracts providing coverage for mortality or morbidity risks, 
including annuity benefits dependent upon the life expectancy of one or 
more individuals.
    Comments requested that the term ``occurred losses'' be changed 
because it is not an industry standard term. Some comments suggested 
that the word ``occurred'' be replaced with the word ``incurred'' or 
``unpaid'' and be clarified to explicitly include incurred but not 
reported (``IBNR'') losses. Other comments suggested that the term be 
defined as the term is used in the Code, U.S. regulatory statements, or 
under U.S. generally accepted accounting principles (``GAAP'') or 
international financial reporting standards (``IFRS''). Two comments 
also requested clarification that unpaid LAE related to both paid and 
unpaid losses be included in the definition of AIL.
    The Treasury Department and the IRS agree that further 
clarification of the definition of AIL is necessary. While still 
covering only losses that have occurred, the final regulations clarify 
the definition of AIL to adopt the comments which requested that AIL 
include incurred losses (both reported and unreported) and unpaid LAE 
on all incurred losses (whether the losses are paid or unpaid).
    Comments differed as to what items should be included in the 
definition of AIL. For example, several comments suggested that AIL 
include insurance liabilities or loss reserves as reported on an AFS 
(without further modification) while other comments suggested that paid 
losses and paid LAE be included as AIL (even though they are not 
liabilities since they have been paid and, as a result, do not appear 
on the AFS as liabilities).
    A comment also requested that special rules be created for 
financial guaranty insurers and another comment requested a special 
rule for mortgage guaranty insurers. The first comment recommended that 
final regulations permit a financial guaranty insurer to include in 
losses the greater of two amounts: (1) The aggregate amount of reserves 
(excluding deficiency, contingency, or unearned premium reserves) held 
for future unaccrued insurance claims or (2) the average of losses 
incurred for policies over the previous ten years of the life of the 
policy, whichever is shorter. The second comment requested that the 25 
percent test be waived for a foreign corporation engaged in the 
business of mortgage insurance and reinsurance if at least 80 percent 
of its net written premiums are

[[Page 4533]]

derived from mortgage guaranty insurance (or reinsurance) and its gross 
investment income is less than 50 percent of its net written premiums 
as reported on its AFS.
    The final regulations do not adopt the suggestion that paid losses 
or paid LAE be treated as AIL nor the proposed special rules for 
financial guaranty insurers and mortgage guaranty insurers. These 
suggestions are contrary to the statute and the intent of Congress. 
Section 1297(f) is limited to amounts that constitute liabilities, 
whereas losses and LAE that have been paid are no longer liabilities 
and therefore do not qualify as AIL. Further, when losses and LAE are 
paid, assets are also reduced. It would not be appropriate to include 
loss and LAE amounts in the numerator of the 25 percent test (or 
alternative facts and circumstances test), when the corresponding 
assets are no longer reported on the AFS and included in the 
denominator. The statute also requires that liabilities include only 
insurance liabilities and further excludes certain types of insurance 
liabilities that may be included in a financial statement, such as 
unearned premium reserves, contingency reserves, and deficiency 
reserves. See section 1297(f)(3)(A); H. Rpt. No. 115-409, 115th Cong. 
1st Sess., at 411; and Conference Rpt. No. 115-466, 115th Cong. 1st 
Sess., at 670 (``Unearned premium reserves with respect to any type of 
risk are not treated as applicable insurance liabilities for purposes 
of the provision.''). Therefore, Sec.  1.1297-4(f)(2)(ii) provides that 
liabilities not within the definition of AIL are not included in the 
numerator of the 25 percent test (or alternative facts and 
circumstances test) and also specifies that amounts that are not 
insurance liabilities (for example, liabilities related to non-
insurance products issued by an insurance company that may be treated 
as debt, such as certain deposit arrangements, structured settlements, 
and guaranteed investment contracts or GICs) are not AIL. The statute 
also does not contemplate averaging liabilities over a multi-year 
period because section 1297(f)(1)(B) provides for an annual calculation 
by looking to the foreign corporation's AFS ``for the last year ending 
with or within the taxable year.'' Therefore, the final regulations do 
not include special rules for specialty insurers that would require 
multi-year averaging or disregard the liability requirement.
    Section 1297(f) contemplates that QIC status is determined on an 
entity-by-entity basis. Therefore, Sec.  1.1297-4(f)(2)(i)(D)(2) 
clarifies that the liabilities eligible to be taken into account in 
determining AIL include only the liabilities of the foreign corporation 
whose QIC status is being determined. For example, if a parent and 
subsidiary both issue insurance contracts to unrelated parties and the 
AFS is a combined financial statement, the AIL of parent and subsidiary 
must be separately determined and each of parent and subsidiary 
includes only the liabilities from the contracts that it has issued 
(without regard to the contracts issued by the other party). This rule 
is consistent with Sec.  1.1297-4(f)(2)(i)(D)(1) which provides the 
general principle that no item may be taken into account more than 
once.
2. Conformity Among Financial Reporting Standards in Computing 
Applicable Insurance Liabilities
    Section 1297(f)(4) contemplates that a foreign corporation can use 
GAAP, IFRS, or the accounting standard used for the annual statement 
required to be filed with the local regulator (if a statement prepared 
for financial reporting purposes using GAAP or IFRS is not available) 
as the starting point to determine AIL. The annual statement required 
to be filed with the local regulator may typically be prepared in 
compliance with local statutory accounting standards. The Treasury 
Department and IRS are aware that GAAP, IFRS, and local statutory 
accounting sometimes have different categories (and nomenclature) and 
different methods of measuring losses and reserves for insurance 
companies. The final regulations define AIL more specifically so that 
only those liabilities that meet the regulatory definition are included 
in AIL irrespective of differences in nomenclature and methods that may 
be used by different financial reporting standards.
    It is anticipated that the starting point for determining the 
amount of AIL will be the AFS balance sheet. However, it may be 
necessary in some circumstances to disaggregate components of balance 
sheet liabilities to determine the amount of a company's insurance 
liabilities that meet the regulatory definition of AIL. For example, 
the International Accounting Standards Board (``IASB'') issued a new 
accounting standard called IFRS 17 for the accounting of insurance 
contracts which was expected to become effective January 1, 2021, and 
is now deferred to be effective January 1, 2023. Some companies may 
have already adopted IFRS 17 for financial reporting purposes on an 
optional basis. IFRS 17 generally does not use the terms unpaid losses 
and LAE or unearned premium reserve on its balance sheet. Instead, 
those amounts are included in the overall insurance liabilities on the 
balance sheet and are required to be separately identified in the 
notes, as respectively, ``liability for incurred claims'' and 
``liability for remaining coverage.'' While they bear a different name, 
they are intended to be substantially the same in concept to claims 
reserves and unearned premium reserves. Therefore, it is expected that 
a foreign corporation using IFRS 17 only include those amounts derived 
from the balance sheet that fall within the final regulation's 
definition of AIL. Similarly, a foreign corporation using IFRS 17 (or 
any other financial reporting standard) is expected to exclude 
contingency reserves and deficiency reserves (in addition to unearned 
premium reserves), as applicable, even when those categories do not 
separately appear on the balance sheet as a liability and are subsumed 
within another reported line item.
    The Treasury Department and IRS recognize that IFRS 17 is a new 
accounting standard and that questions may arise as to how amounts 
relevant to the PFIC insurance exception are derived from an IFRS 17 
AFS. Similar questions may also arise with respect to financial 
statements prepared using GAAP and local statutory accounting, 
particularly as accounting reporting standards evolve. The Treasury 
Department and IRS request comments on whether further guidance is 
necessary to clarify how AILs are determined or make further 
adjustments to ensure that similarly situated taxpayers are treated 
similarly without regard to the financial reporting standard adopted by 
the foreign corporation.

B. Alternative Facts and Circumstances Test

    If a foreign corporation predominantly engaged in an insurance 
business fails the 25 percent test solely due to runoff-related or 
rating-related circumstances involving its insurance business, and the 
ratio of its applicable insurance liabilities to its total assets is at 
least 10 percent, section 1297(f)(2) allows a United States person that 
owns stock in the corporation to elect to treat such stock as stock of 
a QIC. Proposed Sec.  1.1297-4(d) provided guidance regarding this 
election.
1. Predominantly Engaged in an Insurance Business
    Section 1297(b)(2)(B) provides that passive income does not include 
income derived in the active conduct of an insurance business by a QIC. 
Section 1297(f)(1)(A) provides that a QIC must be a foreign corporation 
which would be

[[Page 4534]]

subject to tax under subchapter L if such corporation were a domestic 
corporation. Then, for purposes of the alternative facts and 
circumstances test, section 1297(f)(2)(B)(i) adds another requirement 
that the foreign corporation be predominantly engaged in an insurance 
business under regulations provided by the Secretary based upon the 
applicable facts and circumstances.
    Proposed Sec.  1.1297-4(d)(2) provided more specific guidance 
regarding the circumstances under which a foreign corporation is 
considered to be predominantly engaged in an insurance business for 
purposes of the alternative facts and circumstances test by setting 
forth a predominantly engaged test (separate from the active conduct 
test and the requirements of subchapter L) by reference to the facts 
and circumstances that tend to show (or not show) that a foreign 
corporation is predominantly engaged in an insurance business based 
upon the factors set forth in the legislative history. The proposed 
rule provided that the determination is made based on whether the 
particular facts and circumstances of the foreign corporation are 
comparable to commercial insurance arrangements providing similar lines 
of coverage to unrelated parties in arm's length transactions.
    A comment pointed to a number of ambiguities in the predominantly 
engaged standard and asked for clarification. First, it stated that it 
is not clear whether the proposed regulation's predominantly engaged 
test is in addition to the insurance company status test in subchapter 
L. Second, it stated that it is unclear how non-arm's length insurance 
transactions are taken into account when determining whether more than 
half the business of the foreign corporation is the issuing of 
insurance or annuity contracts or the reinsuring of risks underwritten 
by insurance companies and how to compare related party transactions to 
commercial insurance arrangements. Third, it stated that it is unclear 
whether the list of facts and circumstances is an exclusive set of 
factors.
    In response to the comment, the final regulations make clear that 
the predominantly engaged requirement in the alternative facts and 
circumstances test is in addition to the subchapter L requirement that 
more than half the business of the foreign corporation is the issuing 
of insurance or annuity contracts or the reinsuring of risks 
underwritten by insurance companies. It also deletes the sentence 
regarding comparable commercial insurance arrangements because the 
standard was unclear and instead replaces it with a statement that the 
determination is made upon the character of the business actually 
conducted in the taxable year. Lastly, it clarifies that the list of 
facts and circumstances is not exclusive and can include other factors 
as may be relevant to a specific situation.
2. Runoff-Related Circumstances
    Proposed Sec.  1.1297-4(d)(3) provided that ``runoff-related 
circumstances'' means that the foreign corporation: (1) Was actively 
engaged in the process of terminating its pre-existing, active 
insurance or reinsurance underwriting operation pursuant to an adopted 
plan of liquidation or termination of operations under the supervision 
of its applicable insurance regulatory body; (2) did not issue or enter 
into any insurance, annuity, or reinsurance contract, other than a 
contractually obligated renewal of an existing insurance contract or a 
reinsurance contract pursuant to and consistent with the plan of 
liquidation or a termination of operations; and (3) made payments 
during the annual reporting period covered by the AFS to satisfy the 
claims under insurance, annuity, or reinsurance contracts, and the 
payments cause the corporation to fail to satisfy the 25 percent test.
    A comment recommended that the final regulations remove the 
requirement that the runoff company have a plan of liquidation, remove 
the requirement that amounts paid by the runoff company cause the 
corporation to fail to satisfy the 25 percent test, and add a condition 
that the foreign corporation has no current plan or intention to enter 
into any insurance, annuity, or reinsurance contract other than in the 
case of a contractually obligated renewal. The comment stated that 
there is no prevailing practice in the insurance industry for a 
regulator to supervise a plan of liquidation or termination of a runoff 
company. The comment further stated that runoff carriers may be part of 
a larger insurance group, and that management of the runoff business is 
not necessarily a prelude to liquidation but can be a way for the 
active insurance businesses to shift their core business segments and 
maximize their use of capital. In addition, some companies (known as 
``runoff specialists'') are in the business of acquiring reserve 
liabilities to profitably manage the settlement and payout of claims 
until all of the liabilities are exhausted.
    The Treasury Department and IRS have considered these comments and 
believe that the exception from the 25 percent test should not be 
extended to runoff occurring in the context of the ordinary course of 
an ongoing business. The Conference Report to the Act describes a 
company with runoff-related circumstances as ``not taking on new 
insurance business'' and ``using its remaining assets to pay off claims 
with respect to pre-existing insurance risks on its books.'' See H.R. 
Rep. No. 115-466, at 671 (2017) (Conf. Rep.). The lower 10 percent 
threshold (which permits an insurance company to hold assets that are 
1000 percent of its AIL) should be limited to extraordinary 
circumstances in which the insurance company fails the 25 percent test 
solely because it is in the process of exiting the insurance business 
and is required to hold additional capital in excess of the 400 percent 
of AIL permitted by the 25 percent test due to its business being in 
runoff.
    The final regulations delete, however, the requirement that the 
runoff company have a plan of liquidation and instead require that the 
company be in the process of terminating its pre-existing, active 
conduct of an insurance business under the supervision of its 
applicable insurance regulatory body or any court-ordered receivership 
proceeding (liquidation, rehabilitation, or conservation), which covers 
a broader array of circumstances than the proposed regulation. See 
Sec.  1.1297-4(d)(3)(i).
    The final regulations retain the requirement in the proposed 
regulations that the insurance company make claims payments during the 
annual reporting period. See Sec.  1.1297-4(d)(3)(iii). However, in 
response to comments, the final regulations do not require such 
payments to cause the insurance company's ratio of liabilities to 
assets to fail the 25 percent test and instead clarify in Sec.  1.1297-
4(d)(3)(i) that the company must fail to satisfy the 25 percent test 
because it is required to hold additional assets due to its business 
being in runoff. Finally, for clarity and consistent with the comment's 
suggestion, Sec.  1.1297-4(d)(3)(ii) adds a condition that the foreign 
corporation has no plan or intention to enter into any insurance, 
annuity, or reinsurance contract other than in the case of a 
contractually obligated renewal.
3. Rating-Related Circumstances
    Proposed Sec.  1.1297-4(d)(4) provided that ``rating-related 
circumstances'' means that a foreign corporation's failure to satisfy 
the 25 percent test was a result of specific requirements with respect 
to its capital and surplus that a generally recognized credit rating 
agency imposes that the foreign corporation must comply with to

[[Page 4535]]

maintain the minimum credit rating required for it to be classified as 
secure to write new insurance business for the current year. This 
condition in the proposed regulations was based upon the premise that 
although the generally recognized credit rating agencies (A.M. Best, 
Fitch, Moody's, and Standard and Poor) may use separate rating codes, 
the ratings could be classified into ``secure'' and ``vulnerable'' 
categories, and that the rating agencies require reporting entities to 
maintain a minimum amount of capital appropriate to support its overall 
business operations in consideration of its size and risk profile.
    Comments suggested that the proposed regulation's reference to 
``secure'' be changed. Some comments suggested that the standard should 
be revised to reflect only a rating agency's requirements that are 
``necessary'' to write new business in accordance with the foreign 
corporation's regulatory or board supervised business plan. Another 
comment requested that the term necessary be defined to mean that a 
foreign corporation complies with the requirements of the credit rating 
agency to maintain a rating equivalent to A- by A.M. Best for 
reinsurers or BBB+ by Standard & Poor's for all other insurers.
    The Treasury Department and IRS agree that the use of the term 
``secure'' should be amended. Therefore, the final regulations provide 
that the rating-related circumstances standard requires that the 25 
percent test is not met due to capital and surplus amounts that a 
generally recognized credit rating agency considers necessary for the 
foreign corporation to obtain a public rating with respect to its 
financial strength, and the foreign corporation maintains such capital 
and surplus in order to obtain the minimum credit rating necessary for 
the current year by the foreign corporation to be able to write the 
business in its regulatory or board supervised business plan.
    A comment also requested that the proposed regulations be revised 
to provide that the rating-related circumstances standard not be an 
annual test. The comment requested that once the foreign corporation 
satisfies the rating-related circumstances standard, the alternative 
facts and circumstances test should not need to be reapplied unless 
there is a change in circumstances. The final regulations do not adopt 
this comment because the test for a foreign corporation's PFIC status 
and the AIL tests are annual tests.
    Several comments requested that additional categories of rating-
related circumstances be included under which certain types of entities 
or businesses would be treated as per se meeting the rating-related 
circumstances requirement. These businesses include reinsurance that is 
fully collateralized, mortgage insurance and reinsurance, and financial 
guaranty insurance. Another comment noted that lines of business that 
require a higher level of capital as compared to reserves are those 
that cover risks that are low frequency but high severity, such as 
catastrophic risk (for example, hurricanes and earthquakes) and 
financial obligation insurance such as mortgage and financial guaranty 
insurance.
    Comments noted that financial guaranty and mortgage guaranty 
insurers are generally required to operate as monoline businesses, such 
that the company does not have the option to pool its financial 
obligation risks with other types of risks (whereas pooling of 
different types of risks can reduce overall risk exposure, and thus 
capital needs). Comments also noted that the loss experience of 
mortgage and financial guaranty insurers is closely tied to the economy 
as a whole, such that insurance liabilities are relatively low when the 
economy is strong but much higher in times of economic crisis, and that 
credit rating agencies correspondingly expect such companies to hold 
additional capital to protect policyholders due to the monoline nature 
and volatility of the businesses.
    With respect to mortgage insurers, the Federal Housing Agency 
(FHA), in its role as regulator of Fannie Mae and Freddie Mac 
(government-sponsored entities who purchase or guarantee a majority of 
U.S. home mortgage loans), also prescribes capital requirements that 
must be satisfied by private mortgage insurers to be eligible to 
provide mortgage insurance on loans owned or guaranteed by Fannie Mae 
or Freddie Mac. These guidelines were set after the 2007-2008 financial 
crisis and are designed to ensure that mortgage guaranty insurers 
maintain sufficient capital to cover obligations in times of financial 
distress, when defaults and foreclosures increase. Rating agencies 
evaluate satisfaction of FHA guidelines when rating mortgage guaranty 
insurers, and FHA and rating agency capital standards geared to 
ensuring capital adequacy in times of crisis may result in a mortgage 
guaranty insurer being required to hold an amount of capital that 
causes its current insurance liabilities to be less than 25 percent of 
its assets in low loss years when the economy is strong.
    Financial guaranty insurance is a line of insurance business in 
which an insurance company guarantees scheduled payments of interest 
and principal on a bond or other debt security in the event of issuer 
default. A comment explained that financial guaranty insurance is 
unique in that the policyholder is effectively paying for use of the 
financial guaranty insurer's credit rating. For example, if a 
municipality insures its municipal bond obligations with a financial 
guarantee insurer, the municipality can charge a lower interest rate on 
its bond, because the obligation is guaranteed by the insurer's high 
credit rating. A very high credit rating is thus essential for a 
financial guarantee insurer to write new business. Further (and similar 
to mortgage guaranty insurers) rating agency capital standards for 
financial guaranty insurers are geared to ensuring capital adequacy in 
times of crisis and may require a higher level of capital to get the 
same rating as an insurer with a different portfolio of risks. The 
combination of enhanced rating agency capital requirements and the need 
for a very high credit rating to write new business often results in a 
financial guaranty insurer being required to hold capital such that its 
current insurance liabilities are less than 25 percent of its assets in 
low loss years.
    The Treasury Department and IRS considered these comments and the 
circumstances under which an insurance company would need assets in 
excess of 400 percent of its insurance liabilities in order to obtain 
the credit rating needed to write new business. As described in 
comments, companies that may require a higher level of capital as 
compared to insurance liabilities are companies that provide primarily 
catastrophic loss coverage and also monoline companies providing 
mortgage or financial guaranty insurance that experience significant 
losses on a low frequency but high severity basis. In low loss years, 
these types of companies may have less than 25 percent insurance 
liabilities to assets, but the additional assets may be viewed as 
necessary by rating agencies for the companies to meet insurance 
obligations in high loss years, and thus to receive the credit rating 
that the companies require to write the business in their business 
plan. Thus, the final regulations provide that the rating related 
circumstances exception is only available to a foreign corporation if 
it is a company that exclusively provides mortgage insurance or if more 
than half of the foreign corporation's net written premiums for the 
annual reporting period (or the average of the net written premiums for 
the foreign corporation's annual reporting period and the two 
immediately preceding annual reporting

[[Page 4536]]

periods) are from insurance coverage against the risk of loss from a 
catastrophic loss event (that is, a low frequency but high severity 
loss event). See Sec.  1.1297-4(d)(4)(i).
    The final regulations also provide that a financial guaranty 
insurance company that fails the 25 percent test is deemed to satisfy 
the rating-related circumstances requirement. See Sec.  1.1297-
4(d)(4)(ii). The final regulations define a financial guaranty 
insurance company as an insurance company whose sole business is to 
insure or reinsure only the type of business written by (or that would 
be permitted to be written by) a company licensed under, and compliant 
with, a U.S. state law, modeled after the National Association of 
Insurance Companies Financial Guaranty Insurance Guideline, that 
specifically governs the licensing and regulation of financial guaranty 
insurance companies. See Sec.  1.1297-4(f)(5).
    The final regulations do not include a special rule for fully 
collateralized reinsurance because the decision to fully collateralize 
reinsurance obligations is not necessarily linked to rating agency 
requirements and (as noted in comments) many fully collateralized 
reinsurance companies do not obtain credit ratings.
4. Election To Apply Alternative Facts and Circumstance Test
    Section 1297(f)(2) requires a United States person to make an 
election in order to treat a foreign corporation that satisfies the 
alternative facts and circumstances test as a QIC. Proposed Sec.  
1.1297-4(d)(5) provided that the election could not be made unless the 
foreign corporation directly provided the United States person with a 
statement or made a publicly available statement, in each case 
indicating that the foreign corporation satisfied the requirements of 
the alternative facts and circumstances test. However, the foreign 
corporation's statement could not be relied on if the shareholder knew 
or had reason to know that the statement was incorrect.
    One comment objected to the proposed rule providing that a 
shareholder cannot rely on a statement of the foreign corporation if it 
has reason to know that the statement is incorrect. The comment 
asserted that a shareholder may not have access to the information 
needed to determine the accuracy of a foreign corporation's 
representations. In response to this comment, the final regulations 
clarify that a shareholder is permitted to rely on a statement provided 
by the foreign corporation unless it has reason to know the statement 
is incorrect based on reasonably accessible information. Whether 
information is reasonably accessible is determined based on all 
relevant facts and circumstances, including the size of the 
shareholder's ownership interest and whether the shareholder is an 
officer or employee of the foreign corporation. Thus, reliance is not 
permitted under circumstances in which a reasonable person in the 
shareholder's position would know, based on information to which the 
shareholder has reasonable access, that the foreign corporation's 
statement is incorrect. In any case, an election is not valid unless 
the foreign corporation actually meets the requirements of Sec.  
1.1297-4(d)(1), regardless of whether the foreign corporation 
represents that those requirements have been met.
    A shareholder makes the election on Form 8621, which must be 
attached to the shareholder's U.S. federal income tax return (under the 
final regulations, there is no requirement to attach also the statement 
provided by the foreign corporation). A shareholder who makes the 
election is not required to disclose the value of the foreign 
corporation's stock and, therefore, is not treated as having reported 
the foreign corporation's stock as an asset on Form 8621 for purposes 
of Sec.  1.6038D-7(a)(1)(i)(C). As a result, the shareholder would be 
required to report the stock on Form 8938, subject to the thresholds 
and exceptions provided in section 6038D and the regulations 
thereunder. The final regulations clarify that the election can be made 
by a United States person who holds an option to purchase stock in a 
foreign corporation that meets the requirements of section 1297(f)(2).
    One comment requested a special rule for foreign corporations owned 
indirectly through a foreign parent corporation, under which the 
foreign parent corporation could provide (or make publicly available) 
the statement required by the proposed regulations, and the election 
could be made at the level of the foreign parent corporation. In 
response to this comment, the final regulations have been modified to 
allow a foreign parent corporation to make the required statement 
publicly available on behalf of its subsidiaries. However, the final 
regulations do not permit the election to be made at the foreign parent 
level.
    Some comments asserted that it would be unduly burdensome for 
certain shareholders to file Form 8621 in order to make the election 
under section 1297(f)(2). The comments requested that shareholders of 
publicly traded companies or small shareholders of non-publicly traded 
companies be deemed to make the election under section 1297(f)(2) 
without the need for an affirmative filing.
    In response to these comments, the final regulations provide that a 
shareholder in a publicly traded foreign corporation who owns stock 
(either directly or indirectly) with a value of $25,000 or less is 
deemed to make the election under section 1297(f)(2) with respect to 
the publicly traded foreign corporation and its subsidiaries. If a 
shareholder owns stock in a publicly traded foreign corporation through 
a domestic partnership, an election will not be deemed made unless the 
stock held by the partnership has a value of $25,000 or less. The same 
rule applies to stock owned through a domestic trust or estate, or 
through an S corporation. All the requirements necessary to permit an 
actual election under section 1297(f)(2) must be satisfied in order to 
permit a deemed election under this rule. For example, an election will 
not be deemed made unless the foreign corporation (or its foreign 
parent) provides a statement to the United States person or makes a 
publicly available statement indicating that it has satisfied the 
requirements of the alternative facts and circumstances test.
    In addition, the final regulations provide that if a shareholder 
fails to make the election under section 1297(f)(2) on its original 
return for a taxable year, the election may be made on an amended 
return, provided there is reasonable cause for the failure to make the 
election on the original return. A United States person that makes the 
election on an amended return must be prepared to demonstrate 
reasonable cause upon request, but is not required to provide 
documentation of reasonable cause when the amended return is filed. 
This rule is intended to provide relief to a shareholder that 
inadvertently neglects to make the election under section 1297(f)(2) 
and does not qualify for a deemed election (for example, if the 
shareholder owns stock with a value in excess of $25,000).

C. Limitations on Amount of Applicable Insurance Liabilities

1. Mechanics of the Limitation
    Proposed Sec.  1.1297-4(e) provided rules limiting the amount of 
AIL for purposes of the 25 percent test and the alternative facts and 
circumstances test and stated that AIL may not exceed the lesser of (1) 
AIL shown on the most recent AFS, (2) the minimum AIL required by the 
applicable law or regulation of the jurisdiction of the applicable 
insurance regulatory body, and (3) AIL reported on the most recent 
financial statement

[[Page 4537]]

made on the basis of GAAP or IFRS if such financial statement was not 
prepared for financial reporting purposes.
    A comment requested changes to the second limitation amount under 
the proposed regulations (the minimum AIL required by the applicable 
law or regulation of the jurisdiction of the applicable insurance 
regulatory body). The comment asserted that the reference to a 
``minimum amount'' is either redundant (because the amount required 
under the applicable law or regulation will always be a minimum amount) 
or ambiguous (because the ``minimum amount'' could be interpreted to 
mean a hypothetical minimum amount required for any insurer without 
regard to its particular circumstances, including its lines of 
business). The same comment also noted that proposed Sec.  1.1297-
4(e)(2)(ii) did not take into account AIL actually reported to the 
applicable insurance regulatory body, if lower than the minimum 
required amount (which a local regulator sometimes allows as a 
permitted practice). Other comments requested that the minimum amount 
required under the applicable law or regulation be determined by 
reference to GAAP or IFRS requirements.
    With respect to the third limitation amount under the proposed 
regulations (AIL reported on the most recent financial statement made 
on the basis of GAAP or IFRS if such financial statement was not 
prepared for financial reporting purposes), one comment expressed 
concern that a statement which is not prepared for financial reporting 
purposes is potentially unreliable and should not be used as a basis 
for determining AIL. In addition, the comment requested guidance as to 
the meaning of the terms ``financial statement'' and ``financial 
reporting standard.''
    The limitation under Sec.  1.1297-4(e) has been modified in 
response to these comments. Under the final regulations, a foreign 
corporation's AIL may not exceed the lesser of (1) the amount shown on 
any financial statement filed (or required to be filed) with the 
applicable insurance regulatory body for the same reporting period 
covered by the applicable financial statement; (2) the amount 
determined on the basis of the most recent AFS, if the AFS is prepared 
on the basis of GAAP or IFRS, regardless of whether the AFS is filed 
with the applicable insurance regulatory body; or (3) the amount 
required by the applicable law or regulation of the jurisdiction of the 
applicable regulatory body (or a lower amount allowed as a permitted 
practice). If one of the limitation amounts is not applicable (for 
example, if the AFS is not prepared on the basis of GAAP or IFRS), the 
limitation is equal to the lesser of the other amounts described.
    Although the limitation under section 1297(f)(3) refers to the 
amount reported to the applicable insurance regulatory body in the AFS, 
the final regulations clarify that an AFS prepared under GAAP or IFRS 
is taken into account as part of the limitation under Sec.  1.1297-
4(e)(2)(ii) regardless of whether it is filed with the local regulator. 
This rule is intended to prevent foreign corporations that choose not 
to file GAAP or IFRS statements with the local regulator from relying 
on statutory accounting standards that define liabilities more broadly 
than GAAP or IFRS. The limitation in the proposed regulations 
addressing financial statements prepared for a purpose other than 
financial reporting has been deleted.
    The definition of the term ``financial statement'' has been revised 
to treat a statement as such only if it is prepared for a reporting 
period in accordance with the rules of a financial accounting or 
statutory accounting standard and includes a complete balance sheet, 
statement of income, and a statement of cash flows (or equivalent 
statements under the applicable reporting standard). Consequently, a 
statutory accounting statement that is used for purposes of the 
limitation should provide all information necessary to apply the 25 
percent test and the alternative facts and circumstances test.
2. Discounting
    Under proposed Sec.  1.1297-4(e)(3), if an AFS that was not 
prepared under GAAP or IFRS did not discount losses on an economically 
reasonable basis, AIL were required to be reduced under the discounting 
rules that would apply if a financial statement had been prepared under 
either GAAP or IFRS. Some comments requested that the discounting 
requirement be removed because GAAP does not require discounting of 
liabilities in certain circumstances.
    The Treasury Department and the IRS agree that AIL reported on a 
financial statement that have been discounted to reflect the time value 
of money only to the extent required by GAAP or IFRS have been 
discounted on an economically reasonable basis. Therefore, additional 
discounting of AIL is not necessary under circumstances in which it is 
not required under either GAAP or IFRS. For example, IFRS 17 does not 
require discounting of liabilities under nonlife insurance contracts 
with terms of one year or less. However, the Treasury Department and 
the IRS have determined that discounting is required where AIL have not 
been otherwise discounted on a reasonable basis. Accordingly, the final 
regulations clarify that, where a financial statement described in 
Sec.  1.1297-4(e)(2) does not discount AIL on an economically 
reasonable basis, the foreign corporation may meet this requirement by 
choosing to apply the discounting methods required under either GAAP or 
IFRS.
3. Change of Financial Reporting Standard
    Under proposed Sec.  1.1297-4(e)(4), if a foreign corporation had 
previously prepared a financial statement under GAAP or IFRS, it could 
not cease to do so in subsequent years without a non-Federal tax 
business purpose. If the foreign corporation failed to prepare a 
financial statement under GAAP or IFRS in a subsequent year without a 
non-Federal tax business purpose, it was treated as having no AIL for 
purposes of the 25 percent test and the 10 percent test.
    A comment requested that this rule be removed because taxpayers 
should not be required to establish a business purpose for their choice 
of an accounting standard. In addition, financial reports are prepared 
to inform a corporation's stakeholders and regulators of its financial 
condition, and this function is so significant that a corporation is 
unlikely to change its accounting standard for tax purposes. The 
Treasury Department and the IRS have concluded that other rules and 
limitations provided in the final regulations are sufficient to protect 
the integrity of the amounts reported on the AFS. Therefore, the final 
regulations delete the special rule addressing a change of financial 
reporting standard.

D. Definition of an Insurance Business

    The proposed regulations defined an insurance business to include 
the investment activities and administrative services that are required 
to support (or that are substantially related to) insurance, annuity, 
or reinsurance contracts issued or entered into by the QIC. See 
proposed Sec.  1.1297-5(c)(2). One comment interpreted this definition 
as potentially excluding any investment activities in excess of the 
minimum amount required to meet the QIC's insurance obligations from 
the scope of the exception under section 1297(b)(2)(B). The comment 
requested that the definition be broadened to include all investment 
activities related to insurance, annuity, or reinsurance

[[Page 4538]]

contracts issued or entered into by the QIC. Although the definition of 
an insurance business (now contained in Sec.  1.1297-4(f)(8)) has not 
been changed, it is not intended to provide a maximum threshold for 
investment assets and income that may qualify for non-passive treatment 
under section 1297(b)(2)(B). This definition merely requires a 
sufficient factual relationship between a company's insurance contracts 
and its investment activity.

VI. Comments and Revisions to Proposed Sec.  1.1297-5 and New Sec.  
1.1297-6: Exception From the Definition of Passive Income for Active 
Insurance Income

    Section 1297(b)(2)(B) provides an exclusion from the definition of 
passive income for income derived in the active conduct of an insurance 
business by a QIC. Proposed Sec.  1.1297-5(b) provided a general rule 
that excluded from passive income certain income of a QIC and income of 
a qualifying domestic insurance corporation (QDIC). Proposed Sec.  
1.1297-5(c) described the requirements for income to be treated as 
derived in the active conduct of an insurance business and provided 
rules for determining the amount of a QIC's income that is excluded. 
Proposed Sec.  1.1297-5(d) provided rules for determining whether 
income of a domestic corporation is income of a QDIC. Proposed Sec.  
1.1297-5(e) provided that assets of a QIC are not treated as passive 
assets if they are available to satisfy liabilities of the QIC related 
to its insurance business. In addition, proposed Sec.  1.1297-5(e) 
provided that assets of a QDIC generally are not treated as passive 
assets. Proposed Sec.  1.1297-5(f) provided a special look-through rule 
for interests held by a QIC in subsidiary entities.

A. Active Conduct of an Insurance Business

    Under proposed Sec.  1.1297-5(c)(1), a QIC's passive income was 
treated as derived in the active conduct of an insurance business only 
if its active conduct percentage was at least 50 percent. The active 
conduct percentage was computed for each taxable year based on the 
amount of expenses incurred by a QIC for services of its officers and 
employees (including employees of qualifying related entities) related 
to the production or acquisition of premiums and investment income as a 
fraction of all expenses related to the production or acquisition of 
premiums and investment income.
    Proposed Sec.  1.1297-5(c)(3)(i) provided that active conduct is 
determined based on all the facts and circumstances. In general, a QIC 
was treated as actively conducting an insurance business only if the 
officers and employees of the QIC carried out substantial managerial 
and operational activities. A QIC's officers and employees were 
considered to include the officers and employees of an affiliate if the 
QIC satisfied the control test under proposed Sec.  1.1297-5(c)(3)(ii), 
which incorporated requirements relating to ownership, control and 
supervision, and compensation.
    Comments were generally critical of the proposed active conduct 
test. Some noted that outsourcing is a common practice in the insurance 
industry for reasons of cost and efficiency, and an insurance company 
should be treated as engaged in the active conduct of an insurance 
business even if the fees it pays for outsourced activities (for 
example, to investment advisors or insurance brokers) exceed employee 
expenses. Others expressed concern that some reinsurers (which hold 
substantial investments but employ a limited staff) and alternative 
risk vehicles could have difficulty satisfying the active conduct test 
under the proposed regulations. Comments also criticized the ``cliff 
effect'' of the active conduct percentage, which precluded an insurance 
company with an active conduct percentage that is slightly below 50 
percent from treating any of its income or assets as non-passive under 
section 1297(b)(2)(B).
    Many comments recommended that the proposed active conduct test be 
replaced with a broader facts and circumstances test. Some comments 
alternatively requested that the active conduct percentage be used as a 
safe harbor alongside a more flexible test, or that the threshold for 
the active conduct percentage be reduced to 25 percent.
    A number of comments requested that an insurance company be treated 
as engaged in the active conduct of an insurance business even if its 
day-to-day activities are not performed by employees, so long as its 
officers and employees adequately supervise the outsourced functions. 
For example, some comments recommended a management and control test 
based upon the Limitation on Benefits Article of the 2016 U.S. Model 
Income Tax Convention (which requires a company's executive officers 
and senior management employees to exercise day-to-day responsibility 
for strategic, financial, and operational policy decision-making) or 
regulations issued by the Bermuda Monetary Authority (which permit 
outsourcing subject to the insurance company's supervision and 
oversight). Others proposed that if an entity is treated as an 
insurance company under subchapter L or is treated as a QIC under 
section 1297(f), it should be deemed to be engaged in the active 
conduct of an insurance business without meeting any additional 
requirements.
    Several comments recommended that the active conduct test focus on 
the assumption of insurance risk. One comment specifically identified 
underwriting as a core insurance function that must be performed by an 
insurance company's officers and employees. Another requested that an 
insurance company be treated as engaged in the active conduct of an 
insurance business if it assumes risk under contracts with multiple 
counterparties that are unrelated to one another, or under contracts 
covering multiple divergent lines of business. Some comments proposed 
an active conduct test tied to the amount of premium and investment 
income earned by the QIC.
    For purposes of computing the active conduct percentage, some 
comments requested clarification about whether overhead and claims 
expenses are treated as expenses incurred to produce or acquire premium 
and investment income. One comment recommended that certain functions 
(for example, investment management) be excluded from both the 
numerator and denominator of the fraction.
    Some comments requested that the control test be expanded to cover 
employees of entities that are related to the QIC within the meaning of 
section 954(d)(3) or are under common practical control with the QIC. 
Another proposed that a single active conduct percentage be computed on 
an aggregate basis when multiple insurance companies are wholly owned 
within a single corporate group.
    The Treasury Department and the IRS have determined that the active 
conduct of an insurance business is a requirement mandated by the 
statute in addition to (and separate from) the requirements of 
subchapter L and section 1297(f), but that in response to comments, the 
active conduct test should be amended to provide more flexibility in 
determining whether a QIC is engaged in the active conduct of an 
insurance business. Therefore, the Treasury Department and the IRS are 
issuing a notice of proposed rulemaking (the 2020 NPRM) with a new 
proposed Sec.  1.1297-5 published in the same issue of the Federal 
Register as these final regulations that proposes rules for determining 
whether an insurance company is engaged in the active conduct of an 
insurance business.
    The new active conduct rules are proposed to apply to taxable years 
of

[[Page 4539]]

QICs beginning on or after the date the Treasury Decision adopting 
those rules as final regulations is published in the Federal Register. 
The rules contained in proposed Sec.  1.1297-5(c) and (d) are 
withdrawn. The other rules in proposed Sec.  1.1297-5 have been 
modified as described below and are provided in the final regulations 
under new Sec.  1.1297-6.

B. Qualifying Domestic Insurance Corporations

    Proposed Sec.  1.1297-5(d) defined a QDIC as a domestic corporation 
that is subject to tax as an insurance company under subchapter L of 
chapter 1 of subtitle A of the Code and is subject to Federal income 
tax on its net income. Proposed Sec. Sec.  1.1297-5(b)(2) and 1.1297-
5(e)(2) provided that a QDIC's income and assets are non-passive for 
purposes of determining whether a non-U.S. corporation is treated as a 
PFIC (the QDIC Rule). However, proposed Sec. Sec.  1.1297-5(b)(2) and 
1.1297-5(e)(2) provided that the QDIC Rule did not apply for purposes 
of section 1298(a)(2) and determining if a U.S. person indirectly owns 
stock in a lower tier PFIC (QDIC Attribution Exception). Consequently, 
for attribution purposes, a tested foreign corporation was required to 
apply the section 1297(a) income and assets tests without applying the 
QDIC Rule.
    Several comments requested that the QDIC Attribution Exception be 
removed because U.S. shareholders of a tested foreign corporation that 
would not otherwise be a PFIC but that owns a PFIC and a U.S. insurance 
subsidiary that is a QDIC can become indirect owners of a PFIC as a 
result of the section 1298(a)(2) attribution rule. Another comment 
requested that, if the QDIC Attribution Exception is retained, a 
special exception be provided for active domestic mortgage insurance 
companies if certain criteria are satisfied. The Treasury Department 
and IRS agree that the QDIC Attribution Exception is overbroad, and 
therefore the final regulations do not include it. However, the 
Treasury Department and IRS believe that it may be appropriate to limit 
the amount of a QDIC's assets and income that are treated as non-
passive if they exceed a certain threshold. Accordingly, the 2020 NPRM 
proposes a new limitation.
    The final regulations also clarify that a U.S. insurance company 
must be a look-through subsidiary in order to qualify as a QDIC. If a 
QDIC is a look-through subsidiary of a QIC, the QIC's proportionate 
share of the QDIC's assets that is treated as non-passive may be 
subject to limitation under the special look-through rule provided in 
Sec.  1.1297-6(d), which is described in Part VI.C of this Summary of 
Comments and Explanation of Revisions. Because of the renumbering of 
sections described in Part VI.A of this Summary of Comments and 
Explanation of Revisions, the QDIC rules are now contained in Sec.  
1.1297-6(b)(2), (c)(2), and (e)(1) of the final regulations.

C. Treatment of Income and Assets of Certain Look-Through Subsidiaries 
and Look-Through Partnerships Held by a QIC

    The proposed regulations provided a special look-through rule that 
applied to a subsidiary entity in which the QIC owned at least 25 
percent by value (that is, a look-through subsidiary or a look-through 
partnership) and which was subject to the look-through rules provided 
in section 1297(c), proposed Sec.  1.1297-1(c)(2) and (d)(3), and 
proposed Sec.  1.1297-2(b)(2) (the ``general look-through rules,'' 
which are now provided in Sec.  1.1297-2(b)(2) and (3)). Under the 
general look-through rules, a QIC is treated as earning directly its 
proportionate share of the income, and holding directly its 
proportionate share of the assets, of a look-through subsidiary or a 
look-through partnership.
    Proposed Sec.  1.1297-5(f) provided that, if a QIC was treated as 
earning passive income or holding passive assets of a subsidiary entity 
under the general look-through rules, then the income could be treated 
as derived by the QIC in the active conduct of an insurance business 
(and thus treated as non-passive under proposed Sec.  1.1297-5(c)), and 
the assets could be treated as assets of the QIC held to satisfy 
liabilities related to its insurance business (and thus treated as non-
passive under Sec.  1.1297-5(e)). However, for this rule to apply, the 
subsidiary entity's assets and liabilities were required to be included 
in the QIC's AFS.
    A number of comments asserted that look-through treatment should 
not be denied for subsidiary entities that do not have assets and 
liabilities included in the QIC's AFS (which would typically occur if a 
subsidiary entity is not consolidated with the QIC under the relevant 
financial accounting standard). The comments noted that the equity 
value of a subsidiary entity is reflected on a QIC's AFS even if it is 
not consolidated for financial reporting purposes. Some comments 
requested that the look-through rule under proposed Sec.  1.1297-5(f) 
apply without regard to whether a subsidiary entity's assets and 
liabilities are included in the QIC's AFS. Others requested that the 
look-through rule be applied to a proportionate amount of the income 
and assets of a subsidiary entity, depending on how the value of the 
subsidiary entity is reflected on the AFS.
    In response to these comments, the special look-through rule for 
assets and income of a subsidiary entity held by a QIC (now provided in 
Sec.  1.1297-6(d)) has been modified to apply in all cases in which a 
QIC is treated as owning the assets or earning the income of the 
subsidiary entity under the general look-through rules. However, under 
Sec.  1.1297-6(d)(2), the amount of assets or income that can be 
treated as non-passive under the revised rule is limited to the greater 
of two amounts. The first amount is determined by multiplying the QIC's 
proportionate share of the subsidiary entity's income or assets by a 
fraction equal to (i) the net equity value of the QIC's interests in 
the subsidiary entity divided by (ii) the value of the subsidiary 
entity's assets. The second amount is the amount of income or assets 
that are treated as non-passive in the hands of the subsidiary entity.
    If assets are measured based on value for purposes of applying the 
asset test under section 1297(a)(2), the amount of otherwise passive 
assets that may be treated as non-passive under Sec.  1.1297-6(d) (that 
is, the first amount described above) is limited to the net equity 
value of the interests held by the QIC in the subsidiary entity. If 
assets are measured instead using adjusted bases, the fraction test is 
designed to provide a proportionate limitation. Two examples are added 
to illustrate the operation of these rules. See Sec.  1.1297-6(d)(3).
    Several comments requested clarification regarding the treatment of 
an interest held by a QIC in an entity other than a look-through 
subsidiary or a look-through partnership (for example, a corporation in 
which a QIC owns less than 25 percent of the stock). The income and 
assets of such a subsidiary entity are not treated as earned or held by 
the QIC in the active conduct of an insurance business, consistent with 
the general look-through rules. However, the stock or partnership 
interest held by the QIC (and the income it derives from the subsidiary 
entity) is eligible for the exception under section 1297(b)(2)(B) and 
Sec.  1.1297-6(b) and (c) in the same manner as any other (non-look-
through) asset held by a QIC.

VII. Comments and Revisions to Proposed Sec.  1.1298-4--Rules for 
Certain Foreign Corporations Owning Stock in 25-Percent-Owned Domestic 
Corporations

    Section 1298(b)(7) provides a special characterization rule that 
applies when

[[Page 4540]]

a tested foreign corporation owns at least 25 percent of the value of 
the stock of a domestic corporation and is subject to the accumulated 
earnings tax under section 531 (or waives any benefit under a treaty 
that would otherwise prevent imposition of such tax). In that case, 
section 1298(b)(7) treats the qualified stock held by the domestic 
corporation as a non-passive asset, and the related income as non-
passive income.

A. Interaction of the Domestic Subsidiary Rule and Section 1298(a)(2) 
Attribution Rule

    The proposed regulations included rules that disregarded the 
application of section 1298(b)(7) for purposes of determining whether a 
foreign corporation is a PFIC for purposes of the ownership attribution 
rules in section 1298(a)(2) and Sec.  1.1291-1(b)(8)(ii) (``domestic 
subsidiary attribution rules''). See proposed Sec. Sec.  1.1291-
1(b)(8)(ii)(B) and 1.1298-4(e).
    Several comments recommended that the final regulations eliminate 
the domestic subsidiary attribution rules in proposed Sec. Sec.  
1.1291-1(b)(8)(ii)(B) and 1.1298-4(e). These comments asserted that 
Congress intended for stock that is treated as non-passive pursuant to 
section 1298(b)(7) to be characterized as non-passive for all purposes, 
including for purposes of section 1298(a)(2). Specifically, some of 
these comments noted that the statutory text of section 1298(a)(2) 
already specifies that application of section 1297(d) is excluded and, 
thus, asserted that an additional exclusion from section 1298(a)(2) is 
precluded. The comments also asserted that legislative history suggests 
that Congress intended for section 1298(b)(7) to incentivize 
investments in domestic corporations. Other comments argued that the 
domestic subsidiary attribution rules would be administratively 
burdensome on minority shareholders who would not be able to obtain 
information with respect to lower-tier PFICs to comply with the PFIC 
rules. One comment suggested that Congress acknowledged the lack of 
control that minority investors have in parent companies by providing 
the 50-percent threshold in section 1298(a)(2) to facilitate 
administrability. Another comment recommended that, if the domestic 
subsidiary attribution rules are retained, the final regulations 
provide an exception to allow shareholders who own less than 5-percent 
of the top-tier foreign corporation in a structure to apply section 
1298(b)(7) to determine PFIC status for purposes of the ownership 
attribution rules in section 1298(a)(2).
    The Treasury Department and the IRS have given further 
consideration to the purpose of section 1298(b)(7), and have determined 
that it is appropriate for section 1298(b)(7) generally to apply for 
purposes of the attribution of ownership rules of section 1298(a), 
provided that adequate measures are taken to prevent taxpayers from 
holding primarily passive assets in domestic subsidiaries in order to 
avoid PFIC classification. The Treasury Department and the IRS also 
agree with the comment that the domestic subsidiary attribution rule 
can be administratively burdensome. Accordingly, the Treasury 
Department and the IRS have determined that the application of the 
domestic subsidiary anti-abuse rule discussed in Part VII.B of this 
Explanation of Comments and Summary of Revisions is sufficient to 
address concerns about abusive planning related to section 1298(b)(7) 
without a need for the domestic subsidiary attribution rules. 
Therefore, the domestic subsidiary attribution rules are eliminated in 
the final regulations.
    Several comments were received recommending clarification 
concerning the consequences of disregarding section 1298(b)(7) for 
purposes of the Income Test and the Asset Test and excepting minority 
shareholders from the domestic subsidiary rule. Because the final 
regulations do not adopt the domestic subsidiary attribution rules, 
these recommendations are not adopted.

B. Revisions to Domestic Subsidiary Anti-Abuse Rules

    The proposed regulations provided that section 1298(b)(7) did not 
apply if (i) the tested foreign corporation would be a PFIC if the 
qualified stock held by the 25-percent-owned domestic corporation or 
any income received or accrued with respect thereto were disregarded 
(``qualified stock anti-abuse rule'') or (ii) a principal purpose for 
the tested foreign corporation's formation or acquisition of the 25-
percent-owned domestic corporation was to avoid classification of the 
tested foreign corporation as a PFIC (``principal purpose anti-abuse 
rule''). See proposed Sec.  1.1298-4(f). The preamble to the proposed 
regulations explained that the Treasury Department and the IRS believed 
that a taxpayer should not be permitted to use the domestic subsidiary 
rule in section 1298(b)(7) to avoid the PFIC rules by indirectly 
holding predominantly passive assets through a two-tiered chain of 
domestic subsidiaries.
1. Qualified Stock Anti-Abuse Rule
    Several comments requested that the qualified stock anti-abuse rule 
in proposed Sec.  1.1298-4(f)(1) be withdrawn. These comments asserted 
that Congress was aware of the potential for taxpayers to rely on 
section 1298(b)(7) to avoid PFIC status by treating otherwise passive 
investments as non-passive and intended for the accumulated earnings 
tax (``AET'') to mitigate potential abuse. The comments argued that the 
AET imposed on the tested foreign corporation, the U.S. corporate tax 
imposed on the domestic subsidiaries, and the withholding tax imposed 
on distributions to the tested foreign corporation serve to discourage 
a tested foreign corporation from artificially overweighting its 
investment assets held through domestic subsidiaries. Another comment 
asserted that the qualified stock anti-abuse rule creates a 
hypothetical PFIC test that supersedes the statute when it causes a 
tested foreign corporation to be a PFIC in a fact pattern in which the 
domestic subsidiary rule in section 1298(b)(7) would otherwise cause 
the tested foreign corporation to not be a PFIC.
    The Treasury Department and the IRS have determined that the 
qualified stock anti-abuse rule is unnecessary to address the concerns 
of abuse that were expressed in the preamble to the proposed 
regulations and that tailoring the scope of the principal purpose anti-
abuse rule as discussed in Part VII.B.2 of this Summary of Comments and 
Explanation of Revisions would better target the concerns of abuse. 
Accordingly, the qualified stock anti-abuse rule in proposed Sec.  
1.1298-4(f)(1) is withdrawn.
2. Principal Purpose Anti-Abuse Rule
    Under the principal purpose anti-abuse rule in proposed Sec.  
1.1298-4(f)(2), a principal purpose was deemed to exist when the 25-
percent-owned domestic corporation was not engaged in an active trade 
or business in the United States. One comment asserted that the 
principal purpose anti-abuse rule in proposed Sec.  1.1298-4(f)(2) was 
overbroad and should be narrowly drawn to prevent potential abuse. 
Other comments requested that the principal purpose anti-abuse rule be 
eliminated, because, according to such comments, Congress contemplated 
that taxpayers would plan into section 1298(b)(7) and intended for the 
AET to be the sole limitation on the applicability of the domestic 
subsidiary rule. Some of these comments asserted that the principal 
purpose anti-abuse rule was inconsistent with two private letter 
rulings that, according to such comments, endorsed the use of domestic 
subsidiaries to manage PFIC status.

[[Page 4541]]

    One comment noted that the 25-percent-owned domestic corporation is 
likely to be a holding company without an active trade or business and, 
thus, the tested foreign corporation would likely be deemed to have a 
principal purpose of avoiding PFIC classification. Another comment 
argued that the standard for deeming a principal purpose of avoiding 
PFIC status to exist is misguided because a corporation need not be 
engaged in an active trade or business in order to generate non-passive 
income. Other comments expressed concern that the principal purpose 
anti-abuse rule would disallow planning to manage the PFIC risk of 
start-up companies and active companies undergoing transition.
    The Treasury Department and the IRS have determined that the final 
regulations should retain a principal purpose anti-abuse rule to 
prevent the holding of passive assets through a two-tiered chain of 
domestic subsidiaries for the purpose of avoiding the PFIC rules with 
respect to passive assets held in foreign affiliates. Absent an anti-
abuse rule, a two-tiered chain of domestic subsidiaries could be used 
to shield U.S. investors in a tested foreign corporation from the 
application of the PFIC rules with respect to substantial amounts of 
passive assets held by the tested foreign corporation or its foreign 
subsidiaries. The Treasury Department and the IRS have concluded that 
the promulgation of a principal purpose anti-abuse rule is consistent 
with section 1298 and the broad regulatory authority under section 
1298(g). The legislative history of section 1298(b)(7) envisions that 
U.S. shareholders that hold passive assets through a U.S. corporate 
structure rather than in a foreign corporation in order to avoid the 
PFIC regime will be subject to tax treatment essentially equivalent to 
that of the shareholders of a PFIC. While Congress intended that the 
AET serve this function, because the AET is rarely applied in practice, 
the Treasury Department and the IRS have determined that the AET is 
not, by itself, sufficient to curtail abuse. The imposition of U.S. net 
income tax on the income from passive assets held by a domestic 
subsidiary also does not serve as a sufficient disincentive to hold 
those assets in a domestic subsidiary, because the passive assets may 
generate a small amount of income or the domestic subsidiary may be 
leveraged so that its net income subject to taxation is much less than 
the gross income that would be taken into account under the PFIC rules 
if the assets were held by a foreign affiliate. Section 1298(g) 
provides authority to prevent abuse of the PFIC rules. Moreover, the 
Treasury Department and the IRS have determined that the comments did 
not appreciate the underlying facts of the private letter rulings and 
that the promulgation of the principal purpose anti-abuse rule is not 
inconsistent with the private letter rulings.
    However, the Treasury Department and the IRS agree that it is 
appropriate to more closely tailor the scope of the principal purpose 
anti-abuse rule to the potential abuses of greatest concern. 
Accordingly, the principal purpose anti-abuse rule in the final 
regulations is modified to strike the appropriate balance between 
preventing section 1298(b)(7) from applying inappropriately to avoid 
the PFIC rules and allowing for planning to manage the PFIC risk of 
start-up companies and active companies undergoing transition phases in 
the business cycle. Under the principal purpose anti-abuse rule in the 
final regulations, section 1298(b)(7) does not apply if either (i) a 
principal purpose for the formation, acquisition, or holding of stock 
of either domestic corporation was to avoid PFIC classification or (ii) 
a principal purpose of the capitalization or other funding of the 
second-tier domestic corporation is to hold passive assets through such 
corporation to avoid PFIC classification. See Sec.  1.1298-4(e)(1). 
Unlike the proposed regulations, which applied the principal purpose 
anti-abuse rule only at the level of the upper tier domestic 
corporation, the final regulations were modified to apply the principal 
purpose anti-abuse rule at both levels. See id. Because a two-tiered 
domestic structure can be planned into at either tier level in the 
structure, the first prong of the anti-abuse rule--which targets 
corporate formations, acquisitions, or stock holding--applies at both 
levels. See id. On the other hand, the second prong of the anti-abuse 
rule--which targets capitalizing or funding--applies at the level of 
the second-tier domestic subsidiary because the benefit of section 
1298(b)(7) applies only with respect to assets held at that level. See 
id. The Treasury Department and the IRS continue to study the need to 
narrow the principal purpose anti-abuse test to avoid concerns with 
respect to temporary holdings of passive assets in a U.S. corporate 
structure for valid business reasons, and additional guidance on safe 
harbors to address those concerns is proposed in the 2020 NPRM. See 
proposed Sec.  1.1298-4(e)(2) and (e)(3).

VIII. Comments and Revisions Regarding Applicability Dates

    The preamble to the proposed regulations generally provided that 
until they were finalized, taxpayers could choose to apply the proposed 
regulations other than the rules related to the PFIC insurance 
exception in their entirety to all open tax years as if they were final 
regulations provided that taxpayers consistently applied those rules. 
Similarly, the preamble provided that the rules of proposed Sec. Sec.  
1.1297-4 and 1.1297-5 could be applied for taxable years beginning 
after December 31, 2017, provided those rules were applied 
consistently.

A. Applicability Dates Relating to the PFIC Insurance Exception

    Comments related to the PFIC insurance income exception requested 
that the final regulations apply to taxable years of a U.S. shareholder 
beginning on or after December 31, 2020 (or such date that generally 
provides foreign corporations at least one year to comply with the 
final regulations) or the date of publication of the final regulations. 
Comments asserted that foreign corporations needed additional time to 
make changes to come into compliance with the regulations, and that 
U.S. shareholders needed additional time to evaluate whether they were 
shareholders of a PFIC. Because the final regulations have removed 
rules turning off the QDIC rule and section 1298(b)(7) for purposes of 
testing for indirect ownership of a PFIC and the rules defining active 
conduct of an insurance business have been revised and reproposed, the 
final regulations are significantly less burdensome than as originally 
proposed. Accordingly, the Treasury Department and the IRS have decided 
that additional time is not necessary to comply given that section 
1297(f) has been in effect since January 1, 2018, and Sec. Sec.  
1.1297-4 and 1.1297-6 merely implement section 1297(f).
    Sections 1.1297-4(g) and 1.1297-6(f) therefore provide that the 
final PFIC insurance regulations apply to taxable years beginning on or 
after January 14, 2021. Taxpayers may choose to apply the final PFIC 
insurance regulations to any taxable year beginning after December 31, 
2017, provided that all of those rules are applied consistently with 
respect to that tested foreign corporation for the same year and all 
succeeding taxable years. Id.

B. Applicability Dates Relating to Other Rules

    Comments with respect to the rules unrelated to the PFIC insurance

[[Page 4542]]

exception argued that allowing taxpayers to rely on the 2019 proposed 
regulations for open years would provide insufficient relief, given 
that a foreign corporation is generally treated as a PFIC on an ongoing 
basis with respect to a shareholder if it was ever treated as a PFIC 
with respect to that shareholder (the ``once-a-PFIC, always-a-PFIC'' 
rule). See sections 1291(a)(1) and 1298(b)(1) and Sec.  1.1298-3(a). 
The comments expressed concern that a taxpayer that treated a tested 
foreign corporation as a PFIC in closed years, based on its 
understanding of the rules at that time, would be required to file 
amended returns. The comments stated that requiring taxpayers to file 
amended returns could limit the relief provided by allowing taxpayers 
to rely on the 2019 proposed regulations for open years. One comment 
expressed concern that the application of the once-a-PFIC, always-a-
PFIC rule in this context would penalize taxpayers that took 
conservative positions under prior law, and that filing amended returns 
may involve significant administrative burdens. Another comment 
expressed concern that new investors in a tested foreign corporation 
that would have been a PFIC under prior law but not under the proposed 
regulations would be subject to more favorable rules than historic 
investors in that corporation. Accordingly, comments requested that 
taxpayers be permitted to apply the regulations to closed taxable years 
for purposes of section 1298(b)(1), provided that the relevant tested 
foreign corporation would never have been a PFIC during the taxpayer's 
holding period as a result.
    The Treasury Department and the IRS agree that the once-a-PFIC, 
always-a-PFIC rule is implicated, because in some cases these 
regulations may cause a tested foreign corporation that was previously 
a PFIC with respect to a shareholder to not satisfy the Asset Test or 
Income Test going forward and therefore to become a ``former PFIC'' as 
defined in Sec.  1.1291-9(j)(2)(iv), but the foreign corporation would 
still be treated as a PFIC with respect to the shareholder by reason of 
the once-a-PFIC, always-a-PFIC rule. The Treasury Department and the 
IRS do not agree that taxpayers subject to the once-a-PFIC, always-a-
PFIC rule should be permitted to avoid the need to file amended returns 
or to make an election under section 1298(b)(1) and Sec.  1.1298-3 
(``purging election''). The possible applicability dates of the final 
regulations do not include closed years, and the Treasury Department 
and the IRS do not believe that it would be appropriate for the final 
regulations to apply in whole or part to closed years for purposes of 
alleviating the effects of the once-a-PFIC, always-a-PFIC rule. For 
example, providing the relief requested by commenters would afford a 
benefit to taxpayers that invested in a tested foreign corporation 
treated as a section 1291 fund in a now-closed year and continue to 
hold the stock compared to taxpayers that acquired the stock of the 
tested foreign corporation at the same time but sold the stock in a 
now-closed year, which may be viewed as unfair. If the tested foreign 
corporation would not be treated as a PFIC under the proposed 
regulations or the final regulations, the taxpayers who sold the stock 
during a closed year may have been subject to tax under section 1291 on 
an excess distribution while taxpayers who continue to hold the stock 
would be spared taxation under section 1291.
    Finally, while it is true that the application of the once-a-PFIC, 
always-a-PFIC rule may apply to historic shareholders and not to new 
shareholders, the rule as enacted by Congress is designed to work in 
that manner. For example, an investor that buys shares in a tested 
foreign corporation that is a start-up with no operating income may be 
required to treat that corporation as a PFIC during its entire holding 
period for the shares, while an investor that buys shares in the same 
corporation once it is a going concern may never be required to treat 
the tested foreign corporation as a PFIC.
    However, in light of the issues raised by commenters, the Treasury 
Department and the IRS have concluded that it is appropriate to provide 
taxpayers with some flexibility in choosing if and when to end PFIC 
treatment by causing a former PFIC to no longer be subject to the once-
a-PFIC, always-a-PFIC rule. Under current law, a shareholder seeking to 
end PFIC treatment as a result of a change of facts or law would need 
to make a purging election under section 1298(b)(1) and Sec.  1.1298-
3(b) or (c) on Form 8621 attached to the shareholder's tax return 
(including an amended return filed within three years of the due date, 
as extended under section 6081, of the original return for the election 
year), or request the consent of the Commissioner to make an election 
with respect to a closed taxable year under section 1298(b)(1) and 
Sec.  1.1298-3(e) (``late purging election'') on Form 8621-A. A timely 
purging election under section 1298(b)(1) and Sec.  1.1298-3(b) or (c) 
may be made if the tested foreign corporation ceased to qualify as a 
PFIC under the Income Test and the Asset Test in an open taxable year, 
but the election would not affect the treatment of the tested foreign 
corporation as a PFIC in the earliest open year because it takes effect 
at the end of the year for which the election is made, as described in 
the next paragraph. If the tested foreign corporation ceased to qualify 
as a PFIC at the beginning of the earliest open year, the shareholder 
may request the consent of the Commissioner to make a late purging 
election, as described in the next paragraph.
    When a deemed sale purging election is made, the stock of the 
former PFIC is deemed sold for its fair market value on the last day of 
the last taxable year of the tested foreign corporation during which it 
qualified as a PFIC (the ``termination date''). See Sec.  1.1298-
3(b)(2) and (d). Accordingly, a taxpayer that files a timely deemed 
sale purging election for an open taxable year is treated as selling 
the stock of the PFIC at the end of the tested foreign corporation's 
taxable year, and accordingly the shareholder is subject to the PFIC 
rules with respect to that stock during its relevant taxable year and 
any prior open years. If the taxpayer wishes to end PFIC treatment as 
of its earliest open taxable year, it must request the consent of the 
Commissioner to make a late purging election taking effect as of the 
end of the tested foreign corporation's taxable year in the taxpayer's 
most recent closed taxable year. For example, if a taxpayer had chosen 
to apply the proposed regulations to its earliest open taxable year 
with respect to a tested foreign corporation that has the same taxable 
year and that qualified as a PFIC in closed taxable years, and the 
application of the proposed regulations resulted in the tested foreign 
corporation no longer qualifying as a PFIC, to prevent PFIC treatment 
from continuing into that earliest open taxable year and beyond the 
taxpayer would have had to request the consent of the Commissioner to 
make a late purging election by filing Form 8621-A for the year 
immediately preceding its first open taxable year. See also Sec.  
1.1298-3(c) (deemed dividend purging election available if former PFIC 
was a CFC during its last taxable year that it qualified as a PFIC). 
The result of both timely and late purging elections with respect to 
former PFICs is that the shareholder's holding period resets solely for 
PFIC purposes, such that the shareholder is treated as no longer 
holding stock of a foreign corporation that was ever a PFIC during the 
shareholder's holding period, so the once-a-PFIC, always-a-PFIC rule no 
longer applies.
    The Treasury Department and the IRS are aware that the reference to 
``all open

[[Page 4543]]

tax years'' in the preamble to the proposed regulations may have caused 
confusion as to whether taxpayers could choose to apply the proposed 
regulations prospectively to the first taxable year for which they had 
not yet filed a return, or, alternatively, whether the proposed 
regulations, if applied at all, had to be applied to all open taxable 
years, including taxable years for which returns had already been 
filed, resulting in the necessity to amend returns. As suggested by the 
comments, there may also have been confusion regarding the need to make 
a purging election in order to end PFIC status, even though that is the 
result under the statute and regulations.
    Given these considerations, a taxpayer may choose to apply the 
final regulations (other than the rules related to the PFIC insurance 
exception), with respect to a particular tested foreign corporation, to 
any open taxable year of the taxpayer, provided that all of the rules 
are applied consistently with respect to that tested foreign 
corporation for that year and all succeeding taxable years. See 
Sec. Sec.  1.1291-1(j)(4), 1.1297-1(g)(1), 1.1297-2(h), 1.1297-4(g), 
1.1297-6(f), 1.1298-2(g), and 1.1298-4(f). (This was also how the 
proposed regulations, other than the rules related to the PFIC 
insurance exception, were intended to apply.) For taxable years ending 
on or before December 31, 2020, a taxpayer may rely on proposed Sec.  
1.1297-1(c)(1)(A) in the 2019 proposed regulations concerning the 
application of section 954(h) rather than Sec.  1.1297-1(c)(1)(i)(A) 
with respect to a tested foreign corporation.
    The Treasury Department and the IRS recognize that the 
determination of whether to apply the 2019 proposed regulations or the 
final regulations to a tested foreign corporation may be advantageous 
with respect to some tested foreign corporations and not with respect 
to others. In order to provide flexibility to U.S. investors in tested 
foreign corporations, taxpayers may apply the final regulations in any 
open taxable year to all or less than all of the tested foreign 
corporations whose shares are owned by the taxpayer, subject to the 
consistency rule described in the prior paragraph with respect to any 
particular tested foreign corporation. However, if the consequence of 
applying either the proposed regulations or these final regulations to 
prior open taxable years is that, as of the date of application, a 
tested foreign corporation that was a PFIC ceases to qualify as a PFIC, 
then the once-a-PFIC, always-a-PFIC rule is implicated and a taxpayer 
seeking to end PFIC status must make a purging election or request the 
consent of the Commissioner to make a late purging election.
    A taxpayer may choose to apply the rules to open taxable years even 
if a qualified electing fund election under section 1295 or a mark-to-
market election under section 1296 was in effect. See section 6511(a) 
(period of limitation for filing refund claim).

Effect on Other Documents

    The eighth (concerning the average value of assets for purposes of 
the Asset Test), ninth (concerning the characterization of assets for 
purposes of the Asset Test), fourteenth through sixteenth (concerning 
dealer inventory and investment assets for purposes of the Asset Test), 
eighteenth (concerning look-through rules for purposes of the Income 
Test), and nineteenth (concerning look-through treatment under section 
1297(c)) paragraphs of Notice 88-22, 1988 1 C.B. 489, are obsoleted.

Special Analyses

I. Regulatory Planning and Review--Economic Analyses

    Executive Orders 13771, 13563, and 12866 direct agencies to assess 
costs and benefits of available regulatory alternatives and, if 
regulation is necessary, to select regulatory approaches that maximize 
net benefits, including potential economic, environmental, public 
health and safety effects, distributive impacts, and equity. Executive 
Order 13563 emphasizes the importance of quantifying both costs and 
benefits, reducing costs, harmonizing rules, and promoting flexibility. 
The Executive Order 13771 designation for this final rule is 
regulatory.
    The final regulation has been designated by the Office of 
Information and Regulatory Affairs (OIRA) as subject to review under 
Executive Order 12866 pursuant to the Memorandum of Agreement (MOA, 
April 11, 2018) between the Treasury Department and the Office of 
Management and Budget regarding review of tax regulations. OIRA has 
determined that the final rulemaking is significant and subject to 
review under Executive Order 12866 and section 1(b) of the Memorandum 
of Agreement. Accordingly, the final regulations have been reviewed by 
OMB.

A. Background

    Various provisions of the tax code allow tax on certain sources of 
income to be deferred, which means that the income is not taxed when it 
is earned but at some later date, based on specific events or 
conditions. Tax deferral is advantageous to taxpayers because the 
taxpayer can in the meantime earn a return on the amount that would 
otherwise have been paid as tax. Prior to the Tax Cuts and Jobs Act 
(TCJA), income earned abroad by foreign corporations owned by U.S. 
taxpayers generally was not taxed by the United States until the income 
was repatriated to the United States or, as holds broadly for capital 
gains, the stock of the corporation was sold. However, under controlled 
foreign corporation (CFC) and passive foreign investment company (PFIC) 
rules, U.S. persons owning stock of foreign corporations were in some 
circumstances subject to current tax on some or all of the foreign 
corporation's income. After TCJA, passive income and certain insurance 
income earned abroad by a CFC continues to be taxed immediately to the 
United States shareholders of the CFC. However, income of U.S. persons 
earned by foreign corporations that are not CFCs may still be eligible 
for deferral, or, in the case of certain corporate shareholders, exempt 
from U.S. corporate tax. Deferral is not available, however, for income 
of foreign corporations that are identified as PFICs. The immediate 
taxation of this income discourages U.S. taxpayers from holding mobile, 
passive investments, such as stock, in a foreign corporation in order 
to defer U.S. tax.
    The PFIC rules of the Internal Revenue Code address situations in 
which taxable U.S. persons indirectly hold assets that earn passive 
income (generally interest, dividends, capital gains, and similar types 
of income) through a foreign corporation. Without the PFIC rules, the 
income earned by these assets would be subject to U.S. tax only when 
and if that income is distributed as dividends by the foreign 
corporation or, as capital gains, when the shares of the foreign 
corporate stock are sold by the U.S. shareholder. In the absence of the 
PFIC rules, these types of investment arrangements could significantly 
lower the effective tax rate on passive income faced by U.S. investors 
from that incurred if the assets were held directly.
    Under the PFIC statutory rules, a foreign corporation is considered 
a PFIC if at least 75 percent of the corporation's gross income for a 
given taxable year is passive income (the Income Test) or if at least 
50 percent of the corporation's assets are assets that produce passive 
income (the Asset Test). The PFIC itself is not subject to U.S. tax 
under the PFIC regime; rather, only the U.S. owner of a foreign 
corporation is subject to that regime. The U.S. owner of shares of a 
foreign corporation consequently must

[[Page 4544]]

obtain the appropriate information, usually from the corporation, in 
order to determine whether that corporation is a PFIC (by satisfying 
these and other tests) and if so what tax is due as a result.
    The PFIC provisions provide a long-standing exception from these 
passive income rules for any income earned in the active conduct of an 
insurance business by an insurance company. This exception (the PFIC 
insurance exception) allows insurance companies, which hold significant 
amounts of investment assets (which generate income that would 
otherwise be classified as passive) in the normal course of business to 
fund their insurance obligations, to avoid PFIC status, provided they 
meet other statutory conditions.
    TCJA substantially revised the PFIC insurance exception. Before its 
amendment by TCJA, this exception was provided to a foreign corporation 
that (i) was predominantly engaged in an insurance business and (ii) 
would be taxed as an insurance company if it were a domestic 
corporation. TCJA modified and narrowed the PFIC insurance exception by 
requiring that the excepted income be derived in the active conduct of 
an insurance business by a ``qualifying insurance corporation'' (QIC). 
To be a QIC, a foreign insurance corporation must be an entity that 
would be taxed as an insurance company if it were a domestic 
corporation (consistent with prior-law requirements) and, in addition, 
be able to show that its ``applicable insurance liabilities'' 
constitute more than 25 percent of its total assets. TCJA defines 
applicable insurance liabilities for this purpose as including a set of 
enumerated types of insurance-related loss and expense items. Failing 
this test, the Code provides that U.S. owners of the foreign 
corporation may elect to treat their stock in the corporation as stock 
of a QIC provided the corporation can satisfy an ``alternative facts 
and circumstances test.'' If a corporation is determined to be a QIC, 
only income that is derived in the active conduct of an insurance 
business qualifies as income eligible for the PFIC insurance exception.
    The Treasury Department and the IRS previously published proposed 
regulations pertaining to the PFIC regime and changes due to TCJA (the 
proposed regulations.) See 84 FR 33120.

B. Need for the Final Regulations

    The final regulations are needed because many of the terms and 
calculations required for the determination of PFIC status would 
benefit from greater specificity. The final regulations provide such 
details so that taxpayers can readily and accurately determine if their 
investment is in a PFIC, given the significant tax consequences of 
owning a PFIC. The regulations further resolve ambiguities in 
determining ownership of a PFIC and in the application of the PFIC 
Income and Asset Tests. These final regulations are also needed to 
respond to comments received on the proposed regulations.
    The Treasury Department and the IRS have also identified actions or 
positions that foreign companies might take to claim qualification for 
the passive income exception for income earned in the active conduct of 
an insurance business even though the nature of their insurance 
business would not merit an exception under the intent and purpose of 
the statute. The final regulations are needed to prevent U.S. investors 
from taking certain of these tax avoidance measures.

C. Overview

    The final regulations can be divided into two parts: General 
guidance regarding PFICs (the general rules) and guidance that relates 
specifically to the implementation of the PFIC insurance income 
exception (the PFIC insurance exception rules).
    The economic analysis first discusses the regulations under the 
general rules that: (1) Clarify how assets are measured for the PFIC 
Asset Test; (2) provide rules for applying the statutory rules 
regarding look-through subsidiaries to partnerships; and (3) attribute 
activities undertaken by certain affiliates of the corporation being 
tested for its PFIC status for the purpose of applying certain 
exceptions contained in the passive income definitional rules.
    The economic analysis then discusses the regulations under the PFIC 
insurance exception rules that provide guidance regarding: (1) The 
discounting of applicable insurance liabilities on certain financial 
statements; (2) issues related to the facts and circumstances test for 
treating a foreign corporation as a QIC, including (i) ``runoff-related 
circumstances,'' (ii) ``rating-related circumstances,'' and (iii) the 
deemed election under the facts and circumstances test for small 
shareholders; and (3) application of the insurance exception as it 
relates to look-through subsidiaries of a QIC.

D. Economic Analysis

1. Baseline
    In this analysis, the Treasury Department and the IRS assess the 
benefits and costs of the final regulations relative to a no-action 
baseline reflecting anticipated Federal income tax-related behavior in 
the absence of these final regulations.
2. Summary of Economic Effects
    The final regulations provide certainty and consistency in the 
application of sections 1297 and 1298 of the Internal Revenue Code with 
respect to passive foreign investment companies and qualifying 
insurance corporations by providing definitions and clarifications 
regarding the statute's terms and rules. In the absence of such 
guidance, the chances that different U.S. owners (or potential owners) 
of foreign companies would interpret the statute differentially (either 
differently from each other or distinct from the intent and purpose of 
the statute) would be exacerbated. This divergence in interpretations 
could cause U.S. investors to choose investment vehicles based on 
different interpretations of the statute rather than on different 
economic prospects. For example, one investor might undertake an 
investment opportunity that another investor might forego based on 
different interpretations of how the income from that investment would 
be treated under the Code. When economic investment is not guided by 
uniform incentives across otherwise similar investors and otherwise 
similar investments, the resulting pattern of investment will generally 
be inefficient. Thus, in the context of U.S. investment in foreign 
corporations, the final regulations help to ensure that similar 
economic activities, representing similar passive and non-passive 
attributes, are taxed similarly. The Treasury Department and the IRS 
expect that the definitions and guidance provided in the final 
regulations will lead to an improved allocation of investment among 
U.S. taxpayers, contingent on the overall Code.
    In assessing the economic effects of the final regulations, the 
Treasury Department and the IRS separately considered (i) those 
provisions that may reduce the opportunities for foreign corporations 
to avoid PFIC status, relative to the no-action baseline; and (ii) 
those provisions that may expand the opportunities for foreign 
corporations to avoid PFIC status, relative to the no-action baseline.
    As a result of the first set of provisions, some corporations that 
may not have had PFIC status under the baseline may be treated for tax 
purposes as PFICs under the final regulations. In response to such 
provisions, some foreign companies that are close to qualifying as a 
QIC, for example, may take steps to adjust operations to ensure

[[Page 4545]]

that they meet the QIC qualifications.\5\ Other foreign companies may 
not be able to profitably undertake these actions, possibly because of 
the business's structure or the local regulatory environment and thus 
would now be treated as a PFIC. Yet other foreign companies, 
particularly those that are not reliant on U.S. investors, may also 
remain (following these regulations) classified for U.S. tax purposes 
as PFICs. The Treasury Department and the IRS expect that in these 
latter two cases, current U.S. owners will largely continue to retain 
their holdings of these companies but future investors may turn to 
other foreign corporations that are not classified as PFICs under the 
final regulations or to domestic investments.
---------------------------------------------------------------------------

    \5\ The Treasury Department and the IRS are aware of foreign 
companies that have redomiciled to the U.S. and thereby avoided PFIC 
status, although the number of such companies is believed to small 
and the business calculations likely involved more than PFIC/non-
PFIC considerations. The Treasury Department and the IRS expect that 
the number of foreign companies that do not re-domicile but that are 
likely to change how they operate as the result of these final 
regulations will also be quite small.
---------------------------------------------------------------------------

    This reduction in the pool of non-PFIC investment opportunities can 
be expected to lower the after-tax return to U.S. investors relative to 
the no-action baseline. To the extent that investors retain their 
investments in companies that have been determined to be PFICs or turn 
to domestic investments, U.S. tax revenue may rise relative to the no-
action baseline. These possible responses by U.S. investors (investing 
in a different non-PFIC; retaining investment in the PFIC; investing in 
U.S. companies) will also change the amount and nature of risk in the 
affected investors' portfolios. The nature of this shift is difficult 
to gauge because foreign companies whose PFIC status may change as a 
result of these final regulations (relative to the no-action baseline) 
will generally be earning a mix of passive and non-passive income. 
Thus, the change in the nature of the risk in U.S. investors' 
portfolios cannot be readily determined.
    As a result of the second set of provisions (those that expand 
opportunities for foreign companies to avoid PFIC status relative to 
the no-action baseline), some corporations that may have had PFIC 
status under the baseline may be determined not to be PFICs under the 
final regulations. This expansion of the pool of non-PFIC investment 
opportunities can be expected to raise the after-tax return to U.S. 
investors relative to the no-action baseline and, to the extent that 
investors increase their investment in foreign non-PFICs as a 
substitute for domestic investment, U.S. tax revenue may fall. These 
effects again also change the amount and nature of risk in the affected 
investors' portfolios and in an undetermined direction.
    The Treasury Department and the IRS project that these final 
regulations will have economic effects less than $100 million per year 
($2020), relative to the no-action baseline. The Treasury Department 
and the IRS have not undertaken more precise estimates of the 
differences in economic activity that might result between the final 
regulations and the no-action baseline because they do not have readily 
available data or models that capture in sufficient detail the 
investments that taxpayers might make under the final regulations 
relative to the no-action baseline. They similarly have not estimated 
the differences in compliance costs or administrative burden that would 
arise under the final regulations or the no-action baseline because 
they do not have readily available data or models that capture these 
aspects in sufficient detail.
    The proposed regulations solicited comments on the economic effects 
of the proposed regulations. No such comments were received.
3. Economic Analysis of Specific Provisions of the General PFIC Rules
a. Treatment of Look-Through Subsidiaries and Look-Through Partnerships
    For the purpose of testing whether a foreign corporation is a PFIC, 
the look-through rule of section 1297(c) treats the tested foreign 
corporation (``TFC'') as holding its proportionate share of the assets 
of a look-through entity and having received directly its proportionate 
share of the income of the look-through entity. This rule affects both 
the amount of assets that the TFC is treated as owning and the 
characterization of those assets as passive or non-passive. The statute 
is silent regarding the application of look-through rules to a TFC's 
ownership interest in a partnership. Therefore, the Treasury Department 
and the IRS deemed it necessary to provide rules addressing the 
treatment of TFC ownership interests in partnerships.
    One regulatory option was to apply rules similar to those that 
apply to subsidiaries treated as corporations for tax purposes. Under 
these rules, a partnership generally would be treated as a look-through 
partnership (LTP) only if the TFC owned at least 25 percent of the 
value of the partnership interest during a taxable year (``minimum 
ownership threshold'').
    A second regulatory option was to apply a complete look-through 
rule to partnerships (``aggregate approach''). Under this option, a TFC 
would treat its proportionate share of partnership assets and income as 
assets and income of its own, regardless of the size of its partnership 
ownership share. This option is consistent with the ``aggregate'' 
theory of partnerships under which each partner is treated as incurring 
an allocable share of each partnership item, such as gain, loss, 
income, and expense, with the tax attributes of that item passing 
through to the partner.
    A third regulatory option was to adopt an intermediate approach 
under which look-through rules would apply to partnerships if either 
(i) the partnership would be a look-through subsidiary if it were 
treated as a corporation, or (ii) the TFC partner is actively engaged 
in the business of the partnership. In practice, this approach is 
likely to have consequences similar to the aggregate approach for many 
TFCs engaged in an active business.
    The proposed regulations adopted the first approach, using a 
minimum ownership threshold of 25 percent. The 2019 NPRM asked for 
comments regarding whether this threshold is the appropriate threshold 
for look-through partnership treatment. No comments were received 
recommending a lower threshold. Instead, commenters recommended that 
the aggregate approach be adopted, which in this context would be 
similar to a zero percent minimum ownership threshold.
    Under the aggregate approach, TFCs that are interested in 
attracting capital from U.S. investors would have an incentive to 
purchase small minority investment interests in one or more active 
partnerships in order to increase their share of non-passive assets and 
income so as to enable the TFC to avoid PFIC status. The TFC could do 
this without having any of the partnership activities being connected 
with the business of the TFC and without requiring the TFC to exercise 
control over any of the business activities of these partnerships. In 
this fashion, the aggregate option would create a bias in favor of 
business structures containing entities treated for U.S. tax purposes 
as partnerships and against a structure using corporate subsidiaries, 
since those subsidiaries would require 25 percent ownership shares in 
order to obtain look-through status for the TFC. This bias toward such 
business structures would be tax-driven rather than market-driven and 
unlikely to confer general economic benefits.

[[Page 4546]]

    An aggregate approach to LTPs could allow TFCs that hold 
significant amounts of passive investment assets to purchase sufficient 
amounts of minority investment interests in active business 
partnerships so as to increase the TFC's non-passive assets and income 
to levels that enable the TFC to avoid PFIC status. Thus, the purpose 
of the PFIC regime could be meaningfully defeated, especially if 
foreign corporate subsidiaries chose to be treated as partnerships for 
this purpose.
    The Treasury Department and the IRS determined that minor 
investment shares of TFCs in partnerships are more indicative of 
passive investments on the part of TFCs, so that, in those cases, it is 
appropriate to treat the TFC's distributive share of partnership income 
as wholly passive. Moreover, a 25-percent minimum ownership threshold 
for partnerships has the advantage of being consistent with the look-
through threshold for corporate subsidiaries. It is also broadly 
consistent with a rule (found in the statutory definition of passive 
income) that treats sales of partnership interests by a CFC as sales of 
the partnership's assets if the CFC owns 25 percent of the 
partnership's capital or profits interests. The drawing of a bright 
line for strictly passive treatment of limited partnership interests 
offers greater compliance certainty and ease of tax administration 
because it reduces the informational requirements concerning the 
character of the assets and income of a partnership when the partner 
has only very limited investments. It may be difficult for a TFC that 
holds a less-than-25-percent investment in either a subsidiary or 
partnership to obtain the necessary information for determining the 
character of its share of the entity's income. Furthermore, entities 
with ownership percentages below 25 percent generally do not exercise 
control of the decisions and actions of the owned entity. Consequently, 
there are both policy and administrability reasons supporting the 
treatment of ownership percentages of less than 25 percent in a similar 
fashion for PFIC purposes.
    Because a 25-percent minimum ownership threshold for partnerships 
is not necessarily an accurate proxy for an active business interest, 
one commenter proposed an option under which a look-through approach 
would be taken if a TFC materially participates in the business of the 
partnership; in other words, an aggregate approach would be used but 
only if the TFC showed, through a separate demonstration, that the TFC 
is actively involved in the business of the partnership. The Treasury 
Department and the IRS agreed that, if a tested foreign corporation is 
actively involved in the business of a partnership with active business 
operations, then look-through treatment may be appropriate even if the 
TFC has less than a 25 percent ownership interest. In considering 
material participation and similar standards, however, the Treasury 
Department and the IRS found that current material participation 
standards under the passive activity loss rules are not appropriate in 
the PFIC context. Thus, the final regulations instead modify the LTP 
standard by introducing an active partner test in order to allow look-
through treatment to be applied in certain cases when the ownership 
percentage falls below 25 percent. The active partner test is met as of 
a measurement date if the TFC would not be a PFIC if both the PFIC 
Asset Test and the PFIC Income Test were applied without regard to any 
partnership interest owned by the TFC other than interests in those 
partnerships that qualify as LTPs using the LTS tests. However, the 
final regulations did not make this modification of the look-through 
ownership test mandatory and instead provide an annual election to 
allow the TFC to not to treat a partnership qualifying under the active 
partner test as an LTP.
    The Treasury Department and the IRS have not estimated the volume 
or character of investment that investors would undertake under the 25 
percent minimum ownership threshold relative to other percentages or 
under the aggregate approach applied to taxpayers that satisfy an 
active partner test because they do not have readily available data or 
models that capture this level of specificity.
b. Attribution of Activities for Look-Through Entities
    The definition of passive income contains exceptions for certain 
income that is derived in the active conduct of a trade or business or 
is a gain or loss from the sale of certain business property. Under the 
look-through rules of the statute and these final regulations, a tested 
foreign corporation is treated as if it holds its proportionate share 
of the income and assets of its look-through subsidiaries (LTSs) and 
look-through partnerships (LTPs), where a 25 percent ownership 
requirement is needed to define such entities. Further, the passive or 
non-passive character of the attributed income or assets is determined 
in the hands of the LTS or LTP. However, for legal or commercial 
reasons, some businesses structure their organizations to have all 
employees in one foreign corporation, say FC1, while the assets of the 
business are held in, and income is received by, another foreign 
corporation, say FC2. Without attribution of the business activities of 
FC1 to FC2, the assets and income of the latter corporation do not 
qualify for an exception from the definition of passive income. This 
can result in FC1 being designated as a PFIC even though its income and 
assets would be treated as non-passive if FC1 and FC2 were considered 
as a single entity.
    To address the attribution of activities in foreign businesses 
having such structures, the Treasury Department and the IRS considered 
three options: (1) Do not allow any attribution of business activities 
among separate corporations; (2) allow attribution of business 
activities to a TFC from its LTSs or LTPs; or (3) allow attribution of 
business activities only if the entities are affiliated using an 
ownership standard of greater than 50 percent.
    Under the no-attribution option, a foreign corporate structure that 
separates activities and income could satisfy the passive income 
exception only if it reorganizes in a manner that the TFC not only 
earns rents, royalties or other normally passive income items, but also 
employs the officers and employees that perform the related business 
activities or owns the property that is being sold. This reorganization 
is potentially costly or perhaps even infeasible, depending on 
requirements in the foreign jurisdiction and commercial considerations. 
The Treasury Department and the IRS determined that this alternative 
would either lead to costly reorganizations or, in the absence of such 
reorganizations, inhibit U.S. investment in a foreign corporation that 
carries on an active business activity, both of which are economically 
undesirable outcomes relative to other regulatory options.
    Under the second option, activities of LTSs and LTPs could be 
attributed to a TFC in a manner similar to the look-through rules. The 
look-through rules attribute assets and income of a look-through entity 
to its owner on a proportionate share basis. There are some 
difficulties applying this concept in the context of attribution of 
activities. While income and assets can be allocated between owners 
based on their ownership percentages, activities are not as easily 
allocated among multiple owners. The purpose of activity attribution, 
in combination with the look-through rules, is effectively to treat the 
corporations as a single commercial enterprise; that is, as an 
affiliated group of corporations. But affiliation in this sense usually 
demands a recognition of

[[Page 4547]]

a unified business purpose and combined business activity. The typical 
thresholds in the Code for treating related parties as members of an 
affiliated or consolidated or similar group are more than 50 percent 
and 80 percent thresholds, not 25 percent.
    The third option would require more-than-50-percent ownership in 
order to be able to attribute the business activities of one 
corporation to another. The proposed regulations adopted this third 
alternative but limited its application to rents and royalties earned 
in the active conduct of a trade or business, taking into account only 
the activities performed by the officers and employees of the TFC and 
those of an LTS or LTP in which the TFC owns more than 50 percent by 
value.
    A comment pointed out this attribution rule would allow a TFC to 
recognize certain rents or royalties of an LTS as non-passive income if 
the business activity was conducted in one 50-percent subsidiary and 
assets and income were held in a separate 50-percent subsidiary. 
However, the rule would not prevent the look-through holder of the 
property from being a PFIC, since the rule applied only to income 
received by the TFC. Comments also requested that activity attribution 
apply to other types of income and not only to rents and royalties.
    The final regulations modify the proposed regulations in two 
respects. First, they extend the application of the provision to other 
items of income other than rents and royalties that would be excluded 
from passive income if the income is earned in the active conduct of a 
trade or business. Second, they expand the types of affiliated entities 
from which activities could be attributed. Under these rules, an entity 
is deemed to be engaged in the active conduct of a trade or business by 
taking into account the activities performed by the officers and 
employees of the TFC as well as activities performed by the officers 
and employees of any qualified affiliate of the tested foreign 
corporation. For this purpose, a qualified affiliated group is defined 
using an affiliation standard of more than 50 percent. In addition, the 
group includes only LTSs and LTPs of the parent entity, and the parent 
entity must be a foreign corporation or partnership. This rule allows 
the LTS that holds the relevant assets in the preceding example to 
avoid PFIC status and extends the attribution rules to activities of 
sibling and parent companies of the TFC.
    Accordingly, this final regulation is less restrictive than current 
law by allowing a greater variety of organizational structures among 
foreign corporations and partnerships than would be available by 
applying the passive income rules under current law. The Treasury 
Department and the IRS project that this final regulation will allow 
entities to satisfy the passive income exception under conditions 
consistent with the intent and purpose of the statute without requiring 
potentially substantial reorganization costs relative to alternative 
regulatory approaches or the no-action baseline. The adopted activity 
attribution rule is neither overly restrictive by causing certain 
active foreign corporations to be treated as PFICs nor overly 
permissive by allowing U.S. shareholders to evade the application of 
the PFIC regime through an overindulgent application of attribution 
rules.
4. Economic Analysis of Specific Provisions Related to the PFIC 
Insurance Exception
a. Description of the PFIC Insurance Exception
    For PFIC purposes, passive income does not include income derived 
in the active conduct of an insurance business by a qualifying 
insurance corporation (QIC). Under the statute, a QIC must have 
``applicable insurance liabilities'' (AIL) that generally constitute 
more than 25 percent of its total assets. AIL generally include amounts 
shown on a financial statement for unpaid loss reserves (including 
unpaid loss adjustment expenses) of insurance and reinsurance contracts 
and certain life and health insurance reserves and unpaid claims with 
respect to contracts providing coverage for mortality or morbidity 
risks.
    For the purpose of the QIC test, AIL are based on insurance 
liabilities as they are accounted for on the taxpayer's applicable 
financial statement (AFS). Under the statute, an AFS is a financial 
statement prepared for financial reporting purposes that is based on 
U.S. generally accepted accounting principles (GAAP), or international 
financial reporting standards (IFRS) if there is no statement based on 
GAAP. If neither of these statements exists then an AFS can be an 
annual statement that is required to be filed with an applicable 
insurance regulatory body. Thus, the statute has a preference for 
financial statements prepared on the basis of GAAP or IFRS, which are 
rigorous and widely-respected accounting standards, but will permit a 
foreign corporation to have an AFS that uses a local regulatory 
accounting standard if the foreign corporation does not do financial 
reporting based on GAAP or IFRS.
b. Discounting of Applicable Insurance Liabilities
    Accounting standards have different requirements regarding the use 
of discounting in the measurement of unpaid loss insurance reserves. 
Discounting of unpaid loss reserves would generally be appropriate to 
account for the amount of time expected before future loss payments are 
made. GAAP generally does not require the discounting of current non-
life insurance liabilities but does require discounting for future 
liabilities under life insurance and annuity contracts. IFRS 17 (an 
IFRS standard applicable to insurance contracts with an anticipated 
effective date of January 1, 2023) requires discounting of all 
insurance liabilities whose expected payment exceeds one year.
    To address the discounting of AIL in situations where the foreign 
corporation's AFS was not prepared on the basis of GAAP or IFRS, the 
proposed regulations provided that in situations where the taxpayer's 
AFS does not discount reserves on an economically reasonable basis, 
then the amount of AIL would be reduced in accordance with the 
discounting principles that would have applied under GAAP or IFRS. The 
foreign corporation could choose whether to apply either GAAP or IFRS 
for this purpose. In view of comments received, the Treasury and the 
IRS reconsidered these requirements.
    As one alternative, the Treasury Department and the IRS considered 
not issuing a regulation to govern the discounting of insurance losses. 
This option was rejected as being possibly inconsistent with the intent 
and purpose of the statute because other financial standards specified 
by the statute have rules regarding the discounting of future cash 
flows.
    As a second alternative, the Treasury Department and the IRS 
considered capping the amount of AIL at the amounts that would be 
permitted to a domestic insurance company under the Internal Revenue 
Code; these amounts would have been discounted according to the 
relevant rules. This approach would be considerably more burdensome to 
a foreign corporation than other regulatory alternatives because, as a 
practical matter, it would require foreign corporations to apply 
complex U.S. tax rules with which they are likely not familiar. An 
excessive compliance burden on foreign corporations not subject to U.S. 
taxation would make it less likely that they would do the work 
necessary to enable their minority U.S. owners to determine

[[Page 4548]]

if the corporation is a PFIC. Thus, this alternative was rejected 
because it was not reasonable to require foreign companies to 
recalculate insurance liabilities based on U.S. law requirements and it 
could unduly inhibit U.S. investors from investing in foreign 
corporations that are legitimate active insurance companies, an 
activity that is economically beneficial under the intent and purpose 
of the statute.
    The final regulations specify that if an AFS is not prepared on the 
basis of GAAP or IFRS and does not discount AIL on an economically 
reasonable basis, the amount of AIL must be reduced by applying the 
discounting principles that would apply under either GAAP or IFRS. The 
choice of which accounting standard to use for discounting is left to 
the foreign corporation. Thus, if GAAP or IFRS would not require 
discounting for any of the AIL of the foreign insurer, then no 
additional discounting is required with respect to a non-GAAP/IFRS 
statement filed with a local regulator.
    Compared to the no-action baseline, this regulation could impose 
additional compliance costs on foreign insurance companies, although 
those costs are incurred only if the foreign corporation files a 
financial statement with a local insurance regulator that is not based 
on GAAP or IFRS. This additional compliance cost is felt indirectly by 
U.S. investors and potential investors in these foreign insurers. A 
company may find it too costly to comply with these rules in order to 
attract U.S. investors, in which case it may not be possible for U.S. 
investors to determine whether the company qualifies as a QIC; an 
insurance company that is not a QIC would likely be a PFIC. Thus, the 
Treasury Department and the IRS recognize that under this regulation, 
some U.S. investors may avoid investing in such a company, when they 
would have done so under the no-action baseline. The Treasury 
Department and the IRS recognize further, however, that such investment 
(under the no-action baseline) would not have been consistent with 
efficient behavior under the intent and purpose of the statute.
    The Treasury Department and the IRS have not estimated the amounts 
that U.S. shareholders might invest in foreign insurance companies with 
or without the discounting requirement because they do not have a model 
with this level of specificity. However, because the rule is quite 
flexible, the Treasury Department and the IRS project that the 
discounting requirement will not represent a significant cost burden 
for foreign corporations and thus will not have any meaningful effect 
on investment patterns by U.S. shareholders relative to the no-action 
baseline.
c. Issues Related to the Alternative Facts and Circumstances Test
    Under the statute, a foreign corporation that fails the 25 percent 
AIL-to-total assets test (but satisfies the 10 percent AIL-to-total 
asset test) may still be treated as a QIC if it satisfies a ``facts and 
circumstances test,'' which requires that (1) the corporation is 
predominantly engaged in an insurance business, and (2) the failure to 
have AIL in excess of 25 percent of total assets is due solely to 
runoff-related or rating-relating circumstances involving the 
corporation's insurance business. Each of these items would benefit 
from guidance that provides further clarification of the terms 
involved.
i. Runoff-Related Circumstances
    The proposed regulations defined a corporation satisfying the 
runoff-related circumstances requirement as one that (1) is actively 
engaged in the process of terminating its pre-existing, active 
insurance or reinsurance underwriting operation pursuant to an adopted 
plan of liquidation or a termination of operations under the 
supervision of its applicable insurance regulatory body, (2) does not 
issue or enter into any insurance, annuity, or reinsurance contract 
other than a contractually obligated renewal, consistent with the plan 
of liquidation or termination, and (3) is making payments during the 
year to satisfy claims, and the payments cause the corporation to fail 
the 25 percent test.
    The Treasury Department and the IRS considered whether runoff-
related circumstances should be limited to insurance companies that 
plan to terminate their business operations, as was required under the 
proposed regulations, or whether it should also include situations in 
which (1) an insurance company is merely shifting the focus of its 
business and running off contracts from an ``old'' business that it had 
entered into in the past, or (2) an insurance company acquires and 
manages insurance business that is in runoff, but the company itself 
does not have a plan of termination. Stated another way, this issue is 
whether or why an insurance company described in either of these two 
situations would require assets that are more than four times the 
company's AIL. For example, foreign companies facing a planned 
termination may be required by foreign regulators to hold additional 
capital and assets relative to their insurance liabilities in order to 
ensure that those liabilities will be satisfied when the companies are 
no longer able to rely on new business or new inflows of equity or debt 
to bolster cash flows from which to pay claims. This additional capital 
may not be needed by ongoing firms in either of the two situations 
described above. Unfortunately, no comments on the proposed regulations 
presented data or other information that address this issue.
    The Treasury Department and the IRS concluded that the legislative 
history of the provision supported the argument that ``runoff-related 
circumstances'' was intended to be limited to situations in which a 
corporation is engaged in the process of terminating its pre-existing 
business, but they also concluded that such termination need not be 
pursuant to a supervised plan of liquidation or termination, and could 
also be pursuant to any court-ordered receivership proceeding for the 
company's liquidation, rehabilitation, or conservation. The final 
regulations also clarify that the reason for failing the 25 percent 
test must be that the corporation is required to hold additional assets 
due to its business being in runoff.
    If the definition of runoff-related circumstances were broadened 
further to include active, non-terminating businesses, then, without 
additional restrictions and rules, the facts and circumstances test may 
provide a means by which companies could be treated as QICs in a manner 
that is not consistent with the intent and purpose of the statute. If 
any company with a terminating line of business could qualify, then the 
25 percent test might effectively become a 10 percent test, an outcome 
that would not be consistent with the intent and purpose of the 
statute.
    The final regulations broaden slightly the circumstances under 
which a runoff of business can be conducted, relative to the regulatory 
option provided in the proposed regulations. The Treasury Department 
and the IRS recognize that this change may increase the number of 
foreign insurance companies that are able to meet the requirements for 
being treated as a QIC relative to the proposed regulations.
    The Treasury Department and the IRS have not estimated the number 
of QICs or the nature of their operations under the final regulations 
or alternative regulatory approaches or the no-action baseline because 
they do not have a model with this level of specificity. The Treasury 
Department and the IRS do not have readily available data on the number 
of foreign corporations that would currently be conducting a runoff

[[Page 4549]]

business under the conditions of the final regulations.
ii. Rating-Related Circumstances
    The rating-related circumstances condition required under the 
alternative facts and circumstances test is not defined in the statute 
and thus requires regulatory guidance. The proposed regulations 
provided that a foreign corporation could satisfy the rating-related 
circumstances requirement if failure to satisfy the 25 percent QIC test 
was a result of specific capital and surplus requirements that a 
generally recognized credit rating agency (generally, A.M. Best, Fitch, 
Moody's, and Standard and Poor) imposes, and that the corporation 
complies with these requirements in order to maintain a minimum credit 
rating needed by the corporation to be classified as ``secure'' to 
write new business for any line of insurance that it is underwriting.
    Upon further reflection and after reviewing comments on the 
proposed regulations, the Treasury Department and the IRS decided that 
the rating-related circumstances requirement should focus on those 
corporations that would need to hold assets in excess of 400 percent of 
their AIL because of unique circumstances. The Treasury Department and 
the IRS determined that the proposed rule failed to capture the purpose 
of the PFIC requirements for QICs, but that certain types of business 
often needed higher levels of capital and surplus in order to meet 
rating requirements. As a result, the above requirements were 
maintained in the final regulations, with some technical changes and 
clarifications, but the provision is limited to companies that might 
require at times a higher level of assets to insurance liabilities. 
These companies include insurers that cover risks that are typically 
low-frequency events but with high aggregate costs, such as coverage 
against the risk of loss from a catastrophic loss event, and coverage 
by certain financial guaranty insurance companies.
    The final regulations restrict the application of the provision to 
a foreign corporation for which more than half of its net written 
premiums for the annual reporting period (or the average net written 
premiums over the current year and preceding two years) are from 
insurance coverage against the risk of loss from a catastrophic event. 
Such insurance is characterized by relatively frequent ``good'' years 
in which accumulated assets must be accrued as capital and surplus in 
order to provide sufficient funds to handle the relatively infrequent 
``bad'' years in which losses are exceptionally large. Because unpaid 
loss reserves qualifying as AIL are limited to amounts that represent 
losses that have already been incurred prior to the end of the 
accounting period (whether or not a claim has been made), such reserves 
do not reflect the unknown future losses of the ``bad'' years.
    Under the final regulations, the rating-related circumstances 
provision is also available for insurers whose sole business is to 
insure or reinsure against a lender's loss of all or a portion of the 
principal amount of a mortgage loan upon default of the mortgagor. 
Aggregate losses associated with such insurance are highly correlated 
with the business cycle. In low loss years, the ratio of total assets 
to AIL may exceed 400 percent, but the additional assets may be viewed 
as necessary by rating agencies for the companies to meet insurance 
obligations in high loss years. The two largest insurance reserve 
categories of mortgage guaranty insurers are their unearned premium 
reserves (often including single premium amounts for long-term 
contracts) and contingency reserves (usually established as a fixed 
percentage of net written premiums), but neither of these types of 
reserves are included in the definition of AIL. Consequently, AIL are 
relatively small on average compared with the assets of these insurers. 
In addition, a mortgage guaranty insurer under the final regulations is 
required to operate as monoline business to qualify for the exception 
(in order to isolate the benefit of this provision and as reflective of 
general industry practice), because a monoline company does not have 
the option to pool its financial obligation risks with other types of 
risks (whereas pooling of different types of risks can reduce overall 
risk exposure, and thus capital needs). Credit rating agencies 
correspondingly expect such companies to hold additional assets to 
protect policyholders due to the monoline requirements for such 
business and because of the volatility of their losses.
    The final regulations also apply the rating-related circumstances 
provision to financial guaranty insurance companies. Financial guaranty 
insurance is a line of insurance business in which an insurer 
guarantees scheduled payments of interest and principal on a bond or 
other debt security in the event of issuer default. The policyholder of 
a financial guaranty insurer is effectively paying for use of the 
insurer's credit rating. For example, if a municipality insures its 
municipal bond obligations with a financial guarantee insurer, the 
municipality can charge a lower interest rate on its bond, because the 
obligation is effectively supported by the insurer's high credit 
rating. A very high credit rating is thus essential for a financial 
guarantee insurer to write new business. Furthermore (and similar to 
mortgage guaranty insurers), rating agency capital standards for 
financial guaranty insurers are geared to ensuring capital adequacy in 
times of crisis and may require a higher level of capital to obtain the 
same rating as an insurer with a different portfolio of risks. The 
combination of enhanced rating agency capital requirements and the need 
for a very high credit rating to write new business often results in a 
financial guaranty insurer being required at times to hold assets in 
excess of 400 percent of current insurance liabilities. The final 
regulations provide that a financial guaranty insurance company that 
fails the 25 percent test is deemed to automatically satisfy the 
rating-related circumstances requirement, but it must still satisfy the 
10 percent test in order to be treated as a QIC. The Treasury 
Department and the IRS project that the final regulations will more 
accurately identify those insurance businesses whose activities are 
economically similar to the activities targeted by Congress in creating 
the PFIC insurance exception and the alternative facts and 
circumstances election for QIC treatment.
    Relative to the proposed regulations, the final regulations will 
likely permit fewer foreign insurance corporations to qualify as QICs 
due to rating-related circumstances, and therefore may result in more 
such corporations being designated as PFICs absent other changes in 
business practices.
iii. Requirements for Making the Facts and Circumstances Election and 
Relief for Small Shareholders
    Under the statute, a U.S. shareholder must make an election in 
order to treat a foreign corporation that would not otherwise be a QIC 
but that satisfies the alternative facts and circumstances test 
(including the 10 percent test) as a QIC. To specify the terms of this 
election, the final regulations specify that such election cannot be 
made unless the foreign corporation directly provides the U.S. person 
with a statement, or makes a publicly available statement, indicating 
that the foreign corporation satisfies the requirements of the 
alternative facts and circumstances test, including the 10 percent 
test, and includes a brief description of its runoff-related or rating-
related circumstances. A shareholder generally makes the election on 
Form 8621, which must be attached to the shareholder's U.S.

[[Page 4550]]

federal income tax return for each year in which the election applies.
    For this election, the final regulations further contain a 
provision under which a U.S. person who owns stock with a value of 
$25,000 or less ($50,000 or less if filing a joint return) in a 
publicly traded foreign corporation is deemed to make the alternative 
facts and circumstances election with respect to the publicly traded 
foreign corporation and its subsidiaries (``deemed election''). If a 
shareholder owns stock through a domestic partnership or other domestic 
passthrough entity, an election will not be deemed made unless the 
stock held by the passthrough entity has a value of $25,000 or less. 
All requirements necessary to permit an actual election must be 
satisfied in order to permit a deemed election under this rule. These 
dollar amounts were chosen in part because they were consistent with 
the filing thresholds for Part I of Form 8621.
    A deemed election provision is not required by the statute. The 
Treasury Department and the IRS created the deemed election to relieve 
the burden from taxpayers of making an actual election. Small domestic 
taxpayers may not be very familiar with the PFIC rules, may have 
difficulty in determining their ownership shares of possible PFICs and 
QICs, or may not know how to obtain information on whether a foreign 
corporation has provided the requisite statement regarding the 
alternative facts and circumstances test, especially if they are 
indirect owners.
    The Treasury Department and the IRS considered not providing such a 
deemed election by small shareholders but decided that the reduction in 
compliance burden that the deemed election would provide outweighed the 
tax administrative benefit that a requirement for an explicit election 
would provide. For example, under an explicit election, the IRS would 
know with certainty that the taxpayer has made the election.
    The Treasury Department and the IRS have not estimated the change 
in compliance costs or administrative burden under the final 
regulations versus an alternative regulatory approach of requiring an 
affirmative election because they do not have data or models that 
capture such items.
d. Passive Income Exception for Income and Assets of QIC Look-Through 
Entities
    Under the statute, passive income does not include income derived 
in the active conduct of an insurance business by a QIC, and assets 
held to produce such income are treated as assets that produce non-
passive income. The final regulations contain rules to clarify the 
application of this rule. For example, certain companies structure 
their insurance operations by placing some or all of their investment 
assets in one or more lower-tier investment corporations or 
partnerships while investment managers are employed by the QIC or by a 
related or unrelated service provider. In these cases, unless there is 
an attribution of non-passive status to the income and assets of the 
lower-tier affiliated company, the QIC exclusion granted to income 
earned by the ``active'' entity is somewhat meaningless.
    Under the general PFIC look-through rules, a tested foreign 
corporation (TFC) is treated as receiving directly its proportionate 
share of the income, or holding its proportionate share of the assets, 
of a look-through subsidiary (LTS) or look-through partnership (LTP), 
but the income and assets generally retain the character that they had 
in the hands of the LTS or LTP for purposes of determining the TFC's 
PFIC status. See Sec.  1.1297-2(b) and (c). Under the proposed 
regulations and the final regulations, if certain requirements are met, 
otherwise-passive income or assets of an LTS or LTP owned by a QIC may 
be treated as active in the hands of the QIC, to the extent that such 
income is attributed to the active conduct of the QIC's insurance 
business and such assets are available to satisfy liabilities of the 
QIC's insurance business (``look-through recharacterization rule'').
    Under the proposed regulations, this attribution of non-passive 
character to otherwise-passive income and assets of an LTS or LTP of a 
QIC was not allowed unless the applicable financial statement (AFS) 
used to test the QIC status of the foreign corporation included the 
assets and liabilities of the subsidiary entity. This rule was intended 
to ensure that all otherwise-passive LTS or LTP assets available to 
satisfy the QIC's insurance liabilities and treated as non-passive 
under the look-through recharacterization rule would also necessarily 
be taken into account for purposes of the 25 percent test for judging 
the corporation's QIC status. However, assets and liabilities of a 
subsidiary entity are not included on the parent's financial statement 
unless the financial statement is prepared on a consolidated basis. If 
the QIC's AFS is prepared using separate entity accounting, only the 
QIC's share of the net equity value of the lower-tier entity would be 
included in assets under the 25 percent QIC test. Thus, a QIC could not 
take advantage of the proposed QIC look-through recharacterization rule 
unless it used a consolidated financial statement as its AFS.
    A consolidated financial statement generally (but not always) 
requires at least a 50 percent ownership share in a controlled 
subsidiary in order to include the assets and liabilities of the 
subsidiary in the consolidated financial statement. Less-than-50-
percent subsidiaries generally must be accounted for on an equity 
basis, such that the financial statement reflects the net equity value 
of the subsidiary. Thus, the look-through recharacterization rule of 
the proposed regulations would not have allowed non-passive treatment 
of otherwise-passive assets of an LTS unless the QIC owned at least 50 
percent interest in the subsidiary and had a consolidated AFS. This 
meant that the income and assets of an LTS in which the QIC owned 
between 25 percent and 50 percent interest would generally be treated 
as passive under the proposed regulations, even if all of those income 
and assets were available to satisfy the QIC's insurance liabilities, 
because consolidated accounting treatment was not available. A 
beneficial aspect of the rule, however, was that it treated QICs that 
chose to place their investment assets in a wholly-owned subsidiary 
(which would generally be consolidated with the QIC for financial 
statement purposes) in the same manner as QICs that conducted their 
insurance operations and held their investment assets in a single 
corporation.
    These considerations led the Treasury Department and the IRS to 
adopt an alternative regulatory option. Under the final regulations, 
the amount of assets and income of an LTS or LTP that may be treated as 
non-passive assets and income of the QIC are limited, respectively, to 
the greater of (i) the QIC's proportionate share of assets and income 
of the LTS or LTP, respectively, multiplied by a fraction, the 
numerator of which is the net equity value of the interests held by the 
QIC in the LTS or LTP, and the denominator of which is the QIC's 
proportionate share of the value of assets of the LTS or LTP; or (ii) 
the QIC's proportionate share of assets and income that are treated as 
non-passive in the hands of the LTS or LTP without regard to the look-
through recharacterization rule. This rule reflects the idea that only 
assets of the LTP or LTS that exceed the liabilities of the look-
through entity are available to satisfy liabilities of the insurance 
business of the QIC and should be excludible from passive income under 
the QIC look-through recharacterization rule. However, if the general 
look-through rules determine a greater

[[Page 4551]]

amount of non-passive assets or income, then that rule prevails.
    When assets are measured by value, rather than by adjusted basis, 
part (i) of the above asset formula reduces the amount of potentially 
non-passive assets to the net equity value of the QIC's ownership 
interest in the LTS or LTP. This is the same asset value used in the 25 
percent test for testing QIC status in the case of a non-consolidated 
AFS. Thus, this solution ensures that assets treated as being available 
to satisfy insurance liabilities of the QIC are also taken into account 
for the purpose of the 25 percent test for judging the corporation's 
QIC status.
    Whenever the QIC's subsidiary has liabilities, this rule will 
likely limit the amount of the subsidiary's assets and income that are 
treated as non-passive under the look-through recharacterization rule, 
in which case the QIC would have a greater value of non-passive assets 
if it operated instead as a single corporation. However, the value of 
total assets used in the 25 percent test would also be correspondingly 
higher in that case, perhaps making it less likely for the foreign 
insurance company to satisfy the 25 percent test.
    The Treasury Department and the IRS have not estimated whether the 
adopted option would lead to different values for amounts treated as 
non-passive assets and non-passive income of QICs under the insurance 
exception relative to the no-action baseline. The Treasury and the IRS 
do not have data or models that could estimate quantitatively the 
relative impacts of the alternatives considered. However, the adopted 
option is expected to result in a more accurate identification of non-
passive income used in the active conduct of the QIC's insurance 
business and non-passive assets used to satisfy the insurance 
liabilities of the QIC relative to the no-action baseline and 
alternative regulatory approaches.
5. Number of Affected Taxpayers
    A U.S. person must generally file a separate Form 8621 for each 
PFIC for which it has an ownership interest. Exceptions currently exist 
for persons that indirectly own PFIC stock through another U.S. 
shareholder of a PFIC, unless such persons are required to report PFIC 
income or need to file a Form 8621 in order to make an election. 
Further exceptions exist under current rules, including exemptions for 
tax-exempt entities and for taxable U.S. shareholders owning less than 
$25,000 in aggregate PFIC stock ($50,000 if filing a joint return) that 
is not owned through another U.S. shareholder of a PFIC or through 
another PFIC (unless such shareholders are required to report PFIC 
income or need to file a Form 8621 in order to make an election).
    The accompanying table indicates how many persons have filed at 
least one Form 8621 between 2016 and 2018 based on currently available 
IRS master files of tax return filings. To date, nearly 62,000 Forms 
8621 have been filed for 2018. Over 70 percent of the filings are 
individuals. Another 27 percent are pass-through entities, the 
overwhelming number of which are partnerships, but which also include S 
corporations, estates, and non-grantor trusts. These pass-through 
entities primarily have individuals as partners, shareholders, or 
beneficiaries, but may also have corporate partners. It is likely there 
is some double counting whereby both partnerships and partners are 
filing a Form 8621 for the same PFIC. C corporations constitute just 
over one percent of these filings. Just under two percent of Forms 8621 
do not identify on the form the filing status of the filer.

                                                      Table
----------------------------------------------------------------------------------------------------------------
                                                                      Number of U.S. persons filing Form 8621
                                                                 -----------------------------------------------
                                                                       2016            2017            2018
----------------------------------------------------------------------------------------------------------------
Individuals.....................................................          36,978          40,891          43,406
Passthrough Entities............................................          15,326          16,133          16,607
C Corporations..................................................             713             733             739
Unreported Filer Type...........................................           1,114           1,053           1,084
                                                                 -----------------------------------------------
    All Entities................................................          54,131          58,810          61,836
----------------------------------------------------------------------------------------------------------------

    In 2018, reporting taxpaying persons filed an average of 12 Forms 
8621. This average was 11 forms for individuals, 16 forms for 
partnerships and other pass-through entities, and 28 forms for C 
corporations.
    The Treasury Department and the IRS do not have information in 
current tax filings regarding how many U.S. persons own shares in 
qualifying insurance companies or how many potential filings of Form 
8621 would be avoided by the regulatory provision regarding a small 
investor deemed election for applying the facts and circumstances test 
for purposes of the insurance income exception to passive income. In 
2018 there were 40 actual such elections made on Form 8621, 26 of which 
involved partnerships and 11 of which involved non-grantor trusts, and 
only one that was an individual.
    The numbers in the accompanying table provide a general idea of the 
number of entities that must pay attention to the final regulations but 
do not measure the number of investors whose investment decisions are 
affected by the final regulations. This is because most current PFICs 
will remain PFICs after application of the final regulations. 
Similarly, most non-PFIC foreign corporations will continue not to be 
PFICs after application of the final regulations. The Treasury 
Department and the IRS expect that only a small percentage of current 
PFIC and non-PFIC shareholders will be affected by these regulations.

II. Paperwork Reduction Act

    The collections of information in these final regulations are in 
Sec.  1.1297-1(d)(1)(ii)(B), (d)(1)(iii), and (d)(1)(iv), Sec.  1.1297-
4(d)(5)(i), (ii), and (iii), and Sec.  1.1298-4(d)(2). The information 
in all of the collections of information provided will be used by the 
IRS for tax compliance purposes.

A. Collections of Information Under Existing Tax Forms

    The collections of information in Sec.  1.1297-1(d)(1)(ii)(B), 
(d)(1)(iii), and (d)(1)(iv) are required to be provided by taxpayers 
that make an election or revoke an election to use an alternative 
measuring period or adjusted bases to measure assets for purposes of 
the Asset Test with respect to a foreign corporation. These collections 
of information are satisfied by filing Form 8621 or attachments 
thereto. For purposes of the Paperwork Reduction Act, 44 U.S.C. 3501 et 
seq. (``PRA''), the reporting burden associated with the

[[Page 4552]]

collection of information in the Form 8621 will be reflected in the 
Paperwork Reduction Act Submission associated with that form (OMB 
control number 1545-1002). If a Form 8621 is not required to be filed, 
the collections of information under Sec.  1.1297-1(d)(1)(ii)(B), 
(d)(1)(iii), and (d)(1)(iv) are satisfied by attaching a statement to 
the taxpayer's return. For purposes of the PRA, the reporting burden 
associated with these collections of information will be reflected in 
the Paperwork Reduction Act Submissions associated with Forms 990-PF 
and 990-T (OMB control number 1545-0047); Form 1040 (OMB control number 
1545-0074); Form 1041 (OMB control number 1545-0092); Form 1065 (OMB 
control number 1545-0123); and Forms 1120, 1120-C, 1120-F, 1120-L, 
1120-PC, 1120-REIT, 1120-RIC, and 1120-S (OMB control number 1545-
0123).
    The collection of information in Sec.  1.1297-4(d)(5)(iii) is 
required to be provided by taxpayers that make an election under 
section 1297(f)(2) to treat a foreign corporation as a QIC in order to 
qualify for the exception from passive income under section 
1297(b)(2)(B). In response to comments addressing the notice of 
proposed rulemaking preceding the final regulations, the Treasury 
Department and the IRS have revised the collection of information with 
respect to section 1297(f)(2).
    The collection of information in Sec.  1.1297-4(d)(5)(iii) requires 
a United States person to make an election with respect to an eligible 
foreign corporation under section 1297(f)(2) by completing the 
appropriate part of Form 8621 (or successor form) for each taxable year 
of the United States person in which the election applies. In response 
to comments, Sec.  1.1297-4(d)(5)(iv) generally provides that any 
United States person that owns stock in a publicly traded foreign 
corporation eligible for the election with a value of $25,000 or less 
($50,000 or less if a joint return) is deemed to make the election 
under section 1297(f)(2) without the need to file Form 8621. This rule 
is intended to provide relief to small shareholders who may not be 
aware that an election is required. In addition, Sec.  1.1297-
4(d)(5)(iii) provides that the election under section 1297(f)(2) may be 
made on an amended return.
    The collection of information in Sec.  1.1297-4(d)(5)(iii) is 
satisfied by filing Form 8621. For purposes of the PRA, the reporting 
burden associated with the collection of information in the Form 8621 
will be reflected in the Paperwork Reduction Act Submission associated 
with Form 8621 (OMB control number 1545-1002).
    The number of entities subject to these collections of information 
will be those entities filing Form 8621 or attaching a statement to 
their tax return. The number of filers of Form 8621 in 2018 based on 
current filings was approximately 62,000. The Treasury Department and 
the IRS project that at most, an additional 10 percent of filers 
(6,200) that were not required to file Form 8621 in 2018 may be subject 
to these collections of information. Thus, the upper bound estimate of 
the number of entities subject to these collections of information is 
68,200.
    The accompanying Table shows the upper bound estimates of the 
number of filers filing an election, by Form. The first column shows 
estimates under the assumption that all filers will file the required 
election by filing Form 8621. The second column shows these estimates 
under the assumptions that: (i) Filers who generally file Form 8621 
will file the required election as part of the filing of Form 8621; and 
(ii) an additional ten percent of filers will file the required 
election as an attachment to Form 1040, 1065, 1120-S, 1120, or other 
form, as appropriate.\6\
---------------------------------------------------------------------------

    \6\ Upper bound estimates of the number of filers who will file 
attachments to specific tax forms are derived by multiplying the 
number of filers shown in the Table in I.D.4. by 10 percent, for 
each filing status. The Table in I.D.4 shows that there were 43,406 
individuals, 16,607 passthrough entities, 739 corporations, and 
1,084 unknown filers who filed Form 8621 in 2018 using currently 
available filings, for a total of 61,836 filers.

------------------------------------------------------------------------
                                                        Number of filers
                                                         (upper bound),
                                     Number of filers      assuming a
                                      (upper bound),       portion of
                                       assuming all      elections are
                                      elections are         made as
                                    made on Form 8621    attachments to
                                                         standard forms
------------------------------------------------------------------------
Attachment to Form 1040...........                  0              4,300
Attachment to Form 1065 or 1120-S.                  0              1,700
Attachment to Form 1120 other than                  0                100
 1120-S...........................
Attachment to Form 1040, 1065,                      0                100
 1120-S, 1120 or other form (2018
 Filing status unknown)...........
Form 8621.........................             68,200             62,000
                                   -------------------------------------
    Total.........................             68,200             68,200
------------------------------------------------------------------------
Source: Compliance Data Warehouse (IRS). See text for explanation.

    The current status of the PRA submissions related to the tax forms 
on which reporting under these regulations will be required is 
summarized in the following table. The burdens associated with the 
information collections in the forms are included in aggregated burden 
estimates for the OMB control numbers 1545-0047 (which represents a 
total estimated burden time for all forms and schedules for tax-exempt 
entities of 50.5 million hours and total estimated monetized costs of 
$3.59 billion ($2018)), 1545-0074 (which represents a total estimated 
burden time for all forms and schedules for individuals of 1.784 
billion hours and total estimated monetized costs of $31.764 billion 
($2017)), 1545-0092 (which represents a total estimated burden time for 
all forms and schedules for trusts and estates of 307.8 million hours 
and total estimated monetized costs of $9.95 billion ($2016)), and 
1545-0123 (which represents a total estimated burden time for all forms 
and schedules for corporations of 3.157 billion hours and total 
estimated monetized costs of $58.148 billion ($2017)). The burden 
estimates provided in the OMB control numbers in the following table 
are aggregate amounts that relate to the entire package of forms 
associated with the OMB control number, and will in the future include, 
but not isolate, the estimated burden of only those information 
collections associated with these final regulations. These numbers are 
therefore unrelated to the future

[[Page 4553]]

calculations needed to assess the burden imposed by these regulations. 
To guard against over-counting the burden that international tax 
provisions imposed before the Act, the Treasury Department and the IRS 
urge readers to recognize that these burden estimates have also been 
cited by regulations (such as the foreign tax credit regulations, 84 FR 
69022) that rely on the applicable OMB control numbers in order to 
collect information from the applicable types of filers.
    In 2018, the IRS released and invited comment on drafts of Forms 
990-PF (Return of Private Foundation or Section 4947(a)(1) Trust 
Treated as Private Foundation), 990-T (Exempt Organization Business 
Income Tax Return), 1040 (U.S. Individual Income Tax Return), 1041 
(U.S. Income Tax Return for Estates and Trusts), 1065 (U.S. Return of 
Partnership Income), 1120 (U.S. Corporation Income Tax Return), and 
8621 (Return by a Shareholder of a Passive Foreign Investment Co. or 
Qualified Electing Fund). The IRS received comments only regarding 
Forms 1040, 1065, and 1120 during the comment period. After reviewing 
all such comments, the IRS made the forms available on December 21, 
2018 for use by the public.
    The Treasury Department and the IRS have not estimated the burden 
for any new information collections arising from either the Act or 
these final regulations. The Treasury Department and the IRS request 
comment on all aspects of information collection burdens related to the 
final regulations. In addition, when available, drafts of IRS forms are 
posted for comment at https://apps.irs.gov/app/picklist/list/draftTaxForms.htm.

----------------------------------------------------------------------------------------------------------------
                 Form                         Type of filer          OMB No.(s)                Status
----------------------------------------------------------------------------------------------------------------
Forms 990.............................  Tax exempt entities (NEW        1545-0047  Approved by OIRA 2/12/2020
                                         Model).                                    until 2/28/2021.
                                       -------------------------------------------------------------------------
                                         Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201912-1545-014 014
----------------------------------------------------------------------------------------------------------------
Form 1040.............................  Individual (NEW Model)...       1545-0074  Approved by OIRA 1/30/2020
                                                                                    until 1/31/2021.
                                       -------------------------------------------------------------------------
                                         Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201909-1545-021 021
----------------------------------------------------------------------------------------------------------------
Form 1041.............................  Trusts and estates.......       1545-0092  Approved by OIRA 5/08/2019
                                                                                    until 5/31/2022.
                                       -------------------------------------------------------------------------
                                         Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201806-1545-014 014
----------------------------------------------------------------------------------------------------------------
Form 1065 and 1120....................  Business (NEW Model).....       1545-0123  Approved by OIRA 1/30/2020
                                                                                    until 1/31/2021.
                                       -------------------------------------------------------------------------
                                         Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201907-1545-001 001
----------------------------------------------------------------------------------------------------------------
Form 8621.............................  Share-holders............       1545-1002  Approved by OIRA 12/31/2018
                                                                                    until 12/31/2021.
                                       -------------------------------------------------------------------------
                                         Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201805-1545-007 007
----------------------------------------------------------------------------------------------------------------

B. Collections of Information Generally Not Included on Existing Forms

    The collection of information in Sec.  1.1298-4(d)(2) is required 
for a foreign corporation that relies on the rule in section 1298(b)(7) 
and Sec.  1.1298-4(b)(1). This collection of information is satisfied 
by filing a statement attached to the foreign corporation's return. For 
purposes of the PRA, the reporting burden associated with this 
collection of information will be reflected in the Paperwork Reduction 
Act Submissions associated with Form 1120-F (OMB control number 1545-
0123). The number of affected filers, burden estimates, and PRA status 
for this OMB control number are discussed in connection with the Form 
1120 in Part II.A of the Special Analyses.
    Alternatively, if a foreign corporation is not required to file a 
return, the collection of information in Sec.  1.1298-4(d)(2) is 
satisfied by the foreign corporation's maintaining a statement in its 
records or including it in its public filings.
    The collection of information in Sec.  1.1297-4(d)(5)(i) and (ii) 
is required for a foreign corporation for which a taxpayer makes an 
election under section 1297(f)(2). In response to comments addressing 
the notice of proposed rulemaking preceding the final regulations, the 
Treasury Department and the IRS have revised the collection of 
information from foreign corporations with respect to section 
1297(f)(2). The collection of information under Sec.  1.1297-4(d)(5)(i) 
and (ii) requires a foreign corporation to provide a statement to a 
shareholder or make a statement publicly available. In response to 
comments, Sec.  1.1297-4(d)(5)(i) permits a foreign parent corporation 
to make a publicly available statement on behalf of its subsidiaries.
    The collection of information contained in Sec.  1.1298-4(d)(2) 
(for foreign corporations that are not required to file Form 1120-F) 
and Sec.  1.1297-4(d)(5)(i) and (ii) has been reviewed and approved by 
the Office of Management and Budget under control number [X].
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

III. Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it 
is hereby certified that the final regulations will not have a 
significant economic impact on a substantial number of small entities 
within the meaning of section 601(6) of the Regulatory Flexibility Act 
(``small entities'').
    The statutory provisions in sections 1291 through 1298 (the ``PFIC 
regime'') generally affect U.S. taxpayers that have ownership interests 
in foreign corporations that are not CFCs.
    A U.S. person must generally file a separate Form 8621 for each 
PFIC for which it has an ownership interest. To date, nearly 62,000 
Forms 8621 have been filed for 2018. Over 70 percent of the filings are 
individuals. Another 27 percent are pass-through entities, the 
overwhelming number of which are

[[Page 4554]]

partnerships, but which also include S corporations, estates, and non-
grantor trusts. These pass-through entities primarily have individuals 
as partners, shareholders, or beneficiaries, but may also have 
corporate partners. It is likely there is some double counting whereby 
both partnerships and partners are filing a Form 8621 for the same 
PFIC. C corporations constitute just over one percent of these filings. 
Nearly two percent of Forms 8621 do not identify the filing status of 
the filer.
    Regardless of the number of small entities potentially affected by 
the final regulations, the Treasury Department and the IRS have 
concluded that there is no significant economic impact on small 
entities as a result of the final regulations based on the following 
argument.
    To provide a bound on the impact of these regulations on 
businesses, the Treasury Department and the IRS calculated the ratio of 
the PFIC regime tax to (gross) total income for 2013 through 2018 for C 
corporations that filed the Form 8621. Total income was determined by 
matching each C corporation filing the Form 8621 to its Form 1120. 
Ordinary QEF income, QEF capital gains, and mark-to-market income were 
assumed to be taxed at 35 percent (21 percent for 2018), and the 
section 1291 tax and interest charge were included as reported. Only 
those corporations where a match was found and that had positive total 
income were included in the analysis. For the approximately 150 to 300 
C corporations for which a match was available in a given year, the 
average annual ratio of the calculated tax to total income was never 
greater than 0.00035 percent. For the approximately 60 to 200 C 
corporations with total income of $25 million or less for which a match 
was available, the average annual ratio was never greater than 1.08 
percent.

----------------------------------------------------------------------------------------------------------------
                                        2013         2014         2015         2016         2017         2018
----------------------------------------------------------------------------------------------------------------
                                                                    ($ millions)
----------------------------------------------------------------------------------------------------------------
                                               All C corporations
----------------------------------------------------------------------------------------------------------------
Tax...............................            5           12           14            8           22           42
Total Income......................    4,204,795   10,154,520   19,935,845   20,076,876   21,625,159   13,317,244
Tax to Total Income...............       0.000%       0.000%       0.000%       0.000%       0.000%       0.000%
----------------------------------------------------------------------------------------------------------------
                             C corporations with total income of $25 million or less
----------------------------------------------------------------------------------------------------------------
Tax...............................          (*)          (*)            4            4            5            3
Total Income......................          463          563          627          573          460          741
Tax to Total Income...............       0.060%       0.014%       0.576%       0.689%       1.068%       0.400%
----------------------------------------------------------------------------------------------------------------
Source: RAAS, CDW.
* Indicates less than $1 million.

    The economic impact of the final regulations will generally be a 
small fraction of the calculated tax and thus considerably smaller than 
the effects reported in the table. Thus, the economic impact of the 
final regulations should not be regarded as significant under the 
Regulatory Flexibility Act.
    A portion of the economic impact of the final regulations may 
derive from the collection of information requirements imposed by Sec.  
1.1297-1(d)(1)(ii)(B), (d)(1)(iii)(B), and (d)(1)(iv) and Sec.  1.1297-
4(d)(5)(iii). The Treasury Department and the IRS have determined that 
the average burden is 1 hour per response. The IRS's Research, Applied 
Analytics, and Statistics division estimates that the appropriate wage 
rate for this set of taxpayers is $95 per hour. Thus, the annual burden 
per taxpayer from the collection of information requirement is $95. 
These requirements apply only if a taxpayer chooses to make an election 
or rely on a favorable rule.
    Accordingly, it is hereby certified that the final rule would not 
have a significant economic impact on a substantial number of small 
entities. Pursuant to section 7805(f), the proposed regulations 
preceding these final regulations (REG-105474-18) were submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on their impact on small business. The proposed regulations 
also solicited comments from the public on both the number of entities 
affected (including whether specific industries are affected) and the 
economic impact of this proposed rule on small entities. No comments 
were received.

IV. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 (UMRA) 
requires that agencies assess anticipated costs and benefits and take 
certain other actions before issuing a final rule that includes any 
Federal mandate that may result in expenditures in any one year by a 
state, local, or tribal government, in the aggregate, or by the private 
sector, of $100 million in 1995 dollars, updated annually for 
inflation. This rule does not include any Federal mandate that may 
result in expenditures by state, local, or tribal governments, or by 
the private sector in excess of that threshold.

V. Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on state and local 
governments, and is not required by statute, or preempts state law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive Order. This final rule does not have 
federalism implications and does not impose substantial direct 
compliance costs on state and local governments or preempt state law 
within the meaning of the Executive Order.

VI. Congressional Review Act

    Pursuant to the Congressional Review Act (5 U.S.C. 801 et seq.), 
the Office of Information and Regulatory Affairs designated this rule 
as not a 'major rule', as defined by 5 U.S.C. 804(2).

Statement of Availability of IRS Documents

    IRS Revenue Procedures, Revenue Rulings, notices, and other 
guidance cited in this document are published in the Internal Revenue 
Bulletin (or Cumulative Bulletin) and are available from the 
Superintendent of Documents, U.S. Government Publishing Office, 
Washington, DC 20402, or by visiting the IRS website at www.irs.gov.

[[Page 4555]]

Drafting Information

    The principal drafters of these regulations are Josephine Firehock 
and Christina Daniels of the Office of Associate Chief Counsel 
(International). Other personnel from the Treasury Department and the 
IRS also participated in the development of these regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries for Sec. Sec.  1.1297-1, 1.1297-2, 1.1297-4, 1.1297-5, 1.1297-
6, 1.1298-2, and 1.1298-4 in numerical order to read in part as 
follows:

    Authority:  26 U.S.C. 7805 * * *
    Section 1.1297-1 also issued under 26 U.S.C. 1298(g).
    Section 1.1297-2 also issued under 26 U.S.C. 1298(g).
* * * * *
    Section 1.1297-4 also issued under 26 U.S.C. 1297(b)(2)(B) and 
1298(g).
    Section 1.1297-5 also issued under 26 U.S.C. 1297(b)(2)(B) and 
1298(g).
    Section 1.1297-6 also issued under 26 U.S.C. 1297(b)(2)(B) and 
1298(g).
* * * * *
    Section 1.1298-2 also issued under 26 U.S.C. 1298(b)(3) and (g).
    Section 1.1298-4 also issued under 26 U.S.C. 1298(g).
* * * * *


0
Par. 2. Section 1.1291-0 is amended by:
0
1. Redesignating the entry for Sec.  1.1291-1(b)(8)(iv) as the entry 
for Sec.  1.1291-1(b)(8)(v).
0
2. Adding a new entry for Sec.  1.1291-1(b)(8)(iv).
0
3. Adding entries for newly redesignated Sec.  1.1291-1(b)(8)(v)(A) and 
(B), (b)(8)(v)(A)(1) and (2), (b)(8)(v)(A)(2)(i) and (ii), 
(b)(8)(v)(B)(1) and (2), (b)(8)(v)(C), (b)(8)(v)(C)(1) and (2), 
(b)(8)(v)(D), (b)(8)(v)(D)(1) and (2).
    The revisions and additions read as follows:


Sec.  1.1291-0  Treatment of shareholders of certain passive foreign 
investment companies; table of contents.

* * * * *


Sec.  1.1291-1  Taxation of U.S. persons that are shareholders of 
section 1291 funds.

* * * * *
    (b) * * *
    (8) * * *
    (iv) Successive application.
    (v) Examples.
    (A) Example 1.
    (1) Facts.
    (2) Results.
    (i) Treatment of DC.
    (ii) Treatment of A.
    (B) Example 2.
    (1) Facts.
    (2) Results.
    (C) Example 3.
    (1) Facts.
    (2) Results.
    (D) Example 4.
    (1) Facts.
    (2) Results.
* * * * *

0
Par. 3. Section 1.1291-1 is amended by:
0
1. Redesignating paragraph (b)(8)(iv) as paragraph (b)(8)(v).
0
2. Adding new paragraph (b)(8)(iv).
0
3. Redesignating Example 1 in newly redesignated paragraph (b)(8)(v) as 
paragraph (b)(8)(v)(A).
0
4. Revising newly redesignated paragraph (b)(8)(v)(A).
0
5. Adding paragraphs (b)(8)(v)(B), (C), and (D).
0
6. Revising paragraph (j)(3).
0
7. Adding paragraph (j)(4).
    The revisions and additions read as follows:


Sec.  1.1291-1  Taxation of U.S. persons that are shareholders of 
section 1291 funds.

* * * * *
    (b) * * *
    (8) * * *
    (iv) Successive application. Stock considered to be owned by a 
person by reason of paragraphs (b)(8)(ii) or (iii) of this section is, 
for purposes of applying such paragraphs, considered to be actually 
owned by such person. Subject to the limitations provided in section 
1298(a) and paragraphs (b)(8)(ii) and (b)(8)(iii) of this section, this 
paragraph applies by successively considering a person as actually 
owning its proportionate share of stock or other equity interest 
directly held by an entity directly owned by the person. Paragraph 
(b)(8)(ii)(C)(2) of this section applies after the other subparagraphs 
of paragraph (b)(8) of this section.
    (v) Examples. The rules of this paragraph (b)(8) are illustrated by 
the following examples:
    (A) Example 1--(1) Facts. A is a United States person who owns 49% 
of the stock of FC1, a foreign corporation that is not a PFIC, and 
separately all of the stock of DC, a domestic corporation that is not 
an S corporation. DC, in turn, owns the remaining 51% of the stock of 
FC1, and FC1 owns 100 shares of stock in a PFIC that is not a 
controlled foreign corporation (CFC) within the meaning of section 
957(a). The remainder of the PFIC's shares are owned by unrelated 
foreign persons.
    (2) Results--(i) Treatment of DC. Under paragraph (b)(8)(ii)(A) of 
this section, DC is considered to actually own 51 shares of the PFIC 
stock directly held by FC1 because DC directly owns 50% or more of the 
stock of FC1.
    (ii) Treatment of A. In determining whether A is considered to own 
50% or more of the value of FC1 for purposes of applying paragraphs 
(b)(8)(ii)(A) and (b)(8)(iv) of this section to the PFIC stock held 
through FC1, A is considered under paragraphs (b)(8)(ii)(C)(1) and 
(b)(8)(iv) of this section as indirectly owning all the stock of FC1 
that DC directly owns, before the application of paragraph 
(b)(8)(ii)(C)(2) of this section. Because A also directly owns 49% of 
the stock of FC1, before the application of paragraph (b)(8)(ii)(C)(2) 
of this section A would be treated as owning all 100 shares of PFIC 
stock held by FC1. However, because 51 shares of the PFIC stock held by 
FC1 are indirectly owned by DC under paragraph (b)(8)(ii)(A) of this 
section, pursuant to the limitation imposed by paragraph 
(b)(8)(ii)(C)(2) of this section, only the remaining 49 shares of the 
PFIC stock are considered as indirectly owned by A under paragraph 
(b)(8) of this section.
    (B) Example 2--(1) Facts. B, a United States citizen, owns 50% of 
the interests in Foreign Partnership, a foreign partnership treated as 
a partnership for U.S. federal income tax purposes, the remaining 
interests in which are owned by an unrelated foreign person. Foreign 
Partnership owns 100% of the stock of FC1 and 50% of the stock of FC2, 
the remainder of which is owned by an unrelated foreign person. Both 
FC1 and FC2 are foreign corporations that are not PFICs. FC1 and FC2 
each own 50% of the stock of FC3, a foreign corporation that is a PFIC.
    (2) Results. Under paragraphs (b)(8)(iii)(A) and (b)(8)(iv) of this 
section, for purposes of determining whether B is a shareholder of FC3, 
B is considered to actually own 50% (50% x 100%) of the stock of FC1 
and 25% (50% x 50%) of the stock of FC2. Under paragraphs (b)(8)(ii)(A) 
and (b)(8)(iv) of this section, B is then considered to own 25% (50% x 
100% x 50%) of the stock of FC3 indirectly through FC1, and thus is a 
shareholder of FC3 for purposes of the PFIC provisions. Because B is 
considered to own less than 50% of FC2, B is not considered to own any 
stock of FC3 indirectly through FC2.
    (C) Example 3--(1) Facts. The facts are the same as in paragraph 
(b)(8)(v)(B)(1) of this section (the facts in

[[Page 4556]]

Example 2), except that B owns 40% of the interests in Foreign 
Partnership.
    (2) Results. Under paragraph (b)(8)(iii)(A) and (b)(8)(iv) of this 
section, for purposes of determining whether B is a shareholder of FC3, 
B is considered to actually own 40% (40% x 100%) of the stock of FC1 
and 20% (40% x 50%) of the stock of FC2, and thus is not considered to 
own 50% or more of the stock of FC1 or FC2. Under paragraphs 
(b)(8)(ii)(A) and (b)(8)(iv) of this section, B is not considered to 
own any stock of FC3 indirectly through FC1 or FC2.
    (D) Example 4--(1) Facts. The facts are the same as in paragraph 
(b)(8)(v)(C)(1) of this section (the facts in Example 3), except that 
FP owns only 80% of FC1 and B also directly owns 20% of FC1.
    (2) Results. Under paragraph (b)(8)(iii)(A) and (b)(8)(iv) of this 
section, for purposes of determining whether B is a shareholder of FC3, 
B is considered to own 32% (40% x 80%) of the stock of FC1 and 20% (40% 
x 50%) of the stock of FC2. Because B directly owns 20% of FC1, B is 
considered to actually own 52% (32% + 20%) of the stock of FC1 in 
total. Under paragraphs (b)(8)(ii)(A) and (b)(8)(iv) of this section, B 
is considered to own 26% (52% x 50%) of the stock of FC3 indirectly 
through FC1, and thus is a shareholder of FC3 for purposes of the PFIC 
provisions. B is not considered to own any stock of FC3 indirectly 
through FC2.
* * * * *
    (j) * * *
    (3) Except as otherwise provided in paragraph (j)(4) of this 
section, paragraphs (b)(2)(ii) and (v), (b)(7) and (8), and (e)(2) of 
this section apply to taxable years of shareholders ending on or after 
December 31, 2013.
    (4) Paragraphs (b)(8)(iv) and (b)(8)(v)(A), (B), (C), and (D) of 
this section apply for taxable years of shareholders beginning on or 
after January 14, 2021. A shareholder may choose to apply such 
paragraphs for any open taxable year beginning before January 14, 2021, 
provided that, with respect to a tested foreign corporation, the 
shareholder consistently applies such paragraphs and the provisions of 
Sec. Sec.  1.1297-1 (except that consistent treatment is not required 
with respect to Sec.  1.1297-1(c)(1)(i)(A)), 1.1297-2, 1.1297-4, 
1.1297-6, 1.1298-2, and 1.1298-4 for such year and all subsequent 
years.

0
Par. 4. Section 1.1297-0 is amended by revising the introductory text 
and adding entries for Sec. Sec.  1.1297-1, 1.1297-2, 1.1297-4, 1.1297-
5, and 1.1297-6 in numerical order to read as follows:


Sec.  1.1297-0  Table of contents.

    This section contains a listing of the headings for Sec. Sec.  
1.1297-1, 1.1297-2, 1.1297-3, 1.1297-4, 1.1297-5, and 1.1297-6.

Sec.  1.1297-1 Definition of passive foreign investment company.

    (a) Overview.
    (b) Dividends included in gross income.
    (1) General rule.
    (2) Example.
    (i) Facts.
    (ii) Results.
    (c) Passive income.
    (1) Foreign personal holding company income.
    (i) General rule.
    (ii) Determination of gross income or gain on a net basis for 
certain items of foreign personal holding company income.
    (iii) Amounts treated as dividends.
    (2) [Reserved].
    (3) Passive treatment of dividends and distributive share of 
partnership income.
    (4) Exception for certain interest, dividends, rents, and 
royalties received from a related person.
    (i) In general.
    (ii) Ordering rule.
    (iii) Allocation of interest.
    (iv) Allocation of dividends.
    (A) In general.
    (B) Dividends paid out of current earnings and profits.
    (C) Dividends paid out of accumulated earnings and profits.
    (v) Allocation of rents and royalties.
    (vi) Determination of whether amounts are received or accrued 
from a related person.
    (vii) Allocation of distributive share of income from related 
partnership.
    (d) Asset test.
    (1) Calculation of average annual value (or adjusted bases).
    (i) General rule.
    (ii) Measuring period.
    (A) General rule.
    (B) Election to use alternative measuring period.
    (C) Short taxable year.
    (iii) Adjusted basis election.
    (iv) Time and manner of elections and revocations.
    (A) Elections.
    (B) Revocations and subsequent elections.
    (v) Method of measuring assets.
    (A) Publicly traded foreign corporations.
    (B) Non-publicly traded controlled foreign corporation.
    (1) In general.
    (2) Controlled foreign corporation determination.
    (C) Other foreign corporations.
    (1) In general.
    (2) Lower-tier subsidiaries.
    (i) Lower-tier subsidiaries that are publicly traded foreign 
corporations.
    (ii) Lower-tier subsidiaries that are non-publicly traded 
controlled foreign corporations.
    (iii) Other lower-tier subsidiaries.
    (D) [Reserved].
    (E) Examples.
    (1) Example 1.
    (i) Facts.
    (ii) Results.
    (2) Example 2.
    (i) Facts.
    (ii) Results.
    (3) Example 3.
    (i) Facts.
    (ii) Results.
    (2) [Reserved].
    (3) Dual-character assets.
    (i) General rule.
    (ii) Special rule when only part of an asset produces income.
    (iii) Special rule for stock that previously produced income 
that was excluded from passive income under section 1297(b)(2)(C).
    (iv) Example.
    (A) Facts.
    (B) Results.
    (4) Passive treatment of stock and partnership interests.
    (5) Dealer property.
    (e) Stapled stock.
    (f) Definitions.
    (1) Measuring date.
    (2) Measuring period.
    (3) Non-passive asset.
    (4) Non-passive income.
    (5) Passive asset.
    (6) Passive income.
    (7) Publicly traded foreign corporation.
    (8) Related person.
    (9) Tested foreign corporation.
    (g) Applicability date.
    (1) In general.
    (2) Paragraph (d)(1)(v)(B)(2) of this section.

Sec.  1.1297-2 Special rules regarding look-through subsidiaries and 
look-through partnerships.

    (a) Overview.
    (b) General rules.
    (1) Tested foreign corporation's ownership of a corporation.
    (2) Tested foreign corporation's proportionate share of the 
assets and income of a look-through subsidiary.
    (i) Proportionate share of subsidiary assets.
    (ii) Proportionate share of subsidiary income.
    (A) General rule.
    (B) Partial year.
    (iii) Coordination of section 1297(c) with section 1298(b)(7).
    (3) Tested foreign corporation's proportionate share of the 
assets and income of a look-through partnership.
    (i) Proportionate share of partnership assets.
    (ii) Proportionate share of partnership income.
    (A) General rule.
    (B) Partial year.
    (4) Examples.
    (i) Example 1.
    (A) Facts.
    (B) Results.
    (1) LTS.
    (2) TFC.
    (ii) Example 2.
    (A) Facts.
    (B) Results.
    (iii) Example 3.
    (A) Facts.
    (B) Results.
    (c) Elimination of certain intercompany assets and income.
    (1) General rule for asset test.

[[Page 4557]]

    (i) LTS stock.
    (ii) LTS obligation.
    (2) General rule for income test.
    (i) LTS stock.
    (ii) LTS obligation.
    (3) Partnerships.
    (4) Examples.
    (i) Example 1.
    (A) Facts.
    (B) Results.
    (1) LTS.
    (2) TFC.
    (ii) Example 2.
    (A) Facts.
    (B) Results.
    (iii) Example 3.
    (A) Facts.
    (B) Results.
    (iv) Example 4.
    (A) Facts.
    (B) Results.
    (v) Example 5.
    (A) Facts.
    (B) Results.
    (1) Asset test.
    (2) Income test.
    (3) Treatment of intangible and rental property.
    (d) Related person determination for purposes of section 
1297(b)(2)(C).
    (1) General rule.
    (2) Example.
    (i) Facts.
    (ii) Results.
    (e) Treatment of activities of certain look-through subsidiaries 
and look-through partnerships for purposes of certain exceptions.
    (1) General rule.
    (2) Qualified affiliate.
    (3) Examples.
    (i) Example 1.
    (A) Facts.
    (B) Results.
    (1) Qualified affiliates.
    (2) FS1 and FS2.
    (3) FS4.
    (ii) Example 2.
    (A) Facts.
    (B) Results.
    (iii) Example 3.
    (A) Facts.
    (B) Results.
    (f) Gain on disposition of a look-through subsidiary or look-
through partnership.
    (1) [Reserved].
    (2) Amount of gain taken into account from disposition of look-
through subsidiary.
    (3) Characterization of residual gain as passive income.
    (4) Gain taken into account from disposition of 25%-owned 
partnerships and look-through partnerships.
    (i) Section 954(c)(4) partnerships.
    (ii) Look-through partnerships.
    (5) Examples.
    (i) Example 1.
    (A) Facts.
    (B) Results.
    (ii) Example 2.
    (A) Facts.
    (B) Results.
    (iii) Example 3.
    (A) Facts.
    (B) Results.
    (g) Definitions.
    (1) Direct LTS obligation.
    (2) Indirect LTS obligation.
    (3) Look-through subsidiary.
    (4) Look-through partnership.
    (i) In general.
    (ii) Active partner test.
    (A) Partnership interest under asset test.
    (B) Partnership income under income test.
    (iii) Election.
    (iv) Examples.
    (A) Example 1.
    (1) Facts.
    (2) Results.
    (i) Active partner test with respect to partnership interest.
    (ii) Active partner test with respect to partnership income.
    (iii) Qualification of look-through partnership.
    (B) Example 2.
    (1) Facts.
    (2) Results.
    (i) Active partner test with respect to partnership interest.
    (ii) Active partner test with respect to partnership income.
    (iii) Failure to qualify as look-through partnership.
    (5) LTS debt.
    (6) LTS lease.
    (7) LTS license.
    (8) LTS obligation.
    (9) LTS stock.
    (10) Qualified affiliate.
    (11) Residual gain.
    (12) TFC obligation
    (13) Unremitted earnings.
    (h) Applicability date.

* * * * *
Sec.  1.1297-4 Qualifying insurance corporation.

    (a) Scope.
    (b) Qualifying insurance corporation.
    (c) 25 percent test.
    (d) Election to apply the alternative facts and circumstances 
test.
    (1) In general.
    (2) Predominantly engaged in an insurance business.
    (i) In general.
    (ii) Facts and circumstances.
    (iii) Examples of facts indicating a foreign corporation is not 
predominantly engaged in an insurance business.
    (3) Runoff-related circumstances.
    (4) Rating-related circumstances.
    (5) Election.
    (i) In general.
    (ii) Information provided by foreign corporation.
    (iii) Time and manner for making the election.
    (iv) Deemed election for small shareholders in publicly traded 
companies.
    (A) In general.
    (B) Publicly traded stock.
    (v) Options.
    (6) Stock ownership.
    (e) Rules limiting the amount of applicable insurance 
liabilities.
    (1) In general.
    (2) General limitation on applicable insurance liabilities.
    (3) Discounting.
    (4) [Reserved].
    (5) [Reserved].
    (f) Definitions.
    (1) Applicable financial statement.
    (i) GAAP statements.
    (ii) IFRS statements.
    (iii) Regulatory annual statement.
    (iv) [Reserved].
    (2) Applicable insurance liabilities.
    (i) In general.
    (ii) Amounts not specified in paragraph (f)(2)(i) of this 
section.
    (3) Applicable insurance regulatory body.
    (4) Applicable reporting period.
    (5) Financial guaranty insurance company.
    (6) Financial statements.
    (i) In general.
    (ii) [Reserved].
    (iii) [Reserved].
    (7) Generally accepted accounting principles or GAAP.
    (8) Insurance business.
    (9) International financial reporting standards or IFRS.
    (10) Mortgage insurance company.
    (11) Total assets.
    (g) Applicability date.

Sec.  1.1297-5 [Reserved].
Sec.  1.1297-6 Exception from the definition of passive income for 
active insurance income.

    (a) Scope.
    (b) Exclusion from passive income of active insurance income.
    (c) Exclusion of assets for purposes of the passive asset test 
under section 1297(a)(2).
    (d) Treatment of income and assets of certain look-through 
subsidiaries and look through partnerships for purposes of the 
section 1297(b)(2)(B) exception.
    (1) General rule.
    (2) Limitation.
    (3) Examples.
    (i) Example 1: QIC holds all the stock of an investment 
subsidiary.
    (A) Facts.
    (B) Result.
    (C) Alternative Facts.
    (1) Facts.
    (2) Result.
    (ii) Example 2: QIC holds all the stock of an operating 
subsidiary.
    (A) Facts.
    (B) Result.
    (e) Qualifying domestic insurance corporation.
    (1) General rule.
    (2) [Reserved].
    (3) [Reserved].
    (f) Applicability date.

0
Par. 5. Sections 1.1297-1 and 1.1297-2 are added to read as follows:


Sec.  1.1297-1  Definition of passive foreign investment company.

    (a) Overview. This section provides rules concerning the income 
test set forth in section 1297(a)(1) and the asset test set forth in 
section 1297(a)(2). Paragraph (b) of this section provides a rule 
relating to the definition of gross income with respect to certain 
dividends that are excluded from gross income under section 1502 for 
purposes of section 1297. Paragraph (c) of this

[[Page 4558]]

section provides rules relating to the definition of passive income for 
purposes of section 1297. Paragraph (d) of this section provides rules 
relating to the asset test of section 1297. See Sec. Sec.  1.1297-2 and 
1.1297-6 for additional rules concerning the treatment of the income 
and assets of a corporation subject to look-through treatment under 
section 1297(c). Paragraph (e) of this section provides rules relating 
to the determination of passive foreign investment company (PFIC) 
status for stapled entities. Paragraph (f) of this section provides 
definitions applicable for this section, and paragraph (g) of this 
section provides the applicability date of this section.
    (b) Dividends included in gross income--(1) General rule. For 
purposes of section 1297, gross income includes dividends that are 
excluded from gross income under section 1502 and Sec.  1.1502-13.
    (2) Example--(i) Facts. USP is a domestic corporation that owns 30% 
of TFC, a foreign corporation. The remaining 70% of TFC is owned by FP, 
a foreign corporation that is unrelated to USP. TFC owns 25% of the 
value of USS1, a domestic corporation. USS1 owns 80% of the value of 
USS2, a domestic corporation. USS1 and USS2 are members of an 
affiliated group (as defined in section 1504(a)) filing a consolidated 
return. USS2 distributes a dividend to USS1 that is excluded from 
USS1's income pursuant to Sec.  1.1502-13 for purposes of determining 
the U.S. Federal income tax liability of the affiliated group of which 
USS1 and USS2 are members.
    (ii) Results. Although the dividend received by USS1 from USS2 is 
excluded from USS1's income for purposes of determining the U.S. 
Federal income tax liability of the affiliated group of which USS1 and 
USS2 are members, pursuant to paragraph (b)(1) of this section, for 
purposes of section 1297, USS1's gross income includes the USS2 
dividend. Accordingly, for purposes of section 1297, TFC's gross income 
includes 25% of the dividend received by USS1 from USS2 pursuant to 
section 1297(c) and Sec.  1.1297-2(b)(2)(ii). See section 1298(b)(7) 
and Sec.  1.1298-4 for rules concerning the characterization of the 
USS2 dividend.
    (c) Passive income--(1) Foreign personal holding company income--
(i) General rule. For purposes of section 1297(b)(1), except as 
otherwise provided in section 1297(b)(2), this section, and Sec.  
1.1297-6, the term passive income means income of a kind that would be 
foreign personal holding company income as defined under section 
954(c). For the purpose of this paragraph (c)(1)--
    (A) The exceptions to foreign personal holding company income in 
section 954(c)(1), 954(c)(2)(A) (relating to active rents and 
royalties), 954(c)(2)(B) (relating to export financing income), and 
954(c)(2)(C) (relating to dealers) are taken into account;
    (B) The exceptions in section 954(c)(3) (relating to certain income 
received from related persons), 954(c)(6) (relating to certain amounts 
received from related controlled foreign corporations), and 954(i) 
(relating to entities engaged in the active conduct of an insurance 
business) are not taken into account;
    (C) The rules in section 954(c)(4) (relating to sales of certain 
partnership interests) and 954(c)(5) (relating to certain commodity 
hedging transactions) are taken into account; and
    (D) An entity is treated as a controlled foreign corporation within 
the meaning of section 957(a) for purposes of applying an exception to 
foreign personal holding company income in section 954(c)(1)(B)'s flush 
language, (1)(C)(ii), (1)(D), (4), and (5) and Sec.  1.954-2 and for 
purposes of identifying whether a person is a related person with 
respect to such entity within the meaning of section 954(d)(3).
    (ii) Determination of gross income or gain on a net basis for 
certain items of foreign personal holding company income. For purposes 
of section 1297, the excess of gains over losses from property 
transactions described in section 954(c)(1)(B), the excess of gains 
over losses from transactions in commodities described in section 
954(c)(1)(C), the excess of foreign currency gains over foreign 
currency losses described in section 954(c)(1)(D), and positive net 
income from notional principal contracts described in section 
954(c)(1)(F) are taken into account as gross income. The excess of 
gains over losses (or, with respect to notional principal contracts, 
positive net income) for a category of transactions is calculated by a 
tested foreign corporation taking into account individual items of gain 
or loss (or, with respect to notional principal contracts, net income 
or net deduction) recognized by the tested foreign corporation and 
those items of gain or loss (or, with respect to notional principal 
contracts, net income or net deduction) treated as recognized by the 
tested foreign corporation with respect to its look-through 
subsidiaries and look-through partnerships pursuant to section 1297(c) 
and Sec.  1.1297-2(b)(2) or (3).
    (iii) Amounts treated as dividends. For purposes of section 1297, 
the term dividend includes all amounts treated as dividends for 
purposes of this chapter, including amounts treated as dividends 
pursuant to sections 302, 304, 356(a)(2), 964(e), and 1248.
    (2) [Reserved].
    (3) Passive treatment of dividends and distributive share of 
partnership income. For purposes of section 1297, a tested foreign 
corporation's share of dividends received from a corporation that is 
not a look-through subsidiary (as defined in Sec.  1.1297-2(g)(3)) and 
distributive share of any item of income of a partnership that is not a 
look-through partnership (as defined in Sec.  1.1297-2(g)(4)) with 
respect to a tested foreign corporation are treated as passive income, 
except to the extent that the item of income would not be treated as 
passive under section 1297(b)(2)(C) and paragraph (c)(4) of this 
section.
    (4) Exception for certain interest, dividends, rents, and royalties 
received from a related person--(i) In general. For purposes of section 
1297(b)(2)(C), interest, dividends, rents, or royalties actually 
received or accrued by a tested foreign corporation are considered 
received or accrued from a related person only if the payor of the 
interest, dividend, rent, or royalty is a related person (within the 
meaning of section 954(d)(3)) with respect to the tested foreign 
corporation, taking into account paragraph (c)(1)(i)(D) of this 
section. For rules determining when amounts received or accrued by a 
look-through subsidiary or look-through partnership (and treated as 
received directly by a tested foreign corporation pursuant to section 
1297(c) and Sec.  1.1297-2(b)(2) and (b)(3)) are treated as received 
from a related person, see Sec.  1.1297-2(d).
    (ii) Ordering rule. Gross income that is interest, a dividend, or a 
rent or royalty that is, in each case, received or accrued from a 
related person is allocated to income that is not passive under the 
rules of this paragraph (c)(4). If the related person is also a look-
through subsidiary or a look-through partnership with respect to the 
tested foreign corporation, this paragraph (c)(4) applies after the 
application of the intercompany income rules of Sec.  1.1297-2(c).
    (iii) Allocation of interest. For purposes of section 
1297(b)(2)(C), interest that is received or accrued, as applicable 
based on the recipient's method of accounting, from a related person is 
allocated to income of the related person that is not passive income in 
proportion to the ratio of the portion of the related person's non-
passive gross income for its taxable year that ends with or within the 
taxable year of the recipient to the total amount of

[[Page 4559]]

the related person's gross income for the taxable year. If the related 
person does not have gross income for the taxable year that ends with 
or within the taxable year of the recipient, the interest is either 
allocated to income of the related person that is not passive income to 
the extent the related person's deduction for the interest would be 
allocable to non-passive income of the related person under the 
principles of Sec. Sec.  1.861-9 through 1.861-13T, applied in a 
reasonable and consistent manner taking into account the general 
operation of the PFIC rules and the purpose of section 1297(b)(2)(C) 
or, alternatively, at the election of the tested foreign corporation is 
treated as allocated entirely to passive income.
    (iv) Allocation of dividends--(A) In general. For purposes of 
section 1297(b)(2)(C), the principles of Sec.  1.316-2(a) apply in 
determining from what year's earnings and profits a dividend from a 
related person is treated as distributed. A dividend is considered to 
be distributed, first, out of the earnings and profits of the taxable 
year of the related person that includes the date the dividend is 
distributed (current earnings and profits) and that ends with or within 
the taxable year of the recipient; second, out of the earnings and 
profits accumulated for the immediately preceding taxable year of the 
related person; third, out of the earnings and profits accumulated for 
the second preceding taxable year of the related person; and so forth. 
For purposes of paragraph (c)(4)(iv) of this section, the principles of 
Sec.  1.243-4(a)(6) apply with respect to a deficit in an earnings and 
profits account for a prior year.
    (B) Dividends paid out of current earnings and profits. To the 
extent that a dividend is paid out of current earnings and profits of 
the related person for its taxable year that ends with or within the 
taxable year of the recipient, the dividend is treated as paid ratably 
out of earnings and profits attributable to passive income and to non-
passive income. The portion of the current earnings and profits that is 
treated as paid out of non-passive income of the related person may be 
determined by multiplying the current earnings and profits by the ratio 
of the related person's non-passive gross income as determined under 
this section (including paragraph (c)(1)(ii) of this section) for the 
taxable year to its total gross income as determined under this section 
(including paragraph (c)(1)(ii) of this section) for that year.
    (C) Dividends paid out of accumulated earnings and profits. To the 
extent that a dividend from a related person is treated as paid out of 
the related person's accumulated earnings and profits, the dividend is 
treated as paid ratably out of accumulated earnings and profits of the 
related person for prior taxable years (beginning with the most 
recently accumulated) that are attributable to passive income and to 
non-passive income, which may be determined in the same manner as in 
paragraph (c)(4)(iv)(B) of this section. Alternatively, the accumulated 
earnings and profits may be allocated based on the ratio of accumulated 
earnings and profits that are attributable to passive income and to 
non-passive income during either the related party period or the three-
year period. The related party period is the entire period during which 
the related person was related to the recipient. The three-year period 
is the three taxable years immediately preceding the related person's 
taxable year that ends with or within the current taxable year of the 
recipient. The three-year period may be used only if the related person 
has been related to the recipient for a period longer than the three 
taxable years immediately preceding the recipient's taxable year.
    (v) Allocation of rents and royalties. For purposes of section 
1297(b)(2)(C), rents and royalties that are received or accrued, as 
applicable based on the recipient's method of accounting, from a 
related person are allocable to income of the related person that is 
not passive income to the extent the related person's deduction for the 
rent or royalty is allocable to non-passive gross income of the related 
person under the principles of Sec. Sec.  1.861-8 through 1.861-14T.
    (vi) Determination of whether amounts are received or accrued from 
a related person. For purposes of section 1297(b)(2)(C), the 
determination of whether interest, dividends, rents, and royalties were 
received or accrued from a related person is made on the date of the 
receipt or accrual, as applicable based on the recipient's method of 
accounting, of the interest, dividend, rent, or royalty.
    (vii) Allocation of distributive share of income from related 
partnership. For purposes of section 1297(a)(1), a tested foreign 
corporation includes its distributive share as provided in section 704 
of the separate items of passive or non-passive income from a 
partnership that is a related person (and not a look-through 
partnership) with respect to the tested foreign corporation for the 
taxable year of the tested foreign corporation.
    (d) Asset test--(1) Calculation of average annual value (or 
adjusted bases)--(i) General rule. For purposes of section 1297, the 
calculation of the average percentage of assets held by a tested 
foreign corporation during its taxable year that produce passive income 
or that are held for the production of passive income is determined 
based on the average of the fair market values, or the average of the 
adjusted bases, as appropriate, of the passive assets and total assets 
held (including assets treated as held pursuant to section 1297(c) and 
Sec.  1.1297-2(b)(2)(i) and (b)(3)) by the foreign corporation on the 
last day of each measuring period (measuring date) of the foreign 
corporation's taxable year. The average of the fair market values (or 
the average of the adjusted bases) of the foreign corporation's passive 
assets or total assets for the taxable year is equal to the sum of the 
values (or adjusted bases) of the passive assets or total assets, as 
applicable, on each measuring date of the foreign corporation's taxable 
year, divided by the number of measuring dates in the taxable year.
    (ii) Measuring period--(A) General rule. Except as otherwise 
provided in paragraph (d)(1)(ii)(B) of this section, the measuring 
periods for a tested foreign corporation are the four quarters that 
make up the foreign corporation's taxable year.
    (B) Election to use alternative measuring period. The average 
percentage of assets held by a tested foreign corporation during its 
taxable year that produce passive income or that are held for the 
production of passive income may be calculated using a period that is 
shorter than a quarter (such as a week or month). The same period must 
be used to measure the assets of the foreign corporation for the first 
year (including a short taxable year) that this alternative measuring 
period is used, and for any and all subsequent years, unless a 
revocation is made. An election to use an alternative measuring period 
or a revocation of such an election must be made in accordance with the 
rules of paragraph (d)(1)(iv) of this section.
    (C) Short taxable year. For purposes of applying section 1297 to a 
tested foreign corporation that has a taxable year of less than twelve 
months (short taxable year), the average values (or adjusted bases) are 
determined based on the measuring dates of the foreign corporation's 
taxable year that fall within the short taxable year, and by treating 
the last day of the short taxable year as a measuring date.
    (iii) Adjusted basis election. An election under section 
1297(e)(2)(B) with respect to an eligible tested foreign corporation or 
a revocation of such an election may be made by the tested foreign 
corporation or alternatively by the owner (as defined in paragraph 
(d)(1)(iv) of this section). If made by the

[[Page 4560]]

owner, the election must be made in accordance with the rules of 
paragraph (d)(1)(iv) of this section.
    (iv) Time and manner of elections and revocations--(A) Elections. 
An owner (as defined in this paragraph (d)(1)(iv)) of a foreign 
corporation makes an election described in paragraph (d)(1)(ii)(B) or 
(d)(1)(iii) of this section for a taxable year in the manner provided 
in the Instructions to Form 8621 (or successor form), if the owner is 
required to file a Form 8621 (or successor form) with respect to the 
foreign corporation for the taxable year of the owner in which or with 
which the taxable year of the foreign corporation for which the 
election is made ends. If the owner is not required to file Form 8621 
(or successor form) with respect to the foreign corporation for the 
taxable year, the owner makes such an election by filing a written 
statement providing for the election and attaching the statement to an 
original or amended Federal income tax return for the taxable year of 
the owner in which or with which the taxable year of the foreign 
corporation for which the election is made ends clearly indicating that 
such election has been made. An election can be made by an owner only 
if the owner's taxable year for which the election is made, and all 
taxable years that are affected by the election, are not closed by the 
period of limitations on assessments under section 6501. Elections 
described in paragraphs (d)(1)(ii)(B) and (d)(1)(iii) of this section 
are not eligible for relief under Sec.  301.9100-3 of this chapter. For 
purposes of this paragraph (d)(1)(iv), an owner of a foreign 
corporation is a United States person that is eligible under Sec.  
1.1295-1(d) to make a section 1295 election with respect to the foreign 
corporation, or would be eligible under Sec.  1.1295-1(d) to make a 
section 1295 election if the foreign corporation were a PFIC.
    (B) Revocations and subsequent elections. An election described in 
paragraph (d)(1)(ii)(B) or (d)(1)(iii) of this section made pursuant to 
paragraph (d)(1)(iv)(A) of this section is effective for the taxable 
year of the foreign corporation for which it is made and all subsequent 
taxable years of such corporation unless revoked by the Commissioner or 
the owner (as defined in paragraph (d)(1)(iv)(A) of this section) of 
the foreign corporation. The owner of a foreign corporation may revoke 
such an election at any time. If an election described in paragraph 
(d)(1)(ii)(B) or (d)(1)(iii) of this section has been revoked under 
this paragraph (d)(1)(iv)(B), a new election described in paragraph 
(d)(1)(ii)(B) or (d)(1)(iii) of this section, as applicable, cannot be 
made until the sixth taxable year following the year for which the 
previous election was revoked, and such subsequent election cannot be 
revoked until the sixth taxable year following the year for which the 
subsequent election was made. The owner revokes the election for a 
taxable year in the manner provided in the Instructions to Form 8621 
(or successor form), if the owner is required to file a Form 8621 (or 
successor form) with respect to the foreign corporation for the taxable 
year of the owner in which or with which the taxable year of the 
foreign corporation for which the election is revoked ends, or by 
filing a written statement providing for the revocation and attaching 
the statement to an original or amended Federal income tax return for 
the taxable year of the owner in which or with which the taxable year 
of the foreign corporation for which the election is revoked ends 
clearly indicating that such election has been revoked, if the owner is 
not required to file Form 8621 (or successor form) with respect to the 
foreign corporation for the taxable year.
    (v) Method of measuring assets--(A) Publicly traded foreign 
corporations. For purposes of section 1297, the assets of a publicly 
traded foreign corporation as defined in paragraph (f)(7) of this 
section (including assets treated as held pursuant to section 1297(c) 
and Sec.  1.1297-2(b)(2)(i) and (b)(3)(i), other than assets of a look-
through subsidiary described in paragraph (d)(1)(v)(B) of this section) 
must be measured for all measuring periods of the taxable year on the 
basis of value.
    (B) Non-publicly traded controlled foreign corporation--(1) In 
general. For purposes of section 1297, the assets of a controlled 
foreign corporation that is not described in paragraph (d)(1)(v)(A) of 
this section (including assets treated as held pursuant to section 
1297(c) and Sec.  1.1297-2(b)(2)(i) and (b)(3)(i), other than assets 
held by a look-through subsidiary described in paragraph (d)(1)(v)(A) 
of this section) must be measured for all measuring periods of the 
taxable year during which the foreign corporation is a controlled 
foreign corporation on the basis of adjusted basis.
    (2) Controlled foreign corporation determination. For purposes of 
section 1297(e)(2)(A) and this paragraph (d)(1)(v), the term controlled 
foreign corporation has the meaning provided in section 957, determined 
without applying subparagraphs (A), (B), and (C) of section 318(a)(3) 
so as to consider a United States person as owning stock which is owned 
by a person who is not a United States person.
    (C) Other foreign corporations--(1) In general. Except as provided 
in paragraph (d)(1)(v)(C)(2) of this section, the assets of a foreign 
corporation that is not described in paragraphs (d)(1)(v)(A) or 
(d)(1)(v)(B) of this section (including assets treated as held pursuant 
to section 1297(c) and Sec.  1.1297-2(b)(2)(i)) and (b)(3)(i), other 
than assets held by a look-through subsidiary described in paragraphs 
(d)(1)(v)(A) or (d)(1)(v)(B) of this section) are measured for all 
measuring periods of the taxable year on the basis of value, unless a 
tested foreign corporation or a shareholder makes an election under 
section 1297(e)(2)(B) in accordance with paragraph (d)(1)(iii) of this 
section. In the case of a foreign corporation that is described in 
paragraph (d)(1)(v)(B) of this section for some but not all measuring 
periods during a taxable year, this paragraph (d)(1)(v)(C)(1) applies 
to the remaining measuring period or periods during that taxable year.
    (2) Lower-tier subsidiaries--(i) Lower-tier subsidiaries that are 
publicly traded foreign corporations. For purposes of applying section 
1297(a)(2) to the assets of a foreign corporation that is a lower-tier 
subsidiary of a foreign corporation that directly or indirectly owns 
all or part of the lower-tier subsidiary (a parent foreign 
corporation), if the lower-tier subsidiary is described in paragraph 
(d)(1)(v)(A), the rules of paragraph (d)(1)(v)(A) apply. The previous 
sentence applies both for purposes of applying section 1297(a)(2) to 
the lower-tier subsidiary as a tested foreign corporation, and for 
purposes of applying section 1297(a)(2) to a parent foreign corporation 
with respect to the assets of the lower-tier subsidiary.
    (ii) Lower-tier subsidiaries that are non-publicly traded 
controlled foreign corporations. For purposes of applying section 
1297(a)(2) to the assets of a foreign corporation that is a lower-tier 
subsidiary of a parent foreign corporation, if the lower-tier 
subsidiary is described in paragraph (d)(1)(v)(B), the rules of 
paragraph (d)(1)(v)(B) apply. The previous sentence applies both for 
purposes of applying section 1297(a)(2) to the lower-tier subsidiary as 
a tested foreign corporation, and for purposes of applying section 
1297(a)(2) to a parent foreign corporation with respect to the assets 
of the lower-tier subsidiary.
    (iii) Other lower-tier subsidiaries. For purposes of applying 
section 1297(a)(2) to a foreign corporation that is a lower-tier 
subsidiary of a parent foreign corporation, if the lower-tier 
subsidiary is not described in paragraphs

[[Page 4561]]

(d)(1)(v)(A) or (d)(1)(v)(B) of this section, the assets of the lower-
tier subsidiary (including assets treated as held pursuant to section 
1297(c) and Sec.  1.1297-2(b)(2)(i) and (b)(3)(i)) must be measured 
under the rules of the same paragraph of this section (d)(1)(v) that 
applies to the parent foreign corporation. The previous sentence 
applies both for purposes of applying section 1297(a)(2) to the lower-
tier subsidiary as a tested foreign corporation, and for purposes of 
applying section 1297(a)(2) to a parent foreign corporation. If a 
tested foreign corporation indirectly owns a lower-tier subsidiary that 
is not described in paragraphs (d)(1)(v)(A) or (d)(1)(v)(B) of this 
section through one or more other foreign corporations, the status of 
any parent foreign corporation in that chain of corporations that is 
described in paragraph (d)(1)(v)(A) of this section, or if there is no 
such parent foreign corporation then the status of any parent foreign 
corporation in that chain of corporations that is described in 
paragraph (d)(1)(v)(B) of this section, determines the basis on which 
the assets of the lower-tier subsidiary are measured. In the case of a 
foreign corporation that is a lower-tier subsidiary with respect to 
more than one parent foreign corporation, this rule applies separately 
to measure the assets of the lower-tier subsidiary with respect to each 
parent foreign corporation.
    (D) [Reserved].
    (E) Examples. The following examples illustrate the application of 
this paragraph (d)(1)(v).
    (1) Example 1--(i) Facts. USP, a domestic corporation, owns 60% of 
TFC1, which is a foreign corporation. The remaining 40% of TFC1's stock 
is regularly traded on a national securities exchange that is 
registered with the Securities and Exchange Commission and continues to 
be until September 1 of the taxable year, when USP acquires all of 
TFC1's stock pursuant to a tender offer. TFC1 owns 30% of the stock of 
FS1, a foreign corporation that is neither a publicly traded foreign 
corporation nor a controlled foreign corporation.
    (ii) Results. TFC1 is a controlled foreign corporation with respect 
to USP. TFC1 also is a publicly traded foreign corporation until 
September 1 of the taxable year. For purposes of section 1297, the 
assets of TFC1 (including the assets of FS1 treated as held by TFC1 
pursuant to section 1297(c) and Sec.  1.1297-2(b)(2)(i)) must be 
measured on the basis of value for each measuring period ending before 
September 1, pursuant to paragraph (d)(1)(v)(A) of this section. For 
purposes of applying section 1297 to FS1 as a tested foreign 
corporation with respect to USP, the assets of FS1 must be measured 
using the same method as is used for TFC1's assets, pursuant to 
paragraph (d)(1)(v)(C)(2) of this section.
    (2) Example 2--(i) Facts. A, a United States person, owns 1% of the 
stock of TFC2, a foreign corporation that is neither a publicly traded 
foreign corporation nor a controlled foreign corporation. TFC2 owns 25% 
of the stock of FS2, a foreign corporation that is neither a publicly 
traded foreign corporation nor a controlled foreign corporation.
    (ii) Results. For purposes of applying section 1297 to TFC2, the 
assets of TFC2 (including the assets of FS2 treated as held by TFC2 
pursuant to section 1297(c) and Sec.  1.1297-2(b)(2)(i)) are measured 
for all measuring periods of the taxable year on the basis of value, 
unless A or TFC2 makes an election under section 1297(e)(2)(B) in 
accordance with paragraph (d)(1)(iii) of this section, pursuant to 
paragraph (d)(1)(v)(C)(1) of this section. For purposes of applying 
section 1297 to FS2 as a tested foreign corporation with respect to A, 
the assets of FS2 must be measured using the same method as is used for 
TFC2's assets, pursuant to paragraph (d)(1)(v)(C)(2) of this section.
    (3) Example 3--(i) Facts. The facts are the same as in paragraph 
(d)(1)(v)(E)(2)(i) (the facts in Example 2), except that the 75% of 
FS2's stock not owned by TFC2 is owned by TFC3, a publicly traded 
foreign corporation that is neither related to TFC2 nor to A. B, a 
United States person that is neither related to A nor to TFC2, owns 1% 
of the stock of TFC3.
    (ii) Results. For purposes of applying section 1297 to TFC2, the 
results are the same as in paragraph (d)(1)(v)(E)(2)(ii) (the results 
in Example 2). For purposes of applying section 1297 to FS2 as a tested 
foreign corporation with respect to A, the assets of FS2 must be 
measured using the same method as is used for TFC2's assets, pursuant 
to paragraph (d)(1)(v)(C)(2) of this section. For purposes of applying 
section 1297 to TFC3, the assets of TFC3 must be measured by reference 
to value pursuant to paragraph (d)(1)(v)(A) because it is a publicly 
traded corporation. For purposes of applying section 1297 to FS2 as a 
tested foreign corporation with respect to B, the assets of FS2 must be 
measured by reference to value because TFC3 is a publicly traded 
foreign corporation, pursuant to paragraphs (d)(1)(v)(C)(2) and 
(d)(1)(v)(A) of this section.
    (2) [Reserved].
    (3) Dual-character assets--(i) General rule. Except as otherwise 
provided in paragraph (d)(3)(ii) or (d)(3)(iii) of this section and in 
Sec.  1.1297-2(c), for purposes of section 1297, an asset (or portion 
of an asset) that produces both passive income and non-passive income 
during a taxable year (dual-character asset), including stock and other 
assets that produce passive and non-passive income under section 
1297(b)(2)(C) and paragraph (c)(4) of this section, is treated as two 
assets for each measuring period in the taxable year, one of which is a 
passive asset and one of which is a non-passive asset. The value (or 
adjusted basis) of the dual-character asset is allocated between the 
passive asset and the non-passive asset in proportion to the relative 
amounts of passive income and non-passive income produced by the asset 
(or portion of an asset) during the taxable year. See paragraph 
(d)(3)(iii) of this section for a special rule concerning stock that 
has previously produced dividends subject to the exception provided in 
section 1297(b)(2)(C). For purposes of section 1297(b)(2)(C), a 
partnership interest in a partnership that is a related person to the 
tested foreign corporation is treated as producing passive or non-
passive income in proportion to the tested foreign corporation's 
distributive share of partnership passive or non-passive income for the 
taxable year under paragraph (c)(4)(vii) of this section.
    (ii) Special rule when only part of an asset produces income. For 
purposes of section 1297, when only a portion of an asset produces 
income during a taxable year or a portion of a taxable year, the asset 
is treated as two assets for that period, one of which is characterized 
as a passive asset or a non-passive asset based on the income that it 
produces, and one of which is characterized based on the income that it 
is held to produce. The value (or adjusted basis) of the asset is 
allocated between the two assets pursuant to the method that most 
reasonably reflects the uses of the property. In the case of real 
property, an allocation based on the physical use of the property 
generally is the most reasonable method.
    (iii) Special rule for stock that previously produced income that 
was excluded from passive income under section 1297(b)(2)(C). Stock 
with respect to which no dividends are received during a taxable year, 
but with respect to which dividends were received during one or both of 
the prior two taxable years, is characterized based on the relative 
portion of the dividends received that was passive or non-passive. If 
the dividends were in whole excluded from passive income under section 
1297(b)(2)(C) and paragraph (c)(4)(iv) of this section, the stock is

[[Page 4562]]

treated as a single non-passive asset. If the dividends were in part 
excluded from passive income under section 1297(b)(2)(C) and paragraph 
(c)(4)(iv) of this section, the stock is treated as two assets, one of 
which is a passive asset and one of which is a non-passive asset. The 
value (or adjusted basis) of the stock is allocated between the two 
assets in proportion to the average percentage of aggregate dividends 
received in the prior two taxable years that were characterized as 
passive income and the average percentage of aggregate dividends 
received in the prior two years that were characterized as non-passive 
income, for the previous two taxable years pursuant to section 
1297(b)(2)(C) and paragraph (c)(4)(iv) of this section. If the tested 
foreign corporation did not receive any dividends from the stock for 
the current taxable year or within either of the prior two taxable 
years of the tested foreign corporation, then the stock is treated as a 
passive asset.
    (iv) Example. The following example illustrates the application of 
this paragraph (d)(3).
    (A) Facts. (1) USP is a domestic corporation that owns 30% of TFC, 
a foreign corporation. The remaining 70% of TFC is owned by FP, a 
foreign corporation that is unrelated to USP. TFC owns 20% of the value 
of FS1, a foreign corporation, and FP owns the remaining 80% of the 
value of FS1. FP, TFC, and FS1 are not controlled foreign corporations 
within the meaning of section 957(a), and each has a calendar year 
taxable year.
    (2) In Year 1, FS1 had current earnings and profits of $1000x, 
attributable to passive income of $500x and non-passive income of 
$500x, and paid $300x of dividends to TFC. In Year 2, FS1 had current 
earnings and profits of $1000x, attributable to passive income of $100x 
and non-passive income of $900x, and paid $100x of dividends to TFC. In 
Year 3, FS1 has passive income of $200x and non-passive income of $800x 
and does not pay a dividend.
    (3) Throughout Year 3, TFC holds an obligation of FS1 with respect 
to which FS1 pays $100x of interest.
    (4) In addition to the stock in FS1 and the FS1 obligation, TFC 
holds an office building, 40% of which is rented to FP throughout Year 
3 for $100x per quarter. During Year 3, FP has only passive income. The 
remaining 60% of the office building is leased throughout Year 3 to an 
unrelated person for $300x per quarter, and TFC's own officers or staff 
of employees regularly perform active and substantial management and 
operational functions while the property is leased.
    (B) Results. (1) For purposes of section 1297(b)(2)(C), FP is a 
``related person'' with respect to TFC because FP owns more than 50% of 
the vote or value of TFC, and FS1 is a ``related person'' with respect 
to TFC because FP owns more than 50% of the vote or value of both TFC 
and of FS1.
    (2) Under paragraph (c)(4)(iv) of this section, the dividends paid 
by FS1 in Year 1 were characterized as 50% passive income ($150x) and 
50% non-passive income ($150x). Under paragraph (c)(4)(iv) of this 
section, the dividends paid by FS1 in Year 2 were characterized as 10% 
passive income ($10x) and 90% non-passive income ($90x). Accordingly, 
the average percentage of dividends for the previous two taxable years 
that were characterized as passive income is 40% (((10% x $100x) + (50% 
x $300x))/($100x + $300x)), and the average percentage of dividends 
characterized as non-passive income is 60% (((90% x $100x) + (50% x 
$300x))/($100x + $300x)). Thus, under paragraph (d)(3)(iii) of this 
section, 60% of each share of stock of FS1 is characterized as a non-
passive asset and 40% is characterized as a passive asset for each 
quarter of Year 3 for purposes of applying section 1297(a)(2) to 
determine whether TFC is a PFIC.
    (3) Under paragraph (c)(4)(iii) of this section, the interest 
received by TFC from FS1 is characterized as 20% ($200x/($200x + 
$800x)) passive income and thus 80% non-passive income for purposes of 
applying section 1297(a)(1) to determine whether TFC is a PFIC. 
Accordingly, under paragraph (d)(3)(i) of this section, 20% of the 
obligation of FS1 is characterized as a passive asset and 80% as a non-
passive asset for each quarter of Year 3 for purposes of applying 
section 1297(a)(2) to determine whether TFC is a PFIC.
    (4) Under paragraph (c)(4)(v) of this section, the rent received 
from FP throughout Year 3 is characterized as 100% passive income. 
Under paragraph (c)(1)(i)(A) of this section and section 954(c)(2)(A), 
the rent received from the unrelated person is characterized as 100% 
non-passive income. Accordingly, under paragraph (d)(3)(i) of this 
section, the 40% of the office building rented to FP has a value of 25% 
(($100x x 4)/(($100x x 4) + ($300x x 4))) of the value of the office 
building and that 25% is a passive asset, and the 60% of the office 
building rented to the unrelated person has a value of 75% (($300x x 
4)/(($100x x 4) + ($300x x 4))) of the value of the office building and 
is a non-passive asset for purposes of applying section 1297(a)(2) to 
determine whether TFC is a PFIC.
    (4) Passive treatment of stock and partnership interests. For 
purposes of section 1297(a)(2), shares of stock in a corporation that 
is not a look-through subsidiary (as defined in Sec.  1.1297-2(g)(3)) 
and partnership interests in a partnership that is not a look-through 
partnership (as defined in Sec.  1.1297-2(g)(4)) with respect to a 
tested foreign corporation for a taxable year or portion thereof are 
treated as passive assets for the taxable year or relevant portion 
thereof, except to the extent the stock or partnership interest is 
treated as a dual-character asset under section 1297(b)(2)(C) and 
paragraph (d)(3) of this section because it produces both passive and 
non-passive income, or the stock or partnership interest produces 
solely non-passive income for the taxable year under section 
1297(b)(2)(C) and paragraph (c)(4) of this section or under paragraph 
(d)(5) of this section.
    (5) Dealer property. For purposes of section 1297(a)(2), an asset 
that produces, or would produce upon disposition, income or gain that 
is, or would be, excluded from passive income pursuant to section 
954(c)(2)(C) is treated as a non-passive asset.
    (e) Stapled stock. If a United States person that would be a 
shareholder (within the meaning of Sec.  1.1291-1(b)(7) and (b)(8)) of 
a stapled entity (as defined in section 269B(c)(2)) owns stock in all 
entities that are stapled entities with respect to each other and the 
shares are stapled interests (as defined in section 269B(c)(3)), the 
United States person's interests in the stapled entities are treated as 
an interest in a single entity that holds all of the assets of the 
stapled entities, conducts all of the activities of the stapled 
entities, and derives all of the income of the stapled entities for all 
purposes of the PFIC regime.
    (f) Definitions. The following definitions apply for purposes of 
this section and Sec.  1.1297-2:
    (1) Measuring date. The term measuring date has the meaning 
provided in paragraph (d)(1)(i) of this section.
    (2) Measuring period. The term measuring period means a three-month 
period or an alternative measuring period, within the meaning provided 
in paragraph (d)(1)(ii) of this section.
    (3) Non-passive asset. The term non-passive asset means an asset 
other than a passive asset.
    (4) Non-passive income. The term non-passive income means income 
other than passive income.
    (5) Passive asset. The term passive asset means an asset that 
produces passive income, or which is held for the

[[Page 4563]]

production of passive income, taking into account the rules in 
paragraphs (c) and (d) of this section.
    (6) Passive income. The term passive income has the meaning 
provided in paragraph (c)(1) of this section.
    (7) Publicly traded foreign corporation. The term publicly traded 
foreign corporation means a foreign corporation the stock of which is 
regularly traded on an exchange described in section 1297(e)(3), other 
than in de minimis quantities, for at least twenty trading days during 
a taxable year.
    (8) Related person. For purposes of applying the rules with respect 
to section 1297(b)(2)(C), the term related person means a related 
person within the meaning of section 954(d)(3).
    (9) Tested foreign corporation. The term tested foreign corporation 
means a foreign corporation the PFIC status of which is being tested 
under section 1297(a).
    (g) Applicability date--(1) In general. Except as otherwise 
provided in paragraph (g)(2) of this section, the rules of this section 
apply to taxable years of shareholders beginning on or after January 
14, 2021. A shareholder may choose to apply such rules for any open 
taxable year beginning before January 14, 2021, provided that, with 
respect to a tested foreign corporation, the shareholder consistently 
applies the provisions of this section (except that consistent 
treatment is not required with respect to paragraph (c)(1)(i)(A) of 
this section) and Sec.  1.1291-1(b)(8)(iv) and (b)(8)(v)(A), (B), (C), 
and (D) and Sec. Sec.  1.1297-2, 1.1298-2, and 1.1298-4 for such year 
and all subsequent years.
    (2) Paragraph (d)(1)(v)(B)(2) of this section. Paragraph 
(d)(1)(v)(B)(2) of this section applies to taxable years of 
shareholders ending on or after October 1, 2019. For taxable years of 
shareholders ending before October 1, 2019, a shareholder may apply 
paragraph (d)(1)(v)(B)(2) of this section to the last taxable year of a 
foreign corporation beginning before January 1, 2018, and each 
subsequent taxable year of the foreign corporation, provided that the 
shareholder and United States persons that are related (within the 
meaning of section 267 or 707) to the taxpayer consistently apply such 
paragraph with respect to all foreign corporations.


Sec.  1.1297-2  Special rules regarding look-through subsidiaries and 
look-through partnerships.

    (a) Overview. This section provides rules concerning the treatment 
of income and assets of a look-through subsidiary (as defined in Sec.  
1.1297-2(g)(3)) or look-through partnership (as defined in Sec.  
1.1297-2(g)(4)) for purposes of determining whether a tested foreign 
corporation (as defined in Sec.  1.1297-1(f)(9)) is a passive foreign 
investment company (PFIC) under section 1297(a). Paragraph (b) of this 
section provides guidance for purposes of section 1297(c) on how to 
determine a tested foreign corporation's ownership in a corporation and 
how to determine a tested foreign corporation's proportionate share of 
a look-through subsidiary's or look-through partnership's assets and 
income. Paragraph (c) of this section provides rules that eliminate 
certain income and assets related to look-through subsidiaries and 
look-through partnerships for purposes of determining a tested foreign 
corporation's PFIC status. Paragraph (d) of this section provides a 
rule to determine whether certain income received or accrued by look-
through subsidiaries and look-through partnerships is received or 
accrued from a related person for purposes of section 1297(b)(2)(C). 
Paragraph (e) of this section provides rules concerning the attribution 
of activities from qualified affiliates (as defined in Sec.  1.1297-
2(e)(2)) for purposes of characterizing the income and assets of a 
look-through subsidiary or look-through partnership. Paragraph (f) of 
this section provides rules for determining the amount of gain from the 
direct or indirect sale or exchange of stock of a look-through 
subsidiary or partnership interests in a partnership described in 
section 954(c)(4) that is taken into account under section 1297(a) and 
for determining the passive or non-passive character of gain from the 
sale of a look-through subsidiary. Paragraph (g) of this section 
provides definitions applicable for this section, and paragraph (h) of 
this section provides the applicability date of this section.
    (b) General rules--(1) Tested foreign corporation's ownership of a 
corporation. For purposes of section 1297(c) and this section, the 
principles of section 958(a) and the regulations in this chapter under 
that section applicable to determining direct or indirect ownership by 
value apply to determine a tested foreign corporation's percentage 
ownership (by value) in the stock of another corporation. These 
principles apply whether an intermediate entity is domestic or foreign.
    (2) Tested foreign corporation's proportionate share of the assets 
and income of a look-through subsidiary--(i) Proportionate share of 
subsidiary assets. For each measuring period (as defined in Sec.  
1.1297-1(f)(2)), a tested foreign corporation is treated as if it held 
its proportionate share of each asset of a look-through subsidiary, 
determined based on the tested foreign corporation's percentage 
ownership (by value) (as determined under paragraph (b)(1) of this 
section)) of the look-through subsidiary on the measuring date (as 
defined in Sec.  1.1297-1(f)(1)). A tested foreign corporation's 
proportionate share of a look-through subsidiary's asset is treated as 
producing passive income, or being held to produce passive income, to 
the extent the asset produced, or was held to produce, passive income 
in the hands of such look-through subsidiary under the rules of 
paragraph (b)(2)(ii) of this section.
    (ii) Proportionate share of subsidiary income--(A) General rule. A 
tested foreign corporation is treated as if it received directly its 
proportionate share of each item of gross income or loss of a 
corporation for a taxable year if the corporation is a look-through 
subsidiary with respect to the tested foreign corporation for the 
taxable year of the tested foreign corporation. In such case, a tested 
foreign corporation's proportionate share of a look-through 
subsidiary's gross income or loss is determined based on the 
corporation's average percentage ownership (by value) of the look-
through subsidiary. The exceptions to passive income in section 
1297(b)(2) and the relevant exceptions to foreign personal holding 
company income in section 954(c) that are based on whether income is 
derived in the active conduct of a business or whether a corporation is 
engaged in the active conduct of a business apply to such income only 
if the exception would have applied to exclude the income from passive 
income or foreign personal holding company income in the hands of the 
subsidiary, determined by taking into account only the activities of 
the subsidiary except as provided in paragraph (e) of this section. See 
paragraph (d) of this section for rules determining whether a person is 
a related person for purposes of applying section 1297(b)(2)(C) in the 
case of income received or accrued by a subsidiary that is treated as 
received directly by a tested foreign corporation pursuant to this 
paragraph (b)(2).
    (B) Partial year. When a corporation is not a look-through 
subsidiary with respect to a tested foreign corporation for an entire 
taxable year of the tested foreign corporation, the tested foreign 
corporation may be treated as if it received directly its proportionate 
share of the gross income or loss of the first corporation for each 
measuring period in the year for which the first

[[Page 4564]]

corporation is a look-through subsidiary, if the conditions in 
paragraph (g)(3)(ii)(B) of this section are satisfied. In such case, a 
tested foreign corporation's proportionate share of a look-through 
subsidiary's gross income or loss is determined based on the tested 
foreign corporation's percentage ownership (by value) (as determined 
under paragraph (b)(1) of this section) of the look-through subsidiary 
on the relevant measuring date.
    (iii) Coordination of section 1297(c) with section 1298(b)(7). A 
tested foreign corporation is not treated under section 1297(c) and 
this paragraph (b) as holding its proportionate share of the assets of 
a domestic corporation, or receiving directly its proportionate share 
of the gross income or loss of the domestic corporation, if the stock 
of the domestic corporation is treated as an asset that is not a 
passive asset (as defined in Sec.  1.1297-1(f)(5)) that produces income 
that is not passive income (as defined in Sec.  1.1297-1(f)(6)) under 
section 1298(b)(7) (concerning the treatment of certain foreign 
corporations owning stock in certain 25-percent-owned domestic 
corporations). See Sec.  1.1298-4 for rules governing the application 
of section 1298(b)(7).
    (3) Tested foreign corporation's proportionate share of the assets 
and income of a look-through partnership--(i) Proportionate share of 
partnership assets. For each measuring period (as defined in Sec.  
1.1297-1(f)(2)), a tested foreign corporation is treated as if it held 
its proportionate share of each asset of a look-through partnership, 
determined based on the tested foreign corporation's percentage 
ownership (by value) (as determined under paragraph (b)(1) of this 
section)) of the look-through partnership on the measuring date (as 
defined in Sec.  1.1297-1(f)(1)). A tested foreign corporation's 
proportionate share of a look-through partnership's asset is treated as 
producing passive income, or being held to produce passive income, to 
the extent the asset produced, or was held to produce, passive income 
in the hands of the partnership under the rules in paragraph (b)(3)(ii) 
of this section.
    (ii) Proportionate share of partnership income--(A) General rule. A 
tested foreign corporation is treated as if it received directly its 
proportionate share of any item of gross income or loss of a 
partnership that is a look-through partnership with respect to the 
tested foreign corporation for the taxable year of the tested foreign 
corporation. The exceptions to passive income in section 1297(b)(2) and 
the relevant exceptions to foreign personal holding company income in 
section 954(c) that are based on whether income is derived in the 
active conduct of a business or whether a corporation is engaged in the 
active conduct of a business apply to such income only if the exception 
would have applied to exclude the income from passive income or foreign 
personal holding company income in the hands of the partnership, 
determined by taking into account only the activities of the 
partnership except as provided in paragraph (e) of this section. See 
paragraph (d) of this section for rules determining whether a person is 
a related person for purposes of applying section 1297(b)(2)(C) in the 
case of income received or accrued by a partnership that is treated as 
received directly by a tested foreign corporation pursuant to this 
paragraph (b)(3).
    (B) Partial year. When a partnership is not a look-through 
partnership with respect to a tested foreign corporation for an entire 
taxable year of the tested foreign corporation, the tested foreign 
corporation may be treated as if it received directly its proportionate 
share of the gross income of the partnership for each measuring period 
in the year for which the partnership is a look-through partnership, 
provided that the conditions set forth in paragraph (g)(3)(ii)(B) of 
this section would be satisfied if the partnership were a corporation.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (b). For purposes of these examples, USP is a domestic 
corporation; TFC, LTS, and FS are foreign corporations that are not 
controlled foreign corporations within the meaning of section 957(a); 
USP owns 30% of TFC; and LTS owns 25% of the only class of FS stock.
    (i) Example 1--(A) Facts. TFC directly owns 80% of the only class 
of LTS stock for TFC's and LTS's entire taxable year.
    (B) Results--(1) LTS. Under paragraph (b)(1) of this section and 
pursuant to the principles of section 958(a), LTS owns 25% of the value 
of FS. Under paragraph (b)(2)(i) and (ii) of this section, in 
determining whether LTS is a PFIC under section 1297(a), LTS is treated 
as if it held 25% of each of FS's assets on each of the measuring dates 
in its taxable year and received directly 25% of the gross income of FS 
for the taxable year.
    (2) TFC. Under paragraph (b)(1) of this section and pursuant to the 
principles of section 958(a), TFC owns 80% of the value of LTS and 
indirectly owns 20% of the value of FS. Under paragraph (b)(2) of this 
section, in determining whether TFC is a PFIC under section 1297(a), 
TFC is treated as if it held 80% of each of LTS's assets on each of the 
measuring dates in its taxable year and received directly 80% of the 
gross income of LTS for the taxable year. However, because TFC 
indirectly owns less than 25% of FS, FS is not a look-through 
subsidiary with respect to TFC and, therefore, TFC is treated as if it 
held a 20% interest in the stock of FS (and not the assets of FS), and 
received 80% of any dividends paid from FS to LTS (and not any income 
of FS).
    (ii) Example 2--(A) Facts. TFC directly owns 25% of the only class 
of LTS stock on the last day of each of the first three quarters of its 
taxable year but disposes of its entire interest in LTS during the 
fourth quarter of its taxable year.
    (B) Results. Under paragraph (b)(1) and pursuant to the principles 
of section 958(a), on each of its first three measuring dates, TFC owns 
25% of the value of LTS and indirectly owns 6.25% of the value of FS. 
Under paragraph (g)(3) of this section, if information about the gross 
income of LTS for each of the first three quarters of its taxable year 
is available to TFC, LTS is treated as a look-through subsidiary with 
respect to TFC for those quarters because TFC owned 25% of the value of 
LTS on the measuring dates with respect to those measuring periods. In 
that case, under paragraph (b)(2) of this section, in determining 
whether TFC is a PFIC under section 1297(a), TFC is treated as if it 
held 25% of each of LTS's assets and received directly 25% of the gross 
income of LTS on each of the first three measuring dates in its taxable 
year. For each of its first three quarters, if LTS is treated as a 
look-through subsidiary with respect to TFC under paragraph (g)(3) of 
this section, then TFC is treated as if it held a 6.25% interest in the 
stock of FS (and not the assets of FS) and received 25% of any 
dividends paid from FS to LTS (and not any income of FS). Under 
paragraph (g)(3) of this section, if information about the gross income 
of LTS for each of the first three quarters of its taxable year is not 
available to TFC, then LTS is not a look-through subsidiary with 
respect to TFC.
    (iii) Example 3--(A) Facts. TFC directly owns 100% of the only 
class of LTS stock for TFC's and LTS's entire taxable year. TFC sells 
one item of property described in section 954(c)(1)(B)(i) for a gain of 
$25x and another for a loss of $10x, and no exception from passive 
income applies to either amount. During the taxable year, FS sells one 
item of property described in section 954(c)(1)(B)(i) for a gain of 
$50x and another for a loss of $55x; no exception from passive income 
applies to either amount.

[[Page 4565]]

    (B) Results. Under paragraph (b)(1) of this section and pursuant to 
the principles of section 958(a), TFC owns 100% of the value of LTS, 
and TFC indirectly owns 25% of the value of FS. Under paragraph (b) of 
this section, in determining whether TFC is a PFIC under section 
1297(a), TFC is treated as if it held 100% of LTS's assets on each of 
the measuring dates in its taxable year and received directly 100% of 
the gross income of LTS for the taxable year. Furthermore, TFC is 
treated as if it held 25% of each of FS's assets and received directly 
25% of the gross income of FS. Pursuant to Sec.  1.1297-1(c)(1)(ii), 
the excess of gains over losses from property transactions described in 
section 954(c)(1)(B) is taken into account as gross income for purposes 
of section 1297, and items of gain or loss of look-through subsidiaries 
are treated as recognized by a tested foreign corporation. Accordingly, 
TFC takes into account the net $5x loss from the sales of property by 
FS. TFC's income from its own sales of property constitutes passive 
income pursuant to Sec.  1.1297-1(c) and section 954(c)(1)(B), 
although, pursuant to Sec.  1.1297-1(c)(1)(ii), only the excess of 
gains over losses, $15x ($25x - $10x), is taken into account as gross 
income for purposes of section 1297. As a result, TFC's income 
(including the $5x loss from FS), all of which is passive income, 
equals $10x ($15x - $5x) of gross income.
    (c) Elimination of certain intercompany assets and income--(1) 
General rule for asset test--(i) LTS stock. For purposes of section 
1297(a)(2), a tested foreign corporation does not take into account the 
value (or adjusted basis) of stock of a look-through subsidiary (LTS 
stock), including LTS stock that the tested foreign corporation is 
treated as owning on a measuring date pursuant to section 1297(c) and 
paragraph (b)(2) or (b)(3) of this section. Furthermore, for purposes 
of section 1297(a)(2), a tested foreign corporation does not take into 
account the value (or adjusted basis) of its own stock that it is 
treated as owning on a measuring date pursuant to section 1297(c) and 
paragraph (b)(2) or (b)(3) of this section.
    (ii) LTS obligation. For purposes of section 1297(a)(2), a tested 
foreign corporation does not take into account the value (or adjusted 
basis) of its proportionate share of a direct LTS obligation, an 
indirect LTS obligation or a TFC obligation that it is treated as 
owning on a measuring date. The term direct LTS obligation means a debt 
obligation of, lease to, or license to a look-through subsidiary (LTS 
debt, LTS lease, and LTS license, respectively, and LTS obligation 
collectively) from the tested foreign corporation that the tested 
foreign corporation owns on a measuring date, and the term indirect LTS 
obligation means a LTS obligation from a look-through subsidiary that 
the tested foreign corporation is treated as owning on a measuring date 
pursuant to section 1297(c) and paragraph (b)(2) or (b)(3) of this 
section. The term TFC obligation means a debt obligation of, lease to, 
or a license to the tested foreign corporation from a look-through 
subsidiary that the tested foreign corporation is treated as owning on 
a measuring date pursuant to section 1297(c) and paragraph (b)(2) or 
(b)(3) of this section. The tested foreign corporation's proportionate 
share of a LTS obligation or a TFC obligation is the value (or adjusted 
basis) of the item multiplied by the tested foreign corporation's 
percentage ownership (by value) in each relevant look-through 
subsidiary. For purposes of section 1297(a)(2) and Sec.  1.1297-1(d) as 
applied to a tested foreign corporation, property subject to a LTS 
lease or LTS license or a lease or license to the tested foreign 
corporation is characterized as either producing passive income or non-
passive income (or both) by taking into account the activities of the 
qualified affiliates (as defined in paragraph (e)(2) of this section) 
of the entity that owns the property. For this purpose, the activities 
of the entity that owns the property that is subject to the lease or 
license are not taken into account to the extent that they relate to 
the lease or license.
    (2) General rule for income test--(i) LTS stock. For purposes of 
section 1297(a)(1), a tested foreign corporation does not take into 
account dividends derived with respect to LTS stock, including 
dividends that the tested foreign corporation is treated as receiving 
on a measuring date pursuant to section 1297(c) and paragraph (b)(2) or 
(b)(3) of this section; provided that, notwithstanding the foregoing, a 
tested foreign corporation takes into account dividends that are 
attributable to income that was not treated as received directly by the 
tested foreign corporation pursuant to paragraph (b)(2) of this 
section. For this purpose, the rules of Sec.  1.1297-1(c)(4)(iv)(A) 
apply to determine the earnings and profits from which a dividend is 
paid, substituting the term ``look-through subsidiary'' for ``related 
person.''
    (ii) LTS obligation. For purposes of section 1297(a)(1), a tested 
foreign corporation does not take into account its proportionate share 
of interest, rents, or royalties derived with respect to direct or 
indirect LTS obligations or TFC obligations. The tested foreign 
corporation's proportionate share of interest, rents, or royalties is 
the amount of the item multiplied by the tested foreign corporation's 
percentage ownership (by value) in each relevant look-through 
subsidiary.
    (3) Partnerships. For purposes of section 1297(a)(1) and (a)(2), 
the principles of paragraphs (c)(1) and (2) of this section apply with 
respect to ownership interests in, debt of, and leases or licenses to a 
look-through partnership (as defined in paragraph (g)(4) of this 
section), and with respect to distributions and the distributive shares 
of income from a look-through partnership and interest, rents, or 
royalties derived with respect to the debt, leases or licenses of a 
look-through partnership.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (c). For purposes of these examples, USP is a domestic 
corporation; USP owns 30% of TFC; TFC, LTS, LTS1, LTS2, and FS are 
foreign corporations that are not controlled foreign corporations 
within the meaning of section 957(a); FPS is a foreign partnership; and 
TFC, LTS1, and LTS2 measure assets for purposes of section 1297(a)(2) 
based on value.
    (i) Example 1--(A) Facts. TFC directly owns 80% of the only class 
of LTS stock for TFC's and LTS's entire taxable year, and LTS is a 
look-through subsidiary (as defined in paragraph (g)(3) of this 
section) with respect to TFC. LTS owns 25% of the only class of FS 
stock, and FS is a look-through subsidiary with respect to LTS. 
Pursuant to the principles of section 958(a), TFC owns 80% of the value 
of LTS, LTS owns 25% of the value of FS, and TFC indirectly owns 20% of 
the value of FS. During the first quarter of the taxable year, LTS 
received a $20x dividend from FS.
    (B) Results--(1) LTS. Under paragraph (c)(1)(i) of this section, 
for purposes of applying section 1297(a)(2) to LTS, LTS's assets do not 
include the stock of FS. Under paragraph (c)(2)(i) of this section, for 
purposes of applying section 1297(a)(1) to LTS, LTS's income does not 
include the $20x dividend from FS.
    (2) TFC. Under paragraph (c)(1)(i) of this section, for purposes of 
applying section 1297(a)(2) to TFC, TFC's assets do not include the 
stock of LTS. Under paragraph (b)(2)(ii)(A) of this section, for 
purposes of applying section 1297(a)(1) to TFC, TFC is treated as 
receiving directly the income of LTS. Because TFC indirectly owns less 
than 25% of FS, FS is not a look-through subsidiary with respect to TFC 
and, therefore, TFC's assets include the value of TFC's 20% interest in 
the stock of FS and do not include 20% of FS's assets.

[[Page 4566]]

Similarly, TFC is treated as if it received $16x (80% x $20x) of the 
$20x dividend paid from FS to LTS (and not any income of FS). Because 
the dividend constitutes gross income to LTS (although it is eliminated 
for purposes of applying section 1297(a)(1) to LTS), TFC is treated as 
receiving the dividend from FS directly under paragraph (b)(2)(ii)(A) 
of this section. Because the dividend is from a subsidiary that is not 
a look-through subsidiary with respect to TFC, paragraph (c)(2)(i) of 
this section does not apply to eliminate the $16x dividend for purposes 
of section 1297(a).
    (ii) Example 2--(A) Facts. TFC directly owns 40% of the value of 
LTS1 stock on each of the measuring dates, and thus is treated under 
paragraph (b)(1) of this section as owning 40% of LTS1's assets on each 
of the measuring dates. TFC's assets include a loan to LTS1 with a 
balance of $1,000x on each of the measuring dates. During the first 
quarter of the taxable year, TFC received $20x of dividends from LTS1, 
which were attributable to income of LTS1 treated as received directly 
by TFC pursuant to paragraph (b)(2) of this section, and $30x of 
interest on the loan, both of which were paid in cash.
    (B) Results. Under paragraph (c)(1)(i) of this section, for 
purposes of applying section 1297(a), TFC's assets do not include the 
stock of LTS1, and TFC's income does not include the $20x of dividends 
received from LTS1 pursuant to paragraph (c)(2)(i) of this section. 
Similarly, under paragraph (c)(1)(ii) of this section TFC's assets 
include only $600x ($1,000x loan -(40% x $1,000x)) of the loan to LTS1, 
and under paragraph (c)(2)(ii) of this section, TFC's income includes 
only $18x ($30x interest - (40% x $30x)) of the interest from LTS1. 
However, TFC's assets include the entire $50x of cash ($20x of 
dividends and $30x of interest) received from LTS1.
    (iii) Example 3--(A) Facts. The facts are the same as in paragraph 
(c)(4)(ii)(A) of this section (the facts in Example 2), except that TFC 
also directly owns 30% of the value of LTS2 stock on each of the 
measuring dates, and thus is treated under paragraph (b)(1) of this 
section as owning 30% of LTS2's assets, and LTS1's assets also include 
a loan to LTS2 with a balance of $200x on each of the measuring dates. 
During the first quarter of the taxable year, LTS1 received $5x of 
interest on the loan, which was paid in cash.
    (B) Results. The results are the same as in paragraph (c)(4)(i)(B) 
of this section (the results in Example 1), except that TFC's assets 
also do not include the stock of LTS2. Similarly, although TFC would be 
treated under paragraph (b)(2) of this section as owning $80x (40% x 
$200x) of the LTS1 loan to LTS2, under paragraph (c)(1)(ii) of this 
section TFC does not take into account its proportionate share of an 
indirect LTS obligation and accordingly, TFC does not take into account 
$24x (30% x $80x) of the loan to LTS2. As a result, TFC's assets 
include only $56x ($80x - $24x) of the LTS1 loan to LTS2. Furthermore, 
although TFC would be treated under paragraph (b)(2) of this section as 
receiving $2x (40% x $5x) of the interest received by LTS1 from LTS2, 
under paragraph (c)(2)(ii) of this section TFC does not take into 
account its proportionate share of interest with respect to an indirect 
LTS obligation and thus, TFC does not take into account $0.60x (30% x 
$2x) of the interest received by LTS1. Accordingly, TFC's income 
includes only $1.40x ($2x - $0.60x) of the interest from LTS2. 
Furthermore, TFC's assets include $2x (40% x $5x) of LTS1's cash 
received from LTS2.
    (iv) Example 4--(A) Facts. TFC directly owns 80% of the value of 
LTS1 stock on each of the measuring dates, and thus is treated under 
paragraph (b)(1) of this section as owning 80% of LTS1's assets on each 
of the measuring dates. TFC also directly owns 50% of the value in FPS 
on each of the measuring dates. LTS1's assets include the remaining 50% 
of the value in FPS and a loan to FPS with a balance of $500x on each 
of the measuring dates. FPS's assets include a loan to TFC with a 
balance of $1000x on each of the measuring dates. During the first 
measuring period of the taxable year, FPS received $30x of interest 
from TFC, and LTS1 received $15x of interest from FPS, both of which 
were paid in cash. During the last measuring period of the taxable 
year, FPS received $80x of income from an unrelated person in cash and 
distributed $60x of such income in cash to TFC and LTS1 in proportion 
to their interests in FPS.
    (B) Results. Under paragraph (c)(1)(i) and (ii) of this section, 
for purposes of applying section 1297(a), TFC's assets do not include 
the stock of LTS1, the interests in FPS owned by TFC directly and 
through LTS1, any of the loan by FPS to TFC, or any of the loan by LTS1 
to FPS. Similarly, under paragraph (c)(2)(i) and (ii) of this section, 
TFC's income does not include any of the $30x of interest received by 
FPS from TFC, any of the $15x of interest received by LTS1 from FPS, or 
any of the $60x of distributions received by TFC and LTS1 from FPS. 
However, on each of the measuring dates, TFC's assets include $27x 
((50% x $30x) + (80% x 50% x $30x)) of the $30 of cash received by FPS 
from TFC and $12x (80% x $15x) of the $15x of cash received by LTS1 
from FPS. Moreover, on the last measuring date of the taxable year, 
TFC's assets include $18x ((50% x $20x) + (80% x 50% x $20x)) of the 
$20x ($80x-$60x) of cash received by FPS from the unrelated person and 
retained by FPS and $54x ((50% x $60x) + (80% x 50% x $60x)) of the 
$60x cash received by FPS from the unrelated person and distributed. 
Furthermore, TFC's income includes $72x ((50% x $80x) + (80% x 50% x 
$80x)) of the $80x of income received by FPS from an unrelated person.
    (v) Example 5--(A) Facts. TFC directly owns 80% of the value of the 
stock of LTS1 and 60% of the value of the stock of LTS2 on each of the 
measuring dates, and thus is treated under paragraph (b)(1) of this 
section as owning 80% of LTS1's assets and 60% of LTS2's assets on each 
of the measuring dates. TFC's assets include a license for the use of 
its intangible property by LTS1 with a value of $5,000x on each of the 
measuring dates, LTS1's assets include a sub-license of such license to 
LTS2 with a value of $2,000x on each of the measuring dates, and LTS2's 
assets include a lease of its building to LTS1 with a value of $4,000x 
on each of the measuring dates. LTS1 and LTS2 each use the intangible 
property that is the subject of the license and sub-license in its 
respective trade or business, and LTS1 uses the building in its trade 
or business. During the last quarter of the taxable year, TFC received 
a royalty of $500x from LTS1 with respect to the license, and LTS1 
received a royalty of $200x from LTS2 with respect to the sub-license, 
both of which were paid in cash. LTS2 received $100x of rent paid in 
cash from LTS1 during each quarter of the taxable year with respect to 
the building lease.
    (B) Results--(1) Asset test. Under paragraph (c) of this section, 
for purposes of applying section 1297(a)(2) to TFC's final measuring 
period, the following analysis applies. TFC's assets do not include the 
stock of LTS1 and LTS2. Similarly, TFC's assets include only $1,000x 
($5,000x license - (80% x $5,000x)) of the license to LTS1. However, 
TFC's assets include the entire $500x of cash it received from LTS1 as 
a result of the royalty. Moreover, although TFC would be treated under 
paragraph (b)(2) of this section as owning $1,600x (80% x $2,000x) of 
the LTS1 sub-license to LTS2, under paragraph (c)(1)(ii) of this 
section TFC does not take into account its proportionate share of an 
indirect LTS obligation, and accordingly TFC

[[Page 4567]]

does not take into account $960x (60% x $1,600x) of LTS1's sub-license 
to LTS2. As a result, TFC's assets include $640x ($1,600x - $960x) of 
the sub-license. In addition, TFC's assets include $160x (80% x $200x) 
of LTS1's cash received from LTS2 as a result of the royalty to LTS1. 
Similarly, although TFC would be treated under paragraph (b)(2) of this 
section as owning $2,400x (60% x $4,000x) of the LTS2 lease to LTS1, 
under paragraph (c)(1)(ii) of this section TFC does not take into 
account $1,920x (80% x $2,400x) of the LTS2 building lease, and 
accordingly, its assets include $480x ($2,400x - $1,920x) of the lease. 
TFC's assets also include $240x (60% x $100x x 4) of LTS2's cash 
received from LTS1 as a result of the rental payment to LTS2.
    (2) Income test. Under paragraph (c)(2)(ii) of this section, 
because TFC does not take into account its proportionate share of a 
direct LTS obligation, TFC's income includes only $100x ($500x royalty 
- (80% x $500x)) of the royalties from LTS1. Furthermore, although TFC 
would be treated under paragraph (b)(2) of this section as receiving 
$160x (80% x $200x) of the royalty received by LTS1 from LTS2, under 
paragraph (c)(2)(ii) of this section TFC does not take into account its 
proportionate share of royalties derived with respect to an indirect 
LTS obligation, and accordingly TFC does not take into account $96x 
(60% x $160x) of the royalty received by LTS1. As a result, TFC's 
income includes only $64x ($160x - $96x) of the royalty from LTS2. 
Similarly, although TFC would be treated under paragraph (b)(2) of this 
section as receiving $240x (60% x $100x x 4) of the rent received by 
LTS2 from LTS1, under paragraph (c)(2)(ii) of this section TFC does not 
take into account its proportionate share of rent derived with respect 
to an indirect LTS obligation, and accordingly TFC does not take into 
account $192x (80% x $240) of the rent received by LTS2. Therefore, 
TFC's income includes only $48 ($240x - $192x) of the rent received 
from LTS1.
    (3) Treatment of intangible and rental property. For purposes of 
determining whether the intangible property that TFC owns and the 
building that TFC is treated as owning under paragraph (b)(2) of this 
section is held in the production of passive income, the activities 
performed by TFC and its qualified affiliates with respect to the 
property are taken into account under paragraphs (c)(1)(ii) and (e) of 
this section. Because TFC is the common parent of the affiliated group 
(as determined under paragraph (e)(2) of this section) that includes 
LTS1 and LTS2, LTS1 and LTS2 are qualified affiliates of TFC and the 
activities of their officers and employees with respect to the 
intangible property and building are taken into account to determine 
whether the building and intangible property would be treated as 
passive assets.
    (d) Related person determination for purposes of section 
1297(b)(2)(C)--(1) General rule. For purposes of section 1297(b)(2)(C), 
interest, dividends, rents or royalties received or accrued by a look-
through subsidiary (and treated as received directly by a tested 
foreign corporation pursuant to section 1297(c) and paragraph (b)(2) of 
this section) are considered received or accrued from a related person 
only if the payor of the interest, dividend, rent or royalty is a 
related person (within the meaning of section 954(d)(3)) with respect 
to the look-through subsidiary, taking into account Sec.  1.1297-
1(c)(1)(i)(D). Similarly, for purposes of 1297(b)(2)(C), interest, 
dividends, rents or royalties received or accrued by a look-through 
partnership (and treated as received directly by a tested foreign 
corporation pursuant to paragraph (b)(3) of this section) are 
considered received or accrued from a related person only if the payor 
of the interest, dividend, rent or royalty is a related person (within 
the meaning of section 954(d)(3)) with respect to the look-through 
partnership, taking into account Sec.  1.1297-1(c)(1)(i)(D).
    (2) Example. The following example illustrates the rule of this 
paragraph (d).
    (i) Facts. USP is a domestic corporation that owns 30% of TFC. TFC 
directly owns 30% of the value of FS1 stock, and thus under paragraph 
(b) of this section is treated as owning 30% of FS1's assets and 
earning 30% of FS1's gross income. The remaining FS1 stock is owned by 
an unrelated foreign person. FS1 directly owns 60% of the vote of FS2 
stock and 20% of the value of FS2 stock. The remaining vote and value 
of FS2 stock are owned by an unrelated foreign person. TFC, FS1, and 
FS2 are foreign corporations that are not controlled foreign 
corporations within the meaning of section 957(a). FS1 receives a $100x 
dividend from FS2.
    (ii) Results. Pursuant to section 1297(c) and paragraph (b)(2) of 
this section, TFC is treated as receiving directly $30x of the dividend 
income received by FS1. FS2 is a related person (within the meaning of 
section 954(d)(3)) with respect to FS1 for purposes of section 
1297(b)(2)(C) because FS1 owns more than 50% of the vote of FS2. FS2 is 
not a related person (within the meaning of section 954(d)(3)) with 
respect to TFC for purposes of section 1297(b)(2)(C) because TFC 
indirectly does not own more than 50% of the vote or value of the FS2 
stock. Under paragraph (d)(1) of this section, for purposes of 
determining whether the dividend income received by FS1 is subject to 
the exception in section 1297(b)(2)(C) for purposes of testing the PFIC 
status of TFC, the dividend is treated as received from a related 
person because FS1 and FS2 are related persons within the meaning of 
section 1297(b)(2)(C). Therefore, to the extent the dividend income 
received by FS1 would be properly allocable to income of FS2 that is 
not passive income, the dividend income that TFC is treated as 
receiving under section 1297(c) and paragraph (b)(2)(ii) of this 
section is treated as non-passive income (as defined in Sec.  1.1297-
1(f)(4)).
    (e) Treatment of activities of certain look-through subsidiaries 
and look-through partnerships for purposes of certain exceptions--(1) 
General rule. An item of income received by a tested foreign 
corporation (including an amount treated as received or accrued 
pursuant to section 1297(c) and paragraph (b)(2) or (b)(3) of this 
section) that would be passive income in the hands of the entity that 
actually received or accrued it is not passive if the item would be 
excluded from foreign personal holding company income under the 
following exceptions contained in section 954(c) that are based on 
whether the entity is engaged in the active conduct of a trade or 
business, determined by taking into account the activities performed by 
the officers and employees of the tested foreign corporation as well as 
activities performed by the officers and employees of any qualified 
affiliate of the tested foreign corporation--
    (i) Section 954(c)(1)(B) and Sec.  1.954-2(e)(1)(ii) and (3)(ii), 
(iii) and (iv);
    (ii) Section 954(c)(1)(C) and Sec.  1.954-2(f)(1)(ii) and 
(2)(iii)(D);
    (iii) Section 954(c)(1)(D) and Sec.  1.954-2(g)(2)(ii);
    (iv) Section 954(c)(2)(A) and Sec.  1.954-2(b)(6), (c), and (d);
    (v) Section 954(c)(2)(B) and Sec.  1.954-2(b)(2); and
    (vi) Section 954(c)(2)(C) and Sec.  1.954-2(h)(3)(ii).
    (2) Qualified affiliate. The term qualified affiliate means a 
corporation or a partnership that is included in an affiliated group 
that includes the tested foreign corporation. For purposes of this 
paragraph (e), the term affiliated group has the meaning provided in 
section 1504(a), except that--
    (i) The affiliated group is determined without regard to sections 
1504(a)(2)(A), (b)(2) and (b)(3);

[[Page 4568]]

    (ii) Subject to paragraph (e)(2)(iii) of this section, a 
partnership is treated as an includible corporation;
    (iii) The common parent of the affiliated group is not a domestic 
corporation or domestic partnership;
    (iv) Section 1504(a)(2)(B) is applied by substituting ``more than 
50 percent'' for ``at least 80 percent'';
    (v) A foreign corporation or foreign partnership must be the common 
parent of the affiliated group;
    (vi) Subject to paragraph (e)(2)(vii) of this section, a 
partnership is included as a member of the affiliated group if more 
than 50 percent of the value of its capital interests or profits 
interests is owned by one or more corporations or partnerships that are 
included in the affiliated group; and
    (vii) A corporation or a partnership that is not the common parent 
of an affiliated group is included in the affiliated group only if it 
would be a look-through subsidiary or look-through partnership, as 
applicable, of the common parent if the common parent were a tested 
foreign corporation.
    (3) Examples. The following examples illustrate the rule of this 
paragraph (e).
    (i) Example 1--(A) Facts. USP is a domestic corporation that 
directly owns 20% of the outstanding stock of FS1. The remaining 80% of 
the outstanding stock of FS1 is directly owned by a foreign person that 
is not related to USP. FS1 directly owns 100% of the value of the 
outstanding stock of FS2 and directly owns 80% of the value of the 
outstanding stock of FS3. The remaining 20% of the value of the 
outstanding stock of FS3 is directly owned by a foreign person that is 
not related to USP. FS2 directly owns 80% of the value of the 
outstanding stock of FS4. The remaining 20% of the value of the 
outstanding stock of FS4 is directly owned by a foreign person that is 
not related to USP. FS1, FS2, FS3 and FS4 are all organized in Country 
A and are not controlled foreign corporations within the meaning of 
section 957(a). FS4 owns real property that is leased to a person that 
is not a related person, but does not perform any activities. FS1 and 
FS2 also do not perform any activities. Officers and employees of FS3 
in Country A perform activities with respect to the real property of 
FS4 that, if performed by officers or employees of FS4, would allow the 
rental income in the hands of FS4 to qualify for the exception from 
foreign personal holding company income in section 954(c)(2)(A) and 
Sec.  1.954-2(b)(6) and (c)(1)(ii).
    (B) Results--(1) Qualified affiliates. FS1 is the common parent of 
the affiliated group (as determined under paragraph (e)(2) of this 
section) that includes FS2, FS3, and FS4 because (i) FS1 owns more than 
50% by value of FS2 and FS3, (ii) FS2 owns more than 50% by value of 
FS4, and (iii) FS2, FS3, and FS4 would be look-through subsidiaries 
with respect to FS1 if FS1 were the tested foreign corporation. 
Accordingly, each of FS1, FS2, FS3 and FS4 are qualified affiliates (as 
determined under paragraph (e)(2) of this section) with respect to the 
other members of the group for purposes of determining whether FS1, 
FS2, FS3, or FS4 is a PFIC .
    (2) FS1 and FS2. Under this paragraph (e), for purposes of 
determining whether the rental income actually received by FS4 with 
respect to the real property owned and rented by FS4 and treated under 
section 1297(c) and paragraph (b)(2) of this section as received 
directly by FS1 or by FS2, respectively, is passive income for purposes 
of section 1297, the activities of FS3 are taken into account because 
FS3 is a qualified affiliate of FS1 and FS2, respectively. Thus, the 
exception in section 954(c)(2)(A) would apply, and the rental income 
treated as received by FS1 or by FS2, respectively, would be treated as 
non-passive income for purposes of determining whether FS1 or FS2 is a 
PFIC.
    (3) FS4. Under this paragraph (e), for purposes of determining 
whether the rental income received by FS4 with respect to the real 
property owned and rented by FS4 is passive income for purposes of 
section 1297, the activities of FS3 are taken into account, because FS3 
is a qualified affiliate of FS4. Thus, the exception in section 
954(c)(2)(A) would apply, and the rental income received by FS4 would 
be treated as non-passive income for purposes of determining whether 
FS4 is a PFIC.
    (ii) Example 2--(A) Facts. The facts are the same as in paragraph 
(e)(3)(i)(A) of this section (the facts in Example 1), except that FS2 
also owns real property that is leased to a person that is not a 
related person, and the officers and employees of FS2 in Country A 
engage in activities that would allow rental income received by FS2 
with respect to its real property to qualify for the exception in 
section 954(c)(2)(A) and Sec.  1.954-2(b)(6) and (c)(1)(iv), relying on 
the rule in Sec.  1.954-2(c)(2)(ii) that provides that an organization 
is substantial in relation to rents if active leasing expenses equal or 
exceed 25% of adjusted leasing profit. However, the active leasing 
expenses of FS1 are less than 25% of its adjusted leasing profit, which 
includes the rental income of FS4 treated as received directly by FS1 
as well as the rental income of FS2 treated as received directly by 
FS1.
    (B) Results. Because FS2's rental income constitutes non-passive 
income as a result of the application of Sec.  1.1297-1(c)(1)(i)(A) and 
section 954(c)(2)(A), it is treated as non-passive income that FS1 is 
treated as receiving directly under section 1297(c) and paragraph 
(b)(2) of this section for purposes of determining whether FS1 is a 
PFIC, and accordingly, it is not necessary to rely on paragraph (e) of 
this section.
    (iii) Example 3--(A) Facts. The facts are the same as in paragraph 
(e)(3)(i)(A) of this section (the facts in Example 1), except that USP 
directly owns 60% of the outstanding stock of FS1.
    (B) Results. Under paragraph (e)(2)(iii) of this section, USP 
cannot be the common parent of an affiliated group for purposes of 
paragraph (e)(2) of this section because it is a domestic corporation. 
Because FS1 is a foreign corporation, FS1 may be the common parent of 
an affiliated group for purposes of paragraph (e)(2) of this section. 
The results therefore are the same as in paragraph (e)(3)(i)(B) of this 
section (the results in Example 1).
    (f) Gain on disposition of a look-through subsidiary or look-
through partnership--(1) [Reserved].
    (2) Amount of gain taken into account from disposition of look-
through subsidiary. For purposes of section 1297(a)(1), section 
1298(b)(3), and Sec.  1.1298-2, the amount of gain that is taken into 
account by a tested foreign corporation from the tested foreign 
corporation's direct disposition of stock of a look-through subsidiary, 
or an indirect disposition resulting from the disposition of stock of a 
look-through subsidiary by other look-through subsidiaries or by look-
through partnerships, is the residual gain. The residual gain equals 
the total gain recognized by the tested foreign corporation (including 
gain treated as recognized by the tested foreign corporation pursuant 
to section 1297(c) and paragraph (b)(2) or (b)(3) of this section) from 
the disposition of the stock of the look-through subsidiary reduced 
(but not below zero) by unremitted earnings. Unremitted earnings are 
the excess (if any) of the aggregate income (if any) taken into account 
by the tested foreign corporation pursuant to section 1297(c) and 
paragraph (b)(2) or (b)(3) of this section with respect to the stock of 
the disposed-of look-through subsidiary (including with respect to any 
other look-through subsidiary, to the extent it is owned by the tested 
foreign corporation indirectly through the disposed-of look-through 
subsidiary) over the aggregate dividends (if any)

[[Page 4569]]

received by the tested foreign corporation from the disposed-of look-
through subsidiary with respect to the stock, determined without regard 
to paragraph (c)(2)(i) of this section. For purposes of this paragraph 
(f)(2), the amount of gain derived from the disposition of stock of a 
look-through subsidiary and income of and dividends received from the 
look-through subsidiary is determined on a share-by-share basis under a 
reasonable method.
    (3) Characterization of residual gain as passive income. For 
purposes of section 1297(a)(1), section 1298(b)(3), and Sec.  1.1298-2, 
the residual gain from the direct or indirect disposition of stock of a 
look-through subsidiary is characterized as passive income or non-
passive income based on the relative amounts of passive assets and non-
passive assets (as defined in Sec.  1.1297-1(f)(5) and (3), 
respectively) of the disposed-of look-through subsidiary (and any other 
look-through subsidiary to the extent owned indirectly through the 
look-through subsidiary) treated as held by the tested foreign 
corporation on the date of the disposition of the look-through 
subsidiary. For the purpose of this paragraph (f)(3), the relative 
amounts of passive assets and non-passive assets held by the look-
through subsidiary are measured under the same method (value or 
adjusted bases) used to measure the assets of the tested foreign 
corporation for purposes of section 1297(a)(2).
    (4) Gain taken into account from disposition of 25%-owned 
partnerships and look-through partnerships--(i) Section 954(c)(4) 
partnerships. The amount of gain derived from a tested foreign 
corporation's direct or indirect (through a look-through subsidiary or 
look-through partnership) disposition of partnership interests in a 
partnership described in section 954(c)(4) (treating the tested foreign 
corporation as if it were a controlled foreign corporation) that is 
taken into account by the tested foreign corporation for purposes of 
section 1297(a)(1), section 1298(b)(3), and Sec.  1.1298-2 is 
determined under section 954(c)(4).
    (ii) Look-through partnerships. In the case of a look-through 
partnership that is not described in paragraph (f)(4)(i) of this 
section, the principles of paragraphs (f)(2) and (f)(3) of this section 
apply to determine the amount and characterization of gain derived from 
a tested foreign corporation's direct or indirect (through a look-
through subsidiary or look-through partnership) disposition of 
partnership interests of the look-through partnership that is taken 
into account by the tested foreign corporation for purposes of section 
1297(a)(1), section 1298(b)(3), and Sec.  1.1298-2.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (f). For purposes of the examples in this paragraph (f)(5), 
USP is a domestic corporation, TFC and FS are foreign corporations that 
are not controlled foreign corporations within the meaning of section 
957(a), and USP, TFC, and FS each has a single class of stock with 100 
shares outstanding and a calendar taxable year.
    (i) Example 1--(A) Facts. USP owned 30% of the outstanding stock of 
TFC throughout Years 1, 2, 3, and 4. In Year 1, TFC purchased 5 shares 
of FS stock, representing 5% of the stock of FS, from an unrelated 
person. On the first day of Year 3, TFC purchased 20 shares of FS 
stock, representing 20% of the stock of FS, from an unrelated person. 
TFC owned 25% of the outstanding stock of FS throughout Years 3 and 4. 
Before Year 3, TFC did not include any amount in income with respect to 
FS under section 1297(c)(2). During Years 3 and 4, for purposes of 
section 1297(a)(1), TFC included in income, in the aggregate, $40x of 
income with respect to FS under section 1297(c) and paragraph (b)(2) of 
this section. TFC did not receive dividends from FS during Year 1, 2, 
3, or 4. For purposes of section 1297(a)(2), TFC measures its assets 
based on their fair market value as provided under section 1297(e). On 
the last day of Year 4, TFC recognizes a loss with respect to the sale 
of 5 shares of FS stock, and a $110x gain with respect to the sale of 
20 shares of FS stock. On the date of the sale, FS owns non-passive 
assets with an aggregate fair market value of $150x, and passive assets 
with an aggregate fair market value of $50x.
    (B) Results. For purposes of applying section 1297(a)(1) to TFC for 
Year 4, TFC must take into account $78x of residual gain, as provided 
by paragraph (f)(2) of this section, which equals the amount by which 
the $110x gain recognized on the sale of 20 shares in FS exceeds the 
aggregate pro rata share of $32x income ($40x x 20/25) taken into 
account by TFC with respect to the 20 shares in FS under section 
1297(c) and paragraph (b)(2) of this section during Years 3 and 4. 
There is zero residual gain on the sale of 5 shares of FS stock because 
they were sold at a loss. Under paragraph (f)(3) of this section, 
$58.50x of the residual gain is non-passive income ($78x x ($150x/
$200x)) and $19.50x is passive income ($78x x ($50x/$200x)).
    (ii) Example 2--(A) Facts. The facts are the same as in paragraph 
(f)(5)(i)(A) of this section (the facts in Example 1), except that in 
Year 1, TFC purchased 15 shares of FS stock, representing 15% of the 
stock of FS, from an unrelated person, and on the first day of Year 3, 
TFC purchased an additional 15 shares of FS stock, representing 15% of 
the stock of FS, from an unrelated person, and on the last day of Year 
4, TFC recognizes gain of $10x of the sale of 15 shares of FS stock 
purchased in Year 1, and gain of $60x on the sale of the other 15 
shares of FS stock purchased in Year 3.
    (B) Results. For purposes of applying section 1297(a)(1) to TFC for 
Year 4, TFC must take into account $40x of residual gain with respect 
to the 15 shares acquired in Year 3, as provided by paragraph (f)(2) of 
this section, which equals the amount by which the $60x gain recognized 
on the sale of those 15 shares exceeds the aggregate pro rata share of 
$20x income ($40x x 15/30) taken into account by TFC with respect to 
those 15 shares in FS under section 1297(c)(2) during Years 3 and 4. 
There is zero residual gain on the sale of the 15 shares of FS stock 
acquired in Year 1 because the $10x of gain does not exceed the 
aggregate pro rata share of $20x income taken into account by TFC with 
respect to those 15 shares of FS under section 1297(c) and paragraph 
(b)(2) of this section. Under paragraph (f)(3) of this section, $30x of 
the residual gain is non-passive income ($40x x ($150x/$200x)) and $10x 
is passive income ($40x x ($50x/$200x)).
    (iii) Example 3--(A) Facts. The facts are the same as in paragraph 
(f)(5)(ii)(A) of this section (the facts in Example 2), except that TFC 
received, in the aggregate, $20x of dividends from FS during Year 2.
    (B) Results. The results are the same as in paragraph (f)(5)(ii)(B) 
of this section (the results in Example 2) with respect to the 15 
shares acquired in Year 3 ($40x of residual gain attributable to the 15 
shares acquired in Year 3). For purposes of applying section 1297(a)(1) 
to TFC for Year 4, TFC must also take into account $10x of residual 
gain with respect to the 15 shares acquired in Year 1. As provided by 
paragraph (f)(2) of this section, the residual gain equals the amount 
by which the $10x gain recognized on the sale of those 15 shares 
exceeds the unremitted earnings with respect to those shares. The 
unremitted earnings with respect to the 15 shares acquired in Year 1 
are $0x, the amount by which the pro rata share of aggregate income 
($20x) taken into account by TFC with respect to those 15 shares of FS 
stock under section 1297(c) and paragraph (b)(2) of this section in 
Years 3 and 4 exceeds the aggregate pro rata amount of dividends with 
respect to those 15 shares of FS stock ($20x)

[[Page 4570]]

received by TFC from FS in Year 2. Total residual gain therefore is 
$50x ($40x + $10x). Under paragraph (f)(3) of this section, $37.50x of 
the residual gain is non-passive income ($50x x ($150x/$200x)) and 
$12.50x is passive income ($50x x ($50x/$200x)).
    (g) Definitions. The following definitions apply for purposes of 
Sec.  1.1297-1 and this section:
    (1) Direct LTS obligation. The term direct LTS obligation has the 
meaning provided in paragraph (c)(1)(ii) of this section.
    (2) Indirect LTS obligation. The term indirect LTS obligation has 
the meaning provided in paragraph (c)(1)(ii) of this section.
    (3) Look-through subsidiary. The term look-through subsidiary 
means, with respect to a tested foreign corporation, a corporation as 
to which the asset test of paragraph (g)(3)(i) and the income test of 
paragraph (g)(3)(ii) of this section are satisfied on each measuring 
date during the taxable year of a tested foreign corporation. If a 
corporation satisfies both the asset test of paragraph (g)(3)(i) and 
the income test of paragraph (g)(3)(ii)(B) for some but not all 
measuring periods within the taxable year of a tested foreign 
corporation, the subsidiary is treated as a look-through subsidiary 
only for those measuring periods in which both tests are satisfied.
    (i) For purposes of section 1297(a)(2) and paragraph (b)(2)(i) of 
this section, a corporation at least 25 percent of the value of the 
stock of which is owned (as determined under paragraph (b)(1) of this 
section) by the tested foreign corporation on the measuring date (as 
defined in Sec.  1.1297-1(f)(1));
    (ii) For purposes of section 1297(a)(1), either--
    (A) For the taxable year, a corporation with respect to which the 
average percentage ownership (which is equal to the percentage 
ownership (by value) (as determined under paragraph (b)(1) of this 
section) on each measuring date during the taxable year, divided by the 
number of measuring dates in the year) by the tested foreign 
corporation during the tested foreign corporation's taxable year is at 
least 25 percent; or
    (B) For a measuring period (as defined in Sec.  1.1297-1(f)(2)), a 
corporation at least 25 percent of the value of the stock of which is 
owned (as determined under paragraph (b)(1) of this section) by the 
tested foreign corporation on the measuring date, provided all items of 
gross income of the corporation for each of the measuring periods in 
the taxable year for which the tested foreign corporation owns at least 
25 percent of the value (as determined under paragraph (b)(1) of this 
section) on the relevant measuring dates can be established; and
    (iii) For purposes of paragraph (f) of this section and Sec.  
1.1298-2, a corporation at least 25 percent of the value of the stock 
of which is owned (as determined under paragraph (b)(1) of this 
section) by the tested foreign corporation immediately before the 
disposition of stock of the corporation.
    (4) Look-through partnership--(i) In general. The term look-through 
partnership means, with respect to a tested foreign corporation--
    (A) A partnership that would be a look-through subsidiary (as 
defined in paragraph (g)(3) of this section) if such partnership were a 
corporation; or
    (B) A partnership that is not described in paragraph (g)(4)(i)(A) 
of this section, if the tested foreign corporation satisfies both of 
the active partner tests set forth in paragraphs (g)(4)(ii)(A) and (B) 
of this section on the measurement date or for the taxable year, as 
applicable, unless an election is made under paragraph (g)(4)(iii) of 
this section.
    (ii) Active partner test--(A) Partnership interest under asset 
test. For purposes of paragraph (b)(3)(i) of this section, paragraph 
(g)(4)(i)(B) of this section applies for the measuring period only if 
the tested foreign corporation would not be a PFIC if section 
1297(a)(1) and (2) and the regulations thereunder were applied to the 
tested foreign corporation without regard to any partnership interest 
owned by the tested foreign corporation that is not a partnership 
described in paragraph (g)(4)(i)(A) of this section. For purposes of 
the preceding sentence, the active partner test is applied on the 
measurement date (as defined in Sec.  1.1297-1(f)(1)).
    (B) Partnership income under income test. For purposes of paragraph 
(b)(3)(ii) of this section, paragraph (g)(4)(i)(B) of this section 
applies for the taxable year of the tested foreign corporation or for a 
measuring period (as defined in Sec.  1.1297-1(f)(2)), as applicable, 
only if the tested foreign corporation would not be a PFIC if section 
1297(a)(1) and (2) and the regulations thereunder were applied to the 
tested foreign corporation without regard to any partnership interest 
owned by the tested foreign corporation that is not a partnership 
described in paragraph (g)(4)(i)(A) of this section. For purposes of 
the preceding sentence, the active partner test is applied on the 
measuring date (as defined in Sec.  1.1297-1(f)(1)) or for the taxable 
year, as applicable using the same period that was used under paragraph 
(g)(3)(ii) of this section.
    (iii) Election. For any taxable year, an election may be made with 
respect to a partnership described in paragraph (g)(4)(i)(B) of this 
section to not apply the provisions of this paragraph (g)(4) to such 
partnership.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (g)(4). For purposes of the examples in this paragraph 
(g)(4)(iv), TFC is a foreign corporation that is not a controlled 
foreign corporation; FC1 and FC2 are foreign corporations that are not 
controlled foreign corporations; FPS is a foreign partnership; TFC owns 
100% of the single class of stock of FC1 and FC2; FC2 owns 10% of the 
value of FPS, and the remaining 90% of FPS is owned by an unrelated 
foreign person; and TFC, FC1, FC2, and FPS are all calendar year 
taxpayers.
    (A) Example 1--(1) Facts. During Year 1, FC1 generated $100x of 
non-passive income, FC2 generated $150x of non-passive income, and FPS 
generated $50x of income. On all of the measurement dates in Year 1, 
FC1 has assets with a value of $1000x that FC1 uses in its trade or 
business generating non-passive income, FC2 has assets with a value of 
$1500x that FC2 uses in its trade or business generating non-passive 
income, and FPS has assets with a value of $500x.
    (2) Results--(i) Active partner test with respect to partnership 
interest. Pursuant to section 1297(c) and Sec.  1.1297-2(b)(2), TFC is 
treated as holding directly the assets held by FC1 and FC2. For 
purposes of the active partner test under paragraph (g)(4)(ii)(B) of 
this section, TFC does not take into account its interest in FPS to 
determine whether it would be a PFIC. Because 100% ($2500x/$2500x) of 
the assets of FC1 and FC2 that TFC is treated as directly holding, 
without taking into account the interest in FPS, generates non-passive 
income, TFC satisfies the active partner test in paragraph 
(g)(4)(ii)(B) of this section.
    (ii) Active partner test with respect to partnership income. 
Pursuant to section 1297(c) and paragraph (b)(2) of this section, TFC 
is treated as if it received directly its proportionate share of income 
of FC1 and FC2. For purposes of the active partner test under paragraph 
(g)(4)(ii)(A) of this section, TFC does not take into account its 
interest in FPS to determine whether it would be a PFIC. Because 100% 
($250x/$250x) of the income of FC1 and FC2 that TFC is treated as 
directly receiving, without taking into account the interest in FPS, is 
non-passive income, TFC satisfies the active partner test in paragraph 
(g)(4)(ii)(A) of this section with respect to the income of FPS.
    (iii) Qualification of look-through partnership. For purposes of 
paragraph

[[Page 4571]]

(b)(3) of this section, FPS qualifies as a look-through partnership 
because TFC satisfies the active partner tests of both paragraphs 
(g)(4)(i)(A) and (B) of this section. Unless an election is made not to 
treat FPS as a look-through partnership under paragraph (g)(4)(iii) of 
this section, TFC is treated as receiving directly $5x of income (10% x 
$50x), TFC's pro rata share of the income of FPS, the character of 
which is determined at the level of FPS for purposes of section 1297. 
In addition, TFC is treated as holding directly $50x of FPS's assets 
(10% x $500x), TFC's proportionate share of the assets held by FPS. The 
character of those assets as passive or non-passive is determined in 
the hands of FPS for purposes of section 1297.
    (B) Example 2--(1) Facts. During Year 1, FC1 generated $50x of 
passive income, FC2 earned $175x of non-passive income, and FPS 
generated $50x of income. On all of the measurement dates in Year 1, 
FC1 has assets with a value of $1100x that produce passive income, and 
FC2 has assets with a value of $900x that FC2 uses in its trade or 
business generating non-passive income. The value of FPS is $1000x 
taking into account its assets and liabilities.
    (2) Results--(i) Active partner test with respect to partnership 
interest. Pursuant to section 1297(c) and Sec.  1.1297-2(b)(2), TFC is 
treated as holding directly the assets held by FC1 and FC2. For 
purposes of the active partner test under paragraph (g)(4)(ii)(B) of 
this section, TFC does not take into account its interest in FPS to 
determine whether it would be a PFIC. Accordingly, 55% ($1100x/$2000x) 
of the assets that TFC is treated as directly holding, without taking 
into account the interest in FPS, generate passive income.
    (ii) Active partner test with respect to partnership income. 
Pursuant to section 1297(c) and Sec.  1.1297-2(b)(2), TFC is treated as 
if it received directly its proportionate share of income of FC1 and 
FC2. For purposes of the active partner test under paragraph 
(g)(4)(ii)(A) of this section, TFC does not take into account its 
interest in FPS to determine whether it would be a PFIC. Accordingly, 
77.8% ($175x/$225x) of the income that TFC is treated as directly 
receiving, without taking into account the interest in FPS, is non-
passive income.
    (iii) Failure to qualify as look-through partnership. TFC satisfies 
the active partner test in paragraph (g)(4)(ii)(A) of this section but 
does not satisfy the active partner test in paragraph (g)(4)(ii) (B) of 
this section. Therefore, FPS does not qualify as a look-though 
partnership. Under paragraph (b)(3)(iii) of this section, TFC's share 
of income with respect to FPS is treated as passive income for purposes 
of section 1297 and TFC's $100x interest (10% x $1000x) in FPS is 
treated as a passive asset for purposes of section 1297.
    (5) LTS debt. The term LTS debt has the meaning provided in 
paragraph (c)(1)(ii) of this section.
    (6) LTS lease. The term LTS lease has the meaning provided in 
paragraph (c)(1)(ii) of this section.
    (7) LTS license. The term LTS license has the meaning provided in 
paragraph (c)(1)(ii) of this section.
    (8) LTS obligation. The term LTS obligation has the meaning 
provided in paragraph (c)(1)(ii) of this section.
    (9) LTS stock. The term LTS stock has the meaning provided in 
paragraph (c)(1)(i) of this section.
    (10) Qualified affiliate. The term qualified affiliate has the 
meaning provided in paragraph (e)(2) of this section.
    (11) Residual gain. The term residual gain has the meaning provided 
in paragraph (f)(2) of this section.
    (12) TFC obligation. The term TFC obligation has the meaning 
provided in paragraph (c)(1)(ii) of this section.
    (13) Unremitted earnings. The term unremitted earnings has the 
meaning provided in paragraph (f)(2) of this section.
    (h) Applicability date. The rules of this section apply to taxable 
years of shareholders beginning on or after January 14, 2021. A 
shareholder may choose to apply such rules for any open taxable year 
beginning before January 14, 2021, provided that, with respect to a 
tested foreign corporation, the shareholder consistently applies the 
provisions of Sec.  1.1291-1(b)(8)(iv) and (b)(8)(v)(A), (B), (C), and 
(D) and Sec. Sec.  1.1297-1 (except that consistent treatment is not 
required with respect to Sec.  1.1297-1(c)(1)(i)(A)), 1.1298-2, and 
1.1298-4 for such year and all subsequent years.

0
Par. 6. Sections 1.1297-4, 1.1297-5, and 1.1297-6 are added to read as 
follows:


Sec.  1.1297-4  Qualifying insurance corporation.

    (a) Scope. This section provides rules for determining whether a 
foreign corporation is a qualifying insurance corporation for purposes 
of section 1297(f). Paragraph (b) of this section provides the general 
rule for determining whether a foreign corporation is a qualifying 
insurance corporation. Paragraph (c) of this section describes the 25 
percent test in section 1297(f)(1)(B). Paragraph (d) of this section 
contains rules for applying the alternative facts and circumstances 
test in section 1297(f)(2). Paragraph (e) of this section contains 
rules limiting the amount of applicable insurance liabilities for 
purposes of the 25 percent test described in paragraph (c) of this 
section and the alternative facts and circumstances test described in 
paragraph (d) of this section. Paragraph (f) of this section provides 
definitions that apply for purposes of this section. Paragraph (g) of 
this section provides the applicability date of this section.
    (b) Qualifying insurance corporation. For purposes of section 
1297(b)(2)(B), this section, and Sec. Sec.  1.1297-5 and 1.1297-6, with 
respect to a U.S. person, a qualifying insurance corporation (QIC) is a 
foreign corporation that--
    (1) Is an insurance company as defined in section 816(a) that would 
be subject to tax under subchapter L if the corporation were a domestic 
corporation; and
    (2) Satisfies--
    (i) The 25 percent test described in paragraph (c) of this section; 
or
    (ii) The requirements for an election to apply the alternative 
facts and circumstances test as described in paragraph (d) of this 
section and a United States person has made an election as described in 
paragraph (d)(5) of this section.
    (c) 25 percent test. A foreign corporation satisfies the 25 percent 
test if the amount of its applicable insurance liabilities exceeds 25 
percent of its total assets. This determination is made on the basis of 
the applicable insurance liabilities and total assets reported on the 
corporation's applicable financial statement for the applicable 
reporting period.
    (d) Election to apply the alternative facts and circumstances 
test--(1) In general. A United States person that owns stock in a 
foreign corporation that fails to qualify as a QIC solely because of 
the 25 percent test may elect to treat the stock of the corporation as 
stock of a QIC if the foreign corporation--
    (i) Is predominantly engaged in an insurance business as described 
in paragraph (d)(2) of this section;
    (ii) Failed to satisfy the 25 percent test solely due to runoff-
related circumstances, as described in paragraph (d)(3) of this 
section, or rating-related circumstances, as described in paragraph 
(d)(4) of this section; and
    (iii) Reports an amount of applicable insurance liabilities that is 
at least 10 percent of the amount of the total assets on the 
corporation's applicable financial

[[Page 4572]]

statement for the applicable reporting period.
    (2) Predominantly engaged in an insurance business--(i) In general. 
A foreign corporation is not considered predominantly engaged in an 
insurance business in any taxable year unless more than half of the 
business of the foreign corporation is the issuing of insurance or 
annuity contracts or the reinsuring of risks underwritten by insurance 
companies. This determination is made based on the character of the 
business actually conducted in the taxable year. The fact that a 
foreign corporation has been holding itself out as an insurer for a 
long period is not determinative of whether the foreign corporation is 
predominantly engaged in an insurance business.
    (ii) Facts and circumstances. Facts and circumstances to consider 
in determining whether a foreign corporation is predominantly engaged 
in an insurance business include (but are not limited to)--
    (A) Claims payment patterns for the current year and prior years;
    (B) The foreign corporation's loss exposure as calculated for a 
regulator or for a credit rating agency, or, if those are not 
calculated, for internal pricing purposes;
    (C) The percentage of gross receipts constituting premiums for the 
current and prior years; and
    (D) The number and size of insurance contracts issued or taken on 
through reinsurance by the foreign corporation.
    (iii) Examples of facts indicating a foreign corporation is not 
predominantly engaged in an insurance business. Examples of facts that 
may indicate a foreign corporation is not predominantly engaged in an 
insurance business include (but are not limited to)--
    (A) A small overall number of insured risks with low likelihood but 
large potential costs;
    (B) Employees and agents of the foreign corporation focused to a 
greater degree on investment activities than underwriting activities; 
and
    (C) Low loss exposure.
    (3) Runoff-related circumstances. During the annual reporting 
period covered by the applicable financial statement, a foreign 
corporation fails to satisfy the 25 percent test solely due to runoff-
related circumstances only if the corporation--
    (i) Was engaged in the process of terminating its pre-existing, 
active conduct of an insurance business (within the meaning of section 
1297(b)(2)(B)) under the supervision of its applicable insurance 
regulatory body or pursuant to any court-ordered receivership 
proceeding (liquidation, rehabilitation, or conservation) and fails to 
satisfy the 25 percent test because the corporation is required to hold 
additional assets due to its business being in runoff;
    (ii) Has no plan or intention to enter into, and did not issue or 
enter into, any insurance, annuity, or reinsurance contract, other than 
a contractually obligated renewal of an existing insurance contract or 
a reinsurance contract pursuant to and consistent with the termination 
of its active conduct of an insurance business; and
    (iii) Made payments during the annual reporting period covered by 
the applicable financial statement as required to satisfy claims under 
insurance, annuity, or reinsurance contracts.
    (4) Rating-related circumstances. A foreign corporation fails to 
satisfy the 25 percent test solely due to rating-related circumstances 
only if--
    (i) The 25 percent test is not met due to capital and surplus 
amounts that a generally recognized credit rating agency considers 
necessary for the foreign corporation to obtain a public rating with 
respect to its financial strength, and the foreign corporation 
maintains such capital and surplus in order to obtain the minimum 
credit rating necessary for the annual reporting period by the foreign 
corporation to be able to write the business in its regulatory or board 
supervised business plan. This paragraph (c)(4)(i) applies only if the 
foreign corporation is a mortgage insurance company (as defined in 
paragraph (f)(10) of this section) or if more than half of the foreign 
corporation's net written premiums for the annual reporting period (or 
the average of the net written premiums for the foreign corporation's 
annual reporting period and the two immediately preceding annual 
reporting periods) are from insurance coverage against the risk of loss 
from a catastrophic loss event (that is, a low frequency but high 
severity loss event); or
    (ii) The foreign corporation is a financial guaranty insurance 
company (as defined in paragraph (f)(5) of this section).
    (5) Election--(i) In general. A United States person may make the 
election under section 1297(f)(2) for its taxable year if the foreign 
corporation directly provides the United States person a statement, 
signed by a responsible officer of the foreign corporation or an 
authorized representative of the foreign corporation, or the foreign 
corporation (or its foreign parent corporation on its behalf) makes a 
publicly available statement (such as in a public filing, disclosure 
statement, or other notice provided to United States persons that are 
shareholders of the foreign corporation) that it satisfied the 
requirements of section 1297(f)(2) and paragraph (d)(1) of this section 
during the foreign corporation's applicable reporting period. However, 
a United States person may not rely upon any statement by the foreign 
corporation (or its foreign parent corporation) to make the election 
under section 1297(f)(2) if the shareholder knows or has reason to know 
based on reasonably accessible information that the statement made by 
the foreign corporation (or its foreign parent corporation) was 
incorrect.
    (ii) Information provided by foreign corporation. In addition to a 
statement that the foreign corporation satisfied the requirements of 
section 1297(f)(2) and paragraph (d)(1) of this section, the statement 
described in paragraph (d)(5)(i) of this section also must include:
    (A) The ratio of applicable insurance liabilities to total assets 
for the applicable reporting period; and
    (B) A statement indicating whether the failure to satisfy the 25 
percent test described in paragraph (c) of this section was the result 
of runoff-related or rating-related circumstances, along with a brief 
description of those circumstances.
    (iii) Time and manner for making the election. Except as provided 
in paragraph (d)(5)(iv), the election described in paragraph (d)(1) of 
this section may be made by a United States person who owns stock in 
the foreign corporation by completing the appropriate part of Form 8621 
(or successor form) for each taxable year of the United States person 
in which the election applies. A United States person must attach the 
Form 8621 (or successor form) to its original or amended Federal income 
tax return for the taxable year of the United States person to which 
the election relates. A United States person can attach the Form 8621 
(or successor form) to an amended return for the taxable year of the 
United States person to which the election relates if the United States 
person can demonstrate the reason for not filing the form with its 
original return was due to reasonable cause.
    (iv) Deemed election for small shareholders in publicly traded 
companies--(A) In general. A United States person who owns publicly 
traded stock in a foreign corporation will be deemed to make the 
election under section 1297(f)(2) with respect to the foreign 
corporation and its subsidiaries

[[Page 4573]]

if the following requirements are satisfied:
    (1) The stock of the foreign corporation that is owned by the 
United States person (including stock owned indirectly) has a value of 
$25,000 or less ($50,000 or less in the case of a joint return) on the 
last day of the United States person's taxable year and on any day 
during the taxable year on which the United States person disposes of 
stock of the foreign corporation; and
    (2) If the United States person owns stock of the foreign 
corporation indirectly through a domestic partnership, domestic trust, 
domestic estate, or S corporation (a domestic pass-through entity), the 
stock of the foreign corporation that is owned by the domestic pass-
through entity has a value of $25,000 or less on the last day of the 
taxable year of the domestic pass-through entity that ends with or 
within the United States person's taxable year and on any day during 
the taxable year of the domestic pass-through entity on which it 
disposes of stock of the foreign corporation.
    (B) Publicly traded stock. For the purpose of paragraph 
(d)(5)(iv)(A) of this section, stock is publicly traded if it would be 
treated as marketable stock within the meaning of section 1296(e) and 
Sec.  1.1296-2 (without regard to Sec.  1.1296-2(d)) if the election 
under section 1297(f)(2) is not made.
    (v) Options. If a United States person is considered to own stock 
in a foreign corporation by reason of holding an option, the United 
States person may make the election under section 1297(f)(2) (or may be 
deemed to make an election under paragraph (d)(5)(iv) of this section) 
with respect to the foreign corporation or its subsidiaries in the same 
manner as if the United States person owned stock in the foreign 
corporation.
    (6) Stock ownership. For purposes of this section, ownership of 
stock in a foreign corporation means either direct ownership of such 
stock or indirect ownership determined using the rules specified in 
Sec.  1.1291-1(b)(8).
    (e) Rules limiting the amount of applicable insurance liabilities--
(1) In general. For purposes of determining whether a foreign 
corporation satisfies the 25 percent test described in paragraph (c) of 
this section or the 10 percent test described in paragraph (d)(1)(iii) 
of this section, the rules of this paragraph (e) apply to limit the 
amount of applicable insurance liabilities of the foreign corporation.
    (2) General limitation on applicable insurance liabilities. The 
amount of applicable insurance liabilities may not exceed any of the 
amounts described in paragraphs (e)(2)(i) to (iii) of this section. 
This paragraph (e)(2) applies after applying paragraph (e)(3) of this 
section.
    (i) The amount of applicable insurance liabilities of the foreign 
corporation shown on any financial statement that the foreign 
corporation filed or was required to file with its applicable insurance 
regulatory body for the financial statement's applicable reporting 
period;
    (ii) If the foreign corporation's applicable financial statement is 
prepared on the basis of either GAAP or IFRS, the amount of the foreign 
corporation's applicable insurance liabilities determined on the basis 
of its applicable financial statement, whether or not the foreign 
corporation files the statement with its applicable insurance 
regulatory body; or
    (iii) The amount of applicable insurance liabilities required for 
the foreign corporation by the applicable law or regulation of the 
jurisdiction of the applicable insurance regulatory body at the end of 
the applicable reporting period (or a lesser amount of applicable 
insurance liabilities, if the foreign corporation is holding a lesser 
amount as a permitted practice of the applicable regulatory body).
    (3) Discounting. If an applicable financial statement or a 
financial statement described in paragraph (e)(2) of this section is 
prepared on the basis of an accounting method other than GAAP or IFRS 
and does not discount applicable insurance liabilities on an 
economically reasonable basis, the amount of applicable insurance 
liabilities may not exceed the amount of applicable insurance 
liabilities on the financial statement reduced by applying the 
discounting methods that would apply under either GAAP or IFRS to the 
insurance or annuity contracts to which the applicable insurance 
liabilities at issue relate. The foreign corporation may choose whether 
to apply either GAAP or IFRS discounting methods for this purpose.
    (4) [Reserved].
    (5) [Reserved].
    (f) Definitions. The following definitions apply for purposes of 
this section.
    (1) Applicable financial statement. The term applicable financial 
statement means the foreign corporation's financial statement prepared 
for financial reporting purposes, listed in paragraphs (f)(1)(i) 
through (iii) of this section, and that has the highest priority. The 
financial statements are, in order of descending priority--
    (i) GAAP statements. A financial statement that is prepared in 
accordance with GAAP;
    (ii) IFRS statements. A financial statement that is prepared in 
accordance with IFRS; or
    (iii) Regulatory annual statement. A financial statement required 
to be filed with the applicable insurance regulatory body.
    (iv) [Reserved].
    (2) Applicable insurance liabilities--(i) In general. The term 
applicable insurance liabilities means, with respect to any life or 
property and casualty insurance business--
    (A) Reported losses (which are expected payments to policyholders 
for sustained losses related to insured events under an insurance 
contract that have occurred and have been reported to, but not paid by, 
the insurer as of the financial statement end date), and incurred but 
not reported losses (which are expected payments to policyholders for 
sustained losses relating to insured events under an insurance contract 
that have occurred but have not been reported to the insurer as of the 
financial statement end date);
    (B) Unpaid loss adjustment expenses (including reasonable estimates 
of anticipated loss adjustment expenses) associated with investigating, 
defending, settling, and adjusting paid losses, unpaid reported losses, 
and incurred but not reported losses (of the type described in 
paragraph (f)(2)(i)(A) of this section) as of the financial statement 
end date; and
    (C) The aggregate amount of reserves (excluding deficiency, 
contingency, or unearned premium reserves) held as of the financial 
statement end date to mature or liquidate potential, future claims for 
death, annuity, or health benefits that may become payable under 
contracts providing, at the time the reserve is computed, coverage for 
mortality or morbidity risks;
    (D) Provided, however, that--
    (1) No item or amount shall be taken into account more than once in 
determining applicable insurance liabilities;
    (2) The applicable insurance liabilities eligible to be taken into 
account in applying this paragraph (f)(2) include only the applicable 
insurance liabilities of the foreign corporation whose QIC status is 
being determined; and
    (3) [Reserved].
    (ii) Amounts not specified in paragraph (f)(2)(i) of this section. 
Amounts not specified in paragraph (f)(2)(i) of this section are not 
applicable insurance liabilities. For example, the term applicable 
insurance liability does

[[Page 4574]]

not include any amount held by an insurance company as a deposit 
liability that is not an insurance liability, such as a funding 
agreement, a guaranteed investment contract, premium or other deposit 
funds, structured settlements, or any other substantially similar 
contract issued by an insurance company. The term applicable insurance 
liabilities also does not include the amount of any reserve for a life 
insurance or annuity contract the payments of which do not depend on 
the life or life expectancy of one or more individuals.
    (3) Applicable insurance regulatory body. The term applicable 
insurance regulatory body means the entity that has been established by 
law to license or authorize a corporation to engage in an insurance 
business, to regulate insurance company solvency, and, in the case of 
an applicable financial statement described in paragraph (f)(1)(iii), 
is the entity to which the applicable financial statement is provided.
    (4) Applicable reporting period. The term applicable reporting 
period is the last annual reporting period for a financial statement 
ending with or within the taxable year of a U.S. person owning stock in 
a foreign corporation, within the meaning of paragraph (d)(6) of this 
section.
    (5) Financial guaranty insurance company. The term financial 
guaranty insurance company means any insurance company whose sole 
business is to insure or reinsure only the type of business written by, 
or that would be permitted to be written by a company licensed under, 
and compliant with, a U.S. state law, modeled after the Financial 
Guaranty Insurance Guideline as established by National Association of 
Insurance Companies, that specifically governs the licensing and 
regulation of financial guaranty insurance companies.
    (6) Financial statements--(i) In general. The term financial 
statement means a statement prepared for a legal entity for a reporting 
period in accordance with the rules of a financial accounting or 
statutory accounting standard that includes a complete balance sheet, 
statement of income, and a statement of cash flows (or equivalent 
statements under the applicable reporting standard).
    (ii) [Reserved].
    (iii) [Reserved].
    (7) Generally accepted accounting principles or GAAP. The term 
generally accepted accounting principles or GAAP means United States 
generally accepted accounting principles described in standards 
established and made effective by the Financial Accounting Standards 
Board.
    (8) Insurance business. For purposes of this section, Sec.  1.1297-
5, and Sec.  1.1297-6, insurance business means the business of issuing 
insurance and annuity contracts and the reinsuring of risks 
underwritten by insurance companies, together with those investment 
activities and administrative services that are required to support (or 
are substantially related to) insurance, annuity, or reinsurance 
contracts issued or entered into by the foreign corporation.
    (9) International financial reporting standards or IFRS. The term 
international financial reporting standards or IFRS means accounting 
standards established and made effective by the International 
Accounting Standards Board.
    (10) Mortgage insurance company. For purposes of this section, 
mortgage insurance company means any insurance company whose sole 
business is to insure or reinsure against a lender's loss of all or a 
portion of the principal amount of a mortgage loan upon default of the 
mortgagor.
    (11) Total assets. For purposes of section 1297(f) and this 
section, a foreign corporation's total assets are the aggregate value 
of the real property and personal property that the foreign corporation 
reports on its applicable financial statement as of the financial 
statement end date.
    (g) Applicability date. The rules of this section apply to taxable 
years of shareholders beginning on or after January 14, 2021. A 
shareholder may choose to apply such rules for any open taxable year 
beginning after December 31, 2017 and before January 14, 2021, provided 
that, with respect to a tested foreign corporation, it consistently 
applies the provisions of this section and Sec.  1.1297-6 for such year 
and all subsequent years.


Sec.  1.1297-5  [Reserved].


Sec.  1.1297-6  Exception from the definition of passive income for 
active insurance income.

    (a) Scope. This section provides rules pertaining to the exception 
from passive income under section 1297(b)(2)(B) for income derived in 
the active conduct of an insurance business and rules related to 
certain income of a qualifying domestic insurance corporation. 
Paragraph (b) of this section provides a general rule that excludes 
from passive income certain income of a qualifying insurance 
corporation (QIC), as defined in Sec.  1.1297-4(b), and certain income 
of a qualifying domestic insurance corporation. Paragraph (c) of this 
section provides rules excluding certain assets for purposes of the 
passive asset test under section 1297(a)(2). Paragraph (d) of this 
section provides rules concerning the treatment of income and assets of 
certain look-through subsidiaries and look-through partnerships of a 
QIC. Paragraph (e) of this section provides rules relating to 
qualifying domestic insurance corporations. Paragraph (f) of this 
section provides the applicability date of this section.
    (b) Exclusion from passive income of active insurance income. For 
purposes of section 1297 and Sec.  1.1297-1, passive income does not 
include--
    (1) Income that a QIC derives in the active conduct of an insurance 
business (within the meaning of section 1297(b)(2)(B)); and
    (2) Income of a qualifying domestic insurance corporation.
    (c) Exclusion of assets for purposes of the passive asset test 
under section 1297(a)(2). For purposes of section 1297 and Sec.  
1.1297-1, passive assets (as defined in Sec.  1.1297-1(f)(5)), do not 
include--
    (1) Assets of a QIC available to satisfy liabilities of the QIC 
related to its insurance business (as defined in Sec.  1.1297-4(f)(8)), 
if the QIC is engaged in the active conduct of an insurance business 
(within the meaning of section 1297(b)(2)(B)); and
    (2) Assets of a qualifying domestic insurance corporation.
    (d) Treatment of income and assets of certain look-through 
subsidiaries and look-through partnerships for purposes of the section 
1297(b)(2)(B) exception--(1) General rule. For purposes of applying 
paragraphs (b)(1) and (c)(1) of this section, a QIC is treated as 
receiving the income or holding the assets of a look-through subsidiary 
or look-through partnership to the extent provided in section 1297(c) 
and Sec.  1.1297-2(b)(2) or Sec.  1.1297-2(b)(3). Subject to the 
limitation of paragraph (d)(2) of this section, a QIC's proportionate 
share of the income or assets of a look-through subsidiary or look-
through partnership may be treated as earned or held directly by the 
QIC, and thus as non-passive under paragraphs (b)(1) and (c)(1) of this 
section, if the requirements of those paragraphs are satisfied.
    (2) Limitation. A QIC that is engaged in the active conduct of an 
insurance business (within the meaning of section 1297(b)(2)(B)) may 
not treat its proportionate share of the income or assets of a look-
through subsidiary or look-through partnership as non-passive to the 
extent that it exceeds the greater of--

[[Page 4575]]

    (i) The QIC's proportionate share of the income or assets, 
respectively, of the look-through subsidiary or look-through 
partnership multiplied by a fraction, the numerator of which is the net 
equity value of the interests held by the QIC in the look-through 
subsidiary or look-through partnership, and the denominator of which is 
the value of the QIC's proportionate share of the assets of the look-
through subsidiary or look-through partnership; and
    (ii) The QIC's proportionate share of the income or assets, 
respectively, of the look-through subsidiary or look-through 
partnership that are treated as non-passive in the hands of the look-
through subsidiary or look-through partnership.
    (3) Examples. The following examples illustrate the rules of this 
section.
    (i) Example 1: QIC holds all the stock of an investment 
subsidiary--(A) Facts.
    (1) F1 is a foreign corporation. In Year 1, F1 meets the definition 
of a QIC under section 1297(f) and Sec.  1.1297-4 and is engaged in the 
active conduct of an insurance business within the meaning of section 
1297(b)(2)(B). Throughout Year 1, F1 owns all the stock of F2, a 
foreign corporation that is not a QIC and is engaged solely in the 
investment of passive assets. The stock of F2 is an asset that is 
available to satisfy liabilities of F1 related to its insurance 
business within the meaning of paragraph (c)(1) of this section. The 
assets of F1 are measured on the basis of value under Sec.  1.1297-
1(d)(1)(v)(C).
    (2) Throughout Year 1, F2 owns assets with a value of $1,000x and 
adjusted bases of $500x, all of which are treated as passive in the 
hands of F2. F2 has outstanding debt with a principal amount of $250x. 
On the financial statement end date of F1's applicable financial 
statement, the net equity value of the F2 stock held by F1 is $750x. In 
Year 1, F2 earned $100x of income that is treated as passive in the 
hands of F2.
    (B) Result--(1) Because F1 owns all of the stock of F2, F2 is a 
look-through subsidiary of F1 within the meaning of Sec.  1.1297-
2(g)(3). Under section 1297(c) and Sec.  1.1297-2(b)(2), F1 is treated 
as if it held 100% of the assets of F2 and received directly 100% of 
the income of F2. Under paragraph (d)(1) of this section, because F1 is 
engaged in the active conduct of an insurance business and the stock of 
F2 is an asset that is available to satisfy the insurance liabilities 
of F1, F1 treats its proportionate share of the income and assets of F2 
as non-passive. The amount of income and assets that is treated as non-
passive is subject to the limitation of paragraph (d)(2) of this 
section.
    (2) Under paragraph (d)(2) of this section, the amount of F1's 
proportionate share of F2's income that is treated as non-passive 
cannot exceed the greater of two amounts: $75x, which is F1's 
proportionate share of F2's income ($100x) multiplied by 75% (the net 
equity value of the F2 stock held by F1, which is $750x, divided by the 
value of F1's proportionate share of F2's assets, which is $1,000x); 
and zero, which is F1's proportionate share of the income of F2 that is 
treated as non-passive in the hands of F2. Therefore, for the purpose 
of characterizing F1's proportionate share of F2's income, $75x is 
treated as non-passive, and $25x is treated as passive.
    (3) Under paragraph (d)(2) of this section, the amount of F1's 
proportionate share of F2's assets that is treated as non-passive 
cannot exceed the greater of two amounts: $750x, which is F1's 
proportionate share of F2's assets ($1,000x) multiplied by 75% (the net 
equity value of the F2 stock held by F1, which is $750x, divided by the 
value of F1's proportionate share of F2's assets, which is $1,000x); 
and zero, which is F1's proportionate share of the assets of F2 that 
are treated as non-passive in the hands of F2. Therefore, for the 
purpose of characterizing F1's proportionate share of the assets of F2, 
$750x is treated as non-passive, and $250x is treated as passive.
    (C) Alternative facts--(1) Facts. The facts are the same as in 
paragraph (d)(3)(i)(A) of this section (paragraph (A) of this Example 
1), except that the assets of F1 are measured on the basis of adjusted 
basis under Sec.  1.1297-1(d)(1)(v)(C) pursuant to a valid election 
under Sec.  1.1297-1(d)(1)(iii).
    (2) Result. The result with respect to F1's proportionate share of 
the income of F2 is the same as in paragraph (d)(3)(i)(B)(2) of this 
section (paragraph (B)(2) of this Example 1). Because the assets of F1 
are measured on the basis of adjusted basis under Sec.  1.1297-
1(d)(1)(v)(C), F1's proportionate share of the passive assets of F2 is 
equal to $500x (100% of $500x adjusted bases). Under paragraph (d)(2) 
of this section, the amount of F1's proportionate share of F2's assets 
that may be treated as non-passive cannot exceed the greater of two 
amounts: $375x, which is F1's proportionate share of F2's passive 
assets ($500x) multiplied by 75% (the net equity value of the F2 stock 
held by F1, which is $750x, divided by the value of F1's proportionate 
share of F2's assets, which is $1,000x); and zero, which is F1's 
proportionate share of the assets of F2 that are treated as non-passive 
in the hands of F2. Therefore, for the purpose of characterizing F1's 
proportionate share of the assets of F2, $375x is treated as non-
passive, and $125x is treated as passive.
    (ii) Example 2: QIC holds all the stock of an operating 
subsidiary--(A) Facts.
    (1) F1 is a foreign corporation. In Year 1, F1 meets the definition 
of a QIC under section 1297(f) and Sec.  1.1297-4 and is engaged in the 
active conduct of an insurance business within the meaning of section 
1297(b)(2)(B). Throughout Year 1, F1 owns all the stock of F2, a 
foreign corporation engaged in a manufacturing business that is not a 
QIC. The stock of F2 is an asset that is available to satisfy 
liabilities of F1 related to its insurance business within the meaning 
of paragraph (c)(1) of this section. The assets of F1 are measured on 
the basis of value under Sec.  1.1297-1(d)(1)(v)(C).
    (2) Throughout Year 1, F2 owns assets with a value of $1,200x, of 
which $1,000x is treated as non-passive and $200x is treated as passive 
in the hands of F2. F2 has outstanding debt of $600x. On the financial 
statement end date of F1's applicable financial statement, the net 
equity value of the F2 stock held by F1 is $600x. In Year 1, F2 earned 
$120x of income, of which, in the hands of F2, $100x is treated as non-
passive and $20x is treated as passive.
    (B) Result--(1) Because F1 owns all the stock of F2, F2 is a look-
through subsidiary of F1 within the meaning of Sec.  1.1297-2(g)(3). 
Under section 1297(c) and Sec.  1.1297-2(b)(2), F1 is treated as if it 
held 100% of the assets of F2 and received directly 100% of the income 
of F2. Under paragraph (d)(1) of this section, because F1 is engaged in 
the active conduct of an insurance business and the stock of F2 is an 
asset that is available to satisfy the insurance liabilities of F1, F1 
treats its proportionate share of the income and assets of F2 as non-
passive. The amount of income and assets that is treated as non-passive 
is subject to the limitation of paragraph (d)(2) of this section.
    (2) Under paragraph (d)(2) of this section, the amount of F1's 
proportionate share of F2's income that is treated as non-passive 
cannot exceed the greater of two amounts: $60x, which is F1's 
proportionate share of F2's income ($120x) multiplied by 50% (the net 
equity value of the F2 stock held by F1, which is $600x, divided by the 
value of F1's proportionate share of F2's assets, which is $1,200x); 
and $100x, which is F1's proportionate share of the income of F2 that 
is treated as non-passive in the hands of F2. Therefore, for the 
purpose of characterizing F1's proportionate share of F2's income, 
$100x is treated as non-passive, and $20x is treated as passive.

[[Page 4576]]

    (3) Under paragraph (d)(2) of this section, the amount of F1's 
proportionate share of F2's assets that is treated as non-passive 
cannot exceed the greater of two amounts: $600x, which is F1's 
proportionate share of F2's income ($1,200x) multiplied by 50% (the net 
equity value of the F2 stock held by F1, which is $600x, divided by the 
value of F1's proportionate share of F2's assets, which is $1,200x); 
and $1,000x, which is F1's proportionate share of the assets of F2 that 
are treated as non-passive in the hands of F2. Therefore, for the 
purpose of characterizing F1's proportionate share of the assets of F2, 
$1,000x is treated as non-passive, and $200x is treated as passive.
    (e) Qualifying domestic insurance corporation--(1) General rule. A 
domestic corporation (or a foreign corporation that is treated as a 
domestic corporation pursuant to a valid section 953(d) election and 
that computes its reserves as a domestic insurance company would under 
subchapter L) is a qualifying domestic insurance corporation if it is--
    (i) Subject to tax as an insurance company under subchapter L of 
the Internal Revenue Code;
    (ii) Subject to federal income tax on its net income; and
    (iii) A look-through subsidiary of a tested foreign corporation.
    (2) [Reserved].
    (3) [Reserved].
    (f) Applicability date. The rules of this section apply to taxable 
years of shareholders beginning on or after January 14, 2021. A 
shareholder may choose to apply such rules for any open taxable year 
beginning after December 31, 2017 and before January 14, 2021, provided 
that, with respect to a tested foreign corporation, it consistently 
applies the provisions of this section and Sec.  1.1297-4, for such 
year and all subsequent years.

0
Par. 7. Section 1.1298-0 is amended by:
0
1. Revising the introductory text.
0
2. Adding entries for Sec. Sec.  1.1298-2 and 1.1298-4 in numerical 
order.
    The revision and additions read as follows:


Sec.  1.1298-0  Passive foreign investment company--table of contents.

    This section contains a listing of the paragraph headings for 
Sec. Sec.  1.1298-1, 1.1298-2, 1.1298-3, and 1.1298-4.
* * * * *
Sec.  1.1298-2 Rules for certain corporations changing businesses.

    (a) Overview.
    (b) Change of business exception.
    (c) Special rules.
    (d) Disposition of stock in a look-through subsidiary or 
partnership interests in a look-through partnership.
    (e) Application of change of business exception.
    (f) Examples.
    (1) Example 1.
    (i) Facts.
    (ii) Results.
    (2) Example 2.
    (i) Facts.
    (ii) Results.
    (g) Applicability date.
* * * * *
1.1298-4 Rules for certain foreign corporations owning stock in 25-
percent-owned domestic corporations.
    (a) Overview.
    (b) Treatment of certain foreign corporations owning stock in a 
25-percent-owned domestic corporation.
    (1) General rule.
    (2) Qualified stock and second-tier domestic corporation.
    (c) Indirect ownership of stock through a partnership.
    (d) Section 531 tax.
    (1) Subject to section 531 tax.
    (2) Waiver of treaty benefits.
    (i) Tested foreign corporation that files, or is required to 
file, a Federal income tax return.
    (ii) Tested foreign corporation that is not required to file a 
Federal income tax return.
    (e) Anti-abuse rule.
    (1) General rule.
    (2) [Reserved].
    (3) [Reserved].
    (f) Applicability date.

0
Par. 8. Section 1.1298-2 is added to read as follows:


Sec.  1.1298-2  Rules for certain corporations changing businesses.

    (a) Overview. This section provides rules under section 1298(b)(3) 
and 1298(g) that apply to certain foreign corporations that dispose of 
one or more active trades or businesses for purposes of determining 
whether a foreign corporation is treated as a passive foreign 
investment company (PFIC). Paragraph (b) of this section provides a 
rule that applies to certain foreign corporations that dispose of one 
or more active trades or businesses. Paragraph (c) of this section 
provides special rules. Paragraph (d) of this section provides a rule 
for the treatment of the disposition of the stock of a look-through 
subsidiary (as defined in Sec.  1.1297-2(g)(3)) or partnership 
interests in a look-through partnership (as defined in Sec.  1.1297-
2(g)(4)). Paragraph (e) of this section provides guidance on when a 
tested foreign corporation can apply the change of business exception. 
Paragraph (f) provides examples illustrating the application of the 
rules in this section. Paragraph (g) provides the applicability date 
for this section.
    (b) Change of business exception. A corporation is not treated as a 
PFIC for a taxable year if--
    (1) Neither the corporation (nor any predecessor) was a PFIC for 
any prior taxable year;
    (2) Either--
    (i) Substantially all of the passive income of the corporation for 
the taxable year is attributable to proceeds from the disposition of 
one or more active trades or businesses; or
    (ii) Following the disposition of one or more active trades or 
businesses, substantially all of the passive assets of the corporation 
on each of the measuring dates that occur during the taxable year and 
after the disposition are attributable to proceeds from the 
disposition; and
    (3) The corporation reasonably does not expect to be and is not a 
PFIC for either of the first two taxable years following the taxable 
year.
    (c) Special rules. The rules in this paragraph (c) apply for 
purposes of section 1298(b)(3) and this section.
    (1) Income is attributable to proceeds from the disposition of one 
or more active trades or businesses to the extent the income is derived 
from the investment of the proceeds from the disposition of assets used 
in the active trades or businesses.
    (2) Assets are attributable to proceeds from the disposition of one 
or more active trades or businesses only to the extent the assets are 
the proceeds of the disposition of assets used in the active trades or 
businesses, or are derived from the investment of the proceeds.
    (3) The determination of the existence of an active trade or 
business and whether assets are used in an active trade or business is 
made under Sec.  1.367(a)-2(d)(2), (3), and (5), except that officers 
and employees do not include the officers and employees of related 
entities as provided in Sec.  1.367(a)-2(d)(3). However, if activities 
performed by the officers and employees of a look-through subsidiary of 
a corporation (including a look-through subsidiary with respect to 
which paragraph (d) of this section applies) or of a look-through 
partnership would be taken into account by the corporation pursuant to 
Sec.  1.1297-2(e) if it applied, such activities are taken into account 
for purposes of the determination of the existence of an active trade 
or business and the determination of whether assets are used in an 
active trade or business.
    (4) In the case of a corporation that satisfies the condition in 
paragraph (b)(2)(ii) of this section, the condition in paragraph (b)(3) 
of this section is deemed to be satisfied if the corporation

[[Page 4577]]

completely liquidates by the end of the taxable year following the year 
with respect to which the tested foreign corporation applies the 
exception in paragraph (b) of this section.
    (d) Disposition of stock of a look-through subsidiary or 
partnership interests in a look-through partnership. For purposes of 
paragraph (b) of this section, the proceeds from a tested foreign 
corporation's disposition of the stock of a look-through subsidiary or 
of partnership interests in a look-through partnership are treated as 
proceeds from the disposition of a proportionate share of the assets 
held by the look-through subsidiary or look-through partnership on the 
date of the disposition, based on the method (value or adjusted bases) 
used to measure the assets of the tested foreign corporation for 
purposes of section 1297(a)(2). The proceeds attributable to assets 
used by the look-through subsidiary or look-through partnership in an 
active trade or business are treated as proceeds attributable to the 
disposition of an active trade or business.
    (e) Application of change of business exception. A tested foreign 
corporation can apply the exception in paragraph (b) of this section 
with respect to a taxable year of a disposition of an active trade or 
business or an immediately succeeding taxable year, but cannot apply 
the exception with respect to more than one taxable year for a 
disposition.
    (f) Examples. The following examples illustrate the rules of this 
section. For purposes of these examples: USP is a domestic corporation; 
TFC and FS are foreign corporations that are not controlled foreign 
corporations (within the meaning of section 957(a)); each corporation 
has outstanding a single class of stock; USP has owned its interest in 
TFC since the formation of TFC; each of USP, TFC, and FS have a 
calendar taxable year; and for purposes of section 1297(a)(2), TFC 
measures the amount of its assets based on value.
    (1) Example 1--(i) Facts. (A) USP owns 15% of the outstanding stock 
of TFC. TFC owns 30% of the outstanding stock of FS. FS operates an 
active trade or business and 100% of its assets are used in the active 
trade or business. The value of FS's non-passive assets (as defined in 
Sec.  1.1297-1(f)(3)) is $900x; the value of FS's passive assets (which 
include cash and cash equivalents) is $100x. TFC has not been treated 
as a PFIC for any taxable year before Year 1 and has no predecessor. In 
addition to holding the FS stock, TFC directly conducts its own active 
trade or business. The value of TFC's non-passive assets (other than FS 
stock) is $50x; the value of TFC's passive assets (other than FS stock 
and assets received during Year 1) is $30x. TFC earns $1x of non-
passive income (as defined in Sec.  1.1297-1(f)(4)) from its directly 
conducted active trade or business.
    (B) On January 1, Year 1, TFC sells all of its FS stock for $300x. 
The residual gain computed under Sec.  1.1297-2(f)(1) on the sale of 
the FS stock is $10x. Under Sec.  1.1297-2(f)(3), $9x of residual gain 
is characterized as non-passive income and $1x of residual gain is 
characterized as passive income. TFC earned $5x of passive income from 
the investment of the proceeds from the disposition of the FS stock 
during each quarter of Year 1, and TFC maintained those earnings ($20x 
in total) as well as the disposition proceeds in cash for the remainder 
of the year. TFC reinvests the proceeds of the FS stock sale in an 
active trade or business during Year 2, and, thus, TFC is not a PFIC in 
Year 2 and Year 3. Less than 75% of TFC's gross income in Year 1 is 
passive income (($20x + $1x)/($10x + $20x + $1x) = 68%). However, 
subject to the application of section 1298(b)(3) and this section, TFC 
would be a PFIC in Year 1 under section 1297(a)(2) because the proceeds 
from the sale of the FS stock ($300x) together with TFC's other passive 
assets exceed 50% of TFC's total assets on each quarterly measuring 
date. For example, on the first quarterly measuring date TFC's ratio of 
passive assets to total assets is (($300x + $30x + $5x)/($300x + $30x + 
$5x + $50x)) and on the fourth quarterly measuring date TFC's ratio of 
passive assets to total assets is (($300x + $30x + $20x)/($300x + $30x 
+ $20x + $50x)), each of which exceeds 87%. Therefore, TFC chooses to 
apply the change of business exception in paragraph (b) of this section 
to Year 1.
    (ii) Results. (A) Under paragraph (d) of this section, for purposes 
of applying section 1298(b)(3)(B)(i) in Year 1, TFC's proceeds from the 
disposition of the stock of FS that are attributable to assets used by 
FS in an active trade or business are considered as from the 
disposition of an active trade or business. Because 100% of FS's assets 
are used in its active trade or business, all of TFC's proceeds are 
considered as from the disposition of an active trade or business. 
Therefore, under paragraph (c)(1) of this section, the passive income 
considered attributable to proceeds from a disposition of one or more 
active trades or businesses is $20x (from investment of disposition 
proceeds). Because TFC reasonably does not expect to be a PFIC in Year 
2 and Year 3, and TFC is not, in fact, a PFIC for those years, TFC will 
not be treated as a PFIC in Year 1 by reason of section 1298(b)(3) and 
paragraph (b) of this section, based on the satisfaction of the 
condition in paragraph (b)(2)(i) of this section, because the 95% 
($20x/($20x + $1x)) of TFC's passive income for Year 1 that is 
attributable to proceeds of the disposition of FS's active trade or 
business constitutes substantially all of its passive income.
    (B) TFC would also not be treated as a PFIC in Year 1 by reason of 
section 1298(b)(3) and paragraph (b) of this section, based on the 
satisfaction of the condition in paragraph (b)(2)(ii) of this section, 
because the over 91% of TFC's passive assets on the quarterly measuring 
dates during Year 1 following the disposition of the stock of FS that 
is attributable to proceeds of the disposition of FS's active trade or 
business constitutes substantially all of its passive assets. For 
example, on the first quarterly measuring date TFC's ratio of passive 
assets attributable to the proceeds of the disposition of FS's active 
trade or business to its total passive assets is 91% ($305x/($305x + 
$30x)), and the same ratio for the fourth quarterly measuring date is 
91.4% ($320x/($320x + $30x)).
    (C) Under paragraph (e) of this section, TFC cannot claim the 
section 1298(b)(3) exception in relation to the income attributable to 
the proceeds of the FS stock sale in Year 2 because TFC already claimed 
the exception for Year 1.
    (2) Example 2--(i) Facts. The facts are the same as in paragraph 
(f)(1)(i) of this section (the facts in Example 1), except that during 
the first quarter of Year 1, TFC earned only $4x of passive income ($1x 
per quarter) from the investment of the proceeds from the disposition 
of the FS stock and earned $12x of passive income ($3x per quarter) 
from its other passive assets and maintained such earnings in cash for 
the remainder of the year.
    (ii) Results. The results are the same as in paragraph (f)(1)(ii) 
of this section (the facts in Example 1), except that under paragraph 
(c)(1) of this section, the passive income considered attributable to 
proceeds from a disposition of one or more active trades or businesses 
is $4x (from investment of disposition proceeds). Because 24% ($4x/($4x 
+ $12x + $1x)) of TFC's passive income for Year 1 is attributable to 
proceeds of the disposition of FS's active trade or business, and 24% 
does not constitute substantially all of TFC's passive income for Year 
1, TFC does not qualify for the exception from treatment as a PFIC in 
section 1298(b)(3) and paragraph (b)(2)(i) of this section for Year 1. 
However, under paragraphs (b)(2)(ii) and (d) of this section, more

[[Page 4578]]

than $300x ($300x disposition proceeds + amounts earned from investment 
of disposition proceeds) of TFC's passive assets held on each quarterly 
measuring date after the disposition is considered attributable to the 
disposition of an active trade or business. Because TFC reasonably does 
not expect to be a PFIC in Year 2 and Year 3, and TFC is not, in fact, 
a PFIC for those years, TFC will not be treated as a PFIC in Year 1 by 
reason of paragraph (b) of this section, based on the satisfaction of 
the condition in paragraph (b)(2)(ii) of this section, assuming that 
the average 89% of TFC's passive assets on the quarterly measuring 
dates during Year 1 following the disposition of the stock of FS that 
is attributable to proceeds of the disposition of FS's active trade or 
business constitutes substantially all of its passive assets.
    (g) Applicability date. The rules of this section apply to taxable 
years of shareholders beginning on or after January 14, 2021. A 
shareholder may choose to apply such rules for any open taxable year 
beginning before January 14, 2021, provided that, with respect to the 
tested foreign corporation, the shareholder consistently applies the 
provisions of this section and Sec.  1.1291-1(b)(8)(iv) and 
(b)(8)(v)(A), (B), (C), and (D) and Sec. Sec.  1.1297-1 (except that 
consistent treatment is not required with respect to Sec.  1.1297-
1(c)(1)(i)(A)), 1.1297-2, and 1.1298-4 for such year and all subsequent 
years.

0
Par. 9. Section 1.1298-4 is added to read as follows:


Sec.  1.1298-4  Rules for certain foreign corporations owning stock in 
25-percent-owned domestic corporations.

    (a) Overview. This section provides rules under section 1298(b)(7) 
that apply to certain foreign corporations that own stock in 25-
percent-owned domestic corporations (as defined in paragraph (b) of 
this section) for purposes of determining whether a foreign corporation 
is a passive foreign investment company (PFIC). Paragraph (b) of this 
section provides the general rule. Paragraph (c) of this section 
provides rules concerning ownership of 25-percent-owned domestic 
corporations or qualified stock (as defined in paragraph (b)(2) of this 
section) through partnerships. Paragraph (d) of this section provides 
rules for determining whether a foreign corporation is subject to the 
tax imposed by section 531 (the section 531 tax) and for waiving treaty 
benefits that would prevent the imposition of such tax. Paragraph (e) 
of this section provides an anti-abuse rule for the application of 
section 1298(b)(7). Paragraph (f) provides the applicability date for 
this section.
    (b) Treatment of certain foreign corporations owning stock in a 25-
percent-owned domestic corporation--(1) General rule. Except as 
otherwise provided in paragraph (e) of this section, when a tested 
foreign corporation (as defined in Sec.  1.1297-1(f)) is subject to the 
section 531 tax (or waives any benefit under any treaty that would 
otherwise prevent the imposition of the tax), and owns (directly or 
indirectly under the rules in paragraph (c) of this section) at least 
25 percent (by value) of the stock of a domestic corporation (a 25-
percent-owned domestic corporation), for purposes of determining 
whether the foreign corporation is a PFIC, any qualified stock held 
directly or indirectly under the rules in paragraph (c) of this section 
by the 25-percent-owned domestic corporation is treated as an asset 
that does not produce passive income (and is not held for the 
production of passive income), and any amount included in gross income 
with respect to the qualified stock is not treated as passive income.
    (2) Qualified stock and second-tier domestic corporation. For 
purposes of this section, the term qualified stock means any stock in a 
C corporation that is a domestic corporation and that is not a 
regulated investment company or real estate investment trust and the 
term second-tier corporation means the corporation.
    (c) Indirect ownership of stock through a partnership. For purposes 
of paragraph (b)(1) of this section, a tested foreign corporation that 
is a partner in a partnership is considered to own its proportionate 
share of any stock of a domestic corporation held by the partnership, 
and a domestic corporation that is a partner in a partnership is 
considered to own its proportionate share of any qualified stock held 
by the partnership. An upper-tier partnership's attributable share of 
the stock of a domestic corporation or of qualified stock held by a 
lower-tier partnership is treated as held by the upper-tier partnership 
for purposes of applying the rule in this paragraph (c).
    (d) Section 531 tax--(1) Subject to section 531 tax. For purposes 
of paragraph (b) of this section, a tested foreign corporation is 
considered subject to the section 531 tax regardless of whether the tax 
is imposed on the corporation and of whether the requirements of Sec.  
1.532-1(c) are met.
    (2) Waiver of treaty benefits--(i) Tested foreign corporation that 
files, or is required to file, a Federal income tax return. For 
purposes of paragraph (b) of this section, a tested foreign corporation 
that files, or is required to file, a Federal income tax return waives 
the benefit under a treaty that would otherwise prevent the imposition 
of the section 531 tax by attaching to its original or amended return 
for the taxable year for which section 1298(b)(7) and paragraph (b)(1) 
of this section are applied or any prior taxable year a statement that 
it irrevocably waives treaty protection against the imposition of the 
section 531 tax, effective for all prior, current, and future taxable 
years, provided the taxable year for which the return is filed and all 
subsequent taxable years are not closed by the period of limitations on 
assessments under section 6501.
    (ii) Tested foreign corporation that is not required to file a 
Federal income tax return. For purposes of paragraph (b) of this 
section, a tested foreign corporation that is not required to file a 
Federal income tax return waives the benefit under a treaty that would 
otherwise prevent the imposition of the section 531 tax by a date no 
later than nine months following the close of the taxable year for 
which section 1298(b)(7) and paragraph (b)(1) of this section are 
applied by--
    (A) Adopting a resolution or similar governance document that 
confirms that it has irrevocably waived any treaty protection against 
the imposition of the section 531 tax, effective for all prior, 
current, and future taxable years, and maintaining a copy of the 
resolution (or other governance document) in its records; or
    (B) In the case of a tested foreign corporation described in 
section 1297(e)(3), including in its public filings a statement that it 
irrevocably waives treaty protection against the imposition of the 
section 531 tax, effective for all prior, current, and future taxable 
years.
    (e) Anti-abuse rule--(1) General rule. Paragraph (b) of this 
section does not apply with respect to qualified stock in a second-tier 
domestic corporation owned by a 25-percent-owned domestic corporation 
if a principal purpose for the formation of, acquisition of, or holding 
of stock of the 25-percent-owned domestic corporation or the second-
tier domestic corporation, or for the capitalization or other funding 
of the second-tier domestic corporation, is to hold passive assets (as 
defined in Sec.  1.1297-1(f)(5)) through the second-tier domestic 
corporation to avoid classification of the tested foreign corporation 
as a PFIC.
    (2) [Reserved].
    (3) [Reserved].
    (f) Applicability date. The rules of this section apply to taxable 
years of shareholders beginning on or after

[[Page 4579]]

Janyuary 14, 2021. A shareholder may choose to apply such rules for any 
open taxable year beginning before January 14, 2021, provided that, 
with respect to a tested foreign corporation, the shareholder 
consistently applies the provisions of this section and Sec.  1.1291-
1(b)(8)(iv) and (b)(8)(v)(A), (B), (C), and (D) and Sec. Sec.  1.1297-1 
(except that consistent treatment is not required with respect to Sec.  
1.1297-1(c)(1)(i)(A)), 1.1297-2, and 1.1298-2 for such year and all 
subsequent years.

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
    Approved: November 19, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2020-27009 Filed 1-14-21; 8:45 am]
BILLING CODE 4830-01-P