MayJune 2008

Anti-Deferral and Anti-Tax Avoidance

By Michael J. Miller

IRS Addresses Disposition of PFIC Shares by a Foreign Trust with U.S. Beneciaries

n August 17, 2007, the IRS released a Technical Advice Memorandum (the Ruling) addressing the consequences to the U.S. beneciaries of a foreign trusts disposition of shares of a passive foreign investment company (PFIC).1 As explained below, the Ruling holds that the PFIC rules governing indirect dispositions cannot be avoided on the ground that no implementing regulations have been adopted, or by attempting to distribute the tainted trust income solely to foreign beneciaries.

Overview of the PFIC Rules

Purpose
The PFIC rules, adopted in 1986 with relatively few amendments thereafter, are intended to prevent a taxpayer from enjoying a tax deferral, or converting ordinary income into capital gain, by earning passive income through a foreign corporation.

Denition of a PFIC
A foreign corporation will be a PFIC for a taxable year (of the foreign corporation) if either (1) 75 percent or more of its gross income for the year is passive income (income test), or (2) during that year, the average percentage of its assets that produce (or are held for the production of) passive income is at least 50 percent (asset test).2 For this purpose, passive income is dened as foreign personal holding company (FPHC) income (within the meaning of Code Sec. 954(c)), subject to certain exceptions.3 FPHC income gener-

Michael J. Miller is a Partner in Roberts & Holland LLP, New York, New York.

2008 M.J. Miller

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ally includes, among other things, interest, dividends, rents, royalties, and net gains from sales of property that give rise to such passive income.4 A look-through rule applies to any subsidiary in which the foreign corporation directly or indirectly owns an interest (measured by value) of at least 25 percent.5 Code Sec. 1297(c) provides that, for purposes of determining whether a foreign corporation is a PFIC, the foreign corporation is treated as if it held its proportionate share of the assets and received directly its proportionate share of the income of such 25 percent-owned subsidiary. Thus, for example, a holding company does not become a PFIC merely because its primary (or sole) source of income consists of dividends from its 25 percentowned subsidiaries.6 In contrast with the anti-deferral rules applicable to 10 percent U.S. shareholders of a controlled foreign corporation (CFC),7 the applicability of the PFIC rules does not depend upon a particular U.S. owner (or all U.S. owners collectively) owning a specied percentage interest in the foreign corporation. that is after December 31, 1997, and during which the shareholder was a 10 percent U.S. shareholder of the CFC.12 Thus, for example, the foreign corporation would still be treated as a PFIC for any portion of the shareholders holding period preceding 1998. Due to the once a PFIC, always a PFIC rule (described below), the overlap rule generally does not allow a shareholder to escape the excess distribution regime if the rst year of the shareholders holding period in which the foreign corporation is a PFIC (rst PFIC year) is not included in the qualied portion of its holding period.13

Once a PFIC, Always a PFIC Rule

A foreign corporations status as a PFIC or non-PFIC is determined on a year by year basis, so that a foreign corporation may be a PFIC for one year but not another. The signicance of determining PFIC status year by year is relatively limited, however, due to the once a PFIC, always a PFIC rule. If a foreign corporation is a PFIC at any time during the holding period of a particular shareholder, Code Sec. 1298(b)(1) generally provides that the foreign corporation will forever be treated as a PFIC with respect to that shareholder. This rule is generally known as the once a PFIC, always a PFIC rule. If a foreign corporation has ceased to be a PFIC, but its shares are treated as PFIC shares as to a particular shareholder under the once a PFIC, always a PFIC rule, such shares are sometimes referred to as bearing a PFIC taint. In various circumstances, however, a shareholder may be permitted to make one or more of several different elections to purge the PFIC taint and thereby avoid the unfavorable excess distribution regime.

Taxation Under the Excess Distribution Regime

Shareholders of a PFIC are not required to pay tax currently on their respective shares of the PFICs income. However, a shareholder that receives an excess distribution8 from a PFIC, or disposes of any PFIC shares, is subject to tax in a manner designed to remove the benet of any deferral, and to prevent the conversion of ordinary income to capital gain. Under the excess distribution regime, the amount of such excess distribution or gain is allocated over the shareholders holding period for the stock.9 Any amounts allocable to the current year or the portion (if any) of the shareholders holding period before the foreign corporation became a PFIC are treated as ordinary income in the current year. Any remaining amounts are taxed at the highest rates applicable to ordinary income for the years to which they are allocated and, in addition, subject to an interest charge at the rate applicable to underpayments of tax.10

Elections
A shareholder of a PFIC (or former PFIC) may make various elections to avoid (or mitigate) taxation under the excess distribution regime. If a shareholder makes an election to be taxed under the qualied electing fund (QEF) regime, the shareholder is required to include in income, for each year in which the foreign corporation is a PFIC (or is treated as a PFIC as to that shareholder under the once a PFIC, always a PFIC rule), the shareholders pro rata share of the ordinary earnings and net capital gain of the foreign corporation.14 A distribution of amounts previously taxed under the QEF regime is treated as a tax-free return of capital.15 Notably, a shareholder who elects to be taxed under the QEF regime will still be subject to the excess distribution regime if the QEF election is made after the

Exception for CFC Overlap

A special overlap rule applies if the PFIC is also a CFC and if the PFIC shareholder is a 10 percent U.S. shareholder of the CFC.11 In that event, the foreign corporation is treated as not a PFIC for the qualied portion of the shareholders holding period. The qualied portion is the portion of such holding period

MayJune 2008
purposes of the PFIC rules. For example, Code Sec. rst PFIC year. If a shareholder makes the QEF election 1298(a)(2)(A) generally provides that, if a foreign for a PFIC after the rst PFIC year, then the foreign corporation directly or indirectly owns stock of a corporation is referred to as an unpedigreed QEF.16 PFIC, and a shareholder owns at least 50 percent Alternatively, a shareholder may elect to be taxed of the stock of such foreign corporation (measured under the mark to market regime if the shares of by value), stock of the PFIC will be attributed to the PFIC are considered to be marketable.17 All the shareholder (in proportion to the shareholders mark-to-market gains under the mark-to-market proportionate interest in the foreign corporation).24 regime are treated as ordinary income,18 and markto-market losses generally are allowed to the extent Pursuant to Code Sec. 1298(a)(2)(B), the 50 percent of prior mark-to-market gains.19 Shares for which the limitation, however, does not apply if the foreign corporation that owns the PFIC shares is also a PFIC.25 mark-to-market election is in effect are not subject to the excess distribution regime.20 Similarly, Code Sec. 1298(a)(3) provides that PFIC In addition, various elections may be made in cershares owned, directly or indirectly, by or for a partnertain circumstances to purge the PFIC taint from ship, estate or trust shall be considered as being owned shares of a PFIC or former PFIC. Assuming that the proportionately by its partners or beneciaries. foreign corporation does not again become a PFIC Finally, Code Sec. 1298(a)(4) provides as follows: during the shareholders holding period, the excess To the extent provided Under the excess distribution distribution regime will not in regulations, if any apply to that shareholder. regime, the amount of such excess person has an option For example, Code Sec. to purchase stock, such distribution or gain is allocated 1291(d)(2)(A) permits a stock shall be considover the shareholders holding shareholder of an unpediered as owned by such greed QEF to purge the person. For purposes of period for the stock. PFIC taint from such shares this paragraph, an option by electing to recognize to acquire such an opgain upon a deemed sale of such shares.21 The tion, and each one of a series of such options, shall be considered an option to acquire such stock.26 shareholders gain from the deemed sale is subject 22 to tax under the excess distribution regime. If the unpedigreed QEF is a CFC and the shareholder is a Pursuant to Code Sec. 1298(a)(5), these attribution 10 percent U.S. shareholder of the CFC, then, in lieu rules may be applied successively, e.g., to deal with of deemed-sale treatment, Code Sec. 1291(d)(2)(B) tiered ownership structures. permits the shareholder to elect to include in income, Indirect Dispositions and Indirect Distributions. as a dividend, an amount equal to the post-1986 Code Sec. 1298(b)(5)(A) provides the following rules earnings and prots of the foreign corporation atregarding indirect dispositions and distributions: tributable to the stock owned by such shareholder. Code Sec. 1298(b)(1) also permits a shareholder (A) In General. Under regulations, in any to make certain other purging elections that have case in which a United States person is treated nothing to do with the QEF election. These elections as owning stock in a passive foreign investment may be made to escape the excess distribution regime company by reason of subsection (a) where a foreign corporation (1) ceases to be a PFIC because it no longer satises the income test or the (i) any disposition by the United States person or asset test, or (2) ceases to be treated as a PFIC as to the person owning such stock which results in the a particular 10 percent U.S. shareholder pursuant to United States person being treated as no longer 23 the CFC overlap rule described above. owning such stock, or

Rules Applicable to Indirect Owners

Attribution Rules. Code Sec. 1298(a) provides a number of attribution rules pursuant to which a U.S. person that does not actually own PFIC shares will nevertheless be deemed to own such shares for

(ii) any distribution of property in respect of such stock to the person holding such stock, shall be treated as a disposition by, or distribution to the United States person with respect to the stock in the passive foreign investment company.

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On April 1, 1992, the Treasury Department issued proposed regulations regarding indirect dispositions and distributions. Pursuant to Proposed Reg. 1.1291-3(e), subject to very limited exceptions, an indirect shareholder of shares of a section 1291 fund, 27 would be subject to tax under the PFIC rules on any indirect disposition of such shares. For this purpose, the proposed regulations broadly define an indirect disposition to include: (1) any disposition of such PFIC shares by the actual owner, (2) any other disposition, by an indirect shareholder or any other person, of any interest in a person, if by virtue of such interest the indirect shareholder was treated as owning stock of the section 1291 fund, and (3) any other transaction as a result of which an indirect shareholders ownership of a section 1291 fund is reduced or terminated. Proposed Reg. 1.1291-3(f) similarly provides that an indirect shareholder of a Code Sec. 1291 fund will be taxed, under the excess distribution regime set forth above, on its proportionate share of any excess distribution by a PFIC to the actual owner of shares of the PFIC. These proposed regulations on indirect dispositions and distributions have never been nalized (or issued in temporary form).

Taxpayers Arguments
The taxpayers argued that the distribution to the USBs did not trigger tax under the excess distribution regime. Their grounds for such position included the following: 1. FC was not a PFIC, because the look-through rule of Code Sec. 1297(c) applies. In this regard, the taxpayers argued that the constructive ownership rules of Code Sec. 318 should apply for purposes of applying Code Sec. 1297(c) and that, under such constructive ownership rules, stock of the lower-tier foreign corporation owned by Individual A should be attributed to FC.28 Taking such additional stock into account, FC would satisfy the 25 percent threshold necessary for the look-through rule to apply. Looking through to the income and assets of the lower-tier foreign corporation, FC would have sufcient active income and active assets to avoid PFIC status. 2. The application of the PFIC rules in this situation would be contrary to Congressional intent. 3. The indirect disposition rules of Code Sec. 1298(b) (5)(A) are not self-executing. In the absence of nal (or temporary) regulations, an indirect shareholder is not subject to tax on an indirect disposition under the excess distribution regime. 4. Even if the indirect disposition rules of Code Sec. 1298(b)(5)(A) are self-executing, the distributions to the FBs cleaned out all of FTs distributable net income, so that subsequent distributions to the USBs could not constitute excess distributions.

The Ruling
Facts
The facts of the Ruling are extremely complicated, but the facts most pertinent to the discussion below may be summarized relatively briey as follows: 1. A discretionary foreign trust (FT), in which a U.S. beneciary group (the USBs) and a foreign beneciary group (the FBs) each had a 50 percent benecial interest, owned stock of a foreign corporation (FC). FCs principal asset consisted of a less-than-25 percent interest in another foreign corporation in which Individual A also owned an interest. 2. FT disposed of its FC shares pursuant to a liquidation of FC. Following such liquidation, FT distributed half of its assets to a trust formed solely for the benet of the FBs. Such distribution was not less than the amount of gain recognized by FT upon the liquidation of FC. 3. In the following year, FT distributed its remaining assets to a trust formed solely for the benet of the USBs.

IRS Analysis
Treatment of FC as a PFIC. The look-through rule of Code Sec. 1297(c) provides that if a foreign corporation owns, directly or indirectly, at least 25 percent (by value) of the stock of another corporation, for purposes of determining whether such foreign corporation is a PFIC, such foreign corporation shall be treated as if it (1) held its proportionate share of the assets of such other corporation, and (2) received directly its proportionate share of the income of such other corporation. The IRS pointed out that Code Sec. 1297(c), by its terms, applies only to stock owned directly or indirectly by the potential PFIC. The provision does not expressly incorporate the constructive ownership rules of Code Sec. 318, or any other provision, and the taxpayers argument that the applicability of such rules should somehow be implied seems quite a stretch. As stated in the Ruling: When Congress intends con-

MayJune 2008
structive ownership rules to apply, it will expressly so state. Moreover, it seems clear that the term indirect ownership (which refers solely to ownership through lower-tier foreign entities) is not itself broad enough to include constructive ownership. This is illustrated, for example, in Code Sec. 958. Code Sec. 958(a) sets forth certain direct and indirect ownership rules, while the applicable constructive ownership rules are separately stated in Code Sec. 958(b). The Ruling properly dismissed the taxpayers argument that unstated attribution rules should be read into Code Sec. 1297(c). Congressional Intent. The taxpayers represented to the IRS that the formation of FC was not for tax-deferral or tax-avoidance purposes and argued that the PFIC rules were enacted solely to target U.S. taxpayers who were intentionally investing in a foreign holding company for tax-deferral or tax-avoidance purposes. Acknowledging that the Code does not expressly set forth any tax-avoidance requirement as a condition to the application of the PFIC rules, the taxpayers cited M.A. Marsman,29 as authority for the proposition that a literal application of a statute is not appropriate when such an application is demonstrably at odds with the congressional intent underlying the enactment of that statute. The IRS properly rejected this argument. Marsman involved the application of the FPHC rules, which, prior to their repeal, required certain U.S. owners of stock in an FPHC to include in income, as a dividend, their proportionate share of any undistributed FPHC income earned by the FPHC during the taxable year.30 Marsman presented the question of whether the undistributed FPHC income for the entire year must be taken into account by a shareholder who was a nonresident alien during a portion of the year. Nothing in the statute permitted any reduction for income allocation to the nonresident portion of the year. Nevertheless, the court held that such full inclusion would have been contrary to the intent of Congress and allowed the shareholder to exclude his share of the undistributed FPHC income earned during the portion of the year during which he was a nonresident alien. Congress did not intend to reach the income of persons, such as alien nonresidents, which was not subject to the laws of the United States when it was received by them or by a holding company subject to their control.31 Marsman may or may not have been properly decided, but it is difcult to see how that case would support the argument that the PFIC rules apply solely to shareholders with an impermissible tax-avoidance motive. The Ruling properly rejected this argument, reasoning as follows: The PFIC regime was enacted to counteract the perceived advantage of tax deferral achieved by investing through a foreign holding company, regardless of whether investment through that foreign holding company was explicitly for the purpose of achieving tax deferral. See H.R. Conf. Rep. No. 99-841, 639, 641(1986) (stating that [t] he conferees believe that eliminating the economic benets of deferral is necessary to eliminate the tax advantages that U.S. shareholders in foreign investment funds have heretofore had over U.S. persons investing in domestic funds.). Intent is not a factor to be considered in applying the PFIC rules. Elimination of tax deferral is appropriate whenever the taxpayers passive investments are held in a foreign corporation so that the taxpayer does not obtain an unfair advantage over taxpayers whose investments are held domestically. Finally, it is clear from the language of section 1298(a)(3) and from its legislative history that Congress intended the PFIC regime to apply to beneciaries of a trust, despite the fact that beneciaries often have no role in the formation of a trust and no ability to control distributions from it. See Joint Comm. On Taxation, General Explanation of the Tax Reform Act of 1986, 1020, 1032 (J. Comm. Print 1987) (stating that [i]n attributing stock owned by a trust, it is intended that the general rules of subchapter J apply. That is, in the case of a grantor trust, any stock owned by the trust generally shall be attributed to the grantor of the trust, and any stock owned by a trust which is not a grantor trust shall be attributed to the beneciaries of the trust .) [Emphasis provided in the Ruling.] Indeed, the only manner in which this aspect of the Ruling might deserve criticism is for giving the taxpayers argument far more attention that it really deserved. Application of Code Sec. 1298(b)(5)(A) in the Absence of Final (or Temporary) Regulations. As noted above, Code Sec. 1298(b)(5)(A) provides as follows: (A) In General. Under regulations, in any case in which a United States person is treated as owning stock in a passive foreign investment company by reason of subsection (a)

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(i) any disposition by the United States person or the person owning such stock which results in the United States person being treated as no longer owning such stock, or (ii) any distribution of property in respect of such stock to the person holding such stock, shall be treated as a disposition by, or distribution to the United States person with respect to the stock in the passive foreign investment company. [Emphasis added.] The key phrase here is under regulations. The taxpayers argued that because Code Sec. 1298(b)(5) (A) begins with the phrase under regulations and because no nal (or temporary) regulations have been issued under that provision, the excess distribution regime cannot apply to an indirect disposition. The Ruling reached the contrary conclusion, relying on a number of cases that have deemed provisions of the Code to be self-executing in the absence of the implementing regulations called for under such provision, even when application of the statute imposes results that are not taxpayer favorable such as the imposition of a tax or the disallowance of a credit. The Ruling led off with a discussion of Pittway Corporation.32 In Pittway, the Seventh Circuit considered the applicability of Code Sec. 4662(b)(1), which provided as follows with respect to the excise tax imposed on manufacturers of taxable chemicals under Code Sec. 4661: Under regulations prescribed by the Secretary, methane or butane shall be treated as a taxable chemical only if it is used otherwise than as a fuel or in the manufacture or production of any motor fuel, diesel fuel, aviation fuel, or jet fuel (and, for purposes of section 4661(a), the person so using it shall be treated as the manufacturer thereof). [Emphasis added.] When the case was considered by the Seventh Circuit, more than 15 years after the enactment of Code Sec. 4662(b)(1), there were still no implementing regulations. In an extremely abbreviated analysis (possibly attributable to the fact that the taxpayer made its argument only in passing), the Seventh Circuit reasoned as follows: The plain meaning of legislation should be conclusive ... In this case, the language directs us to a single conclusion: that Pittway, as the user of butane, is the manufacturer responsible for the excise tax imposed on the butane. Even if there were regulations, we would have to question them if they suggested a different result.33 Therefore, the Seventh Circuit held that Pittway, which inserted butane and other ingredients into its customers trademarked containers and shipped such containers to its customers via common carrier, should be subject to the excise tax imposed under Code Sec. 4661 by reason of being considered the manufacturer of such butane under Code Sec. 4662(b)(1). Although not clearly articulated, the Seventh Circuits holding appears to be premised on the view that Congress plainly intended to treat the user of the butane as the manufacturer and that nothing that might reasonably have been included in any regulations issued under that provision would have changed this result. The Ruling also cited International MultiFoods Corporation.34 In International MultiFoods, the Tax Court, holding for the taxpayer, applied Code Sec. 865(j)(1) to source a domestic taxpayers loss on a sale of stock in the United States, notwithstanding the absence of implementing regulations under that provision. Code Sec. 865(a) provides that income realized from the sale of non-inventory personal property is generally sourced at the residence of the seller. Code Sec. 865(j)(1) provides that [t]he secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purpose of this section, including regulations relating to the treatment of losses. That provision is not terribly specic about what the regulations are supposed to provide, but the legislative history provides additional guidance. The General Explanation of the Tax Reform Act of 1986 (commonly referred to as the Bluebook) provides as follows35: The Act provides that regulations are to be prescribed by the Secretary carrying out the purposes of the Acts source rule provisions, including the application of the provisions to losses from sales of personal property * * *. It is anticipated that regulations will provide that losses from sales of personal property generally will be allocated consistently with the source of income that gains would generate but that variations of this principle may be necessary. *** Similarly, the House Report states that the residence of the seller generally is the location of much of

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the underlying activity that generates income derived from sales of personal property.36 Accordingly, the Tax Court concluded that Code Sec. 865(j) generally requires residence-based sourcing of losses, matching the residence-based sourcing of gains prescribed under Code Sec. 865(a). Noting that it was not free to ignore section 865 simply because the Secretary has delayed promulgating the appropriate regulations, and that the IRS did not provide any reason for declining to apply such general rule to the loss at issue, the Tax Court held that, even in the absence of implementing regulations, Code Sec. 865(j)(1) applied to characterize the domestic taxpayers loss as U.S.-source. Curiously, the IRS appears confused about who argued what, and who prevailed, in International MultiFoods. The Ruling erroneously indicates that the taxpayer argued that Code Sec. 865(j)(1) could not apply in the absence of implementing regulations, and that the IRS won the case when this argument was rejected, but in fact it was the other way around. It may be that the Ruling reects wishful thinking on the part of the IRS. Although not entirely apparent from the Rulings discussion of the case law, a number of cases suggest that the courts may be more inclined to view a provision of the Code as self-executing where the result provided thereunder is taxpayer-favorable. For example, in F.W. Maddox Est.,37 the Tax Court stated that in our view, the Secretary cannot deprive a taxpayer of rights which the Congress plainly intended to confer simply by failing to promulgate the required regulations.38 Similarly, in D.H. Hillman,39 the Tax Court stated that [t]he failure to issue regulations should not be a reason to preclude taxpayer from congressionally intended and appropriate relief.40 See also J.A. Francisco,41 (We have frequently held that the Secretary may not prevent implementation of a tax benet provision simply by failing to issue regulations.) One reason for the IRSs wishful thinking may perhaps have been its concern about a related provision, Code Sec. 1298(b)(4). As noted above, Code Sec. 1298(a)(4) provides as follows: To the extent provided in regulations, if any person has an option to purchase stock, such stock shall be considered as owned by such person. For purposes of this paragraph, an option to acquire such an option, and each one of a series of such options, shall be considered an option to acquire such stock. [Emphasis added.]42 Presumably, the IRS will take the view that Code Sec. 1298(a)(4) is self-executing. This conclusion is entirely plausible, but may be subject to somewhat greater doubt than the IRS would like to admit. First, this provision applies by its terms only to the extent provided in regulations.43 Furthermore, the Senate Committee Report states as follows: The bill provides that under regulations any person who has an option to acquire stock shall be treated as owning the stock. The committee anticipates that regulations will provide this treatment where necessary to prevent avoidance of the imposition of interest. Consistent with the to the extent language employed in the statute, the legislative history may be read to suggest that Congress intended option attribution to apply only in specic circumstances where determined by the Treasury Department to be necessary to prevent tax-avoidance. In the absence of any such determination, the courts may be reluctant to take it upon themselves to determine whether an option to purchase PFIC shares in any given scenario presents the tax-abuse potential required to support the presumption that Congress intended option attribution to apply in such circumstances. Alternatively, tracking the language of the legislative history, the courts may be receptive to the argument that Congress should not be presumed to have intended the option attribution rule to apply if, in the taxpayers particular circumstances, option attribution is not necessary to prevent tax-avoidance. For example, a taxpayer holding an option on PFIC shares might persuasively argue that, if the PFIC has no positive earnings and prots for the year (or any prior year during the taxpayers holding period), option attribution is not necessary to prevent any improper deferral of U.S. tax.44 In addition, the New York State Bar Association has persuasively argued that nonqualified compensatory options (which already trigger ordinary income on exercise) do not present a signicant potential for tax-avoidance and thus should not be subject to option attribution.45 When the time comes, it will be interesting to see how or whether the courts take such considerations into account in their analysis of Code Sec. 1298(a)(4). Application of Code Sec. 1298(b)(5)(A). As noted above, the taxpayers argued that, even if the indirect disposition rules are self-executing, the distributions to a trust formed solely for the benet of the FBs

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Anti-Deferral and Anti-Tax Avoidance

cleaned out all of FTs distributable net income, so that subsequent distributions to the USBs could not constitute excess distributions. Such argument was premised in large part on the absence of guidance regarding the manner in which the indirect disposition rules should apply and the exibility accorded to taxpayers, under the preamble to the proposed regulations governing indirect dispositions, to apply the PFIC rules and the trust rules in any reasonable manner that triggers or preserves the interest charge. Indeed, the preamble to the proposed regulations provides as follows: [T]he regulations do not provide explicit rules for determining the tax consequences to a trust or estate (or a beneciary thereof) that directly or indirectly owns stock of a section 1291 fund. Until such rules are issued, the shareholder must apply the PFIC rules and subchapter J in a reasonable manner that triggers or preserves the interest charge. Comments are invited about the manner in which excess distributions paid with respect to stock directly or indirectly owned by trusts or estates should be taxed under section 1291. The IRS accepted these ground rules, but rejected the taxpayers contention that their method satised the requirements of the preamble: It is the Services position that Taxpayers DNI approach is unreasonable because it fails to actually preserve any of the PFIC interest charge. To the contrary, it facilitates the avoidance of the interest charge altogether by allowing the entire excess distribution amount to be carried out to foreign beneciaries who are not subject to the PFIC regime. The purpose of section 1298(a) (3) and (b)(5) is to insure that the PFIC tax is not circumvented by the imposition of a foreign passthrough entity such as a partnership or trust in an ownership chain between a U.S. person and a PFIC. Taxpayers method of applying section 1298(b)(5) would make a trust with both U.S. and foreign beneciaries an effective vehicle for circumvention of the PFIC regime because the PFIC tax and interest charge could be carried out to the foreign beneciaries by manipulating the timing of distributions from the trust, as Taxpayers have done here. Taxpayers method represents neither a reasonable nor a good faith attempt to implement the statute in light of its language and purpose. The preamble language of the proposed section 1291 regulations does contemplate the possibility that, in the trust context, the interest charge might be preserved rather than triggered under certain circumstances and does require that taxpayers implement section 1298(b)(5) in a manner consistent with the principles of subchapter J. Therefore, a method that preserves the interest charge at the trust level and later carries it out to the beneciaries is not per se unreasonable. However, Taxpayers method circumvents the purpose of the PFIC rules and neither triggers nor preserves an interest charge for the U.S. beneciaries despite the fact that, under section 1298(a)(3), U.S. beneciaries indirectly owned 50 percent of a PFIC prior to its liquidation and subsequently received a distribution of 50 percent of the liquidation proceeds of that PFIC. Accordingly, the IRS concluded that the taxpayers purported application of the indirect disposition rules was unreasonable and would not be respected. Given that the taxpayers approach would have eliminated the interest charge entirely, and that the only permissible options under the preamble were to either trigger or preserve the interest charge under the excess distribution regime, it is extremely difcult to quarrel with the IRSs conclusion. The IRS next considered whether tax under the excess distribution regime should be imposed on the USBs at the time of the indirect disposition or somehow preserved until a later time. The IRS chose the former approach on the ground that deeming each U.S. beneciary to have received an excess distribution equal to his proportionate share of the gain recognized by FT on the disposition of PFIC shares clearly comports with a plain reading of the statute. Notably, the IRS considered it relatively clear, under the applicable facts and circumstances, that each of the three USBs had a one-sixth interest in FT.46 Accordingly, notwithstanding the discretionary nature of the trust, it was a simple matter to determine the portion of the PFIC gain arising from the indirect disposition to be allocated to each USB. In other circumstances involving discretionary trusts, it may be much more difcult to make this type of determination. Interestingly, the Ruling suggests that, in the absence of nal or temporary regulations, the IRS would be open to a deferral approach where the
Continued on page 59

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Anti-Deferral
Continued from page 12

imposition of the interest charge can be preserved. The interesting question, however, is how the interest charge could actually be preserved in the absence of such regulations. There are at least two formidable technical obstacles. First, distributions of accumulated income by a foreign trust do not retain their character. Thus, for example, if a foreign trust receives an excess distribution from a PFIC in 2008, a corresponding distribution to beneciaries in 2011 will not be considered an excess distribution and thus could not, it seems, be subject to any interest charge under the PFIC rules.47 Second, and more fundamentally, the portion of an excess distribution that is allocated to any prior year in the shareholders holding period (other than years prior to the shareholders rst PFIC year) does not actually constitute income in any year. Accordingly, distributions by a foreign trust of amounts attributable to excess distributions received by the trust in a prior year would not even be considered distributions of accumulated income; so it is difcult to see how the PFIC interest charge would properly be applied to such distributions. Moreover, above and beyond such technical issues, there are a number of possible scenarios in which the IRSs right to ultimately collect the appropriate tax and interest charge may be doubtful. For example, suppose that a foreign trust with two U.S. beneciaries, USB1 and USB2, as well as several foreign beneciaires, receives an excess distribution from a PFIC.

Suppose further that USB1 pays his tax currently and that USB2, elects (in some fashion agreeable to the IRS) to pay the appropriate tax and interest charge when he receives a distribution from the trust that is allocable to his share of the excess distribution received by the foreign trust from the PFIC. This may work well enough if USB2 ultimately receives the expected distribution. But what if USB2 dies many years later without ever receiving any trust distributions? Will USB2s estate be stuck with the tab? To the extent that amounts allocable to USB2s share of the excess distribution are ultimately distributed by the trust to USB1, instead of USB2, it might seem appropriate for USB1 to pay the appropriate tax and interest charge under the PFIC rules, but it is diffcult to see how USB1 could be required do so, since he was not a party to USB2s deferral arrangment with the IRS. Furthermore, even if the IRS could somehow hold USB1 responsible for USB2s tax and interest charge in such circumstances, query what recourse the IRS would have where the amounts allocable to USB2s share of the excess distribution are ultimately distributed to foreign beneciaires. It may be that workable rules can be constructed to address these issues, but no such rules presently exist. In the absence of such rules, it may be extremely difcult for taxpayers to convince the IRS that the PFIC interest charge can be preserved.

5 6

9 10 11 12 13

14

15 16 17 18 19 20 21 22 23 24

ENDNOTES
1 2

25

3 4

LTR 200733024 (Oct. 26, 2006). Code Sec. 1297(a). Except as otherwise indicated, all Section and references herein are to the Internal Revenue Code of 1986, as amended (the Code). Code Sec. 1297(b). Code Sec. 954(c)(1).

26

Code Sec. 1297(c). For a discussion of the consequences of selling shares of a 25-percent owned subsidiary, see Howard J. Levine and Michael J. Miller, IRS Issues a Welcome Private Letter Ruling on PFIC Look-Through Rule but Key Questions Remain Unanswered, J. TAXN OF GLOBAL TRANS., Summer 2006, at 5. For purposes of the Subpart F rules applicable to United States shareholders of a CFC, Code Sec. 951(b) denes the term United States shareholder as any U.S. person who owns (directly, indirectly, or by attribution) shares possessing 10 percent or more of the total voting power of all classes of voting stock of the CFC. For convenience, United States shareholders (as so dened) are referred to herein as 10-percent U.S. shareholders. A foreign corporation is a CFC if 10-percent U.S. shareholders, in the aggregate, own (directly, indirectly, or by attribution) more than 50 percent of the stock (measured by vote or value) of the foreign corporation. Code Sec. 957(a). A shareholders total excess distribution for a tax year generally equals the excess of total distributions received by the shareholder for the tax year over 125 percent of the average amount of distributions received by the shareholder during the three preceding tax years. Code Sec. 1291(b)(2)(A). Code Sec. 1291(a)(1)(A) & (2). Code Sec. 1291(a)(1)(C) & (c). Code Sec. 1297(e). Code Sec. 1297(e)(2). As indicated below, however, a shareholder to whom the once a PFIC, always a PFIC rule applies may make certain elections to prevent application of the excess distribution regime. Code Sec. 1293(a); Reg. 1.1295-1(c)(2). The foreign corporation must provide certain information, and must make its books and records available, to the shareholder in order for such shareholder to be permitted to make (or maintain) a QEF election. Code Sec. 1293(c). Proposed Reg. 1.1291-1(b)(2)(iii). Code Sec. 1296(a). Code Sec. 1296(c)(1)(A). Code Sec. 1296(c)(1)(B). Reg. 1.1291-1(c)(3). See also Reg. 1.1291-10. Reg. 1.1291-10(a). See Reg. 1.1297-3T & 1298-3. Pursuant to Code Sec. 1298(a)(1)(B), such attribution would not apply if the PFIC shares were instead owned by a domestic corporation. The CFC overlap rule described above is disregarded for this limited purpose. Proposed Reg. 1.1291-1(d) states that an option to acquire stock of a PFIC is considered to be stock of a PFIC for purposes of applying Code Sec. 1291 and the regulations thereunder to a disposition of the option. In addition, Proposed Reg. 1.1291-1(h)(3) states that a shareholders holding period

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27

28

29

30 31 32 33

34 35

36

37 38

39

40

41 42

of a share of PFIC stock acquired upon the exercise of an option includes the period the shareholder held the option. This term generally refers to stock of any PFIC other than a PFIC treated as a pedigreed QEF with respect to such shareholder. See Proposed Reg. 1.1291-1(b)(2)(iii). Although Individual I was listed as the settlor of the trust, the taxpayers argued (and the IRS agreed) that Individual A should be treated as the grantor. CA-4, 53-2 USTC 9507, 205 F2d 335, affd, 54-2 USTC 9628, 216 F2d 7, cert. denied, 348 US 943, 75 SCt 364 (1955). See former Code Sec. 551. Supra note 29, at 340. CA-7, 97-1 USTC 70,069, 102 F3d 932. The court also acknowledged that there may be rare cases in which the literal application of a statute may produce an intended result, but found no reason to believe that such a result would arise in that case. 108 TC 579, Dec. 52,100 (1997). Joint Comm. On Taxation, General Explanation of the Tax Reform Act of 1986, at 922-923 (J. Comm. Print 1987) (emphasis added). H. REPT NO. 99-426, 1986-3 CB (Vol. 2), at 360. 93 TC 228, Dec. 45,924 (1989). Maddox dealt with Code Sec. 2032A(g), which instructed the Treasury Department to prescribe regulations applying the favorable estate-tax rules of Code Sec. 2032A governing the valuation of family farms to circumstances where the family farm is held through an entity. Notwithstanding the absence of implementing regulations, the Tax Court construed Code Sec. 2032A(g) to provide the estate with the same right to a favorable valuation that it would have had if the farm had not been incorporated. 114 TC 103, Dec. 53,768 (2000), revd by, CA-4, 2001-1 USTC 50,354, supplemental opinion, 118 TC 323, Dec. 54,711. Hillman dealt with Code Sec. 469(l)(2), which instructed the Treasury Department to prescribe taxpayer-favorable regulations under the passive activity loss rules to prevent certain self-charged items from creating a mismatch of passive interest deductions and nonpassive interest income. 119 TC 317, Dec. 54,965 (2002). To date, no regulations (other than proposed regulations) have been adopted under this provision. Proposed Reg. 1.1291-1(d) states that an option to acquire stock of a PFIC is considered to be stock of a PFIC for purposes of applying Code Sec. 1291 and the regulations thereunder to a disposition of the option. In addition, Proposed Reg. 1.1291-1(h)(3) states that a shareholders holding period of a share of PFIC stock acquired upon the exercise of an option includes the period the shareholder held the option.

43

44

45

46

47

Thus, Code Sec. 1298(b)(4) stands in marked contrast to provisions, such as Code Sec. 1298(b)(5)(A) (and the provision at issue in Pittway) that use the language under regulations. Cf. D.H. Hillman, supra note 39 (The command provision of section 469(l) does not contain the type of only to the extent language found in statutes that are not self-executing.). Notably, a taxpayer cannot make a QEF election with respect to an option. Reg. 1.1291-1(d)(5). Although not necessarily strictly relevant, a court might consider it undesirable (and perhaps unfair) that an option holder should be forced into the excess distribution regime by reason of being deemed to own PFIC shares for which no QEF election can be made. See NYSBA Tax Section, Proposals for PFIC Guidance, May 22, 2001, reprinted in 91 TAX NOTES 2211 (June 25, 2001). The USBs collectively had a one-half interest, and, based on the pattern of distributions, the IRS determined that each USB had a one-third interest in such half. Of course, the regular rules applicable to distributions of accumulated income by foreign trusts would still apply.

owed to CFCs. For the reasons discussed above, we also believe that the Treasury and the IRS should also exercise their regulatory authority to exempt from the operation of Code Sec. 267(a)(3)(B) accruals of deductible amounts by CFCs.

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Financing Intl
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including the year of change, assuming the request is timely led. It would be helpful if the Treasury and IRS would issue additional guidance and procedures to facilitate these method changes.

IV. Conclusions
Although they have received relatively little attention, the AJCA amendments to Code Sec. 267(a)(3)(B) have potentially far reaching consequences for how U.S.-based multinationals finance and conduct the businesses of their foreign subsidiaries. The Treasury and the IRS need to provide guidance with respect to several significant issues as to how Code Sec. 267(a)(3)(B) applies to accruals of otherwise deductible amounts

10 11

The views express by the authors are their own, and do not necessarily represent the views of PricewaterhouseCoopers LLP. All Code Sec. references are to the Internal Revenue Code of 1986, as amended (the Code), and all Reg. references are to the Treasury Regulations promulgated thereunder. Tax Reform Act of 1986 (P.L. 99-514), 1812(c)(1), 1881, 100 Stat. 2085, 2834, 2914. Code Sec. 163(e)(3) provides a rule analogous to Code Sec. 267(a)(3) with respect to the deduction of original issue discount. American Jobs Creation Act of 2004 (P.L. 108-357), 841(b)(2), 118 Stat 1418. Per Code Sec. 957, a CFC is a foreign corporation of which more than 50 percent of either (1) the total combined voting power of all classes of stock entitled to vote, or (2) the total value of all of the stock is owed by U.S. Shareholders. For this purpose, U.S. Shareholders are dened as U.S. persons owning, directly or indirectly, 10 percent of the voting stock of a foreign corporation within the meaning of Code Sec. 951(b). See Ofce of Tax Policy and Internal Revenue Service 2007-2008 Priority Guidance Plan, 2007 TNT 157-18 (Aug. 13, 2007) updated 2008 TNT 79-27 (Apr. 22, 2008). P.L. 108-357, 841(c), 118 Stat 1418. As a technical correction, the addition of Code Sec. 267(a)(3) carried the same effective date as Code Sec. 267(a)(2). S. REP. NO. 99-313, 99th Cong., 2d Sess., at 959 (1986), reprinted in 1986-3 CB (Vol.3) 1, 959. See also H.R. REP. NO. 426, 99th Cong., 2d Sess. 939 (1986). Id. See, e.g., Notice 89-84, 1989-2 CB 402 (describing the regulations to be promulgated under Code Sec. 267(a)(3), noting that [r]egulations to be issued pursuant to section 267(a)(2) and 267(a)(3) of the Code will provide that any amount otherwise deductible or amortizable described in section 871(a)(1) (other than subparagraph (C) thereof), or in section 881(a) (other than paragraph (3) thereof), or any amount that would be so described if the amount was U.S. source income, owed to a foreign person may not be deducted until paid if the parties are persons specied in section

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