On January 24, the IRS issued (i) final regulations on the treatment of domestic partnerships when determining amounts included in the gross income of the partners from a controlled foreign corporation (a “CFC”) and (ii) proposed regulations regarding the treatment of domestic partnerships and S corporations that own stock of a passive foreign investment company (a “PFIC”) and their domestic partners and shareholders. This alert summarizes certain tax provisions of the final regulations and the proposed regulations separately below that are most relevant to our clients.
These regulations will result in significant changes in how private investment funds treat PFIC and CFC investments.
- Final Regulations (the “Final Regulations”) on Determining Stock Ownership Under Section 958: On June 21, 2019, the IRS issued proposed regulations which provided that a U.S. partner of a domestic partnership would only be required to include his or her share of certain income from a CFC if the U.S. partner owned 10% or more of the vote or value of the CFC’s stock. Under prior law, the 10% determination was made at the domestic partnership level and all U.S. partners of a domestic partnership that was a 10% owner of a CFC were required to include in income their share of certain types of the CFC’s income. The final regulations adopt the proposed regulations and treat domestic partnerships as aggregates of their partners for purposes of determining income inclusions under US federal income tax rules applicable to CFCs. The Final Regulations will generally apply to US Shareholders of CFCs for the 2022 year.
- CFC investment in US property: Aggregate treatment of domestic partnerships also applies for purposes of determining deemed income inclusions under Section 956(a) when a CFC has earnings invested in US property. However, the aggregate treatment does not apply for purposes of Sections 956(c) (United States Property) and (d) (Pledges and Guarantees).
- US partnership’s disposition of CFC stock: Aggregate treatment does not apply for purposes of Section 1248. Future guidance may be issued to address the transactions involving a domestic partnership’s sale of a CFC.
- Non-Grantor Trust and Estates: Aggregate treatment is not extended to domestic non-grantor trusts and domestic estates.
- Impact on Private Funds. These Final Regulations are likely to be beneficial for private investment funds owning a 10% or greater interest in a foreign corporation, such as venture funds and private equity funds. They will reduce the situations in which a U.S. investor in a fund is required to currently include phantom income from a CFC investment by a fund.
- Proposed regulations (the “Proposed Regulations”) regarding the treatment of domestic partnerships and S corporations that own stock of PFICs: Consistent with the CFC regulations discussed above which treat a domestic partnership as an aggregate, the IRS also issued Proposed Regulations which treat domestic partnerships and S corporations as aggregates of their partners and shareholders, respectively, for certain PFIC purposes. The Proposed Regulations generally apply prospectively to taxable years beginning on or after the date they are finalized.
- PFIC Shareholders: Domestic partnerships and S corporations would be excluded from the definition of “shareholder” for PFIC purposes. As a result, neither domestic partnerships nor S corporations are considered shareholders for purposes of making the qualified electing fund (QEF) and mark-to-market (MTM) elections. These elections would be made at the partner/shareholder level.
- QEF Election:
- The election would apply to all PFIC stock of the issuer held by the electing partner or shareholder, including stock that is not held through the partnership or S corporation.
- The electing partner or shareholder would be required to notify the partnership or S corporation of its election and account for its pro rata share of ordinary earnings and net capital gain attributable to QEF stock.
- If a shareholder transfers PFIC stock subject to a QEF election to a pass-through entity of which the transferor is an interest holder, the transferor would continue to have QEF inclusions. Other interest holders of the pass-through entity would have QEF inclusions only if they make a QEF election.
- Existing QEF elections made by a domestic partnership or S corporation would continue for any partner or S corporation shareholder that owns an interest in the PFIC through the pass-through entity on the date the proposed regulations are finalized.
- Impact on Private Funds:
- Under current law, a domestic private investment fund makes a QEF or mark-to-market election at the fund level.
- If the proposed regulations are finalized, each investor of a domestic private investment fund will be able to make (or not make) his or her own election in respect of a PFIC investment.
- These regulations will require domestic funds to provide substantial amounts of additional information to investors regarding the PFIC status of underlying investments.
- In addition, many investors are unlikely to be aware of the potentially negative tax consequences of not making a QEF or mark-to-market election for PFIC stock.
- The Proposed Regulations are likely to attract substantial industry comments and we will continue to monitor any developments in this area.
For additional information on recent income tax changes, please contact Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Daniel C. Murphy (212-574-1210), Brett R. Cotler (212-574-1269) or Ashley Lin (212-574-1374).