CCA 200031015: Insufficient facts to determine foreign corporation's PFIC status

Plain-English summary

Chief Counsel considered whether a foreign corporation was a passive foreign investment company (PFIC) over twelve years. It could not decide the company's status for any year because the facts did not establish whether it met the passive income or asset tests. For the earlier years, the advice rejected an active insurance business exception, and for several years it rejected an active rents or royalties exception for leases to a related company. It also identified years when information about the related-person rent exception, insurance activity, or other leasing activity was insufficient. The distinction matters because PFIC treatment can affect a U.S. shareholder's stock throughout the holding period.

Ruling snapshot

• Question: Was the foreign corporation a PFIC in any of the twelve years at issue, and did its insurance or rental income qualify for exceptions to passive income?
• Outcome: Advice given; PFIC status could not be determined on the limited facts.
• Key authorities: IRC §§ 1291, 1296 (later redesignated § 1297), and 954(c).

Full text (IRS public release)

                           DEPARTMENT OF THE TREASURY
                               I N T E R N AL R E V E N U E S E R V I C E
                                    WASHINGTON, D.C. 20224


                                                                        CC:INTL:Br2

Number: 200031015
Release Date: 8/4/2000
                                   April 17, 2000


UILC: 1296.02-01; 1296.02-04

                       INTERNAL REVENUE SERVICE
                  NATIONAL OFFICE FIELD SERVICE ADVICE


MEMORANDUM FOR



FROM:

SUBJECT:

This Field Service Advice responds to your memorandum dated January 10, 2000.
Field Service Advice is not binding on Examination or Appeals and is not a final
case determination. This document is not to be used or cited as precedent.

LEGEND:
a                 =
Amount 1          =


Amount 2          =
Amount 3          =
Amount 4          =
Amount 5          =
Amount 6          =
Amount 7          =
Amount 8          =
Amount 9          =
Amount 10         =
Amount 11         =
Amount 12         =
Amount 13         =
Amount 14         =
Amount 15         =
Amount 16       =
Amount 17       =
Amount 18       =
Amount 19       =
Amount 20       =
Amount 21       =
Amount 22       =
Amount 23       =
Corporation A   =
Corporation B   =
Corporation C   =
Corporation D   =

Corporation E   =
Costs A         =

Costs B         =

Costs C         =

Country         =
Customers       =
Date A          =
Date B          =
Entities        =
Event A         =
Event B         =

Payments        =

Property A      =
Property B      =
Property C      =
Property D      =
Service A       =
Service B       =

Service C       =


Service D       =
Service E       =
Service F       =



                    -2-
Service G           =

Service H           =
Service I           =


Service J           =
Service K           =
Year 1              =
Year 2              =
Year 3              =
Year 4              =
Year 5              =
Year 6              =
Year 7              =
Year 8              =
Year 9              =
Year 10             =
Year 11             =
Year 12             =
Year 13             =

ISSUES:

1.    Whether Corporation C is a passive foreign investment company (“PFIC”)
under Section 1296(a)1 of the Code for each taxable year, commencing with Year 2
through Year 13.

CONCLUSIONS:

1.     Based on the limited facts provided, we cannot determine for each of the
Years 2 through 13 whether Corporation C is a PFIC. However, with respect to
Years 2 through 9, Corporation C does not qualify for the insurance exception
under section 1296(b)(2)(B), and for Years 5 through 9 Corporation C does not
qualify for the active rents or royalties exception under section 954(c)(2)(A), for
purposes of excluding its income from the classification of “passive income”, or
excepting the assets that produce that income from the classification of passive


      1
         Pub.L. No. 105-34, Sec. 1121, (1997) redesignated the provisions contained
under section 1296 of the Code as section 1297, and redesignated the provisions
contained under section 1297 as section 1298, effective as of August 5, 1997. For
purposes of this document, all references to former section 1296 and current section
1297 will be referred to as section 1296. Similarly, all references to former section
1297 and current section 1298 will be referred to as section 1297.

                                          -3-
assets. In addition, for Years 5 though 13, there is insufficient information to
determine whether the PFIC related person look-thru rents or royalties exception
under section 1296(b)(2)(C) applies. Also, with respect to Years 10 through 13,
there is insufficient information to determine whether Corporation C would be
subject to taxation under subchapter L if it was a domestic corporation, or whether
its leasing activities would qualify for the active rents or royalties exception.

FACTS:

Corporation A is a domestic corporation and provides Service A to Customers. For
the years at issue, as part of this service, Corporation A also provided Service B
                                   . If Customers desired, they could purchase
        Service C by making Payments to Corporation A. Historically, Payments
for Service C were included in the gross income of Corporation A.




        On any particular date, the shareholders of Corporation A were
substantially identical to the shareholders of Corporation C, although the
proportionate ownership interest of a particular shareholder in Corporation A and
Corporation C would likely not be identical.

Transaction I




                                         -4-
Transaction II

In Year 1, Corporation A also entered into a contract for the performance of
Services F and G by Corporation E. In recognition for such services, Corporation A
agreed to pay Corporation E Amount 1, and deducted such amount on its income
tax return.

Following the execution of this contract, Corporation E entered into a separate
contract with Corporation C whereby the latter agreed to perform Service H for
Amount 1, minus certain expenses retained by Corporation E. Pursuant to this
contract, Corporation C agreed to assume Costs B in connection with Event B, and
Corporation E agreed to assume Costs C with respect to such event.

Subsequent to Year 1, Corporation A disregarded the terms of its contract with
Corporation E by paying a sum in excess of Amount 1 to Corporation E. The effect
of such overpayment was to recompense Corporation C for Costs B that it incurred.

Activities of Corporation C in Years 2 through 13

During Years 2 through 13, Corporations A, D, E and C continued to engage in the
respective activities described under Transactions I and II. Furthermore,
Corporation C had additional sources of income as described below.

During Years 2 and 3, Corporation C had earnings from its investment portfolio.
For Year 2, Corporation C earned investment income totaling Amount 2. No
information was provided with respect to Year 3.

In Year 4, Corporation C started to provide Service I, but such activity did not
generate any income. However, Corporation C earned investment income totaling
Amount 3.

In Year 5, Corporation C earned Amount 4 from Service J, and Amount 5 from
investments. In addition, Corporation C entered into two new activities. First,
Corporation C acquired Property A and leased it to Corporation A. Second,

                                         -5-
Corporation C acquired Property B from Corporation A, and entered into a lease-
back of such property to Corporation A. These two new activities produced income
of Amount 6 in Year 5.

In Year 6, Corporation C expanded Service J and earned Amount 7 from such
activity. Revenue from leasing and investment activities for that year totaled
Amounts 8 and 9 respectively. Corporation C’s balance sheet for that year
disclosed asset values of Amount 10 for Properties A and B; Amount 11 for
investments; and Amount 12 for other non-financial assets. Hence, Corporation C
had assets totaling Amount 13, out of which Amount 14 is claimed to be assets
from an active business.

In Years 7 and 8, Corporation C sustained a significant decrease in income from
Service J, while the income from leasing operations increased. No financial
information was provided with respect to the amount of income earned or value of
assets held for either Year 7 or 8.

In Year 9, Corporation C expanded its leasing business including the acquisition of
Property C, which was managed by a third party. Corporation C also engaged in
Service K and derived significant revenue therefrom. However, it sustained a loss
from investment related activities. The leasing related assets totaled Amount 17
and assets related to Service J totaled Amount 18. In addition, assets related to
Service K totaled Amount 19.

In Years 10 and 11, Corporation C expanded Service J, however there is no
indication as to the amounts earned in connection with such activity. Corporation C
also expanded its leasing activities.

In Years 12 and 13, Corporation C increased Service J and continued to engage in
leasing activities. Assets related to leasing activities totaled Amount 20, and
Service J activities totaled Amount 21.

LAW AND ANALYSIS:


                                    The consequence of this determination is to
treat such income as constructive dividends to its shareholders, followed by
deemed contributions of capital to Corporation C by the shareholders. Accordingly,
the assets resulting from the deemed contributions of capital by those shareholders
belong to Corporation C.

The issue in this case is whether Corporation C is a PFIC. To determine whether
Corporation C is a PFIC, it must satisfy either the asset or income test set forth
under section 1296(a). The assets received by Corporation C by virtue of the


                                         -6-
deemed contributions of capital would be subject to the asset test under section
1296(a)(2). Similarly, the income generated by such assets would be included in
determining the income test under section 1296(a)(1). To the extent that
Corporation C is determined to be a PFIC, section 1291 imposes a tax, and special
interest charge on the tax, upon U.S. persons who own stock in a PFIC with respect
to distributions received from the PFIC, and gain recognized upon disposition of the
PFIC stock. The tax is imposed based on the highest rate of tax applicable to the
U.S. person for the particular taxable year.

Furthermore, if a foreign corporation is determined to be a PFIC, section 1297(b)(1)
provides that the stock held by the taxpayer shall be treated as stock in a PFIC if,
at any time during the holding period of the taxpayer with respect to such stock,
such corporation (or any predecessor) was a PFIC which was not a qualified
electing fund. This provision effectively operates to taint the stock held by a U.S.
shareholder in a foreign corporation as stock in a PFIC if at any time during the
shareholder’s entire holding period such foreign corporation was a PFIC for any
taxable year. Hence, it is necessary to analyze each of Years 2 through 13
because it is assumed that there were some changes in shareholder ownership of
Corporation C during those years.

A.    Law and Analysis for Years 2 and 3:

Section 1296(a) defines the term “passive foreign investment company” as any
foreign corporation if —

      (1)   75 percent or more of the gross income of such
      corporation for the taxable year is passive income, or

      (2)   the average percentage of assets (by value) held by such
      corporation during the taxable year which produce passive income or
      which are held for the production of passive income is at least 50
      percent.

Section 1296(b)(1) defines “passive income” as any income which is of a kind which
would be foreign personal holding company income (“FPHCI”) as defined in section
954(c). Section 954(c)(1) defines FPHCI to include dividends, interest, income
equivalent to interest, royalties, rents and annuities. However, section 1296(b)(2)
sets forth four exceptions to “passive income” that are primarily related to income
earned in connection with certain business activities. One of these exceptions,
section 1296(b)(2)(B), provides that “passive income” does not include any
income—

      derived in the active conduct of an insurance business by a
      corporation which is predominantly engaged in an insurance business


                                     -7-
      and which would be subject to tax under subchapter L if it were a
      domestic corporation…

Section 831 of subchapter L sets forth the rules governing the taxation of insurance
companies other than life insurance companies. Although section 831 does not
define what constitutes an insurance company, Treas. Reg. § 1.831-3(a) states that
for purposes of sections 831 and 832, the term “insurance companies” means only
those companies which qualify as insurance companies under former § 1.801-1(b). 2
Specifically, Treas. Reg. § 1.801-3(a)(1) provides:

      The term “insurance company” means a company whose primary and
      predominant business activity during the taxable year is the issuing of
      insurance or annuity contracts or the reinsuring of risks underwritten
      by insurance companies. Thus, though its name, charter powers, and
      subjection to State insurance laws are significant in determining the
      business which a company is authorized and intends to carry on, it is
      the character of the business actually done in the taxable year which
      determines whether a company is taxable as an insurance company
      under the Internal Revenue Code.

Several courts have addressed whether a particular taxpayer should be treated as
an insurance company for tax purposes. In Bowers v. Lawyers Mortgage Co., 285
U.S. 182 (1932), the taxpayer examined titles; procured and furnished information
relating to titles; purchased and sold notes and mortgages; guaranteed and insured
bonds, mortgages and real estate against loss by reason of defective titles; and
insured the payment of debts. Thus, the taxpayer derived income from
performance of services and insuring risks. During the year at issue, approximately
33% of the taxpayer’s income were derived from insurance premiums. To
determine whether the taxpayer was taxable as an insurance company, the Court
explained that such determination “depends on the character of the business
actually done during the taxable year.” Id. at 188. Accordingly, the Court
compared the amount of the taxpayer’s premiums to the amount of its income
derived from other sources, and concluded that the taxpayer was not an insurance
company. The Court noted that the insurance portion of the taxpayer’s business
was incidental to its business of making and selling mortgage loans.

Similarly, the Court in Inter-American Life Ins. Co. v. Commissioner, 56 T.C. 497
(1971), aff’d per curiam, 469 F.2d 697 (9th Cir. 1972), also compared the
taxpayer’s insurance related and non-insurance related income in determining
whether the taxpayer was taxable as an insurance company. In that case, the
taxpayer’s shareholders formed the taxpayer for the ostensible purpose of
reinsuring life insurance risks, and contributed to the taxpayer cash and other

      2
          Former Treas. Reg. § 1,801-1(b) is now § 1.801-3(a)(1).

                                           -8-
assets. During the years in issue, taxpayer did not maintain an active sales force,
and although it initially secured a small amount of reinsurance business, its
predominant source of income was from investments. For the taxable years at
issue, the amount of premiums earned by the taxpayer did not exceed 15% of its
gross investment income. The taxpayer’s “insurance” income was attributable to
related party risks, and thus, it was able to generate premium income without an
active sales force. Upon reviewing the taxpayer’s financial data, the Court
concluded that the taxpayer’s primary and predominant source of income was from
investments and not from the insuring of risks. Moreover, the taxpayer’s primary
and predominant “efforts” were not expended in pursuit of its insurance activities.
Thus, since the taxpayer had not used its “capital and efforts” for the purpose of
earning income from the issuance of insurance, the taxpayer was not taxable as an
insurance company.

The Courts in Cardinal Life Ins. Co. v. United States, 300 F. Supp. 387 (N.D. Tex.
1969), and Industrial Life Ins. Co. v. United States, 344 F. Supp. 870 (D.S.C. 1972),
aff’d per curiam, 481 F.2d 609 (4th Cir. 1973), have employed similar approaches
in rejecting taxpayers’ contentions that they were taxable as insurance companies.
The Court in Cardinal Life explained that the taxpayer earned no insurance
premiums during two of the five years at issue, and its premium income with
respect to the remaining three years represented no more than 9.11% of its total
income, which included income from dividends, interest, rent and capital gains.
The Court also noted that the taxpayer did not employ any brokers, agents or sales
people in an attempt to sell its policies. Similarly, the Court in Industrial Life
explained that although the taxpayer generated 20% of its income by issuing credit
life insurance, its primary source of income was attributable to its investment
portfolio and the sale and leasing of real estate. Thus, the Court concluded that
taxpayer’s “primary and predominant” business activity was not insurance.

In a case where the taxpayer derived more than 50% of its income from premium
income, a Court has held that such taxpayer was taxable as an insurance company.
For instance, in Service Life Ins. Co. v. United States, 189 F. Supp. 282 (D. Neb.
1960), the taxpayer issued a significant amount of life, health and accident policies,
and invested and managed the premiums derived therefrom. In addition to its
insurance activities, the taxpayer derived income by making mortgage loans and by
investing amounts that it borrowed from the Federal Home Loan Bank. More than
50% of the taxpayer’s income was attributable to premium income, and more than
50% of the taxpayer’s income-producing assets were held for policy reserves.
Notably, the Court seemed to make a distinction between investment assets held
as insurance reserves, and other investment assets. After a consideration of all
facts, the Court concluded that the “actual character of the business done” by the
taxpayer was the sale, issuance, and servicing of insurance contracts.

The amounts received by Corporation C in connection with Transaction I were
constructive dividends to its shareholders, followed by deemed contributions by the

                                          -9-
shareholders to the capital of Corporation C. The PFIC tax provisions were not in
effect for Year 1. Based on the facts presented, the income earned by Corporation
C is not excepted from the definition of “passive income” pursuant to section
1296(b)(2)(B) for Years 2 and 3. In order to exclude Corporation C’s income from
passive classification under the “active conduct of an insurance business”,
Corporation C must be taxable as an insurance company under subchapter L if it
was a domestic corporation. The amounts purportedly received by Corporation C in
connection with Transaction I do not constitute insurance related income given that
those activities had no economic substance or business purpose.

As for the amounts received by Corporation C in connection with Transaction II, you
requested that we assume such amounts are not considered insurance related
income. In light of such assumption, Corporation C would not be subject to tax as
an insurance company under subchapter L if it were a domestic corporation, and
thus would not qualify for the exception to “passive income” under section
1296(b)(2)(B) with respect to that transaction. To the extent that Corporation C
would not be subject to tax under subchapter L if it was a domestic corporation
based on Transactions I and II, we need not address whether its activities in Years
2 and 3 rose to the level of being “predominantly engaged in an insurance
business”.

Accordingly, to the extent that Corporation C’s investment income is of the kind
described in section 954(c), then such income would be treated as passive income.
If that income is 75% or more of the gross income earned by Corporation C, then
Corporation C is a PFIC for both Years 2 and 3. Given that the amounts received
by Corporation C under Transaction I are treated as contributions to capital, such
amounts should be disregarded from Corporation C’s total gross income in
determining whether it satisfies the 75% income test. However, the assets resulting
from the deemed contributions of capital related to Transaction I should be included
in determining whether Corporation C had 50% or more of its assets held for the
production of passive income. To the extent that Corporation C had 50% or more
of its total assets held for the production of passive income in each of Years 2 and
3, Corporation C is a PFIC for each of those years respectively.

A.    Law and Analysis for Years 4 through 13:

In Year 4, Corporation C started to provide Service I but derived no income from
such service. In addition, Corporation C continued to receive amounts in
connection with Transactions I and II, and earned investment income totaling
Amount 3. To the extent that Corporation C would not be subject to tax under
subchapter L if it was a domestic corporation based on the limited facts presented,
Corporation C would thus not qualify for the active conduct of insurance business
exception under the PFIC rules.



                                        -10-
In Year 5, Corporation C had income totaling Amount 4 from Service J, Amount 5
from investments and Amount 6 from leasing activities. However, information was
not provided regarding the assets that were set aside as Property D in connection
with Service J. Since Corporation C’s investment and leasing income totaled
Amount 15, we assume that the amount of Corporation C’s assets far exceeded
what was necessary to cover its losses in connection with Service J. If this is
correct, Corporation C would not be subject to tax as an insurance company under
subchapter L if it was a domestic corporation, and hence, neither Amount 4 nor
Amount 5 would be subject to the “passive income” exception under section
1296(b)(2)(B).

However, since Corporation C also engaged in leasing activities with Corporation A
and earned Amount 6 therefrom, the issue is whether that income qualifies for the
active rents or royalties exception set forth under section 954(c)(2)(A). In
determining whether a particular item of income is “passive income”, the PFIC rules
adopt the categories of income that are considered FPHCI under section 954(c).
Under that provision, section 954(c)(2)(A), provides an exception for active rents or
royalties. That is, “rents or royalties derived in the active conduct of a trade or
business and received from a person other than a related person” are not
considered FPHCI. Therefore, such rents or royalties derived from unrelated
persons in the active conduct of a trade or business would also be excepted from
“passive income” under section 1296(b).

The term “related person” is defined in section 954(d)((3)(B) to include a
corporation which is controlled by the same person or persons which control the
controlled foreign corporation (“CFC”). Although the rules under section
954(d)(3)(B) were enacted to define what constitutes a related party within the
context of a CFC, such definition also applies to the PFIC regime in determining
whether the income from Corporation C’s leasing activities with Corporation A
constitute income from a “related person”. Since both Corporations C and A are
controlled by substantially identical shareholders, the income earned by
Corporation C from its leasing activities to Corporation A is considered income from
a related person. As such, the active rents or royalties exception under section
954(c)(2)(A) does not apply.

The leasing activities in Year 5 however, may be subject to the section
1296(b)(2)(C) related person look-thru rents or royalties exception. Section
1296(b)(2)(C) provides that “interest, a dividend, or a rent or royalty, which is
received or accrued from a related person (within the meaning of section 954(d)(3))
to the extent such amount is properly allocable...to income of such related person
which is not passive income...” would be excepted from the definition of “passive
income” under section 1296(b)(1). We do not have sufficient information to
determine whether this exception applies to the leasing activities of Corporation C
for Year 5 or any subsequent year.


                                         -11-
In Year 6, Corporation C had income from Service J totaling Amount 7, and income
from leasing and investment activities totaling Amounts 8 and 9, respectively.
Although Corporation C engaged in Service J, it is unclear how much of Property D
was necessary with respect to the business involving Service J. Since Corporation
C generated total income of Amount 16 and had assets totaling Amount 13, based
on such limited information, it appears that Corporation C’s primary and
predominant activity was managing assets unrelated to its business involving
Service J. As such, Corporation C would not be subject to taxation under
subchapter L for Year 6, and thus neither the income from Service J nor any of the
investment income would qualify for the insurance exception under section
1296(b)(2)(B).

As for the income from leasing activities, to the extent that such income was
derived from transactions with Corporation A, the foregoing analysis described in
Year 5 would apply equally to the leasing activities in Year 6.

In Years 7 and 8, Corporation C sustained a significant decrease in income from
Service J, while the income from leasing operations increased. Since Corporation
C’s income from Service J had decreased in comparison to Year 6, while its level of
leasing income increased, it appears that Corporation C’s primary and predominant
activity remained the management of assets unrelated to the business involving
Service J. Accordingly, Corporation C would neither be subject to tax under
subchapter L nor qualify for the active rents or royalties exception.

In Year 9, Corporation C expanded its leasing business. We do not have sufficient
information to determine whether the leasing activities in Year 9 would qualify for
the active rents or royalties exception, or the PFIC related person look-thru
exception for rents or royalties, given that we do not have any facts surrounding
such activities. As such, we cannot determine whether income from leasing
activities would be considered passive income. Furthermore, since there is no
indication that Corporation C provided Service J or earned any income in
connection with such service, Corporation C would not be subject to taxation under
subchapter L, thus not qualify for the insurance exception.

In Years 10 through 13, Corporation C expanded both Service J and its leasing
activities. In light of the limited factual information, we cannot determine whether
Corporation C would be subject to taxation under subchapter L, and thus qualify for
the insurance exception. Furthermore, we cannot determine whether the degree of
leasing activities would qualify for the active rents or royalties exception, or the
PFIC related person look-thru exception for rents or royalties. As such, we cannot
determine whether Corporation C derived any passive income or held sufficient
assets for the production of passive income.

In sum, if Corporation C satisfies either the income or asset test for any of the
foregoing taxable years, Corporation C would be a PFIC. Consequently, section

                                        -12-
1297(b)(1) operates to treat the stock held by Corporation C’s U.S. shareholders as
stock in a PFIC if at any time during such shareholders’ holding period of such
stock, Corporation C was considered a PFIC. For example, if Corporation C is a
PFIC with respect to Year 2, those U.S. shareholders who own stock in Corporation
C as of Year 2 would be treated as owning stock in a PFIC for all subsequent years
within their respective holding periods.

The shareholders’ basis in the stock of Corporation C may be relevant for purposes
of the PFIC provisions. That is, if a PFIC shareholder disposes of PFIC stock, the
PFIC rules apply to any gain recognized on such disposition in the same manner as
if such gain were an excess distribution. See I.R.C. § 1291(a)(2). To the extent
that the statute of limitations has expired for the shareholders to include the
constructive dividends as income for a particular taxable year, the doctrine of duty
of consistency bars those shareholders from the benefit of a step-up in basis as a
result of the deemed contributions to capital of Corporation C with respect to such
taxable year.




                                        -13-
By:     /s/ Phyllis E. Marcus
        Phyllis E. Marcus
        Chief, Branch 2
        Office of Associate Chief Counsel
         (International)




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