IPO dilution and adviser error permit a retroactive QEF election

Plain-English summary

A domestic partnership indirectly owned an active foreign corporation through another foreign corporation. An initial public offering diluted the intermediate corporation's ownership below the level required for the section 1297(c) look-through rule, causing it to become a passive foreign investment company in a later year. The partnership's tax adviser failed to account for the IPO stock sales and did not advise the partnership about PFIC status or a qualified electing fund election. The error was discovered during preparation of a later return, and both the partnership and adviser submitted sworn affidavits. The partnership agreed to a closing agreement and additional tax and interest to protect the government's interests. The IRS granted consent for a retroactive QEF election under Treas. Reg. § 1.1295-3(f), subject to the time-and-manner rules and with relief from filing amended returns for later open years.

Ruling snapshot

• Question: Could the partnership make a retroactive QEF election after its tax adviser failed to recognize that IPO dilution caused PFIC status?
• Outcome: Approved, subject to the regulation's time-and-manner requirements
• Key authorities: IRC §§ 1295 and 1297; Treas. Reg. § 1.1295-3(f) and (g)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201510040 Third Party Communication: None
Release Date: 3/6/2015 Date of Communication: Not Applicable
Index Number: 1295.02-02
Person To Contact:
-------------------------------------------- ---------------------, ID No. ------------
------------------------------------------------------------ Telephone Number:
------ --------------------
-------------------------------------- Refer Reply To:
------------------------------- CC:INTL:B02
PLR-146428-13
Date:
October 31, 2014

              TY:-------

Legend

Shareholder = ---------------------------------------------------------------------------------------
-----------------------------------
State X = ------------
Country Y = ----------------
Country Z = ------------
FC1 = ----------------------------------
FC2 = --------------------------------
A = ---
B = ---
C = ------
D = ------
Date 1 = ------------------
Date 2 = -----------------------
Date 3 = -----------------------
Year 1 = ------
Year 2 = ------
Year 3 = ------
Year 4 = ------
Year 5 = ------
Tax Advisor 1 = ---------------------------------------
Tax Advisor 2 = --------------

Dear -----------------:

This is in response to a letter dated November 7, 2013, submitted by your authorized
representative that requested the consent of the Commissioner of the Internal Revenue
Service (Commissioner) for Shareholder to make a retroactive qualified electing fund

PLR-146428-13 2

(QEF) election under section 1295(b) of the Internal Revenue Code and Treas. Reg.
§1.1295-3(f) with respect to Shareholder’s investment in FC1.

The ruling contained in this letter is based upon information and representations
submitted on behalf of Shareholder by its authorized representative, and accompanied
by a penalty of perjury statement executed by an appropriate party. While this office has
not verified any of the material submitted in support of this request for ruling, such
material is subject to verification on examination. The information submitted in the
request is substantially as set forth below.

FACTS

Shareholder is a domestic partnership organized under the laws of State X. In Year 1,
Shareholder acquired an A% interest in FC1, an entity organized under the laws of
Country Y that was treated as a corporation for U.S. federal tax purposes, and FC1
acquired a B% interest in FC2, an entity organized under the laws of Country Z that was
treated as a corporation for U.S. federal tax purposes.

In Year 3, FC1 executed an initial public offering (IPO) for FC2. As a result of its initial
sale of FC2 stock pursuant to the IPO, FC1’s ownership interest in FC2 declined to C%
as of Date 1. As a result of a second sale of FC2 stock pursuant to the IPO, FC1’s
ownership interest in FC2 declined to D% as of Date 2.

In Year 4, as a result of a final sale of FC2 stock pursuant to the IPO, FC1 disposed of
its remaining interest in FC2 as of Date 3.

FC1’s only asset in Year 1 through Year 4 was its interest in FC2. FC2 was an active
company that derived income that was not passive income under section 1297(b), and
owned assets that gave rise to non-passive income sufficient to prevent it from
qualifying as a passive foreign investment company (PFIC) as defined in section 1297.
For Year 1 through Year 2, FC1’s B% ownership interest in FC2 was sufficient to allow
FC1 to be treated under section 1297(c) as if it (1) held its proportionate share of the
assets of FC2, and (2) received directly its proportionate share of the income of FC2.
Thus, FC1 did not qualify as a PFIC in Year 1 through Year 2. As a result of the IPO
initiated in Year 3, however, FC1’s C% ownership interest in FC2 as of Date 1 was not
sufficient to allow FC1 to “look through” FC2 under section 1297(c), and thus FC1’s
ownership interest in FC2 was a passive asset. Therefore, FC1 qualified as a PFIC in
Year 3.

For Year 2 through Year 4, Shareholder engaged Tax Advisor 1 to prepare its U.S.
federal partnership returns and its tax filings relating to FC1 and engaged Tax Advisor 2
to prepare its tax filings relating to FC2. In Year 2 through Year 4, Tax Advisor 1,
employing experienced tax professionals, advised Shareholder with respect to U.S.
federal income tax matters relating to Shareholder’s ownership of FC1. Shareholder

PLR-146428-13 3

made available to Tax Advisor 1 the books and records of FC1 and any other
information requested by Tax Advisor 1 to provide tax advice and prepare Shareholder’s
tax returns, including any information relating to FC2. Tax Advisor 1 held itself out as a
qualified tax professional, and Shareholder reasonably believed that Tax Advisor 1 was
competent to render tax advice with respect to the ownership of shares of a foreign
corporation.

With respect to Year 2, Tax Advisor 1 advised that FC1 was not a PFIC, based on
FC1’s B% ownership interest in FC2 and the section 1297(c) “look through” rule. With
respect to Year 3, Tax Advisor 1 did not appropriately take into account the sales of
FC2 stock pursuant to the IPO, and, as a result, incorrectly calculated the average value
of the assets held by FC1 for purposes of the section 1297(a)(2) asset test. Accordingly,
Tax Advisor 1 did not inform Shareholder that FC1 was a PFIC or of the availability of a
QEF election.

During the preparation of Shareholder’s Year 4 tax return in Year 5, Tax Advisor 1
reviewed the transactions completed by FC1 during Year 4. Following its conclusion
that FC1 did not own a sufficient interest in FC2 during Year 4 to be eligible for section
1297(c) “look through” treatment, Tax Advisor 1 reviewed FC1’s Year 3 transactions,
including the date of the initial sale of FC2 stock pursuant to the IPO, Date 1. Tax
Advisor 1 then realized that a mistake was made with respect to Shareholder’s Year 3
tax return and notified Shareholder.

Shareholder has submitted an affidavit, signed under penalties of perjury, describing the
events that led to the failure to make the QEF election before the election due date,
including the role of Tax Advisor 1. Shareholder represents that Tax Advisor 1 did not
identify FC1 as a PFIC for Year 3 or advise Shareholder of the possibility of making a
QEF election with respect to FC1 for Year 3, and thus did not advise Shareholder of the
consequences of making, or failing to make, a QEF election for Year 3. Shareholder has
also submitted an affidavit from Tax Advisor 1, signed under penalties of perjury,
corroborating the statements made by Shareholder.

Both Year 3 and Year 4 are open taxable years that would be affected by Shareholder’s
retroactive QEF election with respect to FC1 for Year 3. Shareholder will not file
amended returns for Year 3 and Year 4 to redetermine its income tax liability, despite its
ability to do so. Instead, Shareholder will enter into a closing agreement with the
Commissioner that confirms that there is no prejudice to the interests of the United
States government as a result of Shareholder’s failure to make a retroactive QEF
election with respect to FC1 for Year 3. The closing agreement also will require
Shareholder to pay an additional amount of tax and interest that would have been owed
by Shareholder’s direct and indirect partners as a result of Shareholder’s failure to treat
FC1 as a PFIC for Year 3 and Year 4.

PLR-146428-13 4

Shareholder represents that, as of the date of this request for ruling, the PFIC status of
FC1 has not been raised by the Internal Revenue Service (IRS) on audit for any of the
taxable years at issue.

RULING REQUESTED

Shareholder requests the consent of the Commissioner to make a retroactive QEF
election with respect to FC1 for Year 3 under Treas. Reg. §1.1295-3(f).

LAW

Section 1295(a) provides that a PFIC will be treated as a QEF with respect to a
shareholder if (1) an election by the shareholder under section 1295(b) applies to the
PFIC for the taxable year; and (2) the PFIC complies with the requirements prescribed
by the Secretary for purposes of determining the ordinary earnings and net capital gains
of the company.

Under section 1295(b)(2), a QEF election may be made for a taxable year at any time
on or before the due date (determined with regard to extensions) for filing the return for
the taxable year. To the extent provided in regulations, the election may be made after
the due date if the shareholder failed to make an election by the due date because the
shareholder reasonably believed the company was not a PFIC.

Under Treas. Reg. §1.1295-3(f), a shareholder may request the consent of the
Commissioner to make a retroactive QEF election for a taxable year if:

   1. the shareholder reasonably relied on a qualified tax professional, within the
      meaning of Treas. Reg. §1.1295-3(f)(2);
   2. granting consent will not prejudice the interests of the United States
      government, as provided in Treas. Reg. §1.1295-3(f)(3);
   3. the request is made before a representative of the IRS raises upon audit the
      PFIC status of the company for any taxable year of the shareholder; and
   4. the shareholder satisfies the procedural requirements of Treas. Reg. §1.1295-
      3(f)(4).

The procedural requirements include filing a request for consent to make a retroactive
election with, and submitting a user fee to, the Office of the Associate Chief Counsel
(International). Treas. Reg. §1.1295-3(f)(4)(i). Additionally, affidavits signed under
penalties of perjury must be submitted that describe:

   1. the events that led to the failure to make a QEF election by the election due
      date;
   2. the discovery of the failure;
   3. the engagement and responsibilities of the qualified tax professional; and

PLR-146428-13 5

   4. the extent to which the shareholder relied on the professional.

Treas. Reg. §1.1295-3(f)(4)(ii) and (iii).

CONCLUSION

Based on the information submitted and representations made with Shareholder’s ruling
request, we conclude that Shareholder has satisfied Treas. Reg. §1.1295-3(f).
Accordingly, consent is granted to Shareholder to make a retroactive QEF election with
respect to FC1 for Year 3, provided that Shareholder complies with the rules under
Treas. Reg. §1.1295-3(g) regarding the time and manner for making the retroactive
QEF election, other than the requirement to file amended returns for all open years
subsequent to the year in which the retroactive election is made.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This private letter ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter
ruling is being sent to your authorized representatives.

A copy of this letter ruling must be attached to any federal income tax return to which it
is relevant. Alternatively, taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and control
number of the letter ruling.

                                         Sincerely,



                                         Barbara E. Rasch
                                         Senior Technical Reviewer, Branch 2
                                         (International)

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