In a big win for the industry, final regulations issued by the Internal Revenue Service and US Department of Treasury do not adopt all the rules set forth in the proposed regulations. Instead, regulated investment companies can now treat income inclusions in respect of controlled foreign corporations and certain passive foreign investment companies as qualifying income regardless of whether the CFCs or PFICs make distributions out of earnings and profits, provided that the income is derived with respect to a corporation’s business of investing in stock, securities, or currencies.
The Internal Revenue Service (IRS) and the US Department of Treasury (Treasury) issued final regulations amending Treasury Regulations § 1.851-2 (the Final Regulations) on March 19. The Final Regulations relate to the September 2016 proposed regulations regarding income inclusions from controlled foreign corporations (CFCs) and certain passive foreign investment companies (PFICs) (the Proposed Regulations) (read our prior analysis).
First, unsurprisingly, the IRS decided to follow the Proposed Regulations’ approach whereby the IRS will not rule on whether a particular financial instrument is a “security” for purposes of Section 851 of the Internal Revenue Code of 1986, as amended (the Code). See Rev. Proc. 2016-50 (2016-43 I.R.B. 522). Despite some commentators’ requests for the IRS to preserve the ability for RICs to seek private letter rulings (PLRs) from the IRS regarding the classification of instruments, the IRS will continue to defer to the US Securities and Exchange Commission’s classification of instruments. While this result is not entirely unexpected, it means that RICs cannot seek binding guidance from the IRS on qualification issues arising from the classification of instruments. Accordingly, continued pressure will be placed on the analysis as to whether instruments are “securities” under the Investment Company Act of 1940, as amended (the 1940 Act), and will require tax advisers to rely heavily on the 1940 Act analysis.
Second, despite having recently revoked PLRs issued to RICs regarding income from “structured notes,” the IRS has decided not to revoke Revenue Ruling 2006-1 (2006-1 C.B. 261) and Revenue Ruling 2006-31 (2006-1 C.B. 1133). As a result, RICs can apparently continue to rely on the analysis and conclusions reached in those authorities.
Third, in a big win for the industry, the Final Regulations did not adopt the rule in the Proposed Regulations that would have treated income allocations from CFCs and certain PFICs to RICs as qualifying income under Section 851(b)(2) of the Code only to the extent the RICs received distributions out of the earnings and profits of the CFCs and PFICs. By way of background, under the Subpart F rules (which apply to CFCs) and the PFIC rules applicable to “qualified electing funds” (QEFs), US holders of shares in CFCs and PFICs, under certain circumstances, are required to include in their taxable income certain income of the CFCs and PFICs, whether or not the CFCs and PFICs make distributions in respect of that income. The Proposed Regulations had suggested that income inclusions under Section 951(a)(1) (Subpart F inclusions) or Section 1293(a) (QEF inclusions) could not be treated as qualifying “other income” derived with respect to a RIC’s business of investing in stock, securities, or currencies within the meaning of Section 851(b)(2)(A). Under the Proposed Regulations, Subpart F inclusions and QEF inclusions had to be accompanied by a distribution from the applicable CFC or PFIC to be treated as qualifying income under Section 851(b)(2). In response to industry comments, the IRS has reversed course, and the Final Regulations now explicitly provide that Subpart F and QEF inclusions can be “qualifying income” under Section 851(b)(2), provided that such income “is derived with respect to a corporation’s business of investing in stock, securities or currencies.” We believe that in many instances RICs will be treated as deriving Subpart F inclusions or QEF inclusions with respect to their business of investing in securities or currencies. While the Final Regulations will be effective 90 days after March 19, 2019, RICs can rely on the rule in the Final Regulations as to Subpart F inclusions and QEF inclusions for taxable years beginning after the issuance of Proposed Regulations on September 28, 2016.
The Proposed Regulations’ rule as to Subpart F inclusions and QEF inclusions had been criticized for numerous reasons. Under the Proposed Regulations’ rule, a RIC’s indirect inclusion of income through a CFC or a PFIC may have been nonqualifying income (absent a distribution), even though the same income, if directly received by the RIC, may have been qualifying income (e.g., dividends, interest, gains from securities or currencies). The rule would also have produced inequitable results for RICs holding noncontrolling stakes in CFCs and PFICs. In such a situation, a RIC often cannot force a PFIC or CFC to make a distribution, which under the Proposed Regulations could have resulted in the RIC receiving an allocation of nonqualifying gross income that it could not treat as qualifying income because it was not accompanied by a distribution.
The adverse consequences that would have flowed from the Proposed Regulations’ rule as to Subpart F inclusions and QEF inclusions would have been exacerbated by the late 2017 enactment of the legislation commonly referred to as the Tax Cuts and Jobs Act, which introduced the Global Intangible Low Taxed Income (GILTI) rules under Section 951A of the Code. Under the GILTI rules, generally US shareholders of a CFC are required to include in gross income earnings of the CFC that heretofore were not subject to inclusions as Subpart F income. While Subpart F inclusions generally stem from passive-type income of a CFC, GILTI inclusions can result from nonpassive income of a CFC. Nevertheless, the GILTI rules specifically provide that GILTI inclusions are treated as Subpart F inclusions for purposes of Section 851(b). Under the GILTI rules, a RIC could be a US shareholder of an unrelated CFC that has significant operating income that is not classified as Subpart F income that the RIC is required to include in gross income as GILTI. Had the IRS adopted the rule as to Subpart F inclusions in the Proposed Regulations, this GILTI inclusion would have been nonqualifying income to the RIC, unless the RIC could somehow cause the CFC to make a corresponding distribution. Given that many CFCs (other than CFCs wholly owned by RICs) before the enactment of the GILTI rules did not generate Subpart F income, the enactment of the GILTI rules would have put added pressure on RIC qualification if Subpart F, GILTI, and PFIC inclusions only produce “qualifying income” if actual distributions equal to such inclusions were made to the RIC.
While there may still be isolated situations where a RIC is uncertain whether its Subpart F, GILTI, or QEF inclusions are derived from the RIC’s business of investing in stock, securities, or currencies, on balance, the Final Regulations provide welcome clarity to the industry. The Final Regulations do not specifically address dozens of PLRs previously issued to RICs with wholly owned CFCs that invest in commodities, but presumably those PLRs continue to be valid because they are consistent with the Final Regulations. The promulgation of the Final Regulations, however, makes it unclear whether all representations that RICs made to the IRS to receive such rulings will continue to have relevance. At the very least, we continue to believe that steps must be taken to ensure that wholly owned CFCs are respected as separate entities for tax purposes.
If you have any questions or would like more information on the issues discussed in this LawFlash, or if you would like to explore the possibility of commenting on the proposed regulations, please contact any of the following Morgan Lewis lawyers:
Jason P. Traue