The CFC/PFIC overlap rule after aggregate treatment

Editor: Greg A. Fairbanks, J.D., LL.M.

Historically, domestic partnerships and S corporations that owned 10% or more of a controlled foreign corporation (CFC) could rely on the so-called CFC/PFIC overlap rule at the entity level to avoid annual passive foreign investment company (PFIC) testing and the application of complex PFIC rules. The CFC/PFIC overlap rule is designed to eliminate double taxation that could occur if a U.S. investor is subject to tax under both the CFC and PFIC regimes. It has also served to simplify compliance for passthroughs and has often ensured that income is taxed under the generally more favorable CFC rules.

With the shift to aggregate treatment for domestic passthrough entities, however, the CFC/PFIC overlap rule no longer applies as broadly as it once did. For tax years beginning in and after 2023, domestic investors that, through domestic partnerships and S corporations, hold less than 10% in a foreign corporation that is both a CFC and a PFIC are generally subject to the PFIC rules and may no longer rely on the CFC/PFIC overlap rule to shield their investment from application of the PFIC rules.

Application of CFC/PFIC overlap rule at partner or shareholder level

The CFC/PFIC overlap rule’s applicability is now evaluated at the level of partner or S corporation shareholder. As a result, some owners may be subject to the CFC regime, while others fall under the PFIC rules, depending on the relative size of their ownership interest in the foreign entity. The already intricate reporting obligations for passthrough entities have become even more complicated, now requiring passthroughs to report both PFIC and CFC information in many cases.

Further, taxpayers that previously benefited from the application of the CFC/PFIC overlap rule at the level of domestic partnerships and S corporations may no longer do so. The unavailability of the rule affects not only entities with passive income but also operating entities holding passive assets such as cash, frequently subjecting investors to the PFIC regime even for entities that are otherwise active.

Taxpayers and passthroughs that previously relied on the overlap rule should reassess its applicability and consider the potential implications on their reporting and tax obligations.

The CFC/PFIC overlap rule

Under Sec. 1297(a), a foreign corporation can be considered a PFIC if 75% or more of its gross income is passive or 50% or more of the average value of its gross assets would produce passive income. Under Sec. 1297(d), if a foreign corporation is both a PFIC and a CFC (as defined in Sec. 957(a)), the foreign corporation would not be considered a PFIC with respect to a shareholder during the shareholder’s “qualified portion” of their holding period (the CFC/PFIC overlap rule). The term “qualified portion” generally means any part of the holding period during which the corporation is a CFC and the shareholder owns 10% or more by vote or value in the CFC (i.e., a U.S. shareholder). Generally, this means that the PFIC regime should not apply to a U.S. person that is subject to the Subpart F rules.

Congress enacted the CFC/PFIC overlap rule due to concern about the simultaneous application of the Subpart F and PFIC regimes to the same shareholders (see H.R. Rep’t No. 105-148, 105th Cong. 1st Sess., at 534 (1997)).

Aggregate treatment for domestic passthroughs with foreign investments

In January 2022, the IRS released concurrent final regulations (T.D. 9960) and proposed regulations (REG-118250-20), which adopt an aggregate approach for domestic passthroughs when applying certain international rules to investments in foreign corporations. Consistent with the aggregate approach previously adopted for global intangible low-taxed income (GILTI), the final regulations also apply the aggregate treatment for purposes of Secs. 951 (Subpart F) and 956(a) (investments in U.S. property) for tax years beginning on or after Jan. 25, 2022.

The proposed regulations (REG-118250-20) would apply aggregate treatment for certain PFIC purposes, including modifying the definition of “shareholder” by excluding passthrough entities. The proposed regulations also clarify that the term “qualified portion” does not include any portion of a domestic passthrough owner’s holding period during which the owner was not a U.S. shareholder with respect to the CFC/PFIC.

The proposed regulations’ preamble specifies that under existing Sec. 1291 regulations, a domestic passthrough is not treated as a shareholder for purposes of Secs. 1291 through 1298 (except for purposes of any information reporting requirements), including the CFC/PFIC overlap rule under Sec. 1297(d).

Potential implications of adoption of aggregate treatment

With the IRS’s adoption of aggregate treatment for domestic passthroughs for tax years beginning on or after Jan. 25, 2022, domestic passthroughs are no longer subject to Subpart F inclusions or Sec. 956 inclusions (collectively, the inclusions) at the entity level. This significantly affects domestic passthroughs that are CFC or PFIC shareholders, as well as U.S. investors that invest through these passthrough entities.

Domestic passthroughs are still treated as U.S. shareholders for purposes of determining whether any foreign corporation is a CFC, as well as certain other purposes. The IRS indicated that, as a result of changing to the aggregate approach when determining Subpart F inclusions, the CFC/PFIC overlap rule no longer applies at the domestic passthrough level and instead is determined at the partner level.

For a U.S. owner of a domestic passthrough that directly or indirectly owns 10% or more in a CFC/PFIC, the U.S. owner is considered a U.S. shareholder of the foreign corporation (the U.S. shareholder partner). Instead of including its allocated portion of the inclusions and GILTI from the domestic passthrough, the U.S. shareholder partner must calculate its inclusions and GILTI based on information furnished by the domestic passthrough. Thus, the CFC/PFIC overlap rule may still apply to the U.S. shareholder partners such that the foreign corporation is not considered to be a PFIC to them.

However, for a U.S. owner that owns less than 10% in a CFC/PFIC, such U.S. owner is not considered a U.S. shareholder of the foreign corporation (a non-U.S. shareholder partner) and is no longer subject to the inclusions. As clarified and confirmed in the proposed regulations, the CFC/PFIC overlap rule does not apply to non-U.S. shareholder partners. Therefore, these non-U.S. shareholder partners may potentially be subject to PFIC rules.

A domestic passthrough that holds an interest in a PFIC’s stock, however, must still make the Sec. 1295 election to treat the PFIC as a qualified electing fund (QEF) or make a mark-to-market (MTM) election under Sec. 1296 if the PFIC stock is marketable. The proposed regulations would change these elections from the entity level to aggregate (i.e., shift the elections from being made at the partnership level to the respective partners’ level). But these regulations do not apply to tax years beginning before their finalization.

As a result, some U.S. owners remain subject to CFC rules under the CFC/PFIC overlap rule, while others may now fall under the PFIC rules with respect to their ownership in the CFC/PFIC through a domestic passthrough. For most taxpayers, tax year 2023 marks the initial application of the PFIC regime for the non-U.S. shareholder partner, which could come as a surprise. It is crucial for domestic passthroughs to fully provide the necessary information required under both the PFIC and CFC rules to their U.S. owners and evaluate whether an entity-level PFIC election should be made.

Who is affected by the aggregate approach?

The shift to the aggregate approach impacts domestic passthroughs that are CFC or PFIC shareholders, as well as U.S. investors who invest through these passthrough entities. Furthermore, the interaction between the aggregate treatment and the CFC/PFIC overlap rule is expected to particularly affect domestic passthroughs with non-U.S. shareholder partners and those partners themselves.

Domestic passthroughs may be required to provide information under PFIC and/or CFC rules, depending on the composition of their U.S. owners. For those with non-U.S. shareholder partners, 2023 may be the first year they need to determine if the foreign corporation is a PFIC, make a QEF or MTM election if applicable, and communicate this to their owners.

Effects on domestic passthroughs’ international information reporting obligations

For 2023 and subsequent tax years, if a domestic passthrough is a U.S. shareholder in a CFC/PFIC, the implementation of aggregate treatment and its interaction with the CFC/PFIC overlap rule could significantly affect the international information reporting obligations of the domestic passthrough. Therefore, the domestic passthrough may need to complete additional forms and schedules, including the following:

• Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations: This form may be required if the domestic passthrough is a U.S. shareholder in a CFC.
• Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund: This form may be required for information reporting purposes under Sec. 1298(f) if the domestic passthrough has at least one non-U.S. shareholder partner and is a PFIC shareholder.
• Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., Part III, box 11: The domestic passthrough is required to report income from a QEF in box 11.
• Schedules K-2, Partners’ Distributive Share Items — International, and K-3, Partner’s Share of Income, Deductions, Credits, etc. — International, Part VI: This part is used to provide information for certain partners to complete Form 8992, U.S. Shareholder Calculation of Global Intangible Low-Taxed Income (GILTI), and Forms 1040, U.S. Individual Income Tax Return, and 1120, U.S. Corporation Income Tax Return, with respect to income inclusions under Secs. 951(a), 951(a)(1)(B), and 951A. If none of the direct or indirect partners are U.S. shareholders of the CFC, Schedules K-2/K-3, Part VI, are not required.
• Schedules K-2/K-3, Part VII: This part is used to provide information partners need to complete Form 8621 and to provide partners with information to determine income inclusions with respect to the PFIC. The domestic passthrough may need to check box (m) to confirm that the PFIC is also a CFC. This part is not required if all direct or indirect U.S. partners are subject to the Subpart F rules or if the U.S. partnership has made a pedigreed QEF election and files Form 8621.

Depending on whether a domestic passthrough’s U.S. owners qualify as U.S. shareholder partners or non-U.S. shareholder partners, domestic passthroughs may be required to file certain forms and schedules with respect to their ownership in a CFC/PFIC. Additionally, owners may need to provide disclosures and white paper statements to avoid confusion. Given that information must be reported under two separate regimes, taxpayers may need to make various adjustments to ensure they are not over- or underreporting.

Next steps to address domestic passthroughs’ varied reporting approaches

Given the lack of updated IRS guidance on 2023 filing, practitioners may have adopted varying approaches, particularly in reporting in Schedules K-1, K-2, and K-3. While further guidance from the IRS is awaited, one key takeaway from the 2023 filing season is the importance of providing clear and accurate instructions in the Schedules K-1/K-3 footnotes. This is especially critical for U.S. owners of passthrough entities, as some individual owners and their tax preparers may not be fully aware of these recent changes.

For domestic passthroughs that did not recognize the changes in a timely manner, corrective measures can be taken. The first step is to determine if there were any non-U.S. shareholder partners. If none existed, the PFIC rules may not apply, and the focus should be on confirming that the U.S. shareholder partners’ inclusions were accurately reported on the Schedule K-3. However, if non-U.S. shareholder partners existed, passthroughs may be required to file an amended return or an administrative adjustment request if subject to the Bipartisan Budget Act (BBA) of 2015, P.L. 114-74, partnership audit rules, to report corrected amounts.

In addition, if a QEF election was not timely made for 2023, a PFIC cleanse election may be available for the 2024 return — either a deemed-sale or deemed-dividend election — along with a QEF election.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.