Recently the US Treasury Department and the Internal Revenue Service (IRS) released new guidance on PFICs and CFC investments for a Regulated Investment Company (RIC). Under US tax law a corporation can qualify as a Regulated Investment Company for a given tax year only when 90% or more of its gross income is derived from specific qualifying sources. These sources include interest, gains resulting from the sale (or other disposition) of stock, dividends and securities or foreign currencies. The principle activity of an RIC is investing in such stock, securities or currencies that generate these specific forms of income. There must also be a certain mix of asset diversification to qualify as an RIC. The income test and the diversification requirements are part of the calculation to determine whether an RIC’s investments are “securities.”
In the past the US Treasury and the IRS have concluded that a “derivative contract with respect to a commodity index is not a security for purposes of the income test and does not generate “other income” within the meaning of the income test.” This position was clarified (Revenue Ruling 2006-31) to state that the previous rule is not intended to “preclude a conclusion that income from certain instruments used to create commodity exposure for the holder could not be qualifying income for purposes of the income test.”
Many RICs created offshore entities treated as Controlled Foreign Corporations or CFCs in order to invest in commodity-related investments. The IRS issued scores of private rulings that income inclusions an RIC received from these CFC subsidiaries would generate “qualifying income” for the purposes of the income test. This was regardless of whether the CFC generated distributions associated with the income inclusions. The IRS also ruled that income sourced from specific commodity related investments would also be considered as “qualifying income” for purposes of the income test. In 2011 the IRS suspended rulings on the issue altogether saying it needed to review the associated issues in a more in depth manner.
The proposed guidance on Passive Foreign Investment Companies or PFICs and CFC investments, if finalized, would establish that an RIC’s income inclusions from CFCs and certain PFICs are going to be treated as dividends under the income test only to the extent that the CFCs and PFICs make distributions to the RIC out of earnings and profits attributable to the income inclusions. Further, contrary to the private letter rulings noted above, the proposed regulations would establish that income inclusions are not other income derived with respect to a RIC’s business of investing in stock, securities, or currencies, within the meaning of the income test.
What does all of this mean? If the new regulations are finalized the status of RICs investing in specific types of CFCs and PFICs would be negatively impacted if the CFCs and PFICs fail to make distributions. International investment continues to be targeted by the IRS, and in the end the IRS has the power and the authority to interpret these issues as they choose to. The experienced tax attorneys and accounting professionals at Allen Barron are able to challenge the IRS revenue officers, and hold them accountable to all laws and Generally Accepted Accounting Principles (GAAP).
If you have questions regarding the proposed guidance on PFICs and CFC investment, CFCs, PFICs or the nature of how an RIC is structured or distributing income we invite you to contact us for a free consultation at 866-631-3470.
