PLR 200604020 (issued January 26, 2006) interprets favourably the Code section 1297(c) lookthrough rule for 25 percent owned subsidiaries of foreign (non-US) corporations. If Forco owns (directly or indirectly) at least 25 percent of another corporation's value, then, in determining whether Forco is a passive foreign investment company (PFIC), the lookthrough rule treats Forco as holding its proportionate share of the subsidiary's assets and as receiving directly its proportionate share of the sub's income. The statute does not address Forco's sale of the sub, and there are no related Treasury regulations, but the IRS has ruled that the lookthrough rule applies in characterizing the gain on such a sale.

Forco is a PFIC if it satisfies an income test (at least 75 percent of its gross income for the taxable year is passive, generally including dividends, interest, royalties, rents, annuities, and gain from the sale or exchange of passive-income-producing property) or an asset test (at least 50 percent of Forco's assets held during the taxable year produce passive income). For the purposes of applying the asset test, publicly traded corporations generally must use FMV in measuring assets; non-publicly traded corporations may use either FMV or adjusted basis, but they may use adjusted basis only if they are also controlled Forcos.

Unlike the controlled foreign corporation (CFC) regime, no threshold level of US ownership of Forco must be met to trigger potential application of the PFIC rules. And unlike the CFC regime, the PFIC regime does not tax US persons currently on Forco's income unless a QEF election is made: US persons are taxed on receipt of excess distributions, which include (1) gain recognized on the sale or deemed disposition of PFIC stock and (2) actual PFIC distributions that in total in the tax year exceed 125 percent of average actual distributions in the preceding three years. An excess distribution is allocated rateably to each day in the US shareholder's holding period for the stock. Current tax year and pre-PFIC holding period allocations are included as ordinary income in the current year; other PFIC period allocations are not included in income but are taxed at the highest US ordinary income rate (currently, 35 percent), plus an interest charge to reflect the benefit of deferral.

In the ruling, Forco sold all the stock of a wholly owned foreign sub that directly or indirectly owned the stock of several European Opcos. If the gain on the sale was classified as passive income, then Forco was a PFIC under the income test for the year. The taxpayer requested a ruling that the lookthrough rule of Code section 1297(c) apply to the gain on the sale, making it active income because it was attributable to the sale of active business assets. Without the benefit of any analysis, the IRS concluded that the lookthrough rule applied and the gain was not passive income. The ruling is significant because it is the first time that the IRS has explicitly stated that the lookthrough rule applies to the sale of stock of a 25 percent owned subsidiary.

The legislative history of section 1297(c) supports the ruling's conclusion. The Conference Report of 1986 (HR rep. no. 99-841, 99th Cong., 2d sess. (1986), II-644) provides the following guidance on the rationale behind the lookthrough rule: "The conferees do not intend that foreign corporations owning the stock of subsidiaries engaged in active businesses be classified as PFICs. To this end, the agreement attributes a proportionate part of assets and income of a 25-percent owned corporation to the corporate shareholder in determining whether the corporate shareholder is a PFIC under either the asset test or income test."

Clearly, Congress did not want a Forco carrying on an active business through subsidiaries to be classified as a PFIC. Thus, it is reasonable to infer that Congress intended that a sale of those active subsidiaries would not cause the Forco to slip into PFIC status. The potentially dire consequences of PFIC classification on US shareholders only serve to underscore this conclusion. The ruling thus appears to be consistent with legislative intent and is welcome guidance to US taxpayers that own stock of a Forco.