SERVICE ISSUES GUIDANCE ON THE OPERATION OF THE ASSET AND INCOME TESTS IN DETERMINATION OF PFIC QUALIFICATION.

Notice 88-22

The Internal Revenue Service will issue regulations under the passive foreign investment company provisions of the Internal Revenue Code of 1986 concerning, among other things, the operation of the asset and income tests under section 1296(a) of the Code.

The Internal Revenue Service recognizes the need for taxpayer guidance under the passive foreign investment company provisions, effective for taxable years beginning after 1986, in advance of the publication of the regulations. In particular, taxpayers require guidance concerning the operation of the definitional tests in section 1296(a) of the Code in order to determine whether the foreign corporations in which they hold stock are passive foreign investment companies. A foreign corporation determined to be a passive foreign investment company under section 1296(a) may elect under section 1295 to be a qualified electing fund for its taxable year beginning in 1987. If a foreign corporation makes the section 1295 election and is later determined not to have qualified as a passive foreign investment company during the year for which the election was made, the election will have no effect for federal income tax purposes.

The section 1295 election may be revoked by the PFIC but only with the consent of the Commissioner. The Commissioner's determination will take into account any enactment of technical corrections to the Tax Reform Act of 1986 after the PFIC made the election, as well as provisions of any PFIC regulations published after the PFIC made the election.

Foreign corporations that are calendar year taxpayers must make the section 1295 election before March 15, 1988, in accordance with section 1295(b)(2), to be qualified electing funds for their 1987 taxable years. See the temporarl regulations issued under section 1295 for the requirements for making, and the effect of, that election.

The absence of guidance in this document on particular aspects of the definitional tests in section 1296 should not be construed as implying that the regulation will not contain guidance on such matters.

ASSET TEST

Section 1296(a)(2) of the Internal Revenue Code provides that a foreign corporation is a passive foreign investment company if the average percentage of the assets (by value) held by the corporation during the taxable year which produce passive income or are held for the production of passive income ("passive assets") is at least 50 percent of all assets (by value) held by the corporation during the taxable year.

BASIS FOR ASSET TEST. The regulations will provide that the asset test will be applied on a gross basis. No liabilities whether secured by particular assets or otherwise traceable to particular assets, will be taken into account.

AVERAGE VALUE OF ASSETS. The average value of assets for the taxable year of the foreign corporation will be the average of the fair market values of the assets determined as of the end of each quarterly period during the taxable year of the corporation. The regulations, in general, will not require that the fair market value of the assets be determined by independent appraisal.

CHARACTERIZATION OF ASSETS. The regulations will establish rules for the characterization of assets as either passive or nonpassive assets. In general, an asset will be characterized as passive if it has generated (or is reasonably expected to generate in the reasonably foreseeable future) passive income as defined in section 1296(b) in the hands of the foreign corporation. Assets held by foreign corporations described in section 1296(b)(2)(A) and (B) that are utilized to produce income in the active conduct of a banking or insurance business will be treated as nonpassive assets. Assets which generate both passive and nonpassive income in a taxable year shall be treated as partly passive and partly nonpassive assets in proportion to the relative amounts of income generated by those assets in that year. The regulations will give specific guidance with respect to certain kinds of assets, including those described below.

DEPRECIABLE PROPERTY USED IN A TRADE OR BUSINESS. Any as that constitutes "property used in the trade or business" with the meaning of section 1231(b) will be considered a nonpassive asset, provided that the trade or business in question is one that does not produce passive income as defined in section 1296(b).

TRADE OR SERVICE RECEIVABLE. A trade or service receivable will be characterized as a passive or nonpassive asset based on the character of the income derived by the corporation from the transaction that generated the receivable. Accordingly, a trade or service receivable derived from sales or services provided by the corporation in the ordinary course of its trade or business which produce nonpassive income will be treated as a nonpassive asset for purposes of the asset test. The regulations will provide that interest incidentally received on a trade or service receivable that is otherwise treated as a nonpassive asset will not affect the characterization of the receivable.

INTANGIBLE ASSETS. Subject to further consideration in prospectively applied regulations, the regulations will provide for the inclusion of intangible assets in testing for passive foreign investment company status. Generally, intangible assets that produce identifiable amounts of income, such as patents and licenses, will be characterized on the basis of the income derived from the intangible assets. Goodwill or going concern value must be identified with a specific income-producing activity of the corporation and characterized as a passive or nonpassive asset based on the income derived from the activity. For purposes of applying the asset test under section 1296(a)(2), intangible assets must be valued according to the guidelines provided in Rev. Rul. 59-60, 1959-1 C.B. 237, as amplified by subsequent revenue rulings published by the Internal Revenue Service.

WORKING CAPITAL. Cash and other current assets readily convertible into cash, including assets which may be characterized as the working capital of an active business, produce passive income, as defined in section 904(d)(2)(A). These assets are, therefore, passive assets for purposes of the section 1296(a)(2) asset test.

DEALER INVENTORY AND INVESTMENT ASSETS. Trading in stock or securities by a foreign corporation for its own account produces passive income. Therefore, under the regulations, stock, securities and other assets related to trading and similar investment activities of a foreign corporation conducted for its own account will be considered passive assets for purposes of the asset test.

The regulations will distinguish the assets of regular dealers in stock and securities held for sale to customers in the ordinary course of their business from the assets held for investment purposes. Any dividend or interest income earned on stock and securities designated as inventory will not affect the characterization of such assets as nonpassive assets.

A foreign corporate dealer's inventory of stock and securities held for sale to customers will be treated as nonpassive assets provided the dealer specifically identifies in its books and records the stock and securities that it holds for sale to customers in the ordinary course of its trade or business and the stock and securities that it holds for investment on its own account. The dealer may not change the initial designation of any share of stock or security as an inventory or an investment asset. Starting 90 days after the publication of this notice, the dealer must specifically identify the inventory and investment assets on the date of acquisition of such assets. If the inventory assets and investment assets are not properly identified or the corporation changes the characterization of a share of stock or a security, all stock and securities will be treated as passive assets. The quantity of stock and securities identified by the dealer as inventory will be treated as inventory only to the extent it does not exceed the reasonable needs of the dealer's trade or business.

TAX-EXEMPT ASSETS. Securities which produce tax-exempt income, such as municipal bonds, will be characterized as passive assets unless: (1) they represent an appropriately identified inventory asset in the hands of a regular dealer in such securities, or (2) the active banking and insurance exception of section 1296(b)(2) applies.

INCOME TEST

Section 1296(a)(2) of the Code provides that a foreign corporation is a passive foreign investment company if 75 percent or more of the gross income of the foreign corporation for the taxable year is passive income. Pursuant to section 1296(b)(1), the term passive income has the same meaning given the term in section 904(d)(2)(A), but without regard to the exceptions provided in section 904(d)(2)(A)(iii). The regulations will provide that the look-through rules of section 904(d)(3) and the regulations issued under that section and section 904(d)(5) will apply to characterize payments received or accrued by the foreign corporation from related controlled foreign corporations and certain related U.S. corporations.

ASSETS AND INCOME OF SUBSIDIARIES

Section 1296(c) of the Code provides that, for purposes of determining whether a foreign corporation is a passive foreign investment company, the foreign corporation is deemed to hold its proportionate share of the assets and to receive directly its proportionate share of the income of its subsidiaries in which owns 25 percent or more of the stock (determined by value). The regulations will apply this rule to the income and assets of a corporation directly or indirectly owned by the foreign corporation. The rule will apply in the case of an indirectly owned corporation provided the foreign corporation's indirect interest in the lower tier company is at least 25 percent (determined by value).

EFFECTIVE DATE

This document serves as an "administrative pronouncement" as that term is used in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure. See Rev. Rul. 87-138, 1987-52 I.R.B. 17. Taxpayers may rely on this notice until the regulations are published. The regulations, described in this notice, generally will be effective for taxable years beginning after December 31, 1986. However, any modification of the rules contained in this notice will be prospective.

Questions concerning this notice may be directed to Gayle Novig of the Office of the Associate Chief Counsel (International) either by writing to CC:INTL:Br6 Room 3042, Internal Revenue Service 1111 Constitution Avenue N.W., Washington, DC 20224, or by calling 202- 634-5423 (not a toll free number).