Passive Foreign Investment Company Rules: Treatment of Income from Certain Government Bonds for Purposes of the Passive Foreign Investment Company Rules

Sullivan & Cromwell LLP - July 2, 2012

In an important notice responding to current economic conditions, the Internal Revenue Service has acknowledged that banks may be holding larger amounts of government securities than they ordinarily would, and that it does not intend this situation to cause them to be treated as “passive foreign investment companies,” a category that may discourage U.S. persons from investing in their shares.

Generally, negative U.S. tax consequences apply to U.S. shareholders of a “passive foreign investment company” (a “PFIC”), a foreign corporation that has passive income or passive assets in excess of certain thresholds—i.e., if 75 percent or more of the foreign corporation’s gross income for the taxable year is passive income or the average percentage of assets held by the corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent. For these purposes, “passive income” does not include any income derived in the active conduct of a banking business by an institution licensed to do business as a bank in the United States or, to the extent provided in regulations, by any other corporation (the “active banking exception”). The Internal Revenue Service previously issued guidance on the active banking exception in the form of Notice 89-81 and proposed regulations issued in 1995.

On June 28, 2012, the Internal Revenue Service issued a notice (the “Notice”) providing that, for purposes of the PFIC rules and for taxable years beginning in 2011, 2012, and 2013, the income from certain government bonds held by an “Active Bank” qualifies for the active banking exception.