Final regulations were issued December 2, 2013, for the net investment income tax imposed under Section 1411. The final regulations adopt with amendments the proposed regulations that were issued in December 2012.
Section 1411 imposes a 3.8 percent tax on certain individuals, estates, and trusts with respect to passive income. Relative to the international aspects of Section 1411, the final regulations contain detailed rules regarding the application of the Section 1411 tax to income derived through CFCs and PFICs.
With respect to income earned through CFCs and PFICs, a U.S. taxpayer must first determine whether the CFC or PFIC is engaged in either (i) a trade or business that is considered a passive activity relative to the U.S. shareholder (within the meaning of § 469), or (ii) a trade or business of trading in financial instruments or commodities. If it is, then amounts included in income under § 951(a) (i.e., Subpart Income or § 956 income inclusions) or § 1293(a) (i.e., income recognized from a qualified electing fund election or “QEF”) that are derived from such trade or business are considered net investment income that is subject to the 3.8% net investment income tax.
If a foreign corporation’s business is not a passive activity or financial instruments/commodities trading business relative to the U.S. taxpayer, the Subpart F, 1.15
Section 956 and QEF income inclusions are not treated as dividends and do not otherwise comprise net investment income; therefore the 3.8% net investment income tax does not apply. Nevertheless, dividends and gains derived from CFC and PFIC investments are subject to the 3.8% tax. The regulations provide that rules governing previously taxed earnings (i.e., Sections 959 and 1293(c)) do not apply for purposes of Section 1411 (i.e., such distributions ARE treated as dividends and subject to 3.8% tax), but only with respect to distributions of post-12/31/12 previously taxed income. Thus, the regulations require separate tracking of previously taxed earnings and stock basis for purposes of Section 1411 versus the Subpart F and PFIC rules.
An alternative election is provided by the regulations whereby a taxpayer may elect to treat all income inclusions under Sections 951 and 1293 as net investment income for purposes of Section 1411. Thus, the election accelerates the timing for recognition and payment of the 3.8% net investment income tax, and any subsequent Section 959(d) or Section 1293(c) distributions would not be treated as dividends for Section 1411 purposes. Once made, the election applies to all CFC and PFIC interests owned by taxpayer, including subsequently acquired interests.
As a modification or clarification to the proposed regulations, the final regulations provide that if earnings and profits of a CFC or a PFIC were included in the net investment income of an individual, estate, or trust pursuant to a Treas. Reg. § 1.1411-10(g) election, then a subsequent distribution of those earnings is excluded from the net investment income of any transferee, provided that the transferee can establish entitlement to the exclusion under rules similar to the rules in Treas. Reg. § 1.959-1(d). Certain further amendments were made to the proposed regulations with respect to aspects of the Treas. Reg. § 1.1411-10(g) election.
In response to comments received, the IRS and Treasury agree that Section 1411 should not apply to foreign estates that often have little or no connection to the United States, and that Section 1411 should apply to United States beneficiaries that receive distributions of accumulated net investment income from a foreign trust rather than to the foreign trust itself. The IRS and the Treasury Department have requested additional comments, however, concerning the treatment of accumulation distributions from foreign trusts and material participation of estates and trusts.
The final regulations are generally effective for taxable years beginning after December 31, 2013, although taxpayers may choose to apply the regulations to taxable years beginning after December 31, 2012.