This document contains amendments to 26 CFR Part 1 relating to the rules under section 954(i) of the Internal Revenue Code (Code) for determining whether a controlled foreign corporation’s (CFC’s) distributive share of partnership income is excluded from foreign personal holding company income under the exception contained in section 954(i).

On July 23, 2002, the IRS and the Treasury Department published in the Federal Register (T.D. 9008, 2002-2 C.B. 335 [67 FR 48020]) final regulations under section 702 and subpart F. Since the publication of T.D. 9008, the IRS and the Treasury Department have received several comments relating to the rule in the final regulations regarding the application of section 954(i) (special rule for income derived in the active conduct of an insurance business). These temporary regulations modify this rule in response to these comments.

Section 1.954-2(a)(5)(ii) sets forth special rules for determining the extent to which a CFC’s distributive share of an item of income of a partnership is foreign personal holding company income. Section 1.954-2(a)(5)(ii)(C) addresses the exception contained in section 954(i) for income derived in the active conduct of an insurance business. Investment income that is excluded from insurance income as exempt insurance income under section 953(e) may nevertheless be treated as subpart F income if it falls within the definition of foreign personal holding company income under section 954(c) and the exception contained in section 954(i) is not satisfied. Section 1.954-2(a)(5)(ii)(C) provides that a CFC’s distributive share of partnership income is excluded from foreign personal holding company income under the exception contained in section 954(i) only if the CFC is a qualifying insurance company, generally as defined in section 953(e)(3), and the partnership, of which the CFC is a partner, generates qualified insurance income within the meaning of section 954(i)(2), taking into account only the income of the partnership. Qualified insurance income is defined under section 954(i)(2) as income of a qualifying insurance company that is derived from investment of certain of its reserves or surplus if certain other requirements are satisfied.

Commentators expressed concern that §1.954-2(a)(5)(ii)(C) would never permit a CFC’s distributive share of partnership income to qualify for the exclusion under section 954(i). Section 7701(a)(3) and the regulations provide that any entity that is an insurance company is treated as a corporation for Federal tax purposes. See Rev. Rul. 83-132, 1983-2 C.B. 270. Thus, any entity engaged in an active insurance business generally would be treated as a corporation and therefore would not be subject to the rule in §1.954-2(a)(5)(ii)(C).

Commentators also distinguished section 954(i) from the other exceptions to foreign personal holding company income in section 954, arguing that those exceptions do not provide the appropriate model for section 954(i). The special rules in the regulations regarding the exception to foreign personal holding company income contained in section 954(c), or the exception for income derived from the active conduct of a banking or similar business contained in section 954(h), turn on whether the income was generated from certain active business activities. In contrast, income that is excluded under section 954(i) may be generated from purely passive investments as long as the amount of the investments satisfies the requirements set forth in section 954(i). Commentators asked for clarification of the regulations to take into account the purposes of section 954(i).

In response to these comments, these temporary regulations provide that a CFC’s distributive share of partnership income will qualify for the exception contained in section 954(i) if the CFC is a qualifying insurance company and the income of the partnership would have been qualified insurance income under section 954(i) if received by the CFC directly. Thus, whether the CFC partner’s distributive share of partnership income is qualified insurance income is determined at the CFC partner level.

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedures Act (5 U.S.C. chapter 5) does not apply to these regulations and, because the regulation does not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this temporary regulation will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Paragraph 1. The authority citation for 26 CFR part 1 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.954-2 is amended by revising paragraphs (a)(5)(ii)(C) and (a)(5)(iii) Example 2, to read as follows: