By Lowell D. Yoder, Esq. McDermott Will & Emery LLP, Chicago, IL
The current financial crisis has increased the focus of U.S. multinationals on ways to improve the efficiency of global cash utilization while avoiding current U.S. taxation. One idea is for a foreign subsidiary to accelerate payments for the purchase of inventory from its U.S. parent.
By way of background, foreign earnings of a foreign subsidiary are not subject to U.S. taxation until distributed as a dividend to its U.S. parent.1 Furthermore, under the general rules, a loan from a subsidiary to its parent is not treated as a dividend. Accordingly, absent a special rule, a U.S. parent could access offshore cash by simply borrowing the cash from its foreign subsidiaries, and only when the cash is permanently repatriated to the United States as a dividend would the earnings of the foreign subsidiary be subject to U.S. taxation.
Nevertheless, §956, a provision unique to the U.S. tax system, treats a loan from a controlled foreign corporation (“CFC”) to its U.S. parent as a dividend, even though the U.S. parent has not actually received a dividend. In other words, absent certain limited exceptions, a U.S. company is prevented from accessing foreign cash through a loan from a foreign subsidiary in a manner that does not cause the loan proceeds to be included in the taxable income of the U.S. shareholder. An important exception is provided for short-term loans, and in view of the current liquidity crunch, the IRS and Treasury recently expanded this exception, permitting a CFC to loan funds to a U.S. related person for as long as 179 days during a taxable year.2
There is another global cash management opportunity when a U.S. company sells products to its foreign subsidiaries. The U.S. company may either manufacture the products or purchase the products from suppliers. The idea relates to the timing of when the U.S. company is paid for the inventory.
For the sake of illustration, assume that a U.S. company (“USP”) manufactures products in the United States and, pursuant to a supply or distribution agreement, sells the products to foreign related distributors (“FRDs”) for resale to foreign customers. USP takes back receivables that are due within 90 days. Under this arrangement, USP is effectively funding the costs of manufacturing the products and carrying the cost of the inventory through 90 days after the products have been sold to the FRDs.
Assume that on average the FRDs have payables outstanding to USP on a rolling basis of approximately $20 million. To provide USP with additional cash for funding its manufacturing and sales operations, the FRDs may accelerate their payment of the amounts due to USP for purchases of inventory. Paying for the products on a current basis provides USP with approximately $20 million to use for business needs.
The payment by the FRDs of the trade payables on a current basis should not raise any material U.S. or foreign tax concerns. The purchase price appropriately should be discounted to reflect the time value of money element of the current payment arrangement, which results in such amount being included in the incomes of the FRDs as additional sales income.
The FRDs also may consider making advance payments to USP for inventory to be purchased. For example, the FRDs might prepay approximately $20 million for the projected amount of purchases of inventory under the supply agreement during the following three months. This might be repeated on a rolling basis and reported as “prepaid inventory” on the balance sheets of the FRDs. Again, the amounts advanced for the inventory should reflect a time value of money discount.
The prepayments made by the FRDs for inventory should not give rise to investments in U.S. property resulting in deemed dividends to USP under §956. Although §956, in relevant part, applies to “obligations” of a related U.S. person, the term “obligation” is limited to indebtedness. More specifically, an obligation is defined in the regulations as including a bond, note, debenture, or “other indebtedness.”3 Generally, an advance payment for goods or services is not considered a loan, and therefore does not give rise to indebtedness, provided that the buyer has agreed to purchase the goods or services (i.e., the buyer will not receive a refund unless the seller defaults). Advance payments are instead generally regarded as payments of income.4 Thus, USP's contractual obligation to provide products in the future should not be considered indebtedness and therefore should not constitute an “obligation” for §956 purposes.5
Also, potentially relevant is §956(c)(2)(C), which provides that the definition of U.S. property does not apply to an obligation arising in connection with the sale or processing of property where the amount does not exceed the amount which would be ordinary and necessary to carry on the trade or business of both the CFC and the U.S. person had the transaction been made between unrelated persons. This exception should be available for trade payables a U.S. company has for purchases of products from a CFC as well as advance payments made by a CFC for the purchase of inventory from its U.S. parent.6 Whether an obligation is “ordinary and necessary” is determined based on the facts and circumstances.7 Accordingly, assuming the “ordinary and necessary” standard is satisfied, the exception should apply to any obligation arising out of the prepayments made by the FRDs to USP.8 This standard should be applied taking into account funding difficulties of the U.S. manufacturer in the current economic environment, particularly where the cash is important to efficiently continue USP's manufacturing operations for purposes of supplying products to the FRDs.
Another reason why the advance payments should not result in a deemed dividend under §956 is because the FRDs may not have basis in any obligation. Where a CFC holds an investment in U.S. property, the amount of the deemed dividend is limited to the CFC's adjusted basis in the property.9 The Code and regulations appear to provide that the advance payments made to USP for inventory should not be capitalized or deducted by the FRDs because economic performance does not occur until the property is provided to the FRDs.10 Accordingly, since the FRDs should not have any basis in any obligation resulting from the advanced payments,11 there should be no amount invested in U.S. property for purposes of §956.12
While the prepayments should not result in deemed dividends under §956, generally the U.S. parent includes in income an advance payment for inventory when such payment is received.13 Nevertheless, such payments may not be required to be reported in income when received if the arrangement qualifies for the “inventoriable goods exception.”14
The inapplicability of §956 to accelerated payments for inventory is appropriate from a policy perspective. Such funding supports the continued manufacturing of products in the United States for sale to customers outside the United States, particularly during times of liquidity problems for U.S. manufacturers.15 Furthermore, the prepayments are not a permanent repatriation of funds; rather, they are advances for the purchase of products. In addition, the amounts advanced to the U.S. parent are reported as sales income included on the U.S. tax return of the U.S. company. Indeed, one may appropriately question why the United States stands out as the only country that effectively penalizes its multinational companies when a foreign subsidiary loans funds to its U.S. parent to help with its U.S. business operations in a financial crisis.16
This commentary also will appear in the March 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Madole, 929 T.M., Controlled Foreign Corporations -- Section 956, and in Tax Practice Series, see ¶7130, U.S. Persons -- Foreign Activities.
1 §§881, 882.
2 Notice 2008-91, 2008-43 I.R.B. 1001; see Yoder, “Notice 2008-91 Expands Code Sec. 956 Exception for Short Term Obligations,” 35 Int'l Tax J. 3 (Jan-Feb 2009); Yoder, “Gleanings from Section 956 Developments,” 38 Tax Mgmt. Int'l J. 39 ( Jan. 2009).
3 Regs. §1.956-2T(d)(2).
4 U.S. v. Wiese,750 F.2d 674 (8th Cir. 1984) (payments received under installment sales contract prior to delivery of merchandise treated as income, rather than as deposits or loans, despite possibility of refunds); S. Garber, Inc. v. Comr., 51 T.C. 733 (1969) (advance payments for custom-made clothing treated as income upon receipt, even though the payments were refundable, because they were received without restriction to their use or disposition); Karns Prime & Fancy Food v. Comr., 494 F.3d 404 (3d Cir. 2007) (amounts received constituted income upon receipt because the taxpayer's right to keep the funds depended solely on its compliance with a supply agreement); Schlude v. Comr., 372 U.S. 128 (1963) (cash paid to a dance studio was income when received, not when lessons were provided); Am. Auto. Ass'n v. U.S., 367 U.S. 687 (1961) (prepaid membership dues are income when received despite the association's obligation to provide membership services during the subsequent year); TAM 200725029 (prepaid amounts for services were not deposits and were includible in gross income upon receipt where there were no restrictions on the use of the funds and they were deposited in the taxpayer's regular bank account). Cf.,Comr. v. Indianapolis Power & Light Co., 493 U.S. 203 (1990) (advance payments made to a utility company treated as loans where the utility's right to retain the funds was contingent upon the customer's future decision to purchase services, such that the customers, rather than the utility, controlled the disposition of the deposited funds); Oak Indus., Inc. v. Comr., 96 T.C. 559, 570 (1991) (security deposit paid by subscribers for over-the-air television was not includible in the year of receipt because the customer had the right to refund of the deposit if the customer performed its obligations).
5 Generally, a buyer's rights under a contract for delivery of merchandise that it has already paid for is not considered as indebtedness. See Lewellyn v. Electric Reduction, 275 U.S. 243 (1927); Beaver v. Comr., 55 T.C. 85 (1970). See also Regs. §1.166-1(c) (“A bona fide debt is a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money”); Prop. Regs. §1.7872-2(a) (“A payment for property, goods, or services under a contract, however, is not a loan merely because one of the payor's remedies for breach of the contract is a recovery of the payment”). See also 1993 FSA LEXIS 341 (8/9/93) and 1993 FSA LEXIS 265 (6/2/93) (refer to the general definition of “indebtedness” under federal tax principles in finding that warrant and call contracts did not constitute “obligations” for purposes of §956). Also, the seller's obligations under the supply contract to supply the products should not change as a result of the advance payment. Under many supply or distribution agreements, the seller's obligation to make and deliver products to the buyer generally occurs when an order is placed by the buyer, not when payment occurs. The payment terms (e.g., when payment occurs, how payment is transmitted to the seller, and the consequences of overdue amounts) generally do not dictate if and when the obligation to make and deliver products occurs.
6 In addition to the language of the Code and regulations, two cases support the position that this exception should be available for an obligation arising from an advance payment made by a CFC to a U.S. seller of inventory. Greenfield v. Comr., 60 T.C. 425 (1973), aff'd, 506 F.2d 972 (5th Cir. 1975); Sherwood Properties, Inc. v. Comr., 89 T.C. 651 (1987). These cases found that the “ordinary and necessary” requirement did not apply under the particular facts, and that the CFCs held investments in U.S. property. It is noted that the cases did not expressly consider the issue of whether mere advance payments for inventory should be considered “obligations” for purposes of §956. More importantly, unlike the fact pattern in this commentary, the facts of Greenfield and Sherwoodindicate that the parties intended to treat the advances as loans, as evidenced by the fact that they were formalized with notes. It is questionable whether the results of the cases would have been the same had the parties not evidenced the advances with notes.
7 Regs. §1.956-2(b)(1)(v).
8 See TAM 8114032 and PLR 200519005 applying the “ordinary and necessary” standard.
9 §956(a)(1); Regs. §1.956-1(e)(1).
10 Although prepaid expenses generally are capitalized, capitalization should not occur until economic performance has occurred. Regs. §1.263(a)-4(d)(3), (f)(8), Ex. 10 (prepaid rental expense is not taken into account through capitalization, deduction, or otherwise until economic performance occurs); cf., Regs. §1.263(a)-4(d)(3), Ex. 1 (prepaid insurance premium subject to immediate capitalization because, for insurance premiums, economic performance occurs when payments are made). Where a taxpayer's liability arises from the acquisition of property from another person, economic performance does not occur until the other person “provides” the property (i.e., the property is delivered or accepted, or title passes). §461(h)(2)(A)(ii); Regs. §1.461-4(d)(2)(i). But seeRegs. §1.461-4(d)(6)(ii) (taxpayer may elect to treat property as provided to the taxpayer as the taxpayer makes payment to the person providing the property).
11 §1012; Regs. §1.263(a)-4(g).
12 If the FRDs receive the inventory while it is located in the United States, such property should qualify for the exception to the definition of U.S. property that applies to inventory located in the United States which is purchased for export to, or use in, foreign countries. §956(c)(2)(B).
14 Regs. §1.451-5(c). Advanced payments for inventory not previously included in income under the taxpayer's accrual method must be included in income by the last day of the second taxable year following the year in which the advance payments were received. USP should also consider any financial accounting impact of the prepayments for inventory.
15 There has been a long-standing fundamental U.S. policy reflected in the Code of encouraging exports of U.S.-manufactured products. In addition to the export property exception to §956 referred to above, see§§991-997 (DISC export incentive); §§921-927 (FSC export incentive); §§114, 941-943 (extraterritorial income exclusion).
16 See Vaughan, Dow Jones Newswires (12/24/08), reporting that Senate tax staff are discussing a possible legislative change that would relax rules on loans from foreign affiliates.
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