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By James J. Tobin, Esq.*
Ernst & Young LLP, New York, NY
Treasury and the IRS provided us a post-summer gift in the form of proposed and temporary regulations under both §954 and §956 dealing with Subpart F income and U.S. property held by a CFC, respectively. In this column I will make a few observations and register a few complaints about the regulations under §956, which expand (and propose to further expand) the instances requiring an income inclusion under §951(a)(1)(B) as a result of a CFC's holding U.S. property.
The proposed and temporary §956 regulations address loans made by a CFC to a foreign partnership, particularly where the foreign partnership has one or more U.S. partners. The temporary regulations would treat a portion of the loan to the foreign partnership as a separate loan to a partner if the partnership makes a distribution to the partner that is funded by the CFC obligation. I'm not crazy about this anti-avoidance rule but it certainly looks good when compared to the more aggressive approach of the proposed regulations, which would adopt an "aggregate" approach to treat an obligation of a foreign partnership as a separate obligation of each partner to the extent of the partner's proportionate interest in partnership profits. Very much an expansion of current law, which is why the regulations are "proposed" and would apply to transactions after the regulations are finalized (if indeed they are finalized in their current form). This proposal for such an aggressive expansion of §956 could be a tactic by Treasury and the IRS to mute criticism of the approach taken in the temporary regulations and maybe they are not serious about the aggregate approach. One can only hope.
The aggregate approach in the proposed regulations would treat a loan to a foreign partnership as a separate loan to each of the partners to the extent of its interest in partnership profits, which is to be determined based on all facts and circumstances relating to the economic arrangement of the partners. Determining a partner's "interest in partnership profits" could get tricky if the economic arrangement involves special allocations of certain partnership items, or preferred partnership interests with largely fixed rate returns. In these cases, a partner's "interest in partnership profits" could vary on the quarterly testing dates for §956, which would change the amount of the partnership obligation treated as an obligation of a specific partner as well.
There's a lot not to like about the mechanics of the aggregate approach. But, in my view, the real problem is that the approach is wrong. Treasury and the IRS requested comments on the potential use of an aggregate approach to foreign partnerships under §956 in 2006 and, in fact, received a quite sensible report from the New York State Bar Tax Committee in that same year. The substance of those comments was that, on balance, an aggregate approach was inappropriate and unnecessary, and that, instead, the issue could be addressed by a focused anti-abuse rule quite similar to that included in the temporary regulations discussed below. So after noodling on these comments for nine years, Treasury and the IRS ignored them and proposed an aggregate approach anyhow, but only for foreign partnerships, because the proposed regulations would not apply the same aggregate approach for loans to U.S. partnerships, even those with no U.S. partners or U.S. assets. To my mind this is another example of the lack of tax policy balance and an overreach driven by the perception of an abuse. If an aggregate approach makes sense for a foreign partnership (a big if), then why doesn't it also make sense for a U.S. partnership? I don't think anyone would object to harmonized rules, and Treasury certainly has the authority, especially once it determined it had the authority for the proposed aggregate approach. Perhaps Treasury and the IRS believe taxpayers have been avoiding CFC loans to U.S. partnerships so it's not really a practical problem. But I really don't think it's good tax policy to have rules that overreach and rely on a taxpayer's ability to modify its behavior to avoid a bad result, which can create traps for the unwary and yet another anti-competitive aspect of the U.S. international tax system.
So I obviously don't agree with the overall aggregate approach and could no doubt ramble on with more reasons why. But space is limited for this column and at least the approach is only in proposed form. I had reason to be looking recently at the proposed regulations under §163(j) and was reminded that they've been in proposed form for 25 years! Given that example and the fact that Treasury and the IRS took nine years after receiving comments on the aggregate approach to even propose this misguided rule, one can hope that it will be quite awhile before (if ever) this rule goes final. So let me turn to the more immediate issues with the temporary regulations.
But wait – before I move on, I have one more complaint about the proposed regulations. The proposed regulations cover guarantees by a CFC with a similar approach to loans when debts of a foreign partnership are guaranteed. That is, where a CFC guarantees debt of a foreign partnership, the CFC would be treated as holding that obligation and, to the extent that obligation is treated as an obligation of a U.S. partner under the aggregate approach, the CFC would be treated as holding U.S. property, likely resulting in a §956 inclusion to the U.S. shareholders of the CFC. In discussing the need for the proposed rule, the Preamble to the proposed regulations states that "as under current law, each pledgor or guarantor is treated as holding the entire unpaid principal amount of the obligation to which its pledge or guarantee relates. As a result the aggregate amount of United States property treated as held by CFCs may exceed the unpaid principal amount of the obligation." Historically this potential for multiple inclusions has been a concern based on a literal reading of the rules in Reg. §1.956-1(e)(2) and Reg. §1.956-2(c). And it's a practical concern since highly leveraged groups often are required to have all affiliates guarantee certain debts. However, neither regulation cited above expressly deals with multiple CFCs guaranteeing the same U.S. obligation and I haven't seen other IRS guidance that does, nor have I seen the IRS assert this result. (In fact, in an FSA issued several years ago, FSA 200216022, the expressed IRS National Office view was not to assert a multiple inclusion.) I would recommend a more reasonable approach, which would limit each inclusion to a portion of the U.S. obligation, perhaps based on the relative values of the CFCs providing the guarantees, which can be determined under transfer pricing principles. Treasury and the IRS have requested comments about whether to implement an allocation approach and how to do such a computation. So that's my comment.
The temporary regulations contain four modifications to the §956 rules, all in the context of anti-abuse rules. The first and simplest and least problematic deals with the existing anti-abuse rule of Reg. §1.956-1T(b)(4), which covers a funding (by equity or debt) of one CFC by another CFC for a principal purpose of avoiding the application of §956. Currently this rule applies only at the discretion of the District Director, and the first change is to delete this requirement so it is clear that the provision is self-executing.
The second change is also to this same anti-avoidance rule and is to make clear, as articulated in recent IRS pronouncements, that all tax attributes are taken into account in determining whether the anti-abuse rule applies. So, for example, a principal purpose to avoid §956 applying to a CFC may exist where CFC 1 funds CFC 2, which acquires U.S. property with the funding, if CFC 2 has a high-tax pool and CFC 1 has a low-tax pool such that the U.S. shareholders of CFC would realize a tax benefit by substituting a §956 inclusion from CFC 2 rather than CFC 1. The IRS stated this to be their position in CCA 211446020. This seems reasonable to me, but in my view it was not completely clear under the language of the existing regulations before these new temporary regulations. As with other aspects of the temporary regulations, the effective date for this modification is prospective with "no inference intended" regarding the application of the prior rules. So it's clear going forward, but there is uncertainty regarding the past.
The third and fourth changes in the temporary regulations deal with partnerships, but fortunately with a less radical provision than is included in the proposed regulations. The third change in the temporary regulations is to expand the coverage of the §956 anti-abuse provision of Reg. §1.956-1T(b)(4) to include controlled partnerships as well as CFCs. As described above, that provision operates when a first CFC funds a second CFC with equity or debt for a principal purpose of avoiding a §956 inclusion, but does not cover the funding of a foreign partnership for a similar tainted purpose. The temporary regulations address that perceived gap by bringing funded partnerships within the scope of the rule.
Current Reg. §1.956-2(a)(3) already provides for look-through on a pro rata basis for a foreign partnership that owns "United States property." A CFC partner with an interest in a partnership that owns U.S. property is considered to own its proportional part of that property, with a potential §956 inclusion to that extent. The effect of including a foreign partnership in the Reg. §1.956-4T anti-abuse rule is to increase the potential §956 inclusion from the pro rata portion of the U.S. property owned by the partnership to the full amount of such property where the funding of the partnership is for a principal purpose of avoiding §956. Also, because funding includes equity or debt, the anti-abuse rule could apply where a CFC loans funds to a foreign partnership that acquires U.S. property (if the required principal purpose exists).
And the fourth §956 change in the temporary regulations deals with loans to foreign partnerships. With an approach much more targeted than that in the proposed regulations, it provides a new anti-abuse rule – Reg. §1.956-1T(a)(5) – focusing on certain foreign partnership distributions funded by CFCs. As such, its application is limited to situations where a CFC holds an obligation of a related foreign partnership that makes a distribution to a U.S. partner and would not have made that distribution but for the funding from the CFC.
This is an approach that was originally advocated in the New York State Bar comments from 2006. Certainly one can see the potential for abuse. A partner in a partnership, unlike a shareholder in a corporation, includes in its partnership interest tax basis the value of its share of certain partnership liabilities. Thus, if a CFC were to lend to a foreign partnership in which a U.S. partner had a zero basis, the U.S. partner would increase its basis by its portion of the liability and could receive a tax-free distribution from the partnership to that extent. In that circumstance, where the CFC loan creates the basis necessary to enable the distribution to be tax-free and to avoid generating a gain, it seems reasonable that the loan is attributed to the U.S. partner. This is what happens under the temporary regulations. My concern is that the rule in the temporary regulations is not limited to situations where the liability payable to the CFC is what supports the basis for the partnership distribution. To illustrate, consider a U.S. parent and a U.S. subsidiary that create a foreign partnership (or a hybrid entity) to conduct a foreign business with initial equity of 100 each. Later the foreign partnership borrows 150 from a CFC and distributes the 150 to the two U.S. partners. I don't see the abuse. The U.S. partners have paid full U.S. tax on the earnings of the partnership and are merely recovering part of their original equity stake. If the foreign partnership in this example were a CFC instead, no §956 or other anti-abuse provision would apply. Of course, in the case of a loan to a CFC followed by a distribution by the CFC, any E&P would first be considered a dividend, but in the case of a partnership the annual income would have flowed up to the U.S. partners as earned. So in my view the anti-abuse rule in the temporary regulations at a minimum should be limited to situations where the U.S. partner's distribution exceeds its contributed basis.
I'm also not crazy about the "but for" test as I can imagine this being too broadly used by the IRS on audit, with resulting uncertainty and controversy. It would be nice to have some examples of loans that would not fail the "but for" test. Refinancing of preexisting liabilities would seem like a good and non-controversial example as would funding to make distributions of partnership earnings. In my view, it is hard to see the abuse in either such case, but some IRS confirmation as well would be welcome.
So overall there are a number of things to work on in the temporary regulations. Hopefully, Treasury and the IRS will focus on needed improvements there and spend less or no time advancing the proposed regulations.
This commentary also appears in the December 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Fried and Liss, 6260 T.M., CFCs — Investment of Earning in United States Property, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.
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