IRS Moves to Curb Tax Advantages on Loans From CFCs to Partnerships

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Sept. 1 — The Internal Revenue Service issued long-awaited proposed and temporary rules to make it harder for controlled foreign corporations to use loans to partnerships to avoid income inclusions under tax code Section 956.

Practitioners said the guidance, released Sept. 1, takes a wide approach to these and other foreign tax issues, with significant changes in the partnership area. “It seems they have concerns about particular types of transactions, and have written very broad rules to cover every permutation,” said John Harrington, former Treasury international tax counsel and a partner at Dentons in Washington.

In the final and temporary rules (T.D. 9733) which are effective immediately, the government said it is cracking down on the use of partnerships to avoid Section 956 inclusions.

Lending an Issue

One example is a transaction where a CFC contributes cash to a partnership in exchange for an interest in the partnership, which in turn lends the cash to a U.S. shareholder of the CFC. In this case, a taxpayer might take the position that the CFC is not treated as indirectly holding the entire obligation of the U.S. shareholder but is treated as holding the obligation only to the extent of the CFC's interest in the partnership under Section 956.

The IRS said it is expanding the reach of Section 956 to include transactions involving partnerships that are controlled by the CFC.

In the temporary rules, the government said it is also seeking to curb situations where a CFC funds a foreign partnership, or guarantees a borrowing by a foreign partnership, and the foreign partnership then makes a distribution to a U.S. partner that is related to the CFC.

Distribution Requirements

Joseph Calianno, partner and international technical tax practice leader at BDO in Washington, said the final and temporary rules do have greater limits than the proposed rules (REG-155164-09), because T.D. 9733 requires that a distribution be made, and that the distribution wouldn't have been made but for the funding of the partnership, for Section 956 to apply.

Those limits don't exist in the proposed rules, where Calianno said taxpayers could have a Section 956 issue even absent a distribution. One big question, Calianno said, is how taxpayers would make the analysis to determine whether the distribution wouldn't have been made but for partnership funding reasons.

Partner Obligations

Harrington pointed to language under the proposed rules that treats an obligation of a foreign partnership as an obligation of its partners for the purposes of Section 956.

Harrington noted that the rules address not just when a CFC makes a loan but when it pledges or guarantees the loan.

Calianno criticized language in the proposed rules that could lead to multiple income inclusions if there is more than one loan guarantee. For example, if a U.S. company gets a loan of $100 that is guaranteed by three different CFCs, it could lead to an income inclusion of $300 for that company, he said.

Pledges and Guarantees

“That approach is inappropriate,” Calianno said. “You should not have inclusion of more than the loan amount. That doesn't make a lot of sense from a policy standpoint.” He acknowledged that the IRS did outline alternative approaches and asked for comments in the proposed rules.

Moving to another feature of the temporary rules, Harrington addressed an exception to active rents or royalties derived in the active conduct of a trade or business.

The IRS said the policy underlying this exception means the CFC itself must actively conduct the business that generates the rents or royalties to qualify for the exception, using its own officers or staff. However, the CFC can use its own staff or officers to conduct business in more than one foreign country, the IRS said.

Cost-Sharing Payments Don't Count

The agency said cost-sharing payments made by a CFC won't cause that CFC's officers and employees to be treated as undertaking the activities of the participant to which the payment is made. These payments “are not active leasing expenses or active licensing expenses for purposes of determining whether an organization is ‘substantial,’ the agency said in the proposed rules.

The temporary and proposed rules will be published in the Sept. 2 Federal Register.

To contact the reporter on this story: Alison Bennett in Washington at
To contact the editor responsible for this story: Cheryl Saenz at

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