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Sept. 11 — Taxpayers could have a tough time under new proposed rules intended to make it harder for controlled foreign corporations to use loans to foreign partnerships as a way to avoid income inclusions under Section 956, practitioners said.
Issued Sept. 1 along with temporary rules to shut down specific transactions, the proposed rules are “overbroad,” Matthew Chen, a practitioner in the International Tax Services Team at PricewaterhouseCoopers LLP, said Sept. 9 (170 DTR G-5, 9/2/15).
Under the regulations (REG-155164-09), in the context of loans, the obligation of a foreign partnership is viewed as an obligation of its partners. “As a result, if a CFC made a loan to a foreign partnership with only U.S. partners, the loan would be treated as an investment in U.S. property,” Amanda Varma, an associate with Steptoe & Johnson LLP,
said Sept. 10.
The proposed rules generally treat a foreign partnership as an aggregate for the purposes of Section 956. That code section determines the amount a U.S. shareholder of a CFC must include in gross income with regard to the CFC.
Practitioners said this approach has a wide reach and would sweep in a broad range of transactions. They contrasted this to the final and temporary regulations (T.D. 9733), effective immediately, which are intended to specifically shut down transactions where distributions have been made. Those rules require that the distribution wouldn't have been made “but for” the funding of the partnership, for Section 956 to apply.
Speaking to Bloomberg BNA in a joint interview with Chen Sept. 9, Elizabeth Amoni said by contrast, the proposed rules apply to “any loan to a partnership,” without the limited scope of the final and temporary regulations. Amoni also is with PwC's International Tax Services Practice. She noted that the rules clarify what interest in a partnership means.
Focus on Partnerships
In general, according to Paul Schmidt, firmwide chair of BakerHostetler's Tax Group, “the rules revolve around the notion that if you have a loan from a CFC to a U.S. person, that creates a Section 956 inclusion. If you interpose a partnership in the middle of that, notwithstanding that the foreign partnership may be owned by a U.S. person, it's still treated as foreign.” Schmidt is the leader of BakerHostetler's international tax practice team.
“The rules make it clear that a partnership could create an abusive transaction if it allows the cash to come back into the U.S.,” he said.
Two Rules a Surprise
Practitioners generally said they had been expecting the guidance, but one questioned the necessity of two rules.
“I don't think there was a big surprise that they issued these rules,” Seth Green, a principal in KPMG LLP's International Tax group, said Sept. 9. “It was a surprise, however, that they issued two rules, one based on whether the partnership used a distribution, and one that applied even where no distribution had occurred. I think with a little more work they could have written one, more comprehensive rule.”
He said with the issuance of two rules, “There's a lot of machinery going on. The proposed rules are closer to general principles. The temporary regulations are more in the nature of stop-gap anti-abuse rules.”
Anti-Abuse Rule Expanded
Several practitioners said the temporary rules take a tougher approach to stopping abuse sooner.
In a joint interview with Schmidt Sept. 8, John Bates, a partner on BakerHostetler's international tax practice team, said those rules “have the immediate effect of expanding the anti-abuse rule under Section 956. This arguably gives Treasury a means to challenge transactions perceived as abusive right away.”
Steptoe's Varma said the rule is now self-executing, meaning the IRS doesn't need to use its discretion to apply it.
Another change, she said, is that the rule for the first time applies to partnerships, where in the past the Section 956 rule only applied to transactions involving foreign corporations controlled by a CFC.
A third change, she said, is that the rule applies to funding by any means, not just through capital contributions or debt.
Rents and Royalties
Some practitioners pointed to language on an exception to active rents or royalties derived in the active conduct or a trade or business as an example of the wide approach of the rules. In issuing the rules, the IRS said 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 agency allowed CFCs to operate in one or multiple jurisdictions to get the benefit.
PwC's Chen said taxpayers should look carefully at language dealing with cost-sharing payments. These 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 IRS said. “I think taxpayers that have historically relied on cost sharing to meet the active development test should read these rules carefully,” Chen said.
Attorneys took varied approaches on how the rules might affect the marketplace.
PwC's Amoni said there might not be a huge impact since not many of these deals have actually been done. KPMG's Green said although not a big number has been done, the guidance is still going to be a roadblock for any more of these structures.
“I'm not sure that there are a huge number of transactions that have closed,” Green said. “I don't know that it's tremendously common in the marketplace. But it's not something that's never been done. By and large this is something that's going to close down these transactions. Most of the games that people want to play will go away.
People can probably figure out what the rules mean and live with them.”
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