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By Lowell D. Yoder, Esq.
McDermott Will & Emery, Chicago, IL
In September 2015, Treasury and the IRS issued revised temporary regulations that expand the §956 indirect investment rule.1 This rule treats a controlled foreign corporation (CFC) that funds a related foreign corporation as holding U.S. property acquired by the other foreign corporation under certain circumstances.
Section 951(a)(1)(B) and §956 require U.S. shareholders of a CFC to include in gross income an amount equal to the average of the amounts of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter, but limited to the CFC's earnings and profits. This amount is reduced by the CFC's previously taxed earnings and profits.
U.S. property is defined to include tangible property located in the United States, stock or obligations of related U.S. persons, and certain intangible property held for use in the United States.2 In addition, a CFC is considered as holding an obligation of a U.S. person if the CFC is a guarantor or pledgor of the obligation.3
Prior Reg. §1.956-1T(b)(4) provided that, at the discretion of the IRS, a CFC will be considered as indirectly holding U.S. property held by a foreign corporation controlled by the CFC4 if one of the principal purposes for creating, organizing, or "funding (by loan or capital contribution)" (emphasis supplied) such other foreign corporation was to avoid the application of §956 to the CFC.5
For example, CFC1 makes a loan to CFC2 in the amount of $10 million, and CFC2 in turn loans $10 million to the U.S. parent of CFC1 and CFC2 (USP). All entities have a calendar taxable year and the loans are outstanding for the entire year. CFC1 has $25 million of earnings and profits and CFC2 has no earnings and profits. CFC2's $10 million loan to USP would be an investment in U.S. property, but under the general rules of §956 there would be no inclusion in the income of USP because CFC2 has no earnings and profits. CFC1's $10 million loan to CFC2 is not U.S. property because it is an obligation of a foreign person. If, however, CFC1 were considered as loaning the $10 million to CFC2 with a principal purpose of avoiding the application of §956 to CFC1, then, under the §956 indirect investment rule, CFC1 would be considered as holding the $10 million obligation of USP held by CFC2, resulting in a $10 million §956 inclusion in the income of USP from CFC1's earnings and profits.6
The revised temporary regulations remove the limit on the types of funding, providing that the indirect investment rule may apply to a CFC that funds another foreign corporation "by any means (including by capital contribution or debt)" (emphasis supplied). No explanation of this change is given, except the Preamble states that the modification to the funding language is consistent with the same change previously made to a similar rule in Reg. §1.304-4(b).7
The only discussion in the Preamble to the revised §304 regulations of the removal of the similar limit on the types of funding indicates that the §956 indirect investment rule may apply in cases where a foreign corporation borrows funds from an unrelated person to acquire U.S. property. A CFC may be treated as funding the other foreign corporation if it facilitates the repayment of that obligation.8
Assume in the above example that CFC2 instead borrows $10 million from a bank and loans the funds to USP. Three months later CFC1 loans $10 million to CFC2 to repay its loan from the bank. Under the revised regulations, CFC1 may be treated as holding the U.S. property held by CFC2 if there was a principal purpose to avoid the application of §956 to CFC1.
Not all situations where a CFC funds another foreign corporation controlled by the CFC are subject to the indirect investment rule. The regulations contain an example where CFC1 sells property to CFC2 for trade receivables due in 60 days. CFC2 makes a loan to USP equal to the amount it owes CFC1, and CFC2 has no earnings and profits. CFC2 pays the trade receivables according to their terms. The example concludes that the indirect investment rule does not apply to treat CFC1 as holding the USP obligation held by CFC2. On the other hand, where CFC2 defers payment of the trade receivables with a principal purpose of avoiding the application of §956 with respect to CFC1, the indirect investment rule applies to treat CFC1 as indirectly holding the loan to USP.9 The examples indicate that the indirect investment rule does not apply to ordinary course transactions that are not undertaken with a principal purpose of avoiding the application of §956 to the funding CFC.
The indirect investment rule should not apply to all transfers of funds to another foreign corporation. For example, a CFC's repayment of a loan from another foreign corporation, or the purchase of property from another foreign corporation, should not be considered as a "funding" subject to this rule. Similarly, a CFC subsidiary that pays a dividend to its foreign parent should not be considered as indirectly funding the foreign parent's investment in U.S. property. Such transfers of funds do not result in an investment by the CFC in the other foreign corporation or any kind of indirect claim on the corporation's assets, whereas the point of the indirect investment rule is to determine when it is appropriate to treat the CFC as holding indirectly the U.S. property acquired by the other foreign corporation. Without an investment in the other foreign corporation, the facts to support the construct of treating the other foreign corporation as a conduit for an investment in U.S. property by the CFC are not present.10
The revised temporary regulations also modify the indirect investment rule by applying it to a situation where the related foreign corporation that actually holds the U.S. property has earnings and profits. This change appears to target funding arrangements where §956 is being used affirmatively to trigger an inclusion of a CFC's earnings and profits with a high effective foreign tax rate, or where a U.S. parent accesses earnings and profits of a CFC through a loan rather than a distribution and the inclusion is subject to no, or minimal, U.S. tax (e.g., high-taxed earnings and profits or previously taxed income).11
Assume in the above example that CFC2 has $10 million of earnings and profits with an effective tax rate of 50%, and CFC1's $25 million of earnings and profits has an effective tax rate of 10%. CFC2 borrows $20 million from CFC1 on March 20 and loans that amount to USP through September 15. The amount of the investment in U.S. property would be $10 million (a $20 million loan to USP outstanding over two quarter ends), and under the general §956 rules would result in a $10 million inclusion of CFC2's earnings and profits in the income of USP. U.S. tax generally would be eliminated with deemed-paid foreign tax credits that accompany the inclusion.12
An example in the revised temporary regulations indicates that the indirect investment rule may apply to treat CFC1 as holding the $20 million loan to USP even though CFC2 has sufficient earnings and profits for the full amount of the investment in U.S. property to be included in USP's income under §951(a)(1)(B).13 The Preamble to the temporary regulations states that, in determining whether there is a principal purpose of avoiding the application of §956 to CFC1, the tax attributes of CFC1 and CFC2 (such as total earnings and profits, previously taxed earnings and profits, and foreign tax credit pools) are taken into account.14 Application of the indirect investment rule would result in U.S. tax costs because CFC1's earnings and profits were subject to a low effective foreign tax rate (i.e., 10%).
This modification of the indirect investment rule is beyond the purpose of §956. The legislative history indicates that the purpose of §956 is to subject to tax CFC earnings and profits repatriated to the United States.15 The full amount of the investment in U.S. property in the above example would be subject to U.S. taxation without the application of the indirect investment rule (i.e., $10 million), and valuable tax credits would be expended in satisfaction of the U.S. tax owed on this repatriation. There is no indication that Congress was concerned about the ultimate tax results of subjecting a CFC's earnings and profits to U.S. taxation. Furthermore, since CFC2 could have instead simply distributed its high-taxed earnings and profits to USP without any residual payment of U.S. tax, this expansion of the indirect investment rule creates unwarranted complexity. Taxpayers now may be required to incur any additional foreign tax costs for CFC2 to actually distribute its earnings and profits, or bear the costs and burdens of CFC2 borrowing from third parties to fund a short-term loan, if certainty is desired.16
On a positive note, the Preamble and an example provide that to the extent the indirect investment rule applies to treat a funding CFC as holding U.S. property acquired by another foreign corporation, §956 will not also apply to the foreign corporation that actually holds the U.S. property. For example, if CFC1 loans $10 million to CFC2 to invest in U.S. property with a principal purpose of avoiding the application of §956 to CFC1—and therefore CFC1 is treated as holding the $10 million of U.S. property—then CFC2 will not also be treated as holding the U.S. property. This avoids double counting.17
In summary, the revised temporary regulations require taxpayers to evaluate whether any transfer of funds made by a CFC to a related foreign corporation that holds an investment in U.S. property might be subject to the indirect investment rule, even where the foreign corporation holding the U.S. property has earnings and profits. In such cases, taxpayers will frequently have strong arguments for why the transfer of funds should not be considered to have a principal purpose of avoiding §956, but careful analysis is recommended. It would be appropriate for final regulations to provide a more limited indirect investment rule to reduce unwarranted complexity and burdens on taxpayers, and more closely align the rule with the purpose of §956.18
This commentary also appears in the February 2016 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 Earnings in United States Property, and in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation.
Copyright©2016 by The Bureau of National Affairs, Inc.
6 Two cases have applied the indirect investment rule to a CFC parent that made a capital contribution to a CFC subsidiary with no earnings and profits which then loaned the funds to a U.S. related corporation on a long-term basis. Schering-Plough Corp. v. United States, 651 F. Supp. 2d 219 (D.N.J. 2009), order denying motion for retrial, Merck & Co v. United States, 2010-1 USTC ¶50,373 (D.N.J. 2010), aff'd,Merck & Co. v. United States, 652 F.3d 475 (3d Cir. 2011); The Limited, Inc. v. Commissioner, 113 T.C. 169 (1999), rev'd on other grounds, 286 F.3d 324 (6th Cir. 2002). See also CCA 201420017 and CCA 201446020 (applied the §956 indirect investment rule where back-to-back loans were made on the same day and in similar amounts).
7 T.D. 9606, 77 Fed. Reg. 75,844 (Dec. 26, 2012); Yoder, Final Regs. §1.304-4: Broad Anti-Avoidance Rules, 42 Tax Mgmt. Int'l J. 239 (Apr. 12, 2013). The final §304 regulations adopted (without change) temporary regulations that were issued in 2009. T.D. 9477, 2010-1 C.B. 385; Yoder, Temp Regs. §1.304-4T Broadens Anti-Avoidance Rule, 39 Tax Mgmt. Int'l J. 222 (Apr. 9, 2010). The original Reg. §1.304-4T and the original Reg. §1.956-1T(b)(4) were adopted at the same time (in 1988).
8 T.D. 9477, above, "Explanation of Provisions," part C ("For example, the regulations may apply when the deemed acquiring corporation facilitates the repayment of an obligation incurred by the acquiring corporation (even if such obligation is with respect to a borrowing from an unrelated party) to acquire the stock of the issuing corporation.").
10 This conclusion is consistent with not treating the CFC that actually holds the U.S. property as subject to §956 because the funding CFC is treated as indirectly holding the U.S. property, which construct would not make sense if the funding CFC had no investment in the CFC holding the U.S. property. T.D. 9733, at p. 52,977; Reg. §1.956-1T(b)(4)(iv) Ex. 3.
11 The IRS has accepted the affirmative use of §956. See Rev. Rul. 90-112, 1990-2 C.B. 186; Reg. §1.902-1(f) Ex. 4; PLR 8912037, PLR 8114032; FSA 961121; FSA 950823; Notice 2008-91, 2008-43 I.R.B. 1001 (making expanded short-term obligation exception elective, presumably to accommodate affirmative use of §956). See also Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (May 4, 1987), at pp. 1085-86, 1089-90; Amstead Industries, Inc. v. Commissioner, Doc. No. 47616-86, discussed in Tax Notes Int'l (July 1989), at p. 72; §960(c) (presupposes that taxpayers may affirmatively trigger an inclusion under §951(a)(1)(B)).
15 This legislative history is quoted in the Preamble to proposed §956 regulations which were issued at the same time as the temporary regulations. REG-155164-09, 80 Fed. Reg. 53,058 (Setp. 2, 2015) ("Section 956 is intended to prevent a United States shareholder of a CFC from inappropriately deferring U.S. taxation of CFC earnings and profits by `prevent[ing] the repatriation of income to the United States in a manner which does not subject it to U.S. taxation.' H.R. Rep. No. 87-1447, 87th Cong., 2d Sess., at 58 (1962). Accordingly, under section 956, the investment by a CFC of its earnings and profits in United States property is `taxed to the [CFC's] shareholders on the grounds that this is substantially the equivalent of a dividend.' S. Rep. No. 87-1881, 87th Cong., 2d Sess., at 88 (1962).").
16 In recent years before the issuance of the revised temporary regulations, the IRS issued two Chief Counsel Advices applying the indirect investment rule where the CFC holding the U.S. property had earnings and profits. CCA 201420017 (12/27/13) and CCA 20144602 (7/27/14). For a critique of these CCAs, see Yoder, IRS Applies the §956 Indirect Investment Rule to a Partnership Loan, 43 Tax Mgmt. Int'l J. 630 (Oct. 10, 2014); Yoder, IRS Expands the Application of the Code Sec. 956 Anti-Conduit Rule, 41 Int'l Tax J. 3 (Mar.-Apr. 2015).
17 Reg. §1.956-1T(b)(4)(iv) Ex. 3; T.D. 9733, at p. 52,977. Other modifications to the indirect investment rule contained in the revised temporary regulations include: (1) making the rule self-executing; (2) changing the phrase "one of the principal purposes" to "a principal purpose" (a change that the IRS emphasized was not substantive in nature); and (3) applying the rule to a partnership controlled by a CFC. Proposed regulations would make similar changes to an indirect investment rule that applies to factored receivables and also provide additional rules for applying §956 to partnerships. REG-155164-09, 80 Fed. Reg. 53,058 (Sept. 2, 20155).
18 We note that whether the indirect investment rule in the regulations constitutes a valid exercise of Treasury's rulemaking authority has not been challenged in court. See, e.g., Lovett v. United States, 621 F.2d 1130 (Cl. Ct. 1980) (invalidated Subpart F regulation as unsupported by express statutory language); cf. Altera Corp. v. Commissioner, 145 T.C. No. 3 (July 27, 2015) (unanimous reviewed Tax Court opinion held that Reg. §1.482-7(d)(2) was invalid because Treasury failed to demonstrate that it engaged in reasoned decision-making as required by the Administrative Procedure Act).
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