Schering-Plough Corp. v. United States: Subpart F Analysis Gone Awry

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By Lowell D. Yoder, Esq.

In Schering-Plough Corp. v. U.S.,1 the U.S. District Court for the District of New Jersey held that advance payments made by two controlled foreign corporations (CFCs) to their U.S. parent pursuant to an interest rate swap arrangement should be treated as loans triggering deemed dividends under §956 of the Code. As a technical matter, this conclusion is contrary to Notice 89-21,2 which characterizes such transactions as sales.3 The court, however, held that the Notice did not apply because the advance payments were in substance loans and that treating the transactions as sales would be inconsistent with the intent of §956 to tax earnings of CFCs upon repatriation to the United States.

In describing its framework for deciding the case, the court stated that, for the taxpayer to prevail, it must show that “the tax shelter that Schering-Plough alleges Notice 89-21 provides is consistent with Congress's legislative intent.”4 This proposition is misguided and fundamentally inconsistent with a long line of Subpart F precedent. Section 956 does not apply to an arrangement unless a CFC holds property that falls within the limited definition of “U.S. property” and none of the numerous exceptions apply. In addition, the courts have consistently rejected the government's arguments to expansively apply Subpart F in order to carry out asserted Congressional intent, even where the CFC's cash is brought back to the United States pursuant to an arrangement that might be considered as abusive.

In the facts before the court, Schering-Plough entered into two 20-year interest rate swap transactions with an unrelated foreign bank. Under the swaps, the two counterparties agreed to exchange periodic payments based on a hypothetical amount (the “notional principal”) and two different interest rate indices. The swap agreements obligated Schering-Plough and the foreign bank to make periodic payments to each other reflecting the movement of the particular interest rate assigned to their respective sides of the transaction.

Schering-Plough assigned the rights to receive interest payments from the foreign bank to two of its Swiss subsidiaries for lump-sum payments totaling approximately $690 million. Under Notice 89-21, Schering-Plough reported the income for the lump sums by amortizing them over the period in which the future income streams had been assigned.

The IRS asserted that the lump-sum payments should be considered as loans for Subpart F purposes.5 Under §956, a loan made by a CFC to a U.S. related person is considered as an investment in U.S. property.6 Under the law in effect for the years at issue, the amount of any increase in such investments is included in the U.S. shareholder's income as a deemed dividend under Subpart F.7

Schering-Plough countered that §956 did not apply because the CFCs purchased the future rights to the interest payments, and therefore the advances were not loans. This characterization of the transactions as sales is provided by Notice 89-21, which governed such arrangements for the years at issue. The Notice was subsequently replaced with regulations that permit the Commissioner to treat any non-periodic swap payment as a loan for purpose of §956.8

The court appears to acknowledge that, under Notice 89-21, advance payment transactions pursuant to swap arrangements like the ones at issue in the case are characterized as sales transactions. Nevertheless, the court, after a lengthy factual and legal analysis, determined that the advance payments at issue were in substance loans. It also concluded that to treat the transactions as sales would be inconsistent with the intent of §956 to tax earnings of CFCs upon repatriation. Accordingly, the court held that Notice 89-21 could not be relied on by the taxpayer to avoid the application of §956.

As mentioned above, the court stated that the taxpayer could prevail only if it demonstrated that treating the advance payments as a purchase of the future rights to the interest payments, and thus not subject to §956, is consistent with Congressional intent. This suggested legislative-intent prerequisite is erroneous. Another recent §956 case demonstrates how a court can go awry by focusing on Congressional intent to expansively apply §956. In The Limited, Inc. v. Comr.,9 the Sixth Circuit reversed the Tax Court's holding that §956 applied to certain investments because the Tax Court “raced to the legislative history,” rather than interpreting the statutory words according to their customary meaning. Unfortunately, the court in Schering-Plough does not even refer to TheLimited case.10

Under the facts of that case, MFE-HK, a Hong Kong CFC, had excess cash of $175 million, which The Limited desired to access for its U.S. business operations. The $175 million was used to purchase certificates of deposit in World Financial Network National Bank (“WFNNB”). WFNNB was a domestic corporation organized under the National Bank Act, and was owned 100% by The Limited. WFNNB's principal business was the issuance of credit cards to customers of various stores owned by the taxpayer.

While the CDs generally would be considered loans to a related U.S. person subject to §956, the taxpayer took the position that the CDs qualified under the exception for “deposits with persons carrying on the banking business” then provided in §956(b)(2)(A). The Tax Court, however, held that the bank deposits exception did not apply, resulting in a $175 million deemed dividend to the taxpayer. The Sixth Circuit reversed the Tax Court.

The Tax Court studied the legislative history underlying the deemed dividend rules of §956 and the exception for bank deposits, and concluded that Congress could not have intended to permit the $175 million in loans by MFE-HK to a U.S. affiliate to escape current taxation. The judge believed that the bank deposits exception was intended to be available only when the U.S. bank facilitates the domestic business of the CFC. The Tax Court further determined that Congress did not intend for the exception to apply to deposits with related entities.

In reversing the Tax Court, the Sixth Circuit concluded that resorting to legislative history and policy for the intent of Congress is not appropriate if the text of the statute may be read unambiguously and reasonably. The Sixth Circuit determined that, under an ordinary and natural reading, WFNNB carries on “the banking business.” As a result, the court stated that “there is little need to stretch a common understanding of 'the banking business' to exclude WFNNB here.” The court noted that the plain language of §956(b)(2)(A) at issue had no related-party prohibition. The Tax Court therefore could not insert such a requirement into the bank deposits exception. There was no need to examine the legislative history on this point because the statute was clear. The Sixth Circuit agreed that, as a matter of policy, a related-party prohibition would have made sense. Nevertheless, the court concluded it was not the Tax Court's role to inject its own policy determinations into the plain language of statutes: “While obviously not the policy that the Tax Court would promote were it an uber-legislature, interpreting §956(b)(2)(A) without a related-party prohibition hardly rises to a level of unreasonableness that merits ignoring the plain text of the statute.”11

The courts that have considered Subpart F cases have generally limited themselves to the actual language of the Code, regulations, and other authority. The courts have pointed out that Congress's intent is difficult to ascertain in the Subpart F context, noting that the Subpart F rules represent a compromise and contain numerous exceptions. For example, in one of the early Subpart F cases, the Tax Court rejected the government's assertions of intent as the basis for deciding against the taxpayer, stating:

Even assuming that the existence of a clear “statutory scheme” would be sufficient to allow this Court to rewrite the language of the statute, we are unable to agree with respondent's premise that such a consistent “statutory scheme” exists. While we do not doubt that Congress sought to achieve the general purposes quoted above in the Senate committee report, it appears that subpart F, as finally enacted, embodies numerous exceptions to those general purposes. A review of the events leading to the enactment of subpart F is sufficient to show that respondent's ideal of a “statutory scheme” is elusive indeed…. But the point to be observed is that the existence of these many exceptions makes it hard to glean from subpart F the precise “statutory scheme” to which respondent alludes. In summary, we are not prepared to say that the purposes and goals of subpart F have been so obviously revealed as to preclude the possibility that Congress intended in certain cases that section 951(d) would provide favorable treatment for the taxpayer.12

The Tax Court in Ludwig v. Comr.13 refused to expand the §956 definition of U.S. property to fill a perceived loophole. In that case, the court rejected the Service's argument that a U.S. shareholder's pledge of CFC stock as collateral for a loan rendered the CFC a “guarantor” of the loan and therefore subject to §956. The government argued that “[t]he purpose of section 956 of the Code is to terminate the tax deferment privilege with respect to the earnings of controlled foreign corporations when such earnings are directly or indirectly repatriated.” The Tax Court acknowledged the possibility that the failure of the statute to address stock pledge transactions was an oversight, but concluded that this possibility should not affect its decision: “If the draftsmen's handiwork fell short of fully accomplishing the objectives sought, it must be left to Congress to repair such shortfall.”

In a subsequent case, the Claims Court similarly rejected the government's arguments that §956 should be applied because the taxpayer's position may be considered abusive. In Lovett v. U.S.,14 the court invalidated a Subpart F regulation that was unsupported by the express statutory language. The court recounted: “Defendant views the legislative history of subpart F as revealing two paramount Congressional aims: (1) to tax as a dividend the repatriation of earnings by foreign corporations through investment in United States property, and (2) to avoid the double taxation of foreign corporate income while achieving the first purpose.” The government argued that the regulation is necessary “to avoid the 'absurd’ results which flow from a literal application of the language in §951(d).”

The court stated that “[w]e agree that one of the general Congressional purposes in enacting subpart F was the taxation of repatriated earnings. However, it is clear that this general purpose was modified in the specific and detailed statutory scheme which Congress adopted. Subpart F contains a variety of exceptions to, and limitations on, the taxation of repatriated earnings.” The court went on to say that “[w]e are not certain that defendant's characterization of this result as 'absurd’ is correct. A Congressional decision to treat dissimilarly situated taxpayers in a dissimilar manner is not absurd simply because it may result in the Treasury receiving less revenue.” In rejecting the government's arguments, the court quoted from U.S. v. Calamano,15 “ '[n]either we nor the Commissioner may rewrite the statute simply because we feel that the scheme it creates could be improved upon.’ ”

This refusal to decide Subpart F issues in favor of the government on the basis of Congressional intent runs through other Subpart F cases. In MCA, Inc. v. U.S.,16 the Ninth Circuit found in favor of the taxpayer holding that royalties received by a 95% CFC partner from a partnership were not Subpart F income because a partnership controlled by a CFC was not a related person. The court presented the government's arguments as follows:

The government suggests that even if the distributorships technically satisfy the partnership test of §301.7701-2, we should construe the regulations broadly to classify the distributorships as corporations, thereby eliminating an abusive tax shelter. The government reasons that Congress enacted subpart F to eliminate the tax deferral advantage of doing business through controlled foreign corporations, by taxing currently to United States shareholders all income that is deemed earned by those shareholders. The government asserts that in enacting subpart F Congress was more concerned with the nature of the income than the form of the entity generating the income, and that CIC's distributorship income is precisely the kind that Congress intended to tax currently under I.R.C. §951(a).

 

 

The court rejected the government's arguments, stating:

We find this argument unpersuasive. Although we agree that CIC's distributorship income is apparently the kind that Congress intended to tax currently if received from a controlled corporation, we decline the government's invitation to depart from the plain language of the statute. Congress wrote the statute unambiguously to apply to subpart F income received from controlled “corporations” only. If the omission of income received from controlled partnerships has indeed created an unjustified loophole in the tax laws, the remedy lies in new legislation, not in judicial improvisation.

 

 

In a subsequent Subpart F case involving partnerships, Brown Group Inc. v. Comr.,17 the government sought to treat a CFC partner's distributive share of sales income derived by a partnership as Subpart F income, notwithstanding the fact that the statute in effect at the time failed to so provide. The Eighth Circuit recounted that the Service contended that the Tax Court opinion “was 'unnecessarily broad and can reasonably be interpreted in a manner that effectively repeals virtually all of the subpart F provisions of the Code.’” The court rejected the Service's position even though it acknowledged that policy considerations clearly supported it: “Although our holding may result in a tax windfall to the Brown Group due to the particularized definition of 'related person’ under the pre-1987 version of section 954(d)(3) of the Internal Revenue Code, such a tax loophole is not ours to close but must rather be closed or cured by Congress.”

Similarly, in Vetco v. Comr.,18 the Tax Court rejected the government's plea to shut down a structure that it believed was abusive. The taxpayer took the position that the Subpart F branch rule did not apply where a Swiss CFC hired its U.K. subsidiary to manufacture the products it sold, and the Swiss CFC did not have its own employees. The government asserted that the taxpayer used “contractual wizardry” in an attempt at tax avoidance, and that the Subpart F branch rule was a “broad loophole-closing provision” and thereby should cause the taxpayer's income to be subject to Subpart F. Nevertheless, the court held for the taxpayer, refusing to apply the government's arguments based on Congressional intent.

Most recently, the Tax Court rejected the Service's Subpart F policy arguments in Dover Corp. v. Comr.,19 in which a taxpayer elected to disregard a CFC as a separate entity prior to selling it in order to treat the sale as a sale of operating assets (not subject to Subpart F) instead of a sale of stock (subject to Subpart F). The court concluded that, to the extent that policy concerns were raised by the intersection of the entity classification regulations and the rules of Subpart F, the government should address them by amending the regulations, rather than aggressively interpreting the existing regulations in pursuit of a particular policy result:

Finally, we note that, consistent with his admonition in the preamble to the final check-the-box regulations, T.D. 8697, 1997-1 C.B. at 216, that “Treasury and the IRS will continue to monitor carefully the uses of partnerships [and, by extension, disregarded entities] in the international context and will take appropriate action when … [such entities] are used to achieve results that are inconsistent with the policies and rules of particular Code provisions,” respondent was, of course, free to amend his regulations to require a minimum period of continuous operation of a foreign disregarded entity's business, prior to the disposition of that business, as a condition precedent to treating the owner as having been engaged in the trade or business for purposes of characterizing the gain or loss. But, in the absence of respondent's exercise of that authority, we must apply the regulation as written.20

 

 

The court in Schering-Plough fails to discuss, or even cite to, any of the above Subpart F authorities. The lack of a reference to the above cases, which analyze in detail the role of the legislative history in deciding Subpart F issues, is particularly disconcerting because the court sets up as a precondition of the taxpayer prevailing that it must prove that treating the advance payments as sales transactions is consistent with Congressional intent.21 As the above authorities uniformly hold, this proposition is erroneous, even where the arrangement might be considered abusive. The courts refused to go beyond the express language of Subpart F to carry out what might appear to be appropriate policies.

Furthermore, the opinion lacks any substantive discussion of the §956 rules and exceptions, and the purported Congressional intent. The court apparently views repatriation to the United States of a CFC's earnings as the Congressional intent that the advance payments must not be inconsistent with, as evidenced from the following statement: “The legislation -- Subpart F of the Internal Revenue Code -- mandates taxation of foreign E&P upon repatriation to the United States.” Similarly, the opinion quotes from Jacobs Engineering Group, Inc. v. U.S.22 as follows: “Subpart F 'aimed at preventing repatriation of income to the United States in such a way that the income is not subject to U.S. taxation.’ ” Thus, the Congressional intent focused on by the court is “repatriation” of CFC earnings, but the opinion does not define the meaning of that term or the scope of arrangements that Congress intended to be subject to the deemed dividend treatment provided by §956.

The term “repatriation” often is used to refer to dividends paid by foreign subsidiaries to their U.S. shareholders. At such time, the earnings become subject to U.S. taxation. This result, however, is not provided in Subpart F, but in the general provisions of the Code that apply to distributions from corporations to their shareholders.23 The court found that the advance payments were loans, not constructive dividends. Accordingly, as a general matter, the advance payments would not violate a policy to tax a CFC's earnings upon distribution to the U.S. shareholders, because that did not occur under the facts of the case.

Section 956 modifies the general rules that apply to corporations and their shareholders to treat certain investments by a CFC into the United States (U.S. property investments) as a deemed repatriation of earnings. Nevertheless, only specified investments into the United States are subject to this special rule, and there are numerous exceptions. Unfortunately, the court does not indicate that it is aware of the limited scope of §956, but seems to suggest by its general reference to “repatriation” without limitation that Congress intended to subject to current taxation any funds of a CFC brought back to the United States.

For example, a CFC may use its earnings to purchase a machine or other property from its U.S. parent, and ship the property to a foreign destination. The CFC clearly does not have an investment in U.S. property because it does not own a tangible asset located in the United States. Furthermore, §956 provides an exception when a CFC purchases inventory that is located in the United States where the inventory is for export. Even though CFC funds cross the border into the United States and are received by a related U.S. person, and might be considered a “repatriation” of the CFC's earnings to the United States, it is indisputable that such transactions are not subject to §956. It is not the transfer of funds by the CFC into the United States that causes §956 to apply, but whether the particular property is within the limited definition of U.S. property.24

In addition, while loans to U.S. persons generally constitute an investment in U.S. property subject to §956, there are numerous exceptions. For example, an exception is provided for loans to unrelated U.S. persons. Interestingly, while initially such loans were considered a deemed repatriation of funds to the United States, Congress subsequently amended §956 to provide that loans to unrelated U.S. persons are not U.S. property to encourage CFCs to loan excess cash to U.S. borrowers. Deposits with U.S. banks and U.S. government obligations are not U.S. property, even though the funds are effectively “repatriated” to the United States. In addition, the Code provides exceptions for CFC loans to related U.S. persons where they arise from the sale of inventory or provision of services. Again, the court does not indicate whether it is even aware of such exceptions to the application of §956 to the “repatriation” of CFC earnings to the United States.

It is particularly important to point out that the court's reasoning should not be construed as calling into question the Service's practice of not applying §956 to CFCs making short-term loans to U.S. affiliates. While such loans are technically subject to §956 and may be considered a “repatriation” of CFC earnings to the United States, the IRS has provided an exception in Notice 88-10825 where the CFC loans are collected within 30 days and the CFC does not have loans outstanding to related U.S. persons for 60 or more days during the year. Indeed, recently the IRS issued Notice 2008-91,26 which effectively extended the 30/60 day rule to a 60/180 day rule on an elective basis in light of current economic conditions, although the Notice applies for only two years.

The Schering-Plough opinion makes certain statements that might be troubling to taxpayers relying on the above Notices. The opinion states: “Notice 89-21 does not supplant, qualify, or displace Subpart F. The statutory scheme and the 'administrative pronouncement’ are not on equal footing. The former reflects congressional will, and the latter 'merely represents the commissioner's position with respect to a specific factual situation,’” and such “does not constitute authority for deciding a case in this Court.”27 In addition, the opinion states: “The Court concludes that Notice 89-21 was not intended to permit United States shareholders of controlled foreign corporations to repatriate offshore revenues without incurring an immediate repatriation tax. In a clash between the short-lived notice and the enveloping Subpart F regime, the Court is faced with an easy choice….” This language might be read as creating some uncertainty for taxpayers relying on Notice 88-108 and, in particular, on the “short-lived” Notice 2008-91. Nevertheless, despite the court's sweeping statements, a taxpayer should be able to rely on those Notices, which were issued specifically to provide that certain short-term loans are not subject to §956.28

In summary, the court's statement that the taxpayer may prevail only if it establishes that treating the advance payments as sales transactions is consistent with Congressional intent is fundamentally inconsistent with a long line of precedent addressing Subpart F issues and, in particular, cases addressing issues under §956, even where the result might be considered abusive. Furthermore, any suggestion that the mere transfer by a CFC of its earnings to the United States is inconsistent with the intent of §956 is contrary to the statutory scheme of providing a specific and limited definition of U.S. property and numerous exceptions. Finally, any aspersions that might be cast by the court's opinion on two key notices providing an exception to §956 for certain short-term loans to related U.S. persons must be disregarded.

In the final pages of its lengthy opinion the court discusses “The Big Picture: Subpart F vs. Notice 89-21.” This section begins with: “the Court is mindful not to 'miss the forest for the trees’… wholly apart from the Court's economic analysis above is the powerful fact that Schering-Plough desired -- from the outset -- to bring $690 million of previously untaxed foreign income back to the United States without paying an up-front tax.” The following paragraphs discuss the apparent Congressional intent to tax “repatriation” of CFC earnings, without any meaningful discussion of the specific §956 rules providing a limited definition of U.S. property and numerous exceptions. It seems to me that the court “missed the trees for the forest.” Contrary to the court's suggestions, taxpayers can rely on the proposition that the rules of Subpart F should not apply to arrangements outside the language of the Code, regulations, and other authorities, even where the policies underlying Subpart F arguably could be furthered by an expansionary interpretation.

This commentary also will appear in the December 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 Schering-Plough Corp. v. U.S., 2009-2 USTC ¶50,614 (D.N.J. 2009).

, 2009-2 USTC ¶50,614 (D.N.J. 2009).

2 1989-1 C.B. 651.

3 The government issued a field service advice concluding that a similar transaction should be treated as a sale under Notice 89-21, and accordingly the advance payment was not treated as a loan and was not subject to §956. 1997 FSA LEXIS 206 (8/29/97). In a prior decision, the court granted the government's motion for partial summary judgment on the taxpayer's claim that the government abused its discretion in treating the taxpayer differently from similarly situated taxpayers. Schering-Plough Corp. v. U.S., 2007 U.S. Dist. LEXIS 88387 (D.N.J. 12/3/07).

4 2009-2 USTC ¶50,614, at p. 89,668.

5 The IRS also asserted that the advance payments were constructive dividends. The court did not address this argument.

6 §956(c)(1)(C).

7 §951(a)(1)(B).

8 Regs. §1.446-3(g)(4).

9 286 F.3d 324 (6th Cir. 2002).

10 Interestingly, the Schering-Plough opinion cites to an article supporting the Tax Court's decision in TheLimited written by a law clerk who worked on that opinion, but the court in Schering-Plough does not refer to the appellate court opinion that overruled the Tax Court's decision. 2009-2 USTC ¶50,614, at p. 89,702, n. 35.

11 286 F.3d at 336. Congress subsequently amended the statute prospectively to limit the exception to deposits with a bank holding company or a corporation owned by a bank holding company or financial holding company, but without a related-party prohibition. §956(c)(2)(A).

12Estate of Leonard E. Whitlock, 59 T.C. 490 (1972). See also Dougherty v. Comr., 60 T.C. 917, 927 (1973) (the court noted the “multiplicity of legislative purposes which underlay the enactment of subpart F,” and found that “the search for a unified legislative purpose in subpart F proves to be elusive”).

13 68 T.C. 979 (1977).

14 621 F.2d 1130 (Cl. Ct. 1980).

15 354 U.S. 351, 357 (1957).

16 685 F.2d 1099 (9th Cir. 1982).

17 77 F.3d 217 (8th Cir. 1996).

18 95 T.C. 579 (1990). See also Ashland Oil, Inc. v. Comr., 95 T.C. 348 (1990) (the Tax Court similarly rejected the government's arguments to broadly apply the Subpart F branch rule as a loophole closing provision).

19 122 T.C. 324 (2004).

20 122 T.C. at 352. Regulations were issued which would have provided a different result, but those regulations were subsequently withdrawn.See Yoder, “Check-and-Sell Transactions: Proposed Regulations Withdrawn, But Still Under Attack,” 32 Tax Mgmt. Int'l J. 515 (10/10/03).

21 This precondition may not have been necessary to the court's holding because it found that the arrangements were in substance loans. Nevertheless, the court seems to be influenced in its decision-making by its often expressed view that the advance payments were fundamentally a repatriation of CFC earnings and should be taxed currently under Subpart F.

22 79 AFTR 2d 97-1673 (C.D. Cal. 1997), aff'd, 168 F.2d 488 (9th Cir. 1999) (unpub. opin.). The court in Jacobs Engineering treated successive short-term loans as continuously outstanding, and therefore subject to §956. Unlike the other §956 cases discussed herein, the District Court in Jacobs Engineering refers to the legislative history in support of its holding. Interestingly, the IRS was issuing private rulings to other taxpayers blessing the same practices during the years at issue. For a discussion of this case, see Yoder & McGill, “Treatment of CFC Loans to U.S. Affiliates: The Sword and Sickle of Subpart F,” 26 Tax Mgmt. Int'l J. 454 (9/12/97).

23 §301.

24See Yoder, “Improving Efficiency of Global Cash Utilization: Accelerated Payments for Inventory,” 38 Tax Mgmt. Int'l J. 171 (3/13/09).

25 1988-2 C.B. 445. See Yoder, “IRS Applies Section 956 Thirty-Day Exception to Quarters,” 36 Tax Mgmt. Int'l J. 664 (12/14/07).

26 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).

27 2009-2 USTC ¶50,614, at p. 89,702. The court quotes from Stark v. Comr., 86 T.C. 243, 250-51 (1986).

28 Taxpayers may rely on notices to the same extent as revenue rulings. See Regs. §601.601(d)(2)(v)(e); Rev. Rul. 87-138, 1987-2 C.B. 287.