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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
Courts have rejected IRS policy arguments as the basis for deciding Subpart F cases, and two lower court decisions that relied on Subpart F policy were overturned on appeal.1 The district court's opinion in Schering-Plough Corp. v. U.S.,2 however, appeared to depart from this precedent, discussing Subpart F policy as a basis for deciding against the taxpayer. Nevertheless, in a second opinion, the district court clarified that the references to Subpart F policy were not necessary for its decision, and an Appellate Court recently affirmed the lower court's holding without mention of Subpart F policy.3
The Schering-Plough case addressed the application of §956 to certain transactions involving a controlled foreign corporation (CFC). By way of background, foreign earnings of a foreign subsidiary generally are not subject to U.S. taxation until distributed as a dividend to its U.S. parent.4 Furthermore, a loan from a subsidiary to its parent, or any other investment, generally is not considered as a dividend.5 Section 956 provides an exception to these rules.
Specifically, §956 treats certain "investments in U.S. property" held by a CFC as a deemed dividend to the U.S. parent. Such investments include stock and "obligations" of related U.S. persons, pledges, and guarantees of obligations of U.S. related persons, tangible property located in the United States, and certain rights to use intangible property in the Untied States.6 An obligation for this purpose means "indebtedness."7 For example, a $100 loan made by a foreign subsidiary to its U.S. parent outstanding for the year would be treated as a $100 deemed dividend to the U.S. parent.8 The legislative history indicates that the general purpose of this rule is to subject to U.S. taxation a CFC's earnings effectively repatriated to the United States in non-dividend transactions.9
The Code, regulations, and administrative guidance provide a number of exceptions for stock, obligations, and tangible property that would otherwise be considered U.S. property (e.g., accounts payable for the purchase of products or services and short-term loans).10In addition, a number of investments resulting from transactions whereby cash of a CFC is transferred into the United States are not within the definition of U.S. property, e.g., the purchase of foreign property from a U.S. affiliate or a deposit in a U.S. bank account. Therefore, the policy underlying §956 to subject to U.S. taxation CFC earnings effectively repatriated to the United States is not intended to apply to all transfers of CFC cash to the United States, but is limited to investments that fall within the express definition of U.S. property.
The courts have literally applied the definition of U.S. property, rejecting expansive interpretations argued by the government based on the general policy underlying §956. For example, the Tax Court in Ludwig v. Comr.11 refused to expand the §956 definition of U.S. property to fill a perceived loophole, rejecting 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. In Lovett v. U.S.,12 the court invalidated a Subpart F regulation that was unsupported by the express statutory language, refusing to apply §956 to an investment in U.S. property made by a foreign personal holding company because the coordination rule prevented the application of Subpart F. In The Limited, Inc. v. Comr.,13 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. In that case, a CFC acquired certificates of deposit in a wholly owned U.S. bank of its U.S. parent. The Sixth Circuit rejected the Service's policy arguments, and sided with the taxpayer that the CDs qualified under the exception for "deposits with persons carrying on the banking business" then provided in §956(b)(2)(A).14 In these cases the courts acknowledged that the general Subpart F policy of taxing earnings effectively repatriated to the United States arguably applied, but determined that it was limited by the statutory language in deciding the case, even if the holding created a perceived loophole.15
The district court's opinion in Schering-Plough appeared to take a contrary approach, indicating that Subpart F policy provided a basis for applying §956 to an investment. That case addressed whether payments made by two CFCs to their U.S. parent should be subject to §956. Schering-Plough had 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. 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.
Pursuant to Notice 89-21,16 Schering-Plough reported the transactions as a purchase by the CFCs of the future rights to the interest payments and accordingly not subject to §956. The court, however, after a lengthy factual and legal analysis, determined that the payments at issue were in substance loans to the U.S. parent and therefore subject to §956.
The district court's opinion appeared to provide an independent basis for its decision based on the general policy of Subpart F to tax earnings of a CFC effectively repatriated 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."17 Near the end the opinion states, "[T]he 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 court, in its conclusion, states, "by repatriating $690 million in offshore earnings, Schering-Plough cannot avoid—under the pretext of Notice 89-21—the obvious intent of Congress to capture a portion of such sums under Subpart F."18 The opinion contains no discussion of the above cases that rejected general legislative intent as the basis for applying §956, nor does it mention the numerous transactions whereby a CFC can transfer cash to the United States without being subject to §956.
The taxpayer filed a motion for retrial challenging the district court's reliance on, among other things, Subpart F policy (i.e., the court's "Big Picture" analysis). The district court denied the motion for retrial, stating that it considered the transactions as loans made by the CFC to a related U.S. person and therefore subject to §956. The court did not believe that the Subpart F theory was necessary to reach its ultimate conclusion, stating:Merck's refund suit failed not because the Court held that Notice 89-21 could never apply to notional principal contracts, but rather because the Court concluded that the transactions were loans in this case, and were thus expressly not protected from subpart F taxation by the notice…Additionally, before beginning its analysis under ACM, the court specifically stated that `[h]aving found that under various branches of the substance-over-form doctrine, the 1991 and 1992 swap-and-assign transactions were loans not eligible for tax-deferred treatment under Notice 89-21, the Court need go no further to render judgment for the government.' In other words, the substance-over-form analysis was sufficient to support the judgment; the ACM and `Big Picture' analysis were therefore not intertwined with it.19
Accordingly, the Subpart F theory discussed by the district court in the original Schering-Plough opinion should be viewed not only as dictum but also as irrelevant in a case where the words of the statute and regulations provide for a result that the IRS asserts is in conflict with the Subpart F policies. Therefore, the district court's opinion should not be read as preventing taxpayers from continuing to rely on the proposition that the definitions of U.S. property should not be expanded beyond the plain language of the Code and regulations, even where the policies underlying Subpart F arguably could be furthered by such expansionary interpretations.20
The irrelevance of Subpart F policy is confirmed by the appellate court opinion. The Third Circuit affirmed the lower court decision solely on the conclusion that the transactions in substance constituted loans from the CFC to Schering-Plough, a related U.S. person. The appellate decision contains no mention of the Subpart F theory.21 The Third Circuit's opinion thus further supports the proposition that the district court's Subpart F policy discussion was irrelevant dictum that has no precedential value.
It is not the transfer of cash by a CFC into the United States that causes §956 to apply, but whether the particular transaction results in an investment that is within the limited definition of U.S. property.22 Section 956 applies to the above transactions only if it is determined that the arrangements constituted indebtedness of a related U.S. person.23 If a determination were made that the transactions in Schering-Plough constituted a sale, then §956 would not apply.24
This commentary also will appear in the August 2011 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 ¶7150, U.S. Persons—Worldwide Taxation.
5 See §§61(a)(7), 301(a), (c) (dividends include only distributions of property made to a shareholder with respect to its stock). See also Merck & Co., above, at fn. 3 (§956's taxation of a CFC's loan to a related U.S. person "is in contrast to the ordinary treatment of loans, which are usually not treated as income for tax purposes").
7 An obligation is defined in the regulations as including a bond, note, debenture, or "other indebtedness." Regs. §1.956-2T(d)(2). For a further discussion of the definition of obligation, see Yoder, "Improving Efficiency of Global Cash Utilization: Accelerated Payments for Inventory," 38 Tax Mgmt. Int'l J. 171 (3/13/09).
8 The amount of a CFC's §956 investments is determined based on the quarterly average of the amounts of the CFC's investments in U.S. property, subject to certain earnings and profits limitations. §956(a), (b).
14 Yoder and Christensen, "The Limited, Inc. v. Comr.: Appellate Court Slams Tax Court's Narrow Interpretation of §956 Bank Deposits Exception," 31 Tax Mgmt. Int'l J. 453 (9/13/02); Yoder, "The Limited Case: A Refresher in Statutory Interpretation," 2 J. of Tax'n of Global Trans. 3 (Winter 2003).
15 Ludwig v. Comr., 68 T.C. 979, 989-92 (1977): "[i]f the draftsmen's handiwork fell short of fully accomplishing the objectives sought, it must be left to Congress to repair such shortfall." For a discussion of these and other Subpart F cases, see Yoder, "Schering-Plough Corp. v. United States: Subpart F Analysis Gone Awry," 38 Tax Mgmt. Int'l J. 705 (12/11/09).
16 1989-1 C.B. 651; see 1997 FSA LEXIS 206 (8/29/97). The Notice was subsequently replaced with regulations that permit the Commissioner to treat any non-periodic swap payment as a loan for purposes of §956. Regs. §1.446-3(g)(4).
17 2009-2 USTC, at p. 89,668. The district court states, "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., 79 AFTR 2d 97-1673 (C.D. Cal. 1997), aff'd, 168 F.2d 488 (9th Cir. 1999) (unpublished opinion) 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.'"
18 See Schering-Plough v. U.S., 651 F. Supp. 2d at 272 ("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.").
19 See Notice 89-21 ("No inference should be drawn from this notice as to the proper treatment of transactions that are not properly characterized as notional principal contracts, for instance, to the extent such transactions are in substance properly characterized as loans").
20 This appears to be consistent with the view of the government as expressed in its (Final) Brief for Appellee: "The District Court's decision does not prohibit tax-planning…. The Internal Revenue Code mandates that, as soon as that cash is invested in U.S. property as defined in §956, U.S. taxes can no longer be avoided and must be paid on that investment." P. 36 (emphasis added).
22 The court in Lovett, above, 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."
24 See Merck & Co., fn. 3, above, (after discussing that loans from CFCs to U.S. related persons are taxable, the court says "[a] U.S. company therefore has an incentive to characterize funds received from a foreign subsidiary as the proceeds of a sale, rather than a loan."); p. 13 ("The District Court's decision rested on its findings that the Transactions were, in substance, loans rather than sales.")
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