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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
Section 956 generally treats a loan made by a controlled foreign corporation ("CFC") to its United States shareholder ("U.S. shareholder") as an investment in United States property ("U.S. property"), triggering an income inclusion to the U.S. shareholder to the extent of the CFC's earnings and profits ("E&P") that are not previously taxed income. Section 956(d) leads to the same result where a CFC guarantees a loan made to the U.S. shareholder, and where more than two-thirds of, the stock of a CFC is pledged for such a loan.
Back in 2006, Treasury and the IRS alerted the tax community to the fact that they were thinking about issuing regulations under §956 to address the case in which a CFC makes a loan to a foreign partnership in which one or more U.S. shareholders of the CFC are partners.1 In early September 2015, Treasury and the IRS released those regulations in both temporary and proposed form.2 The two sets of regulations could not be more different! As applied to CFC loans to foreign partnerships, the temporary regulations are eminently sensible. However, the proposed regulations addressing the same question are anything but sensible.3 While it would take a much longer commentary to do the proposed rules justice, this short commentary will set forth the reasons why they should not be finalized in their present form.
The temporary regulations eschew an aggressively "aggregate" approach to partnerships, under which any loan from a CFC to a foreign partnership in which a U.S. shareholder of that CFC is a partner would be treated as an investment in U.S. property within the meaning of §956. Unfortunately, the proposed regulations adopt precisely that approach. This means, for example, that even where a partnership is an active operating business (as many are) with its own creditors, a CFC loan would be treated, per se, as having been made to its U.S. partners.4 For this and other reasons, the New York State Bar Association Tax Section, among others, had argued that a CFC loan should be so treated only in abusive cases, such as where the loan proceeds were distributed, pursuant to a plan, to the U.S. partners.5
Under the new temporary regulations, a CFC loan (or a guarantee by a CFC of a third-party loan) to a foreign partnership will be treated as made to a partner of the partnership only if: (1) the partnership distributes "an amount" of money or property to that partner; (2) the partnership "would not have made the distribution but for" the funding of the partnership by the loan; and (3) the partner is related to the CFC.6 The amount of the loan treated as an obligation of the partner is the lesser of the actual amount loaned by the CFC and the amount of the "but for" distribution.7
The temporary regulation sensibly avoids a tracing rule, requiring only that "an amount" be distributed. The breadth of that term is curtailed by the "but for" test. Thus, for example, if a partnership makes tax distributions or other ordinary recurring distributions to its partners, a CFC loan or guarantee should not be treated as made to a partner merely for that reason. In most cases, a non-pro-rata distribution by the partnership to its partners should not raise an issue, although it would depend on the facts and circumstances.
Some might be heard to complain that the "but for" test is overly vague. Yet the test has a long and useful history and is nothing new. Examples of the successful use of a "but for" test can be found in Rev. Rul. 87-89,8 which was declared obsolete only because the anti-conduit regulations were adopted, incorporating the "but for" test in part.9 The concept underlying those rules was that a series of transactions can be integrated under a conduit analysis if the intermediary entity would not have participated – e.g., made a guarantee or loan – but for another party's participation. Similarly, the ruling described situations in which a loan would not have been made on the same terms but for a related-party guarantee. Another example of the use of a "but for" test is found in the statutory definition of "acquisition indebtedness" in the unrelated debt-financed income rules of §514(c)(1). An indebtedness incurred before or after the unleveraged acquisition of property is treated as acquisition indebtedness only if it would not have been incurred but for such acquisition.
The "but for" approach of the temporary regulations gives comfort to those who are just trying to get on with business, and gives pause to those who are up to something. This is precisely the right approach in the context of §956. The aggregate rule should apply only in the context of planned transactions in which a U.S. shareholder is attempting to receive funds from a CFC through a conduit. It should not apply to ordinary course commercial transactions where no such planning occurs. If a CFC makes a loan to a foreign partnership for use in that partnership's business, and stands in the position of an unrelated creditor looking to the operations and assets of the foreign partnership for repayment, there is no reason to treat such loan as if it had been made to the partners of the borrower partnership.
In fact, it is a shame that this portion of the new temporary regulations applies only to foreign partnerships. Treasury and the IRS continue to credit the fiction that a domestic partnership is a U.S. person within the meaning of Subpart F. In the context of §956, this rule is proposed to be enshrined in Prop. Reg. §1.956-4(e) (and its disregarded entity counterpart, Prop. Reg. §1.956-2(a)(3)).10 Under that view, any CFC loan to a related domestic partnership always results in an investment in U.S. property, even if there is no distribution of the proceeds to a U.S. partner and zero potential for abuse. At least until the proposed regulations become effective, this was an artificial reason for using a foreign partnership when a domestic one would do just as well. The world would be a better place if Treasury and the IRS would let go of their attachment to this fiction and treat domestic partnerships exactly the way foreign partnerships are treated: generally as aggregates of their partners, but applying §956 only in the case of conduit loans.
The proposed regulations also provide more generally applicable rules for measuring a CFC's share of the obligations of a partnership. Presumably the IRS felt more guidance was needed in light of the expansion of the aggregate rules from those in existing Reg. §1.956-2(a)(3). Where a CFC is a partner in a partnership, one concern with an aggregate rule is that it is unclear whether the basis of the partnership's U.S. property taken into account by the CFC partner under §956 should be the CFC's share of the partnership's "inside" basis or should be limited to the CFC partner's "outside" basis. Rev. Rul. 90-112 adopted a rule that looks to inside basis but caps the CFC's investment in U.S. property at its outside basis.11 The proposed regulations include a basis rule that looks to the CFC's attributable share of the partnership's inside basis. In general, attributable share is measured by looking at the partners' interests in partnership profits.12 The Preamble explains that this method of measurement was also chosen to measure a partner's benefit from a loan by a CFC to the partnership because the partners will benefit from the loan to the extent of their interests in partnership profits. Frankly, that reasoning is hard to follow. And oddly, the proposed regulations use a different measurement -- liquidation value -- in the context of CFC loans to foreign partnerships.13 In neither case is any mention made of a cap equal to a partner's outside basis in its partnership interest.
If the rules contained in the proposed regulations were limited to anti-abuse situations, it would not be necessary to limit the amount of the investment to a partner's outside basis. Where a CFC makes a loan to a partnership for the express purpose of avoiding the purposes of §956, one need not be overly concerned with measurement of the resulting inclusion. People just won't do it. In the real world of real deals, tax professionals are careful to avoid bringing up unintended §956 inclusions, avoiding CFC guarantees and pledges in excess of two-thirds of the CFC's stock. No one allows CFCs to invest in partnerships that own U.S. property within the meaning of §956. If the proposed regulations are finalized in their current form, inadvertent §956 inclusions are much more likely to arise, and improper measurements of the §956 inclusion are likely to be one fall-out.
The temporary regulations package includes other changes to Subpart F, none of which was anticipated by prior announcements. The most surprising, and curious, is the expansion of the anti-abuse rule in Reg. §1.956-1T(b).14 Prior to its expansion, the anti-abuse rule applied only when a CFC funded a controlled corporation. For example, if a CFC with lots of E&P set up and funded a new subsidiary CFC with no E&P, with the aim that the new CFC would make a loan to a related U.S. shareholder, the regulations have long treated this as an indirect repatriation of the first CFC's E&P.15 This rule did not formerly apply to CFC funding of a partnership, even a controlled partnership. Instead, under the Brown Group regulations, a CFC is treated as owning its share of a partnership loan to a related U.S. shareholder.16 The temporary regulations expanded the anti-abuse rule such that if a CFC "funds" a controlled partnership with an evil intent, 100% of any loan made by the partnership to a related U.S. person will be treated as an investment by such CFC in U.S. property.17 This new anti-abuse rule applies only to the extent that it results in the holding of an amount of U.S. property that exceeds the amount that would be attributed to the CFC under the general look-through rule.18
It is hard to understand the purpose of this new anti-abuse rule. The purpose of the existing rule is to prevent taxpayers from avoiding a §956 inclusion by making use of an entity with little or no E&P. It is basically a relocation rule, testing the "funding" CFC rather than the corporation that in form made the loan. A partnership, of course, does not have E&P. If one accepts the premise of the aggregate construct, it is hard to see why it matters that a CFC controls a partnership, even if it has a bad motive. After all, the most that the CFC can be said economically to own is its proportion of the partnership's loan. Perhaps the rule is targeting a funding of a partnership whose partners are related CFCs with little or no E&P? If so, one would have thought that the existing rule adequately covers that case. In fact, Example (1) contained in the proposed regulations related to the factoring rule of §956(c)(3), which picks up on the "funding" rule, seems to illustrate what most folks thought the law already was.19 The only new feature of that rule, like all of the proposed regulations, is that if there is a proscribed evil intent, then the entire amount at issue, not just the CFC's partnership share, is tainted. This author has little concern with any rule that applies only in the presence of a motive to avoid §956, at least assuming it is relatively clear when such a motive will be deemed to be present.
The temporary regulations make other changes to the anti-abuse rule of Temp. Reg. §1.956-1T(b). One, long presaged, was to eliminate the requirement that the IRS first exercise its discretion to challenge a taxpayer's transaction as abusive.20 Another change was presaged by CCA 201446020. There the IRS found that the anti-abuse rule applied even though the actual transaction resulted in a §956 inclusion. The CCA observed that, as a result of the taxpayer's transactions, the amount of the §956 inclusion was smaller than it would otherwise have been. It also noted that the CFC that in form made an investment in U.S. property had usable foreign taxes that could be pulled up as credits, whereas the funding CFC had zero or at least fewer foreign taxes in its pool. The language of the anti-abuse rule has now been changed to take into account each CFC's tax attributes, such as its foreign tax pool, in determining whether the anti-abuse rule applies.21
This commentary also appears in the October 2015 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.
4 For a longer explanation of why partnerships (and even disregarded entities) engaged in an active business should not be treated as aggregates for purposes of §956, see Blanchard, Guidance Needed for CFC Lending Transactions, 126 Tax Notes 201 (Jan. 11, 2010).
10 Oddly, these portions of the proposed regulations will not go into effect until the regulations are finalized, even though, as the Preamble makes clear, the IRS views them as current law. See Prop. Reg. §1.956-4(f)(4) and Prop. Reg. §1.956-2(h)(1).
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