VideoA rule change released by the Internal Revenue Service regarding so-called controlled foreign corporations (CFCs) may give tax managers pause as they head to the end of the year. The reason: the change — dubbed Notice 2008-91 — and put in place to help companies weather the credit crisis, could fail to do its job if a precedent-setting case involving Jacobs Engineering Group is widely applied.
A discussion of CFCs in light of the new notice, and how it affected Jacobs Engineering is notable. First, consider the structure of a CFC as defined by the government. While a CFC is a foreign corporation, it is unusual because more than 50 percent of its stock is owned by one or more U.S. persons, and each of those persons own 10 percent or more of the foreign corporation's voting stock.
Now consider a CFC that makes an investment in "U.S. property," in which the amount of the investment — unless an exception applies — produces a deemed dividend, and the dividend amount is equivalent to the investment for the CFC's U.S. shareholders. Such an investment is regarded as an effective repatriation of the CFC's undistributed earnings. As a result, it is a proper occasion for taxing the U.S. shareholders.
The investment is a repatriation because under the tax code — specifically Section 956(c) — the IRS defines U.S. property to include an obligation — such as a loan — of a U.S. person. Therefore, a loan from a foreign subsidiary to its U.S. parent would be taxed under repatriation rules.
However, an exception to the repatriation rules was announced in 1988 (Notice 88-108, 1988-2 C.B. 445). The rule amendment excludes from the repatriation definition any loan amount collected within 30 days from the time it is incurred. So short-term loan would garner tax-free status. At the time, the IRS warned that the 30-day exclusion would not apply if the CFC holds the loan for 60 or more calendar days during the taxable year the obligation constitutes an investment in U.S. property. (In addition, the loan has to be on hand at the end of the CFC's taxable year.)
Then two months ago, in response to the current credit crisis, the Treasury Department and the IRS extended the holding period of CFC loans. In a gallant effort to "facilitate liquidity," the IRS announced on Oct. 6, that a CFC loan to its American parent may exclude from the repatriation definition if the obligation is collected within 60 days from the time it is incurred (Notice 2008-91, I.R.B. 2008-43). The exclusion does not apply, however, if the CFC holds the loan for 180 or more calendar days during its taxable year.
For example, under the October rule, a foreign subsidiary may loan its parent funds for up to 60 days without triggering tax consequences. If a loan is not paid back within the prescribe period, the parent corporation is required to pay taxes on the income at its effective marginal rate —l which could reach 35 percent.
The October rule applies to a CFC's first two taxable years ending after Oct. 3, 2008 —. So in effect, the October IRS notice allows for a total of three 60 day loans during the taxable year from the CFC to its U.S. shareholder, without causing the foreign corporation to be seen as having made an investment in U.S. property.
But an unresolved issue persists regarding the October rule. That is, whether the loans can be consecutive, or whether some period of time must elapse between the termination of one loan and the initiation of another. This issue arises because there is case law — as well as a controversial IRS revenue ruling — suggesting that consecutive loans can be treated, in substance, as a single, continuous loan.
If the IRS intends the case precedents and revenue ruling to be applied to the loans referred to in the October notice, taxpayers will have to be extremely careful to avoid having what is, in form, consecutive loans viewed as a single loan that exceeds the 60-day period laid out in Notice 2008-91.
Jacobs Engineering
The case law pertinent to the question about consecutive loans involves Jacobs Engineering, a widely-held and publicly-traded domestic corporation. Jacobs owned 100 percent of the stock of a Panamanian corporation called JILI. In dire need of working capital, Jacobs structured a series of 12 loans from JILI spread out from 1982 through 1984. Each loan lasted not longer than a few months.
The IRS determined that the loans constituted "repatriated income" subject to tax. But Jackobs disagreed with the government's assertion and the dispute landed in court. (See Jacobs Engineering Group, Inc. v. United States, 97-1 USTC Para. 50,340 (USDC CD. CA. 1997).) The court observed that the tax code, in Section 956(c), subjects a domestic corporation "to income" to the extent that the earnings of a foreign subsidiary are invested in the obligations of a U.S. person. Prior to 1988, the term obligation did not include any indebtedness that was collected within one year from the time it was incurred.
Accordingly, JEG structured 12 short-term loans from JILI each to be collected within one year from the date it was incurred. The IRS argued that, in substance, these transactions were a repatriation that benefited JEG's shareholders beyond the one year maximum allowed by law. The government argued that "the fact that JEG was in possession of the funds for almost all of the two and one-half year period reflects the economic reality that JEG repatriated foreign capital for more than one year." The court agreed that this argument was "persuasive."
Reader Comments» Post a comment