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In a move to stave off the effects of the credit crisis, the IRS extended the loan payback period for tax-free loans from foreign subsidiaries. But now another issue emerges that could wipe out that benefit.
Robert Willens, CFO.com | US
December 8, 2008
A 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.
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."
In addition, the court noted that the "individual loans should not be viewed as separate steps, but should be taken together as related steps in a unified transaction." The court observed, in reaching this conclusion, that the first loan in the series would have been useless by itself because the term of that loan lasted only a few weeks.
Indeed, JEG needed working capital for a substantially longer period so it arranged subsequent loans. The transactions, therefore, were interdependent (the economic relationships created by one such transaction would have been fruitless without a completion of the series.) Therefore, under well-established step-transaction doctrine principles, the series of loans must be viewed as one unified transaction.
In the Jacobs case, the step transaction doctrine applied because "nowhere is it stated that JEG needed to raise capital 12 separate times for separate reasons." Thus, the court found an investment in U.S. property on the part of JILI because JEG had the benefit of investment capital from a foreign subsidiary for almost two and one-half years "contrary to Section 956."
Similarly, in Revenue Ruling 89-73 (1989-1 C.B. 258) compared two examples to underscore the step-transaction doctrine. In the first example, called Situation 1, a CFC purchased debt obligations issued by its U.S. shareholder on Feb. 15, 1987, which were duly repaid on Nov. 15, 1987. Then, almost a year later, on Jan. 15, 1988, the CFC purchased debt obligations issued by its U.S. shareholder and sold the obligations to an unrelated third party on Nov. 10, 1988.
In the second example, Situation 2, the CFC purchased debt obligations issued by its U.S. shareholder on Feb. 1, 1987, which matured and were repaid on June 30, 1987. On Jan. 15, 1988, the CFC purchased debt obligations issued by its U.S. shareholder all of which were sold by the CFC to an unrelated third party on Nov. 15, 1988.
The IRS ruling observes that Section 956 is intended to prevent a tax-free repatriation of earnings even in circumstances that would not constitute a dividend distribution from the "lender" to the "borrower." The ruling then concludes that if a CFC lends earnings to its U.S. shareholder interrupted only by brief periods of repayment which include the last day of the taxable year, those earnings are, in substance, repatriated within the objectives of Sec. 956.
Accordingly, in the first example, the ruling concludes that the brief period between termination of the loan on Nov. 15, 1987, and its reinstatement on Jan. 15, 1988 will be disregarded in determining whether there is, as of the close of the taxable year, an investment in U.S. property. Thus, in these cases, the investment and reinvestment will be considered together.
By contrast, in Situation 2, the ruling notes that "the period between the termination of investment and the reinvestment is not brief compared to the overall period the obligations are outstanding." Accordingly, the obligations did not constitute an investment in U.S. property in 1987.
As a result, the IRS will apply step-transaction doctrine principles to treat a series of loans as a single loan. In light of the fact that October's Notice 2008-91 does not expressly renounce this line of reasoning, it seems abundantly clear that the loans referred to in that ameliorative pronouncement might also be vulnerable to the type of "telescoping" that tripped up the taxpayers in both Jacobs Engineering Group and in Situation 1 of Revenue. Ruling 89-73.
For that reason, it appears that taxpayers seeking to avail themselves of the benefits of Notice 2008-91, must take steps to insure that the period between the termination of one loan and the initiation of a successor loan is not regarded as unduly brief. Therefore, pending further guidance from the IRS, taxpayers seeking to take advantage of Notice 2008-91 will, almost certainly, feel constrained to "put some distance" between the termination of one 60 day loan and the institution of another. In fact, it might be prudent to provide for a 60 day waiting period to elapse between the termination of one such loan and its eventual renewal.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.