In the realm of overseas investment earnings, the Internal Revenue Code — specifically Section 956(c) — defines “U.S. property” to include an obligation of a “related U.S. person” held by a controlled foreign corporation (CFC). In general, an investment in U.S. property by a CFC produces dividend income for the CFC’s U.S. shareholders in an amount equal to the amount of the investment.1
For this purpose, a related U.S. person includes a “U.S. shareholder” of the CFC, as well as any domestic corporation whose voting stock is at least 25% owned (directly, indirectly, and constructively) by the U.S. shareholder.2
In October 2008, the Internal Revenue Service issued guidance (Notice 2008-91, 2008-43 I.R.B. 1000) explaining that a CFC may exclude from the term “obligation,” the commitments of a related U.S. person that is collected within 60 days of the time it is incurred. This exclusion, however, does not apply under certain circumstances. Notably, the exclusion does not apply if the CFC holds for 180 or more calendar days during its taxable year obligations that — without regard to the 60-day exculpatory rule — would constitute investments in U.S. property.
By February of this year, the IRS followed-up with new guidance (Notice 2009-10, 2009-5 I.R.B. 419) that extends the application of last October’s guidance to the third consecutive taxable year of a foreign corporation, if any, that ends after October 3, 2008, and that ends on or before December 31, 2009.
“The legal memorandum also reminds us that transactions that seek to avoid IRS rules do not qualify for exemptions.” — Robert Willens
Then last month, the IRS’s chief counsel’s office weighed in with related guidance (AM 2009-013) that attempts to resolve some of the thorniest issues raised by the October 2008 guidance, including how to handle involvement by two CFCs.
The legal guidance states that if more than one CFC holds one or more obligations of a related U.S. person during the same taxable year, each CFC may separately qualify — and choose to apply Notice 2008-91. Because each CFC may meet the less-than-180-day requirement during different days of the taxable year, obligations of the same related U.S. person may qualify for the exclusion if a condition is met. Specifically, the obligations must be held by more than one CFC that, in the aggregate, remains outstanding for 180 or more days during the taxable year.
The legal memorandum from the IRS also concludes that if a CFC fails to meet the conditions of Notice 2008-91, an obligation of a related U.S. person will be considered U.S. property as of its origination date.3
The legal memorandum also reminds us that transactions that seek to avoid IRS rules do not qualify for exemptions. For example, consider a situation in which a CFC of a related U.S. person is acquired by another foreign corporation that is controlled by the CFC. In that case, the CFC indirectly holds an obligation if one of the principal purposes for creating, organizing, or funding the other foreign corporation is to avoid the application of the tax code — specifically Section 956 — with respect to the CFC. This rule must be taken into account in assessing a taxpayer’s entitlement to the benefits of Notice 2008-91.
In other words, a CFC is considered as holding an obligation of a U.S. person if such CFC is a “pledgor” or “guarantor” of such obligation. The legal memorandum provides that, in certain cases, where the related U.S. person whose obligation is held by a CFC is “financially impaired,” the “undertaking,” expressed or implied, by another CFC may be treated as a pledge or guarantee.
This may occur if a related U.S. person: (1) incurs obligations from multiple CFCs, and (2) repayment of one obligation within the 60-day period is contingent on a subsequent obligation to another CFC. Moreover, if the assets of a CFC “serve as security” for the performance of an obligation of a related U.S. person, the CFC will be considered a pledgor or guarantor of that obligation.
Single Transaction?
The legal memorandum intones that each obligation may not be executed as one “in a series of related steps in a unified transaction.”4 Should it be determined that a series of obligations constitutes “rollovers” of a single obligation, the periods of disinvestment will be ignored for purposes of testing the 60- and 180-day rules. Whether a series of obligations is, in substance, a single obligation is ultimately a question of fact, and the legal memo sets forth factors to consider in making this determination, including:
• The volatility of economic conditions;
• The related U.S. person’s access to commercial paper markets; and
• A reasonable evaluation of whether these conditions will persist during the term of the loan.
Moreover, as might be expected, the legal notice provides that the analysis should evaluate the period of disinvestment; that is, the time that elapses between the repayment of one 60-day loan and the institution of another one. The legal guidance also cites an IRS Revenue Ruling (Rev. Rul. 89-73, 1989-1 C.B. 258) for the following reason: in the revenue ruling, it was held that “brief periods of disinvestment,” relative to the period the loans being evaluated were outstanding, should in fact be disregarded.
Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
Footnotes
1 A CFC is any foreign corporation more than 50% of the voting power or value of the stock of which is owned by U.S. shareholders on any day during the foreign corporation’s taxable year. See Sec. 957(a).
2 A U.S. shareholder is a U.S. person who owns at least 10% of the total combined voting power of all classes of the foreign corporation’s stock entitled to vote. See Sec. 951(b).
3 An obligation of a related person is an investment in which triggers a deemed dividend to the CFC’s U.S. shareholders.
4 See Jacobs Engineering Group, Inc. v. United States, 79 AFTR, 2d 97-1673.