IRS Taking Closer Look at Section 956 Inclusions
Each “U.S. Shareholder” of a controlled foreign corporation (“CFC”) is required to include in their gross income as a deemed distribution their pro rata share of the amount determined under section 956 for that year (i.e., “Section 956 inclusion”). A Section 956 inclusion is generally equal to the lesser of (i) the amount of “U.S. property” held (directly or indirectly) by the CFC or (ii) the CFC’s earnings and profits (“E&P”), reduced to account for any previous income inclusions. Generally, Section 956 measures the CFC’s investment in U.S. property by reference to the basis of that property, and for this purpose averages the amounts outstanding at the end of each calendar quarter of a tax year.
For Section 956 purposes, U.S. property generally includes (subject to certain exceptions): (i) tangible property located in the United States; (ii) stock of a domestic corporation; (iii) obligations of a U.S. person that is related to the CFC; and (iv) any right to the use in the United States of a patent or copyright, an invention, a model or design, a secret formula or process, or any other similar property right.
In addition to the acquisition of a U.S. obligation, if the CFC is a pledgor or guarantor of such obligation, the CFC is treated as holding an obligation of a U.S. person. An issue that easily can be overlooked without proper guidance is that, if a U.S. obligor pledges more than two-thirds of the stock of a CFC to the lender as security for a loan, and the stock pledge is accompanied by negative covenants designed to protect the lender against dissipation of the CFC’s assets, the stock pledge is treated as an indirect pledge of the CFC’s assets and therefore triggers a Section 956 inclusion.
The Section 956 regulations also contain an anti-abuse rule under which a CFC is considered to hold, at the discretion of the IRS District Director, investments in U.S. property that are acquired by any other foreign corporation that is controlled by the CFC, if one of the principal purposes for creating, organizing or funding the other foreign corporation is to avoid the application of Section 956 with respect to the CFC. In addition, the Section 956 regulations treat a CFC that is a partner in a partnership as owning its pro rata share of the assets held by the partnership for purposes of determining whether the CFC holds U.S. property.
Recent IRS Internal Memoranda
While international tax practitioners are always on the lookout for potential Section 956 issues in U.S. outbound structures, it appears that the IRS recently has stepped up its enforcement efforts in this area with the release of two chief counsel advisory memoranda focusing on the proper amount of a Section 956 inclusion.
Treatment of Accrued Interest
In Chief Counsel Advice (CCA) 201436047, IRS advised that where a CFC holds the debt obligation of one of its U.S. shareholders, interest that has accrued and is unpaid on the obligation should be treated as U.S. property under Section 956. In the CCA, a CFC was indirectly owned by a domestic corporation (“Borrower”). The stated interest on the obligations was unconditionally payable by the Borrower at least annually. The Borrower and the CFC both used an accrual method of accounting for federal income tax purposes and, as a result, included interest in income when it accrued, and not when it was paid.
The CCA concludes that accrued but unpaid interest on the obligations of Borrower constitutes U.S. property because it is an “obligation” of the U.S. shareholder within the meaning of Regulation Section 1.956-2T(d)(2)(i) and thus U.S. property for purposes of Section 956(c). The IRS argued that the term “obligation” includes, in addition to an itemized list of types of indebtedness, “other indebtedness.” While the IRS acknowledged that the term “other indebtedness” was not defined in the Section 956 regulations, the definition of indebtedness that is uniformly applied throughout the Code is, in general, a restatement of the common law definition applied to debts which arise from a debtor-creditor relationship based upon a valid obligation to pay a fixed or determinable sum of money. This definition, according to the IRS, encompasses accrued but unpaid interest.
Although not surprising given the IRS’s aggressive stance on Section 956 inclusions (see, e.g., FSA 200216022, in which the IRS argued that multiple guarantees by more than one CFC of the same U.S. obligation could result in a Section 956 inclusion that exceeds the principal amount of the loan), this position clearly contradicts the regulations under Section 956(d), which generally only treat the unpaid principal amount of a U.S. obligation as giving rise to a Section 956 inclusion, at least where the CFC is a guarantor or pledgor of such obligation (emphasis added). It seems odd that the IRS chose to rely on the common law definition of obligation in this context when it could have simply looked to the regulations under Section 956(d).
Application of Anti-Abuse Rule
In CCA 201420017, the IRS provided advice on the proper application of the Section 956 anti-abuse rule to a U.S. parent corporation (the “Taxpayer”) with CFCs that were partners in a foreign partnership. Under the facts of the CCA, the foreign partnership (“FP”) wholly owned a disregarded entity (“DRE”), which functioned as an internal finance entity, using excess funds from partners and lending to others as needed. DRE loaned money to one of the CFC partners (“CFC1″) of FP. CFC1 also obtained a loan from its CFC parent. An amount equal to the combined loans was shortly thereafter loaned to the Taxpayer. The loan remained outstanding for the requisite period of time to create a Section 956 inclusion. Because the earnings and profits of the lending CFC were less than the loan amount, however, the Section 956 inclusion was limited to this lesser amount on the Taxpayer’s U.S. federal income tax return.
The IRS argued that the structuring of the loan through the specific CFC partner with limited earnings and profits was done for the sole purpose of limiting the amount of the Section 956 inclusion. Applying the anti-abuse rule contained in Regulation Section 1.956-1T(b)(4), the IRS advised that the loan to the Taxpayer should be treated as having been made by FP. Consequently, each of the CFC partners was deemed to hold an interest in the U.S. property equal to its interest in the FP. This caused the Section 956 inclusion to no longer be limited to CFC1′s earnings and profits, but rather also to include the earnings and profits of the other CFC partners.
Loans to Foreign Partnerships with U.S. Partners
In addition to the release of the two CCAs mentioned above, the IRS recently has indicated that regulations will be issued in the near future relating to loans by CFCs to foreign partnerships with U.S. partners. This is evidenced by this topic being included in the 2014-2015 IRS and Treasury priority guidance plan. Specifically, a key concern of the IRS is the situation where a domestic corporation (“USP”) is a majority partner in a foreign partnership (“FP”), which owns all of the stock of a foreign corporation (“CFC”), and the CFC makes a loan to FP, which uses the proceeds in an active business in FP’s country of formation.
In 2006, the IRS requested comments on whether under this fact pattern CFC should be treated as making a loan to USP, thus triggering a Section 956 inclusion. In its response to that request, the New York State Bar Association (“NYSBA”) concluded that because the subpart F regime treats a domestic partnership as a U.S. person, subpart F similarly should treat a foreign partnership as a separate entity that is not a U.S. person. Thus, the CFC generally should not be treated as holding an obligation of a U.S. person for purposes of Section 956. The NYSBA acknowledged, however, that to the extent FP invested the proceeds in U.S. property, including any loan of the proceeds to USP, or distributed the proceeds to USP, and one of the principal purposes for the transaction was the avoidance of Section 956, it would be appropriate for the IRS to treat CFC as holding U.S. property.
While it is not entirely clear what types of transactions the IRS will go after in the forthcoming regulations, it is likely that those regulations will deal with the transaction described above in a similar manner.