IRS Clarifies Rule on Loans Involving CFC Investments: An Article Authored by Paul Oliveira, CPA from KLR - Accounting Firm Boston, Massachusetts, Providence, Rhode Island

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IRS Clarifies Rule on Loans Involving CFC Investments

posted Jul 14, 2014 by Paul Oliveira, CPA

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The IRS’s Office of Chief Counsel concluded that common taxpayer corporations of affiliated groups of controlled foreign corporations must include in income loans deemed to have been made by a disregarded foreign entity to the foreign group during a specific fiscal year.

The IRS’s Office of Chief Counsel has shed light on the application of the anti-abuse rule that applies to companies with Controlled Foreign Corporations (CFCs) that are members of foreign partnerships.

In Chief Counsel Advice 201420017, the IRS rejected a convoluted loan scheme aimed at reducing a parent taxpayer’s investment in U.S. property under the rules governing controlled foreign corporations. Essentially, the Chief Counsel’s office concluded that, under the law, the parent of an affiliated group of CFCs must include as income loans made by a disregarded foreign entity to the CFC.

The Anti-Abuse Rule

U.S. stockholders of a CFC who own shares in that company on the last day of its tax year generally must, under Internal Revenue Code Sec. 956, include in gross income the lesser of:

  1. The excess of (A) such shareholder’s pro rata share of the average of the amounts of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter of such tax year, over (B) that portion of the CFC’s earnings and profits attributable to amounts included previously in that shareholder’s gross income on account of investment in U.S. property (or which would have been so included except that it had already been included under another provision of the CFC rules) or
  2. The shareholder’s pro rata share of the applicable CFC earnings.

The law generally treats a debt or obligation of a related U.S. person as U.S. property that triggers deemed dividend treatment. So, when a CFC lends money to its parent, the transaction is treated as a dividend, and the parent generally must include the loan as dividend income, limited by the parent’s pro rata share of the CFC’s earnings. This limit was the key to the Chief Counsel’s Advice.

Facts at Issue

The taxpayer indirectly owned numerous CFCs, some of which were partners in a foreign partnership (“FPS”). In the year in question, the partnership owned a foreign entity (“DE1”) that operated as an internal finance company for the taxpayer. The taxpayer owned CFC 2, which owned all of CFC Partner 1 (a member of the foreign partnership).

The convoluted loan scheme ran like this:

On one day:

  • DE1 lent Amount 1 to CFC Partner 1 (the FPS loan),
  • CFC 2 lent Amount 2 to CFC Partner 1, and
  • CFC Partner 1 lent the sum of those two loans (Amount 3) to the parent.

On another day:

  • The taxpayer repaid the CFC Partner 1 loan, and
  • CFC Partner 1 repaid the FPS loan.

Between those two days, a fiscal quarter of the CFC Partners’ ended. The parent included the amount in its annual earnings, based on the position that CFC Partner 1 held U.S. property in the amount of the sum of the two loans.

The earnings and profits of the CFC Partners would have increased the parent’s earnings substantially if DE1 had lent the first amount directly to the taxpayer rather than to CFC Partner 1, which then lent the total amount to the parent. The taxpayer contended that the anti-abuse rule did not apply because the partnership’s funding of CFC Partner 1 and its subsequent 956 loan did result in an inclusion although it was less than the amount of the loan. 

The IRS rejected that claim and determined that applying the law does not depend on a loan from a CFC directly to a CFC, as opposed to a loan from a partnership comprising the CFCs. Rather, the law applies when “one of the principal purposes for ...  funding ...  such other foreign corporation is to avoid the application of Section 956 with respect to the controlled foreign corporation.”

The IRS also noted that applying the rule in this situation complies with the portion of tax law that treats a CFC as owning an interest in U.S. property when it is in a partnership that owns that property. Consequently, if DE1 had lent Amount 1 directly to the taxpayer, the law would have treated the CFC Partners as holding an interest in U.S. property. This would have resulted in the taxpayer having a larger inclusion.

Take note of this memorandum

Observers note that the regulations mentioned in the Chief Counsel’s Advice have been cited very often either in guidance from the IRS or court decisions. That makes it noteworthy for United States multinationals to tread carefully when setting up financial structures offshore.