In a Chief Counsel Advice (CCA 201446020), IRS determined that a series of back-to-back loans between related parties was entered into with the principal purpose of avoiding the deemed distribution effect of Code Sec. 956. The IRS used its authority under a broad anti-abuse rule, designed to prevent the use of an intermediary company to make an “investment in U.S. property” in order to avoid Code Sec. 956. Accordingly, the IRS decided that the U.S. taxpayer’s taxable income inclusion was not limited to the applicable earnings of the intermediaries (that were disregarded by the IRS.) Instead the income inclusion was greater, as it was based on the larger applicable earnings pools of the companies that originated the back-to-back loans.
Background on Section 956
Section 956 can be described as a “trap for the unwary.” A “United States shareholder” of a “controlled foreign corporation” (CFC) must include in its gross income, among other items, “the amount determined under section 956 with respect to such shareholder for such year (but only to the extent not excluded from gross income under section 959(a)(2)).” For this rule to apply, the U.S. shareholder must own stock in the CFC on the last day of the CFC’s tax year. A CFC is a foreign corporation that is more than 50% controlled (by vote or value) by U.S. shareholders. A U.S. shareholder generally is a US “person” who owns 10% or more of the voting power of a CFC.
Layering on to the above, an “investment of earnings in U.S. property” by a CFC occurs when that CFC has acquired certain U.S. assets, or become party to certain financing arrangements. In particular, when a CFC acquires tangible property located in the United States; stock of a domestic corporation; an obligation of a United States person; or any right to the use in the United States of a range of intangible assets, that CFC has made an “investment in U.S. property.” This causes the U.S. shareholder(s) of the CFC to include in taxable income, on a current basis, a “deemed distribution” from the CFC. The “investment” for the year is computed by averaging the balance of the investment at each quarter-end. It is then compared to the “applicable earnings” of the CFC that are not “previously taxed income” with respect to the shareholder, and the deemed distribution is the lesser of the quarterly average, or the applicable earnings. Effectively, Section 956 causes the U.S. shareholder to recognize taxable income when the CFC uses its assets or earnings in a manner that benefits the U.S. shareholder, albeit indirectly.
A CFC’s “investment in U.S. property” includes the amount of property held both “directly and indirectly.” The corresponding regulations contain a broad anti-abuse rule that prevents a CFC from using an intermediary to make an investment in U.S. property in order to avoid Section 956. Under this rule, a CFC will be considered to hold indirectly (A) the investments in United property held on its behalf by a trustee or a nominee or (B) at the discretion of the District Director, investments in U.S. property acquired by any other foreign corporation that is controlled by the CFC, if one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) such other foreign corporation is to avoid the application of Section 956 with respect to the CFC. The anti-abuse rule applies even if one of the principal purposes of using an intermediary is the avoidance of section 956 (rather than the only purpose.) This means that even if the taxpayer has a business purpose for a particular transaction with the intermediary, the anti-abuse rule can still apply.
Finally, under the facts in the CCA, the taxpayer caused upper-tier CFC’s that possessed significant amounts of non-previously-taxed earnings to make loans to lower-tier CFC’s under common control. The lower-tier CFC’s then made loans to the taxpayer, but these CFC’s possessed only a limited amount of earnings, and the taxpayer attempted to limit the “dividend” under Section 956 to the earnings of the lower-tier CFC’s. The IRS treated the upper-tier CFC’s as having made the loans indirectly to the taxpayer by invoking the anti-abuse rule and disregarding the intermediate loans between the CFC’s. Thus the larger earnings “pool” of the upper-tier CFC’s caused a larger taxable income inclusion to the taxpayer.
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