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IRS Issues Temporary and Proposed Regs Preventing CFCs from Using Partnerships to Defer U.S. Taxation.

(Parker Tax Publishing September 17, 2015)

The IRS has issued proposed and temporary regulations that provide rules regarding the treatment as U.S. property of property held by a controlled foreign corporation (CFC) in connection with certain transactions involving partnerships. In addition, the temporary regs provide rules regarding when a CFC is considered to derive rents and royalties in the active conduct of a trade or business for purposes of determining foreign personal holding company income (FPHCI). T.D. 9733; REG-155164-09.

Background

Code Sec. 956 determines the amount that a U.S. shareholder of a controlled foreign corporation (CFC) must include in gross income under Code Sec. 951with respect to the CFC. In general, the amount taken into account with respect to any U.S. property, including obligations of U.S. persons related to the CFC, is the adjusted basis of the property, reduced by any liabilities.

An anti-avoidance rule in Reg. Sec. 1.956-1T(b)(4) provides that a CFC will be considered to indirectly hold 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) the foreign corporation is to avoid the application of Code Sec. 956 with respect to the CFC.

Congress has stated that Code Sec. 956 is intended to prevent a U.S. shareholder of a CFC from inappropriately deferring U.S. taxation of CFC earnings and profits by preventing the repatriation of income to the U.S. in a manner which does not subject it to U.S. taxation. Accordingly, under Code Sec. 956, the investment by a CFC of its earnings and profits in United States property is taxed to the CFC's shareholders on the grounds that this is substantially the equivalent of a dividend.

Proposed Regulations Expand Scope of Code Sec. 956 to Include Obligations of Foreign Partnerships

The current regulations under Code Sec. 956 do not specifically address when the obligations of a foreign partnership will be treated as United States property.

The IRS has determined that failing to treat an obligation of a foreign partnership as an obligation of its partners could allow deferral of U.S. taxation of CFC earnings and profits in a manner inconsistent with the purposes of Code Sec. 956. The proposed regulations thus treat an obligation of a foreign partnership as an obligation of its partners for purposes of Code Sec. 956, subject to an exception for obligations of foreign partnerships in which neither the lending CFC nor any person related to the lending CFC is a partner.

The proposed regulations provide that the determination of a partner's share of a foreign partnership's obligation is made in accordance with the partner's interest in partnership profits. The determination of the partner's share is to be made at the close of each quarter of the CFC's taxable year in connection with the calculation of the amount of U.S. property held by the CFC for purposes of Code Sec. 956(a)(1)(B).

The proposed regulations also include a special rule that increases the amount of a foreign partnership obligation that is treated as U.S. property when certain requirements are satisfied. When these requirements are satisfied, proposed Reg. Sec. 1.956-4(c)(3) provides that the amount of the partnership obligation that is treated as an obligation of the distributee partner (and thus as U.S. property held by the CFC) is the lesser of the amount of the distribution that would not have been made but for the funding of the partnership and the amount of the partnership obligation.

Existing Reg. Sec.1.956-2(c)(1) provides that, in general, any obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor is considered U.S. property held by the CFC. The proposed regulations provide that these pledge and guarantee rules apply to a CFC that directly or indirectly guarantees an obligation of a foreign partnership treated as an obligation of a U.S. person and extend the pledge and guarantee rule to pledges and guarantees made by partnerships.

Temporary Regulations Modify Anti-Avoidance Rule

The temporary regulations modify the current anti-avoidance rule in Reg. Sec. 1.956-1T(b)(4) to apply when a foreign corporation controlled by a CFC is funded other than through capital contributions or debt. In addition, the temporary regs expand the anti-avoidance rule to include transactions involving partnerships that are controlled by the CFC.

Example: Pi Co. is a domestic corporation that wholly owns two controlled foreign corporations, Sif Co. and Fis Co. Sif Co. has $100,000 of undistributed earnings and profits and $10,000 foreign income taxes, but does not have any cash. Fis Co, has earnings and profits of at least $100,000, no foreign income taxes, and substantial cash. Fis Co. loans $100,000 to Sif Co., which then loans $100,000 to Pi Co. A principal purpose of funding Sif Co. through the loan from Fis Co. is to avoid the application of Code Sec. 956 with respect to Fis Co. As a result, Fis Co. is considered to indirectly hold the $100,000 obligation of Pi Co. that is held by Sif Co. Pi Co. will have an income inclusion of $100,000 under Code Secs. 951(a)(1)(B) and 956 with respect to Fis Co., and the foreign income taxes deemed paid by Pi Co. under Code Sec. 960 is $0.

The IRS has determined that CFCs may be engaging in transactions in which a CFC lends funds to a foreign partnership, which then distributes the proceeds from the borrowing to a U.S. partner who is related to the CFC and whose obligation would be United States property if it were held (or treated as held) by the CFC. Taxpayers take the position that Code Sec. 956 does not apply to these transactions even though the CFC's earnings are effectively repatriated to a related U.S. partner.

In response to these transactions, the temporary regs add Reg. Sec. 1.956-1T(b)(5) to address certain cases in which a CFC funds a foreign partnership (or guarantees a borrowing by a foreign partnership) and the foreign partnership makes a distribution to a U.S. partner that is related to the CFC. For purposes of Code Sec. 956, the temporary regs treat the partnership obligation as an obligation of the distributee partner to the extent of the lesser of the amount of the distribution that would not have been made but for the funding of the partnership or the amount of the foreign partnership obligation.

OBSERVATION: Reg. Sec. 1.956-1T(b)(5) generally has the same purpose and effect as proposed Reg. Sec. 1.956-4(c)(3) (discussed above) and will be removed when the proposed regulations are finalized.

Temporary Regs Require CFCs to Perform the Relevant Activities for the Active Rents and Royalties Exception

Under Code Sec. 954, foreign base company income (FBCI) generally is income earned by a CFC that is taken into account in computing the amount that a U.S. shareholder of the CFC must include in income under Code Sec. 951. FBCI includes foreign personal holding company income (FPHCI), which includes rents and royalties, unless they are received from a person other than a related person and derived in the active conduct of a trade or business.

The active rents and royalties exception in Code Sec. 954(c)(2)(A) and Reg. Sec. 1.954-2(b)(6) exclude from FPHCI rents and royalties derived in the active conduct of a trade or business and received from a person that is not a related person. In general, the active rents and royalties exception is intended to distinguish between a CFC that passively receives investment income and a CFC that derives income from the active conduct of a trade or business.

The IRS has determined that the CFC must perform the relevant activities (that is, activities related to the manufacturing, production, development, or creation of, or, in the case of an acquisition, the addition of substantial value to, the property at issue) through its own officers or staff of employees in order to satisfy the active rents and royalties exception. Thus, the temporary regs expressly provide that the CFC lessor or licensor must perform the required functions through its own officers or staff of employees. The temporary regs also allow the relevant activities undertaken by a CFC through its officers or staff of employees to be performed in more than one foreign country.

Effective Dates

The temporary regs apply to the tax years of CFCs ending on or after 9/2/15, and to the tax years of U.S. shareholders in which or with which such tax years end.

The proposed regulations are effective for tax years of CFCs ending on or after the date the regulations are finalized, and for tax years of U.S. shareholders in which or with which such tax years end.

For a discussion of amounts a U.S. shareholder of a controlled foreign corporation must include in gross income under Code Sec. 951, see Parker Tax ¶ 201,510.20. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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