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Third Circuit Rejects Challenge to Controlled Foreign Corp Loan Guarantee Regs

(Parker Tax Publishing May 2019)

The Third Circuit affirmed a Tax Court decision holding that (1) the U.S. parent company of two controlled foreign corporations (CFCs) had to include in income the unpaid principal amount of notes that were guaranteed by the CFCs, and (2) the income to the parent company was ordinary, rather than qualified dividend, income. The Third Circuit reasoned that it could not invalidate IRS regulations as arbitrary and capricious based on subsequent IRS practice because its review was limited to the administrative record available at the time the regulations were adopted; with respect to the applicable tax rate, the court found that when Congress decided to tax Code Sec. 956(c)(1)(C) income as dividend income, it knew how to do so. SIH Partners LLLP v. Comm'r, 2019 PTC 181 (3d Cir. 2019).


SIH Partners LLLP (SIHP) is one of a cluster of companies affiliated with Susquehanna International Holdings (SIH). Through the SIH family, SIHP owns two controlled foreign corporations (CFCs). In 2007, another SIH affiliate, investment firm Susquehanna International Group, LLP (SIG), borrowed $1.5 billion from Merrill Lynch in a loan guaranteed by over 30 SIH affiliates, including the two CFCs owned by SIHP. Merrill Lynch insisted on having the CFCs guarantee the loan in order "ring fence" the transaction - that is, for protection in case the deeper-pocketed domestic guarantors tried to move their assets overseas with the CFCs.

In 2011, when the CFCs distributed earnings to SIHP, their domestic shareholder, the IRS stepped in and determined that SIHP should have reported its income from the CFCs at the time they guaranteed the loan to SIG. The IRS treated each CFC as if it had made the entire loan directly, though the amount included in SIHP's income was reduced from the $1.5 billion principal amount to the CFCs' combined applicable earnings under Code Sec. 956(a)(2). This addition to income resulted in an additional tax of approximately $378 million to SIHP. The IRS also raised SIHP's tax rate. Although the distribution of CFC earnings would have been taxed at 15 percent as a qualified dividend, the IRS found that the Code Sec. 956 income inclusion was not a dividend and therefore was taxable at the then-applicable 35 percent ordinary income rate.

In the Tax Court, SIHP challenged both the validity of the regulations under Code Sec. 956 and the use of the ordinary income tax rate. The Tax Court granted summary judgment for the IRS, and SIHP appealed to the Third Circuit.


Under Code Sec. 956, a domestic shareholder of a CFC must include in its income any increase in investment in U.S. properties made by a CFC it controls. The rationale for this is that any investment in U.S. properties is tantamount to its repatriation. Code Sec. 956(c)(1)(C) defines U.S. property to include an obligation of a U.S. person. Code Sec. 956(d) provides that, under regulations prescribed by the Treasury Secretary, a CFC is considered as holding an obligation of a U.S. person if it guarantees the obligation. In 1964, the IRS issued two regulations dealing with CFC guarantees. Reg. Sec. 1.956-2(c)(1) states that if a CFC guarantees any obligation of a U.S. person, the obligation is considered to be held by the CFC. Reg. Sec. 1.956-1(e)(2) provides that the amount of the obligation treated as held as a result of a guarantee is the unpaid principal amount of the obligation.

SIHP argued that the regulations are arbitrary and capricious because they do not account for the possibility that if multiple CFCs guarantee the entire amount of a loan, the CFC shareholder may incur income larger than the loan - indeed potentially an amount many times the loan amount. SIHP contended that instead, only those guarantees that are necessary for a shareholder to obtain a loan should be regarded as a repatriation. According to SIHP, the regulations are arbitrary and capricious because the IRS failed to exercise its expertise to recognize the multiple inclusion issue. SIHP also contended that, if income was validly attributed to it, the applicable tax rate should be the dividend rate rather than the higher ordinary income tax rate.

Validity of the Regulations

The Third Circuit found that SIHP's argument failed, but for a reason on which the Tax Court did not rely. The court explained that SIHP was asking it to review the regulations taking into account hindsight derived from matters occurring after their adoption. The court pointed out that, in determining the validity of the regulations, its review was confined to the administrative record that was before the agency at the time it took the action under review. The court reasoned that even if IRS guidance and rulings demonstrated the IRS's post-adoption recognition that the regulations do not always address economic reality, they were not evidence that the regulations were arbitrary and capricious at the time they were issued.

The Third Circuit rejected SIHP's contention that the IRS failed to exercise its expertise at the time the regulations were issued, reasoning that agency regulations need not be the best or most perfect solution possible to the problem at hand. The court found that the regulations make an obvious and straightforward determination that the amount to be included in the domestic shareholder's income should equal the amount of the loan the CFC guaranteed up to the amount of the CFC's earnings, a reading that was supported by Code Sec. 956. The court also pointed out, as the Tax Court did, that no comments were received at the time the IRS was considering adoption of the regulations regarding the possibility of multiple-counting of loan guarantors.

Tax Rate

The Third Circuit recognized the crux of SIHP's argument to be that loan guarantees under Code Sec. 956(c)(1)(C) ordinarily are given for the benefit of shareholders, and thus loan proceeds are akin to distributions and should be taxed as dividends if they are taxed at all. But the court found that Code Sec. 956(c)(1)(C) mandates the inclusion of a loan guarantee as income when the CFC holds an obligation of a U.S. person, and that person does not have to be a shareholder. The court also reasoned that Code Sec. 951(a) deems income as dividend income for certain purposes and said that if Congress desired to tax Code Sec. 956(c)(1)(C) income as dividends, it knew how to do so. If SIHP wanted the CFCs' income to be treated as dividends, the CFCs could have paid out actual dividends to shareholders, as they had done in 2010 and 2011, the court concluded.

For a discussion of the taxation of U.S. shareholders of a CFC, see Parker Tax ¶201,510.

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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