Last week, we considered the U.S. taxation of a closely held foreign corporation that owned a minority interest in a partnership that was engaged in business in the U.S. This week, we turn our sights to the U.S. taxation of a domestic corporation that owned foreign corporate subsidiaries.

Policy Underlying the CFC Rules

In general, a U.S. person must include in its gross income its directly-earned income from foreign sources; thus, if a U.S. person operates a business through a branch located overseas, the net business income attributable to that branch is included in the U.S. person’s gross income.

Absent the so-called “Subpart F rules,” the inclusion of this foreign source income may be circumvented when the U.S. person chooses to operate overseas indirectly, through a controlled foreign corporation (“CFC”), rather than through a foreign branch. In that case, the foreign subsidiary corporation is generally treated as a separate taxpayer from its U.S. owner; the foreign-source income earned by the CFC is generally not included in the U.S. owner’s gross income; and the imposition of U.S. income tax on the foreign-source income earned by the CFC is deferred until it is repatriated by the CFC to the U.S.

Anti-deferral

That a U.S. person may defer the inclusion in its gross income of the foreign-source income earned by its controlled foreign corporate subsidiaries does not, in and of itself, violate any U.S. tax policy. However, Congress and the IRS have sought to defeat the deferral benefit in situations where certain “U.S. shareholders” may direct the flow of certain types of income (“Subpart F Income”) to a low-tax jurisdiction; for example, income earned in transactions between related corporations that are located in different countries, one of which is a tax haven. In those situations, the Code and the IRS’s regulations require the current inclusion of the CFC’s un-repatriated Subpart F Income in the U.S. shareholder’s gross income.

Deemed Repatriation

Although the current inclusion of Subpart F Income is a major concern of the Subpart F rules, they also seek to prevent the tax-free repatriation of other foreign income through investments in U.S. property. In general, the foreign-source income earned by a CFC (other than Subpart F Income) is subject to U.S. tax when the income is repatriated as a dividend. If the CFC, instead, invested the foreign-source income in the U.S., by the purchase of U.S.-situs property, or by a loan to the U.S. parent corporation, the foreign income would effectively be repatriated in a manner that would escape current U.S. tax.

In order to address this situation, the Code generally provides that certain “investments” by a CFC in U.S.-situs property will be treated as the repatriation of the CFC’s foreign-source income, as a result of which, the U.S. shareholder must include in its gross income an amount calculated by reference to the amount deemed to have been repatriated by the CFC.

A recent decision by the U.S. Tax Court considered the application of this deemed repatriation rule.

Investment in U.S. Property?

Taxpayer was a domestic “C” corporation and the parent of a group of domestic and foreign subsidiary corporations. The IRS determined that the CFCs had invested substantial amounts of untaxed foreign profits in “U.S. property”. Accordingly, the IRS determined that Taxpayer was required to include in its gross income the amounts that the CFCs had invested. As a result, the IRS asserted income tax deficiencies against the Taxpayer, and the Taxpayer petitioned the Tax Court for relief.

According to the IRS, Taxpayer’s CFCs made investments in U.S. property through the following transactions: (1) they extended loans to a domestic subsidiary, in the form of intercompany cash advances; and (2) one of them guaranteed of a loan that a domestic subsidiary had obtained from Foreign Bank.

Intercompany Loans

Taxpayer was the sole shareholder of US-Sub, a domestic corporation, which in turn was the sole shareholder of four CFCs. Taxpayer and US-Sub were U.S. shareholders of these CFCs because they owned (directly or indirectly) 100% of the total combined voting power of all classes of the CFCs’ stock.

At various times, the CFCs had made loans to US-Sub. Substantial balances on these loans remained outstanding throughout the tax periods at issue.

Guaranty Transaction

US-Sub also borrowed money from Foreign Bank. As a condition of extending credit, Foreign Bank required US-Sub to secure a guaranty for the loan, preferably from a subsidiary located in the same jurisdiction as Foreign Bank. One of Taxpayer’s CFCs (“F-Sub”) supplied the requisite guaranty.

US-Sub was also required to pledge as security for the Foreign Bank loan all the stocks that US-Sub then owned or thereafter acquired, including its equity interest in the CFCs.

The outstanding balance on the Foreign Bank loan remained constant throughout the tax periods at issue, as did F-Sub’s guaranty of the loan.

IRS Audit

Neither Taxpayer nor US-Sub had previously included in income, for any year, any portion of this outstanding loan balance.

Taxpayer filed consolidated Forms 1120, U.S. Corporation Income Tax Return, for the years at issue. The IRS examined Taxpayer’s returns and determined that the CFCs had held substantial investments in U.S. property, which Taxpayer had neglected to include in gross income; specifically, the IRS contended that Taxpayer’s CFCs held two sets of investments in U.S. property that Taxpayer was required to include in gross income: (1) the outstanding loan balances owed by US-Sub to the CFCs; and (2) F-Sub’s guaranty of the Foreign Bank loan to US-Sub. As a result, the IRS issued a notice of deficiency, and Taxpayer petitioned the Tax Court.

Governing Statutory Framework

A CFC is a foreign corporation more than 50% of whose stock (in terms of voting power or value) is owned (directly or constructively) by U.S. shareholders. A U.S. shareholder is a U.S. person who owns (directly or constructively) 10% or more of the total combined voting power of the foreign corporation’s stock.

In general, a U.S. shareholder owning CFC stock on the last day of the CFC’s taxable year must include in gross income the lesser of: (1) the excess of such shareholder’s pro rata share of the amount of U.S. property held by the CFC as of the close of such taxable year, over the amount of CFC profits otherwise included in such shareholder’s gross income; or (2) such shareholder’s pro rata share of the applicable earnings of such CFC.

“U.S. property” includes (among other things) an obligation of a U.S. person, such as a bond, note, or other indebtedness. According to IRS regulations, 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. A CFC will be considered a guarantor if its assets serve at any time, even though indirectly, as security for the performance of an obligation of a U.S. person.

The amount of the investment with respect to an obligation of a U.S. person is the CFC’s adjusted basis in the obligation. In the case of a pledge or guaranty, the amount includible is based on the unpaid principal amount of the obligation with respect to which the CFC is the pledgor or guarantor. The amount includible is reduced by any previously taxed profits of the CFC, and it cannot exceed the U.S. shareholder’s pro rata share of the CFC’s earnings.

The Court’s Analysis

With respect to the loans made by Taxpayer’s CFCs to US-Sub, the Court found that substantial loan balances remained outstanding during the tax periods at issue. The Taxpayer asserted that some of the loans might have been “discharged,” but was unable to provide specific facts supporting its claim.

Thus, the Court concluded that the intercompany loan balance owed by US-Sub to each CFC constituted U.S. property held by that CFC, and that the Taxpayer was required to include in gross income, subject to the net profits of the CFCs.

CFC as Guarantor and as Pledgor

The Court next turned to US-Sub’s loan from Foreign Bank. This loan had a substantial outstanding balance during the periods at issue, and F-Sub’s guarantee of the loan remained in place throughout these periods. Neither Taxpayer nor US-Sub had previously included in income, for any year, any portion of this outstanding loan balance.

The IRS contended that F-Sub, as a guarantor of the Foreign Bank loan, was considered as holding the obligation of a U.S. person. The IRS accordingly concluded that the unpaid principal balance of that loan was includible in Taxpayer’s gross income.

Although F-Sub’s status as a guarantor would have been sufficient to support inclusion in Taxpayer’s gross income, F-Sub also appeared to have been a pledgor in support of the Foreign Bank loan. A CFC will be regarded as a pledgor if its assets serve directly or indirectly as “security for the performance of an obligation” of a U.S. person.

According to IRS regulations, the pledge by a U.S. shareholder of stock of a CFC will be considered as the indirect pledge of the CFC’s assets if at least two-thirds of the total combined voting power of all classes of CFC stock is pledged, and if the pledge of stock is accompanied by one or more negative covenants or similar restrictions on the shareholder effectively limiting the corporation’s discretion with respect to the disposition of assets and the incurrence of liabilities other than in the ordinary course of business.

Because US-Sub was required to pledge to Foreign Bank its 100% stock ownership interest in the CFCs, including F-Sub, F-Sub was treated as having pledged all of the assets which it then held or thereafter acquired. To the extent that this pledge effectively limited US-Sub’s discretion with respect to the disposition of F-Sub’s assets and the incurrence of liabilities, the Foreign Bank loan contained “negative covenants or similar restrictions,” that rendered F-Sub an indirect pledgor as well as a guarantor.

Financial Condition of CFC?

Taxpayer argued that F-Sub’s guaranty had little or no value, and represented a “meaningless gesture.” According to Taxpayer, S-Sub’s guaranty furnished only a secondary form of collateral that provided no incremental security for Foreign Bank.

The Court failed to see the relevance of this argument. A CFC, it stated, is considered as holding an obligation of a U.S. person if the CFC “is a pledgor or guarantor of such obligation.” That is the end of the inquiry, the Court said; neither the Code nor the regulations issued thereunder inquire into the relative importance that the creditor attaches to the guarantee.

In any event, the Court continued, Taxpayer failed to offer any facts to support its assertion. Foreign Bank demanded a guaranty from a company with assets in Foreign Bank’s location, and F-Sub provided that guarantee. When a bank agrees to make a substantial loan only after securing a guaranty from a local company with local assets, it is logical to assume that the bank regarded that guaranty as valuable security.

Alternatively, Taxpayer asserted that F-Sub’s guaranty was worthless because other liabilities encumbering F-Sub’s assets exceeded the fair market value of those assets at the time F-Sub guaranteed the loan.

The Court, however, observed that Taxpayer did not supply any balance sheets, income statements, or other documentation concerning F-Sub’s financial position or its insolvency. Moreover, F-Sub’s guaranty remained in place continuously, and Taxpayer did not provide any documents suggesting that Foreign Bank ever questioned the value of F-Sub’s collateral or demanded additional security.

In any event, the Court stated, it was not clear that a CFC’s financial condition is even relevant in determining whether its guaranty gives rise to an investment in U.S. property. The Code provides that a CFC shall be considered as holding an obligation of a U.S. person if such CFC is a pledgor or guarantor of such obligation. The regulations provide that any obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor shall be considered U.S. property held by the CFC. They make no reference to the likelihood that the CFC will be called upon, or will be able, to make good on its guarantee. According to the Court, this reflects the common sense proposition that a lender would not ask for, or be satisfied with, a guarantee from a person who lacked the financial capacity to provide the security that the lender desires.

For these reasons, the Court concluded that F-Sub’s guarantee of the Foreign Bank loan gave rise to an investment in U.S. property and, subject to F-Sub’s earnings and profits, Taxpayer was required to include in gross income for the years at issue the outstanding balance of the Foreign Bank loan.

Takeaway

Many closely held U.S. businesses have realized that there are ample opportunities for growth and profits overseas. In pursuing such opportunities, however, a U.S. taxpayer must be mindful of the complex rules that apply in determining the taxation of overseas profits – including the Subpart F rules, discussed above – and the reporting thereof.

With an understanding of these rules, and with the guidance of knowledgeable advisers, a U.S. taxpayer may be able to structure its overseas investments, and the repatriation of its overseas earnings, in a more tax efficient manner.

Where business exigencies are such that a less than ideal tax structure has to be employed, the U.S. taxpayer must at least be able to account for the additional tax cost in analyzing the economic prospects and anticipated returns of its overseas investments and operations.