In a ruling with tax implications for U.S. corporations with foreign subsidiaries, the U.S. Tax Court has held that transactions between a U.S. parent company and its controlled foreign corporations constitute “United States property” and must be included in the parent company’s gross income. The decision in Crestek v. Commissioner (July 27, 2017) illustrates several common fact patterns in which certain tax code Section 956 problems can arise and serves as a reminder of issues that should not be overlooked in ongoing cash management and financial transactions between a U.S. affiliate and its CFCs.
A planning objective that may be very important for a U.S. corporation (or other controlling U.S. shareholder) with foreign subsidiaries is deferral of U.S. tax on the un-repatriated earnings of those subsidiaries. Where such subsidiaries are CFCs as defined in Section 957 of the code, deferral can be terminated and U.S. tax immediately come due not only because of actual cash distribution but by deemed dividends resulting from inclusions of subpart F income or investments in United States property under Section 956 of the Code.
In Crestek, the Tax Court upheld the IRS’ assessment of tax (and accuracy related penalties) arising from several Section 956 U.S. property investments made by the taxpayer’s CFCs. The case involves several common sources of Section 956 problems involving CFCs in practice. Specifically, the U.S. parent was required to include a deemed dividend out of its CFCs’ earnings as a result of the following transactions: (1) intercompany loans by the CFCs to U.S. affiliates from advances of cash; (2) a guarantee by a locally resident CFC to a foreign bank that made a loan to the U.S. entity; and (3) accounts payable owing from a U.S. affiliate to two different CFCs from purchase of manufactured inventory. With one exception, the court rejected the taxpayer’s arguments for why Section 956 did not apply.
At the threshold, the taxpayer argued that the IRS was too late in assessing the tax under the applicable statute of limitations. This argument had two parts. First, as to one of the two taxable years at issue (2008 and 2009), the IRS mailed the statutory notice of deficiency after the normal three-year statute of limitations in Section 6501(a) had expired. Second, some of the Section 956 investments had been made many years before the year at issue, in some cases as early as 2001. The taxpayer argued that tax attributable to such Section 956 investments should have been assessed in the earlier years when the Section 956 investments were first made.
On the first question, the Tax Court found the IRS’s notice of assessment to be timely under the sometimes-overlooked six-year statute of limitations for omissions from gross income attributable to inclusions under Section 951(a). See Section 6501(e)(1)(C). Under this provision, which was added as part of the 2004 JOBS Act, if the taxpayer omits an item from gross income under Section 951(a), the IRS has six years from the tax return filing date to assess the tax. Note that this special rule applicable to Subpart F applies regardless of the amount of the omission, or whether it exceeds 25 percent of gross income.
On the second argument, in an earlier case involving a previous version of Section 956, McCulloch Corp. v. Commissioner, TC Memo 1984-422, the Tax Court had ruled that the statute of limitations barred the IRS from assessing a deficiency with respect to a Section 956 investment made in a prior, closed taxable year. Under the statute at that time, the Section 956 inclusion was determined based on the increase in CFC’s earnings invested in U.S. property as compared to the preceding year.
By contrast, under the current version of Section 956, which was at issue in Crestek, the Section 956 inclusion is determined as the lesser of (1) the excess of the Section 956 investment over previously taxed earnings under Section 956 and (2) the CFC’s “applicable earnings.” In Crestek, since the Section 956 investments from earlier years had never been actually included in gross income of the U.S. shareholder, there was no previously taxed income to shelter the Section 956 investment. Since the taxpayer had not “picked up” the Section 956 investment in a prior year, it was fully includible in the later years audited by the IRS. Under this rationale, an unreported Section 956 investment effectively has no statute of limitations so long as it is outstanding. Coupled with the six-year statute of limitations for assessment under Section 6501(e)(1)(C), Section 956 issues may have a long or indefinite shelf life.
While not at issue in the case, note that if an amount representing the PTI is distributed after the initial Section 956 investment, that Section 956 investment can be taxed again to the U.S. shareholder of the CFC. This also can “extend” the shelf life of a Section 956 investment.
With respect to the intercompany loans made by CFCs to a U.S. affiliate for cash, the taxpayer argued that the loans had been effectively “discharged” due to the debtor’s failure to make payments. However, the court found this assertion to be unsupported. Also, as noted by the court, discharge of the loans payable would have constituted a taxable income from cancellation of indebtedness under Section 61(a)(12).
Section 956 issues can potentially arise in the context of third-party borrowing supported by a CFC’s guarantee or other credit support.
In Crestek, one of the taxpayer’s U.S. affiliates borrowed from a bank in Malaysia. As a condition of loan, one of the CFCs in Malaysia guaranteed the repayment of the debt directly. The shareholder also pledged that CFC’s shares to the bank as collateral and entered certain agreements restricting the CFC’s disposition of its assets in the nature of negative covenants.
This pledge and guarantee seemed to fall squarely within the scope of the pledge and guarantee rules of Section 956(d) and Treas. Reg. 1.956-2(c). Under those rules, the pledging CFC was deemed to hold a Section 956 investment equal to the U.S. shareholder’s entire unpaid principal balance of the loan.
To avoid this unfortunate result, the taxpayer argued that Section 956’s guarantee rule should be limited in some fashion to the pledging CFC’s wherewithal to support the guarantee. Specifically, the taxpayer argued that the pledging CFC lacked sufficient net assets to support the guarantee, which accordingly had no value to the lender. In support, the taxpayer cited an example from the 1979 proposed regulations under Section 956 that suggests that the guaranteeing CFC’s asset base might be relevant.
The Tax Court rejected this argument. It found a lack of facts to support the taxpayer’s argument that the pledging CFC’s were insufficient to support the guarantee. The court also said that having an in-country company guarantee repayment to the Malaysia bank may well have had value to the bank, which was making the loan to a foreign, non-Malaysian borrower. In addition, the Tax Court’s discussion suggested that, even if proven, the limited asset base of the guaranteeing CFC may not be relevant.
Under the latter analysis, a CFC making a guarantee will have an inclusion that may outweigh the benefit of the guarantee to the lender (or secondarily the taxpayer) in obtaining the loan. This is unlike a direct loan or other Section 956 investment where the inclusion equals the amount of earnings invested in U.S. property. Since the cost of a CFC guarantee to the taxpayer may outweigh the benefit from it, the case serves as a reminder to avoid CFC guarantees and limit pledges to the amounts permitted in the regulations.
Lastly, in yet another recurring fact pattern, the Tax Court addressed Section 956 investments attributable to a U.S. affiliate’s unpaid trade receivable balances owing to two CFCs arising from purchase of inventory manufactured by the CFCs. Trade receivables from inventory and services transactions between CFCs and U.S. group members are common. While Section 956(c)(2)(C) contains an exception to Section 956 treatment for certain accounts receivable, the Crestek case illustrates that taxpayers can inadvertently fall out of this exception if such receivables are not properly managed.
In Crestek, the issue arose in two different fact patterns.
In the first fact pattern, an account receivable owing from a U.S. affiliate to the CFC remained outstanding several years after the CFC’s manufacture and sale of goods to the parent ceased. The CFC extending credit had, in fact, ceased its manufacturing operations in a prior year. The Tax Court ruled for the IRS as a matter of law that this account was not “ordinary and necessary” to the two affiliates’ trade or business. As stated by the court, the receivable had “lost any connection to ongoing commercial transactions” and “was not ‘ordinary and necessary’ because [the affiliates] were no longer engaged in a trade or business with each other.” 149 T.C. No. 5, at *14.
Similar issues could arise in other fact patterns where a trade receivable ages too far or is transferred between entities. In those situations, at what point does an ordinary and necessary trade receivable “lose its connection” to the trade or business activities of the CFC?
Secondly, the court addressed a trade receivable in place between the U.S. affiliate and CFC pursuant to an ongoing relationship of purchasing and selling goods to the U.S. affiliate. The receivables balance from the U.S. to the CFC steadily increased over the years at issue. The CFC also incurred accounts payable to the parent from purchases of raw materials, but these payables the CFC promptly settled.
As to this balance, the court expressed some doubts that the receivables might be “excessive,” but held that the application of ordinary and necessary was a factual issue for trial.
The Crestek case addresses several garden variety Section 956 issues that can frequently come up in practice. While the court’s decision does not break any new ground in analysis of these issues, it nonetheless illustrates some of the fact patterns in which these issues can arise and thus serves as a useful reminder of Section 956 traps to be monitored and avoided in ongoing cash management between a U.S. shareholder and its CFCs.
1 Before the JOBS Act, the lengthened six-year statute of limitations applied only to inclusions under the foreign personal holding company rules (Section 552(a)). Along with repealing the FPHC rules, Congress amended the six-year statute of limitations to also apply to subpart F. Crestek appears to be the first case or other authority applying this easily forgotten statute of limitations provision.
2 Alternatively, given that any such discharge would have arisen in a corporate-shareholder relationship, it is more likely that the discharge would have been taxed as a dividend under Section 301. However, the court did not reach the characterization of such a debt discharge as COD income versus a constructive dividend.
3 Additionally, in one chief counsel advice, ILM 201436047 (Sept. 8, 2014), the IRS advised that the guaranteed “principal balance” also includes any accrued but unpaid interest on the loan.
4 The reference to the guaranteeing CFC’s assets was removed from the corresponding example in the Final Regulations. Compare Treas. Reg. Section 1.956-2(c)(3), Example 3 with Prop. Reg. 1.956-2(c)(3), Example 3, 44 Fed. Reg. 23883 (Apr. 23, 1979) (stating that book value of guaranteeing CFC’s assets exceeded the principal balance of the loan).