Recent CCA shows IRS continuing to challenge taxpayer’s cash repatriation strategies that try to side step Section 956.
Background
Section (Sec.) 956 is designed to treat the U.S. monetization of foreign earnings as a deemed dividend to the U.S. shareholder from the foreign entity. It only applies to controlled foreign corporations (“CFC”). A foreign corporation is a CFC if U.S. persons, who own 10 percent or greater of its shares by vote, collectively own greater than 50 percent of the vote or value of its shares. For example, the types of transactions typically caught by Sec. 956 are:
- Loans from a CFC to the U.S.
- Pledges by a U.S. shareholder of 66 2/3 percent or more of the CFC shares to obtain a loan.
The amount of inclusion under Sec. 956 is limited to the earnings and profits (“E&P”) of the CFC. And, to determine the amount included, the amount of investment in U.S. property is determined at the end of each quarter, and then averaged.
Recent Guidance – the IRS attacks
In Chief Counsel Advice (“CCA”) 201420017, the taxpayer tried to minimize the deemed dividend amount under Sec. 956, by using a foreign partnership (“FP”) owned by a number of CFCs (CFC1, CFC2, CFC3), then made a loan to CFC1 from FP and from another CFC (CFC4) in the group. CFC1 then took all the cash and made a large loan to the U.S. What the taxpayer was apparently trying to accomplish here, was to minimize the Sec. 956 inclusion by limiting the E&P in the entity making the loan. They argued that the loans from FP and CFC4 did not move E&P into CFC1. IRS disagreed and sought a CCA.
The CCA sided with IRS by using the related-party and anti-abuse rules to essentially shift the E&P from the other CFC partners of FP that made the loan to CFC1, which made the loan back to the U.S. The taxpayer argued unsuccessfully that the related-party and anti-abuse rules should not apply because there was an inclusion, although small, under Sec. 956.
A more common way that cash is repatriated is through a return of capital from CFC1. (Profile is key and you need high tax basis in CFC1’s shares with low E&P). One can surmise from the CCA here, that the basis in CFC1’s shares was probably low, therefore, a distribution would ultimately have produce a capital gain. Therefore, they tried the back-to-back loan route, unsuccessfully. We may find this the subject of future litigation.
Note that in its annual budget, the Obama administration is proposing legislation essentially shutting down the loan and return of capital strategy. (IRS probably has more difficulty invoking the anti-abuse rule with a return of capital than with a loan.) The legislation, if enacted, would shift the E&P from the CFC making the loan to the CFC making the distribution – turning a tax-free return of capital into a taxable dividend. Although significant U.S. tax legislation seems unlikely before 2015, some interim piecemeal legislation is quite possible – which might include the shutdown of loan and return of capital strategy. Accordingly, taxpayers may want to consider this strategy now.
Takeaway
Section 956 is complex and can be difficult to maneuver in a cash repatriation context. In addition, IRS continues to chip away at these strategies. However, there are still many viable cash repatriation strategies available. For these strategies to work you need a strong business case to identify the plan that fits your profile, coupled with careful evaluation, planning, documentation and execution.
