This article summarizes recent US tax developments of interest to Canadian tax advisers, including proposed regulations limiting the use of the check-the-box regime, a case that denied an exemption from withholding taxes on interest income, and congressional action to maintain the privacy of advance pricing agreements.
Proposed Check-the-Box Regulations
The Service and the US Treasury Department ("Treasury") have been monitoring taxpayers' application of the check-the-box regulations to see whether taxpayers were taking any "inappropriate" actions, and have determined that certain taxpayers were using disregarded entities to achieve results deemed to be inconsistent with the policies and rules of the Internal Revenue Code.3
The proposed regulations were promulgated to prevent check-the-box elections when they are used to avoid subpart F income or to change the source of income in a sale of all of the interests in a disregarded entity. When stock is sold in a foreign entity, gain on the sale is taxable immediately under the subpart F regime, while the recognition of gain on a sale of assets can be deferred. In addition to the timing of the gain recognition, there are several other advantages to having a transaction viewed as an asset sale rather than an equity sale. Gain on a sale of equity, when treated as foreign source, is placed in the passive income basket under section 904, while gain on a sale of foreign business assets goes into the general active income basket and can maximize the use of foreign tax credits.
The Service and Treasury apparently believe that the most appropriate way to avoid these "abuses" is to revoke the entity's classification as a disregarded entity. The new rules apply to "extraordinary transactions"4 that occur within a period beginning one day before and ending 12 months after the date the foreign entity changed its entity classification to a disregarded entity. This rule applies only if the entity was previously taxable as a corporation at some point during the 12-month period before the extraordinary transaction.5
Extraordinary transactions include any form of disposition of a 10% or greater interest in the electing foreign entity. It does not matter how many transactions are needed during the 12 month and one day period to achieve the 10% disposition. The regulations are unclear whether the limit is 10% of value or voting power.
The extraordinary transaction rule also applies to certain "shelf" entities, that is, dormant or relatively small eligible entities. An extraordinary transaction is deemed to occur when four conditions are met: the owner elects to treat the entity as disregarded; the entity acquires assets from another foreign entity that was taxable as a corporation at some point during the 12-month period before the extraordinary transaction in a tax-free transaction (such as a merger); the acquired assets constitute 80% or more of the value of the assets of the disregarded entity; and the entity is engaged in a 10% or greater disposition event within 12 months of the date of completion of the asset acquisition. In making the 80 percent value determination, the government can disregard cash and marketable securities that exceed the reasonable needs of the entity's business .
The proposed regulations provide examples of transactions that will be prevented. In one example, an entity elects to treat its wholly owned subsidiary as a disregarded entity immediately before it is to be sold. Under the proposed regulations, the check-the-box election will not be respected; instead, the seller will be treated as if it sold stock of the wholly owned subsidiary (rather than its assets).
In another example in the proposed regulations, a parent company owns all of the ownership interests in a two-year-old dormant eligible entity for which it initially made a check-the-box election. The parent then merges another foreign subsidiary (one that had been taxable as a corporation) into the disregarded entity, and sells the disregarded entity to a third party. Under the proposed regulations, the subsequent sale will be treated as an extraordinary transaction, the check-the-box election will be ignored, and the parent will be treated as if it had sold the stock in the disregarded company.
It appears that most practitioners did not view these transactions as abuses, but rather as ways to achieve equitable treatment between asset sales and equity sales.6 There is no clear rationale for the distinction in tax treatment in subpart F and the foreign tax credit rules between asset sales and sales of equity interests in a wholly owned subsidiary, except that other nations make such distinctions. Note, however, that these results may currently be available under section 338 of the Code.
The proposed regulations, while attempting to draw a bright line, still allow a taxpayer to structure a transaction in order to achieve the desired tax results. For example, with respect to a shelf corporation, the parent can place other assets (other than cash and marketable securities) into the disregarded entity before the merger to pass the 80% test.
The proposed regulations also restrict the use of entities whose tax status as partnerships was grandfathered before the list of "per se" corporations was published in 1997. Per se corporations are certain types of entities that are treated automatically as corporations. The Service is concerned that US corporations have been purchasing per se corporations that have grandfathered status as partnerships in order to avoid current US income tax. The proposed regulations terminate an entity's grandfathered status when there is a change in 50% or more of the ownership of the entity.
No Exemption from Withholding Taxes
The use of financing subsidiaries has been greatly limited by the inclusion of treaty-shopping provisions in most new US treaties and by Treasury's conduit financing regulations,9 applicable to payments made by financed entities on or after September 11, 1995. This issue may still arise, however, in cases not covered by a treaty-shopping provision or the conduit financing regulations.
Northern Indiana Precedent
NAIS lent the funds to DEL for five years at an interest rate of prime plus 1.5%. DEL secured this loan by a general assignment of rents. DEL also provided an undertaking as security of the third-party bank loan to CFin, which allowed the bank to place a mortgage on the real property of DEL. The undertaking required DEL to provide the bank with annual financial statements, to insure its property, to assign its insurance policies to the bank, to defer paying dividends to its shareholders, and to pay the bank the proceeds from the sale of any of its real property in satisfaction of the outstanding loan.
When DEL first began making interest payments on its loan to NAIS, it made them directly to NAIS, which reported them as income on its books and records. NAIS then transferred the funds to either CFin or CHS, which then used the funds to repay the bank loan. After a year and a half, DEL began to make the interest payments directly to CFin, although its books still reflected that it was making payments to NAIS. Six months later, the bank raised the interest rate that it was charging CFin to prime plus 1.5%. DEL did not file any US federal withholding tax forms with respect to any of its payments.
Holding.The court applied the step transaction doctrine, collapsing the series of transactions into a loan from CFin and treating the intermediary companies as mere conduits. The court relied on the fact that DEL had provided guarantees for CFin's bank loan, that NAIS passed on the interest payments that it received from DEL to CFin to service the bank loan, and that eventually DEL made the interest payments directly to CFin. The court found that NAIS had acted as a mere shell or conduit with respect to the loan payments that it received from DEL.
The court in Del Commercial distinguished the holding in Northern Indiana by stating that that case involved a loan to a US corporation from a foreign subsidiary that obtained its funds from a third-party lender and that an interest rate spread existed, thus allowing the foreign subsidiary to earn income on the transaction. In Del Commercial, NAIS received funds from another entity in its group, and the initial interest rate spread disappeared after the bank raised the rate on its loan.
Analysis.The Tax Court and the Seventh Circuit in Northern Indiana relied on the principle that as long as a foreign subsidiary conducts bona fide business activities, its existence will not be disregarded, even if such activities are minimal and the subsidiary was created in an attempt to minimize US federal income taxes.10 The court in Del Commercial, however, ignored the interest rate spread that existed for the first two years of the loan, and, more important, the fact that NAIS had been capitalized with equity, not debt. The payments made by NAIS to CFin and CHS were presumably advances that it recorded as loans on its books, on which it earned additional interest income.11 NAIS was merely trying to earn income on the money that was contributed to its capital, a legitimate business activity. NAIS was not merely passing funds to its shareholder as a dividend.
Neither court in Northern Indiana considered applying the step transaction doctrine. Nor is it clear that the step transaction doctrine has ever been used to attack a financing transaction. Indeed, it is hard to see how the court in Del Commercial correctly applied the step transaction doctrine, which usually collapses two or more steps into one when: (1) there was a binding commitment to take the later steps at the time the first step was taken; (2) the separate steps are prearranged parts of a single transaction intended from the beginning to have a specific end result; or (3) the steps are so interdependent that the legal relationships created by one step would be meaningless without the completion of all of the steps. In the present case, the corporate structure remained intact, preventing the usual application of the step transaction doctrine.
It is understandable, however, to see why the court reached the result that it did. The parties in Del Commercial were not diligent in respecting the form of their structure (for example, DEL made payments directly to CFin in later years, and the spread disappeared in later years).
It remains to be seen whether this memorandum decision will be relied upon in future cases.
Advance Pricing Agreements - New Law
In response to this litigation and to subsequent lobbying by taxpayers and their advisers, the US Congress enacted legislation aimed at keeping APAs confidential; President Clinton signed the bill into law on December 17, 1999.14
The new statute expands the reach of section 6103 (which extends confidential return information status) to include APAs and related background information. The statute also requires that Treasury produce an annual report disclosing aggregated APA information and containing general descriptions of covered transactions and methodologies. The first report was issued by Treasury on March 30, 2000.
It should be noted that there have been complaints about the new provision, mostly from those favoring disclosure, who fear that the information will not be helpful in summary format. Initial reaction to the first report has been favorable, however, and practitioners find the aggregated format detailed and very useful.15
1. REG-110385-99, 1999 TNT 228-3.
2. An eligible entity is an organization that is recognized as an entity for US federal income tax purposes but is not specifically classified as a corporation. A wholly owned eligible entity can elect to be treated as an association taxable as a corporation or as an entity disregarded from its owner as a separate entity.
3. Internal Revenue Code of 1986, as amended (herein referred to as "the Code"). Unless otherwise indicated, all statutory references in this article are to the Code, or to the Treasury Regulations promulgated thereunder.
4. The Service and Treasury intend to issue guidance that will identify specific transactions that will be excluded from the application of this rule once the proposed regulations are finalized.
5. If the taxpayer can establish that the classification as a disregarded entity does not materially alter the US federal income tax consequences of the extraordinary transaction, this rule will not apply.
6. Although this objective might also be achieved by a tax-free liquidation, it would involve more paperwork and additional filing requirements.
7. 78 TCM 1183 (1999).
8. 105 TC 341 (1995), aff'd. 115 F.3d 506 (7th Cir. 1997).
9. Treas. Reg. section 1.881-3.
10. See the decision of the Seventh Circuit, supra footnote 8, at 511-12.
11. The court record does not recite how these advances were reported by any of the parties.
12. Peter A. Glicklich and Anthony C. Infanti, "APA Disclosure: Can the Process Survive?" Selected US Tax Developments feature (1999), vol. 47, no. 4 Canadian Tax Journal 1048-56.
13. 5 USC section 552
14. Section 521 of H.R. 1180, the Ticket to Work and Work Incentives Improvement Act, Pub. L. no. 106-170, enacted on December 17, 1999.
15. "US Treasury Issues First APA Report" (April 10, 2000), vol. 20, no. 15 Tax Notes International 1615.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.