Regulations Prevent CFCs From Using Partnerships to Avoid Sec. 956

By Sally P. Schreiber, J.D.

The IRS issued temporary regulations on Wednesday aimed at preventing controlled foreign corporations (CFCs) from using partnerships to avoid the application of Sec. 956 (T.D. 9733). At the same time, the IRS issued proposed regulations on related CFC issues (REG-155164-09).

The amount that a U.S. shareholder of a CFC must include in gross income with respect to the CFC is determined under Sec. 956. This amount is partly based on how much U.S. property the CFC holds, directly or indirectly.

Temporary regulations

Temp. Regs. Sec. 1.956-1T(b)(4) contains an anti-avoidance rule, under which a CFC is considered to indirectly hold investments in U.S. property acquired by any other foreign corporation that is controlled by the CFC, if one of the principal purposes of creating, organizing, or funding that corporation is to avoid the application of Sec. 956. The new rules modify this anti-avoidance rule so it will apply when a foreign corporation a CFC controls is funded other than through capital contributions or debt.

Second, the temporary regulations add a rule to prevent taxpayers from using partnerships to structure transactions that are similar to the types of transactions addressed by existing Temp. Regs. Sec. 1.956-1T(b)(4). To avoid having Sec. 956 apply, a CFC may contribute cash to a partnership in exchange for an interest in the partnership, which in turn lends the cash to a U.S. shareholder. In that case, a taxpayer may take the position that the CFC is not treated as indirectly holding the U.S. shareholder’s entire obligation, but instead is treated as holding the obligation only to the extent of the CFC’s interest in the partnership. Accordingly, the temporary regulations expand Temp. Regs. Sec. 1.956-1T(b)(4) to include transactions involving partnerships that are controlled by the CFC.

Third, there is a new rule on foreign partnership distributions funded by CFCs. The IRS understands that taxpayers are undertaking transactions in which a CFC lends funds to a foreign partnership, which then distributes the proceeds to a U.S. partner related to the CFC and whose obligation would be U.S. property if the CFC held it or if it was treated as held by the CFC. Another version involves a CFC guaranteeing a loan to a foreign partnership, which then distributes the loan proceeds to a related U.S. partner. Taxpayers take the position that Sec. 956 does not apply to these transactions even though the CFC’s earnings are effectively repatriated to a related U.S. partner. To prevent this, the new Temp. Regs. Sec. 1.956-1T(b)(5) treats the partnership obligation as the distributee partner’s obligation to the extent of the lesser of (1) the amount of the distribution that would not have been made without the funding of the partnership or (2) the amount of the foreign partnership obligation.

The rules also add new definitions for determining whether rents and royalties are considered derived in the active conduct of a trade or business, in which case they are excluded from foreign personal holding company income. The tests for exclusion are (1) the active development test and (2) the active marketing test. The regulations explain that the CFC’s officers or employees must perform the tasks at issue to qualify for the exclusion. In addition, the regulations clarify that for purposes of applying these tests, payments made by a CFC under a cost-sharing agreement will not cause the CFC’s officers and employees to be treated as undertaking the activities of the controlled participant to which the payments are made.

The temporary regulations are effective Sept. 2, 2015.

Proposed regulations

The proposed regulations contain additional rules regarding the treatment as U.S. property of property held by a CFC in connection with certain transactions involving partnerships. Under the proposed regulations, an obligation of a foreign partnership is treated as an obligation of its partners for purposes of Sec. 956, subject to an exception for obligations of foreign partnerships in which neither the lending CFC nor any person related to the lending CFC is a partner. A special rule increases the amount of a foreign partnership obligation treated as U.S. property under the general rule in the case of certain distributions.

The proposed regulations also clarify that a CFC that is a pledger or guarantor of an obligation of a U.S. person is treated as holding the obligation. In addition they provide rules on the determination of the amount of property that is U.S. property where a CFC is treated as holding the property indirectly through a partnership.

Further, the proposed regulations revise the rules regarding when accounts receivable from factoring transactions are included in U.S. property. Finally, they state explicitly that, for purposes of Sec. 956, an obligation of a disregarded entity is treated as an obligation of the owner of the disregarded entity.

Most of the rules in the proposed regulations are proposed to apply to property acquired, or pledges or guarantees entered into, on or after Sept. 1, 2015.

Sally P. Schreiber (sschreiber@aicpa.org) is a TTA senior editor.

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