In Crestek, Inc., 149 T.C. No. 5 (2017), the Tax Court granted, in part, the government's motion for summary judgment that intercompany transactions between a U.S. parent company's controlled foreign corporations (CFCs) and its domestic subsidiaries (consisting of a loan from the CFCs, a guaranty of a loan by a CFC, and trade receivables owed to the CFCs) resulted in the CFCs holding U.S. property under Sec. 956 that is includible in the parent company's gross income under Sec. 951.
Facts
Crestek is the parent of a group of companies that includes, at issue here, five CFCs (referred to as CFCs 1 through 5), as well as a domestic subsidiary (S1) that owns another domestic subsidiary (S2). Three sets of transactions between the CFCs and domestic subsidiaries are at issue: intercompany loans, a guarantee, and trade receivables. The tax years in question were 2008 and 2009. The facts relating to these transactions have been simplified for purposes of this discussion.
Intercompany loans: At various times before 2008, CFC1, CFC2, and CFC3 made loans to S1. The balances of these loans, of approximately $11 million, $4 million, and $3 million at the end of the first quarter of 2008, remained constant throughout 2008 and 2009. CFC4 also made an intercompany loan of less than $1 million midway through 2008 that increased slightly in 2009.
Guaranty: In 2001, S1 borrowed $11 million from a Malaysian bank. CFC1, a Malaysian entity, guaranteed this loan. At the end of the first quarter of 2008, $10.7 million remained outstanding on this loan; this amount remained constant throughout the rest of 2008 and 2009.
Trade receivables: Before 2005, CFC1, a manufacturer, sold products to S2. CFC1 ceased manufacturing activities in 2005. At the end of the first quarter of 2008, S2 owed CFC1 $8 million in trade receivables; that amount remained constant throughout 2008 and 2009. After CFC1 ceased manufacturing, CFC5 took over production and continued to sell to S2. The net trade receivables account owed by S2 to CFC5 was $9 million in June 2007 and grew to $18 million in June 2009.
On its 2008 and 2009 tax returns, Crestek did not report any income as a result of these transactions except for $2 million on the trade receivable held by CFC5. On examination of the returns, the IRS determined that the transactions resulted in Crestek's CFCs having substantial investments in U.S. property under Sec. 956(c)(1)(C). Accordingly, the IRS stated that Crestek was required to include amounts in gross income under Sec. 951(a)(1)(B). The IRS asserted deficiencies and accuracy-related penalties. Crestek timely petitioned the Tax Court.
Law
Sec. 951(a)(1)(B) subjects a U.S. shareholder of a CFC to tax on its pro rata share of the CFC's earnings that are invested in U.S. property under Sec. 956. Sec. 956(c)(1)(C) defines U.S. property as including an "obligation of a [U.S.] person." Therefore, a loan or receivable held by a CFC and owed by a U.S. shareholder or related U.S. person generally constitutes an investment in U.S. property unless an exception applies, and, as such, is potentially subject to inclusion in a U.S. shareholder's income under Sec. 951 (a Sec. 956 inclusion).
One exception, under Sec. 956(c)(2)(C) and Regs. Sec. 1.956-2(b)(1)(v), applies to trade receivables from the sale or processing of property to the extent those trade receivables are "ordinary and necessary" to carrying on the parties' trade or business had the sale been made between unrelated parties.
In addition, under Sec. 956(d) and Regs. Sec. 1.956-2(c), an obligation of a U.S. person for which a CFC serves as a pledgor or guarantor similarly is considered U.S. property held by the CFC.
Opinion
The IRS filed a motion for summary judgment arguing that, as a matter of law, the CFCs at issue held investments in U.S. property under Sec. 956(c)(1)(C) as a result of the transactions. The Tax Court agreed with respect to the loan and the guaranty, and, in part, with respect to the trade receivables.
Threshold arguments: Before analyzing each obligation, the court dismissed three threshold arguments Crestek made. First, Crestek argued that the statute of limitation had passed for the assessments, but the court found that Crestek was subject to the longer six-year statute of limitation under Sec. 6501(e) on the omitted Sec. 956 inclusions.
The court also dismissed Crestek's argument that almost all of the IRS's adjustment must be made in prior tax years during which the obligations and guaranty arose. The court held that Sec. 956:
does not require that the inclusion be made for the first year in which the CFC acquires its investment [in U.S. property] or that the inclusion be made for any particular year. To the contrary: The statute defines the inclusion for any particular year by reference to "the amounts of United States property held (directly or indirectly) by the controlled foreign corporation" during that year... Thus, [when] a CFC holds an item of United States property for multiple years, [Sec.] 956(a) permits an inclusion in income for any one of those years. [emphasis added by the Tax Court]
The court also noted that the only relevant limitation is that a Sec. 956 inclusion cannot be made more than once under Sec. 959(c)(1)(A) — that is, an investment in U.S. property by a CFC can be shielded from a Sec. 956 inclusion to the extent of previously taxed earnings.
Lastly, Crestek argued that Sec. 6214 required the court to redetermine Crestek's income in previous years to correctly account for Crestek's earnings and profits in the years under examination. The court dismissed that argument, noting that only the tax attributes of the CFCs were relevant to determine whether an adjustment was required.
Intercompany loans: Regarding the intercompany loans, Crestek acknowledged that the amounts were outstanding and did not fit an exception to U.S. property under Sec. 956, but argued (1) that the amounts might have been discharged or, alternatively, (2) that any Sec. 956 inclusion should have been made before 2008. The court rejected both arguments. The loans, it stated, were outstanding, and therefore not discharged, and Crestek offered no evidence to the contrary. As noted, the court also dismissed the argument that the IRS was required to assert the Sec. 956 inclusion in an earlier year. Accordingly, the loans were U.S. property under Sec. 956, includible in income under Sec. 951.
Guaranty: Crestek argued that CFC1's guaranty of the loans from the Malaysian bank to S1 should not be considered U.S. property because the guaranty, according to Crestek, was essentially worthless. Crestek asserted that S1 had pledged sufficient collateral to the Malaysian bank without CFC1's guaranty, and, thus, the guaranty was a "meaningless gesture." Moreover, CFC1 was purportedly insolvent, though Crestek provided no evidence to support this fact outside of testimony of a corporate officer. The court did not accept either argument.
The court regarded both arguments as principally irrelevant due to the mechanical nature of Sec. 956 and its regulations. The court also noted that it is reasonable to assume the Malaysian bank has adequate reasons to demand the guaranty from CFC1, so it is inappropriate of Crestek to claim otherwise, absent supportive evidence. Further, the court dismissed the notion that CFC1 was insolvent, due to lack of evidence, and also noted that, even if CFC1 were insolvent, the guaranty would still result in a Sec. 956 inclusion because the law does not require solvency or test the worthiness of the guarantor.
Trade receivables: Crestek argued that the trade receivables owed by S2 to CFC1 and CFC5 fit the "ordinary and necessary" exception under Sec. 956(c)(2). The court disagreed with respect to the trade receivables owed by S2 to CFC1. Because CFC1 had ceased manufacturing in 2005, and, accordingly, CFC1 and S2 had not been engaged in trade for several years, there was nothing "ordinary and necessary" about the outstanding trade receivables. Nonetheless, regarding the receivable owed by S2 to CFC5, with which S2 was actively engaged in trade, the court stated that — while the amount outstanding seemed excessive — what amount was ordinary and necessary was a question of fact. Accordingly, it granted the IRS's motion for summary judgment for the amounts owed to CFC1 but not the amounts owed toCFC5.
Implications
Crestek is a reminder that taxpayers should be diligent in monitoring all intercompany transactions with their CFCs. The rules under Sec. 956 can be a trap for the unwary and can lead to inadvertently triggering a Sec. 956 inclusion. Intercompany loans, guaranties from CFCs or pledges of a CFC's assets or stock, and intercompany trade balances are common offenders and should be monitored with diligence. In addition, this case warns that, when a CFC holds an item of U.S. property for multiple years, Sec. 956 permits an inclusion in any of those years and not just in the year in which the investment in U.S. property first arose.
EditorNotes
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
