The funding rule under Sec. 4501(d) prop. regs.

Editors: Alexander J. Brosseau, CPA, and Greg A. Fairbanks, J.D., LL.M.

On April 12, 2024, the IRS and Treasury released proposed regulations under Sec. 4501 (REG–115710–22) providing rules for application of Sec. 4501, which imposes an excise tax of 1% of the fair market value of a corporation’s stock that certain corporations repurchase during a tax year (the stock repurchase excise tax). Prop. Regs. Sec. 58.4501–7(e) provides that a U.S. corporation owned by a foreign publicly traded parent may be subject to the tax if such corporation “funds by any means” a repurchase of stock by its foreign parent with a principal purpose of avoiding the Sec. 4501(d) excise tax (the funding rule).

Although the IRS may provide additional clarification when final regulations are issued, the version of the funding rule in the proposed regulations presents an issue of how to interpret the phrase “funds by any means.” This phrase is not explicitly defined, and although a similar phrase has been used in other anti–avoidance rules in other regulations (i.e., Regs. Secs. 1.956–1(b) and 1.304–4(b)(1)), there are fundamental differences between the transactions targeted by the funding rule and those targeted by these other anti–avoidance rules that create significant ambiguity in the application of the funding rule.

Background of Sec. 4501’s funding rule

Sec. 4501 provides that a domestic publicly traded corporation (covered corporation) may be subject to the stock repurchase excise tax for stock that it repurchases or that is purchased by one of its “specified affiliates.” Under Sec. 4501(c)(2)(B), a specified affiliate includes “any corporation more than 50% of the stock of which is owned (by vote or by value), directly or indirectly, by such corporation.” Sec. 4501(d) provides that if there is an acquisition of stock of a foreign publicly traded corporation (an applicable foreign corporation) by a domestic specified affiliate of that corporation (an applicable specified affiliate), the acquiring applicable specified affiliate would be treated as a covered corporation, with such purchase being treated as a repurchase for purposes of the stock repurchase excise tax.

Under Prop. Regs. Sec. 58.4501–7(e)(1), “[a]n applicable specified affiliate of an applicable foreign corporation is treated as acquiring stock of the applicable foreign corporation to the extent the applicable specified affiliate funds by any means (including through distributions, debt, or capital contributions), directly or indirectly, a covered purchase with a principal purpose of avoiding the section 4501(d) excise tax” (defined above as the funding rule). While many issues exist as to the implementation of the funding rule, one of the most fundamental regards the interpretation of “funds by any means.”

Interpreting ‘funds by any means’

The proposed regulations do not define the phrase “funds by any means,” nor is it explicitly defined anywhere else in the Code or regulations. Even in ordinary use, the interpretation of “funds by any means” appears ambiguous. Merriam–Webster’s dictionary defines “fund,” the verb, as “to provide funds for” and then defines “funds,” the noun, as “a sum of money or other resources whose principal or interest is set apart for a specific objective” (Merriam–Webster.com Dictionary, s.v. “fund”).

However, when dealing with related entities, it is difficult to interpret what “funds” may mean for money set apart for a specific objective. In the loosest interpretation of “funds by any means,” the rule could be read to encompass any monetary payment that is used to repurchase stock of the foreign publicly traded parent. While it is unlikely the IRS seeks to encompass all monetary payments, there is still significant uncertainty as to which transactions constitute fundings.

The only clarification the proposed regulations give to the meaning of “funds by any means” is the parenthetical in Prop. Regs. Sec. 58.4501–7(e), which states, “including through distribution, debt, or capital contributions.” The examples under Prop. Regs. Sec. 58.4501–7(p) provide no additional clarification because they only include fundings through those three transactions. Other regulations, however, provide some insight of what is considered a “funding,” most notably Regs. Sec. 1.956–1.

Sec. 956 generally deems a U.S. shareholder to receive a distribution from a controlled foreign corporation (CFC) to the extent that the CFC invests in U.S. property. Since the rule simply creates a deemed distribution, the amount of tax owed due to such acquisition of U.S. property depends on the earnings or profits (E&P) of the CFC. As such, absent the anti–tax–avoidance rules provided in Regs. Sec. 1.956–1(b), it would be possible for one CFC with high E&P to transfer funds to a second CFC owned by the same U.S. shareholder that had no E&P, then have the second CFC invest in U.S. property and avoid the U.S. shareholder’s being subject to tax on the deemed distribution. To prevent such abuse, Regs. Sec. 1.956–1(b)(1) provides:

United States property held indirectly by a controlled foreign corporation includes … (ii) United States property acquired by any other foreign corporation that is controlled by the controlled foreign corporation if a principal purpose of creating, organizing, or funding by any means (including through capital contributions or debt) the other foreign corporation is to avoid the application of section 956 with respect to the controlled foreign corporation.

One noteworthy aspect of this regulation is that the IRS, in response to certain comments, directly addressed the intended scope of the phrase “funding by any means” in the preamble (T.D. 9792, Nov. 4, 2016), as follows:

The policy concerns addressed by the anti–avoidance rule are not limited to fundings by debt or equity …. In addition, the Treasury Department and the IRS disagree with the view expressed in the comment that the expanded scope of fundings could result in common business transactions being subject to the anti–avoidance rule. … The Treasury Department and the IRS agree, however, that examples illustrating that the anti–avoidance rule should not apply to certain common transactions would be helpful. Accordingly, these final regulations add new examples that address common transactions highlighted by the comment to further illustrate the distinction between funding transactions that are subject to the anti–avoidance rule and common business transactions to which the anti–avoidance rule does not apply.

The regulations under Sec. 956 then provide several examples, explicitly addressing whether such transactions constitute a funding.

Payment for property or services

One example in Regs. Sec. 1.956–1(b)(4)(v) provides that a sale of inventory did not constitute a funding under the following facts:

Example 5.

(A) Facts. FS1 sells inventory to FS2 in exchange for $100x. The sale occurred in the ordinary course of FS1’s trade or business and FS2’s trade or business, and the terms of the sale are consistent with terms that would be observed among parties dealing at arm’s length. FS1 makes a $100x loan to P. FS2 has no earnings and profits, and FS1 has substantial accumulated earnings and profits.

(B) Result. FS2 will not be considered to indirectly hold United States property under [Regs. Sec. 1.956–1(b)] because a sale in the ordinary course of business for cash on terms that are consistent with those that would be observed among parties dealing at arm’s length does not constitute a funding.

The conclusion in Example 5 is noteworthy because it is explicit that monetary payment in exchange for the sale of property did not constitute a funding of the selling entity. Although this example only addresses the sale of inventory, it might be extended to other arm’s–length transactions where one party pays cash in exchange for the purchase of property, use of property, or provision of services, as long as the transactions occur in the ordinary trade or business of both parties and have terms that would be observed among the parties at arm’s length.

Another aspect of Example 5 is that it involves a current cash payment in exchange for the inventory, which is an important distinguishing fact from transactions where a sale occurred, cash did not transfer immediately, and a trade receivable was established. Such a fact pattern is analyzed in Example 1of Regs. Sec. 1.956–1(b)(4)(i):

Example 1.

(A) Facts. FS1 sells inventory to FS2 in exchange for trade receivables due in 60 days. Avoiding the application of section 956 with respect to FS1 was not a principal purpose of establishing the trade receivables. FS2 has no earnings and profits, and FS1 has substantial accumulated earnings and profits. FS2 makes a loan to P equal to the amount it owes FS1 under the trade receivables. FS2 pays the trade receivables according to their terms.

(B) Result. FS1 will not be considered to indirectly hold United States property under [Regs. Sec. 1.956–1(b)] because the funding of FS٢ through the sale of inventory in exchange for the establishment of trade receivables was not undertaken with a principal purpose of avoiding the application of section ٩٥٦ with respect to FS١.

Example 1 concludes that such transaction results in FS1 funding FS2, even though no money exchanged hands. While the example does not expand on why such a transaction is considered a funding, the example seems to be recognizing the fungibility of money, treating such transaction as a funding of FS2 because FS2 received property for no current expense, enabling FS2 to use money to acquire U.S. property.

In addition to the specific facts above, Example 1 may also apply to transactions that have a similar result, where a funded entity establishes a liability related to a transaction in the ordinary course of its trade or business in lieu of making a cash payment, for example, transactions where the funding entity pays an expense on behalf of the funded entity and the funded entity establishes a liability in lieu of making an immediate reimbursement.

Repayment of liabilities in multinational groups

Another common transaction in multinational groups that could potentially constitute fundings is the repayment of liabilities. Regs. Sec. 1.956–1(b)(4)(vi), Example 6, addressed one such transaction, concluding that a loan repayment did not constitute a funding under the following set of facts:

Example 6.

(A) Facts. In Year 1, FS2 loans $100x to FS1 to finance FS1’s trade or business. The terms of the loan are consistent with those that would be observed among parties dealing at arm’s length. In Year 2, FS1 repays the loan in accordance with the terms of the loan. Immediately after the repayment by FS1, FS2 loans $100x to P. FS2 has no earnings and profits, and FS1 has substantial accumulated earnings and profits.

(B) Result. FS1 will not be considered to indirectly hold United States property under [Regs. Sec. 1.956–1(b)] because a repayment of a loan that has terms that are consistent with those that would be observed among parties dealing at arm’s length and that is repaid consistent with those terms does not constitute a funding.

It is important to note that Regs. Sec. 1.956–1(b)(1) provides a parenthetical similar to the parenthetical in the proposed regulations, which states that “funding by any means” includes “capital contributions or debt.” Notwithstanding the contemplation that “debt” may constitute a funding, Example 6 concludes that the loan repayment does not constitute a funding. This implies that “debt,” as used in such parenthetical, means the loaning of money constitutes a funding, not necessarily the repayment of such debt.

Although Example 6 does not explicitly provide that repayment of interest is also not a funding, it does provide that the loan has terms consistent with those among parties dealing at arm’s length. Thus, it may be reasonable to assume that Example 6 applies to repayment of both principal and interest on such loans. Although Example 6 only addresses the repayment of a loan established in exchange for money, the rationale in such an example might extend to other repayments of liabilities that were created in the ordinary course of a borrowing entity’s trade or business, such as reimbursement of expenses incurred by another party and repayment of cash pooling obligations.

One very important aspect of the facts in Example 6 is that the loan was made to finance the business of FS1, and it is unclear whether such an example should be extended to repayment of loans where the proceeds from the original loan were not used in the borrowing entity’s business. It is common with foreign–parented multinational groups for U.S. subsidiaries to have a loan due to their foreign parent or other foreign member that owns the U.S. subsidiary borrower. Such loans are often established as either a note distribution from the U.S. subsidiary (assuming Regs. Sec. 1.385–3 does not apply to characterize such a loan as equity) or loans established in connection with the acquisition of a U.S. target where funds are loaned to a foreign parent’s subsidiary and used to acquire the U.S. target, with funds ultimately transferred to the sellers.

In the case of a note established in connection with the acquisition of a U.S. target, such proceeds from the loan generally end up in the hands of the selling shareholders and are not used in the borrower’s business. In addition, the purpose of establishing such loans (as opposed to funding with a contribution) is often so that the U.S. subsidiary can make payments to its foreign parent as interest instead of dividend distributions. Furthermore, in the ordinary use of the word “funding,” interest payments from such loans may be considered as funding the foreign parent, as it is the main mechanism for the U.S. group to transfer its business profits to its foreign parent. On the other hand, it is difficult to distinguish such loans from Example 6, as it is unclear why the use of proceeds from the original monetary loan would dictate whether the repayment of such a loan is considered a funding.

In the case of a note distribution where no funds are actually transferred to the subsidiary upon creation of the note, the repayment of such a loan is essentially just a delayed distribution. Thus, it would seem appropriate for such a repayment to be treated similarly to a distribution. This also raises the question whether a note distribution should be treated as a funding upon distribution, as no funds are transferred upon creation of the note. Notwithstanding that a note distribution may constitute a distribution for tax purposes, it is difficult to see such a note distribution as funding any acquisition of property until such amounts are repaid, which may support treating repayment of such a note as a funding. This would also extend Example 6from Regs. Sec. 1.956–1(b)(4)(vi) to such a fact pattern because the tax–avoidance transaction being prevented by Regs. Sec. 1.956–1(b) cannot be accomplished through a distribution.

Difference between the ‘funding rule’ and uses of the phrase in other regulations

The preamble to the proposed regulations (REG–115710–22) cites Regs. Secs. 1.956–1(b) and 1.304–4(b)(1) as providing authority for the funding rule, stating, “longstanding rules in other Treasury regulations provide that, if a taxpayer funds an acquisition of property by a relevant related party rather than acquiring the property itself, the taxpayer can be treated in appropriate circumstances as acquiring the property for certain Federal income tax purposes if the funding satisfies a principal purpose requirement.”

The type of tax–avoidance transactions being prevented by Regs. Secs. 1.956–1(b) and 1.304–4(b)(1) differs significantly from what is at issue under Sec. 4501. Although the rules technically deal with the acquisition of property, the true aim of the Regs. Sec. 1.956–1(b) and 1.304–4(b)(1) anti–tax–avoidance rules is to prevent a corporation from using related entities to transfer money to its shareholders while manipulating which entity is treated as making the distribution of money.

As is clear from the examples under Sec. 956, the U.S. property that is of particular concern is a note with the shareholder of the related entities. Because a loan to a U.S. person is considered U.S. property, Sec. 956 treats a loan to a U.S. shareholder as if the loaning entity made a distribution to such shareholder. Thus, Regs. Sec. 1.956–1(b) prevents a corporation from using related entities to indirectly transfer funds to its shareholders while trying to manipulate which entity is treated as making the distribution.

Regs. Sec. 1.304–4(b)(1) prevents a similar type of tax–avoidance transaction. Generally, Sec. 304 treats the purchase of a corporation from a shareholder that owns both the acquiring and target corporations as a deemed distribution. Similar to Regs. Sec. 1.956–1(b), Regs. Sec. 1.304–4(b)(1) prevents a corporation from using related corporations to manipulate which entity is treated as making such distribution.

It is unclear what tax–avoidance transaction the funding rule is attempting to prevent, as the only rule provided in Sec. 4501(d) is that the applicable specified affiliate is not permitted to directly acquire the stock of its foreign publicly traded parent. The IRS fails to make clear why a distribution of funds to a foreign parent that the foreign parent uses to repurchase its own stock is a transaction avoiding the application of Sec. 4501(d), particularly since it is unlikely the U.S. subsidiary would desire to acquire such stock even absent the enactment of Sec. 4501(d).

Even though it is unclear what tax–avoidance transaction the funding rule is preventing, the purpose of the funding rule differs significantly from the purpose of Regs. Secs. 1.956–1(b) and 1.304–4(b)(1), and the purpose of such rules should be considered when looking to such regulations for guidance on the meaning of “funds by any means.”

Editors

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office. Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact thetaxadviser@aicpa.org.

Contributors are members of or associated with Deloitte Tax LLP or Grant Thornton LLP as noted in the byline.

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