By Anthony Diosdi
Internal Revenue Code Section 956 provides that a U.S. Shareholder must include his or her income his or her pro rata share of a controlled foreign corporation’s (“CFC”) increase in its earnings and profits (“E&P”) in U.S. property for the taxable year. This section of the Internal Revenue Code is an anti-abuse rule, designed to prevent the enjoyment of the benefit of repatriation to the U.S. of untaxed foreign earnings through reinvestment here. For purposes of Section 956, U.S. property includes most tangible and intangible property owned by the CFC. In enacted Section 956, Congress concluded that if any CFC loaned its accumulated earnings to its U.S. shareholders, earnings to the U.S. shareholders had occurred and, consequently, the loan should be treated as a constructive dividend. This treatment tax is based on the theory that, because the U.S. shareholder has use of the money loaned to it, it could reasonably be treated as if it had received the funds as a dividend even though it had an unconditional obligation to repay the principal of the loan.
For example, let’s assume that on January 1 of last year, DC, a U.S. corporation, formed a wholly owned foreign subsidiary, FC, which is a CFC. FC is engaged in a foreign business that generated $100,000 of net income during last year. On February 1 of last year, FC made a bona fide loan of $100,000 to DC and such loan remained outstanding at the end of the year. Under Section 956, the loan from FC to DC is treated as an investment of FC’s earnings in U.S. property. Thus, DC must include $10,000 in gross income as if FC had distributed that amount to DC.
It is fundamentally worth noting that Section 956 diminished its relevance in the context of cross-border intercompany loans after the enactment the 2017 Tax Cuts and Jobs Act, because the Section 965 transition tax eliminated most untaxed offshore E&P, leaving large pools of previously taxed E&P that will ultimately be repatriated to the U.S. without additional tax. In addition, the global low-taxed income or GILTI causes most foreign source income to be taxed. Thus, this discussion is limited to foreign E&P that is the result of 10 percent QBAI from GILTI or taxable income deferred under the Section 954 ight tax election.
At one time a CFC measured its investment in U.S. property for Section 956 purposes at the end of the tax year. CFCs used this to their advantage by making intercompany loans to their U.S. parent corporations at the start of each tax year and repaying the debt just before the end of the tax year. In form, the CFC would never have a 956 inclusion because the loan was repaid before the end of the tax year. However, in substance, the U.S. parent had use of the CFC untaxed funds for almost a year. In cases of circular loans, the U.S. parent could have use of the CFC untaxed funds for much longer than a year. In order to prevent this perceived abuse, the IRS enacted Rev. Rul. 89-73, 1989-1 C.B. 258.
What if a CFC does not actually make a loan to CFC shareholder? Or what if a CFC grants security to obtain a loan for a CFC shareholder? Section 956(d) states that a CFC shall, under regulations prescribed be considered holding an obligation of a U.S. Shareholder if the CFC “is a pledgor or guarantor of such obligation.” Treasury Regulation Section 1.956-2(c)(1) restates Section 956(d) by stating any obligation of a U.S. person “with respect to which a CFC is a pledgor or guarantor” is considered U.S. property held by the foreign corporation for U.S. tax purposes.
The U.S. tax consequence of this language is harsh. For example, suppose that an individual U.S. shareholder of a CFC borrowed $100. Let’s also assume that the individual CFC shareholder gives a guaranty for the $100 loan. If the individual CFC shareholder does not repay the $100 loan, the CFC must pay the $100 or, if less, the amount of the shortfall. Under Treasury Regulation Section 1.956-1(e)(2), the amount that must be taken into account with respect to any pledge or guaranty described in Treasury Regulation Section 1.956-2(c)(1) is “the unpaid principal amount … of the obligation with respect to which the CFC is a pledgor or guarantor.” The unqualified use of “unpaid principal amount” suggests that the regulations mean what they state. Applying the regulations promulgated under Section 956, the CFC’s $100 guaranty would require the individual U.S. CFC shareholder to report the full $100 as income, assuming the CFC has sufficient E&P. The regulation under Section 956 indicates an individual CFC shareholder should not pledge CFC shareholders or pledge CFC shares as a guarantee to obtain a loan.
The situation is different for domestic C corporate CFC shareholders. CFC’s held by U.S. domestic corporate borrowers will generally be able to provide guarantees and pledges in support of their U.S. corporate parent’s debt without triggering a 956 related tax liability. However, as is usually the case in any international tax matter, careful planning needs to be done in order to avoid an unexpected tax liability.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.