By Anthony Diosdi
In Dynamo Holdings L.P. v. Commissioner, T.C. Memo 2018-61 (2018), (hereinafter Dynamo Holdings) the U.S. Tax Court issued an opinion finding, in part, in favor of a Canadian U.S. family that engaged in successful real estate developments both in Canada and the U.S. that certain bona fide indebtedness existed with respect to cross-border restructuring as described below, but also finding that certain transfers were not made at fair market value, thus also finding that certain transfers were not made at fair market value, thus, triggering a constructive distribution, withholding tax exposure, and other hazards. This article analyzes the Dynamo Holdings case, which is a blueprint of how inbound restructuring should be carefully addressed and handled.
Factual Background
The Canadian-based Moog family had a strong track record in successful real estate development in Canada, and over the years, this business expanded into the United States. Beekman Vista, Inc. (hereinafter “Beekman Vista”) was a corporation wholly owned by a Canadian entity controlled by Mrs. Moog. Beekman Vista was organized as a Delaware corporation to enter the U.S. real estate market. Beekman Vista was a wholly owned subsidiary of a Canadian corporation, Canada Square Management, Ltd. (Canada Square”). Canada Square was a wholly owned subsidiary of Kolter Property Co. Kolter Property Co.’s preferred shares were held by 1231024 Ontario, Inc., and Kolter’s Property Co’s common shares and ownership control were held by 2020072 Ontario, Ltd. 1231024 Ontario, Inc’s commotion stock was held in a 60/40 split, with Delia Moog owned all its preferred shares. 2020072 Ontario, Ltd. was wholly owned by 2020064 Ontario, Ltd. 2020064 Ontario, Ltd.’s nonvoting was held in a 60/40 split with Delia Moog Family Trust #2 holding 60% and Robert Julien Family Trust #2 holding 40%; Mrs. Moog held all of its voting control. Mrs. Moog’s ownership of the voting stock of 2020064 Ontario, Ltd. gave her indirect control over Beekman Vista.
Beekman’s principal business activity was real estate management and development. Beekman Vista’s subsidiary owned and operated office buildings in Dallas, Texas, and developed residential real estate in South Florida also held a hedge fund portfolio, the Dynamo Fund, that produced investment income.
Dynamo Holdings Limited Partnership was a Delaware limited partnership (“Dynamo Holdings”). Dynamo Holdings was owned by two trusts that were limited partners and a corporation that was a general partner. The 2005 Christina Moog Family Delaware Dynasty Trust held a 59.9995% limited partnership interest, the 2005 Robert Julien Family Delaware Dynasty Trust held a 39.9995% limited partnership interest, and Dynamo GP held a .001% general partnership interest. Dynamo’s principal business was real estate development and sales in Florida.
Beekman Vista made significant transfers of real properties to Dynamo for less than fair market value.
Upon formation and through the years, Beekman Vista advanced funds to Dynamo, and Dynamo recorded the funds on its ledgers as an account payable to Beekman Vista. When Beekman Vista advanced funds to Dynamo, the funds were recorded on the general ledgers in the “due from/to”account. Interest accrued on that balance. And when Dynamo made repayments, the repayments were recorded on the general ledgers as well.
Beekman Vista and Dynamo did not follow many customary lending practices. Beekman Vista did nor demand payments, require collateral or security, or provide a fixed due date. The Beekman Vista and Dynamo management teams did not believe that formal lending procedures were necessary. The companies shared a single management team that had full knowledge of and access to both companies’ information, and the companies had a long history of advances and repayments over the years. Given that the management team had control over both the lenders and the borrowers, they believed that formal lending procedures were redundant and unnecessary. They also believed that it was unnecessary to demand payments because past repayments were made without demand. At a later date, Beekman Vista and Dynamo executed a written promissory note memorializing the loans.
Less than Fair Market Value Transfers and FIRPTA Withholding
Beekman Vista sold multiple properties to Dynamo Holdings through a number of bargain sales transactions that exceeded $200 million. The Internal Revenue Service (“IRS”) took the position that the bargain sales transactions were consummated at less than fair market value. Fair market value has been defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts.
Because the transactions at issue were bargain sales at less than fair market value between related parties, the IRS claimed that the transactions constituted constructive taxable distributions up the entity chain to the Canadian owners who then made gifts to the U.S. based owners. A constructive dividend is a payment, allowance, loan or other form of financial benefit from a corporation to a shareholder that is not intended to be a dividend payment but that ends up being classified by the IRS as a dividend. The IRS further argued that special scrutiny was required between and among entities controlled by family members or related parties.
The Tax Court determined that the bargain sales transactions served no valid business purpose and that the transfers occurred principally for the common shareholder’s personal benefit. Since the real estate transfers occurred principally for the common shareholder’s personal benefit rather than for a valid business purpose, the court determined that the bargain sales resulted in a taxable constructive distribution. Having determined that the transfers in question resulted in taxable constructive distributions, the court went on to apply Internal Revenue Code Section 1445(e)(3) to apply the then applicable ten percent withholding (now 15 percent) on the amount realized in excess of the dividends under Section 897 (in legislation called the Foreign Investment in Real Property Tax Act or “FIRPTA”). Section 1445 requires that, when a foreign person disposes of a U.S. real property interest, the “transferee” must typically now withhold 15 percent of the amount realized by the transferor on the disposition and pay it to the U.S. Treasury. In this case, Section 1445 gave rise to certain withholding obligations which had not been satisfied, resulting in substantial penalties.
Related Party Debt
The Dynamo case also dealt with the treatment of certain related party loans. The establishment of several family members in the United States resulted in tax inefficiencies. To address these cross-border tax inefficiencies, a U.S. based structure was organized to fund U.S. operations. To fund U.S. operations, advances in the form of loans were made to Dynamo. The IRS took the position that the advances were not bona fide loans but rather should be treated as gifts and thus, the “loans” would be deemed constructive distributions up to the Canadian ownership chain followed by deemed gifts to the underlying beneficial owners of the entities involved in the loan transactions. The IRS also asserted that withholding tax is applicable to the deemed distributions that flowed up to Canada. Most of the forms of U.S.-source income received by foreign persons that are not effectively connected with a U.S. trade or business will be subject to a flat tax of 30 percent on the gross amount of income received. Sections 871(a) (for nonresident aliens) and 881(a) (for foreign corporations) impose the 30-percent tax on interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income. This enumeration is often referred to as “FDAP income.” The collection of such taxes is effected primarily through the imposition of an obligation on the person or entity making the payment to the foreign person to withhold the tax and pay it over to the IRS.
As discussed above, Beekman Vista advanced funds to Dynamo to finance operating expenses. Those advances were booked as “due to/from” on the companies’ books. The original balances accrued interest. However, the parties did not formalize this arrangement through arm’s-length type agreements. When making the advances, there was no security, no fixed maturity date, no written promissory note (although later the parties executed a promissory note with more typical third-party terms). The court ruled that the loans from Beekman Vista to Dynamo should be treated as bona fide loans despite the absence of many customary lending practices. The court instead focused on the stream of payments made by the borrower to the affiliated lender on an annual basis. In determining that the loans were bona fide, it noted that a commercially-reasonable interest rate was charged and paid as a part of the debt retirement. In addition, at the time of the advance, Dynamo had the financial ability to repay the advance.
Conclusion
The Dynamo case establishes that related parties in the cross-border context can provide benefits to one another without suffering negative tax consequences. However, when related parties are transferring U.S. real property through a sale or other means, careful considerations must be given to the FIRPTA withholding rules. Besides, complying with all withholding requirements stated in Section 1445, it is crucial to have a full appraisal determined at the time real estate is transferred between related parties and the acquisition price should reflect the fair market value of the real property being transferred.
In the context of related party party loans, in order to avoid having the IRS to treat a loan as a bona fide loan, the loan should be evidenced by the following:
1) A promissory note or other evidence of indebtedness;
2) Interest should be charged at the commercial rate;
3) The loan should be secured by security or collateral;
4) The loan should have a fixed maturity date;
5) The terms of the loan instrument should be followed;
6) The loan transaction should be reported to the IRS that is consistent with the loan.
In the event that the above discussed customary loan practices are not followed, at a minimum, both parties should record the loan on their respective general ledgers, the borrower should repay the loan with interest each year of the term of the loan and reduce the outstanding loan balance.
Anthony Diosdi is an international tax attorney at Diosdi & 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.