By Anthony Diosdi
Introduction
For those who are or will be involved in international business and investment transactions, it is important to have some basic understanding of the relevant tax laws. These series of articles are intended to warn individual shareholders of controlled foreign corporations (“CFCs”) (whether individual or corporate) of mistakes that will likely catch the attention of the Internal Revenue Service (“IRS”) and trigger a potential costly audit. This is the first of a series of articles designed to educate CFC shareholders of mistakes that can catch the attention of the IRS. We will begin this series with the rules governing intercompany loans and advances.
As a result of the pandemic, IRS examinations of tax returns have significantly declined. With that said, even before the pandemic, the number of IRS audits were steadily decreasing over the past few years. However, audits of tax returns disclosing international transactions seems to be bucking the trend. The IRS has been steadily increasing its audits of CFCs. In our experience, one of most highly contested areas in CFC audits are intercompany loans and advances. When a domestic corporation owns a number of CFCs, the domestic corporations and the CFCs usually engage in a variety of intercompany transactions such as intercompany loans and advances. These controlled entities must charge an arm’s length rate of interest on any intercompany loans or advances. These rules are not always followed. Failure to charge arm-length rates of interest on intercompany loans and advances can result in significant penalties being assessed by the IRS.
The Application of Section 482 to Intercompany Loans and Advances
Affiliated organizations that operate internationally generally must charge each other an arm’s length rate of interest on any intercompany loans or advances. See 1.482-2(a)(1)(i). For example, if a U.S. parent corporation lends money to a wholly owned CFC, the domestic parent must charge an arm’s length rate of interest. There is an exception, however, for intercompany trade receivables, which are debts that arise in the ordinary course of business and are not evidenced by a written agreement requiring the payment of interest. See Treas. Reg. Section 1.482-2(a)(1)(iii)(A). For CFC borrowers from a U.S. parent, it is not necessary to charge interest on an intercompany trade receivable until the first day of the fourth month following the month in which the receivable arises. See Treas. Reg. Section 1.482-2(a)(1)(iii)(C).
Below, please see Illustration 1 which demonstrates how the regulations of Section 482 apply to intercompany loans from a U.S. parent to a foreign controlled entity.
Illustration 1.
A, a domestic corporation, owns 100 percent of B, a foreign corporation. On November 1, B purchased $1 million of inventory on account from A. The $1 million debt, on which B pays no interest, is still outstanding on December 31, which is the end of A’s taxable year. Since the $1 million intercompany trade receivable was outstanding for only two months, A does not have to recognize any interest income. However, if the $1 million debt were still outstanding on January 31 of the following year, B would owe A interest.
Longer interest free periods are possible if the controlled lender ordinarily allows unrelated parties a longer interest free period or if a controlled borrower purchases the goods for resale in a foreign country and the average collection period for its sales is longer than the interest free period. See Treas Reg. Section 1.482-2(a)(1)(iii)(D) and Treas. Reg. Section 1.482-2(a)(1)(iii)(E).
Intercompany debt other than a trade receivable generally must bear an arm’s length interest charge. See Treas. Reg. Section 1.482-2(a)(1)(i). In other words, If a U.S. parent corporation advances money to a controlled foreign corporation or a controlled foreign corporation provides an intercompany loan to another controlled CFC, an arm’s length interest rate must be charged. To determine the arm’s length rate, the corporate lender must consider all relevant factors, including the amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender for comparable loans between uncontrolled parties. See Treas. Reg. Section 1.482-2(a)(2)(i). If an arm’s length rate is not readily determinable, the corporate lender or borrower can still protect itself against an IRS adjustment by satisfying the requirements of a safe-harbor provision. Under this safe harbor, an interest rate is deemed to be an arm’s length rate if it is between 100 percent and 130 percent of the applicable federal rate. See Treas. Reg. Section 1.482-2(a)(2)(iii)(B). The applicable federal rate is the average interest rate (redetermined monthly) on obligations of the federal government with maturities similar to the term on the intercompany loan. See IRC Section 1274(d).
Below, please see Illustration 2 which demonstrates the safe harbor rule for intercompany loans and advances.
Illustration 2.
A, a CFC, owns 100 percent of B, another CFC. During the current year, A borrows $1 million from B. The loan is determined in U.S. dollars and has a three-year term. At the time of the loan, the applicable federal rate for a three year obligation is 8 percent. Under the safe harbor provision, an interest rate of between 8 percent (100 percent of the applicable federal rate) and 10.4 percent (130 percent of the applicable federal rate) is automatically acceptable to the IRS. A rate lower than 8 percent or higher than 10.4 percent can also be used if it can establish that it is an arm’s length rate, taking into account all of the relevant facts and circumstances.
Special Situs Rules
A special rule applies if a U.S. parent corporate lender obtains funds used to make the intercompany loan at the situs of the CFC borrower. In such cases, the CFC lender is treated as a mere conduit for the loan entered into with the unrelated lender. The arm’s length rate on such pass-through loans is assumed to be equal to the rate paid by the controlled lender on the original loan, increased by any associated borrowing costs, unless it can establish that a different rate is more appropriate under the general rules. See Treas. Reg. Section 1.482-2(a)(2)(ii).
Below, please see Illustration 3 which demonstrates the special situs rules governing intercompany loans.
Illustration 3.
A, a domestic corporation, owns 100 percent of B, a Hungarian corporation. During the current year, A borrowed $10 million from a U.S. bank at a 10 percent rate and then relends the funds to B. The arm’s length rate on the intercompany loan is deemed to be equal to 10 percent plus any borrowing costs incurred by A in securing the original loan. A rate other than 10 percent also can be used if A can establish that such a rate is arm’s length, taking into account all of the relevant facts and circumstances.
Conclusion
Controlled groups that operate cross border often utilize intercompany loans and advances. Anytime intercompany loans or advances are utilized in international transactions, the rules and regulations of Internal Revenue Code Section 482 must carefully be followed. Failure to follow these rules and regulations may not only result in a change of how taxable income is allocated among group members, the failure to properly charge an arm’s-length rate of interest on intercompany loans or advances can trigger penalties that increase the reallocated income by 40 percent.
If you are concerned that about how to treat intercompany loans or advances or are concerned how intercompany loans or advances were previously treated for U.S. tax,
you should consult with a qualified international tax professional. We provide international compliance assistance and international tax planning services to domestic corporations. We also assist other tax professionals who need guidance regarding international tax compliance matters. We have significant experience in advising controlled entities how to treat cross-border intercompany loans or advances. We also have represented multinational corporations engaged in a variety of intercompany transactions before the IRS.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.