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By Thomas J. Meehan, CPA

We often hear older folks reminiscing about the "good old days" when things were simpler, safer, and less expensive. On the other hand, many other people remember the good old days with far less fondness, since for them it was a time of hardship, war, and perhaps poverty. However, in the area of the U.S. taxation of off-shore finance subsidiaries, it is an unmistakable fact that the good old days really were just that. As demonstrated by a recent case in the Seventh Circuit Court of Appeals (Northern Indiana Public Service Co. v. Commissioner, 79 AFTR2d Par. 97-974 No.96-1659), the days prior to the effective date of the IRS's anti-conduit regulations were much more taxpayer-friendly.


During the early 1980s, U.S. interest rates were around 20%, thus encouraging many U.S. corporate borrowers to turn to foreign investors for less expensive funding. In 1981, Northern Indiana Public Service Company (NIPSCO) incorporated Northern Indiana Public Service Finance N.V. (Finance) in the Netherlands Antilles for the purpose of financing the construction of additions to NIPSCO's facilities in Indiana. Finance was formed by issuing 20 shares to NIPSCO for which it paid $20,000.

On October 15, 1981, Finance issued $70 million of Euronotes at 17.25% interest due in October 1988, which were guaranteed by NIPSCO. On the same day, NIPSCO issued a $70 million note to Finance at 18.25%, which was also due in October 1988. Finance remitted the net proceeds of the Euronote offering to NIPSCO.

On October 10, 1985, NIPSCO repaid its 18.25% note to Finance, plus accrued interest and an early payment premium. This enabled Finance to repay the Euronotes, also with accrued interest and early payment premium, on October 15, 1985. Finance was liquidated on September 22, 1986, with all of its net assets going to NIPSCO.

From 1982 through 1985, Finance received an annual profit of $700,000 ($70,000,000 x (18.25%­17.25%), which was invested with unrelated third parties to earn additional interest income.

NIPSCO did not withhold any U.S. tax on the interest payments to Finance, under authority of the U.S.­Netherlands tax treaty (as extended to the Netherlands Antilles). Each year NIPSCO filed IRS Forms 1042 and 1042S reporting its interest payments to Finance, but excluding Finance's interest payments to the Euronote holders. On August 1, 1991, the IRS issued a notice of deficiency for U.S. withholding tax on NIPSCO's interest payments, claiming that Finance was not properly capitalized, and on October 25, 1991, NIPSCO filed a petition in the U.S. Tax Court.

During litigation the IRS argued that Finance was a mere "conduit" or "agent" of NIPSCO, but on November 6, 1995, the Tax Court held for NIPSCO, reasoning that Finance was recognizable for U.S. tax purposes because it engaged in business activity at a profit.

Appeals Court's Analysis

It was undisputed that NIPSCO structured its transactions with Finance to avoid the 30% U.S. withholding tax on interest, but what was disputed was the legal significance of that tax avoidance motive. The Appeals Court said that a taxpayer has the right to conduct business so as to avoid taxes, citing Gregory v. Helvering, 293 U.S. 465 (1935); Yosha v. Commissioner, 861 F.2d 494 (7th Cir. 1988); Aiken Industries, Inc. v. Commissioner, 56 T.C. 925 (1971); and Bass v. Commissioner, 50 T.C. 595 (1968). However, the court said that the business form chosen by the taxpayer must have a substantial business purpose or must actually engage in substantive business activity.

The Tax Court had held that so long as Finance conducted even minimal business activity, it would not be disregarded for Federal tax purposes. Cases relied upon for this principle were Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943); Hospital Corp. of Am. v. Commissioner, 81 T.C. 520 (1983); Ross Glove Co. v. Commissioner, 60 T.C. 569 (1973); Bass, supra; and Nat Harrison Assoc., Inc. v. Commissioner, 42 T.C. 601 (1964).

On appeal the IRS argued that the relevant issue was not whether Finance should be disregarded, but whether the transactions between Finance and NIPSCO should be disregarded. As support, the IRS cited Knetsch v. United States, 364 U.S. 361 (1960) and a number of captive insurance company cases for the proposition that even valid corporations might engage in sham transactions which the IRS can disregard. The Appeals Court thought it inappropriate to sever a corporation from its transactions in analyzing a case, and held that the Tax Court was entitled to rely on Moline Properties, Hospital Corp., Ross Glove, Bass, and Nat Harrison. It said that a corporation and its transactions are recognizable for tax purposes, as long as the corporation engages in economically-based transactions.

Additionally, the Appeals Court interpreted the Gregory and Aiken Industries cases as meaning that transactions involving a foreign corporation should be disregarded if the corporation is transitory, engaging in no business activity for profit. Transactions should also be disregarded if the foreign corporation lacks dominion and control over the interest it collects. The court observed that Finance conducted recognizable business activity, albeit minimal, and it made a profit. Finance netted $700,000 annually from its borrowing and lending activities, and, unlike Aiken Industries, Finance borrowed its funds from unrelated third parties, i.e., the Euronote holders. Moreover, Finance put the $700,000 annual profit into unrelated investments to earn additional interest income. Therefore, the Appeals Court found that the Tax Court did not err in its earlier determination.

Comparison of NIPSCO Ruling with The Anti-Conduit Regulations (Sec. 1.881-3)

Background of the Anti-Conduit Regulations. With IRC section 770 1 (1), as added by the Revenue Reconciliation Act of 1993 (RRA '93), Congress bolstered the IRS's ability to prevent what was considered to be unwarranted avoidance of tax through multiple-party financial engineering. The lawmakers did not intend for the IRS to be bound by the standards on which prior rulings (i.e., Rev. Rul. 84152, 1984-2 C.B. 381; Rev. Rul. 84-153, 1984-2 C.B. 383; & Rev. Rul. 87-89, 1987-2 C.B. 195) were based in developing the anti-conduit regulations. The IRS was given the regulatory authority by R.R.A. '93 to recharacterize financing transactions, if it was found necessary or appropriate to do so. Congress did not want the IRS to be limited to "lack of dominion and control" as the standard for ignoring an intermediate entity and recharacterizing multiple-party financing transactions.

The anti-conduit regulations are effective for payments made by financed entities on or after September 11, 1995, except they do not apply to certain interest payments made by U.S. corporations (a) on debt issued before October 15, 1984, or (b) on U.S. affiliate obligations to controlled foreign corporations issued before June 22, 1984.

Analysis of Case Under Anti-Conduit Regulations. The regulations permit the IRS to disregard, for purposes of IRC section 881, the participation of an intermediate entity in a financing arrangement where such entity is acting as a conduit entity [Reg. section 1.881-3(a)(1)]. Per Reg. section 1.881-3(a)(2)(i)(A), a financing arrangement includes a series of transactions by which a person or persons advances money (the financing entity or, in this case, the Euronote holders) and another person receives money (the "financed entity," in this case, NIPSCO), if the advance or receipt are effected through an intermediate entity (Finance), and there are financing transactions linking the financing entity, the intermediate entity, and the financed entity. Reg. section 1.881-3 (a)(2)(ii)(A)(1) provides that a financing transaction includes debt, such as the Euronotes issued by Finance and the note issued by NIPSCO to Finance.

According to Reg. section 1.881-3(a)(4)(i), an intermediate entity is a conduit entity with respect to a financing arrangement if 1) the participation of the intermediate entity in the financing arrangement reduces the tax imposed by IRC section 881 (Finance's participation reduced the tax to zero under the U.S.-Netherlands tax treaty), 2) the participation of the intermediate entity in the financing arrangement is pursuant to a tax avoidance plan, and 3) the intermediate entity is related to either the financing entity or the financed entity. (Finance was wholly-owned by NIPSCO.) Reg. section 1.881-3(b)(1) provides that a "tax avoidance plan" is a plan one of the principal purposes of which is the avoidance of tax imposed by IRC section 881. Remember, it was undisputed that NIPSCO structured its transactions with Finance to avoid the 30% U.S. withholding tax.

Under Reg. section 1.881-3(b)(3)(i), if an intermediate entity is related to either or both a financing entity or a financed entity and the intermediate entity performs significant financing activities with respect to the financing transactions forming part of a financing arrangement to which it is a party, then it is presumed that the participation of the intermediate entity in the financing arrangement is not pursuant to a tax avoidance plan. An intermediate entity performs significant financing activities with respect to such financing transactions only if officers and employees of the intermediate entity participate actively and materially in arranging the intermediate entity's participation in such financing transactions and perform certain business activities and risk management activities with respect to such financing transactions. Also, the participation of the intermediate entity in the financing transactions must produce (or must reasonably be expected to produce) efficiency savings by reducing transaction costs and overhead and other fixed costs [Reg. section 1.881-3(b)(3)(ii)(B)(1)]. However, Finance did not even have employees to perform significant financing activities.

What Does It All Mean?

It is clear that under the anti-conduit regulations, Finance would have been deemed to be a conduit, and the 30% U.S. withholding tax could not have been avoided. Thus, in the area of foreign subsidiary financing arrangements, the Good Old Days prior to the enactment of Reg. section 1.881-3 really were the Good Old Days from a taxpayer's point of view. *

Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Richard M. Barth, CPA

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