Foreign holding company income changes. (International Taxation)by Tannenbaum, Elliot
TRA 86 substantially expanded the Subpart F definition of Foreign Personal Holding Company (FPHC) income contained in Sec. 954(c). In essence, FPHC income represents a category of foreign base company income of a Controlled Foreign Corporation (CFC) which, when earned, triggers a constructive dividend under Subpart F to the U.S. shareholder. TRA 86 also made the definition of passive income, as used for foreign tax credit limitations, essentially along the same lines as the Subpart F definition of FPHC income. Moreover, in determining whether a foreign corporation is a Passive Foreign Investment Company, Sec. 1296(b)(1) refers to FPHC income. Thus, the FPHC income definition contained in Sec. 954(c) is important beyond the Subpart F context.
The current temporary regulations governing FPHC income not only deal with areas introduced by TRA 86, but also make changes in areas arguably not part of the new legislation. It appears the Treasury took the opportunity presented by TRA 86 to address certain concerns it had with existing regulations.
Synopsis of Statutory Changes
TRA 86 decoupled the definition of FPHC income for Subpart F purposes from the definition of FPHC income as defined in Sec. 553 of the Code. The definition is now "self-contained" in Sec. 954. TRA 86 also added other types of income to the definition of FPHC income, the principal ones being described below.
Gains on Sales of Property Which Do Not Generate Active Income. While stock and securities gains were previously FPHC income, TRA 86 expanded this rule by including gains from other property held for investment, e.g., diamonds or property which gave rise to passive income (such as, patents or licensees not used in a trade or business). Dealers in such property will not generate FPHC income on the sale thereof.
Commodities Transactions. Before TRA 86, private and other unregulated futures transactions, as well as certain other commodities transactions, were literally outside Subpart F. Now, gains from all commodities transactions (including futures, forward and similar transactions) are now FPHC income, unless "substantially all of the controlled foreign corporation's business is as an active producer, processor, merchant or handler of commodities." Also exempt are certain bona fide hedging transactions related to such aforementioned active businesses.
Foreign Currency Gains. Foreign currency gains attributable to Sec. 988 transactions are now FPHC income unless the transaction directly relates to the CFChs business needs. Highly simplified, a Sec. 988 transaction means certain specified transactions where the taxpayer is entitled to receive (or must pay) an amount: 1) denominated in terms of a nonfunctional currency; or 2) determined by reference to the value of one or more nonfunctional currencies.
Income equivalent to Interest. Any income equivalent to interest, including income from commitments fees (or similar amounts) for loans made is now FPHC income.
Related Party Exception. The exception for certain income received from related persons does not apply if the interest, rent or royalty payment reduces the payor's Subpart F income.
Regulatory Changes Based on
Due to the length and complexity of the new Temporary regulations (Sec.1.954-2T), this article will merely highlight certain selected aspects.
Paragraph (a)(2). Para. (a)(2) of the regulation describes the ordering rules for characterizing income which falls into more than one category of FPHC income.
The rules are summarized as follows:
Order of Priority
Income Equivalent to Interest 1
Foreign Currency Gain 2
Gain from Commodities Transaction 3
Certain Property Transactions 4
Where there is a change in use of the property in question, the general rule is that the use during the period shortly before disposition is the most significant. However, if the most recent use would cause the gain to be non-FPHC income and such use did not last for most of the CFC's holding period, such use is disregarded.
Paragraph (e). Para. (e) expands on the new statutory provision which treats as FPHC income gain from property which does not generate active income. Notably, any excess of losses over gains from such property cannot reduce other categories of FPHC income. This restrictive principle appears as well in the commodities and foreign exchange sections of the regulations. These "no loss" rules do not appear to be supported by the statute.
Paragraph (f). Para. (f) of the temporary regulations deals with commodity transactions. One of the exclusions, a qualified active sale, occurs where substantially all (85%) of taxable income is from an "active" producer, processor, merchant, or handler of commodities of "like kind." The other exclusion, a Qualified Hedging Transaction, is one reasonably necessary to the CFC's business as producer, processor, merchant or handler of a commodity. The hedge must be bona fide and must be entered into in order to reduce the risk of price change (not currency fluctuation) of the commodity. Generally, the CFC must "clearly identify" the hedge on its records within five days after the hedge was entered into an when there is a reasonable risk of loss. The five-day time frame appears to be an unreasonable pre- condition.
Paragraph (g). Para. (g) deals with foreign currency gain and, as in the case of commodities, several exclusions are discussed. The temporary regulations effect the business needs exception through adopting two categories of exclusions: qualified business transactions and qualified hedging transactions. To qualify, such transactions generally must be clearly identified on the CFC's records within five days after the transaction takes place.
An important election is provided to treat all gains and losses attributable to Sec. 988 transactions and Sec. 1256 foreign currency contracts as FPHC income--the so called "net inclusion election." The net includsion election permits netting of foreign currency losses against FPHC income. Albsent such election, the temporary regulations preclude the allocation of such losses to reduce other FPHC income. As a result of the net inclusion election, the business nees exception would not apply and the tracing rule is avoided. The net inclusion election may be revoked only with the Commissioner's consent and applies to all related persons.
Paragraph (h). Para. (h) treats as interest the income from transactions which predominantly reflect income from the time value of money or the use of forbearance of money, including commitment fees, certain factoring income and certain property transactions.
Regulatory Changes Not Directly
Related to TRA 86
As mentioned previously, the Treasury apparently used the temporary regulations as an opportunity to address certain concerns in the existing regulations.
One of the areas modified by the temporary regulations involves the exclusion from FPHC income of interest and dividends from a related person under IRS Sec. 954(d)(3). This exception applies if the payor and payee are incorporated in the same country and if "a substantial part of the payor's assets are used in a trade or business in the payor's country of incorporation." Two major changes were made in the regulatory interpretation of this "same country" dividend/interest exclusion. First, substantial assets are now defined as more than 50% of average total assets including non-business assets. (The old test was 80% or more of assets used in the payor's trade or business). Second, the old regulation allowed the substantial assets test to be met based on facts and circumstances where the 80% was not met. This subjective test has been eliminated.
In another regulatory change not directly grounded in TRA 86, Para. (b)(4) provides a new anti-abuse rule to guard against use of more than one CFC to utitlize the 5%/$1,000,000 de minimus rule or to avoid the 70% full inclusion rule of Sec. 954(b)(3). The anti-abuse rule treats all of the CFCs affected as a single entity if "one principal purpose" of setting up multiple CFCs wast o utilize the de minimus rule or to avoid the full inclusion rule.
Paragraph (b)(6) provides that tax-exempt interest is included in the calculation of FPHC income. However, the net foreign base company income of a controlled foreign corporation that is attributable to such tax-exempt interest shall be treated as tax-exempt interest in the hands of the U.S. shareholders of the foreign corporation. Thus, the tax- exempt interest is potentially subject to the alternative minimum tax. Rev. Rul. 72-527 (1972), which held that tax-exempt interest was not foreign base company income and not FPHC income, appears no longer viable.
Changes Made by RAMRA
Some statutory changes to Sec. 954(c) were also made in the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). These changes were formulated shortly after TRA 86, but it took over a year for the legislative process to effect the changes. The changes include treatment of gains of interests in trusts, partnerships, and REMICs as FPHC income. TAMRA also provides that under the new hedging exception, dealers who recognize gains and losses from bona fide hedging transactions which relate to dealer property do not include such transactions in calculating FPHC income. TAMRA also clarified that losses from inventory or other dealer property do not reduce FPHC income.
TRA 86 expanded the FPHC income definition under Sec. 954(c) for Subpart F and other purposes of the Code. These changes coupled with the provisions of the temporary regulations will make FPHC income a more formidable issue for practitioners to deal with.
Tighter Restrictions Under Sec. 956
on Loans from Controlled Foreign
Several recent pronouncements from the IRS have significantly reduced the ability of U.S. corporations to borrow effectively from their Controled Foreign Corporations ("CFCs") without running afoul of the Sec. 956 provisions. Under Sec. 956, investments in U.S. property, including loans to related parties may result in deemed dividends to U.S. shareholders.
Before June 14, 1988, U.S. corporations were able to utilize the guidilines provided under Reg. Sec. 1.956-2(d)(2) in order to utilize excess cash of their CFCs by obtaining loans from them. The issuance of Temp. Reg. Sec. 1.956-2T(d)(2), (1988), and Rev. Rul. 89-73, (1989), have significantly restricted the ability of CFCs to loan funds to related U.S. corporations without being subject to Sec. 956.
The prior regulations indicated that a loan from a CFC to a related domestic corporation was not an investment in U.S. property if the loan was collected within one year from the time it was incurred, or alternatively, if the loan matured within one year from the time it was incurred, but was not collected within that period solely by the inability or uniwillingness of the U.S. obligor to make payment within such period.
Regulations Made More Stringent
The IRS believed that these regulations were too liberal and enabled CFCs to make successive loans to their U.S. affiliates with maturities of less than one year as a way of avoiding the provisions of Sec. 956. Under the temporary regulations, an obligation of a U.S. person which arises in connection with services provided by a CFC to the U.S. person, does not exceed an amount which would be ordinary and necessary to carry on the trade or business of the CFC and the U.S. person will be excluded from the definition of an investment in U.S. property. Furthermore, only obligations which are paid within 60 days will be considered ordinary and necessary. Therefore, as drafted under the temporary regulations, except this one exception, any obligation of a related U.S. person which is outstanding at the end of the CFCs tax year will be considered to be an investment in U.S. property. Under the prior regulations, many U.S. corporations borrowed from their CFCs on a short term basis to pay off third party borrowings, thereby enhancing their year end consolidated balance sheets. However, as originally promulgated, the temporary regulations would have removed this year end planning device.
Response to Outcry
In response to the outcry that followed the issuance of these temporary regulations, the IRS issued Notice 88-108, (1988). The Notice provides that final regulations under Sec. 956 will exclude from the definition of the term "obligation" an obligation that would constitute an investment in U.S. property if held at the end of the CFC's taxable year, so long as the obligation is collected within 30 days from the time it is incurred. This exclusion will not apply if the CFC holds tainted obligations for 60 or more days during its taxable year. Based on this exception U.S. multinational corporations will still be able to "clean up" their year end and quarterly consolidated balance sheets, subject to the limitation of this Notice and as discussed below.
Issue Still Not Clear
To deal with situations where U.S. taxpayers pay down loans from CFCs and shortly thereafter reestablish the loans, the IRS issued Rev. Rul. 89-73, (1989). In Example 1 of Rev. Rul. 89-73, a loan from a foreign subsidiary to a U.S. parent was paid on November 15, 1987. Two months later, the loan was reestablished. In example 2, a loan from a foreign subsidiary to its U.S. parent was paid off June 30, 1987, and reestablished six and a half months later. In connection with example 1, the IRS concluded that the repayment on November 15, 1987, would be disregarded, as the loan was reestablished two months later. Therefore, the CFC, a calendar year corporation, had an investment in U.S. property on December 31, 1987. Conversely, in example 2 the IRS held that the reestablishment of the loan six and one half months later would be a sufficient period to treat the initial loan as having been paid. The issue that taxpayers will continue to face is whether a loan which is reestablished within the two month to six and one half month time frame will be considered to be outstanding during that period, resulting in an investment in U.S. property.
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