On October 11, 1994, the Treasury issued proposed regulations pursuant to IRC Sec. 7701(1). To the relief of many, the proposed regulations take a reasonable approach to when financing arrangements might be recharacterized. The preamble to the proposed regulations indicates, however, that the IRS and Treasury will monitor developments in certain areas (such as potential use of debt guarantees and equity investments to avoid U.S. withholding tax) and that the proposed regulations may be expanded to cover any abuses detected in these areas.

Under the proposed regulations, recharacterization would apply only for U.S. withholding tax purposes, and the new rules would apply only to payments made more than 30 days after publication in final form. However, there would be no "grandfathering" of existing financing arrangements.

Scope of the New Rules

The proposed regulations would grant the IRS discretion to disregard, for purposes of IRC Secs. 871, 881, 1441, and 1442, the participation of one or more "intermediate entities" in certain "financing arrangements" involving multiple parties. An understanding of certain new terms (including the following) is necessary to determine when a financing arrangement could be recharacterized under the proposed regulations.

* Financing Arrangement - defined as two or more "financing transactions" pursuant to which one person (the "financing entity") advances money or other property to another person (the "intermediate entity"), and the intermediate entity advances money or other property to a third person (the "financed entity"). Also included in the definition are arrangements where two or more financing transactions achieve substantially the same result through any other series of steps. However, where more than one intermediate entity is involved, there must generally be a chain of financing transactions linking each intermediate entity in order for the arrangement to meet the financing arrangement definition.

* Financing Transaction - defined as any of several specified transactions, which include i) advances (of money or other property) in exchange for debt, ii) certain advances in exchange for stock (or a similar interest in a partnership or trust) where the holder possesses or is likely to obtain a right to require that the issuer redeem or otherwise make a payment with respect to the stock (or other interest) or it is likely that the issuer will exercise a right to redeem the stock (or other interest), iii) leases, and iv) licenses.

* Conduit Entity - an intermediate entity whose participation is disregarded in whole or in part under the regulations.

Standard for Conduit Treatment

Under the proposed regulations, a district director would be authorized to treat an intermediate entity as a conduit entity (and disregard its participation for withholding tax purposes) where three conditions are met. First, the intermediate entity's participation in the financing arrangement must reduce U.S. withholding tax liability. Second, the intermediate entity's participation must be pursuant to a tax avoidance plan. Third, either the intermediate entity must be related to the financing entity or the financed entity, or the intermediate entity would not have participated in the arrangement on substantially the same terms but for the fact that the financing entity entered into the transaction with the intermediate entity.

The first condition would depend upon a comparison of the U.S. withholding tax liability under the arrangement (assuming it was respected) with the liability that would have applied if the intermediate entity was disregarded. This determination should be easy to make, taking into account relevant tax treaties.

The second condition would be present where one of the principal purposes of the intermediate entity's participation (as distinguished from purposes pertaining to the existence of the financing arrangement in general) is to avoid taxation. This is a subjective determination, based upon all relevant facts and circumstances. Potentially relevant factors include i) whether the intermediate entity's participation (if respected) significantly reduces withholding tax liability (although the presence of this factor, by itself, would not be dispositive, inasmuch as it is nothing more than a reiteration of the first condition discussed above); ii) whether the intermediate entity would have been able to advance the money or other property to the financed entity without the advance to it by the financing entity; and iii) the length of time separating the advance by the financing entity to the intermediate entity and the advance by the intermediate entity to the financed entity. Moreover, where the intermediate entity is related to the financed entity, the absence of a tax avoidance plan would generally be indicated with respect to a transaction that finances a trade or business of the financed entity that is related to a business actively conducted by the intermediate entity.

With respect to the third condition, it would be presumed that the intermediate entity would not have participated in the financing arrangement on substantially the same terms where the financing entity guarantees the financed entity's liability to the intermediate entity. (Such a situation would be presented, for example, where a foreign parent corporation maintains amounts on deposit with an unrelated bank that lends money to a U.S. subsidiary of the parent and the parent guarantees the subsidiary's indebtedness to the bank.) For this purpose, a guarantee is defined by reference to IRC. Sec. 163(j) concepts, which are intended to cover a broad variety of direct and indirect third party credit enhancement mechanisms, many of which do not rise to the level of a legally enforceable guarantee.

Reporting Rules

A financed entity that is a "reporting corporation" for purposes of IRC Sec. 6038A(a) or is required to file information reports under IRC Sec. 6038(b) could be subjected to .additional reporting requirements under the proposed regulations. Such additional reporting would be required with respect to any financing transaction to which such a financed entity corporation is a party, provided that the corporation knows or has reason to know that the transaction is part of a financing arrangement that meets the first and third conditions for recharacterization described above. Thus, it is not necessary that the corporation know or have reason to know of the existence of a tax avoidance plan in order for it to be subjected to additional reporting.

For purposes of the reporting requirement, if a financed entity knows (or has reason to know) that a financing entity has guaranteed the financed entity's liability under a financing arrangement, the financed entity will be treated as knowing (or having reason to know) that the intermediate entity would not have participated in the arrangement on substantially the same terms but for its transaction with the financing entity. As indicated by the above discussion, this is relevant to the treatment of an intermediate entity that is not related to either the financing entity or the financed entity.

Financed entities subject to the reporting requirement would be required to provide detailed information regarding the financing arrangement on a statement attached to IRS Form 5471 or 5472 (whichever applies). However, the proposed regulations would not generally require duplication of information otherwise required to be reported on one of these forms under existing IRC Sec. 6038 or IRC Sec. 6038A regulations.