Applicability of Notice 88-108 after OBRA 1993.

The Omnibus Budget Reconciliation Act of 1993 (OBRA) made several substantive changes to section 956 of the Internal Revenue Code, relating to the U.S. investment of the earnings of a controlled foreign corporation. This letter addresses the need to clarify that the 1993 amendments did not affect the principles enunciated in Notice 88-108, 1988-2 C.B. 445, which delineates an exception from the definition of U.S. property for certain short-term loan obligations. TEI urges the IRS and Treasury to affirm that Notice 88-108 remains applicable and to extend that notice's exception to loans made over the end of a fiscal quarter. We believe that such a result is explicitly supported by the legislative history of the OBRA amendments.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 5,000 members represent more than 2,700 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the amendments enacted under OBRA to section 956 of the Code, relating to the taxation of the investment of a controlled foreign corporations's earnings in U.S. property.

Historic Treatment of Loan Obligations

Prior to the enactment of OBRA, section 956(a) provided that if a controlled foreign corporation (CFC) had an investment in U.S. property "at the close of the taxable year," its U.S. shareholder was deemed to have received a dividend from the CFC equal to the shareholder's pro-rata share of the CFC's increase in earnings invested in such property for the year.(1) As amended by OBRA, section 956 now provides that the investment in U.S. property of a CFC equals the average of the amounts of U.S. property held by the CFC at the end of each quarter of its taxable year. OBRA did not, however, change the definition of "United States property"; that term continues to be defined as any property acquired after December 31, 1962, which is (i) tangible property located in the United States, (ii) stock of a domestic corporation, (iii) an obligation of a United States person, or (iv) certain intangible rights such as copyrights and patents. Thus, the term "United States property" includes an obligation arising in respect of a loan by a CFC to its U.S. parent corporation. It is this last situation that Notice 88-108 addresses.

The issuance of Notice 88-108 was the third step in IRS and Treasury's guidance on the treatment of loans made by CFCs to their U.S. parents. As originally promulgated in 1964, Treas. Reg. [sections] 1.956-2(d)(2)(ii) provided that the term "obligation of a United States person" did not include an indebtedness that a CFC collected within one year from the time it was incurred. T.D. 6704 (Feb. 16, 1964). Twenty-four years later, because of concern that the one-year rule could be abused if successive short-term, back-to-back loans were made, the IRS withdrew Treas. Reg. [sections] 1.956-2(d)(2), effective for loans made on or after June 14, 1988. T.D. 8209 (June 13, 1988), 1988-2 C.B. 174 (substituting Temp. Reg. [sections] 1.956-2T(d)(2)). See also Rev. Rul. 89-73, 1989-1 C.B. 258 (addressing the circumstances under which a loan from a CFC will be deemed outstanding on the last day of the taxable year, even if the loan has been repaid). The repeal of the one-year rule means that a CFC holding a U.S. parent's obligation on the last day of the year will be treated as holding U.S. property, regardless of the surrounding circumstances.

Soon after the issuance of the 1988 temporary regulations, the IRS published Notice 88-108, which provides an exception to section 956 treatment for an obligation that would otherwise be U.S. property if held at the end of the CFC's taxable year. This exception for obligations that are collected within 30 days from the time incurred, however, is only available if the CFC does not hold for more than 60 days obligations that would qualify as U.S. property if held at the end of the CFC's taxable year. The notice was issued to accommodate the situation in which a U.S. parent corporation borrows from its foreign affiliates at the end of each quarter to pay down external debt. This practice permits the U.S. parent to reflect its debt/equity ratio in its financial statement balance sheets more accurately than if it had large amounts of borrowed funds matched by excess funds held by affiliates.

Notice 88-108 sanctions the use of short-term loans to consolidate debt at the end of each quarter, but the 60-day limitation imposed on all obligations prevents taxpayers from effectively repatriating foreign earnings. The notice thus strikes a balance between the need of the taxpayer for flexibility in its financial presentation and the interest of the government in preventing abuses.

Vitality of Notice 88-108 After Enactment of OBRA

OBRA amended section 956(a) of the Code to read, as follows:(2)

(a) General Rule.--In the case of any controlled foreign corporation, the amount determined under this section with respect to any United States shareholder for any taxable year is the lesser of --

(1) the excess (if any) of --

(A) such shareholder's pro rata share of the average of the amounts of United States property held (directly or indirectly) by the controlled foreign corporation as of the close of each quarter of such taxable year, over

(B) the amount of earnings and profits described in section 959(c)(1)(A) with respect to such shareholder, or

(2) such shareholder's pro rata share of the applicable earnings of such controlled foreign corporation.

The amount taken into account under paragraph (1) with respect to any property shall be its adjusted basis as determined for purposes of computing earnings and profits, reduced by any liability to which the property is subject. (Emphasis added.)

TEI urges the IRS and Treasury to confirm that the exception set forth is Notice 88-108 remains valid under amended section 956. This result is supported by the legislative history of OBRA. Specifically, the report of the Senate Finance Committee states:

The controlled foreign corporation's U.S. property is measured as the average of the adjusted basis (as determined for purposes of calculating earnings and profits) of such property held (directly or indirectly) by the controlled foreign corporation as of the close of each quarter of its taxable year, less any liability to which the property is subject (as under present law). The committee intends that the measurement of assets as of the close of each quarter of the taxable year shall disregard short-term loans or other temporary arrangements with regard to the corporation's assets, where one of the principal purposes of such an arrangement was to avoid taking assets into account for purposes of this provision. Examples of what the IRS views as such arrangements are discussed in Rev. Rul. 89-73 (1989-1 C.B. 258), interpreting present law.

The bill is not intended to change the measurement of U.S. property that may apply, for example, in the case of certain short-term obligations, as provided in IRS Notice 88-108 (1988-2 C.B. 445), interpreting present law. Obligations subject to the special treatment of IRS Notice 88-108 are those that are collected within 30 days of their issuance, but the exclusion of such short-term obligations does not apply if the controlled foreign corporation holds obligations that would constitute U.S. property if held by the controlled foreign corporation on the date of measurement (determined without regard to this 30-day rule) for agregate periods totalling at least 60 days in the taxable year, without regard to whether any such obligations are held on the date of measurement.

Report of Senate Committee on Finance, 103d Cong., 1st Sess., on Revenue Provisions of the Omnibus Budget Reconciliation Act of 1993, at 155, reprinted in BNA Special Supplement, No. 118 at S-64 to S-65 (June 22, 1993) (emphasis added).(3) The legislative history of the section 956 amendments thus explicitly confirms the continued viability of Notice 88-108.

Expansion of Exception To Loans Made Over a Fiscal Quarter

New section 956(a) does not itself specifically include a provision applying Notice 88-108 to the amount of investment in U.S. property held at the end of each quarter of the CFC's taxable year. Nor does new subsection (b)--which contains special rules relating to "applicable earnings"; U.S. property that was acquired before the foreign corporation becomes a CFC; and foreign corporations that cease to be CFCs--address the subject. We suggest, however, that the legislative history clearly manifests congressional intent to apply the same year-end exception of the 1988 notice to short-term loans made on a quarterly basis. In Notice 88-108, the IRS recognized that certain short-term loans do not result in an impermissible repatriation of earnings--the concern addressed by section 956. See H.R. Rep. No. 1447, 87th Cong., 2d Sess. 58 (1962) (section 956 was enacted to "prevent the repatriation of income to the United States in a manner which does no subject it to U.S. taxation."). The notice recognized congressional intent that exceptions to section 956's broad definition of U.S. property were appropriate to allow CFCs to enter into "normal commercial transactions" with U.S. persons in which there was no intent to permit the funds to "remain in the United States indefinitely...." S. Rep. No. 87-1881, 87th Cong., 2d Sess. 81 (1962). We urge the IRS and Treasury to issue an announcement extending its reasoning in Notice 88-108 to loans made over the end of a fiscal quarter.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the continued application of Notice 88-108 after the enactment of the Omnibus Budget Reconciliation Act of 1993. If you have any questions, please do not hesitate to call Philip J. Bergquist, chair of TEI's International Tax Committee, at [phone], or Mary L. Fahey of the Institute's professional staff at [phone].

(1)This assumes that there had been no cash dividends to the U.S. shareholder in respect of the same increase in the CFC's earnings.

(2)The 1993 statute struck out old subsection (a) of section 956, inserted new subsections (a) and (b), and redesignated old subsections (b) and (c) as subsections (c) and (d).

(3)The Conference Committee Report on OBRA makes no mention of Notice 88-108. (The Conference Report discusses only a new rule that covers the acquisition of U.S. property by a foreign corporation before it becomes a CFC and directs the Treasury Department to conduct a study on investments in U.S. property; the study is aimed at determining whether a CFC should not be treated as investing in U.S. property if it invests in an obligation of an unrelated U.S. person other than a corporation.) H.R. Rep. No. 103-213, 103d Cong., 1st Sess. 642-43 (1993). There is nothing in that report, however, that casts doubt on the continued viability of the notice.