Comments on Rev. Rul. 89-73: use of short-term loans under Section 956, December 1, 1989.

Comments on Rev. Rul. 89-73: Use of Short-Term Loans under Section 956

December 1, 1989

This letter discusses Rev. Rul. 89-73, 1989-21 I.R.B. 19 (May 22, 1989), relating to the use of short-term loans from controlled foreign corporations (CFCs), which was issued by the Internal Revenue Service on May 21, 1989. Not only is this ruling contrary to the language of section 956 of the Internal Revenue Code, but it undermines the prospective effect of the temporary regulations issued last year under section 956. Tax Executives Institute recommends that the ruling be withdrawn.

Background

On June 13, 1988, the IRS issued proposed and temporary regulations under section 956, relating to certain investments in U.S. property. The temporary regulations amended Treas. Reg. $S 1.956-(d)(2) by eliminating the "one-year rule" which provided that, for purposes of determinging the amount of a CFC's earnings invested in "United States property," the definition of such property does not include a debt obligation of a related domestic corporation that either (a) is collected within one year from the time it is incurred, or (b) matures within one year from the time it is incurred (but is not collected within such period solely by reason of the inability or unwillingness of the debtor to make payment within such period). The temporary regulations are effective with respect to investments made on or after June 14, 1988 -- the day after the regulations were issued.

The Institute filed comments on the temporary regulations on September 7, 1988, objecting to the elimination of the one-year rule and recommending that, at a minimum, any change be effective with the first taxable year beginning after the date the regulations were issued. On September 16, 1988, the IRS announced in Notice 88-108 that the final regulations would 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, as long as the obligation is collected within 30 days from the time it is incurred.

Rev. Rul. 89-73 Expands the

Scope of the Statute

Under section 956 of the Code, if a CFC has an investment in U.S. property "at the close of the taxable year," its U.S. shareholder will be 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) Rev. Rul. 89-73 represents the IRS's most recent attempt to address a perceived circumvention of section 956 through the use of short-term loans from CFCs.

Rev. Rul. 89-73 provides two examples addressing the circumstances under which a loan from a CFC will be deemed to be outstanding on the last day of a taxable year (even if the loan has been repaid). In Example (1), a CFC purchases its U.S. parent's debt obligation which is repaid 9.5 months later; 2 months later, the CFC purchases another debt obligation. The ruling concludes that the 2-month period between the sale and repurchase of the debt obligations is too brief and deems the CFC to have an investment in U.S. property outstanding at the end of the taxable year.

In Example (2), the CFC purchases its U.S. parent's debt obligation which is repaid 5 months later; 6.5 months thereafter, the CFC purchases another debt obligation which it holds for 11 months and then sells. Comparing the time between the CFC's investments in U.S. property with the aggregate period the debt obligations were outstanding, the ruling concludes that the CFC did not have an investment in U.S. property at the close of the taxable year.

The general conclusion of Rev. Rul. 89-73 is that a "clean-up" period just prior to year-end, during which a loan from a CFC is repaid by the U.S. shareholder, will be disregarded if the clean-up period is "brief" compared to the overall period the debt obligations were outstanding. The ruling invokes the concept of "effective repatriation" of earnings treated as a taxable amount for purposes of section 956.

Srvyion 956 was enacted as part of the Revenue Act of 1962 to--

prevent the repatriation of income to the United States in a manner which does not subject it to U.S. taxation.... This objective also accounts for some of the features of this provision, which deny tax deferral where funds are brought back and invested in the United States in a manner which does not otherwise subject them to U.S. taxation.

H.R. Rep. No. 1447, 87th Cong., 2d Sess. 58 (1962). Citing this language, the IRS concludes in Rev. Rul. 8973 that the legislative drafters would have wanted to tax certain short-term transactions. It thus deems two separate loans to be one. Cast aside in the process is the language of the statute which expressly requires the debt to be outstanding "at the close of the taxable year.c The IRS thereby effectively disregards other statements in the legislative history which evince Congress's intent to provide an exception from taxation for normal commercial practices.

Under section 956, the inquiry properly focuses on whether a particular loan is outstanding at year-end and thus must be included in the CFC's year-end investment in U.S. property. This analysis includes determining whether (i) the loan was in fact repaid before year-end and (ii) such repayment had economic substance. See, e.g., Greenfield v. Commissioner, 60 T.C. 425 (1973), aff'd, 506 F.2d 972 (5th Cir. 1975); Letter Ruling No. 8441041; Letter Ruling No. 8534070; Letter Ruling No. 8538034. (2) Thus, for years taxpayers and the IRS alike reasonably concluded that loans actually repaid at year-end under commercial law principles were excluded from the amount of a taxpayer's investment in U.S. property under section 956.

This interpretation is consistent with the legisltive history of section 956. In enacting the statute, Congress concluded that a CFC's investment in U.S. property should be taxed to U.S. shareholders when such investments were "substantially equivalent" to a dividend. S. Rep. No. 1881, 87th Cong., 2d Sess. 87-88 (1962); H.R. Rep. No. 1447 at 63-66. Congress excepted certain practices, however, to allow CFCs to enter into "normal commercial transactions" with U.S. persons in which there was no intent to permit the funds to cremain in the United States indefinitely ...." S. Rep. No. 1881 at 87-88; H.R. Rep. No. 1447 at 63-66.

The use of short-term loans represents such a "normal commercial transaction." These loans -- undertaken as a legitimate debt management tool -- are a far cry from the indefinite, long-term repatriation of earnings envisioned by Congress in enacting section 956 and should not be considered the equivalent of a dividend. TEI recommends that the ruling be withdrawn. (3)

The Revenue Ruling

Lacks Clarity

In addition to being inconsistent with the language of the statute, Rev. Rul. 89-73 is unacceptably vague. We recommend that the ruling be withdrawn for its lack of clarity. Specifically, the ruling provides --

if a controlled foreign corporation lends earnings to its U.S. shareholder interrupted only by brief periods of repayment which include the last day of the controlled foreign corporation's taxable year, there exists, in substance, a repatriation of earnings to the U.S. shareholder, within the objectives of section 956. (Emphasis added.)

Although the ruling concludes that a 2-month interval between loans is "brief" and a 6.5-month period is not, it is decidedly vague on how that determination is made. For example, is "brief" determined on the basis of the absolute number of months between the loans or the number of months relative to the terms of the obligations sought to be aggregated? Thus, it is unclear whether the 6.5-month period between loans is sufficient to avoid aggregation because (i) this period is not "brief" in an absolute sense, (ii) this period is in excess of 40 percent (6.5 divided by 16) of the time during which the two obligations were outstanding or (iii) this period is in excess of 28 percent (6.5 divided by 22.5) of the total time covered by the obligations and the intervening period. (4)

Such a vague standard can only serve to create complexity, confusion, and, eventually, litigation. The IRS's inability to fashion a bright-line test in this area only underscores why the revenue ruling should be withdrawn.

Retroactivity 

Particularly disturbing to TEI is the retroactive nature of Rev. Rul. 89-73. Because the ruling focuses on transactions occurring in 1987 -- the year before the issuance of the 1988 temporary regulations -- the ruling apparently applies to all open years. (There is no statement to the contrary.) It also appears to represent a back-door retroactive repeal of the one-year rule, even for years prior to the effective date of the 1988 temporary regulations. (5)

TEI strongly objects to the retroactive application of Rev. Rul. 89-73. Taxpayers should not be penalized for their good faith reliance on the statute. The radical nature of the change underscores why its retroactive application is inappropriate. In the interest of equity and fairness, the ruling, if not withdrawn, should at least be applied on a prospective-only basis.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on Rev. Rul 89-73. If you have any questions, please do not hesitate to call Bernard J. Jerlstrom, Chair of TEI's International Tax Committee, at [phone], extension 2163 or the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at [phone].

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

(2) Although the IRS has withdrawn these rulings, the revocation was based on the impropriety of ruling on factual issues, rather than any disagreement with their legal analysis. See, e.g., Letter Ruling No. 8512018 (revoking Letter Ruling No. 8441041).

(3) Obviously, this would not preclude the IRS from arguing that a particular set of transactions constituted a sham. We submit, however, that the IRS should make this argument straightforwardly in those cases where it is warranted, rather than endeavoring to construct a broader rule than section 956 on its face permits.

(4) Similarly, it is unclear whether the 2-month period is found wanting because (i) this period is "brief" in an absolute sense, (ii) this period is only 10 percent (2 divided by 20) of the time for which the two obligations were outstanding, or (iii) this period is less than 10 percent (2 divided by 22) of the total time covered by the obligations and the intervening period.

(5) The policy considerations underlying Rev. Rul. 89-73 could be employed to aggregate obligations for purposes of the one-year rule. The same rationale that requires the taxpayer to disregard a 2-month period between loans in determining whether an obligation is outstanding at year-end may also be applied in determining whether an obligation is outstanding for more than one year for purposes of former Treas. Reg. $S 1.956-2(d).