Foreign corporation's interest subject to withholding under step-transaction doctrine.

The District of Columbia Circuit held in Del Commercial Properties, Inc., 6/8/01, that a corporation was liable for withholding taxes on interest paid to a related entity; it rejected the assertion that the payments were to another corporation, making them exempt from U.S. withholding.

Del Commercial Properties' principal place of business is in Ontario, Canada. It is a fourth-tier subsidiary of an affiliated group of corporations whose common parent is DL Shekels Holdings Ltd. Delcom Financial is a second-tier subsidiary in the group. Delcom Financial is a Canadian corporation that owns 100% of the outstanding stock of Delcom Holdings, another Canadian corporation. In turn, Delcom Holdings owns 100% of Delcom Cayman (a corporation organized in the Cayman Islands), which owns 100% of the outstanding stock of Delcom Antilles (a corporation organized in the Netherlands Antilles). Delcom Antilles owns 100% of the outstanding stock of Del Investments Netherlands B.V. (Del B.V.), a corporation organized in the Netherlands.

From 1990-1993, Del Commercial Properties' principal business was leasing industrial real estate it owned in the U.S. In 1990, when it needed funding to refinance and improve some of its American properties, one of DL Shekel's first tier subsidiaries, Tridel Corporation, made the financial arrangements. On July 18, 1990, the Royal Bank of Canada loaned $18 million (in U.S. dollars) to Delcom Financial. That same day, Delcom Financial made two unsecured interest-bearing loans to Delcom Holdings. One of those loans was for $14 million. Delcom Holdings then contributed "about $14 million to Delcom Cayman for common shares of stock." On the same day, "Delcom Cayman contributed about $14 million to Delcom Antilles and received common shares of stock in that entity. Later on that same date, Delcom Antilles contributed about $14 million to Del B.V. and received common stock in that entity."

The following day, July 19, Del Commercial Properties borrowed $14 million from Del B.V. That same day, Del Commercial Properties "guaranteed repayment of a portion of amounts owed by Delcom Financial to Royal Bank" and authorized Royal Bank to place a mortgage on its real property in the U.S. It also agreed to provide Royal Bank with "annual financial statements, to insure its real property, to assign the insurance policies to Royal Bank, to defer paying dividends to shareholders, and to use the proceeds from any sales of real property to make payments on the $14 million Royal Bank loan."

On Jan. 1, 1991, Del Commercial Properties began to repay Del B.V., which transferred these payments "either to Delcom Holdings or Delcom Financial. The funds were used to pay principal and interest owed on the $14 million Royal Bank loan."

Beginning in July 1992, however, Del Commercial Properties began to make its loan payments directly to Delcom Financial, "and Delcom Financial then forwarded funds to Royal Bank in payment on the Royal Bank loan." Throughout this time, Del B.V. reported the interest paid by Del Commercial Properties as income on its Netherlands tax returns. Meanwhile, it did not file U.S. withholding returns or deposit withholding taxes on any payments related to the loan.

Exhibit 1 presents the case's transactions as a flowchart.

[ILLUSTRATION OMITTED]

IRS/Tax Court Position

On Oct. 30, 1997, the IRS assessed Del Commercial Properties for taxes and additions based on the interest payments made between 1990-1993. Del Commercial Properties brought suit in the Tax Court, contending that under a treaty between the U.S. and the Netherlands, no tax was due to the U.S. on interest payments that an American corporation makes to a Dutch corporation. The Tax Court held that the series of loans and stock contributions that began with Delcom Financial and ended with Del Commercial Properties "reflect a step transaction created simply to bypass U.S. withholding tax."

Court of Appeals

Del Commercial Properties challenged the Tax Court's decision on two grounds. First, it argued that the Tax Court erred in concluding that the corporation was responsible for withholding U.S. taxes on the interest payments it made to Del B.V. According to Del Commercial Properties, the financial arrangement was not solely to avoid U.S. taxes, but to allow the affiliated group to achieve substantial Canadian tax savings, a permissible business purpose under American tax law. Second, Del Commercial Properties contended that even if it should have withheld U.S. taxes on the interest payments, the Tax Court erred by imposing a penalty for the corporation's failure to file withholding returns or to deposit withholding tax. Specifically, Del Commercial Properties suggested that it did not deserve a penalty because its decision not to withhold represented a reasonable difference of opinion with the Service.

Under the step-transaction doctrine, a particular step in a transaction is disregarded for tax purposes if a taxpayer could have achieved its objective more directly, but instead included the step for no other purpose than to avoid U.S. taxes. In step-transaction cases, the "existence of formal business activity is a given but the inquiry turns on the existence of a nontax business motive." The absence of a nontax business purpose is fatal. Although taxpayers "are entitled to structure their transactions in such a way as to minimize tax," there must be a purpose for the "business activity ... other than tax avoidance" and that purpose cannot be a "facade."

If the sole purpose of a transaction with a foreign corporation were to dodge U.S. taxes, the treaty would not shield the taxpayer from the step-transaction doctrine. For the taxpayer to enjoy the treaty's tax benefits, the transaction must have a sufficient business or economic purpose.

From July 1992 through 1993, Del Commercial Properties made its loan payments directly to Delcom Financial. This fact is uncontested. Although Del B.V. may have recorded interest payments in its ledgers and reported them on its Dutch returns, there is no evidence that Del Commercial Properties paid anything to Del B.V. during this period.

The U.S.-Netherlands Tax Treaty does not apply to direct transactions between a U.S. corporation and a Canadian corporation. Accordingly, Del Commercial Properties unquestionably should have withheld taxes on its payments to Delcom Financial, beginning in July 1992. The Tax Court did not err in coming to this conclusion.

Several facts demonstrate the nexus between the original Royal Bank loan and the loan from Del B.V. to Del Commercial Properties:

1. The interest rates and repayment schedules of the two loans closely correspond;

2. Royal Bank obtained a guaranty of repayment from Del Commercial Properties and a security interest in the corporation's real property; and

3. Beginning in the third quarter of 1992, Del Commercial Properties made payments on the loan directly to Delcom Financial at Royal Bank's request.

Del Commercial Properties failed to carry its burden of proving that Del B.V. was in substance the real lender for tax purposes. If instead it received the loan from Royal Bank or Delcom Financial directly, the interest payments would have been taxable under the U.S.-Canada Tax Treaty. Del Commercial Properties did not show that Del B.V. served any role with a "sufficient business or economic purpose to overcome the conduit nature of the transaction."

FROM WILLIAM ZINK, CHICAGO, IL