Implications of charging interest on intercompany advances received from foreign parent companies.

Companies must now take into account additional factors when deciding if operating funds required by a U.S. corporation will be funded with related-party debt from a foreign parent company, or with third-party debt. Historically, in these situations, foreign parent companies used related-party debt to fund their U.S. subsidiaries. However, with the release of the proposed regulations under Secs. 267(a) and 163(j), as well as increased IRS examination of transactions between related foreign and U.S. companies, it is important to reexamine the possible U.S. tax benefits derived from using related-party financing in these situations.

Charging of interest

on related-party advances

In a number of cases, a foreign parent corporation will charge interest on advances to its U.S. subsidiary. Interest might be charged because the foreign corporation wants to recognize additional income on its own financial statements, or perhaps because the U.S. subsidiary is profitable and can afford to pay the interest. In such instances, the U.S. subsidiary will be the agent for U.S. withholding tax purposes under Sec. 1442. As such, 30% (or a reduced withholding rate if under an applicable U.S. income tax treaty) of the interest paid must be withheld an remitted to the IRS.

If interest is being charged, the new proposed Sec. 267(a) regulations should be analyzed to determine the deductibility of the interest expense. Prop. Regs. Sec. 1.267(a)-3, which applies to fixed or determinable annual or periodic (FDAP) gains, profits and income payments under Secs. 871(a) and 881(a), can disallow the deduction for expenses accrued to related foreign parties.

Prop. Regs. Sec. 1.267(a)-3(b) will generally defer the deduction for interest expense accrued to related foreign persons (as defined under Sec. 267(b) or 707(b)) until actual payment is made. The interest is treated as paid if it would be considered paid under the withholding provisions of Sec. 1441 or 1442. This deferral rule will apply even if the withholding tax on the interest is reduced or eliminated under an income tax treaty.

When the accrued interest is actually paid to the foreign corporation, the U.S. subsidiary, acting as withholding agent, would withhold 30% (or the appropriate treaty-reduced withholding amount) on the interest payment. (It should be noted that a treaty-based return may need to be filed in certain situations under Sec. 6114.)

However, even when the interest is actually paid (and thus the requirements for deduction under Prop. Regs. Sex. 1.267(a)-3 are satisfied), the interest deduction may nevertheless be deferred. If the interest paid to the foreign corporation is subject to a reduced (or zero) withholding tax rate under a U.S. tax treaty, the U.S. subsidiary's interest deduction may be deferred, in whole or in part, under the so-called "earnings-stripping" provisions of Sec. 163(j). The payment of interest on related-party obligations issued after July 10, 1989 would be disallowed in the current year if the U.S. subsidiary has "excess interest expense" and a debt to equity ratio tax exceeds 1.5 to 1 at the end of the tax year. The amount of disallowed interest cannot exceed the amount of excess interest expense. Any disallowed interest is carried over indefinitely to subsequent years, and can be deducted in a year the corporation has no excess interest expense limitation.

Excess interest expense is defined as the excess of the U.S. subsidiary's net interest expense over 50% of taxable income before deduction for net interest, expense, depreciation, depletion, amortization, and net operating loss carryover, as well as certain other items listed in the proposed regulations. Highly leveraged companies, whether profitable or not, will be affected the most by this provision. Even though the interest expense is only deferred, if the company continues to have an excess interest expense limitation in future years, it will essentially lose the tax benefit for the related-party interest.

It is important to note that the earnings-stripping provisions may apply even if third-party debt is guaranteed by the foreign parent or if a "back-to-back" loan is used. These issues are scheduled to be addressed in the second set of proposed regulations, which are to be forthcoming.

Any time there is a transaction between controlled companies (particularly a foreign corporation and its U.S. subsidiary), the possible effect of Sec. 482 must be considered. If the IRS does use its broad poewr under Sec. 482 in an intercompany loan situation, the IRS may make an adjustment to interest charged in order to reflect an "arm's-length" interest rate.

Regs. Sec. 1.482-2(a)(2)(iii) provides safe harbor rules to determine if the interest rate being charged will be considered an arm's-length rate. (The safe harbor rules apply only to interest and loans denominated in U.S. dollars.) Generally, the interest charged will be within the safe harbor rates if the rate is between 100% and 130% of the applicable federal rate. The applicable federal rates are dictated by the length of the obligation's term. Interest rates being charged by the foreign related party should be analyzed in light of these safe harbor rates.

Interest-free advances

There may be situations, particularly for a U.S. subsidiary in a loss position, in which the parties decide no interest or below-market interest should be charged. It is precisely this type of situation that the Service might question. (It should be noted that under Temp. Regs. Sec. 1.7872-5T(c)(2) intrest generally cannot be imputed on loans from foreign persons. An exception to this general rule would apply if the foreign lender's interest income is effectively connected with the conduct of a U.S. trade or business.)

In the past, the IRS has imputed interest income to a foreign corporation under Sec. 482 on advances to U.S. subsidiaries. The typical fact patterns the Service has attacked is a U.S. corporation that is in a loss position and has debt outstanding to a related foreign party. The IRS has imputed interest under Sec. 482 in order to collect the withholding tax under Sec. 1441 or 1442. The Service would look to the U.S. subsidiary as the withholding agent for payment of the assessed withholding tax. Furthermore, the U.S. corporation receives no current income tax benefit from the imputed interest deduction, since it is already in a loss position.

If the IRS is successful in imputing interest, that interest would be considered paid under Sec. 1441 or 1442. Accordingly, that interest expense would presumably also be considered paid (and therefore deductible by the U.S. subsidiary) for purposes of Prop. Regs. Secs. 1.267(a)-3 and 1.163-12. However, the imputed interest expense would also be subject to the rules of Sec. 163(j).

In the past, it would have been less likely for the Service to impute interest to a profitable U.S. corporation, since the tax benefits of a current deduction at 34% would negate a current withholding tax of 30% (or less under a treaty). However, due to the earnings-stripping provisions of Sec. 163(j), the IRS may now have more incentive to impute interest to U.S. subsidiaries on advances from foreign corporations; if the U.S. subsidiary's imputed interest deduction is deferred, present value concepts would allow the Service to benefit from imputing interest.

Conclusion

Many controlled groups have used related-party financing because it was believed to be a cheaper source of funds. Any interest taht was charged was often at a rate lower than what could be obtained from third parties. However, due to the deferral (and possible permanent disallowance) of interest expense under Prop. Regs. Sec. 1.267(a)-3 and the earnings-stripping rules, an advance from a foreign parent corporation to its U.S. subsidiary, which might have otherwise had a lower interest rate, may actually result in a higher, if future, after-tax interest rate to the U.S. subsidiary. Such a result would make third-party loans more attractive.

From Lori Rock, CPA, and Kevin Polchow, CPA, Denver, Colo.