Planning around the CFC netting rule.

If a U.S. parent company borrows externally and in turn makes a loan to its controlled foreign corporation (CFC), it may be subject to the CFC netting rule under Regs. Sec. 1.861-10(e). If applicable, the CFC netting rule requires a direct allocation of the U.S. parent company's third-party interest expense against foreign-source interest income received from the CFC when computing the foreign tax credit (FTC) limitation. The impetus behind the CFC netting rule was to curtail a perceived abuse that had U.S. taxpayers generating low-taxed foreign-source income to use excess FTCs; the effect is a reduction in foreign-source income and the FTC, which results in a higher U.S. tax liability.

The applicability of the CFC netting rule in any given year will depend on whether the taxpayer has both "excess related group indebtedness" (ERGI) and "excess U.S. shareholder indebtedness" (ESI). ERGI equals the amount by which related group indebtedness (average current year loans to CFCs) exceeds allowable related group indebtedness (generally, the average current year assets of CFCs multiplied by the average of the previous five years' ratios of average loans to CFCs to their average assets). ESI is correspondingly the amount by which the U.S. parent company's unaffiliated indebtedness exceeds allowable unaffiliated indebtedness (generally, the average current year assets of the U.S. shareholder multiplied by the average of the previous five years' ratios of average unaffiliated loans to average assets of the U.S. shareholder). (There are certain safe harbor provisions and elections available to mitigate the impact of the CFC netting rule; however, they are beyond the scope of this discussion.)

If ERGI and ESI are both present, the U.S. parent company's third party interest expense is allocated against interest income from CFCs using the following formula:

Interest income      Lesser of ERGI
 from related           or ESI
   group         x   Related group
indebtedness         indebtedness

As a possible way to eliminate (or at least minimize) the impact of the CFC netting rule, the U.S. shareholder could (in lieu of making direct loans to its CFCs) capitalize an intermediary finance subsidiary in a tax haven with sufficient cash and have that subsidiary lend to the applicable CFCs. It may also be possible to contribute existing direct loans to the finance subsidiary, provided gain under Sec. 367 could be avoided or minimized. By structuring internal financing in this manner, the interest payments to the U.S. shareholder are effectively recharacterized as dividends. As a result, there is no interest income from related group indebtedness when the above formula is applied; therefore, there is no direct allocation of interest expense under the CFC netting rule.

This planning idea appears to be specifically allowable under Regs. Sec. 1.861-10(e)(8)(v), which provides that if a U.S. shareholder owns stock in a CFC that is a resident of a country that (1) does not impose a withholding tax of 5% or more on dividend payments to U.S. shareholders and (2) does not subject the CFC's income to a tax rate greater than 90% of the maximum U.S. rate, and that CFC makes loans to other CFCs, such loans will be treated as having been made directly by the U.S. shareholder (and therefore related group indebtedness). However, the key is, that for purposes of this formula, Regs. Sec. 1.861-10(e)(8)(v) states that "interest income derived by the U.S. shareholder during the year from related group indebtedness shall not include any income derived with respect to the U.S. shareholder's ownership of stock in the related controlled foreign corporation that made such loans ...." In other words, although the loans from the intermediary finance CFC will be considered directly made from the U.S. shareholder (and thus related group indebtedness), the interest income that passes through the intermediary finance CFC (and is consequently recharacterized as dividend income) will not be considered interest income for purposes of the formula. Although the interest income at the intermediary finance company level will be subpart F income under Sec. 954(c)(1), requiring current recognition (i.e., deemed dividend to the U.S. shareholder) for U.S. tax purposes, the U.S. shareholder should be no worse off, since interest income from a direct loan would have been currently recognized as well. It may even be possible to avoid subpart F entirely by using certain structuring arrangements commonly employed with international finance subsidiaries. Furthermore, the lookthrough rules under Sec. 904(d)(3) should apply to deemed and actual dividends from the intermediary finance CFC in the same manner as with a direct payment of interest by the CFCs to the U.S. shareholder, providing general basket classification for FTC purposes.

Finally, success or savings will depend on a number of other tax and nontax factors, including (but not limited to):

* Whether additional withholding tax is incurred with an interest payment to, and a dividend payment from, the intermediary finance CFC, as compared to the withholding tax on a direct interest payment to the United States (it could be less total withholding depending on the location of the intermediary finance company) and, if additional withholding is incurred, whether it can be fully credited in the United States.

* Whether any local taxes are incurred in the intermediary finance company's country of incorporation, and if so, whether such taxes can be fully credited in the United States.

* What additional costs (e.g., organizational and ongoing operational) are incurred with respect to the intermediary finance company.

* The impact of treaty shopping provisions or future conduit legislation.