The conduit regulations: a primer.

Overview

The Revenue Reconciliation Act of 1993 added section 7701(l) to the Internal Revenue Code. The new provision consists of a single sentence that authorizes the Department of the Treasury to issue regulations "recharacterizing any multiple-party financing transaction as a transaction directly among any two or more of such parties" where the Internal Revenue Service determines that this is necessary to prevent tax avoidance.

The statutory language is very broad, but the legislative history described the particular situations intended to be addressed solely in terms of international transactions, primarily loans where an intermediate entity is inserted between the lender and the borrower for treaty-shopping purposes.

The typical treaty-shopping situation arises when interest payments to the "real" lender would be subject to the 30-percent U.S. withholding tax but interest payments to the intermediate entity would be protected from all or most of the U.S. withholding tax by a tax treaty between its country and the U.S. Assuming that the intermediate entity can avoid tax in its own country on the interest it receives by deducting the interest it pays to the real lender, the tax savings can be substantial.

On October 14, 1994, the Internal Revenue Service promulgated proposed regulations under the new conduit provision. The regulations are reasonably restrained in most respects and generally limited to the "treaty shopping" problem described in the legislative history.(1) Taxpayers should be aware, however, that the conduit rules are rather aggressive in two respects--their retroactivity and their effect on tax treaties.

As promulgated, the conduit regulations are to be applied to payments made after 30 days from the time they are published in final form. This effective date would be retroactive in the sense that the regulations would apply to deny the expected benefits of lower U.S. withholding rates for future interest payments on hundreds of existing financings, even if the financings were entered into before the publication of the proposed regulations or even before the enactment of section 7701(l).(2)

Modern U.S. tax treaties contain provisions specifically dealing with treaty shopping. If these anti-treaty shopping provisions are satisfied, the treaty benefits should be available. Under the proposed regulations, however, a new and rigoroous set of requirements must be met. The question whether this constitutes an improper override of treaties is discussed at the end of this article.

Basic Framework of Proposed Regulations

The proposed regulations focus exclusively on the use of back-to-back financings designed to avoid tax liability under section 881, which imposes U.S. tax on foreign entities receiving interest and dividend income from U.S. sources.(3) The scope of the regulations could clearly have been broader. Indeed, the legislative history of section 7701(l) refers to section 956, dealing with loans by controlled foreign corporations to a related U.S. borrower, but the conduit regulations do not extend to section 956 or any other section of the Code not related to the taxation of U.S. source income. Lest too much comfort be drawn from the limitation to section 881 and the related sections, the preamble to the regulations states that the IRS and Treasury are considering the circumstances under which the recharacterization provided for in the regulations should be extended to other Code sections.

Because the substantive rules generally refer only to section 881, incorporating the related sections simply by reference, the proposed regulations are primarily located in Prop. Reg. [sections] 1.881-3, with some recordkeeping and reporting requirements in Prop. Reg. [sections] 1.881-4. New paragraphs have also been added to the withholding regulations at Prop. Reg. [sections][sections] 1.1441-3(j) and 1.1441-7(d), and conforming changes made to regulations under other related sections. Of particular interest in Prop. Reg. [sections] 1.881-3(f) is a set of 16 examples illustrating the operation of the new substantive rules.

The basic case to which the regulations refer is a relatively simple three-party transaction. The first party is a foreign "financing entity" that is the source of the financing. The second party is an "intermediate entity," which receives funds from the financing entity and then lends funds to the third party, a U.S. entity referred to as the "financed entity" in the regulations but as the "borrower" in this article.

The chief purpose of the regulations is to define the circumstances when, in the basic case or one of its variations, the intermediate entity is a conduit. "Conduit," as used in the regulations, refers only to an intermediate entity whose participation in the transaction is to be disregarded. In such cases, the interest paid by the borrower is considered to be paid directly to the financing party. That interest, therefore, is subject to a U.S. withholding tax that would have been wholly or in part avoided if the interest were considered to be paid to the conduit, which is typically located in a country with a favorable tax treaty.

The decision whether an intermediate party is a conduit is made by the IRS, applying the standards in the regulations.(4) The preamble to the regulations states that this decision will be subject to judicial review under an abuse of discretion standard. In determining tax liability, the conduit regulations can only be used by the IRS and cannot be invoked affirmatively by the taxpayer to overturn the form of its transactions, though a taxpayer may comply with the regulations in order to avoid the imposition of interest and penalties.(5)

Standards to Be Applied

Generally speaking, the proposed regulations provide that, where the intermediate party is related to one or both of the other parties, the IRS may treat the intermediate party as a conduit if the participation of the intermediate party in the financing arrangement (i) reduces the tax imposed by section 881, and (ii) is pursuant to a tax avoidance plan.(6) The term "financing arrangement" means two or more financing transactions pursuant to which the financing entity advances money to an intermediate party, and the intermediate party advances money to the borrower. It also covers cases where there are multiple intermediate entities, or "any other series of steps" that achieve substantially the same result.(7)

Since the regulations do not apply unless there is a financing arrangement, and there is no financing arrangement without two financing transactions, the definition of financing transaction operates as a substantive limitation on the scope of the regulations. "Financing transaction" means an advance of money or property in exchange for debt or some other obligation to repay. In addition to debt transactions, the definition also includes a lease or license. On the other hand, the definition does not include a guaranty, the posting of collateral, or, generally, the payment of money for stock.(8)

With respect to transfers for stock, the exception from the definition of a financing transaction does not apply where the stockholder has a right to compel redemption of the stock or to compel certain other kinds of payments. Not considered as a "right to compel," however, is a "right derived from ownership of a controlling interest in the issuer."

Even if guarantees do not constitute financing transactions, they are relevant. Not only can they give rise to an adverse presumption in the case of an unrelated intermediate party (discussed below), but they can also affect reporting requirements.

Even if both a tax saving and a tax avoidance plan are present, the regulations will disregard an intermediate party if that party is unrelated to either the financing party or the borrower--unless the intermediate party would not have participated in the financing arrangement on substantially the same terms but for the fact that the financing entity engaged in the financing transaction with the intermediate party. Moreover, the regulations establish a presumption (which can be rebutted by the taxpayer only by "clear and convincing" evidence) that the intermediate party would not have participated without the back-to-back loan from the financing entity if the financing entity also guarantees the liability of the borrower to the intermediate party.(9) The presumption does not arise unless the financing party has lent money to the alleged conduit--as well as giving a guarantee--since a guarantee, by itself, does not constitute a financing transaction.

On balance, this regulatory presumption does not seem particularly logical. One can justifiably ask why it should be presumed that the financing entity's guarantee of the loan to the borrower demonstrates that the intermediate party would not have extended credit in the absence of the back-to-back loan from the financing entity. Why does the guarantee furnish any evidence whatever about the role that the financing entity's loan played in motivating the intermediate party? Concededly, the presence of a guarantee may suggest that the intermediate party would not have extended credit in the absence of the guarantee itself, but it provides scant evidence that the financing entity's loan was the motivating factor for the intermediate party's loan to the borrower.

Other Rules on Presence or Absence of Relationship

Because the structure generally required for conduit treatment is so simple--two financing transactions, one providing funds to the intermediate party and one involving a loan by the intermediate party--taxpayers may attempt to avoid conduit treatment by using multiple intermediate parties or omitting a required financing transaction between related parties. The regulations, however, have special provisions designed to prevent this possibility, particularly where the parties in question are related.

In determining whether parties are related, the regulations use an extremely broad definition: They combine the relationship rules and attribution rules of sections 267(b), 267(c), 707(b)(1), and 318 with the concept of "controlled" under section 482.(10)

Example 4 uses the relationship of the parties to deal with a case where equity instead of debt is used to break a chain of financing transactions. In the example, money flows from FP to FS to FS2 to DS, but the transfer from FS to FS2 is for stock rather than a debt instrument. The example does not treat that transfer as a financing transaction but, based on the parties' relationship, treats FS and FS2 as a single intermediate party.

Tax Avoidance Plans

"Tax avoidance plan" is another defined term in the regulations. The plan must have the avoidance of section 881 as one of its principal purposes, as opposed to its being the principal purpose, in order for the regulations to apply. In addition, the plan may be written or oral, may involve only one of the parties to the financing arrangement, may be inferred from facts and circumstances, and need not come into existence until the last date that any of the financing transactions are entered into. Specifically mentioned as relevant facts and circumstances are the purposes for the participation of the intermediate party.(11)

Among the facts and circumstances that are to be taken into account in determining whether the participation of an intermediate party in a financing transaction is pursuant to the existence of a tax avoidance plan are the following:

* It is an adverse factor the participation of the intermediate party significantly reduces the tax under section 881. The intermediate party's being a resident of a country with a favorable U.S. tax treaty, however, is not sufficient, by itself, to establish the existence of a tax avoidance plan.

* Another adverse factor is whether the intermediate party would not have been able to make the advance of money without the advance made to it by the financing entity. This factor is applied both to related and to unrelated intermediate entities, unlike the more general test on whether the intermediate party would have made its loan to the borrower "but for" the loan to it by the financing entity. (The latter test is not merely a factor but a requirement if an unrelated intermediate party is to be subjected to conduit treatment.)

* Still another adverse factor is whether a short period of time separates the receipt of money by the intermediate party and its disbursement to the borrower. Example 9 of the regulations deals with this factor, and it holds that even a one-year time period is indicative of a tax avoidance plan.

* The regulations provide that the absence of a tax avoidance plan is indicated where the intermediate party is related to the borrower, and the borrower actively engages in a business that is part of or complementary to a substantial active business carried on by the intermediate party.(12)

In addition to the above evidentiary factors, the regulations provide a taxpayer-favorable presumption that arises where the related intermediate party performs significant financing activities with respect to the relevant financing transactions.(13) The IRS may rebut the presumption, however, by establishing that the participation of the intermediate party was pursuant to a tax avoidance plan.

The relationship between the foregoing presumption and the delineated tax-avoidance factors is illustrated by Example 14, where a favorable presumption arose from the fact that the intermediate party, FS, did perform significant financing activities with respect to the loan it received from its parent and the loan it made to its U.S. sister company. The example states that the IRS may rebut the presumption by establishing a tax avoidance plan, based on all the facts and circumstances. It then cites three adverse factors as instances of such facts and circumstances: (i) FS is a resident of a country with a favorable tax treaty, not enough by itself but relevant in conjunction with other factors; (ii) the loan from the parent and the loan to the sister company were made on the same day; and (iii) FS would not have had sufficient funds to make its loan to its sister company had it not received the loan from its parent.

The definition of "significant financing activities" in the regulations is very strict. The officers and employees of the intermediate party, without the material participation of any officer or employee of a related person, must participate actively and materially in arranging the entity's participation (subject to a detailed exception in the case of trade receivables financing). They must also, within the treaty country, manage the intermediate party's strategic decisionmaking and the day-to-day operations of a substantial business or the "supervision, administration and financing of a substantial group of related persons," and they must actively manage material business risks, including currency and interest rate fluctuations.

Another favorable, albeit rebuttable, presumption arises if the financing entity is unrelated to the intermediate party and the borrower and if the intermediate party is actively engaged in a substantial trade or business.(14) For this purpose, making or managing investments is not a business, except where it is done pursuant to a banking, insurance, financing, or similar trade or business the income from which is earned predominantly in transactions with unrelated persons. Example 15 illustrates this presumption in a case where the parent, a manufacturing company, is itself the intermediate party located in a country with a favorable treaty, and the financing entity is an unrelated bank in a country with no treaty.

A second rule applicable to a financing entity unrelated to either of the other parties is that it is not liable for tax under section 881 if it does not know or have reason to know of the tax avoidance plan, even if it is aware of the relevant financing transactions. If conduit treatment does apply, however, the borrower is required to withhold tax on the interest, and no party to the transaction can sue for refund.(15)

Reporting, Recordkeeping, and Withholding

The regulations impose reporting requirements only on the borrower. A borrower that is a reporting corporation within the meaning of section 6038A(a), which generally means a 25-percent foreign-owned U.S. corporation, and a borrower that is required to report pursuant to section 6038(a) are subject to the reporting requirements in the conduit regulations with respect to certain financing transactions.(16) A reportable financing transactions is one to which the borrower is a party and that the borrower knows or has reason to know forms part of a financial arrangement as described in Prop. Reg. [sections] 1.881-3(a)(4), determined without regard to whether the participation of the intermediate entity is pursuant to a tax avoidance plan.

Thus, the rule requires the borrower to determine, for reporting purposes, whether a particular arrangement reduces taxes imposed by section 881; whether a relevant relationship exists; and whether the intermediate entity, if unrelated, would have participated in the financing arrangement on substantially the same terms but for the fact that the financing entity engaged in the financing transaction with the intermediate entity. If the borrower knows or has reason to know that the financing entity has guaranteed the borrower's liability, he is considered to know that the financing arrangement has failed the "but for" test.

The reporting requirements apply only if a person with respect to which the borrower is required to report under section 6038 or 6038A is a party to the financing arrangement. The IRS, however, may prescribe other reporting requirements in instructions to forms or otherwise.

If the reporting requirements apply, the reporting party must provide (on either IRS Form 5471 or 5472) detailed information, in English and in U.S. dollars, about each financing transaction. The existence of a guarantee is one of the facts to be reported.(17)

The specified information needs to be supplied, however, only to the extent that it would not duplicate information disclosed on the tax return or other forms. A financing transaction's being included with other financing transactions in aggregate totals on some other form does not constitute such duplication.

The usual recordkeeping requirements apply to information relevant under the proposed regulations after the regulations become effective. In addition, the provisions of sections 6038 and 6038A (and the related regulations), including their penalty provisions, would apply to any of the information subject to the reporting and recordkeeping requirements of the proposed regulations.(18)

With respect to withholding, the regulations provide that the borrower or any other withholding agent must withhold on the basis of the transaction as recharacterized under such regulations if it knows or has reason to know that the financing arrangement falls within the requirements of the regulations. The preamble to the proposed regulations states that the "knows or has reason to know" standard so invoked is that exemplified in certain provisions of Rev. Rul. 85-4, 1985-1 C.B. 294, 295, and Rev. Rul. 76-224, 1976-1 C.B. 268, 269. If the withholding party knows of the financial transactions that compose the financing arrangement but does not know or have reason to know facts sufficient to establish that the participation of the intermediate entity was pursuant to a tax avoidance plan, the withholding party is not considered to know or have reason to know that recharacterization is required.(19)

Prior U.S. Law on Conduits and Back-to-Back Loans

Prior to the enactment of section 7701(l) and the issuance of the proposed regulations, the U.S. tax law in the area of conduits consisted primarily of one case, several rulings, and a technical advice memorandum. These authorities are still relevant because the regulations have not yet been issued in final form, because they help to illuminate the issues included (or omitted) in the proposed regulations, and because they have some relevance to the question whether the regulations are inconsistent with existing tax treaties.

The case in question is Aiken Industries v. Commissioner, 56 T.C. 925(1971), acq., 1972-2 C.B. 1, where a Bahamian conglomerate had both U.S. and Honduran subsidiaries. The Bahamian parent lent funds to its U.S. subsidiary and then sold the loan to its Honduran subsidiary. As payment, the Bahamian parent received nearly identical notes from the Honduran subsidiary. Thereafter, the U.S. subsidiary made all its payments to the Honduran subsidiary which, in turn, paid on its own corresponding obligations to the Bahamian parent.

In holding that this arrangement was not protected by the U.S.-Honduran treaty, the Tax Court focused on the applicable provision of the treaty referring to interest "received by" the protected party. It concluded that the Honduran subsidiary was a mere "conduit" and therefore not the true recipient of the interest payments made by the U.S. subsidiary. The court reasoned that "receipt," for purposes of the U.S.-Honduras treaty, required more than the "obtaining of physical possession on a temporary basis" of the payments, and that "receipt" further required that the payee must be able to exert "complete dominion and control" over the sums. The court found that the Honduran subsidiary had no such claim or control over the amounts paid to it by the U.S. subsidiary, and that its loan transactions fulfilled no economic purpose.

Subsequent to Aiken Industries, the IRS applied the conduit principle on several occasions. In Rev. Rul. 76-192, 1976-1 C.B. 205, the IRS examined the applicability of section 956 to a multi-tiered loan transaction. Under the facts, corporation X, the foreign subsidiary of a U.S. parent, borrowed funds from third parties and deposited those funds in an independent, foreign financial institution. That financial institution then lent the funds to Z, a foreign subsidiary of X, and Z in turn lent those borrowed funds to the U.S. parent. The IRS determined that Z was only a conduit for X and therefore the "loan" from Z to the parent was in fact an investment of earnings by X in its U.S. parent. In reaching this conclusion, the IRS emphasized that the foreign financial institution would not have lent funds to Z absent the deposit made to it by X.

In Rev. Rul. 84-152, 1984-2 C.B. 381, a Swiss parent corporation owned all of the stock of both its Netherlands Antilles subsidiary and its U.S. manufacturing subsidiary. Neither subsidiary was thinly capitalized. The Swiss parent first lent funds to its Antilles subsidiary. The Antilles subsidiary in turn lent an identical amount to its U.S. sibling at an interest rate one-percentage point higher than the rate at which it had borrowed from its parent. Interest payments of this type "derived by" a Netherlands Antilles entity were exempt from withholding tax.

Citing Aiken Industries and Gregory v. Helvering, 293 U.S. 465 (1935), the IRS ruled that, since the Antilles subsidiary failed to exercise complete dominion and control of the funds it received from the U.S. subsidiary and the transaction served no business purpose, the Antilles subsidiary was a mere conduit and agent for its Swiss parent. In reaching its conclusion, the IRS noted that the Antilles subsidiary would have been unable to make its loan to the U.S. subsidiary without first receiving a loan from its Swiss parent. As such, the interest payments were treated as if made directly to the Swiss parent and so subject to the applicable withholding tax.

In Rev. Rul. 84-153, 1984-2 C.B. 383, a U.S. parent corporation arranged for its wholly owned Netherlands Antilles subsidiary to borrow from various foreign lenders. The Antilles subsidiary then lent those funds to a U.S. subsidiary of the U.S. parent at an interest rate one-percentage point higher than it was paying to its foreign lenders. Again citing Aiken Industries and Gregory, the IRS ruled that the Antilles subsidiary "lack[ed] sufficient business or economic purpose to overcome the conduit nature of the transaction, even though it could be demonstrated that the transaction might serve some business or economic purpose."

Finally, in Rev. Rul. 87-89, 1987-2 C.B. 195, the IRS applied the Aiken Industries doctrine to three types of financing transactions. In two types of transactions, an unrelated, foreign intermediary loaned funds to the U.S. subsidiary after receiving funds, in excess of those amounts loaned, from a foreign parent. The foreign parent either "loaned" or "deposited" the funds to the intermediary. The third type of transaction involved a U.S. parent and a foreign subsidiary. Here, the U.S. parent deposited funds with a foreign intermediary bank, and the intermediary then lent a smaller amount to the foreign subsidiary.

In all three cases, the intermediary's loans to the subsidiaries would either not have been made or made only at a higher interest rate without the transfer of funds from the parent to the intermediary. The key fact for the IRS was the dependent nature of the transactions. Citing Gregory, the ruling concluded that any interest payments made to the intermediary by the subsidiaries (in any of the transactions) would be viewed as if made to the parent.

Technical Advice Memorandum 9133004 dealt with facts similar to the published rulings except that the financing entity, which owned almost all the stock of the intermediate entity, supplied the necessary funds in part as a contribution to capital, and the payments it received back from the intermediary were in part dividends. Notwithstanding this difference, the IRS again found that the intermediary did not have complete dominion and control over the interest it received and, hence, that the interest was actually paid to the financing entity.

Do the Regulations Improperly Override Tax Treaties?

The proposed regulations clearly assert priority over the tax treaties.(20) The question whether this is improper is raised most clearly by the new U.S.-Netherlands tax treaty. It is accepted U.S. law that a treaty can be overridden by a subsequently enacted law. Section 7701(l), however, was enacted in 1993, and the U.S.-Netherlands tax treaty did not come into force until 1994. The regulations were proposed later in 1994, but presumably they have no more force than the Code provision that authorizes them.

There are at least two reasons for considering the regulations and the treaty to be inconsistent. One is that the treaty states that residents of the Netherlands are not subject to U.S. withholding tax on interest payments received from the United States. The treaty squarely addresses the question of when a corporation can be considered a resident of the Netherlands for this purpose, and the parties agreed to detailed requirements on the point.(21) The treaty provision is at odds with the provision of the regulations stating that, even if a corporation meets the treaty requirements for being treated as a resident of the Netherlands, the withholding tax does apply if the Netherlands corporation is a conduit.

The second reason for considering the regulations inconsistent is that the treaty itself explicitly considered the question of conduits, i.e., corporations that receive interest receipts from the United States and then make deductible interest payments to non-Dutch corporations. The United States agreed to a definition of the term "conduit," and agreed that conduits would qualify for the treaty benefits provided that the interest payments made were not greater than a certain specified share of the interest payments received.(22) Having agreed with the Netherlands about the proper treatment of conduit corporations, how can the United States seek to change the treatment of conduits by regulation?

The Treasury was itself concerned with this issue, since the Treasury has historically been the leading defender of the tax treaty process and the leading opponent of treaty overrides. The defense it has made is that treaties are not meant to override or preclude the substance-over-form rules of the respective countries. The proposed regulations, like the IRS's other pronouncements on conduits, deal with the question of which party actually received or derived the interest payments. The treaties deal with the tax treatment of the real recipients as thus determined. Thus, the Treasury argues, the Netherlands treaty did not override the already existing U.S. anti-conduit rules discussed above, and the new proposed regulations do not override the treaty.

Whatever the theoretical merits of this issue, it seems highly likely that the Treasury's position will receive strong congressional support, if that is needed, and may well be sustained.

Conclusion

For many years, tax practitioners have complained about the length and complexity of new regulations. More recently, regulations have become shorter and more general, until the new proposed partnership regulations were strongly criticized as being so general that they fail to provide adequate guidance. The proposed conduit regulations strike a good balance. They define the type of transactions triggering conduit treatment with sufficient precision so that, in most innocent cases not involving guarantees, taxpayers can have confidence that they are outside the target area. They are sufficiently flexible, however, to make it difficult to design transactions that violate the spirit of the regulations but technically fall just outside their reach.

(1)The proposed regulations were published in the Federal Register on October 14, 1994 (59 Fed. Reg. 52,100) with minor non-substantive amendments being published in the Federal Register for October 26, 1994 (59 Fed. Reg. 53,771).

(2)Prop. Reg. [sections] 1.881-3(g). The regulations would not apply to interest payments by U.S. corporations to Netherlands Antilles corporations relating to debt issued before October 15, 1984, nor to payments covered by section 127 (g)(3) of the Tax Reform Act of 1984, relating to payments of interest by U.S. affiliates to certain of their controlled foreign corporations under obligations issued before June 22, 1984.

(3)Prop. Reg [sections] 1.881-3(e) provides that references to the tax under section 881 also includes, as the context requires, the tax imposed under sections 871, 884(f)(1)(A), 1441, and 1442.

(4)Prop. Reg. [sections] 1.881-3(a)(3)(i).

(5)Prop. Reg. [sections] 1.881-3(a)(3)(ii).

(6)Prop. Reg. [sections] 1.881-3(a)(4).

(7)Prop. Reg. [sections] 1.881-3(a)(2)(i).

(8)Prop. Reg. [sections] 1.881-3(a)(2)(ii).

(9)Prop. Reg. [sections][sections] 1.881-3(a)(4)(i)(C)(2) and 1.881-3(b).

(10)Prop. Reg. [sections] 1.881-3(a)(2)(v).

(11)Prop. Reg. [sections] 1.881-3(c)(1).

(12)Prop. Reg. [sections] 1.881-3(c)(2).

(13)Prop. Reg. [sections] 1.881-3(c)(3).

(14)Prop. Reg. [sections] 1.881-3(c)(4)(i).

(15)Prop. Reg. [sections] 1.881-3(c)(4)(ii).

(16)Prop. Reg. [sections] 1.881-4(b)(i).

(17)Prop. Reg. [sections] 1.881-(4)(b)(2).

(18)Prop. Reg. [sections][sections] 1.881-4(c) and (d).

(19)Prop. Reg. [sections] 1.1441-7(d).

(20)Prop. Reg. [sections] 1.881-3(d)(3).

(21)Netherlands-U.S. Tax Treaty, Art. 26, para. 1(c).

(22)Netherlands-U.S. Tax Treaty, Art. 26, para. 8(m) and 5(d).