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Proposed new anti-conduit regulations.


The IRS recently issued proposed anti-conduit regulations under Sec. 7701(l) designed to prevent both abuse of the portfolio interest exemption and treaty shopping by disregarding the existence of a conduit entity in certain situations.

Treaty shopping occurs when a financing entity that is a resident of a country that has no income tax treaty with the United States (or has an unfavorable treaty) forms an intermediate entity, a foreign corporation in a country with a favorable treaty, to invest in the United States. The financing entity may, for example, loan money or license property to the intermediate entity, which will reloan or sublicense the property to a financed entity, usually a related U.S. person. The intermediate entity is often formed principally to get the treaty reduction in U.S. withholding tax on interest, royalties or dividends paid by the U.S. person. (Under the Service's preregulation position, the intermediate entity was denied treaty benefits if a conduit. The company was a conduit if (1) it did not retain for more than a temporary period the payments received from its U.S. affiliate but transferred most or all of those payments to the financing entity and (2) there was not a sufficient business purpose, apart from the treaty benefit, to justify interposing the intermediate entity between the shareholder and the U.S. affiliate. See Rev. Rul. 84-152 and Aiken Industries, Inc., 56 TC 925 (1971).)

The portfolio interest exemption (PIE) exempts U.S.-source interest income paid on certain obligations from withholding tax if received by a foreign person. that is not a bank and that owns less than 10% of the U.S. payor. In the legislative history to Sec. 7701(l), Congress expressed concern that a foreign taxpayer, the financing entity, might attempt to circumvent the 10% shareholder and bank exception rules through a back-to-back arrangement. For example, the financing entity might advance money to an unrelated intermediate entity, who then relends that money to a U.S. person, the financed entity.

The regulations will apply to determine the appropriate rate of U.S. withholding tax for inbound financing arrangements involving - back-to-back loans; - back-to-back leases or licenses; - certain back-to-back stock investments; and - a combination of the above.

They will apply when the payor of the dividends, interest or royalties is a foreign-owned U.S. subsidiary or other person, and - the foreign payee is related to the payor, or - the foreign payee is unrelated, but has a financial relationship with a foreign person who is related to the payor.

The regulations may also affect the appropriate rate of U.S. withholding tax on interest treated a actually paid under Sec. 884(f)(1)(a) by the U.S. branch of foreign corporation doing business in the United States and involved in a back-to-back arrangement.

The regulations generally do not apply to outbound financing transactions engaged in by a U.S. multinational corporation, unless the multinational owns a foreign financing subsidiary that borrows money and makes loans to U.S. affiliates and the interest payments on the loans have not otherwise been grandfathered. Effective date: The proposed regulations are generally effective for any payments made 30 days after the regulations are finalized, but do not apply to certain interest payments made by U.S. corporations (1) on debt issued before Oct. 15, 1984, or (2) on U.S. affiliate obligations issued before June 22, 1984. See Rev. Ruls. 87-79 and 85-163.

General discussion

Prop. Regs. Sec. 1.881-3 specifies factors to be used by the IRS in deciding when one or more intermediate entities will be disregarded solely for purposes of determining the appropriate U.S. withholding tax rate applicable to U.S.-source interest, royalties and dividends under Secs. 871, 881, 1441, 1442 and 884(f)(1)(a). An intermediate entity can only be disregarded if the following conditions are met: 1. There is a financing arrangement. 2. The participation of the intermediate entity in the financing arrangement reduces the U.S. withholding tax imposed by Sec. 871 or 881 either by an income tax treaty or the PIE. 3. a. The intermediate entity is related to either the financing or financed entity, or b. If the intermediate entity is unrelated, it would not have participated in the financing arrangement on substantially the same terms without the financing entity entering into a transaction with it, such as guaranteeing the obligations of the financed entity. 4. The participation of the intermediate entity in the financing arrangement is pursuant to a plan, one of the principal purposes of which is avoidance of U.S. withholding tax.

Financing arrangements

A financing arrangement exists at least three parties (a financing entity, an intermediate entity an a financed entity) participate in least two related financing transactions. In one financing transaction, the financing entity (a foreign corporation) advances money or other property to the intermediate entity (usually a foreign corporation). In the other financing transaction, the intermediate entity or an affiliate advances the money or property to the financed entity or to another intermediate entity so that ultimately the chain ends with an advance to the financed entity, a U.S. person. These transactions may occur in any order.

Financing transactions generally include the following advance of money or property: * Loans in which money or property is exchanged for debt (see Rev. Rul. 84-152). * Assignments by the financing entity of the financed entity's loan to an intermediate entity (see Aiken Industries). * Leases and licenses (see Rev. Rul. 80-362). * Deposits or other advances in which the transferee is obligate to repay or return a substantial portion of the money or property advanced or other property of equivalent value (see Rev. Rul. 87-89). * Certain tainted stock investments, but not ordinary common stock or ordinary perpetual preferred stock investments. * Similar tainted interests in a partnership or trust.

The fact that guarantees are not treated as financing transactions may present some tax planning opportunities, unless this treatment is changed in final regulations. Exception for ordinary common and preferred stock: Because a ordinary preferred or common stock investment made in, or by, an intermediate entity is not financing transaction, that investment, coupled with a loan or license, will not be a financing arrangement except in certain cases involving multiple intermediate entities; see Prop. Regs. Sec. 1.881-3(a)(2)(ii)(b) and (f) (Example 4). Thus, under the proposed regulations, the IRS cannot disregard for withholding tax purposes (i.e., treat as a conduit) an intermediate entity that is equity-financed or that makes equity investments. For example, if a financing entity capitalizes an intermediate entity only through an ordinary common stock investment and the intermediate entity lends the funds to the financed entity, there will not be a financing arrangement. Subsequent interest paid by the U.S. subsidiary to the intermediate entity will not be subject to recharacterization under the regulations as a payment directly to the financing entity. A similar result may be achieved if the financing entity makes a loan to the intermediate entity and the intermediate entity uses the loan proceeds to capitalize the U.S. subsidiary only through an ordinary common stock investment. Although the Service does hold out the possibility that the regulations could be amended at a future date to apply to ordinary common stock investments, it has made a clear policy decision not to do so at this time.

This treatment of equity is a significant change in position. he IRS has previously applied conduit principles to disregard an intermediate entity apparently in an ordinary preferred stock situation; see Letter Ruling (TAM) 9133004 (stock investment in intermediate entity, followed by loan to the financed entity, its U.S. subsidiary). Tainted stock investments: A stock investment will be considered not to be ordinary common or perpetual preferred stock, and thus will be treated as a financing transaction, if it has one of the following attributes: * The holder has from the date of issue, or will have at a later date, the right to cause a redemption of his stock (a put). * The stock is callable and it is more likely than not that the issuer will call the stock. * The holder has the right to cause the issuer, directly or indirectly, to make a payment (like a dividend distribution) on his stock investment. This right may include creditors' rights, such as the right to enforce the payment through a legal proceeding or a liquidation, or to elect a majority of the issuer's board of directors, but does not include rights derived from the mere ownership of a controlling interest in the issuer. * Under similar circumstances, the holder has the right to require a person related to the issuer to acquire his stock or make a payment with respect to the stock.

Tax avoidance plan

A tax avoidance plan is a plan one of the principal purposes of which is the avoidance of U.S. withholding tax imposed by Sec. 881 or 871. Its existence must be determined from an analysis of all the relevant facts and circumstances. Prop. Regs. Sec. 1.881-3(c)(2) lists several nonexclusive factors relevant to this determination: 1. Whether the participation of the intermediate entity in the financing arrangement significantly reduces the U.S. withholding tax that otherwise would have been imposed. The fact that an intermediate entity is a resident of a country that has a treaty with the United States that significantly reduces the tax that otherwise would have been imposed under Sec. 881 or 871 is not sufficient, by itself, to establish the existence of a tax avoidance plan. Therefore, if the tax is significantly reduced because of a treaty obligation, another factor must be present before a tax avoidance plan may exist; 2. Whether the intermediate entity would have been able to make the advance to the financed entity without the advance to it from the financing entity; 3. The length of time that separates the advance by the financing entity to the intermediate entity from an advance by the intermediate entity to the financed entity. A short period of time, such as 12 months, is indicative of a tax avoidance plan, in the absence of countervailing factors.

If over a period of years an intermediate entity did not function as a conduit because it retained the payments received from its U.S. affiliate without transferring them to the financing entity, this would suggest that there was no plan to avoid U.S. withholding tax. (This point is not discussed in the regulations.) Whether this may be conclusive is unclear; in the preamble, the Service expressed its concern about the extent to which the similarity of repayment terms is a useful indicator of tax avoidance.

The regulations also set out three exceptions that create a rebuttable presumption that there is no tax avoidance plan. The complementary business exception: An intermediate entity that is related to the financed entity is presumed not to take part in a tax avoidance plan if the financing arrangement allows the financed entity to actively engage in a business that forms a part of, or is complementary to, a substantial business actively engaged in by the intermediate entity. An example is a financed entity that manufactures a product that is a principal component of the product manufactured by the intermediate entity. The significant financing activity exception: An intermediate entity that is related to the financing entity or the financed entity is presumed not to take part in a tax avoidance plan if the intermediate entity performs significant financing activities in connection with the financing transactions.

Significant financing activities for nonlease or nonlicense transactions generally will be found if officers and employees of the intermediate entity on their own meet all of the following requirements: (1) they materially participate and actively arrange the intermediate entity's participation in the financing transactions (except in the case of certain factoring operations), (2) they exercise management and oversight of the entity's strategic business decisionmaking process and day-to-day operations (which must consist of a "substantial" business, or supervision, administration and financing of a "substantial" group of related persons) in the intermediate entity's country of incorporation and (3) they actively manage, on an ongoing basis, material business risks arising from the financing transactions (without totally eliminating those risks) as an integral part of the management of the entity's financial and capital requirements and the entity's short-term investments of working capital. (An intermediate entity is considered to perform significant financing activities with respect to leases or licenses (that are financing transactions) if rents or royalties earned are derived from the active conduct of a trade or business under rules identical to those under Temp. Regs. Sec. 1.954-2T(c) or (d).)

It is unclear which financing transactions already in place on the effective date of final regulations will be treated as meeting requirement (1) above, and what qualifies as a substantial business or a substantial group of related persons under requirement (2). The example in the regulations hardly clarifies the substantiality issue because the cash management operation used to illustrate this exception involves 100 employees, an atypical case. This could be an indication that the IRS intends to interpret this exception narrowly. See Prop. Regs. Sec. 1.881-3(f) (Example 12). The unrelated financing entity exception: A financing entity that is not related to the intermediate entity or the financed entity will be presumed not to take part in a tax avoidance plan if the intermediate entity is actively engaged in a substantial business (with certain exceptions).

Relationship to treaties

Under the proposed regulations, an intermediate entity can still be treated as a conduit and thus denied treaty withholding tax benefits, even though that entity otherwise qualifies as a treaty resident, by satisfying the treaty limitation-on-benefits article. This result is questionable, given the fact that limitation-on-benefits articles were inserted in U.S. treaties specifically to combat treaty shopping. Similarly, an intermediate entity may still be subject to withholding for purposes of the branch interest tax under Sec. 884(f)(1)(a), even though the intermediate entity is a qualified resident of a treaty country under Sec. 884.

Information reporting


A financed entity that is either a reporting corporation under Sec. 6038A (usually a 25% foreign-owned U.S. corporation) or a U.S. person controlling a controlled foreign corporation under Sec. 6038 is required to report certain information on any financing transaction to which it is a party, if it knows or has reason to know that such transaction is part of a financing arrangement. The financed entity is considered to know this, for example, if its liability to the intermediate entity has been guaranteed by the financing entity.

Specifically, the financed entity must attach a statement to Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, or Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business (Under Sections 6038A and 6038C of the Internal Revenue Code), whichever is applicable, setting forth the following information for each financing transaction (if not already disclosed elsewhere on the return): the character of the financing transaction; the name of the intermediate entity that made the advance to the financed entity and the name of the entity to which the financed entity has made payments; the date and amount of each advance (loan of money, etc.) to the financed entity; the date and amount of each payment by the financed entity; a description of any guarantees involved in the financing arrangement; and, with respect to each party to the financing transaction that is related to the financed entity, the name, address, taxpayer identification number (if any), and country of residence of the related person, along with a description of the relationship.

These information reporting requirements apply only if a person with respect to which the financed entity is required to report under Sec. 6038 or 6038A is a party to that financing arrangement.

A financed entity, or other person subject to the recordkeeping requirements of Sec. 6001 or 6038A, must keep the permanent books or records that may be relevant in determining whether that person is a party to a financing arrangement subject to recharacterization under the regulations.

The regulations also treat these information reporting and record maintenance requirements as part of the information required to be reported or maintained under Sec. 6038 or 6038A, if the financed entity is already required to furnish information or maintain records under those sections on any transactions between the financed entity and any other party to the financial arrangement. Thus, penalties may apply for failure to report information or maintain these records.

Withholding requirements and

derivative treaty benefit

Withholding will be required if the withholding agent (the U.S. subsidiary, affiliate or branch) knows or has reason to know that the financing arrangement is subject to recharacterization. The requisite knowledge will not be present, however, if the agent does not have reason to know of facts sufficient to establish that the intermediate entity's participation was pursuant to a tax avoidance plan. Since this is a difficult determination, withholding agents in many cases may simply withhold tax at the higher rate rather than risk penalties or interest.

If the agent has the requisite knowledge or the Service treats an intermediate entity as a conduit under these rules, a portion of each payment made by the financed entity will be subject to recharacterization as a payment directly between the financed entity and the financing entity. To determine the payment amount that will be recharacterized (and thus subject to withholding), multiply the amount of the payment by a ratio, the numerator of which is the average principal amount advanced by the financing entity to the intermediate entity and the denominator is the average principal amount advanced by the intermediate entity to the financed entity. This ratio may not be greater than 1:1 Special rules apply in the case of multiple intermediate entities.

The recharacterized portion of the payment will be subject to tax at the rate that would have been applicable (usually 30%) had the payments been made by the financed entity directly to the financing entity. For example, if an Irish company owned by a Japanese parent borrowed funds on the Eurodollar market from unrelated lenders and loaned the funds to a U.S. affiliate, recharacterization under the conduit regulations may permit the unrelated customers to claim that they qualify for the PIE as though the payment were made directly by the U.S. subsidiary, assuming the Code requirements are met. Finally, if the intermediate entity is disregarded, the rate of withholding can be reduced by any favorable provisions of a U.S. income tax treaty with the financing entity's country (the derivative treaty).

Affirmative use of conduit


A financing entity cannot use the proposed regulations to disregard the form of a financing transaction to reduce its U.S. income tax liability, even if it would be consistent with the transaction's substance. Thus, unless changed, the regulations may not be used by foreign parent corporations that intentionally use back-to-back arrangements to circumvent restrictive foreign laws on exporting capital from their country for U.S. investment and who currently treat the arrangements as conduits for U.S. tax purposes. In addition, if an applicable treaty contains a limitation-on-benefits article and the IRS determines that it is not met, offshore finance subsidiaries that borrow on the Eurodollar market may not use the regulations to obtain derivative benefits for the European investors, even if those investors would otherwise qualify for the PIE.
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Author:Dichter, Arthur
Publication:The Tax Adviser
Date:Mar 1, 1995
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