Rev. Rul. 69-377

Advice has been requested concerning the interest equalization tax and certain income tax consequences under the circumstances described below.

X, a domestic corporation, formed Y, also a domestic corporation, as a wholly owned subsidiary. X contributed 5,000x dollars to the capital of Y. In order to provide funds for the development of the businesses of certain of X's foreign affiliates, Y sold 25,000x dollars of 20-year debt obligations to foreign persons through a public offering in foreign countries and invested in or loaned to the foreign affiliates of X the funds thus derived.

The debt obligations of Y are convertible into the capital stock of X. Payments of the principal and interest on the debt obligations and the performance of the obligation to convert the debt obligations into X's capital stock are guaranteed by X, so that in the event Y fails to make any such payments on time, or fails to perform its obligation to convert, X will cause such payment to be made, or will perform the obligation to convert. All other indicia of bona fide indebtedness exist with respect to the debt obligations of Y.

Section 4911 of the Internal Revenue Code of 1954 imposes the interest equalization tax on each acquisition by a United States person of stock of a foreign issuer, or a debt obligation of a foreign obligor, if such obligation has a period remaining to maturity of one year or more.

Section 4912(b)(3) of the Code provides, in part, that the acquisition of stock or a debt obligation of a domestic corporation, formed or availed of for the principal purpose of obtaining funds (directly or indirectly) for a foreign issuer or obligor, shall be deemed an acquisition (from such foreign issuer or obligor of) stock or a debt obligation of such foreign issuer or obligor.

Section 4918(a) of the Code provides, in relevant part, that the interest equalization tax shall not apply to an acquisition of stock of a foreign issuer or a debt obligation of a foreign obligor if it is established in the manner provided in that section that the person from whom such stock or debt obligation was acquired was a United States person throughout the period of his ownership or continuously since July 18, 1963, and was not ineligible to dispose of such stock or debt obligation as a United States person and such person had paid the tax imposed by section 4911 of the Code with respect to the acquisition of such stock or debt obligation by such person or acquired such stock or debt obligation without liability for payment of such tax.

Since Y was formed or availed of for the principal purpose of obtaining funds for a foreign issuer or obligor pursuant to section 4912(b)(3) of the Code, the stock and the debt obligations issued by Y are deemed to be the stock of such foreign issuer or the debt obligation of such foreign obligor. Therefore, the acquisition by United States persons of such stock or debt obligations of Y is subject to the interest equalization tax unless one or more specific statutory exemptions is applicable.

In order to warn United States persons who acquire the stock or the debt obligations of Y of interest equalization tax liability, Y placed a legend on its capital stock and on the debt obligations which read, as applicable, substantially as follows:

United States Interest Equalization Tax

"The issuer of this debt obligation [or stock] has been formed or availed of for the principal purpose of obtaining funds (directly or indirectly) for foreign issuers or foreign obligors. Consequently the United States Internal Revenue Service has ruled that United States persons (as that term is defined in Section 4920(a)(4) of the U.S. Internal Revenue Code of 1954) will be required to report and pay United States interest equalization tax with respect to acquisition of this debt obligation [or stock] except where a specific statutory exemption is applicable."

Y invested the net proceeds from the sale of the debt obligations and the cash contributed by X in foreign corporations by acquiring the stock or debt obligations of such foreign corporations.

Section 4915(a) of the Code provides, in relevant part, that the interest equalization tax imposed by section 4911 of the Code shall not apply to the acquisition by a United States person of stock or debt obligations of a foreign corporation if immediately after the acquisition such person (or one or more includible corporations in an affiliated group, as defined in section 1504 of the Code, of which such person is a member) owns directly or indirectly 10 percent or more of the total combined voting power of all classes of stock of such foreign corporation.

Section 1504(a) of the Code provides that the term "affiliated group" means one or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation if:

(1) Stock possessing at least 80 percent of the voting power of all classes of stock and at least 80 percent of each class of the nonvoting stock of each of the includible corporations (except the common parent corporation) is owned directly by one or more of the other includible corporations; and

(2) The common parent corporation owns directly stock possessing at least 80 percent of the voting power of all classes of stock and at least 80 percent of each class of the nonvoting stock of at least one of the other includible corporations.

Section 4915(c)(1) of the Code provides that section 4915(a) of the Code shall be inapplicable in any case where the foreign corporation is formed or availed of by the United States person for the principal purpose of acquiring, through such foreign corporation, an interest in stock or debt obligations of one or more other foreign issuers or obligors, the direct acquisition of which by the United States person would be subject to the interest equalization tax imposed by section 4911 of the Code.

Section 4915(d) of the Code provides that section 4915(a) of the Code shall be inapplicable in any case where the acquisition of stock or debt obligations of the foreign corporation is made with intent to sell, or to offer to sell, any part of the stock or debt obligations acquired to United States persons.

Accordingly, under section 4915(a) of the Code, subject to the exceptions set forth in sections 4915(c) and 4915(d) of the Code, the interest equalization tax does not apply to the acquisition by Y of the stock or debt obligations of a foreign corporation, if X or Y owns 10 percent of the total combined voting power of all classes of stock of such foreign issuer or obligor immediately after such acquisition by Y, and X and Y constitute an affiliated group pursuant to section 1504 of the Code.

Section 163(a) of the Code provides that there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.

Accordingly, since the debt obligations of Y have all the indicia of bona fide indebtedness, the interest paid by Y on each debt obligation of Y is deductible under section 163(a) of the Code so long as such debt obligation is held by a person other than X or one of its affiliates.

Y derived more than 80 percent of its gross income from the dividends and interest paid on stock or debt obligations of foreign issuers and obligors.

Section 1441(a) of the Code provides, in relevant part, that all persons, in whatever capacity acting, having the control, receipt, custody, disposal, or payment of any of the items of income specified in section 1441(b) of the Code (which section includes interest) to the extent that any of such items constitutes gross income from sources within the United States, of any nonresident alien individual, or of any foreign partnership, shall deduct and withhold from such items a tax equal to 30 percent thereof.

Section 1442 of the Code provides, in relevant part, that in the case of foreign corporations, subject to income taxation under the Code, there shall be deducted and withheld at the source in the same manner and on the same items of income as is provided in section 1441 of the Code a tax equal to 30 percent thereof.

Section 862(a)(1) of the Code provides, in relevant part, that interest other than that derived from sources within the United States as provided in section 861(a)(1) of the Code shall be treated as income from sources without the United States.

Section 861(a)(1)(B) of the Code provides, in relevant part, that interest on obligations of a domestic corporation shall be treated as income from sources within the United States unless it is shown to the satisfaction of the Secretary or his delegate that less than 20 percent of the gross income from all sources of such domestic corporation has been derived from sources within the United States, as determined under the provisions of sections 861, 862, 863 and 864 of the Code for the 3-year period ending with the close of the taxable year of such domestic corporation preceding the payment of such interest, or for such part of such period as may be applicable.

Section 861(d) of the Code provides, in relevant part, that for purposes of section 861(a)(1)(B) of the Code if the domestic corporation has no gross income from any source for the 3-year period (or part thereof) specified, the 20 percent test shall be applied with respect to the taxable year of the payer in which payment of the interest is made.

Accordingly, no United States withholding of tax under section 1441 or 1442 of the Code is required on the interest from the debt obligations of Y paid to nonresident alien individuals, foreign partnerships or foreign corporations, if less than 20 percent of Y's gross income has been derived from sources within the United States pursuant to sections 861 through 864 of the Code.

Whether a debt obligation issued by Y, if acquired by X or one of its affiliates or if X or one of its affiliates makes any payment of principal or interest on such debt obligation pursuant to X's guaranty to make payments of principal and interest in the event that Y fails to make such payments, is bona fide indebtedness and whether interest paid or accrued on such debt obligation by X or one of its affiliates is deductible are questions to be determined on the basis of all the facts and circumstances of each case.