Rev. Rul. 84-153

ISSUE

Whether the exemption provided by Article VIII(1) of the United States-Netherlands Income Tax Convention (the Convention), T.D. 5778, 1950-1 C.B. 92, as supplemented by the Protocol of June 15, 1955 and extended on November 10, 1955 to the Netherlands Antilles (Antilles), 1956-2 C.B. 1116, and as modified and supplemented by the Protocol of October 23, 1963 (1963 Protocol), 1965-1 C.B. 624, is applicable to interest payments made by a domestic corporation to an Antilles corporation under the circumstances described below.

FACTS

P a corporation organized under the laws of the United States, owns 100 percent of the stock of S, a corporation organized under the laws of the Antilles in 1982.

P determined that its wholly owned domestic subsidiary corporation, R, required a significant increase in working capital to upgrade R's production facilities. P desired to obtain funds for this purpose outside the United States where interest rates would be lower. P arranged to have S issue bonds that were not registered within the meaning of section 163(f)(2)(B)(ii) of the Internal Revenue Code and the regulations thereunder (bearer bonds), in two separate offerings, on July 1 and September 1, 1984. The bonds were sold to foreign persons in public offerings outside the United States. However, the issuance of the bonds on September 1, 1984, did not meet the requirements of section 163(f)(2)(B) of the Code and the regulations thereunder. S loaned the proceeds from the bond offerings to R at a rate of interest that was one percentage point higher than the rate payable by S on the S bonds.

Thereafter, R made timely interest payments to S and S made timely interest payments to its bondholders. Any excess revenue after expenses with respect to the financing arrangement was retained by S. Neither P, R, nor S is thinly capitalized.

S is not entitled to any of the special tax benefits provided under Articles 1 3, 14, or 14A of the Netherlands Antilles' National Ordinance on Profit Tax of 1940, as in effect on September 1, 1963, or to substantially similar tax benefits granted under any law of the Antilles enacted after that date.

S is not engaged in a trade or business within the United States through a permanent establishment.

LAW AND ANALYSIS

Sections 871(a)(1)(A) and 881(a)(1) of the Code, except as provided in the portfolio interest exemption in sections 871(h) and 881(c), respectively (added to the Code by section 127 of the Tax Reform Act of 1984), generally impose a 30 percent tax on any interest received by non-United States persons from sources within the United States, to the extent such interest is not effectively connected with the conduct of a trade or business within the United States. Sections 1441(a) and 1442(a) provide generally that such tax is to be deducted and withheld at the source of the income.

Under sections 871(h) and 881(c) of the Code, the 30 percent tax under sections 871(a)(1)(A) or (C) and 881(a)(1) or (3) is not imposed on portfolio interest received by non-U.S. persons from sources within the United States. Portfolio interest generally means interest on certain obligations that are issued in either registered or bearer form under the conditions specified in sections 871 and 881 and the regulations thereunder. One of those conditions is that the obligations, if they are bearer bonds, must satisfy the requirements of section 163(f)(2)(B).

Section 127(g)(1) of the Tax Reform Act provides that, except as otherwise provided in subsection (g), the amendments made by section 127 (including the addition of sections 871(h) and 881(c) of the Code) shall apply to interest received after the date of the enactment of the Act (July 18, 1984) with respect to obligations issued after such date, in taxable years ending after such date. In addition, section 127(g)(3) of the Act provides a special grandfather rule for certain United States affiliate obligations issued before June 22, 1984.

Section 894(a) of the Code provides that income of any kind, to the extent required by any treaty obligation of the United States, shall not be included in gross income and shall be exempt from income taxation.

Article VIII(1) of the Convention, as extended to the Antilles, provides generally that interest (other than mortgage interest) derived from sources within the United States by a resident or corporation of the Antilles not engaged in trade or business in the United States through a permanent establishment shall be exempt from United States tax. Article I of the 1963 Protocol, which limits the applicability of Article VIII(1) of the Convention, does not apply because S is not entitled to any of the special tax benefits provided under Articles 13, 14, or 14A of the Netherlands Antilles' National Ordinance on Profit Tax of 1940, as in effect on September 1, 1963, or to substantially similar tax benefits granted under any law of the Antilles enacted after that date.

Under the facts presented here, in order for the interest exemption under Article VIII(1) of the Convention to apply to interest paid by R, such interest must be `derived . . . by` S from R. The words `derived . . . by` refer not merely to S's temporarily obtaining physical possession of the interest paid by R, but to S's obtaining complete dominion and control over such interest payments. See Aiken Industries, Inc. v. Commissioner, 56 T.C. 925 (1971), acq. on another issue, 1972-2 C.B. 1. In substance, S, while a valid Antilles corporation, never had such dominion and control over R's interest payments, but rather was merely a conduit for the passage of R's interest payments to the foreign bondholders. The primary purpose for involving S in the borrowing transaction was to attempt to obtain the benefits of the Article VIII(1) interest exemption for interest paid in form by R, a domestic corporation, to S, an Antilles corporation, thus, resulting in the avoidance of United States tax. This use of S lacks sufficient business or economic purpose to overcome the conduit nature of the transaction, even though it can be demonstrated that the transaction may serve some business or economic purpose. See Gregory v. Helvering, 293 U.S. 465 (1935), and Aiken Industries, Inc. v. Commissioner, supra. Thus, for purposes of the interest exemption in Article VIII(1) of the Convention, the interest payments by R will be considered to be `derived . . . by` the foreign bondholders and not by S.

Sections 871(h) and 881(c) of the Code do not apply to payments of interest on the bonds issued on July 1, 1984, because these bonds were not issued after July 18, 1984, the date of the enactment of the Tax Reform Act. In addition, sect ions 871(h) and 881(c) do not apply to payments of interest on the bonds issued on September 1, 1984, because, as stated in the facts, that issuance did not m eet the requirements of section 163(f)(2)(B) and the regulations thereunder. Fu rther, the grandfather rule in section 127(g)(3) of the Tax Reform Act does not apply since the two offerings in the present case were issued after June 21, 1 984.

HOLDING

Under the facts of this case, the interest payments by R are not exempt from taxation by the United States under Article VIII(1) of the Convention, as extended to the Antilles. Further, such interest payments will be subject to a 30 percent United States withholding tax under sections 1441(a) and 1442(a) of the Code or a lower treaty rate if applicable.

Similar types of arrangements, depending upon the facts and circumstances, may also involve other issues relating to the true nature of a debt obligation issued by a financing subsidiary such as S. See Rev. Rul. 74-464, 1974-2 C.B. 46, which provides that the repeal of the Interest Equalization Tax eliminated any rationale for treating finance subsidiaries differently than other corporations with respect to their corporate validity or the validity of their corporate indebtedness.

See Rev. Rul. 84-152, page 8, this Bulletin, in which the United States income tax consequences of using another type of Antilles debt structure are considered.