Rev. Rul. 87-89

Rev. Rul. 87-89

ISSUE

For purposes of the withholding tax on interest under sections 881 and 1442 of the Internal Revenue Code of 1986 and for purposes of determining whether a controlled foreign corporation has an increase in its earnings invested in United States property under section 956 of the Code, under what circumstances will a lender be considered to have made a direct loan to a related borrower where the lender deposits funds with an unrelated entity and that entity, in turn, lends funds to the borrower?

FACTS

Situation (1)

FP is a corporation organized in country X, a country that does not have in effect an income tax convention with the United States. DS is FP's wholly owned domestic operating subsidiary. BK is a publicly held unrelated bank organized and engaged in business in country Z. An income tax convention is in effect between the United States and country Z. Under the terms of that convention, no United States income tax is imposed on interest paid by a United States person to a country Z resident.

During 1987, FP deposited 100x dollars denominated as a demand deposit with BK. Subsequently, BK loaned 80x dollars to DS for use in expanding DS's business. During the term of BK's loan to DS, the amount of FP's deposit with BK exceeded the balance due BK from DS. The difference between the interest paid by BK to FP on its deposit and the interest charged by BK on the loan to DS was less than one percentage point. The interest rate charged by BK on the loan to DS would have differed absent the deposit by FP in BK.

Situation (2)

The facts are the same as in Situation (1) except that BK is organized in country X and is not a bank. Furthermore, FP's "deposit" with BK is in the nature of a long term, short term, or demand loan.

Situation (3)

DP is a domestic operating corporation that owns all of the stock of FS, a country Y corporation. BK is an unrelated bank organized and engaged in business in country Y. An income tax convention is in effect between the United States and Country Y. Under the terms of that convention, no United States income tax is imposed on interest paid by a United States person to a country Y resident.

During 1987, FS deposited 100x dollars denominated as a demand deposit with BK. Subsequently, BK loaned 80x dollars to DP for use in expanding DP's business. During the term of BK's loan to DP, the amount of FS's deposit with BK exceeded the balance due BK from DP. The difference between the interest paid by BK to FS on its deposit and the interest charged by BK on the loan to DP was less than one percentage point. The interest rate charged by BK on the loan to DP would have differed absent the deposit by FS in BK.

LAW

Situations (1) and (2)

Under sections 881(a) and 1442(a) of the Code, United States source interest income is subject to a 30 percent withholding tax when paid to a foreign corporation not engaged in a United States trade or business. Under section 894(a), such interest, to the extent required by any treaty obligation of the United States, is exempt from the tax. Furthermore, under section 881(c), the 30 percent tax under section 881(a) is not imposed on portfolio interest received by a foreign corporation from sources within the United States. However, pursuant to section 881(c)(3)(B), portfolio interest does not include interest received by a 10 percent shareholder of the issuer of the obligation on which the interest is paid. Additionally, under section 881(c)(3)(A), portfolio interest generally does not include interest received by a bank.

In the first situation, if the deposit by FP and subsequent loan by BK to DS are treated as independent transactions, the interest paid to BK is not subject to United States withholding tax imposed under sections 881(a) and 1442(e) of the Code, pursuant to the income tax convention between the United States and country Z. Interest paid on a loan made directly by FP to DS, however, is not covered by the provisions of the income tax treaty since FP is a resident of country X, a non-treaty jurisdiction. Thus, any interest considered paid by DS to FP is subject to the United States withholding tax of 30 percent.

In the second situation, if the loan by FP to BK and subsequent loan by BK to DS are treated as independent transactions, section 881(c) of the Code exempts the interest paid to BK from the United States withholding tax that would otherwise be imposed under sections 881(a) and 1442(a). Interest paid on a loan made directly by FP to DS, however, is not covered by section 881(c) because FP is a 10 percent shareholder of DS.

Situation (3)

Under section 951(a)(1)(B) of the Code, a United States shareholder of a controlled foreign corporation (CFC) generally must include in gross income its pro rata share (determined under section 956(a)(2)) of the CFC's increase in earnings invested in United States property during the taxable year. Section 956(a)(1) provides that the amount of earnings of a CFC invested in United States property at the close of any taxable year is the aggregate amount of such property held, directly or indirectly, by the CFC at the close of the taxable year, to the extent the amount would have constituted a dividend if it had been distributed.

Section 956(b)(1)(C) of the Code provides, in part, that for purposes of section 956(a), the term "United States property" includes any property acquired after December 31, 1962, that is an obligation of a United States person. Under section 7701(a)(30)(C), a domestic corporation is a United States person. Section 956(b)(2)(F) provides that the term "United States property" does not include the obligations of domestic corporations in certain situations. However, the section 956(b)(2)(F) exception does not apply if the domestic corporation whose obligation is acquired is the sole shareholder of the acquiring CFC.

If the deposit by FS and subsequent loan by BK are treated as independent transactions, FS will not be considered to have invested its earnings in United States property within the meaning of section 956 of the Code. However, if FS holds, directly or indirectly, DP's obligation, section 956 will apply.

ANALYSIS

The principal issue presented in each of the three situations is whether the deposit of funds with BK and the loan from BK are in substance a direct loan from FP to DS (in Situations (1) and (2)) or from FS to DP (in Situation (3)). Rev. Rul. 76-192, 1976-1 C.B. 205, deals with a similar issue. In that revenue ruling, a CFC deposited funds with a financial institution that then loaned funds of a similar amount to another CFC related to the depositing CFC. The borrowing CFC then loaned the funds to the common domestic parent corporation. The borrowing CFC was a newly organized corporation with no earnings and profits.

The revenue ruling holds that the deposit of the funds with the financial institution was part of an overall plan by the United States parent to avoid a section 956 investment of earnings in United States property that would result from a direct loan from the depositing CFC to the domestic parent. The ruling recharacterizes the transaction as a loan from the depositing CFC to the domestic parent on the basis that the loan from the financial institution would not have been made but for the corresponding deposit by the depositing CFC.

In each of the three present situations, if the deposit and loan are independent transactions such that the loan from BK would be made or maintained on the same terms irrespective of the deposit, the form of the transaction will be respected for United States income tax purposes. If the loan would not have been made or maintained by BK on the same terms without the corresponding deposit in BK (or a related person of BK), the transaction will be recharacterized as a direct loan because the deposit and loan are dependent transactions used as a device to disguise the substance of the transaction. Gregory v. Helvering, 293 U.S. 465 (1935).

The determination whether the loan would have been made or maintained on substantially the same terms irrespective of the deposit will be made taking into account all the facts and circumstances of the relationship between the lender and the borrower (and parties related to the borrower). A statutory or contractual right on the part of BK to offset the deposit against the liability on the subsequent loan is presumptive evidence that BK would not have made or maintained the loan on the same terms without the deposit. Even if BK does not have a statutory or contractual right to offset the deposit against the debtor's liability on the loan from BK, additional facts and circumstances may indicate that the loan from BK would not have been made or maintained on the same terms but for the deposit.

HOLDING

Situations (1) and (2)

Under the facts presented above, the loan by BK to DS would not have been made or maintained on the same terms but for FP's deposit of funds in BK. The two transactions will therefore be treated as a direct loan from FP to DS. Interest paid by DS on the loan will be subject to the 30 percent United States withholding tax under sections 881(a) and 1442(a) of the Code.

Situation (3)

Under the facts presented above, the loan by BK to DP would not have been made or maintained on the same terms but for FS's deposit of funds in BK. The two transactions will therefore be treated as a direct loan from FS to DP. The loan will be considered United States property under section 956(b)(1)(C) of the Code.

These holdings do not provide a taxpayer the right to compel the Internal Revenue Service to disregard the form of its transactions for Federal income tax purposes. See Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134 (1974).