Court Precedent Looms over IRS “Crisis” Fix

In a move to stave off the effects of the credit crisis, the IRS extended the loan payback period for tax-free loans from foreign subsidiaries. But now another issue emerges that could wipe out that benefit.

A rule change released by the Internal Revenue Service regarding so-called controlled foreign corporations (CFCs) may give tax managers pause as they head to the end of the year. The reason: the change — dubbed Notice 2008-91 — and put in place to help companies weather the credit crisis, could fail to do its job if a precedent-setting case involving Jacobs Engineering Group is widely applied.

A discussion of CFCs in light of the new notice, and how it affected Jacobs Engineering is notable. First, consider the structure of a CFC as defined by the government. While a CFC is a foreign corporation, it is unusual because more than 50 percent of its stock is owned by one or more U.S. persons, and each of those persons own 10 percent or more of the foreign corporation’s voting stock.

Now consider a CFC that makes an investment in “U.S. property,” in which the amount of the investment — unless an exception applies — produces a deemed dividend, and the dividend amount is equivalent to the investment for the CFC’s U.S. shareholders. Such an investment is regarded as an effective repatriation of the CFC’s undistributed earnings. As a result, it is a proper occasion for taxing the U.S. shareholders.

The investment is a repatriation because under the tax code — specifically Section 956(c) — the IRS defines U.S. property to include an obligation — such as a loan — of a U.S. person. Therefore, a loan from a foreign subsidiary to its U.S. parent would be taxed under repatriation rules.

However, an exception to the repatriation rules was announced in 1988 (Notice 88-108, 1988-2 C.B. 445). The rule amendment excludes from the repatriation definition any loan amount collected within 30 days from the time it is incurred. So short-term loan would garner tax-free status. At the time, the IRS warned that the 30-day exclusion would not apply if the CFC holds the loan for 60 or more calendar days during the taxable year the obligation constitutes an investment in U.S. property. (In addition, the loan has to be on hand at the end of the CFC’s taxable year.)

Then two months ago, in response to the current credit crisis, the Treasury Department and the IRS extended the holding period of CFC loans. In a gallant effort to “facilitate liquidity,” the IRS announced on Oct. 6, that a CFC loan to its American parent may exclude from the repatriation definition if the obligation is collected within 60 days from the time it is incurred (Notice 2008-91, I.R.B. 2008-43). The exclusion does not apply, however, if the CFC holds the loan for 180 or more calendar days during its taxable year.

For example, under the October rule, a foreign subsidiary may loan its parent funds for up to 60 days without triggering tax consequences. If a loan is not paid back within the prescribe period, the parent corporation is required to pay taxes on the income at its effective marginal rate &#8212l which could reach 35 percent.

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