Silicon Valley Chapter

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1 Silicon Valley Chapter Subpart F: Section 956 Review and Planning Strategies March 23, 2017 Biltmore Hotel & Suites, Santa Clara Lowell D. Yoder

2 Basic Rule A CFC s investment of its earnings in U.S. property results in a deemed dividend to its U.S. shareholders Sections 951(a)(1)(B) & 956 1

3 Overview Definition of U.S. property Amount of investment in U.S. property E&P limitation on the amount taxable Consequences of a 956 investment Planning and common issues 2

4 Definition of U.S. Property Tangible property located in U.S. Stock of related U.S. corporations Obligations of related U.S. persons Certain intangible property used in the U.S. CFC is a pledgor or guarantor of related U.S. person obligation/u.s. person pledges CFC stock Note: Related persons include U.S. shareholders and entities with 25% common ownership 3

5 Tangible Property Located in the U.S. Warehouse Inventory* Machinery Land U.S. Foreign Irish CFC *Export exception 4

6 Loans to Related U.S. Persons US Parent US Sub Swiss CFC Loan Loan #1 #2 ( 956) (not 956) UK CFC China DE * ( 956?) *What if USP owned 10% of Chinese entity (i.e., a foreign partnership)? 5

7 Recent Developments: Loans to Foreign Persons Treated as U.S. Property Loan to a foreign partnership owned by related U.S. persons (Reg (c)) Loan to foreign parent of an inverted company (Reg T(a)(4)) Loan to (or any funding of) a related CFC that holds U.S. property (expanded indirect investment rule) (Reg (b)(1)) 6

8 Amount of Investment Identify U.S. property investments held on the last day of each quarter, total amounts of such investments, and divide by four The amount of each U.S. property investment is the adjusted basis of the property (reduced by certain related liabilities) There is no de minimis or high tax exception 7

9 E&P Limitation The amount included in the income of U.S. shareholders cannot exceed current and accumulated E&P (nimble dividend rule applies) The inclusion amount is reduced by previously taxed income for all years Ordering Rules Before applying 956, PTI is increased by Subpart F income inclusions for the year, and E&P/PTI are reduced by current year distributions Note: Rules are applied afresh annually 8

10 Consequences of 956 Inclusion Treated as a deemed dividend of CFC s E&P Deemed-paid foreign taxes accompany the inclusion CFC s earnings that are subject to U.S. taxation are reclassified as previously taxed income U.S. shareholder s basis in CFC stock is increased by the amount of inclusion 9

11 Computational Illustration CFC Un-taxed E&P: $100 PTI: $50 Investment Q1 & Q2 U.S. Property FMV: $1,000 Basis: $500 Investment in U.S. Property: ($500 + $500) 4 = $250 Less PTI (50) Net $200 E&P Limitation/Amount Taxable $100 10

12 Safely Investing Offshore Cash Without Triggering a 956 Inclusion Deposits with banks (U.S. or foreign) U.S. Treasury notes & bills Obligations of states and municipalities Debt & stock of unrelated U.S. corporations (or of foreign corporations) Idea: CFC can purchase from a U.S. affiliate an obligation of a foreign or unrelated U.S. corporation (but not trade receivables of a U.S. person) 11

13 Intercompany Receivables

14 Business Receivables Exception* CFC Sells Property to, or Perform Services for, USP Sells Property for Receivables US Parent Provides Services for Receivables UK CFC Canadian CFC *No exception for royalty receivables. 13

15 Exception for Trade or Service Receivables (slide 13) An exception applies to trade or service receivables that are ordinary and necessary to carry on the trade or business of the parties Trade Receivables Outstanding for two months generally okay (facts may support a longer period) Service Receivables Outstanding for two months satisfies safe harbor (facts may support a longer period) U.S. payable can be netted against a CFC receivable (but not automatic) (Gulf Oil & FSA ) Note: New 385 documentation requirements apply 14

16 CFC Funds Foreign Toll Manufacturing *Hong Kong CFC obtains funds from related CFCs. US Parent Sales Trade Payable Chinese Toll Manufacturer Manufacturing Services Hong Kong* Owns Raw Materials, WIP & Finished Goods 15

17 Prepayments USP Sells Property to, or Performs Services for, CFCs Sells Products for Receivables US Parent Provides Services for Receivables German CFC Singapore CFC 16

18 CFCs Prepay USP for Products and Services (slide 16) German CFC and Singapore CFC can prepay amounts for inventory and for services The amount prepaid by a CFC to USP should not be considered as an obligation of a U.S. related person provided the amount is not considered as a deposit or indebtedness (e.g., no right to refund) There may be zero basis in the prepayment asset German CFC can purchase inventory while located in the U.S. (exception for inventory purchased for export) 17

19 Export Property Exception An exception is provided for inventory purchased in the U.S. for export to, or use in, a foreign country The inventory should be exported within a reasonable period (see PLR , raw materials exported within one year) See 956(c)(2)(B); Reg (b)(1)(iv). 18

20 CFC Purchases Foreign Trade Receivables Foreign trade receivables purchased from U.S. affiliates are not U.S. property But, trade receivables of related or unrelated U.S. obligors purchased from a U.S. related person constitute U.S. property ( 956(c)(3); Reg ) 19

21 Intangible Property

22 U.S. Property Intangibles U.S. property includes Any right to the use in the U.S. of A patent, copyright, invention, model, design, secret formula or process, or other similar property right, Which is acquired or developed by the CFC for use in the U.S. Note: The definition of U.S. property does not include marketing intangibles (e.g., trade names and trademarks) 21

23 CFC Acquires Intangibles Pursuant to an Acquisition, Collaboration or Buy-In Unrelated Party Sell Business 1 US Parent Puerto Rico CFC Buy-In/ Cost Share Payments 3 Collaboration Payments 2 Unrelated Party 22

24 Where are Intangibles Used? Where is a manufacturing intangible used (e.g., is a patent used where manufacturing occurs or where the product is sold)? What if intangible property is actually used both in the U.S. and outside the U.S. Statute indicates an intent test applies (was the intangible acquired for use in the U.S.?) Regulations provide that IP generally is 956 property if actually used principally in the U.S. (actual use is evidentiary) Where is IP used during the development phase (if anywhere)? 23

25 Source of Income Guidance Place of exploitation (e.g., location of customers): Rev. Rul (trademark); Rev. Rul (copyright royalties) Place of manufacturing: Rev. Rul (know-how to produce products); Sanchez (patents used to manufacture products in the U.S.) Where patent legally protected (exclude others from exploiting rights) 24

26 When is Software U.S. Property? The IRS ruled that software manufactured outside the U.S. and sold to U.S. customers was not U.S. IP; the IRS later revoked the ruling without comment (PLR , revoked by PLR ) CCA With similar facts as the prior ruling, the IRS stated that the acquisition or development of the copyright rights to manufacture software outside the U.S. and sell software to U.S. customers was an investment in U.S. property Does not discuss the meaning of use in the U.S. (e.g., where copyright is commercially exploited or developed?) But, 956 apparently did not apply because the CFC had zero basis in the IP 25

27 Zero Basis Intangibles No 956 inclusion if the CFC has no basis in the IP, for example CFC develops its own IP or is a party to a cost sharing arrangement Buy-in (PCT) structured as a license vs. sale IP is transferred to a CFC in a 367(d) transaction Caveats: Basis arises with asset acquisitions, 338(g) election, and intercompany sales of IP (collaboration payments?) 26

28 Prepaid Royalty Planning Prepay Royalty USP Singapore CFC Prepaid royalties should not create an obligation of USP as long as the arrangement is not considered as indebtedness (e.g., non-refundable) CFC rights should not be U.S. property as long as the IP is foreign IP or marketing IP Any basis in prepaid asset? Note: Amount of royalty prepaid generally is current income to USP (one-year deferral option) 27

29 Indirect Investment Rule

30 Regulations: Indirect Investment Regulations treat a CFC that funds another CFC as holding U.S. property purchased by the second CFC if there was a principal purpose to avoid the application of 956 to the funding CFC The regulations were recently expanded to include funding by any means (including capital contributions and debt) Reg (b)(1)(ii) 29

31 Funding: Capital Contribution Deemed $100 Loan? $100 Capital Contribution 1 US Parent CFC1 (E&P: $200) CFC2 (E&P: $0) $100 Loan 2 30

32 Funding: Loan Deemed $100 Loan? US Parent $100 Loan 2 CFC1 (E&P: $200) $100 Loan 1 CFC2 (E&P: $0) 31

33 Different FTC Pool ETR/PTI Deemed $100M Loan? US Parent $100M Loan Swiss CFC (8%) E&P: $250 Taxes: $20 $100M Loan Japan CFC (35%) PTI: $50 E&P: $1,300 Taxes: $700 Reg (b)(4), Ex. 3 (but, no double inclusion). 32

34 Funding by Any Means Comments requested exceptions for cash paid by CFC1 to CFC2 to purchase property, to repay a loan, or to pay a dividend because there is no increase in CFC2 s assets The IRS and Treasury rejected the request, but provided examples that under particular circumstances a purchase of property or repayment of a loan was not a funding It would seem that the indirect investment rule should not apply if it is necessary to create a fictional U.S. property asset on the balance sheet of a CFC 33

35 Do These Constitute a Funding? US Parent $450 Loan CFC1 $100 $150 1 Repay CFC2 Property Loan 2 CFC3 Zero E&P, PTI, or high-taxed E&P CFC4 $200 Dividend 3 Reg (b)(4), Exs. 5 & 6. 34

36 Facilitates Repayment of Loan Deemed $100M Loan? USP $100M Loan 1b $100M 1a Loan Bank CFC1 $100M Loan 2a CFC2 Repay $100M Loan 2b

37 Bank Intermediary Makes Loan to US Parent Deemed $100 Loan? US Parent Loan $100 2 Bank CFC1 1 * $100 deposit is deemed loan to US Parent if it facilitates Bank s loan to US Parent (Reg (b)(4), Ex. 4; Rev. Rul ) 36

38 Bank Intermediary Makes Loan to Related CFC Deemed $100M Loan? US Parent $100M Loan 3 CFC1 CFC2 1 $100M Deposit $100M Loan 2 Reg (b)(4), Ex. 4; Rev. Rul Bank 37

39 Short Term Loans

40 Exceptions for Short Term Loans Generally subject to /60 day exception Intra-quartile loans Alternating CFC loans 39

41 30/60 Day Exception Obligation collected within 30 days, and CFC does not have 956 loans to related U.S. persons outstanding during the year for 60 or more days Reg T(d)(2)(iv)(2016); see also Notice /GLAM

42 General Financing Structure USP (FY 12/31) $500 Commercial Paper Loan 3 rd Party Lenders CFC (FY 12/31) $500 Bank Deposit BANK 41

43 Quarter-End Loans: 30/60 Exception 2a 2b $500 Repayment USP 12/31 Year-End $500 Loan $500 Loan $500 Repayment 1b 1a 3 rd Party Lenders Loan to USP Repay CFC 3/25 4/ /25 7/10 15 Days Outstanding CFC 12/31 Year-End 9/25 10/ /25 1/10 16 Total 52 in year 1 10 in year 2 42

44 Potential Traps (slide 40) An inadvertent small loan of a CFC to a U.S. affiliate outstanding for a brief period can cause the CFC to fail the 60 day limitation ( cliff rule ) Loans of previously taxed income are counted (even though they do not result in a deemed dividend) But, 30/60 day test should apply on a CFC-by-CFC basis (subject to indirect investment rule) 43

45 USP Quarter-End Loans: CFC with Different Tax Year Does not rely on 30/60 exception $500 Repayment USP (FY 12/31) CFC (FY 11/30) $500 Loan Avoids cliff rule Loans can be outstanding more than 30 days (but equal days on and off to avoid step transaction) Loan to USP Repay CFC 3/15 5/1 47 6/15 8/1 47 9/15 11/ /15 2/1 48 Days Outstanding Total 157 in year 1 32 in year 2 44

46 Alternating CFC Loans: U.S. Cash Remains Constant Several CFCs may alternate in making loans to USP such that the U.S. cash remains constant Each CFC should have excess cash equal to its loan amount (whether deposited in a separate bank account or in a cash pool CFC) The U.S. borrower should be able to repay a CFC loan without the necessity of borrowing from another CFC IRS may challenge (but see GLAM : supports alternating loans). 45

47 $20 Million CFC Cash Continuously in U.S. $20M Loan * $20M Loan 1/1/11 to 3/26/11 7/5/11 to 9/26/11 USP $20M Loan 3/26/11 to 4/5/11 6/26/11 to 7/5/11 9/26/11 to 10/5/11 12/27/11 to 1/5/11 4/5/11 to 6/26/11 10/5/11 to 12/27/1 CFC #1 (FY 12/31) CFC #2 (FY 12/31) CFC #3 (FY 12/31) * Qualifies for 30/60 day exception (option to change one CFC to FY 11/30 to not rely on 30/60 exception). 46

48 Guarantees & Pledges

49 Beware of 956 Investments Resulting From Support of USP Obligations CFC guarantee of loan to USP (or crosscollateralization) USP pledges CFC stock as security for a loan CFC deposits cash with a bank that makes a loan to USP Multiple CFCs guarantee same loan? 48

50 Guarantee of U.S. Borrowing BANK Loan $1,000 USP CFC (E&P: $5,000) $1,000 Deemed Dividend* *See FSA (inclusions from each CFC guaranteeing same USP loan); CCA (accrued but unpaid interest on loan to USP is U.S. property). 49

51 Pledge CFC Stock to Support U.S. Loan * BANK $1,000 Loan US Parent 100% $1,000 Deemed Dividend CFC (E&P: $5,000) * Not an investment in U.S. property if pledge only 66% of voting stock. 50

52 Triggering 956 Inclusions

53 Foreign Tax Credit Planning Section 956 can be used affirmatively to cause earnings of a CFC to be treated as deemed distributed to the U.S. shareholders High taxed earnings may be triggered to provide FTCs to reduce U.S. tax on low taxed foreign source income (e.g., royalties) Low taxed earnings may be triggered to use up expiring FTCs New 960(c) limits the hopscotch rule Note: New 385 documentation requirements apply 52

54 Affirmatively Using 956 Loan from a CFC to a U.S. affiliate CFC guarantees obligation of U.S. affiliate Considerations IRS might seek to apply indirect investment rules to source 956 deemed dividend to another CFC that funds the CFC making a loan to a U.S. affiliate Quarter-end computations limit amount of deemed dividend (e.g., need twice amount desired if loan outstanding over 2 quarters) Avoid 30/60 exception 53

55 Utilization of Expiring FTCs $90 Loan (12 months) U.S. Parent Swiss Sales CFC (ETR: 10%) Absorbs $25 of excess credits. Creates PTI that can be distributed in a later year. Note: Using 956 avoids withholding tax and dividend restrictions. 54

56 CCA U.S. Parent USS1 $100 Loan (Per IRS) USS2 $100 Loan 1 2 CFC (10%) 55

57 Triggering Excess FTCs $600 Loan U.S. Parent Japan CFC (ETR: 40%) Brings $50 of excess FTCs Creates PTI that can be distributed in a later year Avoids dividend restrictions 56

58 Section 960(c) Section 960(c) limits deemed paid FTCs to the lesser of: FTs deemed paid under hopscotch rule ( tentative credit ) FTs deemed paid if the amount were distributed through the chain of ownership ( hypothetical credit ) FTs not deemed paid remain in the CFC s pool Note: 960(c) does not apply to Subpart F income inclusions (or 304 transactions) 57

59 Section 956 Applied to Lower-Tier CFC Compared to Prior Hopscotch Rule USP Former 956 Inclusion: $100/$200 x $100 = $50 FTCs $100 Loan LT CFC (ETR: 0%) E&P: $200 Taxes: $0 Section 960(c): Deemed $100 Dividend Thru Chain of Ownership $100/$300 x $50 = $16.7 FTCs HT CFC (ETR: 33%) E&P: $200 Taxes: $100 58

60 Computational Comparison Former ( Sec ) (Dividend) 960(c) Inclusion Sec. 78 GU U.S. Income U.S. Tax Before FTCs (35%) FTCs (50) (16.7) U.S. Tax

61 Intermediate HoldCo w/o E&P USP Section 954(c)(6): Tentative Credit - $43 Hypo Credit - $14 E&P: $200 Taxes: $0 E&P: $0 Taxes: $0 Swiss HoldCo Lux HoldCo $100 Loan DP FTCs - $14 No Section 954(c)(6): Tentative Credit - $43 Hypo Credit - $43 (hopscotch rule) DP FTCs - $43 E&P: $233 Taxes: $100 UK CFC Alt.: UK CFC pays dividend to Lux (See Notice ) 60

62 $2 for $1 of Taxable Dividend $100 Loan 1 $100 Basis 2 U.S. Parent Foreign Holding ($0 E&P) Foreign OpCo ($500 E&P) ($125 Taxes) $100 Distribution 4 $100 Loan 3 Foreign OpCo has earnings with a 20% effective tax rate The transactions provides the use of $200 in the U.S. with taxation on only $100 This provides an effective incremental U.S. tax rate of 7.5% (rather than 15%) Note: USP has zero basis in Foreign HoldCo, and thus a distribution of PTI would trigger taxable income (leave loan to USP outstanding) 61

63 Partnerships

64 Applying 956 to U.S. Property Held by a Partnership U.S. property held by a partnership is treated as owned by the partners in proportion to the liquidation value percentage (amount determined based on basis partnership has in property) (Reg (b)) If a CFC funds the U.S. property investment, the indirect investment rules may apply (Reg (b)(1)(iii)) First treat CFC as owning property under the general rule Second, CFC is treated as owning additional U.S. property under the funding rule 63

65 CFC Loan to a Foreign Partnership With U.S. Partners A CFC loan to a foreign partnership with related U.S. partners is treated as a loan to the U.S. partners (Reg (c)) In proportion to the liquidation value percentage Increased if partnership distributes a larger amount to the U.S. partners Similar rules if CFC guarantees a partnership obligation 64

66 Applying 956 to Partnerships CFC1 $100 Loan 1 25% US Parent 40% 35% Foreign Partnership CFC2 $100 Loan 2 Analysis General Rules: Loan 1: CFC1 treated as loaning $40 to USP Loan 2: CFC1 treated as holding $25 and CFC2 treated as holding $35 (LVP) If indirect investment rule applies, CFC1 treated as holding $100 of U.S. property (and CFC2 not treated as holding any) Reg (b)(4)(iv), Ex

67 CFC Loans to US Partnership or DE A domestic partnership is treated as a U.S. person (Reg (e)) Thus, a loan to a domestic partnership generally is treated as U.S. property even if all partners are CFCs The loan would not be U.S. property if neither the CFC nor any person related to the CFC (within the meaning of 954(d)(3)) is a partner Cf., Notice (domestic partnership owned by CFCs treated as a foreign partnership for certain purposes, although not for purposes of defining 956 U.S. property) An obligation of a disregarded entity is treated as an obligation of its owner (Reg (a)(3)). 66

68 CFC Loan to U.S. Partnership US Parent Analysis CFC1 s $100 loan is U.S. property CFC1 CFC2 CFC3 The $100 loan would not be U.S. property if US LLC were instead a foreign partnership 75% 25% US LLC 67

69 CFC Loan to Disregarded Entity Analysis Foreign DE $100 Loan 1 US Parent CFC1 CFC2 $100 loan to Foreign DE treated as loan to USP (U.S. property) $150 loan to US LLC treated as loan to CFC2 (not U.S. property) 2 US LLC 68

70 Post-Inversion Loans $100M Loan Shareholders Foreign Parent U.S. OpCo CFCs Dividend 1 Repay Debt 2 Loan or Capital Contribution 3a 3b Banks A loan to a foreign parent is not an investment in U.S. property (i.e., it is a loan to a foreign corporation). Query: If the cash is used to fund U.S. OpCo, could it be subject to the indirect investment rule? Reg T(a)(4)/Notice : Loan to foreign parent is U.S. property even if cash is not provided to U.S. OpCo (rule applies to inversions closed after )