Chief Counsel Advice concludes that accrued but unpaid interest constitutes an obligation of a US person for purposes of Section 956

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1 11 September 2014 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date Chief Counsel Advice concludes that accrued but unpaid interest constitutes an obligation of a US person for purposes of Section 956 Executive summary In Chief Counsel Advice memorandum (the CCA), the IRS Office of Chief Counsel International concluded that accrued but unpaid interest expense due on an obligation of a United States person itself constituted an obligation of a United States person for purposes of Section Discussion In general, each United States shareholder of a controlled foreign corporation (CFC) must include currently in its gross income the amount determined under Section 956 for that shareholder. 2 The amount determined under Section 956 for a US shareholder of a CFC for any tax year is the lesser of: (1) the excess, if any, of the shareholder s pro rata share of the average of the amounts of United States property held (directly or indirectly) by the CFC as of the close of each quarter of that tax year, over the amount of earnings and profits of the CFC described in Section 959(c)(1)(A) for that shareholder; or (2) the shareholder s pro rata share of the applicable earnings of the CFC. 3 An obligation of certain United States persons constitutes United States property for this purpose. The Treasury regulations under Section 956 define an obligation to include any bond, note, debenture, certificate, bill receivable, account receivable, note receivable, open account, or other indebtedness, whether or not issued at a discount and whether or not bearing interest. 4 The CFC need not hold

2 the obligation directly; a CFC is treated as holding any obligation of a United States person for which the CFC is a pledgor or guarantor. 5 The amount of the United States property considered held by the CFC is the unpaid principal amount of the obligation. 6 In the CCA, a United States corporation (US Borrower) had certain outstanding obligations. The exact nature of a pledge or guarantee is unclear. 7 The CCA provides as a fact, however, that the CFC is treated as holding the US Borrower s obligation for purposes of Section 956. The US Borrower s obligations unconditionally required it to pay stated interest at least annually. The CCA determined that the definition of an obligation under the Section 956, as well as the common law definition of indebtedness, 8 would treat any accrued but unpaid interest of an accrual-basis obligor (e.g., the US Borrower) as an obligation for purposes of Section 956. The CCA concluded that, due to the existing pledge or guarantee, the CFC was treated as holding not only the principal amount of the primary obligation, 9 but also the US Borrower s accrued but unpaid interest. Implications The CCA confirms that the amount of an obligation of a United States person that a CFC is considered to hold is not limited to the obligation s unpaid principal but also any accrued but unpaid interest (at least interest that is required unconditionally to be paid). In particular, United States shareholders with inclusions under Section 956 from one or more CFCs as a result of direct loans into the United States or pledges or guarantees of US indebtedness should consider the analysis of the CCA to determine whether the appropriate income inclusion is being reported. Further, for outstanding obligations not subject to Section 960(c), 10 query whether the CCA suggests that accrued but unpaid interest is a distinct obligation that, if created after the effective date of Section 960(c), may be subject to the foreign tax credit limitation under that section. 2 International Tax Alert

3 Endnotes 1. Section in this Alert references the applicable section of the Internal Revenue Code of 1986, as amended (the Code). Treas. Reg. Section references that section of the Treasury regulations promulgated under the Code. 2. Section 951(a). 3. Section 956(a). 4. Temp. Treas. Reg. Section T(d)(2)(i). 5. Treas. Reg. Section (c)(1). The pledge of two-thirds or more of the voting stock of a CFC is considered the indirect pledge of the CFC s assets if accompanied by certain negative covenants. Treas. Reg. Section (c)(2). 6. Treas. Reg. Section (e)(2). 7. Certain facts in the CCA were redacted. 8. The CCA cites a number of cases in support of this proposition. The CCA also notes several Treasury regulations and revenue rulings unrelated to Section 956 that are arguably congruent with the CCA s conclusion. See Treas. Reg. Section (c) (determining when a receivable of an accrual method taxpayer is treated as debt for purposes of Section 166); Treas. Reg. Section P-1(c) (defining indebtedness as including stated interest for purposes of information reporting for discharge of indebtedness); Revenue Ruling , (treating accrued interest as debt for which a bad debt deduction could be taken); and Revenue Ruling (treating the right to accrued but unpaid interest as a receivable). 9. See Treas. Reg. Section (e)(2) and Revenue Ruling (supra). 10. Section 960(c) limits the foreign tax credit for Section 956 inclusions to the amount of foreign income taxes that would have been deemed to have been paid during the tax year by the US shareholder if cash distributions in an amount equal to the Section 956 inclusion had been distributed directly or through the chain of ownership which begins with the relevant CFC, without considering foreign taxes imposed on actual distributions. International Tax Alert 3

4 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, Washington, DC Jose Murillo Allen Stenger Maria Martinez Ernst & Young LLP, International Tax Services, New York Stephen O Neil stephen.oneil@ey.com International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Jonny Lindroos, McLean, VA Financial Services Phil Green, New York Central Mark Muktar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City South America Luiz Sergio Vieira, São Paulo 4 International Tax Alert

5 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. International Tax Services About Ernst & Young s International Tax Services practices Our dedicated international tax professionals assist our clients with their cross-border tax structuring, planning, reporting and risk management. We work with you to build proactive and truly integrated global tax strategies that address the tax risks of today s businesses and achieve sustainable growth. It s how Ernst & Young makes a difference EYGM Limited. All Rights Reserved. EYG No. CM4717 This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com