The Subpart F rules can result in foreign profits being subject to tax in the U.S. In the recent Crestek v. Commissioner, 49 T.C. 5 (2017), the court addresses unpaid advances a controlled foreign corporation made to its U.S. parent. The case shows how easy it is for a U.S. corporation that has an outbound transactions to miss a transaction that results in foreign profits being subject to tax in the U.S.
About Section 956 Loans & Guarantees
Section 956 is part of the Subpart F rules enacted to subject profits of controlled foreign corporations (“CFC”) to tax in the U.S. Section 956 applies to investments in U.S. property. U.S. property includes related party loans and guarantees and, as described below, certain intercompany payables and receivables.
Prior to the enactment of Section 956, the earnings of CFCs were only subject to tax in the U.S. when the funds were repatriated or brought back to the U.S. via a dividend from the CFC to the U.S. parent Instead of bringing the funds back, the U.S. parent could just borrow the money from its CFC and avoid U.S. income tax despite having use of the money. Section 956 was intended to put a stop to this.
Under Section 956, the CFC’s current and accumulated earnings are deemed to have been distributed as a dividend to the U.S. parent at the time certain loans are made by the CFC to the U.S. parent or U.S. subsidiaries owned by the parent. This includes the CFC guaranteeing a loan or payment obligation for the U.S. parent or U.S. subsidiaries owned by the U.S. parent.
This is referred to as a “956 inclusion.” The tax departments for most U.S. corporations are constantly on the lookout for Section 956 inclusions. They are also planning around Section 956 to repatriate profits to the U.S. in a tax efficient manner. This is particularly true for U.S. corporations that have implemented transfer pricing structures to transfer substantial assets and/or accrue profits overseas.
The Crestek v. Commissioner Case
This brings us to the Crestek case. The taxpayer in Crestek is a U.S. corporation that owns several CFCs. The CFCs made loans to the taxpayer. The loans were recorded on the taxpayer’s books, but no payments were made on the loans. The taxpayer did not include the loans as income on its U.S. income tax returns.
One of the CFCs also guaranteed a loan from a third party bank (the bank was also located in a foreign country) for the U.S. corporation. The taxpayer did not include the loan guarantee as income on its U.S. income tax returns.
Two of the CFCs, both of which manufactured products overseas, purchased raw materials from one of the taxpayer’s U.S. subsidiaries. The CFCs then sold the manufactured products back to the taxpayer’s U.S. subsidiary. These transactions were recorded as intercompnay payables and receivables. The net amount owed by the U.S. subsidiary exceeded the amount owed to the U.S. subsidiary by the CFCs. These amounts were not included in the taxpayer’s income on its U.S. income tax returns.
The manufacturing and sale arrangement between the taxpayer and its CFCs was likely structured this way to ensure that the manufacturing profits were not subject to tax in the U.S. The case does not indicate whether this is the case, but the foreign CFC may even have had a favorable ruling to ensure that the foreign profits were not subject to tax or very high tax in the foreign country. The manufacturing and sale arrangement was likely even supported by a transfer pricing study.
The IRS audited the taxpayer’s returns and concluded that the intercompany loans, loan guarantee, and intercompany receivables held by the CFCs were taxable in the U.S. under Section 956.
The Intercompany Receivables
The court had little difficulty in concluding that the IRS was correct with respect to the intercompnay loans and loan guarantee. These are textbook examples of Section 956 inclusions. Most U.S. corporations will have an international tax director or manager who monitors and is able to identify and deal with these transactions. The intercompany receivables is where it gets interesting.
The intercompany receivables here were from a foreign manufacturing entity that purchased raw materials from the U.S. subsidiary and sold the final product back to the U.S. subsidiary. The manufacturing operations were transferred to another CFC prior to the years under audit and the second CFC essentially carried on the activities of the other CFC from that point on. The intercompany account receivable on the first CFC’s books was never closed out.
The Sale and Manufacturing Exception
As the taxpayer pointed out, normally, these intercompany receivables held by the CFCs would not be subject to Section 956. Section 956 includes an exception for obligations of U.S. persons arising in connection with the sale or processing of property.
The court noted that this exception does not apply here, at least to one of the CFCs, as the CFC had ceased its manufacturing operations:
This $7,919,758 receivable was a legacy of a business activity that CUM had terminated two years previously. While it was an obligation that originally arose “in connection with the sale or processing of property,” by FYE 2008 it was simply an open account owed to CUM by its U.S. affiliates. Having lost any connection to ongoing commercial transactions, the receivable was not “ordinary and necessary” because CUM and Ultrasonics were no longer engaged in a trade or business with each other.
Thus, by failing to close out or plan for the intercompany receivable held by this CFC when it ceased its manufacturing operations, its foreign profits from the prior tax years, which were reflected in an unpaid intercompany receivable on its books in the later periods under audit, were subject to tax in the U.S.
This is a type of arrangement that is very common and one that many U.S. corporations may miss when reviewing their intercompany transactions for Section 956 inclusions.