Corporation's Intercompany Transactions with CFCs Result in Income Recognition

(Parker Tax Publishing August 2017)

The Tax Court granted summary judgment and held that the following transactions constituted investments in U.S. property and thus resulted in various amounts being included in a corporation's income: (1) an outstanding intercompany loan balance owed by a subsidiary of the corporation to a controlled foreign corporation (CFC); (2) a CFC's guarantee of a subsidiary's loan and direct or indirect pledge of assets as security for that loan; and (3) a trade receivable balance owed by a subsidiary to a CFC. However, no summary judgment was granted where there remained a material dispute of fact as to whether trade receivable balances owed by a subsidiary to another CFC, which were incurred in an ongoing trade or business between those entities, were "ordinary and necessary" to carrying on their respective trades or businesses. Crestek, Inc. & Subs v. Comm'r, 149 T.C. No. 5 (2017).

Facts

Crestek, Inc. is the parent of a group of companies that includes a number of controlled foreign corporations (CFCs). Before fiscal year (FY) 2008, one of Crestek's domestic subsidiaries (S1) borrowed money from the CFCs, and those loans remained outstanding throughout FY 2008 and FY 2009. Also before FY 2008, S1 borrowed money from a Malaysian bank. CFC-1, Crestek's Malaysian subsidiary, guaranteed this loan. Before mid-2005, CFC-1 sold completed products to another domestic subsidiary (S2), for which S2 incurred payment obligations in the form of trade receivables. CFC-1 stopped manufacturing operations in mid-2005. The net trade receivable balance owed by S2 to CFC-1 remained constant at $7.92 million from mid-2005 through the end of FY 2009.

After mid-2005, another CFC, CFC-2, assumed the manufacturing activities of CFC-1 and sold completed products to S2. The net trade receivable balance owed by S2 to CFC-2 rose to $18.41 million in the last quarter of FY 2009.

After auditing Crestek, the IRS determined that all of these transactions gave rise to investments in "United States property" under Code Sec. 956(c)(1)(C) and accordingly determined that Crestek was required to include various amounts in gross income under Code Sec. 951(a)(1)(B).

Income Resulting from U.S. Ownership of a CFC

Under Code Sec. 951(a)(1)(B), each U.S. shareholder of a CFC generally must currently include in its gross income an amount determined under Code Sec. 956 with respect to that shareholder. Code Sec. 956 provides that U.S. shareholders of a CFC that invests certain earnings and profits in U.S. property must recognize income on the grounds that the investment is substantially the equivalent of a dividend being paid to them. The income inclusion amount is the lesser of:

(1) the excess, if any, of (a) the shareholder's pro rata share of the average of the amounts of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter of such tax year, over (b) the amount of earnings and profits of the CFC described in Code Sec. 959(c)(1)(A) with respect to such shareholder; or

(2) the shareholder's pro rata share of the applicable earnings of the CFC.

Code Sec. 956(c)(1) defines U.S. property for purposes of this rule and Code Sec. 956(c)(1)(C) provides that U.S. property includes an obligation of a U.S. person. Under Reg. Sec. 1.956-1(e)(1), the amount of the investment in U.S. property with respect to such obligation is the CFC's adjusted basis in the obligation reduced by certain liabilities. The amount includible in income is reduced by any previously taxed E&P of the CFC and the includible amount cannot exceed the U.S. shareholder's pro rata share of the applicable earnings of the CFC.

There are several types of property that are not considered U.S. property. For example, Code Sec. 956(c)(2)(C) provides that U.S. property does not include any obligation of a U.S. person arising in connection with the sale or processing of property if the amount of the obligation outstanding at no time during the tax year exceeds the amount that would be ordinary and necessary to carry on the trade or business of both the other party to the sale or processing transaction and the U.S. person had the sale or processing transaction been made between unrelated persons.

Crestek's Arguments

Crestek made several arguments against the income inclusion and an argument that most of the IRS's proposed Code Sec. 956 inclusions were attributable to investments in U.S. property that the CFCs had made in tax periods before FY 2008. In Crestek's view, the IRS was obligated to make any adjustments under Code Sec. 956 for the year in which the CFCs first acquired the U.S. property in question, not for any later period.

Crestek also argued that, even if a Code Sec. 956(a) inclusion is required, the Tax Court must redetermine its income for previous years to correctly account for current earnings and profits. Crestek cited Code Sec. 6214 for the proposition that the Tax Court, in redetermining a deficiency for a particular year, "shall consider such facts with relation to the taxes for other years as may be necessary correctly to redetermine the amount of such deficiency."

Tax Court's Decision

The Tax Court held that Crestek had to recognize income as a result of being a U.S. shareholder of CFCs that were investing E&P in U.S. property. According to the court, the outstanding intercompany loan balance owed by S1 to the CFCs constituted U.S. property held by the CFCs, within the meaning of Code Sec. 956(c)(1)(C), during FY 2008 and FY 2009. The court also held that CFC-1's guaranty of S1's loan and the direct or indirect pledge of assets as security for that loan constituted U.S. property held by CFC-1, within the meaning of Code Sec. 956(c)(1)(C) and (d), during FY 2008 and FY 2009. With respect to the $7.92 million trade receivable balance owed by S2 to CFC-1, which had been outstanding for at least three years and bore no interest, the court found that this was in excess of the amount that "would be ordinary and necessary" in a transaction between unrelated parties, within the meaning of Code Sec. 956(c)(2)(C), to carry on their respective trades or businesses. Thus, the court said, the trade receivable constituted U.S. property held by CFC-1 during FY 2008 and FY 2009.

However, the court denied summary judgment with respect to the CFC-2 transaction because there remained a material dispute of fact as to whether the trade receivable balances owed by S2 to CFC-2, which were incurred in an ongoing trade or business between those entities, were "ordinary and necessary" to carrying on their respective trades or businesses.

With respect to Crestek's argument that the IRS had to make any adjustments under Code Sec. 956 for the year in which the CFCs first acquired the U.S. property in question, the court said that the statute does not require that the income inclusion be made for the first year in which the CFC acquires its investment or that the inclusion be made for any particular year. To the contrary, the court noted that Code Sec. 956(a)(1)(A) defines the inclusion for any particular year by reference to "the amounts of United States property held (directly or indirectly) by the controlled foreign corporation" during that year. Thus, where a CFC holds an item of U.S. property for multiple years, Code Sec. 956(a) permits an inclusion in income for any one of those years.

With respect to the argument that the Tax Court had to redetermine Crestek's income for previous years to correctly account for current earnings and profits, the court found this argument misguided. Crestek's own E&P, the court said, was wholly irrelevant in determining the proper amount of a Code Sec. 956 inclusion attributable to investment in U.S. property by Crestek's CFCs. The entities whose tax attributes are relevant to this determination, the court said, are the CFCs and not Crestek's.

For a discussion of income resulting from investment in U.S. property, see Parker Tax ¶201,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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