[Federal Register Volume 60, Number 155 (Friday, August 11, 1995)]
[Rules and Regulations]
[Pages 40997-41016]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-19446]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[TD 8611]
RIN 1545-AS40
Conduit Arrangements Regulations
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to conduit
financing arrangements issued under the authority granted by section
7701(l). The final regulations apply to persons engaging in multiple-
party financing arrangements. The final regulations are necessary to
determine whether such arrangements should be recharacterized under
section 7701(l).
EFFECTIVE DATE: The regulations are effective September 11, 1995.
FOR FURTHER INFORMATION CONTACT: Elissa J. Shendalman of the Office of
the Associate Chief Counsel (International), (202) 622-3870 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in these final regulations
has been reviewed and approved by the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act (44 U.S.C.
3504(h)) under control number 1545-1440. The estimated annual burden
per recordkeeper is 10 hours.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP,
Washington, DC 20224, and to the Office of Management and Budget, Attn:
Desk Officer for the Department of Treasury, Office of Information and
Regulatory Affairs, Washington, DC 20503.
Background
On August 10, 1993, Congress enacted section 7701(l) of the
Internal Revenue Code (Code), which authorizes the
[[Page 40998]]
Secretary to ``prescribe regulations recharacterizing any multiple-
party financing transaction as a transaction directly among any 2 or
more parties where such recharacterization is necessary to prevent
avoidance of any tax imposed by [title 26].'' The legislative history
to section 7701(l) noted with approval a series of tax court and IRS
pronouncements that used ``substance over form'' principles to
recharacterize conduit financing arrangements, but stated that the
Secretary was not bound by the principles of these pronouncements in
developing regulations.
On October 14, 1994, the IRS published a notice of proposed
rulemaking in the Federal Register (59 FR 52110) under section 7701(l)
of the Code. These proposed regulations permit the district director to
disregard the participation of one or more intermediate entities in a
conduit financing arrangement for purposes of sections 871, 881, 1441,
and 1442.
Written comments responding to the notice were received, and a
public hearing was held on December 16, 1994. After considering the
written comments received and the statements made at the hearing, the
IRS and Treasury adopt the proposed regulation as revised by this
Treasury decision.
Explanation of Provisions and Summary of Significant Comments
A. Overview of Provisions
The final regulations make few substantive changes to the proposed
regulations. Most changes are in the nature of refinements to, and
clarifications of, the principles in the proposed regulations. It
should be noted that the IRS and Treasury will continue to monitor
conduit financing arrangements in the context of sections 871, 881,
1441 and 1442 after the publication of these final regulations. If the
rules announced herein do not sufficiently address the avoidance of
these taxes, the IRS and Treasury will consider modifying or
supplementing these rules as they find necessary.
Section 1.881-3(a)(2) of the final regulations provides definitions
of certain terms used throughout the regulations. A financing
arrangement is defined as a series of transactions by which one person
(the financing entity) advances money or other property, or grants
rights to use property, and another person (the financed entity)
receives money or other property, or the right to use property, if the
advance and receipt are effected through one or more other persons
(intermediate entities) and there are financing transactions linking
the financing entity, each of the intermediate entities, and the
financed entity. The final regulations supplement this basic rule with
an anti-abuse rule that allows the IRS to treat related persons as a
single entity where a taxpayer interposes a related person in an
arrangement that would otherwise qualify as a financing arrangement to
circumvent the application of the conduit rules.
A financing transaction includes a debt instrument, lease or
license. In addition, an equity instrument may qualify as a financing
transaction if the equity has certain debt-like characteristics. The
term financing transaction also includes any other advance of money or
property pursuant to which the transferee is obligated to repay or
return a substantial portion of the money or other property advanced or
the equivalent in value.
Section 1.881-3(a)(3)(i) authorizes the district director to
determine that an intermediate entity is a conduit entity under the
rules set forth in Sec. 1.881-3(a)(4). Section 1.881-3(a)(3)(ii)
describes the effects of conduit treatment. Section 1.881-
3(a)(3)(ii)(B) generally provides that the character of the payments
made under the recharacterized transaction (i.e. interest, rents, etc.)
is determined by reference to the character of the payments made to the
financing entity. However, if the financing transaction to which the
financing entity is a party gives rise to a type of payment that would
not be deductible if paid by the financed entity (e.g., dividends, as
determined under U.S. tax principles), the character of the payments is
not affected by the recharacterization.
Section 1.881-3(a)(3)(ii)(E) provides that a financing entity that
is unrelated to both the intermediate entity and the financed entity is
not liable for the tax imposed by section 881 unless it knows or has
reason to know of a conduit financing arrangement. Moreover, the final
regulations create a presumption that an unrelated financing entity
does not know or have reason to know of a conduit financing arrangement
where the intermediate entity that is a party to the financing
transaction with the financing entity is engaged in a substantial trade
or business.
Section 1.881-3(a)(4) provides the standards for determining
whether an intermediate entity is a conduit entity for purposes of
section 881. If an intermediate entity is related to either the
financing entity or the financed entity, the intermediate entity will
be a conduit entity only if (i) the participation of the intermediate
entity in the financing arrangement reduces the U.S. withholding tax
that otherwise would have been imposed, and (ii) the participation of
the intermediate entity in the financing arrangement is pursuant to a
plan one of the principal purposes of which is the avoidance of the
withholding tax.
If a financing arrangement involves multiple intermediate entities,
Sec. 1.881-3(a)(4)(ii)(A) provides that the district director will
determine whether each of the intermediate entities is a conduit
entity. The factors, presumptions, and other rules in the regulations
generally state how they should be applied in the case of multiple
intermediate entities. The regulations state that, if no such rule is
provided, the district director should apply principles consistent with
the standards described above. Section 1.881-3(a)(4)(ii)(B) provides a
general anti-abuse rule that allows the district director to treat
related intermediate entities as a single intermediate entity if he
determines that one of the principal purposes for the involvement of
multiple intermediate entities in the financing arrangement is to
prevent the characterization of an intermediate entity as a conduit
entity, to reduce the portion of a payment that is subject to
withholding tax or otherwise to circumvent the provisions of this
section. The district director's determination is to be based upon all
of the facts and circumstances, including, but not limited to, the
factors indicating whether the intermediate entity's participation in a
financing arrangement is pursuant to a tax avoidance plan.
Section 1.881-3(b) provides that the district director will weigh
all available evidence regarding the purposes for the intermediate
entity's participation in the financing arrangement. Moreover,
Sec. 1.881-3(b)(3) provides a presumption that a tax avoidance plan
does not exist where an intermediate entity that is related to either
the financing entity or the financed entity performs significant
financing activities with respect to the financing transactions making
up the financing arrangement.
In the case of an intermediate entity that is not related to either
the financing entity or the financed entity, the intermediate entity
will not be a conduit entity unless the requirements applicable to
related parties are met (that is, there is a reduction in the tax
imposed by section 881 and a tax avoidance plan) and, in addition, the
intermediate entity would not have participated in the financing
arrangement on substantially the same terms but for the fact that the
financing entity advanced money or property to (or entered into a lease
or license with) the intermediate entity. See Sec. 1.881-
[[Page 40999]]
3(a)(4)(i)(C). Under Sec. 1.881-3(c)(2), the district director may
presume that the intermediate entity would not have participated in the
financing arrangement on substantially the same terms but for the
financing transaction between the financing entity and the intermediate
entity if another person has provided a guarantee of the financed
entity's obligation to the intermediate entity. The term guarantee
includes, but is not limited to, a right of offset between the two
financing transactions to which the intermediate entity is a party.
Once the district director has disregarded the participation of a
conduit entity in a conduit financing arrangement, Sec. 1.881-
3(d)(1)(i) provides that a portion of each payment made by the financed
entity is recharacterized as a payment directly between the financed
entity and the financing entity. If the aggregate principal amount of
the financing transaction(s) to which the financed entity is a party is
less than or equal to the aggregate principal amount of the financing
transaction(s) linking any of the parties to the financing arrangement,
the entire amount of the payment by the financed entity shall be
recharacterized. If the aggregate principal amount of the financing
transaction(s) to which the financed entity is a party is greater than
the aggregate principal amount of the financing transaction(s) linking
any of the parties to the financing arrangement, then the
recharacterized portion shall be determined by multiplying the payment
by a fraction the numerator of which is equal to the lowest aggregate
principal amount of the financing transaction(s) linking any of the
parties to the financing arrangement and the denominator of which is
the aggregate principal amount of the financing transaction(s) to which
the financed entity is a party.
Under Sec. 1.881-3(d)(1)(ii)(A), the principal amount of a
financing transaction generally equals the amount of money, or the fair
market value of other property, advanced, or subject to a lease or
license, valued at the time of the financing transaction. However, in
the case of a financing arrangement where the same property is
advanced, or rights granted from the financing entity through the
intermediate entity (or entities) to the financed entity, the property
is valued on the date of the last financing arrangement. This rule is
intended to minimize the distortive effect of currency or other market
fluctuations when there is a time lag between financing transactions.
In addition, the principal amount of certain types of financing
transactions is subject to adjustment. Sections 1.881-3(d)(1)(ii) (B)
through (D) provide more detailed guidance regarding how these general
rules are applied to different types of financing transactions.
Section 1.881-4 uses the general recordkeeping requirements under
section 6001 to require a financed entity or any other person to keep
records relevant to determining whether such person is a party to a
financing arrangement and whether that financing arrangement may be
recharacterized under Sec. 1.881-3. Corporations that otherwise would
report certain information on total annual payments to related parties
pursuant to sections 6038(a) and 6038A(a) must also maintain such
records where the corporation knows or has reason to know that such
transactions are part of a financing arrangement. Specifically, the
final regulations require the entity to retain all records relating to
the circumstances surrounding its participation in the financing
transactions and financing arrangements, including minutes of board of
directors meetings and board resolutions and materials from investment
advisors regarding the structuring of the transaction.
Under Sec. 1.1441-7(d), any person that is a withholding agent for
purposes of section 1441 with respect to the transaction (whether the
financed entity or an intermediate entity that is treated as an agent
of the financing entity) must withhold in accordance with the
recharacterization if it knows or has reason to know that the financing
arrangement is a conduit financing arrangement. The final regulations
provide examples of how the ``knows or has reason to know'' standard,
which generally applies to all withholding agents, is to be applied in
this context.
B. Discussion of Significant Comments
Significant comments that relate to the application of the proposed
regulation and the responses to them, including an explanation of the
revisions made to the final regulation, are summarized below. Technical
or drafting comments that have been reflected in the final regulations
generally are not discussed.
1. General Approach
As described above, the final regulations adopt the general ``tax
avoidance'' standard of the proposed regulations. Several commentators
criticized the proposed regulations for setting forth new standards for
the recharacterization of conduit transactions. They argued that the
rulings that preceded these regulations required matching cash flows
from the financed entity to the conduit entity and from the conduit
entity to the financing entity. Some commentators argued that, because
in their view the regulations adopt new standards, the regulations
should only be effective for transactions entered into after the
enactment of section 7701(l), while others argued that the regulations
should only apply to transactions entered into after the publication of
the final regulations. Finally, some commentators suggested that the
regulations constituted an override of our treaty obligations and might
therefore be invalid.
The IRS and Treasury believe that pre-section 7701(l) conduit
rulings rested on a taxpayer having a tax avoidance purpose for
structuring its transactions. The fact that an intermediate entity
received and paid matching, or nearly matching, cash flows was evidence
that the participation of the intermediate entity in the transaction
did not serve a business purpose. Nevertheless, the fact that cash
flows were not matched did not mean that the transaction had a business
purpose.
The final regulations generally apply to payments made by financed
entities after the date which is 30 days after the date of publication
of the regulations because the IRS and Treasury believe that the
regulations reflect existing conduit principles. Moreover, even if the
regulations had adopted a new standard, it would be inappropriate to
grandfather transactions that admittedly had a tax avoidance purpose.
The final regulations do not apply to interest payments covered by
section 127(g)(3) of the Tax Reform Act of 1984, and to interest
payments with respect to other debt obligations issued prior to October
15, 1984 (whether or not such debt was issued by a Netherlands Antilles
corporation). Prior law continues to apply with respect to payments on
any such debt instruments.
As noted in the preamble to the proposed regulations, the IRS and
Treasury believe that these regulations supplement, but do not conflict
with, the limitation on benefits articles in tax treaties. They do so
by determining which person is the beneficial owner of income with
respect to a particular financing arrangement. Because the financing
entity is the beneficial owner of the income, it is entitled to claim
the benefits of any income tax treaty to which it is entitled to reduce
the amount of tax imposed by section 881 on that income. The conduit
entity, as an agent of the financing entity, cannot claim the benefits
of a treaty to reduce the amount of tax due under section 881
[[Page 41000]]
with respect to payments made pursuant to the financing arrangement.
2. Discretion given to District Director
a. Determination of whether conduit entity's participation will be
disregarded. Because the proposed regulations utilize a tax avoidance
test that depends on the facts and circumstances, discretion is given
to the district director to determine whether the participation of an
intermediate entity had as one of its principal purposes the avoidance
of U.S. withholding tax. Among other things, the district director may
determine the composition of the financing arrangement and the number
of parties to the financing arrangement.
Some commentators criticized this grant of discretion because they
claimed that the regulations provide insufficient guidance regarding
what factors the district director should take into account. Several
commentators proposed adding presumptions, making certain existing
presumptions irrebuttable or otherwise providing bright-line tests. One
commentator suggested that the district director's discretion to
determine the parties to a financing arrangement should be limited to
the extent necessary to ensure that a taxpayer could prove that a
different party that was entitled to treaty benefits was the real
financing entity. Finally, another commentator suggested that the
determination whether an intermediate entity's participation will be
disregarded should be subject to review by a central control board in
the National Office of the IRS.
Because the final regulations retain the facts and circumstances
test used in the proposed regulations, the final regulations do not
significantly reduce the district director's discretion. As discussed
below, it was not considered necessary to add additional factors
because the objective list of factors is not exclusive. The final
regulations do, however, provide more guidance regarding the tax
avoidance purpose test by adding several more examples. In addition,
the final regulations modify the factor relating to whether there has
been a significant reduction in tax to allow the taxpayer to produce
evidence that there was not a reduction in tax because the entity that
was the ultimate source of funds also was entitled to treaty benefits.
See Sec. 1.881-3(b)(2)(i).
The final regulations do not adopt the suggestion that the district
director's discretion be subject to review at the National Office
level. The final regulations, like the proposed regulations, provide
that the determination of whether a tax avoidance plan exists is based
on all of the facts and circumstances surrounding the intermediate
entity's participation in the financing arrangement. The IRS and
Treasury believe that such a determination would best be made at the
local level.
b. Judicial standard of review. Because the district director is
granted discretion by the regulations, his determinations generally
will be reviewed by the court under an abuse of discretion standard.
Commentators suggested that the district director's determination that
an intermediate entity's participation should be disregarded should be
reviewed by the court under this standard. One commentator instead
suggested that courts review a district director's determination using
a de novo standard of review. Another suggested that the IRS should be
afforded only its normal presumption of correctness. The final
regulations do not adopt these suggestions because they are
fundamentally inconsistent with the grant of discretion to the district
director.
3. Definitions
a. Financing transaction, in general. Commentators pointed out that
thedefinition of financing transaction in the proposed regulations
encompassed transactions that clearly were not meant to be covered by
the proposed regulations. For example, under the proposed regulations,
a foreign parent that contributed an existing note from its domestic
subsidiary to a foreign subsidiary in exchange for common stock of the
subsidiary that did not have any debt-like features nevertheless would
be treated as a financing entity because the foreign parent had made an
advance of property (the note) pursuant to which the foreign subsidiary
had ``become a party to an existing financing transaction''.
The definitions of financing transaction and financing arrangement
have been redrafted to address these concerns. See Sec. 1.881-3(a)(2)
(i) and (ii). The effect of the new definitions is to take a
``snapshot'' after all the transactions are in place to determine
whether there is a financing arrangement.
b. Equity. Commentators noted that the proposed regulations were
inconsistent in their treatment of how a controlling interest in a
corporation, either before or after a default, affected whether an
equity arrangement was a financing transaction. In addition,
commentators requested that the final regulations explicitly exempt
``common stock'' and ``ordinary preferred stock'' from treatment as
financing transactions.
In response to the first of these comments and in a general attempt
to clarify the types of equity instruments that are financing
transactions, the final regulations revise the definition of financing
transaction with respect to equity. See Sec. 1.881-3(a)(2)(ii) (A)(2)
and (B). The new definition provides that the right to elect the
majority of the board of directors will not, in and of itself, cause an
equity instrument to be a financing arrangement. See Sec. 1.881-
3(a)(2)(ii)(B)(2)(i).
As to the second suggestion, the final regulations do not create a
separate exception from the definition of financing transaction for
``common stock'' or ``ordinary perpetual preferred stock.'' Whether a
transaction constitutes a financing transaction depends upon the terms
of the transaction, not simply on the label attached to the
transaction. Moreover, because these terms are not themselves well-
defined in either the Code or common law, the IRS and Treasury believe
that excluding these categories of instruments would lead to disputes
as to whether a particular instrument is ``common stock'' or, if not,
whether it is ``ordinary'' perpetual preferred stock.
c. Guarantees. Commentators asked that final regulations explicitly
provide that guarantees are exempted from treatment as financing
transactions. The IRS and Treasury believe that the new definition of
financing transaction, which does not treat becoming a party to a
financing transaction as itself a financing transaction, clarifies that
a guarantee is not a financing transaction. Moreover, the final
regulations add an example to eliminate any doubt in this regard. See
Sec. 1.881-3(e) Example 1.
d. Leases and licenses. The proposed regulations provide that
leases and licenses are financing transactions. Some commentators
suggested that the regulations not include leases and licenses in the
definition of financing transaction or that the IRS reserve on the
subject of leases until it had more time to study the matter.
Other commentators proposed that certain types of leases, for
instance short-term leases and leveraged leases, be excluded from the
definition of financing transaction. The commentators pointed out that
certain leveraged leases would be subject to recharacterization under
the proposed regulations even though, in substance, the financing
arrangement is the equivalent of a loan from a financing entity
entitled to a zero rate of withholding on interest. Under Sec. 1.881-
3(d)(2) of the proposed regulations,
[[Page 41001]]
which provides that the nature of the recharacterized payments is
determined by reference to the transaction to which the financed entity
is a party, the participation of the intermediate entity in a leveraged
lease would substantially reduce the tax imposed under section 881 if
the treaty between the United States and the country in which the
lender was organized allowed withholding on rental payments. Because
all of the negative factors of Sec. 1.881-3(c)(2) and the ``but-for''
test of Sec. 1.881-3(b) of the proposed regulations are met in a
standard leveraged lease, this reduction in tax would allow the
district director to recharacterize the financing arrangement as a
conduit financing arrangement.
The IRS and Treasury believe that all leases and licenses, of
whatever duration, can be used by taxpayers to structure a conduit
financing arrangement. Accordingly, the final regulations continue to
include leases and licenses in the definition of financing transaction.
See Sec. 1.881-3(a)(2)(ii)(A)(3). However, the final regulations change
the character rule in the case of deductible payments. In those cases,
the character of the payments under the recharacterized transaction is
determined by reference to the financing transaction to which the
financing entity is a party. As a result, under the final regulations,
a leveraged lease generally will not be recharacterized as a conduit
arrangement if the ultimate lender would be entitled to an exemption
from withholding tax on interest received from the financed entity,
even if rental payments made by the financed entity to the financing
entity would have been subject to withholding tax.
e. Related. As noted above, it is more difficult for an
intermediate entity to be a conduit entity if it is not related to
either the financing entity or the financed entity. The definition of
persons who are related to another person generally follows the
definition used in section 6038A. One commentator suggested that the
final regulations eliminate the constructive ownership rule of section
267(c)(3) from the definition of related. The same commentator further
suggested that a person under common control within the meaning of
section 482 should not be a related person for purposes of this
regulation.
The IRS and Treasury believe that the term related should be
broadly defined to ensure that the additional protection from
recharacterization provided by the so-called ``but for'' test flows
only to those entities that are not under the effective control of
either the financing or the financed entity. Accordingly, the final
regulations retain the definition of related provided in the proposed
regulations. See Sec. 1.881-3(a)(2)(v).
4. Factors Indicating the Presence or Absence of a Tax Avoidance Plan
a. In general. The proposed regulations provide that whether the
participation of the intermediary in the financing arrangement is
pursuant to a tax avoidance plan is determined based on all the
relevant facts and circumstances. In addition, the proposed regulations
provide a list of some of the factors that will be taken into account:
the extent of the reduction in tax; the liquidity of the intermediate
entity; the timing of the transactions; and, in the case of related
entities, the nature of the business(es) of such entities.
Commentators asked that the final regulations adopt a number of
additional factors. For example, commentators asked that the
dissimilarity of cash flows or of financing transactions making up the
financing arrangement constitute a positive factor (i.e., a factor that
evidences the absence of a tax avoidance plan). Commentators also
suggested that the positive factors include the fact that income was
subject to net tax in the United States or in a foreign jurisdiction
or, alternatively, that the transaction reduced other U.S. or foreign
taxes more than it reduced the U.S. withholding tax (indicating that
the purpose of the transaction was to avoid taxes other than the tax
imposed by section 881).
The factors proposed by commentators generally relate to the issue
of whether there were purposes, other than the avoidance of the tax
imposed by section 881, for the participation of the intermediate
entity in the financing arrangement. The final regulations do not add
factors relating to purposes for the participation of an intermediate
entity in a financing arrangement. However, Sec. 1.881-3(b)(1) of the
final regulations addresses the issue by clarifying that the district
director will consider all available evidence regarding the purposes
for the participation of the intermediate entity.
b. Factor relating to a complementary or integrated business. One
of the factors listed in the proposed regulations is whether, if the
intermediate entity is related to the financed entity, the two parties
enter into a financing transaction to finance a trade or business
actively engaged in by the financed entity that forms a part of, or is
complementary to, a substantial trade or business actively engaged in
by the intermediate entity. One commentator expressed uncertainty as to
the policy behind this factor.
The intent of this factor was to take into account the fact that
related corporations engaged in integrated businesses may enter into
many financing transactions in the course of conducting those
businesses, the vast majority of which have no tax avoidance purpose.
Accordingly, Sec. 1.881-3(b)(2)(iv) of the final regulations clarifies
that the district director will take into account whether a transaction
is entered into in the ordinary course of integrated or complementary
trades or businesses in determining whether there is a tax avoidance
plan. In addition, the factor is broadened so as to apply not only to
transactions between the intermediate entity and the financed entity
but to transactions between any two parties to the financing
arrangement that are related to each other.
5. Presumption Regarding Significant Financing Activities
The proposed regulations provide that, in the case of an
intermediate entity that is related to either the financing entity or
the financed entity, a presumption of no tax avoidance arises where the
intermediate entity performs significant financing activities for such
entities. Among other things, the provision required employees of the
intermediate entity (other than an intermediate entity that earned
``active rents'' or ``active royalties'') to manage ``business risks''
arising from the transaction on an ongoing basis. The proposed
regulations provide an example showing that, if there are no such
business risks because the intermediate entity has hedged itself fully
at the time it entered into the financing transactions, the entity is
not described in the provision.
One commentator criticized the articulation of the significant
financing activities presumption in the proposed regulations on the
grounds that the test should be solely whether the participation of the
intermediate entity produces (or could be expected to produce)
efficiency savings through a reduction in overhead costs and the
ability to hedge the group's positions on a net basis. Another
commentator proposed extending the presumption for significant
financing activities to intermediate entities that are unrelated to
both the financed entity and the financing entity.
As to the first comment, the IRS and Treasury agree that there is
not a sufficient business purpose for the centralization of financing
activities of a group of related corporations in a single
[[Page 41002]]
corporation unless the taxpayer anticipates efficiency savings.
Although the prospect of such savings in general may establish a
business purpose for the establishment of the subsidiary, it does not
prevent the subsidiary from acting as a conduit with respect to any
particular financing arrangement. This is demonstrated by the hedging
example described above, the rationale for which is that either the
financed entity or the financing entity could have entered into the
long-term hedge so there is no economic justification for the
participation of the intermediate entity in the particular financing
arrangement. The IRS and Treasury believe that an affiliate that is not
taking a continuing active role in coordinating and managing a
financing transaction should not be entitled to the presumption that
its participation is not pursuant to a tax avoidance plan.
As to the suggestion of extending the significant financing
activities presumption to unrelated parties, the IRS and Treasury
believe that this extension would be inconsistent with the purpose of
the presumption. The significant financing presumption recognizes that
there are legitimate business reasons for conducting financing
activities through a centralized financing and hedging subsidiary. The
decision to have an unrelated intermediate entity participate in a
financing transaction is based on different considerations, including
the regulatory effects of such transactions and the interests of the
shareholders of the unrelated intermediary. These considerations are
addressed by providing that such entities will not be conduit entities
unless they satisfy the ``but for'' test. The final regulations do not
extend the significant financing activities presumption to unrelated
parties.
Accordingly, the requirements for the significant financing
activities presumption in Sec. 1.881-3(b)(3) of the final regulations
are generally the same as those in the proposed regulations. However,
the final regulations do add a requirement that the participation of
the intermediate entity generate efficiency savings, and change the
term business risks to market risks (to differentiate the risks of
currency and interest rate movements from other, primarily credit,
risks). In addition, one of the examples that illustrates the
significant financing activities presumption has been revised to
indicate that a finance subsidiary may be managing market risks even in
the case of a fully-hedged transaction if the intermediate entity
routinely terminates such long term arrangements when it finds cheaper
hedging alternatives. See Sec. 1.881-3(e) Example 22.
6. ``But for'' Test
a. In general. Under the proposed regulations, if the intermediate
entity is not related to either the financing entity or the financed
entity, the financing arrangement will not be recharacterized unless
the intermediate entity would not have participated in the financing
arrangement on substantially the same terms ``but for'' the fact that
the financing entity advanced money or property to (or entered into a
lease or license with) the intermediate entity.
Commentators asked for clarification regarding what it means for
terms to be not substantially the same. One commentator proposed using
the standards for material modifications under section 1001.
The IRS and Treasury believe that an attempt to set forth a
comprehensive system of bright-line rules like those suggested by
commentators would add unnecessary complexity to the regulation, given
its anti-abuse purpose. Accordingly, the final regulations make no
change to the proposed regulations in this regard.
b. Presumption where financing entity guarantees the liability of
the financed entity. Under the proposed regulations, it is presumed
that the intermediate entity would not have participated in the
financing arrangement on substantially the same terms if, in addition
to entering into a financing transaction with the intermediate entity,
the financing entity guarantees the financed entity's liabilities under
its financing transaction with the intermediate entity. A taxpayer may
rebut this presumption by producing clear and convincing evidence that
the intermediate entity would have participated in the financing
arrangement on substantially the same terms even if the financing
entity had not entered into a financing transaction with the
intermediate entity.
Several commentators asked for clarification of this presumption.
Some commentators suggested that the existence of a guarantee makes the
existence of the financing transaction between the financing entity and
the intermediate entity irrelevant to the determination of whether the
intermediate entity would have participated in the financing
arrangement on substantially the same terms. Another commentator
proposed eliminating the ``clear and convincing evidence'' standard on
the grounds that it is too difficult an evidentiary burden for the
taxpayer to overcome.
The presumption regarding guarantees originated in Rev. Rul. 87-89
(1987-2 C.B. 195), which articulated the ``but for'' test in
substantially the same terms as adopted in the final regulations. Rev.
Rul. 87-89 provided that a statutory or contractual right of offset is
presumptive evidence that the unrelated intermediary would not have
participated in the financing arrangement on substantially the same
terms without the financing transaction from the financing entity. The
proposed regulations extend the presumption to all guarantees in order
to prevent taxpayers from using forms of credit support other than the
right of offset to avoid this presumption. The final regulations retain
this rule. See Sec. 1.881-3(c)(2).
The final regulations also retain the ``clear and convincing
evidence'' standard. The taxpayer always must overcome the presumption
of correctness in favor of the government by a preponderance of the
evidence. Therefore, in order for this additional presumption to have
any effect, it is necessary to raise the evidentiary standard. In
addition, this standard of proof is not unreasonable, because an
intermediate entity that is unrelated to the financing entity and the
financed entity and that proves, by clear and convincing evidence, that
it would have entered into the financing arrangement on substantially
the same terms will avoid recharacterization as a conduit entity even
though its participation in the financing arrangement is pursuant to a
tax avoidance plan.
7. Multiple Intermediate Entities
a. In general. The proposed regulations provide guidance as to how
some but not all of the operative provisions and presumptions apply to
multiple intermediate entities. Several commentators asked that the
final regulations clarify the manner in which the operative rules apply
in the case of multiple intermediate entities. The final regulations
provide additional guidance in the relevant operative rules and
presumptions. In addition, the final regulations modify the example in
the proposed regulations relating to multiple intermediate entities to
clarify how some of these provisions and presumptions apply. See
Sec. 1.881-3(e) Example 8.
b. Special rule for related persons. Section 1.881-3(a)(4)(ii)(B)
of the proposed regulations allows the district director to treat
related persons as a single intermediate entity if he determines that
one of the principal purposes for the structuring of a transaction was
the avoidance of the
[[Page 41003]]
application of the conduit financing arrangement rules. Several
commentators suggested that the final regulations eliminate this
section. One commentator suggested that the rule be limited to
situations where one related corporation made an equity investment in
another. Another believed that the IRS and Treasury should ``wait and
see'' whether such a rule was really necessary to prevent taxpayers
from circumventing the conduit financing arrangement rules.
The IRS and Treasury believe that an anti-abuse rule is necessary
to prevent the circumvention of these rules through manipulation of the
definition of financing arrangement. Accordingly, Sec. 1.881-
3(a)(2)(i)(B) of the final regulations retains the related party anti-
abuse rule. Moreover, the final regulations include another more
general anti-abuse rule that allows the district director to treat
related intermediate entities as a single intermediate entity if he
determines that one of the principal purposes for the involvement of
multiple intermediate entities in the financing arrangement is to
prevent the characterization of an entity as a conduit, to reduce the
portion of a payment that is subject to withholding tax or otherwise to
circumvent any other provision of this section. See Sec. 1.881-
3(a)(4)(ii)(B). This rule prevents a taxpayer from structuring a
financing transaction with a small principal amount to reduce the
amount of the recharacterized payment, and thus replaces the second
half of the rule set forth in proposed regulation Sec. 1.881-
3(a)(4)(ii)(B). This rule is illustrated in Sec. 1.881-3(e) Example 7.
8. Principal Amount
The proposed regulations provide that the principal amount of a
financing transaction shall be determined on the basis of all of the
facts and circumstances. Under the proposed regulations, the principal
amount generally equals the amount of money, or the fair market value
of other property (determined as of the time that the financing
transaction is entered into), advanced in the financing transaction.
The principal amount of a financing transaction is subject to
adjustments, as appropriate.
Some commentators asked for clarification regarding whether
adjustments would be made to the principal amount of a financing
transaction to take account of amortization or depreciation. Another
commentator suggested that the final regulations provide that
calculations be performed in the functional currency of the
intermediate entity in order to isolate currency fluctuations.
The final regulations provide that adjustments for depreciation and
amortization are made when calculating the principal amount of a
leasing or licensing financing transaction. See Sec. 1.881-
3(d)(1)(ii)(A).
Although the IRS and Treasury agree that the effect of currency
fluctuations should be minimized, they believe that determining the
principal amount in the functional currency of the intermediate entity
would not always yield the correct result. Accordingly, the final
regulations eliminate currency and market fluctuations to the extent
possible by providing that, when the same property has been advanced by
the financing entity and received by the financed entity, the
determination of the principal amount is made as of the date the last
financing transaction is entered into. See Sec. 1.881-3(d)(1)(ii)(A).
An example has been added to demonstrate how this rule applies to
transactions in currencies other than the U.S. dollar. See Sec. 1.881-
3(e) Example 25.
9. Correlative Adjustments
The proposed regulations do not provide for correlative adjustments
in the case of the district director's recharacterization of a
financing arrangement as a transaction directly between a financing
entity and a financed entity.
Commentators have requested that taxpayers be allowed to make
correlative adjustments if their transactions are recharacterized.
Commentators generally would not, however, allow the IRS to make
correlative adjustments where such adjustments would result in greater
tax liability.
The final regulations, like the proposed regulations, do not
provide for correlative adjustments. The IRS and Treasury agree with
commentators that it is not appropriate to use regulations that are
intended to prevent the avoidance of tax under section 881 to
recharacterize transactions for purposes of other code sections.
Accordingly, taxpayers should not be able to use these regulations to
make correlative adjustments to their tax returns.
10. Recordkeeping and Reporting Requirements
The proposed regulations require corporations that would otherwise
report certain information on total annual payments to related parties
pursuant to sections 6038(a) and 6038A(a) to report such information on
a transaction-by-transaction basis where the corporation knows or has
reason to know that such transactions are part of a financing
arrangement. In addition, the proposed regulations require a financed
entity or any other person to keep records relevant to determining
whether such person is a party to a financing arrangement that is
subject to recharacterization as part of their general recordkeeping
requirements under section 6001.
Commentators criticized the reporting requirements imposed by the
proposed regulation as unduly burdensome in that they would require
reporting of all financing arrangements and not simply those subject to
recharacterization as conduit financing arrangements. Moreover, they
pointed out that, because the regulations only would require reporting
of those transactions to which the financed entity is a party, the
information reported would not be of significant value. The reported
information would not be sufficient to allow the IRS to connect the
reported financing transaction to the other financing transactions
making up a financing arrangement.
The final regulations eliminate the reporting requirements provided
in the proposed regulations and provide more specific guidance as to
the type of records affected entities must retain. The recordkeeping
requirements of Sec. 1.881-4 have been revised to incorporate all of
the information that entities would have had to report under the
proposed regulations. In addition, the final regulations require the
entity to retain all records relating to the circumstances surrounding
its participation in the financing transactions and financing
arrangements, including minutes of board of directors meetings and
board resolutions and materials from investment advisors regarding the
structuring of the transaction. See Sec. 1.881-4(c)(2).
11. Withholding Obligations
Under the proposed regulations, a person that is otherwise a
withholding agent is required to withhold tax under section 1441 or
section 1442 in accordance with the recharacterization of a financing
arrangement if the person knows or has reason to know that the
financing arrangement is subject to recharacterization under sections
871 or 881. Commentators asked for additional guidance regarding the
application of the ``know or have reason to know'' standard in the
context of conduit financing arrangements. The final regulations
include several examples regarding the circumstances in which a
financed entity does and does not have
[[Page 41004]]
reason to know of the existence of a conduit financing arrangement.
C. Status of Revenue Rulings
The proposed regulations did not address the status of the existing
revenue rulings relating to conduit arrangements. Commentators have
asked for guidance regarding their status.
Concurrent with the publication of these regulations, the IRS is
issuing a revenue ruling modifying the existing rulings. The revenue
ruling limits the application of the old revenue rulings in the context
of withholding tax to payments made before the effective date of the
final regulations and to other provisions not covered by the conduit
regulations.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It is hereby certified that
these regulations will not have a significant economic impact on a
substantial number of small entities. Accordingly, a regulatory
flexibility analysis is not required. This certification is based on
the information that follows. These regulations affect entities engaged
in cross-border multiple-party financing arrangements. It is assumed
that a substantial number of small entities will not engage in such
financing arrangements. Pursuant to section 7805(f) of the Internal
Revenue Code, the notice of proposed rulemaking preceding these
regulations was submitted to the Small Business Administration for
comment on its impact on small businesses.
Drafting Information: The principal author of these regulations
is Elissa J. Shendalman, Office of the Associate Chief Counsel
(International). However, other personnel from the IRS and the
Treasury Department participated in their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by
removing the entry for ``Sections 1.6038A-1 through 1.6038A-7'' and
adding entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.871-1 also issued under 26 U.S.C. 7701(l). * * *
Section 1.881-3 also issued under 26 U.S.C. 7701(l).
Section 1.881-4 also issued under 26 U.S.C. 7701(l). * * *
Section 1.1441-3 also issued under 26 U.S.C. 7701(l). * * *
Section 1.1441-7 also issued under 26 U.S.C. 7701(l). * * *
Section 1.6038A-1 also issued under 26 U.S.C. 6038A.
Section 1.6038A-2 also issued under 26 U.S.C. 6038A.
Section 1.6038A-3 also issued under 26 U.S.C. 6038A and 7701(l).
Section 1.6038A-4 also issued under 26 U.S.C. 6038A.
Section 1.6038A-5 also issued under 26 U.S.C. 6038A.
Section 1.6038A-6 also issued under 26 U.S.C. 6038A.
Section 1.6038A-7 also issued under 26 U.S.C. 6038A. * * *
Section 1.7701(l)-1 also issued under 26 U.S.C. 7701(l). * * *
Par. 2. In Sec. 1.871-1, paragraph (b)(7) is added to read as
follows:
Sec. 1.871-1 Classification and manner of taxing alien individuals.
* * * * *
(b) * * *
(7) Conduit financing arrangements. For rules regarding conduit
financing arrangements, see Secs. 1.881-3 and 1.881-4.
* * * * *
Par. 3. Sections 1.881-0, 1.881-3 and 1.881-4 are added to read as
follows:
Sec. 1.881-0 Table of contents.
This section lists the major headings for Secs. 1.881-1 through
1.881-4.
Sec. 1.881-1 Manner of Taxing Foreign Corporations
(a) Classes of foreign corporations.
(b) Manner of taxing.
(1) Foreign corporations not engaged in U.S. business.
(2) Foreign corporations engaged in U.S. business.
(c) Meaning of terms.
(d) Rules applicable to foreign insurance companies.
(1) Corporations qualifying under subchapter L.
(2) Corporations not qualifying under subchapter L.
(e) Other provisions applicable to foreign corporations.
(1) Accumulated earnings tax.
(2) Personal holding company tax.
(3) Foreign personal holding companies.
(4) Controlled foreign corporations.
(i) Subpart F income and increase of earnings invested in U.S.
property.
(ii) Certain accumulations of earnings and profits.
(5) Changes in tax rate.
(6) Consolidated returns.
(7) Adjustment of tax of certain foreign corporations.
(f) Effective date.
Sec. 1.881-2 Taxation of Foreign Corporations Not Engaged in U.S.
Business
(a) Imposition of tax.
(b) Fixed or determinable annual or periodical income.
(c) Other income and gains.
(1) Items subject to tax.
(2) Determination of amount of gain.
(d) Credits against tax.
(e) Effective date.
Sec. 1.881-3 Conduit Financing Arrangements
(a) General rules and definitions.
(1) Purpose and scope.
(2) Definitions.
(i) Financing arrangement.
(A) In general.
(B) Special rule for related parties.
(ii) Financing transaction.
(A) In general.
(B) Limitation on inclusion of stock or similar interests.
(iii) Conduit entity.
(iv) Conduit financing arrangement.
(v) Related.
(3) Disregard of participation of conduit entity.
(i) Authority of district director.
(ii) Effect of disregarding conduit entity.
(A) In general.
(B) Character of payments made by the financed entity.
(C) Effect of income tax treaties.
(D) Effect on withholding tax.
(E) Special rule for a financing entity that is unrelated to
both intermediate entity and financed entity.
(iii) Limitation on taxpayers's use of this section.
(4) Standard for treatment as a conduit entity.
(i) In general.
(ii) Multiple intermediate entities.
(A) In general.
(B) Special rule for related persons.
(b) Determination of whether participation of intermediate
entity is pursuant to a tax avoidance plan.
(1) In general.
(2) Factors taken into account in determining the presence or
absence of a tax avoidance purpose.
(i) Significant reduction in tax.
(ii) Ability to make the advance.
(iii) Time period between financing transactions.
(iv) Financing transactions in the ordinary course of business.
(3) Presumption if significant financing activities performed by
a related intermediate entity.
(i) General rule.
(ii) Significant financing activities.
(A) Active rents or royalties.
(B) Active risk management.
(c) Determination of whether an unrelated intermediate entity
would not have participated in financing arrangement on
substantially same terms.
(1) In general.
[[Page 41005]]
(2) Effect of guarantee.
(i) In general.
(ii) Definition of guarantee.
(d) Determination of amount of tax liability.
(1) Amount of payment subject to recharacterization.
(i) In general.
(ii) Determination of principal amount.
(A) In general.
(B) Debt instruments and certain stock.
(C) Partnership and trust interests.
(D) Leases and licenses.
(2) Rate of tax.
(e) Examples.
(f) Effective date.
Sec. 1.881-4 Recordkeeping Requirements Concerning Conduit
Financing Arrangements
(a) Scope.
(b) Recordkeeping requirements.
(1) In general.
(2) Application of sections 6038 and 6038A.
(c) Records to be maintained.
(1) In general.
(2) Additional documents.
(3) Effect of record maintenance requirement.
(d) Effective date.
Sec. 1.881-3 Conduit financing arrangements.
(a) General rules and definitions--(1) Purpose and scope. Pursuant
to the authority of section 7701(l), this section provides rules that
permit the district director to disregard, for purposes of section 881,
the participation of one or more intermediate entities in a financing
arrangement where such entities are acting as conduit entities. For
purposes of this section, any reference to tax imposed under section
881 includes, except as otherwise provided and as the context may
require, a reference to tax imposed under sections 871 or 884(f)(1)(A)
or required to be withheld under section 1441 or 1442. See Sec. 1.881-4
for recordkeeping requirements concerning financing arrangements. See
Secs. 1.1441-3(j) and 1.1441-7(d) for withholding rules applicable to
conduit financing arrangements.
(2) Definitions. The following definitions apply for purposes of
this section and Secs. 1.881-4, 1.1441-3(j) and 1.1441-7(d).
(i) Financing arrangement--(A) In general. Financing arrangement
means a series of transactions by which one person (the financing
entity) advances money or other property, or grants rights to use
property, and another person (the financed entity) receives money or
other property, or rights to use property, if the advance and receipt
are effected through one or more other persons (intermediate entities)
and, except in cases to which paragraph (a)(2)(i)(B) of this section
applies, there are financing transactions linking the financing entity,
each of the intermediate entities, and the financed entity. A transfer
of money or other property in satisfaction of a repayment obligation is
not an advance of money or other property. A financing arrangement
exists regardless of the order in which the transactions are entered
into, but only for the period during which all of the financing
transactions coexist. See Examples 1, 2, and 3 of paragraph (e) of this
section for illustrations of the term financing arrangement.
(B) Special rule for related parties. If two (or more) financing
transactions involving two (or more) related persons would form part of
a financing arrangement but for the absence of a financing transaction
between the related persons, the district director may treat the
related persons as a single intermediate entity if he determines that
one of the principal purposes for the structure of the financing
transactions is to prevent the characterization of such arrangement as
a financing arrangement. This determination shall be based upon all of
the facts and circumstances, including, without limitation, the factors
set forth in paragraph (b)(2) of this section. See Examples 4 and 5 of
paragraph (e) of this section for illustrations of this paragraph
(a)(2)(i)(B).
(ii) Financing transaction--(A) In general. Financing transaction
means--
(1) Debt;
(2) Stock in a corporation (or a similar interest in a partnership
or trust) that meets the requirements of paragraph (a)(2)(ii)(B) of
this section;
(3) Any lease or license; or
(4) Any other transaction (including an interest in a trust
described in sections 671 through 679) pursuant to which a person makes
an advance of money or other property or grants rights to use property
to a transferee who is obligated to repay or return a substantial
portion of the money or other property advanced, or the equivalent in
value. This paragraph (a)(2)(ii)(A)(4) shall not apply to the posting
of collateral unless the collateral consists of cash or the person
holding the collateral is permitted to reduce the collateral to cash
(through a transfer, grant of a security interest or similar
transaction) prior to default on the financing transaction secured by
the collateral.
(B) Limitation on inclusion of stock or similar interests--(1) In
general. Stock in a corporation (or a similar interest in a partnership
or trust) will constitute a financing transaction only if one of the
following conditions is satisfied--
(i) The issuer is required to redeem the stock or similar interest
at a specified time or the holder has the right to require the issuer
to redeem the stock or similar interest or to make any other payment
with respect to the stock or similar interest;
(ii) The issuer has the right to redeem the stock or similar
interest, but only if, based on all of the facts and circumstances as
of the issue date, redemption pursuant to that right is more likely
than not to occur; or
(iii) The owner of the stock or similar interest has the right to
require a person related to the issuer (or any other person who is
acting pursuant to a plan or arrangement with the issuer) to acquire
the stock or similar interest or make a payment with respect to the
stock or similar interest.
(2) Rules of special application--(i) Existence of a right. For
purposes of this paragraph (a)(2)(ii)(B), a person will be considered
to have a right to cause a redemption or payment if the person has the
right (other than rights arising, in the ordinary course, between the
date that a payment is declared and the date that a payment is made) to
enforce the payment through a legal proceeding or to cause the issuer
to be liquidated if it fails to redeem the interest or to make a
payment. A person will not be considered to have a right to force a
redemption or a payment if the right is derived solely from ownership
of a controlling interest in the issuer in cases where the control does
not arise from a default or similar contingency under the instrument.
The person is considered to have such a right if the person has the
right as of the issue date or, as of the issue date, it is more likely
than not that the person will receive such a right, whether through the
occurrence of a contingency or otherwise.
(ii) Restrictions on payment. The fact that the issuer does not
have the legally available funds to redeem the stock or similar
interest, or that the payments are to be made in a blocked currency,
will not affect the determinations made pursuant to this paragraph
(a)(2)(ii)(B).
(iii) Conduit entity means an intermediate entity whose
participation in the financing arrangement may be disregarded in whole
or in part pursuant to this section, whether or not the district
director has made a determination that the intermediate entity should
be disregarded under paragraph (a)(3)(i) of this section.
(iv) Conduit financing arrangement means a financing arrangement
that is effected through one or more conduit entities.
(v) Related means related within the meaning of sections 267(b) or
707(b)(1), or controlled within the meaning of section 482, and the
regulations under those sections. For purposes of
[[Page 41006]]
determining whether a person is related to another person, the
constructive ownership rules of section 318 shall apply, and the
attribution rules of section 267(c) also shall apply to the extent they
attribute ownership to persons to whom section 318 does not attribute
ownership.
(3) Disregard of participation of conduit entity--(i) Authority of
district director. The district director may determine that the
participation of a conduit entity in a conduit financing arrangement
should be disregarded for purposes of section 881. For this purpose, an
intermediate entity will constitute a conduit entity if it meets the
standards of paragraph (a)(4) of this section. The district director
has discretion to determine the manner in which the standards of
paragraph (a)(4) of this section apply, including the financing
transactions and parties composing the financing arrangement.
(ii) Effect of disregarding conduit entity--(A) In general. If the
district director determines that the participation of a conduit entity
in a financing arrangement should be disregarded, the financing
arrangement is recharacterized as a transaction directly between the
remaining parties to the financing arrangement (in most cases, the
financed entity and the financing entity) for purposes of section 881.
To the extent that a disregarded conduit entity actually receives or
makes payments pursuant to a conduit financing arrangement, it is
treated as an agent of the financing entity. Except as otherwise
provided, the recharacterization of the conduit financing arrangement
also applies for purposes of sections 871, 884(f)(1)(A), 1441, and 1442
and other procedural provisions relating to those sections. This
recharacterization will not otherwise affect a taxpayer's Federal
income tax liability under any substantive provisions of the Internal
Revenue Code. Thus, for example, the recharacterization generally
applies for purposes of section 1461, in order to impose liability on a
withholding agent who fails to withhold as required under Sec. 1.1441-
3(j), but not for purposes of Sec. 1.882-5.
(B) Character of payments made by the financed entity. If the
participation of a conduit financing arrangement is disregarded under
this paragraph (a)(3), payments made by the financed entity generally
shall be characterized by reference to the character (e.g., interest or
rent) of the payments made to the financing entity. However, if the
financing transaction to which the financing entity is a party is a
transaction described in paragraph (a)(2)(ii)(A)(2) or (4) of this
section that gives rise to payments that would not be deductible if
paid by the financed entity, the character of the payments made by the
financed entity will not be affected by the disregard of the
participation of a conduit entity. The characterization provided by
this paragraph (a)(3)(ii)(B) does not, however, extend to qualification
of a payment for any exemption from withholding tax under the Internal
Revenue Code or a provision of any applicable tax treaty if such
qualification depends on the terms of, or other similar facts or
circumstances relating to, the financing transaction to which the
financing entity is a party that do not apply to the financing
transaction to which the financed entity is a party. Thus, for example,
payments made by a financed entity that is not a bank cannot qualify
for the exemption provided by section 881(i) of the Code even if the
loan between the financed entity and the conduit entity is a bank
deposit.
(C) Effect of income tax treaties. Where the participation of a
conduit entity in a conduit financing arrangement is disregarded
pursuant to this section, it is disregarded for all purposes of section
881, including for purposes of applying any relevant income tax
treaties. Accordingly, the conduit entity may not claim the benefits of
a tax treaty between its country of residence and the United States to
reduce the amount of tax due under section 881 with respect to payments
made pursuant to the conduit financing arrangement. The financing
entity may, however, claim the benefits of any income tax treaty under
which it is entitled to benefits in order to reduce the rate of tax on
payments made pursuant to the conduit financing arrangement that are
recharacterized in accordance with paragraph (a)(3)(ii)(B) of this
section.
(D) Effect on withholding tax. For the effect of recharacterization
on withholding obligations, see Secs. 1.1441-3(j) and 1.1441-7(d).
(E) Special rule for a financing entity that is unrelated to both
intermediate entity and financed entity--(1) Liability of financing
entity. Notwithstanding the fact that a financing arrangement is a
conduit financing arrangement, a financing entity that is unrelated to
the financed entity and the conduit entity (or entities) shall not
itself be liable for tax under section 881 unless the financing entity
knows or has reason to know that the financing arrangement is a conduit
financing arrangement. But see Sec. 1.1441-3(j) for the withholding
agent's withholding obligations.
(2) Financing entity's knowledge--(i) In general. A financing
entity knows or has reason to know that the financing arrangement is a
conduit financing arrangement only if the financing entity knows or has
reason to know of facts sufficient to establish that the financing
arrangement is a conduit financing arrangement, including facts
sufficient to establish that the participation of the intermediate
entity in the financing arrangement is pursuant to a tax avoidance
plan. A person that knows only of the financing transactions that
comprise the financing arrangement will not be considered to know or
have reason to know of facts sufficient to establish that the financing
arrangement is a conduit financing arrangement.
(ii) Presumption regarding financing entity's knowledge. It shall
be presumed that the financing entity does not know or have reason to
know that the financing arrangement is a conduit financing arrangement
if the financing entity is unrelated to all other parties to the
financing arrangement and the financing entity establishes that the
intermediate entity who is a party to the financing transaction with
the financing entity is actively engaged in a substantial trade or
business. An intermediate entity will not be considered to be engaged
in a trade or business if its business is making or managing
investments, unless the intermediate entity is actively engaged in a
banking, insurance, financing or similar trade or business and such
business consists predominantly of transactions with customers who are
not related persons. An intermediate entity's trade or business is
substantial if it is reasonable for the financing entity to expect that
the intermediate entity will be able to make payments under the
financing transaction out of the cash flow of that trade or business.
This presumption may be rebutted if the district director establishes
that the financing entity knew or had reason to know that the financing
arrangement is a conduit financing arrangement. See Example 6 of
paragraph (e) of this section for an illustration of the rules of this
paragraph (a)(3)(ii)(E).
(iii) Limitation on taxpayer's use of this section. A taxpayer may
not apply this section to reduce the amount of its Federal income tax
liability by disregarding the form of its financing transactions for
Federal income tax purposes or by compelling the district director to
do so. See, however, paragraph (b)(2)(i) of this section for rules
regarding the taxpayer's ability to show that the participation of one
or more intermediate entities results in no significant reduction in
tax.
[[Page 41007]]
(4) Standard for treatment as a conduit entity--(i) In general. An
intermediate entity is a conduit entity with respect to a financing
arrangement if--
(A) The participation of the intermediate entity (or entities) in
the financing arrangement reduces the tax imposed by section 881
(determined by comparing the aggregate tax imposed under section 881 on
payments made on financing transactions making up the financing
arrangement with the tax that would have been imposed under paragraph
(d) of this section);
(B) The participation of the intermediate entity in the financing
arrangement is pursuant to a tax avoidance plan; and
(C) Either--
(1) The intermediate entity is related to the financing entity or
the financed entity; or
(2) The intermediate entity would not have participated in the
financing arrangement on substantially the same terms but for the fact
that the financing entity engaged in the financing transaction with the
intermediate entity.
(ii) Multiple intermediate entities--(A) In general. If a financing
arrangement involves multiple intermediate entities, the district
director will determine whether each of the intermediate entities is a
conduit entity. The district director will make the determination by
applying the special rules for multiple intermediate entities provided
in this section or, if no special rules are provided, applying
principles consistent with those of paragraph (a)(4)(i) of this section
to each of the intermediate entities in the financing arrangement.
(B) Special rule for related persons. The district director may
treat related intermediate entities as a single intermediate entity if
he determines that one of the principal purposes for the involvement of
multiple intermediate entities in the financing arrangement is to
prevent the characterization of an intermediate entity as a conduit
entity, to reduce the portion of a payment that is subject to
withholding tax or otherwise to circumvent the provisions of this
section. This determination shall be based upon all of the facts and
circumstances, including, but not limited to, the factors set forth in
paragraph (b)(2) of this section. If a district director determines
that related persons are to be treated as a single intermediate entity,
financing transactions between such related parties that are part of
the conduit financing arrangement shall be disregarded for purposes of
applying this section. See Examples 7 and 8 of paragraph (e) of this
section for illustrations of the rules of this paragraph (a)(4)(ii).
(b) Determination of whether participation of intermediate entity
is pursuant to a tax avoidance plan--(1) In general. A tax avoidance
plan is a plan one of the principal purposes of which is the avoidance
of tax imposed by section 881. Avoidance of the tax imposed by section
881 may be one of the principal purposes for such a plan even though it
is outweighed by other purposes (taken together or separately). In this
regard, the only relevant purposes are those pertaining to the
participation of the intermediate entity in the financing arrangement
and not those pertaining to the existence of a financing arrangement as
a whole. The plan may be formal or informal, written or oral, and may
involve any one or more of the parties to the financing arrangement.
The plan must be in existence no later than the last date that any of
the financing transactions comprising the financing arrangement is
entered into. The district director may infer the existence of a tax
avoidance plan from the facts and circumstances. In determining whether
there is a tax avoidance plan, the district director will weigh all
relevant evidence regarding the purposes for the intermediate entity's
participation in the financing arrangement. See Examples 11 and 12 of
paragraph (e) of this section for illustrations of the rule of this
paragraph (b)(1).
(2) Factors taken into account in determining the presence or
absence of a tax avoidance purpose. The factors described in paragraphs
(b)(2)(i) through (iv) of this section are among the facts and
circumstances taken into account in determining whether the
participation of an intermediate entity in a financing arrangement has
as one of its principal purposes the avoidance of tax imposed by
section 881.
(i) Significant reduction in tax. The district director will
consider whether the participation of the intermediate entity (or
entities) in the financing arrangement significantly reduces the tax
that otherwise would have been imposed under section 881. The fact that
an intermediate entity is a resident of a country that has an income
tax treaty with the United States that significantly reduces the tax
that otherwise would have been imposed under section 881 is not
sufficient, by itself, to establish the existence of a tax avoidance
plan. The determination of whether the participation of an intermediate
entity significantly reduces the tax generally is made by comparing the
aggregate tax imposed under section 881 on payments made on financing
transactions making up the financing arrangement with the tax that
would be imposed under paragraph (d) of this section. However, the
taxpayer is not barred from presenting evidence that the financing
entity, as determined by the district director, was itself an
intermediate entity and another entity should be treated as the
financing entity for purposes of applying this test. A reduction in the
absolute amount of tax may be significant even if the reduction in rate
is not. A reduction in the amount of tax may be significant if the
reduction is large in absolute terms or in relative terms. See Examples
13, 14 and 15 of paragraph (e) of this section for illustrations of
this factor.
(ii) Ability to make the advance. The district director will
consider whether the intermediate entity had sufficient available money
or other property of its own to have made the advance to the financed
entity without the advance of money or other property to it by the
financing entity (or in the case of multiple intermediate entities,
whether each of the intermediate entities had sufficient available
money or other property of its own to have made the advance to either
the financed entity or another intermediate entity without the advance
of money or other property to it by either the financing entity or
another intermediate entity).
(iii) Time period between financing transactions. The district
director will consider the length of the period of time that separates
the advances of money or other property, or the grants of rights to use
property, by the financing entity to the intermediate entity (in the
case of multiple intermediate entities, from one intermediate entity to
another), and ultimately by the intermediate entity to the financed
entity. A short period of time is evidence of the existence of a tax
avoidance plan while a long period of time is evidence that there is
not a tax avoidance plan. See Example 16 of paragraph (e) of this
section for an illustration of this factor.
(iv) Financing transactions in the ordinary course of business. If
the parties to the financing transaction are related, the district
director will consider whether the financing transaction occurs in the
ordinary course of the active conduct of complementary or integrated
trades or businesses engaged in by these entities. The fact that a
financing transaction is described in this paragraph (b)(2)(iv) is
evidence that the participation of the parties to that transaction in
the financing arrangement is not pursuant to a tax avoidance plan. A
loan will not be considered to occur in the ordinary
[[Page 41008]]
course of the active conduct of complementary or integrated trades or
businesses unless the loan is a trade receivable or the parties to the
transaction are actively engaged in a banking, insurance, financing or
similar trade or business and such business consists predominantly of
transactions with customers who are not related persons. See Example 17
of paragraph (e) of this section for an illustration of this factor.
(3) Presumption if significant financing activities performed by a
related intermediate entity--(i) General rule. It shall be presumed
that the participation of an intermediate entity (or entities) in a
financing arrangement is not pursuant to a tax avoidance plan if the
intermediate entity is related to either or both the financing entity
or the financed entity and the intermediate entity performs significant
financing activities with respect to the financing transactions forming
part of the financing arrangement to which it is a party. This
presumption may be rebutted if the district director establishes that
the participation of the intermediate entity in the financing
arrangement is pursuant to a tax avoidance plan. See Examples 21, 22
and 23 of paragraph (e) of this section for illustrations of this
presumption.
(ii) Significant financing activities. For purposes of this
paragraph (b)(3), an intermediate entity performs significant financing
activities with respect to such financing transactions only if the
financing transactions satisfy the requirements of either paragraph
(b)(3)(ii)(A) or (B) of this section.
(A) Active rents or royalties. An intermediate entity performs
significant financing activities with respect to leases or licenses if
rents or royalties earned with respect to such leases or licenses are
derived in the active conduct of a trade or business within the meaning
of section 954(c)(2)(A), to be applied by substituting the term
intermediate entity for the term controlled foreign corporation.
(B) Active risk management--(1) In general. An intermediate entity
is considered to perform significant financing activities with respect
to financing transactions only if officers and employees of the
intermediate entity participate actively and materially in arranging
the intermediate entity's participation in such financing transactions
(other than financing transactions described in paragraph
(b)(3)(ii)(B)(3) of this section) and perform the business activity and
risk management activities described in paragraph (b)(3)(ii)(B)(2) of
this section with respect to such financing transactions, and the
participation of the intermediate entity in the financing transactions
produces (or reasonably can be expected to produce) efficiency savings
by reducing transaction costs and overhead and other fixed costs.
(2) Business activity and risk management requirements. An
intermediate entity will be considered to perform significant financing
activities only if, within the country in which the intermediate entity
is organized (or, if different, within the country with respect to
which the intermediate entity is claiming the benefits of a tax
treaty), its officers and employees--
(i) Exercise management over, and actively conduct, the day-to-day
operations of the intermediate entity. Such operations must consist of
a substantial trade or business or the supervision, administration and
financing for a substantial group of related persons; and
(ii) Actively manage, on an ongoing basis, material market risks
arising from such financing transactions as an integral part of the
management of the intermediate entity's financial and capital
requirements (including management of risks of currency and interest
rate fluctuations) and management of the intermediate entity's short-
term investments of working capital by entering into transactions with
unrelated persons.
(3) Special rule for trade receivables and payables entered into in
the ordinary course of business. If the activities of the intermediate
entity consist in whole or in part of cash management for a controlled
group of which the intermediate entity is a member, then employees of
the intermediate entity need not have participated in arranging any
such financing transactions that arise in the ordinary course of a
substantial trade or business of either the financed entity or the
financing entity. Officers or employees of the financing entity or
financed entity, however, must have participated actively and
materially in arranging the transaction that gave rise to the trade
receivable or trade payable. Cash management includes the operation of
a sweep account whereby the intermediate entity nets intercompany trade
payables and receivables arising from transactions among the other
members of the controlled group and between members of the controlled
group and unrelated persons.
(4) Activities of officers and employees of related persons. Except
as provided in paragraph (b)(3)(ii)(B)(3) of this section, in applying
this paragraph (b)(3)(ii)(B), the activities of an officer or employee
of an intermediate entity will not constitute significant financing
activities if any officer or employee of a related person participated
materially in any of the activities described in this paragraph, other
than to approve any guarantee of a financing transaction or to exercise
general supervision and control over the policies of the intermediate
entity.
(c) Determination of whether an unrelated intermediate entity would
not have participated in financing arrangement on substantially the
same terms--(1) In general. The determination of whether an
intermediate entity would not have participated in a financing
arrangement on substantially the same terms but for the financing
transaction between the financing entity and the intermediate entity
shall be based upon all of the facts and circumstances.
(2) Effect of guarantee--(i) In general. The district director may
presume that the intermediate entity would not have participated in the
financing arrangement on substantially the same terms if there is a
guarantee of the financed entity's liability to the intermediate entity
(or in the case of multiple intermediate entities, a guarantee of the
intermediate entity's liability to the intermediate entity that
advanced money or property, or granted rights to use other property).
However, a guarantee that was neither in existence nor contemplated on
the last date that any of the financing transactions comprising the
financing arrangement is entered into does not give rise to this
presumption. A taxpayer may rebut this presumption by producing clear
and convincing evidence that the intermediate entity would have
participated in the financing transaction with the financed entity on
substantially the same terms even if the financing entity had not
entered into a financing transaction with the intermediate entity.
(ii) Definition of guarantee. For the purposes of this paragraph
(c)(2), a guarantee is any arrangement under which a person, directly
or indirectly, assures, on a conditional or unconditional basis, the
payment of another person's obligation with respect to a financing
transaction. The term shall be interpreted in accordance with the
definition of the term in section 163(j)(6)(D)(iii).
(d) Determination of amount of tax liability--(1) Amount of payment
subject to recharacterization--(i) In general. If a financing
arrangement is a conduit financing arrangement, a portion of each
payment made by the financed entity with respect to the
[[Page 41009]]
financing transactions that comprise the conduit financing arrangement
shall be recharacterized as a transaction directly between the financed
entity and the financing entity. If the aggregate principal amount of
the financing transaction(s) to which the financed entity is a party is
less than or equal to the aggregate principal amount of the financing
transaction(s) linking any of the parties to the financing arrangement,
the entire amount of the payment shall be so recharacterized. If the
aggregate principal amount of the financing transaction(s) to which the
financed entity is a party is greater than the aggregate principal
amount of the financing transaction(s) linking any of the parties to
the financing arrangement, then the recharacterized portion shall be
determined by multiplying the payment by a fraction the numerator of
which is equal to the lowest aggregate principal amount of the
financing transaction(s) linking any of the parties to the financing
arrangement (other than financing transactions that are disregarded
pursuant to paragraphs (a)(2)(i)(B) and (a)(4)(ii)(B) of this section)
and the denominator of which is the aggregate principal amount of the
financing transaction(s) to which the financed entity is a party. In
the case of financing transactions the principal amount of which is
subject to adjustment, the fraction shall be determined using the
average outstanding principal amounts for the period to which the
payment relates. The average principal amount may be computed using any
method applied consistently that reflects with reasonable accuracy the
amount outstanding for the period. See Example 24 of paragraph (e) of
this section for an illustration of the calculation of the amount of
tax liability.
(ii) Determination of principal amount--(A) In general. Unless
otherwise provided in this paragraph (d)(1)(ii), the principal amount
equals the amount of money advanced, or the fair market value of other
property advanced or subject to a lease or license, in the financing
transaction. In general, fair market value is calculated in U.S.
dollars as of the close of business on the day on which the financing
transaction is entered into. However, if the property advanced, or the
right to use property granted, by the financing entity is the same as
the property or rights received by the financed entity, the fair market
value of the property or right shall be determined as of the close of
business on the last date that any of the financing transactions
comprising the financing arrangement is entered into. In the case of
fungible property, property of the same type shall be considered to be
the same property. See Example 25 of paragraph (e) for an illustration
of the calculation of the principal amount in the case of financing
transactions involving fungible property. The principal amount of a
financing transaction shall be subject to adjustments, as set forth in
this paragraph (d)(1)(ii).
(B) Debt instruments and certain stock. In the case of a debt
instrument or of stock that is subject to the current inclusion rules
of sections 305(c)(3) or (e), the principal amount generally will be
equal to the issue price. However, if the fair market value on the
issue date differs materially from the issue price, the fair market
value of the debt instrument shall be used in lieu of the instrument's
issue price. Appropriate adjustments will be made for accruals of
original issue discount and repayments of principal (including accrued
original issue discount).
(C) Partnership and trust interests. In the case of a partnership
interest or an interest in a trust, the principal amount is equal to
the fair market value of the money or property contributed to the
partnership or trust in return for that partnership or trust interest.
(D) Leases or licenses. In the case of a lease or license, the
principal amount is equal to the fair market value of the property
subject to the lease or license on the date on which the lease or
license is entered into. The principal amount shall be adjusted for
depreciation or amortization, calculated on a basis that accurately
reflects the anticipated decline in the value of the property over its
life.
(2) Rate of tax. The rate at which tax is imposed under section 881
on the portion of the payment that is recharacterized pursuant to
paragraph (d)(1) of this section is determined by reference to the
nature of the recharacterized transaction, as determined under
paragraphs (a)(3)(ii)(B) and (C) of this section.
(e) Examples. The following examples illustrate this section. For
purposes of these examples, unless otherwise indicated, it is assumed
that FP, a corporation organized in country N, owns all of the stock of
FS, a corporation organized in country T, and DS, a corporation
organized in the United States. Country T, but not country N, has an
income tax treaty with the United States. The treaty exempts interest,
rents and royalties paid by a resident of one state (the source state)
to a resident of the other state from tax in the source state.
Example 1. Financing arrangement. (i) On January 1, 1996, BK, a
bank organized in country T, lends $1,000,000 to DS in exchange for
a note issued by DS. FP guarantees to BK that DS will satisfy its
repayment obligation on the loan. There are no other transactions
between FP and BK.
(ii) BK's loan to DS is a financing transaction within the
meaning of paragraph (a)(2)(ii)(A)(1) of this section. FP's
guarantee of DS's repayment obligation is not a financing
transaction as described in paragraphs (a)(2)(ii)(A)(1) through (4)
of this section. Therefore, these transactions do not constitute a
financing arrangement as defined in paragraph (a)(2)(i) of this
section.
Example 2. Financing arrangement. (i) On January 1, 1996, FP
lends $1,000,000 to DS in exchange for a note issued by DS. On
January 1, 1997, FP assigns the DS note to FS in exchange for a note
issued by FS. After receiving notice of the assignment, DS remits
payments due under its note to FS.
(ii) The DS note held by FS and the FS note held by FP are
financing transactions within the meaning of paragraph
(a)(2)(ii)(A)(1) of this section, and together constitute a
financing arrangement within the meaning of paragraph (a)(2)(i) of
this section.
Example 3. Financing arrangement. (i) On December 1, 1994 FP
creates a special purposes subsidiary, FS. On that date FP
capitalizes FS with $1,000,000 in cash and $10,000,000 in debt from
BK, a Country N bank. On January 1, 1995, C, a U.S. person,
purchases an automobile from DS in return for an installment note.
On August 1, 1995, DS sells a number of installment notes, including
C's, to FS in exchange for $10,000,000. DS continues to service the
installment notes for FS.
(ii) The C installment note now held by FS (as well as all of
the other installment notes now held by FS) and the FS note held by
BK are financing transactions within the meaning of paragraph
(a)(2)(ii)(A)(1) of this section, and together constitute a
financing arrangement within the meaning of paragraph (a)(2)(i) of
this section.
Example 4. Related persons treated as a single intermediate
entity. (i) On January 1, 1996, FP deposits $1,000,000 with BK, a
bank that is organized in country N and is unrelated to FP and its
subsidiaries. M, a corporation also organized in country N, is
wholly-owned by the sole shareholder of BK but is not a bank within
the meaning of section 881(c)(3)(A). On July 1, 1996, M lends
$1,000,000 to DS in exchange for a note maturing on July 1, 2006.
The note is in registered form within the meaning of section
881(c)(2)(B)(i) and DS has received from M the statement required by
section 881(c)(2)(B)(ii). One of the principal purposes for the
absence of a financing transaction between BK and M is the avoidance
of the application of this section.
(ii) The transactions described above would form a financing
arrangement but for the absence of a financing transaction between
BK and M. However, because one of the principal purposes for the
structuring of these financing transactions is to prevent
characterization of such arrangement as a financing arrangement, the
district director may treat the financing transactions between
[[Page 41010]]
FP and BK, and between M and DS as a financing arrangement under
paragraphs (a)(2)(i)(B) of this section. In such a case, BK and M
would be considered a single intermediate entity for purposes of
this section. See also paragraph (a)(4)(ii)(B) of this section for
the authority to treat BK and M as a single intermediate entity.
Example 5. Related persons treated as a single intermediate
entity. (i) On January 1, 1995, FP lends $10,000,000 to FS in
exchange for a 10-year note that pays interest annually at a rate of
8 percent per annum. On January 2, 1995, FS contributes $10,000,000
to FS2, a wholly-owned subsidiary of FS organized in country T, in
exchange for common stock of FS2. On January 1, 1996, FS2 lends
$10,000,000 to DS in exchange for an 8-year note that pays interest
annually at a rate of 10 percent per annum. FS is a holding company
whose most significant asset is the stock of FS2. Throughout the
period that the FP-FS loan is outstanding, FS causes FS2 to make
distributions to FS, most of which are used to make interest and
principal payments on the FP-FS loan. Without the distributions from
FS2, FS would not have had the funds with which to make payments on
the FP-FS loan. One of the principal purposes for the absence of a
financing transaction between FS and FS2 is the avoidance of the
application of this section.
(ii) The conditions of paragraph (a)(4)(i)(A) of this section
would be satisfied with respect to the financing transactions
between FP, FS, FS2 and DS but for the absence of a financing
transaction between FS and FS2. However, because one of the
principal purposes for the structuring of these financing
transactions is to prevent characterization of an entity as a
conduit, the district director may treat the financing transactions
between FP and FS, and between FS2 and DS as a financing
arrangement. See paragraph (a)(4)(ii)(B) of this section. In such a
case, FS and FS2 would be considered a single intermediate entity
for purposes of this section. See also paragraph (a)(2)(i)(B) of
this section for the authority to treat FS and FS2 as a single
intermediate entity.
Example 6. Presumption with respect to unrelated financing
entity. (i) FP is a corporation organized in country T that is
actively engaged in a substantial manufacturing business. FP has a
revolving credit facility with a syndicate of banks, none of which
is related to FP and FP's subsidiaries, which provides that FP may
borrow up to a maximum of $100,000,000 at a time. The revolving
credit facility provides that DS and certain other subsidiaries of
FP may borrow directly from the syndicate at the same interest rates
as FP, but each subsidiary is required to indemnify the syndicate
banks for any withholding taxes imposed on interest payments by the
country in which the subsidiary is organized. BK, a bank that is
organized in country N, is the agent for the syndicate. Some of the
syndicate banks are organized in country N, but others are residents
of country O, a country that has an income tax treaty with the
United States which allows the United States to impose a tax on
interest at a maximum rate of 10 percent. It is reasonable for BK
and the syndicate banks to have determined that FP will be able to
meet its payment obligations on a maximum principal amount of
$100,000,000 out of the cash flow of its manufacturing business. At
various times throughout 1995, FP borrows under the revolving credit
facility until the outstanding principal amount reaches the maximum
amount of $100,000,000. On December 31, 1995, FP receives
$100,000,000 from a public offering of its equity. On January 1,
1996, FP pays BK $90,000,000 to reduce the outstanding principal
amount under the revolving credit facility and lends $10,000,000 to
DS. FP would have repaid the entire principal amount, and DS would
have borrowed directly from the syndicate, but for the fact that DS
did not want to incur the U.S. withholding tax that would have
applied to payments made directly by DS to the syndicate banks.
(ii) Pursuant to paragraph (a)(3)(ii)(E)(1) of this section,
even though the financing arrangement is a conduit financing
arrangement (because the financing arrangement meets the standards
for recharacterization in paragraph (a)(4)(i)), BK and the other
syndicate banks have no section 881 liability unless they know or
have reason to know that the financing arrangement is a conduit
financing arrangement. Moreover, pursuant to paragraph
(a)(3)(ii)(E)(2)(ii) of this section, BK and the syndicate banks are
presumed not to know that the financing arrangement is a conduit
financing arrangement. The syndicate banks are unrelated to both FP
and DS, and FP is actively engaged in a substantial trade or
business--that is, the cash flow from FP's manufacturing business is
sufficient for the banks to expect that FP will be able to make the
payments required under the financing transaction. See Sec. 1.1441-
3(j) for the withholding obligations of the withholding agents.
Example 7. Multiple intermediate entities--special rule for
related persons. (i) On January 1, 1995, FP lends $10,000,000 to FS
in exchange for a 10-year note that pays interest annually at a rate
of 8 percent per annum. On January 2, 1995, FS contributes
$9,900,000 to FS2, a wholly-owned subsidiary of FS organized in
country T, in exchange for common stock and lends $100,000 to FS2.
On January 1, 1996, FS2 lends $10,000,000 to DS in exchange for an
8-year note that pays interest annually at a rate of 10 percent per
annum. FS is a holding company that has no significant assets other
than the stock of FS2. Throughout the period that the FP-FS loan is
outstanding, FS causes FS2 to make distributions to FS, most of
which are used to make interest and principal payments on the FP-FS
loan. Without the distributions from FS2, FS would not have had the
funds with which to make payments on the FP-FS loan. One of the
principal purposes for structuring the transactions between FS and
FS2 as primarily a contribution of capital is to reduce the amount
of the payment that would be recharacterized under paragraph (d) of
this section.
(ii) Pursuant to paragraph (a)(4)(ii)(B) of this section, the
district director may treat FS and FS2 as a single intermediate
entity for purposes of this section since one of the principal
purposes for the participation of multiple intermediate entities is
to reduce the amount of the tax liability on any recharacterized
payment by inserting a financing transaction with a low principal
amount.
Example 8. Multiple intermediate entities. (i) On January 1,
1995, FP deposits $1,000,000 with BK, a bank that is organized in
country T and is unrelated to FP and its subsidiaries, FS and DS. On
January 1, 1996, at a time when the FP-BK deposit is still
outstanding, BK lends $500,000 to BK2, a bank that is wholly-owned
by BK and is organized in country T. On the same date, BK2 lends
$500,000 to FS. On July 1, 1996, FS lends $500,000 to DS. FP pledges
its deposit with BK to BK2 in support of FS' obligation to repay the
BK2 loan. FS', BK's and BK2's participation in the financing
arrangement is pursuant to a tax avoidance plan.
(ii) The conditions of paragraphs (a)(4)(i)(A) and (B) of this
section are satisfied because the participation of BK, BK2 and FS in
the financing arrangement reduces the tax imposed by section 881,
and FS', BK's and BK2's participation in the financing arrangement
is pursuant to a tax avoidance plan. However, since BK and BK2 are
unrelated to FP and DS, under paragraph (a)(4)(i)(C)(2) of this
section, BK and BK2 will be treated as conduit entities only if BK
and BK2 would not have participated in the financing arrangement on
substantially the same terms but for the financing transaction
between FP and BK.
(iii) It is presumed that BK2 would not have participated in the
financing arrangement on substantially the same terms but for the
BK-BK2 financing transaction because FP's pledge of an asset in
support of FS' obligation to repay the BK2 loan is a guarantee
within the meaning of paragraph (c)(2)(ii) of this section. If the
taxpayer does not rebut this presumption by clear and convincing
evidence, then BK2 will be a conduit entity.
(iv) Because BK and BK2 are related intermediate entities, the
district director must determine whether one of the principal
purposes for the involvement of multiple intermediate entities was
to prevent characterization of an entity as a conduit entity. In
making this determination, the district director may consider the
fact that the involvement of two related intermediate entities
prevents the presumption regarding guarantees from applying to BK.
In the absence of evidence showing a business purpose for the
involvement of both BK and BK2, the district director may treat BK
and BK2 as a single intermediate entity for purposes of determining
whether they would have participated in the financing arrangement on
substantially the same terms but for the financing transaction
between FP and BK. The presumption that applies to BK2 therefore
will apply to BK. If the taxpayer does not rebut this presumption by
clear and convincing evidence, then BK will be a conduit entity.
Example 9. Reduction of tax. (i) On February 1, 1995, FP issues
debt to the public
[[Page 41011]]
that would satisfy the requirements of section 871(h)(2)(A) (relating
to obligations that are not in registered form) if issued by a U.S.
person. FP lends the proceeds of the debt offering to DS in exchange
for a note.
(ii) The debt issued by FP and the DS note are financing
transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of
this section and together constitute a financing arrangement within
the meaning of paragraph (a)(2)(i) of this section. The holders of
the FP debt are the financing entities, FP is the intermediate
entity and DS is the financed entity. Because interest payments on
the debt issued by FP would not have been subject to withholding tax
if the debt had been issued by DS, there is no reduction in tax
under paragraph (a)(4)(i)(A) of this section. Accordingly, FP is not
a conduit entity.
Example 10. Reduction of tax. (i) On January 1, 1995, FP
licenses to FS the rights to use a patent in the United States to
manufacture product A. FS agrees to pay FP a fixed amount in
royalties each year under the license. On January 1, 1996, FS
sublicenses to DS the rights to use the patent in the United States.
Under the sublicense, DS agrees to pay FS royalties based upon the
units of product A manufactured by DS each year. Although the
formula for computing the amount of royalties paid by DS to FS
differs from the formula for computing the amount of royalties paid
by FS to FP, each represents an arm's length rate.
(ii) Although the royalties paid by DS to FS are exempt from
U.S. withholding tax, the royalty payments between FS and FP are
income from U.S. sources under section 861(a)(4) subject to the 30
percent gross tax imposed by Sec. 1.881-2(b) and subject to
withholding under Sec. 1.1441-2(a). Because the rate of tax imposed
on royalties paid by FS to FP is the same as the rate that would
have been imposed on royalties paid by DS to FP, the participation
of FS in the FP-FS-DS financing arrangement does not reduce the tax
imposed by section 881 within the meaning of paragraph (a)(4)(i)(A)
of this section. Accordingly, FP is not a conduit entity.
Example 11. A principal purpose. (i) On January 1, 1995, FS
lends $10,000,000 to DS in exchange for a 10-year note that pays
interest annually at a rate of 8 percent per annum. As was intended
at the time of the loan from FS to DS, on July 1, 1995, FP makes an
interest-free demand loan of $10,000,000 to FS. A principal purpose
for FS' participation in the FP-FS-DS financing arrangement is that
FS generally coordinates the financing for all of FP's subsidiaries
(although FS does not engage in significant financing activities
with respect to such financing transactions). However, another
principal purpose for FS' participation is to allow the parties to
benefit from the lower withholding tax rate provided under the
income tax treaty between country T and the United States.
(ii) The financing arrangement satisfies the tax avoidance
purpose requirement of paragraph (a)(4)(i)(B) of this section
because FS participated in the financing arrangement pursuant to a
plan one of the principal purposes of which is to allow the parties
to benefit from the country T-U.S. treaty.
Example 12. A principal purpose. (i) DX is a U.S. corporation
that intends to purchase property to use in its manufacturing
business. FX is a partnership organized in country N that is owned
in equal parts by LC1 and LC2, leasing companies that are unrelated
to DX. BK, a bank organized in country N and unrelated to DX, LC1
and LC2, lends $100,000,000 to FX to enable FX to purchase the
property. On the same day, FX purchases the property and engages in
a transaction with DX which is treated as a lease of the property
for country N tax purposes but a loan for U.S. tax purposes.
Accordingly, DX is treated as the owner of the property for U.S. tax
purposes. The parties comply with the requirements of section 881(c)
with respect to the debt obligation of DX to FX. FX and DX
structured these transactions in this manner so that LC1 and LC2
would be entitled to accelerated depreciation deductions with
respect to the property in country N and DX would be entitled to
accelerated depreciation deductions in the United States. None of
the parties would have participated in the transaction if the
payments made by DX were subject to U.S. withholding tax.
(ii) The loan from BK to FX and from FX to DX are financing
transactions and, together constitute a financing arrangement. The
participation of FX in the financing arrangement reduces the tax
imposed by section 881 because payments made to FX, but not BK,
qualify for the portfolio interest exemption of section 881(c)
because BK is a bank making an extension of credit in the ordinary
course of its trade or business within the meaning of section
881(c)(3)(A). Moreover, because DX borrowed the money from FX
instead of borrowing the money directly from BK to avoid the tax
imposed by section 881, one of the principal purposes of the
participation of FX was to avoid that tax (even though another
principal purpose of the participation of FX was to allow LC1 and
LC2 to take advantage of accelerated depreciation deductions in
country N). Assuming that FX would not have participated in the
financing arrangement on substantially the same terms but for the
fact that BK loaned it $100,000,000, FX is a conduit entity and the
financing arrangement is a conduit financing arrangement.
Example 13. Significant reduction of tax. (i) FS owns all of the
stock of FS1, which also is a resident of country T. FS1 owns all of
the stock of DS. On January 1, 1995, FP contributes $10,000,000 to
the capital of FS in return for perpetual preferred stock. On July
1, 1995, FS lends $10,000,000 to FS1. On January 1, 1996, FS1 lends
$10,000,000 to DS. Under the terms of the country T-U.S. income tax
treaty, a country T resident is not entitled to the reduced
withholding rate on interest income provided by the treaty if the
resident is entitled to specified tax benefits under country T law.
Although FS1 may deduct interest paid on the loan from FS, these
deductions are not pursuant to any special tax benefits provided by
country T law. However, FS qualifies for one of the enumerated tax
benefits pursuant to which it may deduct dividends paid with respect
to the stock held by FP. Therefore, if FS had made a loan directly
to DS, FS would not have been entitled to the benefits of the
country T-U.S. tax treaty with respect to payments it received from
DS, and such payments would have been subject to tax under section
881 at a 30 percent rate.
(ii) The FS-FS1 loan and the FS1-DS loan are financing
transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of
this section and together constitute a financing arrangement within
the meaning of paragraph (a)(2)(i) of this section. Pursuant to
paragraph (b)(2)(i) of this section, the significant reduction in
tax resulting from the participation of FS1 in the financing
arrangement is evidence that the participation of FS1 in the
financing arrangement is pursuant to a tax avoidance plan. However,
other facts relevant to the presence of such a plan must also be
taken into account.
Example 14. Significant reduction of tax. (i) FP owns 90 percent
of the voting stock of FX, an unlimited liability company organized
in country T. The other 10 percent of the common stock of FX is
owned by FP1, a subsidiary of FP that is organized in country N.
Although FX is a partnership for U.S. tax purposes, FX is entitled
to the benefits of the U.S.-country T income tax treaty because FX
is subject to tax in country T as a resident corporation. On January
1, 1996, FP contributes $10,000,000 to FX in exchange for an
instrument denominated as preferred stock that pays a dividend of 7
percent and that must be redeemed by FX in seven years. For U.S. tax
purposes, the preferred stock is a partnership interest. On July 1,
1996, FX makes a loan of $10,000,000 to DS in exchange for a 7-year
note paying interest at 6 percent.
(ii) Because FX is required to redeem the partnership interest
at a specified time, the partnership interest constitutes a
financing transaction within the meaning of paragraph
(a)(2)(ii)(A)(2) of this section. Moreover, because the FX-DS note
is a financing transaction within the meaning of paragraph
(a)(2)(ii)(A)(1) of this section, together the transactions
constitute a financing arrangement within the meaning of (a)(2)(i)
of this section. Payments of interest made directly by DS to FP and
FP1 would not be eligible for the portfolio interest exemption and
would not be entitled to a reduction in withholding tax pursuant to
a tax treaty. Therefore, there is a significant reduction in tax
resulting from the participation of FX in the financing arrangement,
which is evidence that the participation of FX in the financing
arrangement is pursuant to a tax avoidance plan. However, other
facts relevant to the existence of such a plan must also be taken
into account.
Example 15. Significant reduction of tax. (i) FP owns a 10
percent interest in the profits and capital of FX, a partnership
organized in country N. The other 90 percent interest in FX is owned
by G, an unrelated corporation that is organized in country T. FX is
not engaged in business in the United States. On January 1, 1996, FP
contributes $10,000,000 to FX in exchange for an instrument
documented as perpetual subordinated debt that provides for
quarterly interest payments at 9 percent per annum. Under the terms
of the instrument, payments
[[Page 41012]]
on the perpetual subordinated debt do not otherwise affect the
allocation of income between the partners. FP has the right to
require the liquidation of FX if FX fails to make an interest
payment. For U.S. tax purposes, the perpetual subordinated debt is
treated as a partnership interest in FX and the payments on the
perpetual subordinated debt constitute guaranteed payments within
the meaning of section 707(c). On July 1, 1996, FX makes a loan of
$10,000,000 to DS in exchange for a 7-year note paying interest at 8
percent per annum.
(ii) Because FP has the effective right to force payment of the
``interest'' on the perpetual subordinated debt, the instrument
constitutes a financing transaction within the meaning of paragraph
(a)(2)(ii)(A)(2) of this section. Moreover, because the note between
FX and DS is a financing transaction within the meaning of paragraph
(a)(2)(ii)(A)(1) of this section, together the transactions are a
financing arrangement within the meaning of (a)(2)(i) of this
section. Without regard to this section, 90 percent of each interest
payment received by FX would be treated as exempt from U.S.
withholding tax because it is beneficially owned by G, while 10
percent would be subject to a 30 percent withholding tax because
beneficially owned by FP. If FP held directly the note issued by DS,
100 percent of the interest payments on the note would have been
subject to the 30 percent withholding tax. The significant reduction
in the tax imposed by section 881 resulting from the participation
of FX in the financing arrangement is evidence that the
participation of FX in the financing arrangement is pursuant to a
tax avoidance plan. However, other facts relevant to the presence of
such a plan must also be taken into account.
Example 16. Time period between transactions. (i) On January 1,
1995, FP lends $10,000,000 to FS in exchange for a 10-year note that
pays no interest annually. When the note matures, FS is obligated to
pay $24,000,000 to FP. On January 1, 1996, FS lends $10,000,000 to
DS in exchange for a 10-year note that pays interest annually at a
rate of 10 percent per annum.
(ii) The FS note held by FP and the DS note held by FS are
financing transactions within the meaning of paragraph
(a)(2)(ii)(A)(1) of this section and together constitute a financing
arrangement within the meaning of (a)(2)(i) of this section.
Pursuant to paragraph (b)(2)(iii) of this section, the short period
of time (twelve months) between the loan by FP to FS and the loan by
FS to DS is evidence that the participation of FS in the financing
arrangement is pursuant to a tax avoidance plan. However, other
facts relevant to the presence of such a plan must also be taken
into account.
Example 17. Financing transactions in the ordinary course of
business. (i) FP is a holding company. FS is actively engaged in
country T in the business of manufacturing and selling product A. DS
manufactures product B, a principal component in which is product A.
FS' business activity is substantial. On January 1, 1995, FP lends
$100,000,000 to FS to finance FS' business operations. On January 1,
1996, FS ships $30,000,000 of product A to DS. In return, FS creates
an interest-bearing account receivable on its books. FS' shipment is
in the ordinary course of the active conduct of its trade or
business (which is complementary to DS' trade or business.)
(ii) The loan from FP to FS and the accounts receivable opened
by FS for a payment owed by DS are financing transactions within the
meaning of paragraph (a)(2)(ii)(A)(1) of this section and together
constitute a financing arrangement within the meaning of paragraph
(a)(2)(i) of this section. Pursuant to paragraph (b)(2)(iv) of this
section, the fact that DS' liability to FS is created in the
ordinary course of the active conduct of DS' trade or business that
is complementary to a business actively engaged in by DS is evidence
that the participation of FS in the financing arrangement is not
pursuant to a tax avoidance plan. However, other facts relevant to
the presence of such a plan must also be taken into account.
Example 18. Tax avoidance plan--other factors. (i) On February
1, 1995, FP issues debt in Country N that is in registered form
within the meaning of section 881(c)(3)(A). The FP debt would
satisfy the requirements of section 881(c) if the debt were issued
by a U.S. person and the withholding agent received the
certification required by section 871(h)(2)(B)(ii). The purchasers
of the debt are financial institutions and there is no reason to
believe that they would not furnish Forms W-8. On March 1, 1995, FP
lends a portion of the proceeds of the offering to DS.
(ii) The FP debt and the loan to DS are financing transactions
within the meaning of paragraph (a)(2)(ii)(A)(1) of this section and
together constitute a financing arrangement within the meaning of
paragraph (a)(2)(i) of this section. The owners of the FP debt are
the financing entities, FP is the intermediate entity and DS is the
financed entity. Interest payments on the debt issued by FP would be
subject to withholding tax if the debt were issued by DS, unless DS
received all necessary Forms W-8. Therefore, the participation of FP
in the financing arrangement potentially reduces the tax imposed by
section 881(a). However, because it is reasonable to assume that the
purchasers of the FP debt would have provided certifications in
order to avoid the withholding tax imposed by section 881, there is
not a tax avoidance plan. Accordingly, FP is not a conduit entity.
Example 19. Tax avoidance plan--other factors. (i) Over a period
of years, FP has maintained a deposit with BK, a bank organized in
the United States, that is unrelated to FP and its subsidiaries. FP
often sells goods and purchases raw materials in the United States.
FP opened the bank account with BK in order to facilitate this
business and the amounts it maintains in the account are reasonably
related to its dollar-denominated working capital needs. On January
1, 1995, BK lends $5,000,000 to DS. After the loan is made, the
balance in FP's bank account remains within a range appropriate to
meet FP's working capital needs.
(ii) FP's deposit with BK and BK's loan to DS are financing
transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of
this section and together constitute a financing arrangement within
the meaning of paragraph (a)(2)(i) of this section. Pursuant to
section 881(i), interest paid by BK to FP with respect to the bank
deposit is exempt from withholding tax. Interest paid directly by DS
to FP would not be exempt from withholding tax under section 881(i)
and therefore would be subject to a 30% withholding tax.
Accordingly, there is a significant reduction in the tax imposed by
section 881, which is evidence of the existence of a tax avoidance
plan. See paragraph (b)(2)(i) of this section. However, the district
director also will consider the fact that FP historically has
maintained an account with BK to meet its working capital needs and
that, prior to and after BK's loan to DS, the balance within the
account remains within a range appropriate to meet those business
needs as evidence that the participation of BK in the FP-BK-DS
financing arrangement is not pursuant to a tax avoidance plan. In
determining the presence or absence of a tax avoidance plan, all
relevant facts will be taken into account.
Example 20. Tax avoidance plan--other factors. (i) Assume the
same facts as in Example 19, except that on January 1, 2000, FP's
deposit with BK substantially exceeds FP's expected working capital
needs and on January 2, 2000, BK lends additional funds to DS.
Assume also that BK's loan to DS provides BK with a right of offset
against FP's deposit. Finally, assume that FP would have lent the
funds to DS directly but for the imposition of the withholding tax
on payments made directly to FP by DS.
(ii) As in Example 19, the transactions in paragraph (i) of this
Example 20 are a financing arrangement within the meaning of
paragraph (a)(2)(i) and the participation of the BK reduces the
section 881 tax. In this case, the presence of funds substantially
in excess of FP's working capital needs and the fact that FP would
have been willing to lend funds directly to DS if not for the
withholding tax are evidence that the participation of BK in the FP-
BK-FS financing arrangement is pursuant to a tax avoidance plan.
However, other facts relevant to the presence of such a plan must
also be taken into account. Even if the district director determines
that the participation of BK in the financing arrangement is
pursuant to a tax avoidance plan, BK may not be treated as a conduit
entity unless BK would not have participated in the financing
arrangement on substantially the same terms in the absence of FP's
deposit with BK. BK's right of offset against FP's deposit (a form
of guarantee of BK's loan to DS) creates a presumption that BK would
not have made the loan to DS on substantially the same terms in the
absence of FP's deposit with BK. If the taxpayer overcomes the
presumption by clear and convincing evidence, BK will not be a
conduit entity.
Example 21. Significant financing activities. (i) FS is
responsible for coordinating the financing of all of the
subsidiaries of FP, which are engaged in substantial trades or
businesses and are located in country T, country N, and the United
States. FS maintains a centralized cash management accounting system
for FP and its subsidiaries in which it records all
[[Page 41013]]
intercompany payables and receivables; these payables and receivables
ultimately are reduced to a single balance either due from or owing
to FS and each of FP's subsidiaries. FS is responsible for
disbursing or receiving any cash payments required by transactions
between its affiliates and unrelated parties. FS must borrow any
cash necessary to meet those external obligations and invests any
excess cash for the benefit of the FP group. FS enters into interest
rate and foreign exchange contracts as necessary to manage the risks
arising from mismatches in incoming and outgoing cash flows. The
activities of FS are intended (and reasonably can be expected) to
reduce transaction costs and overhead and other fixed costs. FS has
50 employees, including clerical and other back office personnel,
located in country T. At the request of DS, on January 1, 1995, FS
pays a supplier $1,000,000 for materials delivered to DS and charges
DS an open account receivable for this amount. On February 3, 1995,
FS reverses the account receivable from DS to FS when DS delivers to
FP goods with a value of $1,000,000.
(ii) The accounts payable from DS to FS and from FS to other
subsidiaries of FP constitute financing transactions within the
meaning of paragraph (a)(2)(ii)(A)(1) of this section, and the
transactions together constitute a financing arrangement within the
meaning of paragraph (a)(2)(i) of this section. FS's activities
constitute significant financing activities with respect to the
financing transactions even though FS did not actively and
materially participate in arranging the financing transactions
because the financing transactions consisted of trade receivables
and trade payables that were ordinary and necessary to carry on the
trades or businesses of DS and the other subsidiaries of FP.
Accordingly, pursuant to paragraph (b)(3)(i) of this section, FS'
participation in the financing arrangement is presumed not to be
pursuant to a tax avoidance plan.
Example 22. Significant financing activities--active risk
management. (i) The facts are the same as in Example 21, except
that, in addition to its short-term funding needs, DS needs long-
term financing to fund an acquisition of another U.S. company; the
acquisition is scheduled to close on January 15, 1995. FS has a
revolving credit agreement with a syndicate of banks located in
Country N. On January 14, 1995, FS borrows 10 billion for 10
years under the revolving credit agreement, paying yen LIBOR plus 50
basis points on a quarterly basis. FS enters into a currency swap
with BK, an unrelated bank that is not a member of the syndicate,
under which FS will pay BK 10 billion and will receive $100
million on January 15, 1995; these payments will be reversed on
January 15, 2004. FS will pay BK U.S. dollar LIBOR plus 50 basis
points on a notional principal amount of $100 million semi-annually
and will receive yen LIBOR plus 50 basis points on a notional
principal amount of 10 billion quarterly. Upon the closing of
the acquisition on January 15, 1995, DS borrows $100 million from FS
for 10 years, paying U.S. dollar LIBOR plus 50 basis points
semiannually.
(ii) Although FS performs significant financing activities with
respect to certain financing transactions to which it is a party, FS
does not perform significant financing activities with respect to
the financing transactions between FS and the syndicate of banks and
between FS and DS because FS has eliminated all material market
risks arising from those financing transactions through its currency
swap with BK. Accordingly, the financing arrangement does not
benefit from the presumption of paragraph (b)(3)(i) of this section
and the district director must determine whether the participation
of FS in the financing arrangement is pursuant to a tax avoidance
plan on the basis of all the facts and circumstances. However, if
additional facts indicated that FS reviews its currency swaps daily
to determine whether they are the most cost efficient way of
managing their currency risk and, as a result, frequently terminates
swaps in favor of entering into more cost efficient hedging
arrangements with unrelated parties, FS would be considered to
perform significant financing activities and FS' participation in
the financing arrangements would not be pursuant to a tax avoidance
plan.
Example 23. Significant financing activities--presumption
rebutted. (i) The facts are the same as in Example 21, except that,
on January 1, 1995, FP lends to FS DM 15,000,000 (worth $10,000,000)
in exchange for a 10 year note that pays interest annually at a rate
of 5 percent per annum. Also, on March 15, 1995, FS lends
$10,000,000 to DS in exchange for a 10-year note that pays interest
annually at a rate of 8 percent per annum. FS would not have had
sufficient funds to make the loan to DS without the loan from FP. FS
does not enter into any long-term hedging transaction with respect
to these financing transactions, but manages the interest rate and
currency risk arising from the transactions on a daily, weekly or
quarterly basis by entering into forward currency contracts.
(ii) Because FS performs significant financing activities with
respect to the financing transactions between FS, DS and FP, the
participation of FS in the financing arrangement is presumed not to
be pursuant to a tax avoidance plan. The district director may rebut
this presumption by establishing that the participation of FS is
pursuant to a tax avoidance plan, based on all the facts and
circumstances. The mere fact that FS is a resident of country T is
not sufficient to establish the existence of a tax avoidance plan.
However, the existence of a plan can be inferred from other factors
in addition to the fact that FS is a resident of country T. For
example, the loans are made within a short time period and FS would
not have been able to make the loan to DS without the loan from FP.
Example 24. Determination of amount of tax liability. (i) On
January 1, 1996, FP makes two three-year installment loans of
$250,000 each to FS that pay interest at a rate of 9 percent per
annum. The loans are self-amortizing with payments on each loan of
$7,950 per month. On the same date, FS lends $1,000,000 to DS in
exchange for a two-year note that pays interest semi-annually at a
rate of 10 percent per annum, beginning on June 30, 1996. The FS-DS
loan is not self-amortizing. Assume that for the period of January
1, 1996 through June 30, 1996, the average principal amount of the
financing transactions between FP and FS that comprise the financing
arrangement is $469,319. Further, assume that for the period of July
1, 1996 through December 31, 1996, the average principal amount of
the financing transactions between FP and FS is $393,632. The
average principal amount of the financing transaction between FS and
DS for the same periods is $1,000,000. The district director
determines that the financing transactions between FP and FS, and FS
and DS, are a conduit financing arrangement.
(ii) Pursuant to paragraph (d)(1)(i) of this section, the
portion of the $50,000 interest payment made by DS to FS on June 30,
1996, that is recharacterized as a payment to FP is $23,450 computed
as follows: ($50,000 x $469,319/$1,000,000) = $23,450. The portion
of the interest payment made on December 31, 1996 that is
recharacterized as a payment to FP is $19,650, computed as follows:
($50,000 x $393,632/$1,000,000) = $19,650. Furthermore, under
Sec. 1.1441-3(j), DS is liable for withholding tax at a 30 percent
rate on the portion of the $50,000 payment to FS that is
recharacterized as a payment to FP, i.e., $7,035 with respect to the
June 30, 1996 payment and $5,895 with respect to the December 31,
1996 payment.
Example 25. Determination of principal amount. (i) FP lends DM
10,000,000 to FS in exchange for a ten year note that pays interest
semi-annually at a rate of 8 percent per annum. Six months later,
pursuant to a tax avoidance plan, FS lends DM 5,000,000 to DS in
exchange for a 10 year note that pays interest semi-annually at a
rate of 10 percent per annum. At the time FP make its loan to FS,
the exchange rate is DM 1.5/$1. At the time FS makes its loan to DS
the exchange rate is DM 1.4/$1.
(ii) FP's loan to FS and FS' loan to DS are financing
transactions and together constitute a financing arrangement.
Furthermore, because the participation of FS reduces the tax imposed
under section 881 and FS' participation is pursuant to a tax
avoidance plan, the financing arrangement is a conduit financing
arrangement.
(iii) Pursuant to paragraph (d)(1)(i) of this section, the
amount subject to recharacterization is a fraction the numerator of
which is the average principal amount advanced from FS to DS and the
denominator of which is the average principal amount advanced from
FP to FS. Because the property advanced in these financing
transactions is the same type of fungible property, under paragraph
(d)(1)(ii)(A) of this section, both are valued on the date of the
last financing transaction. Accordingly, the portion of the payments
of interest that is recharacterized is ((DM 5,000,000 x DM 1.4/$1)/
(DM 10,000,000 x DM 1.4/$1) or 0.5.
(f) Effective date. This section is effective for payments made by
financed entities on or after September 11, 1995. This section shall
not apply to interest payments covered by section 127(g)(3) of the Tax
Reform Act of 1984, and to interest payments with respect to other debt
obligations issued prior to October
[[Page 41014]]
15, 1984 (whether or not such debt was issued by a Netherlands Antilles
corporation).
Sec. 1.881-4 Recordkeeping requirements concerning conduit financing
arrangements.
(a) Scope. This section provides rules for the maintenance of
records concerning certain financing arrangements to which the
provisions of Sec. 1.881-3 apply.
(b) Recordkeeping requirements--(1) In general. Any person subject
to the general recordkeeping requirements of section 6001 must keep the
permanent books of account or records, as required by section 6001,
that may be relevant to determining whether that person is a party to a
financing arrangement and whether that financing arrangement is a
conduit financing arrangement.
(2) Application of Sections 6038 and 6038A. A financed entity that
is a reporting corporation within the meaning of section 6038A(a) and
the regulations under that section, and any other person that is
subject to the recordkeeping requirements of Sec. 1.6038A-3, must
comply with those recordkeeping requirements with respect to records
that may be relevant to determining whether the financed entity is a
party to a financing arrangement and whether that financing arrangement
is a conduit financing arrangement. Such records, including records
that a person is required to maintain pursuant to paragraph (c) of this
section, shall be considered records that are required to be maintained
pursuant to section 6038 or 6038A. Accordingly, the provisions of
sections 6038 and 6038A (including, without limitation, the penalty
provisions thereof), and the regulations under those sections, shall
apply to any records required to be maintained pursuant to this
section.
(c) Records to be maintained--(1) In general. An entity described
in paragraph (b) of this section shall be required to retain any
records containing the following information concerning each financing
transaction that the entity knows or has reason to know comprises the
financing arrangement--
(i) The nature (e.g., loan, stock, lease, license) of each
financing transaction;
(ii) The name, address, taxpayer identification number (if any) and
country of residence of--
(A) Each person that advanced money or other property, or granted
rights to use property;
(B) Each person that was the recipient of the advance or rights;
and
(C) Each person to whom a payment was made pursuant to the
financing transaction (to the extent that person is a different person
than the person who made the advance or granted the rights);
(iii) The date and amount of--
(A) Each advance of money or other property or grant of rights; and
(B) Each payment made in return for the advance or grant of rights;
(iv) The terms of any guarantee provided in conjunction with a
financing transaction, including the name of the guarantor; and
(v) In cases where one or both of the parties to a financing
transaction are related to each other or another entity in the
financing arrangement, the manner in which these persons are related.
(2) Additional documents. An entity described in paragraph (b) of
this section must also retain all records relating to the circumstances
surrounding its participation in the financing transactions and
financing arrangements. Such documents may include, but are not limited
to--
(i) Minutes of board of directors meetings;
(ii) Board resolutions or other authorizations for the financing
transactions;
(iii) Private letter rulings;
(iv) Financial reports (audited or unaudited);
(v) Notes to financial statements;
(vi) Bank statements;
(vii) Copies of wire transfers;
(viii) Offering documents;
(ix) Materials from investment advisors, bankers and tax advisors;
and
(x) Evidences of indebtedness.
(3) Effect of record maintenance requirement. Record maintenance in
accordance with paragraph (b) of this section generally does not
require the original creation of records that are ordinarily not
created by affected entities. If, however, a document that is actually
created is described in this paragraph (c), it is to be retained even
if the document is not of a type ordinarily created by the affected
entity.
(d) Effective date. This section is effective September 11, 1995.
This section shall not apply to interest payments covered by section
127(g)(3) of the Tax Reform Act of 1984, and to interest payments with
respect to other debt obligations issued prior to October 15, 1984
(whether or not such debt was issued by a Netherlands Antilles
corporation).
Par. 4. In Sec. 1.1441-3, the OMB parenthetical at the end of the
section is removed and paragraph (j) is added to read as follows:
Sec. 1.1441-3 Exceptions and rules of special application.
* * * * *
(j) Conduit financing arrangements--(1) Duty to withhold. A
financed entity or other person required to withhold tax under section
1441 with respect to a financing arrangement that is a conduit
financing arrangement within the meaning of Sec. 1.881-3(a)(2)(iv)
shall be required to withhold under section 1441 as if the district
director had determined, pursuant to Sec. 1.881-3(a)(3), that all
conduit entities that are parties to the conduit financing arrangement
should be disregarded. The amount of tax required to be withheld shall
be determined under Sec. 1.881-3(d). The withholding agent may withhold
tax at a reduced rate if the financing entity establishes that it is
entitled to the benefit of a treaty that provides a reduced rate of tax
on a payment of the type deemed to have been paid to the financing
entity. Section 1.881-3(a)(3)(ii)(E) shall not apply for purposes of
determining whether any person is required to deduct and withhold tax
pursuant to this paragraph (j), or whether any party to a financing
arrangement is liable for failure to withhold or entitled to a refund
of tax under sections 1441 or 1461 to 1464 (except to the extent the
amount withheld exceeds the tax liability determined under Sec. 1.881-
3(d)). See Sec. 1.1441-7(d) relating to withholding tax liability of
the withholding agent in conduit financing arrangements subject to
Sec. 1.881-3.
(2) Effective date. This paragraph (j) is effective for payments
made by financed entities on or after September 11, 1995. This
paragraph shall not apply to interest payments covered by section
127(g)(3) of the Tax Reform Act of 1984, and to interest payments with
respect to other debt obligations issued prior to October 15, 1984
(whether or not such debt was issued by a Netherlands Antilles
corporation).
Par. 5. In Sec. 1.1441-7, the OMB parenthetical at the end of the
section is removed and paragraph (d) is added to read as follows:
Sec. 1.1441-7 General provisions relating to withholding agents.
* * * * *
(d) Conduit financing arrangements--(1) Liability of withholding
agent. Subject to paragraph (d)(2) of this section, any person that is
required to deduct and withhold tax under Sec. 1.1441-3(j) is made
liable for that tax by section 1461. A person that is required to
deduct and withhold tax but fails to do so is liable for the payment
[[Page 41015]]
of the tax and any applicable penalties and interest.
(2) Exception for withholding agents that do not know of conduit
financing arrangement--(i) In general. A withholding agent will not be
liable under paragraph (d)(1) of this section for failing to deduct and
withhold with respect to a conduit financing arrangement unless the
person knows or has reason to know that the financing arrangement is a
conduit financing arrangement. This standard shall be satisfied if the
withholding agent knows or has reason to know of facts sufficient to
establish that the financing arrangement is a conduit financing
arrangement, including facts sufficient to establish that the
participation of the intermediate entity in the financing arrangement
is pursuant to a tax avoidance plan. A withholding agent that knows
only of the financing transactions that comprise the financing
arrangement will not be considered to know or have reason to know of
facts sufficient to establish that the financing arrangement is a
conduit financing arrangement.
(ii) Examples. The following examples illustrate the operation of
paragraph (d)(2) of this section.
Example 1. (i) DS is a U.S. subsidiary of FP, a corporation
organized in Country N, a country that does not have an income tax
treaty with the United States. FS is a special purpose subsidiary of
FP that is incorporated in Country T, a country that has an income
tax treaty with the United States that prohibits the imposition of
withholding tax on payments of interest. FS is capitalized with
$10,000,000 in debt from BK, a Country N bank, and $1,000,000 in
capital from FS.
(ii) On May 1, 1995, C, a U.S. person, purchases an automobile
from DS in return for an installment note. On July 1, 1995, DS sells
a number of installment notes, including C's, to FS in exchange for
$10,000,000. DS continues to service the installment notes for FS
and C is not notified of the sale of its obligation and continues to
make payments to DS. But for the withholding tax on payments of
interest by DS to BK, DS would have borrowed directly from BK,
pledging the installment notes as collateral.
(iii) The C installment note is a financing transaction, whether
held by DS or by FS, and the FS note held by BK also is a financing
transaction. After FS purchases the installment note, and during the
time the installment note is held by FS, the transactions constitute
a financing arrangement, within the meaning of Sec. 1.881-
3(a)(2)(i). BK is the financing entity, FS is the intermediate
entity, and C is the financed entity. Because the participation of
FS in the financing arrangement reduces the tax imposed by section
881 and because there was a tax avoidance plan, FS is a conduit
entity.
(iv) Because C does not know or have reason to know of the tax
avoidance plan (and by extension that the financing arrangement is a
conduit financing arrangement), C is not required to withhold tax
under section 1441. However, DS, who knows that FS's participation
in the financing arrangement is pursuant to a tax avoidance plan and
is a withholding agent for purposes of section 1441, is not relieved
of its withholding responsibilities.
Example 2. Assume the same facts as in Example, 1 except that C
receives a new payment booklet on which DS is described as
``agent''. Although C may deduce that its installment note has been
sold, without more C has no reason to know of the existence of a
financing arrangement. Accordingly, C is not liable for failure to
withhold, although DS still is not relieved of its withholding
responsibilities.
Example 3. (i) DC is a U.S. corporation that is in the process
of negotiating a loan of $10,000,000 from BK1, a bank located in
Country N, a country that does not have an income tax treaty with
the United States. Before the loan agreement is signed, DC's tax
lawyers point out that interest on the loan would not be subject to
withholding tax if the loan were made by BK2, a subsidiary of BK1
that is incorporated in Country T, a country that has an income tax
treaty with the United States that prohibits the imposition of
withholding tax on payments of interest. BK1 makes a loan to BK2 to
enable BK2 to make the loan to DC. Without the loan from BK1 to BK2,
BK2 would not have been able to make the loan to DC.
(ii) The loan from BK1 to BK2 and the loan from BK2 to DC are
both financing transactions and together constitute a financing
arrangement within the meaning of Sec. 1.881-3(a)(2)(i). BK1 is the
financing entity, BK2 is the intermediate entity, and DC is the
financed entity. Because the participation of BK2 in the financing
arrangement reduces the tax imposed by section 881 and because there
is a tax avoidance plan, BK2 is a conduit entity.
(iii) Because DC is a party to the tax avoidance plan (and
accordingly knows of its existence), DC must withhold tax under
section 1441. If DC does not withhold tax on its payment of
interest, BK2, a party to the plan and a withholding agent for
purposes of section 1441, must withhold tax as required by section
1441.
Example 4. (i) DC is a U.S. corporation that has a long-standing
banking relationship with BK2, a U.S. subsidiary of BK1, a bank
incorporated in Country N, a country that does not have an income
tax treaty with the United States. DC has borrowed amounts of as
much as $75,000,000 from BK2 in the past. On January 1, 1995, DC
asks to borrow $50,000,000 from BK2. BK2 does not have the funds
available to make a loan of that size. BK2 considers BK1 to enter
into a loan with DC but rejects this possibility because of the
additional withholding tax that would be incurred. Accordingly, BK2
borrows the necessary amount from BK1 with the intention of on-
lending to DC. BK1 does not make the loan directly to DC because of
the withholding tax that would apply to payments of interest from DC
to BK1. DC does not negotiate with BK1 and has no reason to know
that BK1 was the source of the loan.
(ii) The loan from BK2 to DC and the loan from BK1 to BK2 are
both financing transactions and together constitute a financing
arrangement within the meaning of Sec. 1.881-3(a)(2)(i). BK1 is the
financing entity, BK2 is the intermediate entity, and DC is the
financed entity. The participation of BK2 in the financing
arrangement reduces the tax imposed by section 881. Because the
participation of BK2 in the financing arrangement reduces the tax
imposed by section 881 and because there was a tax avoidance plan,
BK2 is a conduit entity.
(iii) Because DC does not know or have reason to know of the tax
avoidance plan (and by extension that the financing arrangement is a
conduit financing arrangement), DC is not required to withhold tax
under section 1441. However, BK2, who is also a withholding agent
under section 1441 and who knows that the financing arrangement is a
conduit financing arrangement, is not relieved of its withholding
responsibilities.
(3) Effective date. This paragraph (d) is effective for payments
made by financed entities on or after September 11, 1995. This
paragraph shall not apply to interest payments covered by section
127(g)(3) of the Tax Reform Act of 1984, and to interest payments with
respect to other debt obligations issued prior to October 15, 1984
(whether or not such debt was issued by a Netherlands Antilles
corporation).
Par. 6. In Sec. 1.6038A-3, paragraphs (b)(5) and (c)(2)(vii) are
added to read as follows:
Sec. 1.6038A-3 Record maintenance.
* * * * *
(b) * * *
(5) Records relating to conduit financing arrangements. See
Sec. 1.881-4 relating to conduit financing arrangements.
(c) * * *
(2) * * *
(vii) Records relating to conduit financing arrangements. See
Sec. 1.881-4 relating to conduit financing arrangements.
* * * * *
Par. 7. Section 1.7701(l)-1 is added to read as follows:
Sec. 1.7701(l)-1 Conduit financing arrangements.
(a) Scope. Section 7701(l) authorizes the issuance of regulations
that recharacterize any multiple-party financing transaction as a
transaction directly among any two or more of such parties where the
Secretary determines that such recharacterization is appropriate to
prevent avoidance of any tax imposed by title 26 of the United States
Code.
(b) Regulations issued under authority of section 7701(l). The
following regulations are issued under the authority of section
7701(l)--
[[Page 41016]]
(1) Sec. 1.871-1(b)(7);
(2) Sec. 1.881-3;
(3) Sec. 1.881-4;
(4) Sec. 1.1441-3(j);
(5) Sec. 1.1441-7(d);
(6) Sec. 1.6038A-3(b)(5); and
(7) Sec. 1.6038A-3(c)(2)(vii).
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 8. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Par. 9. In Sec. 602.101, paragraph (c) is amended by adding an
entry in numerical order and revising an entry to the table to read as
follows:
Sec. 602.101 OMB Control numbers.
* * * * *
(c) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------
* * * * *
1.881-4.................................................... 1545-1440
* * * * *
Sec. 1.6038A-3............................................ 1545-1191
1545-1440
* * * * *
------------------------------------------------------------------------
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: July 26, 1995.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-19446 Filed 8-10-95; 8:45 am]
BILLING CODE 4830-01-U
