Partnership's CFC loan guarantees result in ordinary income inclusion

Jan 22, 2018
Jan 22, 2018
0 min. read

Tax Court rejects challenge to validity of section 956 regulations

In a recent case, see SIH Partners LLLP v. Commissioner (Docket No. 3427-15) 150 T.C. No. 3 (2018), the Tax Court rejected the taxpayer’s claim that certain federal tax regulations were invalid. The regulations at issue require U.S. shareholders of a controlled foreign corporation (CFC) to recognize income when the CFC guarantees a shareholder obligation. Accordingly, the court concluded that loans guaranteed by two CFC’s constituted an interest in U.S. real property, and therefore triggered an income inclusion to the U.S. parent. In addition, the court also held that the resulting income inclusion was a not a qualified dividend eligible for the lower 15 percent rate, instead concluding that the resulting inclusion was taxable at higher ordinary income rates.

In this case, SIH Partners LLLP (SIH) was a Delaware partnership that was a shareholder in two CFC’s. During the years in question, both of the CFC’s were guarantors on loans made to SIG, a related U.S. investment firm. 

Generally, U.S. shareholders of a CFC must include in current income specific types of income of the CFC. Under these rules, an investment in U.S. property generally triggers an income inclusion. Such property includes tangible property located within the U.S., stock of a U.S. corporation, certain loans made by a CFC to a U.S. shareholder, and the right to the use of certain intangible property within the U.S. In addition, guarantees by a CFC of an obligations of a related U.S. person can also create an income inclusion under these rules. However, the specific rules regarding the guarantee of a U.S. obligation by a CFC are not set forth in the Internal Revenue Code but are instead contained in relevant regulations.

In SIH Partners LLLP, SIH argued that the regulations relating to guarantees were invalid because the Treasury acted in an arbitrary and capricious manner because the Treasury failed to engage in reasoned decision making or provide a reasoned explanation of the rules. The court, however, disagreed.

In its analysis, the court concluded that the Treasury had satisfied the notice and comment requirements of the Administrative Procedures Act, and found nothing to indicate that the regulations were arbitrary or capricious. Moreover, the court concluded the regulations were in no way contrary to congressional intent, instead stating that the regulations “sought to implement the clear wording of the statute.”

After concluding that the regulations were indeed valid, the court then found that the rules applied to SIH for the tax years in question and held that SIH had income inclusions as a result of the CFCs loan guarantees in an amount equal to the both CFCs applicable earnings. Furthermore, the court rejected SIH’s argument that the resulting income inclusions were entitled to qualified dividend treatment, and instead held that such inclusions were ordinary income.

U.S. parents considering the use of CFC’s to provide credit support should pay particular attention to these rules since the IRS is clearly active in this area.

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