Issues to consider when multiple foreign subs guarantee the same loan
Bank loans to U.S. companies can result in U.S. taxation of income deferred in a foreign corporation if the assets of a controlled foreign corporation (CFC) are pledged as collateral up to the amount of the loan. However, in some cases, a U.S. taxpayer may have multiple inclusions of income that exceed the total loan amount under an obscure technical tax rule.
Generally, U.S. shareholders of a CFC must currently include certain types of income and recognize income equal to the amount of any U.S. investments made by the CFC even if the CFC makes no cash distributions. Investments in “U.S. property”, such as loans to a U.S. shareholder, trigger income inclusions under this rule. In addition, a CFC’s guarantee (including the pledge of the CFC’s assets) of a loan made by a third party to a U.S. shareholder may also trigger an income inclusion up to the amount of the principal balance of the loan.
However, when multiple CFCs guarantee a single obligation, multiple income inclusions can result. For example, if more than one CFC guarantees the same loan, each CFC may be deemed to have made a separate investment in U.S. property in an amount equal to the unpaid principal balance of the obligation guaranteed. In this case, the U.S. shareholder may have to take into income its share of the separate investments in U.S. property of each CFC, which in the aggregate may exceed the entire principal amount of the obligation.
The preamble to proposed regulations addressing the treatment of investments in U.S. property seems to contemplate this exact result, providing several possible approaches to dealing with the issue. One such approach would be to allow taxpayers to allocate the unpaid principal among the CFC guarantors based on any consistent, reasonable method that results in the full inclusion of the unpaid principal. Yet another approach mentioned – possibly a more administrable one – would be to allow taxpayers to allocate the unpaid principal among CFC guarantors based on the CFCs earnings and profits. In the absence of definitive guidance, it is possible that taxpayers may be required to include an amount greater than the principal amount of the loan, an onerous result indeed.
U.S. parents companies with CFCs that provide credit support should carefully analyze their loan arrangement and take steps to avoid this trap for the unwary.