CCA 201336018 / Collateral Consequences for Foreign Tax Purposes

The payment of interest, other than in currency, between related corporations carries consequences for the calculation of the foreign tax credit (FTC).

Chief Counsel Advice 201336018 (CCA) addresses such a situation in a U.S. consolidated group setting. The facts in the CCA are a U.S. parent corporation (P) owned all of the shares of two U.S. corporations (US-1 and US-2). P loaned US-1 funds that US-1 re-loaned to US-2.  US-2 then transferred these funds down its chain of foreign subsidiary companies to finance the acquisition of foreign assets.

The terms of the loan agreement gave US-2 the option to pay interest either in currency baws on a LIBOR formula or in units of a foreign limited partnership (“FLP”) that is treated as a corporation for U.S. tax purposes.  Internal Revenue Code §163(l) disallows a deduction for interest paid or accrued using equity and classifies the equity as “disqualified debt.”  Payment of interest other than in currency impacts the U.S. consolidated return and the calculation of the foreign tax credit.  Unfortunately, the impact can be different.

The consolidated return rules treat the non-deductible interest paid to the recipient as tax-exempt interest and the basis in the stock of the subsidiary is increased by the payment.  No doubt the author of the CCA considered the possibility of inflating basis using FLP units to make payments. If that were to occur, the basis in the stock of the subsidiary would be overstated without a basis adjustment to accommodate the goal of §163(l). Unfortunately, these rules treat tax-exempt interest and interest on disqualified debt for purposes differently for purposes of the basis adjustment.

The next complication comes from the impact of basis adjustments upon the calculation of the foreign tax credit (FTC).  Simply stated, the FTC is limited to the U.S. tax that would be imposed upon foreign source income. In order to calculate foreign source income, we must deduct (a) those expenses and losses which can be definitely allocated.  and (b) then deduct a ratable allocation of other expenses which cannot be definitely allocated. Interest cannot be definitely allocated because it is considered fungible. Rather, interest is allocated between domestic and foreign source income on the basis of either income or assets, using either fair market value or tax book basis.

The taxpayer in the CCA took the position that the interest disallowed also requires the basis in the shares of the foreign company to be reduced to maintain consistency with the consolidated return rule.

What was at stake for the taxpayer?

The reduction in the basis of foreign asset (FLP units) would reduce the basis of  foreign assets that would receive an allocation of interest. A lesser allocation of interest would increase foreign source net income and the foreign tax credit limitation.  The higher limitation would increase the foreign tax credit available to offset U.S. income tax.

The regulation under 1.861-12T(f) permits the reduction of basis for purposes of the allocation where the basis of the asset is funded by disallowed interest. The CCA concludes that the taxpayer did not satisfy the “in connection with” requirement. The CCA stated that the provision of the loan agreement permitting payment in the form of stock was gratuitous .

Clearly, the Service’s view limits the use of the exceptions under 1.861-12T.  The CCA  reduces the taxpayer’s ability to increase its FTC which increases its tax bill.  It is unclear whether the CCA will be challenged by taxpayer in an administrative appeal of any assessment or in Tax Court.