Firm Seeks Changes to Proposed Regs on U.S. Property Held by CFCs

We greatly appreciate recognition by the Treasury Department (the "Treasury") and the Service that the application of section 956 where there are multiple pledgors or guarantors is an area of concern that has not been adequately addressed, and we thank you for initiating discussion on the appropriate rules for the issues raised. While we have attempted to set forth our thoughts in full, we would be glad to answer any questions that our submission raises.

The Preamble asserts their view that under existing Treas. Reg. § 1.956-1(e)(2), where there are multiple pledgors or guarantors of a single obligation of a U.S. person, each and every CFC that is a pledgor or guarantor should be considered to make a separate investment in United States property ("U.S. property") equal to the entire unpaid balance of the obligation. It acknowledges that under that interpretation of the existing regulation, the aggregate amount of investment in U.S. property by all of the CFC pledgors and guarantors could exceed the amount of the obligation, and the amount required to be included in income by a United States shareholder ("U.S. shareholder") under section 951(a)(1)(B) with respect to the pledges and guarantees of a single obligation could exceed the amount of that obligation.

The Preamble states that the Treasury and the Service are considering whether to exercise their authority under section 956(e)¹ to allocate the amount of the obligation among the CFC pledgors and guarantors. Section 956(e) grants authority to prescribe regulations "as may be necessary to carry out the purposes of section 956. The Preamble indicates that the regulations under consideration could limit the aggregate inclusion under section 951(a)(1)(B) to the unpaid principal amount of the obligation and allocate the aggregate inclusion among the pledgors and gurarantors that are CFCs or partnerships with CFC partners.

The Preamble describes several possible ways to allocate the unpaid balance of an obligation among multiple pledgors or guarantors. One described approach would be to allow taxpayers to select any consistently applied, reasonable method for allocating the amount of the obligation among the guarantor CFCs and partnerships. Another option would be to allocate the obligation among CFC and partnership guarantors "in accordance with their available credit capacities measured, for example, by the relative net values of their assets." The Preamble states that such option would be consistent with how a creditor analyzes the guarantees, but expresses concerns about the administrability of that approach. The Preamble also suggests that allocation could be made based on the earnings and profits of the CFC pledgors and guarantors in several different ways. For example, the suggestion is that the allocation might be made among the CFC pledgors and guarantors (i) in accordance with their "applicable earnings" as defined in section 956(b), (ii) in accordance with their non-previously taxed earnings and profits described in section 959(c)(3) or (iii) first to CFCs with positive non-previously taxed earnings and profits described in section 959(c)(3) and then to the remainder of the CFCs in accordance with their applicable earnings.

The Preamble states that the Treasury and the Service will consider, among other things, whether it is appropriate to allow the aggregate section 951(a)(1)(B) inclusions relating to multiple pledges and guarantees of a single obligation to total less than the amount of the obligation in any particular year, whether any allocation method would allow for inappropriate planning opportunities, whether an allocation rule would be administrable and how various complexities might affect the application of an allocation rule.

Comments are specifically requested on (i) whether the Treasury and the Service should limit the aggregate section 951(a)(1)(B) inclusions to the unpaid principal amount of the obligation and (ii) potential problems that could arise under various possible allocation methods.

The Treasury and the Service should issue regulations to limit the aggregate investment in U.S. property by the pledgors and guarantors of a single obligation to the unpaid principal amount of the obligation. Such regulations are necessary to ensure results that are consistent with the statutory structure and purpose of section 956. The legislative purpose of section 956 is to impose a U.S. dividend tax on transactions that, in substance, repatriate a CFCs untaxed foreign-source earnings to the United States. The legislative history of section 956, as well as the Service's pronouncements and relevant case law, has consistently focused on whether and how much of a CFC's assets have been repatriated to the United States. See, e.g., Rev. Rul. 89-73, 1989-1 C.B. 258 ("The application of section 956 is concerned with the substance of a transaction, not its form. . . . The facts and circumstances of each case must be reviewed to determine if, in substance, there has been a repatriation of the earnings of the controlled foreign corporation."); Jacobs Engineering Group Inc. v. United States, 79 A.F.T.R.2d 97-1673, 97-1676 (CD. Cal. 1997), aff'd 168 F.3d 499 (9^th Cir. 1999) ("this Court upon determining the facts must simply decide whether those facts 'fall within the intended scope of the Internal Revenue Code provision at issue.' . . . As mentioned above, [section 956] . . . was enacted to curb perceived abuses by taxpayers who, through controlled foreign corporations, would repatriate otherwise nontaxable foreign income for the use and benefit of domestic shareholders."); TAM 8042001 (Mar. 18, 1980) ("The facts and circumstances of each case have to be examined to determine if a pledge of a controlled foreign corporation's stock by a U.S. person causes the controlled foreign corporation to be considered as holding an obligation of a U.S. person. We believe that a proper interpretation of the statute is reached when one focuses not on the highly technical meaning of the terms 'pledge' and 'guarantor' as used in commercial transactions, but instead on the purpose of section 956(c) of the Code."). In all of those instances, there was a careful examination of the economics, ignoring form or other distractions from the economic elements. The forthcoming regulations that address the treatment of multiple guarantors and pledgors should have the same focus.

We are concerned that the alternatives set forth in the Preamble could be inconsistent with the structure and purpose of section 956, and we have included recommendations for consideration that we believe would properly address those concerns.

As an overview, we recommend two major goals for these regulations, the details of which will be described:

• The regulations first should limit the aggregate investment in U.S. property to the unpaid balance of the obligation and allocate the unpaid balance among the various sources of credit support: i.e., the creditor, the pledgors and the guarantors. As demonstrated later in our comment letter by use of examples, failure to do this could result in income inclusions that are multiples of the amount of the obligation and the amount of funds actually received by the borrower. It is critical that the limit be on the aggregate investment in U.S. property, rather than the aggregate amount of section 951(a)(1)(B) inclusions. As a matter of economic substance, the aggregate investment in U.S. property cannot be any greater than the amount of the U.S. person's obligation. It would be unreasonable for the forthcoming regulations to allow the aggregate investment in U.S. property to exceed the maximum amount of repatriation that could possibly be achieved by a transaction. In addition to getting a more appropriate determination for section 956 purposes, such a limit would follow the separate steps required by the section 956 statutory language for determining the amount of any section 951(a)(1)(B) inclusion.

• The regulations should allocate the unpaid balance of the obligation among the creditor, pledgors and/or guarantors in the manner that is most consistent with the statutory purpose of section 956(d) -- to deem an investment in U.S. property by a CFC only when and to the extent a CFC pledge or guarantee facilitates borrowing by a U.S. person such that a portion of the funds received are appropriately viewed as attributable to the CFC pledge or guarantee. The detailed comments below discuss two possible ways of allocating the amount of the obligation that generally would be consistent with the purpose of section 956(d). Such allocation should be made among all creditors, pledgors and guarantors, not just CFCs. It is the only way to determine the portion of the loan "facilitated" by the CFCs.

• C. Detailed Comments

   

  1. Section 956 regulations to address multiple pledges and guarantees with respect to a single loan must limit the aggregate investment in U.S. property to the unpaid balance of the obligation and allocate the amount of the investment in U.S. property among all creditors, pledgors and/or guarantors.

   

  i. The mechanics of section 956

The first step in computing the amount of the section 951(a)(1)(B) inclusion is to determine the U.S. shareholder's pro rata share of the CFCs investment in U.S. property for the taxable year, which is determined by averaging the CFCs investment in U.S. property over four quarterly measurement dates. Section 956(a)(1)(A). The items that constitute U.S. property for this purpose, and certain items that do not constitute U.S. property, are set forth in section 956(c). The items that constitute U.S. property include an obligation of a U.S. person (subject to certain exceptions not relevant to this discussion). In most cases, the amount of the CFCs investment in U.S. property on a measurement date is determined by reference to the CFCs adjusted basis in the property. Section 956(a). Under these rules, if a CFC lends some or all of its assets to a U.S. person in exchange for the U.S. person's obligation to repay the loan, the CFC generally is considered to have invested in U.S. property in an amount equal to the lent funds.

As a supplement to the general definition of U.S. property in section 956(c), section 956(d) provides, "For purposes of subsection (a), a [CFC] shall, under regulations prescribed by the Secretary, be considered as holding an obligation of a United States person if such [CFC] is a pledgor or guarantor of such obligation." The statutory grant directs the Treasury to issue regulations that deem a CFC to have made an investment in an obligation of a U.S. person if the CFC grants a pledge or guarantee in support of the obligation. However, section 956(d) did not mandate that all pledges and guarantees be treated as indirect investments in the U.S. person's obligation; nor did it mandate that pledges and guarantees that are treated as indirect investments in the U.S. person's obligation be measured or valued in any particular ways. The grant of regulatory authority in section 956(d) requires the Treasury and the Service to determine when and how to apply section 956(d) by analysis and evaluation of facts. In this way, section 956(d) stands in contrast to section 956(c), which specifically enumerates which types of property held by a CFC are U.S. property and which exceptions to the listed items exist. Treas. Reg. § 1.956-1(e)(2) provides that the amount of the investment in U.S. property by a CFC pledgor or guarantor equals the unpaid principal amount of the obligation.

To understand what regulations under section 956(d) (or section 956(e), since such regulations should "carry out the purposes of section 956) should cover, it is necessary and helpful to review the purpose of the regulatory grant contained in section 956(d). Section 956(d) simply directs an extension of the items listed as U.S. property in section 956(c) to include an obligation as to which the CFC is a pledgor or guarantor, rather than a lender. Congress' fundamental interest under section 956(d) was to treat a CFC as having invested in U.S. property to the extent that the CFC's assets facilitated a loan to a U.S. borrower. By facilitating the loan, the CFC can, indirectly, achieve a result that is similar to a direct loan of its assets to the U.S. borrower. Congress understood this connection between CFC guarantees and asset pledges and direct loans by CFCs. See Senate Finance Cmte. Rept. 94-938 on the Tax Reform Act of 1976 (June 10, 1976) at 225-27 ("It is intended that if the facts indicate that the controlled foreign subsidiary facilitated a loan to, or borrowing by, a U.S. shareholder, the controlled foreign corporation is considered to have made a loan to (or acquired an obligation of) the U.S. shareholder."); Ludwig v. Commissioner, 68 T.C. 979, 990 (1977) ("Less directly, the controlling stockholders could derive nearly identical benefits by borrowing funds from another source and having the loan guarantied by the controlled foreign corporation or secured by a pledge of such corporation's assets. Such use of the credit or assets of the controlled foreign corporation indirectly effects a repatriation of available earnings."). The Proposed Regulations further clarify the role of section 956(d) to treat CFC pledges and guarantees like direct loans by CFCs by providing that a CFC that is a guarantor or pledgor of an obligation of a U.S. person is treated as holding the obligation (i.e., as if the CFC were the lender). Prop. Reg. § 1.956-2(c)(1).

Consequently, both a direct investment in an obligation of a U.S. person and an indirect investment in an obligation of a U.S. person through the grant of a pledge or guarantee should be treated in the same way. In each case, there is a threshold question before the amount of the section 951(a)(1)(B) inclusion can be determined: How much of an investment in U.S. property has been made by the CFC? After the amount of investment in U.S. property is determined on a quarterly basis, then, and only then, does section 956 consider the amount of earnings and profits of the CFC, the portion of those earnings contained in each section 959(c) account and the amount of distributions made during the year in order to calculate the amount of income inclusion required under section 956 and section 951(a)(1)(B). In light of the numerous steps to calculate the section 956 deemed dividend, the deemed dividend from a CFC may be less than the amount of the CFC's investment in U.S. property.

In FSA 200216022 (Apr. 19, 2002), several CFCs of a U.S. borrower entered into agreements that the Service regarded as guarantees of the borrower's debt. The FSA stated the rule of Treas. Reg. § 1.956-1(e)(2) and observed, in the "Law and Analysis" portion of the FSA, that section 956 and the regulations under that section do not prohibit multiple guarantors from each being considered to have acquired an investment in U.S. property equal to the full amount of the guaranteed obligation. There is no analysis beyond the literal reading of the Service's own regulation. Notwithstanding that language, subsequently released guidance to the Field under the heading "Case Development, Hazards and Other Considerations" (which was initially redacted) observed that neither the section 956 statute nor regulations specifically deal with the treatment of multiple guarantors, and that "strange results" could be produced if taxpayers were required to treat every CFC guarantee of the same loan as a separate investment in U.S. property.³ That guidance to the Field recommended that the total amount of the loans be allocated among the CFCs that provided guarantees. In reaching that recommendation, the FSA quoted a 1989 FSA that, to our knowledge, has not been released to the public. The 1989 FSA was quoted as stating that it is the Service's position "that a single investment in U.S. property can only serve as the base for one investment in U.S. property, and thus, one section 956 inclusion."

The description in the Preamble of the current application of section 956 follows the initial view expressed in the "Law and Analysis" section of FSA 200216022 (without the further analysis of the "Case Development, Hazards and Other Considerations" section) and states that under Treas. Reg. § 1.956-1(e)(2), when there are multiple guarantors of a single loan to a U.S. borrower, each and every CFC pledgor and guarantor is considered to make a separate investment in U.S. property equal to the entire unpaid balance of the obligation.

The Preamble further states that the Treasury and the Service are considering whether to exercise their authority under section 956(e) to allocate the amount of the obligation among the CFC pledgors and guarantors. The regulations under consideration could limit the aggregate inclusion under section 956 to the unpaid principal amount of the obligation and allocate the aggregate inclusion among the pledgors and gurarantors that are CFCs or partnerships with CFC partners.

For instance, under the Preamble's interpretation of the current regulation, if CFC1 and CFC2 each guaranteed a loan of $100 to their U.S. parent company, USP, CFC1 and CFC2 would each be considered to have invested $100 in U.S. property, and if the CFCs had sufficient untaxed earnings and profits, USP would be deemed to receive $200 of total section 951(a)(1)(B) inclusions ($100 from each of CFC1 and CFC2). That result is nonsensical when USP would have received only $100 of loan proceeds. Obviously, no more than $100 of the CFCs' assets could have been repatriated to USP by the guarantees of a single $100 loan.

If CFC1 and CFC2 had joined together to lend $100 to USP themselves, it would be absolutely clear that the aggregate investment in U.S. property by CFC1 and CFC2 would equal $100 because their participation interests in the loan would add up to $100. Even if the CFC1-CFC2 lending venture were characterized as a partnership rather than as each CFC holding an undivided interest in USP's obligation, existing Treas. Reg. § 1.956-2(a)(3) would treat each CFC as holding only its proportionate interest in the USP obligation. Treas. Reg. § 1.956-2(a)(3) ("For purposes of section 956, if a controlled foreign corporation is a partner in a partnership that owns property that would be United States property, within the meaning of paragraph (a)(1) of this section, if owned directly by the controlled foreign corporation, the controlled foreign corporation will be treated as holding an interest in the property equal to its interest in the partnership and such interest will be treated as an interest in United States property."). Because CFC1 and CFC2 would have an aggregate investment in U.S. property of only $100 if they directly funded the loan to USP, their aggregate investment in U.S. property should be no greater than $100 if they instead make an indirect repatriation to USP by facilitating a $100 loan to USP from another lender.

This simple example makes clear that where a U.S. person receives the proceeds of an obligation that has benefited from a pledge or guarantee from more than one guarantor, the aggregate amount of repatriated CFC assets should never exceed the unpaid balance of the loan. The unpaid balance is the full amount that the U.S. person has received from anyone, including the CFC guarantors and pledgors.

The Preamble makes clear that the Treasury and the Service are interested in regulations that resolve the ambiguity that exists under current law. Such regulations must construe Treas. Reg. § 1.956-1(e)(2) in a manner that makes sense where there is more than one guarantor or pledgor. This ambiguity is well illustrated by the tension between the "Law and Analysis" and "Case Development, Hazards and Other Considerations" sections of FSA 200216022. A proper interpretation should limit the aggregate investments in U.S. property to the amount lent to the U.S. borrower ($100 in the example) rather than treat each and every pledgor or guarantor as having made its own separate investment in U.S. property equal to the unpaid balance of the obligation.

As discussed in the Preamble and in our comments below, there are critical issues that arise when there are multiple guarantors of a U.S. person's obligation, and any regulations will need to address these issues in a comprehensive manner.

Both as a technical matter and as a conceptual matter, any forthcoming regulations must respect the separate analytical steps of the calculation of the income inclusion under section 956(a). The proper focus of the regulations should be on determining the amount of the investment in U.S. property by the CFC pledgors or guarantors where there are multiple pledges or guarantees with respect to the same obligation. Once the amount of any investment in U.S. property is determined, the section 956(a) calculation will account for the CFC's earnings and profits and distributions in the same manner that it does for any other investment in U.S. property. Thus, the regulations should limit the aggregate investment in U.S. property, rather than the aggregate section 951(a)(1)(B) inclusion, to the unpaid principal amount of the obligation and allocate the amount of the obligation among the creditors, pledgors and guarantors so as to eliminate the potential for multiple investments in a single item of U.S. property.

Consider again the example discussed above, in which CFC1 and CFC2 each guaranteed a loan of $100 to their U.S. parent company, USP. In addition, assume a U.S. subsidiary of USP ("USS") also guarantees the loan. The question is, what is the most appropriate method of allocating the investment in U.S. property among the lender, the pledgors and the guarantors?

We believe that the conceptually correct method of allocating the investment in U.S. property among the lender, the pledgors and the guarantors is to allocate based on the relative contributions of the borrower, the pledgors and the guarantors to the credit support for the U.S. person's obligation. If some or all of the loan could be made on the same terms without pledges or guarantees, then the creditor should be the only person with an investment in the U.S. person's obligation. Once pledgors and guarantors contribute to the facilitation of the loan, then they should share in the investment in the obligation. For example, if the $100 loan to USP were supported by guarantees by USS, CFC1 and CFC2, but it was clear that USP could have borrowed $50 from the lender on the same terms without the guarantees, then $50 of the loan should be considered a transaction directly between the creditor and USP so that the creditor is allocated that $50 investment in U.S. property. Only the remaining $50 of the loan that was facilitated by the guarantees should be considered to be an investment in U.S. property by the guarantors. Thus, in order to determine the relative contributions of the borrower and each pledgor and guarantor to the facilitation of the obligation, the first question is, could the loan have been made without any guarantor at all?

The Service employed the same analysis in a similar context in Revenue Ruling 87-89, 1987-2 C.B. 195. In that ruling, a CFC deposited an amount of cash with an unrelated bank and the bank loaned a smaller amount of cash to the CFC's U.S. parent. During the term of the bank loan to the U.S. parent, the amount owed by the U.S. parent was always less than the amount of the CFC's deposit in the bank. The interest rate paid by the U.S. parent to the bank was less than one percentage point more than the interest rate paid by the bank to the CFC, and the interest rate charged by the bank on the loan to U.S. parent would have been different without the CFC's deposit. The ruling frames the issue as whether the bank loan would have been made or maintained on the same terms without the deposit. That determination, the ruling states, would be made taking into account all of the facts and circumstances of the relationship between the borrower and its related parties and the lender. Under the facts described, the ruling recharacterizes the CFC's bank deposit and the bank's loan to the U.S. parent as a loan from the CFC to the U.S. parent because the bank loan would not have been made or maintained on the same terms but for the CFC's deposit.

The question asked by Revenue Ruling 87-89, whether the loan could have been made or maintained on the same terms without the deposit, should be relevant where the deposit is replaced with a guarantee or pledge because in all three situations -- deposit, guarantee or pledge -- there has been a repatriation of the CFC's assets, using the bank as a conduit, only if the bank would not have made the same loan on the same terms without the deposit, pledge or guarantee. If a CFC's guarantee or pledge does not facilitate the availability of funds to the U.S. person, then there has not been an indirect repatriation by the CFC. That is, as an economic matter, there is no repatriation from a CFC to a U.S. borrower where a third-party lender determines the terms of its loan to a U.S. person solely by reference to the credit, assets and cash flows of the U.S. person, even if the CFC provides a guarantee or asset pledge to the lender. As a business matter, that might arise from other considerations other than credit enhancement (e.g., concern about assets shifting among entities under common control).

In our example, if it were known that USP could borrow $50 of the loan on the same terms without any guarantees such that the guarantee only facilitated the remaining $50 of the loan, then, by applying the reasoning of Revenue Ruling 87-89, it could be concluded that there is only a $50 investment in U.S. property by the guarantors in total (while the other $50 investment in the obligation of the U.S. obligor remains with the lender). We believe that outcome is most consistent with the spirit and purpose of section 956.

Such an outcome is analogous to the decision in Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5^th Cir. 1972). In Plantation Patterns, the court held that the nominal guarantor was the true borrower of indebtedness rather than the nominal borrower. The court based that holding on the inadequacy of the borrower's assets to support repayment of the loan and its finding that the lender relied on the guarantor, not the borrower, for repayment. If a similar analysis determined when to apply section 956(d) to a guarantor, the guarantor would have an investment in U.S. property for any loan as to which the lender relies upon the guarantor, rather than the borrower, for repayment. Revenue Ruling 87-89 calls section 956 into action more readily than a Plantation Patterns analysis would, because it applies section 956 anytime the loan would not have been made on the same terms without the guarantee (which may occur even if the lender will primarily rely on the borrower to make repayment). The analysis is similar, however, because in each case the law is seeking out who are the real economic parties to the transaction. The first step of the correct economic answer to the question of how much a CFC pledgor or guarantor repatriated indirectly by granting the pledge or guarantee asks how much of the obligation the U.S. person could have supported on its own.

It is critical to begin with the borrower's contribution to the support for the obligation in order for the allocation to reflect the true economic reality of which party's assets and earnings facilitated the loan. For example, if the $100 loan to USP were supported by guarantees by USS, CFC1 and CFC2, but the aggregate net assets of USS, CFC1 and CFC2 were only $20, it would be senseless to allocate the $100 entirely to the guarantors. It would be entirely clear that the majority of the loan was facilitated solely by the assets and earnings of USP and thus there could be an economic basis for allocating only a small piece of the total investment in the USP obligation to the guarantors.

The second step is to ask, how much of the portion of the loan that was facilitated by the pledgors and guarantors was facilitated by each pledgor and guarantor? To continue the example, if it were known (after determining that $50 of the loan would have been made on the same terms without pledges or guarantees) that the guarantee of USS facilitated $30 of the loan, the guarantee of CFC1 facilitated $15 of the loan and the guarantee of CFC2 facilitated $5 of the loan, then it would be appropriate for CFC1 to have invested only $15 and for CFC2 to have invested only $5 in U.S. property. That is, it would be known that $80 of the loan would have been made without any CFC guarantees, so the aggregate investment in U.S. property by the two CFCs should be only $20, allocated in accordance with their relative contributions to the facilitation of the loan.

It may, of course, not be feasible for taxpayers or the Service to know how much of a loan was facilitated by each guarantor in the subjective view of the lender. It is very likely that the lender itself has not spent effort determining how much of the loan was facilitated by each pledgor and guarantor. Nevertheless, it is useful to identify the proper allocation of the investment in the U.S. person's obligation conceptually and then consider which approach, among those that are feasible, would most closely approximate the right conceptual answer.

The Preamble identified the available credit capacities of the pledgors and guarantors measured by their relative net assets as a possible method of allocation, but expressed concern over the administrability of such a rule. We agree that the best way to figure out how much of the U.S. person's obligation was facilitated by each of the borrower, the pledgors and the guarantors is to look at the same factors that a creditor would consider, and that relative net asset values would be an appropriate proxy for figuring out how much of the obligation was facilitated by each party. Another useful indicator would be the relative current income or net cash flows of the borrower and any pledgors and guarantors.

We agree that the administrability of the allocation method adopted in regulations should be an important consideration. Where the assets of the pledgors and guarantors are easily valued, the net assets value method may be most appropriate. We recognize that where the net asset values of each pledgor and guarantor may not be readily determinable, a current income or net cash flows approach may be more practical.

Either a net asset values or current income method is necessary to allocate responsibility for facilitating the loan between the borrower, on one hand, and the pledgors and guarantors, on the other hand. Once that initial allocation is made, another alternative would be for the investment in U.S. property to be allocated among multiple pledgors and/or guarantors in accordance with their ultimate liabilities for the obligation if the U.S. obligor were unable to pay (i.e., in accordance with their economic risk of loss in that scenario). The determination of each pledgor's and guarantor's economic risk of loss would take into account each such person's rights to contributions or reimbursement from the other pledgors and guarantors under their contractual agreements or under applicable commercial laws. An allocation based on economic risk of loss would be objectively determinable. Such method would allocate the investment in U.S. property among the pledgors or guarantors that would have ultimate liability for the loan if the U.S. obligor did not pay. It would also have the advantage of being based on a concept, economic risk of loss, that is already familiar to taxpayers and the Government from Code sections 465 and 752.

Allocating the investment in U.S. property based on ultimate liability for the U.S. person's obligation also is generally consistent with the rationale for why pledges and guarantees result in section 956 investments in U.S. property. As discussed above, when there are CFC pledgors and/or guarantors of a U.S. person's obligation, the CFC pledgors and guarantors are deemed to have made an investment in the U.S. person's obligation in order to treat CFCs that indirectly repatriate their assets through the U.S. person's lender in the same manner as if they had directly repatriated their assets to the U.S. person themselves. The pledgors and guarantors are deemed to make an investment in U.S. property as if the pledgors and guarantors themselves made funds available directly to the U.S. person and simultaneously funded themselves by borrowing on a recourse basis from the U.S. person's creditor. Cf. Rev. Rul. 89-12, 1989-1 C.B. 319 (revoking Rev. Rul. 71-373 on the basis that, when a CFC borrows on a recourse basis, on-lends to its U.S. parent and pledges the parent's note as collateral, the CFC has made an investment in U.S. property and there is no specific charge against the investment).

Where there are multiple pledgors and/or guarantors with respect to a single obligation of a U.S. person, the appropriate characterization of the deemed investment in U.S. property is that the multiple pledgors and guarantors have each borrowed a portion of the total loan from the U.S. person's creditor and repatriated their portion to the U.S. person. Alternatively, one can view the pledgors and guarantors as partners in a partnership standing between the U.S. person and the creditor. The partnership has borrowed from the creditor and on-lent to the U.S. person. If the U.S. person defaults, the partnership has repayment (or subrogation) rights against the U.S. person but must repay the creditor regardless of those rights. Thus, the liability of each guarantor or pledgor is akin to the responsibility of each partner in a general partnership to repay the partnership's debt to the creditor. That responsibility may be allocated among the guarantors and pledgors by an agreement amongst themselves or, in the absence of such agreement, by the applicable commercial law, the same as if they had formed a partnership.

Where a partnership holds an obligation of a U.S. person, under existing Treas. Reg. § 1.956-2(a)(3), the partnership's interest in the U.S. person's obligation is allocable among the partners in accordance with their interests in the partnership. If multiple pledgors and guarantors are viewed as partners in a venture to lend to a U.S. person, the partners' interests in the partnership would inevitably depend on how much of the U.S. person's obligation they contributed to the partnership, and that in turn would depend on their shares of the obligation to the creditor,

To resume the example in which CFC1, CFC2 and USS guarantee a loan of $100 to USP, assume further that CFC1, CFC2 and USS agreed that if they were obligated to repay the $100 loan, CFC1 would be responsible for $30, CFC2 would be responsible for $10 and USS would be responsible for $60 of the liability. Each would have a right of contribution against the others if it was called upon to pay more than its share of the obligation. After $50 of the obligation is considered to be held by the lender (because in the example USP could have borrowed that amount on the same terms without the guarantees), the guarantees and agreement regarding the guarantors' shares of the liability are equivalent to an arrangement in which CFC1, CFC2 and USS together borrow the remaining $50 from USP's lender and then makes the $50 available to USP directly. That $50 obligation could be allocated among CFC1, CFC2 and USS in proportion to the relative amounts of the $100 obligation to the lender for which CFC1, CFC2 and USS have agreed to be responsible if USP does not pay. Under that approach, CFC1 would be considered to hold $15, CFC2 would be considered to hold $5 and USS would be considered to hold $30 of the obligation of USP. We believe that result appropriately reflects the economic reality of which guarantor is ultimately responsible for each portion of the loan if the U.S. obligor is unable to make payment, at least as long as each guarantor is financially able to support the portion for which it is responsible.

In order to ensure that there is economic reality to each pledge or guarantee and to the rights of contribution, the regulations could include requirements that a guarantee or right of contribution must meet in order to be taken into account. These requirements could include some or all of the requirements that are ultimately adopted in the section 752 regulations in order for a guarantee to be sufficiently substantive to warrant an allocation of recourse liabilities on the basis of the guarantee. Truly substantive guarantees and rights of contribution should not be susceptible to abuse because they will deserve to be allocated a portion of the obligation.

We think this last point is particularly important in light of the concerns expressed in the Preamble about "planning opportunities" that might exist if the investment in the U.S. person's obligation is allocated. An allocation that is based on the each party's economic facilitation of the loan should not be subject to abuse because, as the above examples illustrate, a pledgor or guarantor will not be allocated a portion of the obligation unless it contributes to either the relative net assets or current earnings supporting the obligation or it takes on liability for the obligation vis-a-vis the other guarantors and pledgors. If CFC pledgors or guarantors contribute very little to the aggregate net assets and earnings supporting the loan, then the CFC pledgors and guarantors will be allocated less of the obligation than if they represented a greater portion of such assets and earnings, but that is a wholly appropriate result that is consistent with the purpose and spirit of section 956(d).

Finally, the Preamble suggests that allocations might be made based on earnings and profits, either by reference to "applicable earnings," to section 959(c)(3) earnings and profits or to a combination of those two amounts. We believe that such an approach is less appropriate than the foregoing approaches because there is no direct connection between the earnings and profits accounts of a pledgor or guarantor and the amount that should be considered to have been invested in U.S. property by that pledgor or guarantor. Accumulated earnings and profits, along with contributed capital, unrealized appreciation and depreciation and liabilities, are but one of the components of the net assets of a guarantor to which a creditor will look for credit enhancement. There is no reason to focus on accumulated earnings and profits over the other components of the net assets of the pledgor or guarantor; instead, it would be preferable to rely on net assets or current income, each a more appropriate metric of payment expectation. Furthermore, as a general matter, the investment in U.S. property by a CFC is determined without regard to earnings and profits. The amount of earnings and profits of the CFC determines the amount of the section 951(a)(1)(B) inclusion only after the amount of the investment in U.S. property is determined. It would inappropriately conflate these separate steps in the statutory calculation of the investment in U.S. property if the earnings and profits of each guarantor or pledgor were to be used to determine the amount of the investment in U.S. property by each CFC.

The method of allocating the investment to be adopted in regulations should be the method that is administrable and best reflects the relative economic positions of the borrower, pledgors and guarantors with respect to each other. Furthermore, in order to accurately reflect the contribution of every borrower, guarantor or pledgor toward the facilitation of a loan, we think it is critical that the obligation should be allocated among the primary obligation and all pledges and guarantees that have sufficient economic substance, including those that are granted by entities that are not CFCs. To the extent that a group of guarantors facilitates a loan, the transaction is, in substance, identical to a transaction in which the group of guarantors borrows from the lender and makes funds available to the borrower. Regardless of the form in which they do that, the rule in Treas. Reg. § 1.956-2(a)(3) requires that, if the guarantors actually make a loan to a U.S. borrower through a joint venture or partnership, each CFC guarantor will be treated as holding only its allocable share of the loan to the U.S. borrower. Similarly, if instead of making an actual loan, the group guarantees a loan made by a third party to a U.S. borrower, they will be treated as having made funds available to the U.S. borrower, and the result has to be the same as if they actually made the loan that they facilitated -- each guarantor has to be treated as having made an allocable share of the loan funds available to the U.S. borrower. We believe that one appropriate way of matching each party's share of the obligation with their relative contributions to the facilitation of the loan would be to allocate the investment among the borrower, the guarantors and pledgors in accordance with their relative net asset values or their relative current income or net cash flows. Another appropriate way would be to allocate the investment that is allocated to guarantors and pledgors among those persons based on their economic risk of loss if the U.S. obligor is unable to make payment. An allocation based on applicable earnings or section 959(c)(3) earnings and profits is not likely to have the necessary connection to the economic realities of the transaction to be an appropriate way of determining each pledgor's and guarantor's investment in U.S. property.

We would be happy to discuss these matters further and provide any assistance you may require. Please feel free to contact us at (202) 508-8020, (202) 508-8186 or (202) 508-8046.

² Furthermore, given that the existing regulations were issued without any statement or analysis of basis and purpose or cogent explanation regarding the treatment of multiple pledgors or guarantors (or any other issue), we believe that a significant issue exists as to the validity of the current regulations. See Motor Vehicle Manufacturers Assoc. v. State Farm Mutual Automobile Insurance Co., 463 U.S. 29 (1983). In any event, we do think it is important that the Service is attempting to provide the necessary explanation in the forthcoming regulations.

³ As initially released to the public in April 2002, the "Case Development, Hazards and Other Considerations" discussion in FSA 200216022 was fully redacted. See Tax Notes Doc. No. 2002-9512. Over the past several years, we became aware that a subsequent version of the very same FSA disclosed a paragraph of analysis under the "Case Development, Hazards and Other Considerations" heading that had been previously redacted. See, e.g., FSA 200216022 as available at http://www.irs.gov/pub/irs-wd/0216022.pdf.