Fund Transfers to Foreign Parent Aren't Deductible Interest Payments

Third Party Communication: None

LEGEND:

Throughout the Tax Years in Issue, Taxpayer maintained a "general account" into which it deposited amounts derived from all sources, including, among others, advances from third party banks under lines of credit, active business income, Income Source A, and advances from its foreign parent. Taxpayer withdrew from this account amounts necessary for the day-to-day operation of its business, including employee wages, capital expenditures including new physical plant, taxes, and so on.

Also throughout the Tax Years in Issue, Taxpayer claims to have made, out of this account, payments of interest to its foreign parent on certain advances, including a Year 1 advance of $Amount A (the "Year 1 Advance"). In each instance, funds sufficient to cover these "payments" (made via wire transfers) were obtained shortly before or shortly after a claimed payment of interest, either through additional loans from the foreign parent or pursuant to draw-downs on one or more lines of credit with the foreign parent that were similarly credited to the taxpayer's general account.¹ These loans (collectively the "New Loans"), unless documented as advances pursuant to a pre-existing line of credit, were documented by notes (the "New Notes"). The principal amount of each New Note is payable only at maturity after several years, is subordinated to existing Taxpayer senior debt and also, we understand, is subordinated to any additional future senior debt that Taxpayer may choose to incur. The terms of the New Notes are such that any future senior debt may be incurred without obtaining the consent of any current or future holder(s). The New Notes are unfunded and unsecured. We understand that no New Note has ever been transferred to an unrelated third party for value.

Taxpayer treated each wire transfer to the parent described in the preceding paragraph as a payment of interest not subject to deferral under section 267(a)(3). Taxpayer has asserted, and the audit team has not contested, that if such amounts are properly treated as payments of interest within the meaning of the cash method of accounting that are not deferrable under section 267(a)(3), no withholding upon them is required by reason of an applicable income tax treaty (specifically, the income tax treaty between the United States and Country A).

Taxpayer's business was impacted by Events A. Taxpayer's deductions of the amounts here at issue increased or gave rise to net operating losses (NOLs) that were carried back to other tax years and generated refunds of taxes paid for those years.

Importantly, throughout the Tax Years in Issue, Taxpayer's borrowings from its foreign parent substantially increased. In Year 1, according to Taxpayer, the amount borrowed from the foreign parent by members of Taxpayer's consolidated group, not including the Year 1 Advance, increased by $Amount B; in Year 2, such borrowings increased by $Amount C. Taxpayer asserts that it "paid" interest during the Tax Years in Issue equal to $Amount D and $Amount E, respectively.

This advice addresses the appropriate treatment of the bulk of the claimed interest payment transactions described above.² Taxpayer characterized these transactions as deductible payments of interest with respect to the Year 1 Advance and other loans from its foreign parent. Although the audit team has concluded that the Year 1 Advance should be characterized as equity, the team has not challenged the characterization of these other advances as debt for federal tax purposes in this audit cycle. Since the questioned "payments" of interest with respect to the Year 1 Advance raise the same issues and require the same analysis as claimed "payments" of interest with respect to other loans from the foreign parent, all these are considered collectively herein.

During audit, the team has identified three types of claimed interest payments made during the Tax Years in Issue. In the first type ("Category (1) Payments"), interest was "paid" to the foreign parent by directly netting a required interest "payment" against a foreign parent new advance. In the second ("Category (2) Payments"), documentary evidence (specifically, e-mail traffic) shows that portions of a new advance were "earmarked" to "pay" interest on a pre-existing debt even though the interest "payment" was not netted. In the third ("Category (3) Payments"), "payments" of interest were made close in time to new advances from the foreign parent.

Category (3) Payments constitute the bulk of claimed payments that the audit team concluded should be deferred under section 267(a)(3) in this audit. Because some of Category (3) advances were much larger than the amounts of the claimed interest payments here at issue, it is clear that significant portions of these advances funded bona fide Taxpayer operating expenses. The audit team has concluded that the substance of the Category (3) payment transactions requires that they be treated in the same manner as Category (1) and Category (2) payments to the extent that they funded claimed interest payments.

Taxpayer has not responded directly to the team's proposed treatment of the Category (3) payments by distinguishing among them based on any specific principled criteria (such as the length of time between a "payment" and a foreign parent loan during which the funds may have been available to the taxpayer or subject to the claims of third party creditors). Further, Taxpayer has not contended that any of its "payments" of interest were traceable to any specific advances under third-party lines of credit that were deposited into its general account.³

Taxpayer appears to contest the application of well-settled law in this area for two reasons. Taxpayer argues first that because Battelstein v. Internal Revenue Service, 631 F.2d 1182 (5th Cir. 1980) (en banc), cert. denied, 451 U.S. 938, Davison v. Commissioner, 107 T.C. 35 (1996), aff'd, 141 F.3d 403 (2^nd Cir. 1998), and similar cases construe provisions of law other than section 267(a)(3), these cases have no bearing upon the construction of section 267(a)(3) or Treas. Reg. § 1.267(a)-3. In a slightly different vein, Taxpayer contends that these cases are irrelevant to its situation because the cases involved small, unsophisticated businesses with a single lender and Taxpayer is a large corporation with a foreign parent and complex financial profile involving numerous sources of funds and expenditures.

Despite Taxpayer's apparent attempt to confine these precedents narrowly to their particular facts, Battelstein, Davison and other cases dealing with the taxation of lender-borrower circular cash flows stand for the proposition that a borrower's claimed payment of interest to its lender with funds borrowed for that purpose from the lender is not a payment within the meaning of the cash method of accounting. There is no reason to believe, or any authority to imply, that these holdings cannot be applied to make determinations regarding the cash method of accounting wherever that method is relevant, including under section 267(a)(3), or that the principles enunciated in these cases apply only to individual taxpayers with simple financial lives. The facts upon which Taxpayer relies to distinguish these cases -- that they concern individual taxpayers using the cash method and (Taxpayer contends) with limited sources of funds -- were not the basis for the courts' holdings in those cases, but the critical issue -- whether "payments" of interest, within the meaning of the cash method of accounting, and with funds borrowed for that purpose from the same lender -- is the same. After reviewing these cases, this advice will discuss why the principles set out in these cases support the audit team's proposed adjustments under section 267(a)(3).

This principle and holding has been applied or echoed in a wide variety of contexts.⁵ Taxpayer can cite no authority or valid reason why it does not apply in the context of purported "payments" of interest when those "payments" are part of lender-borrower circular cash flows that also may be subject to deferral under section 267(a)(3).

Davison signals the most recent (1996) detailed analysis by the Tax Court of lender-borrower circular cash flows. In Davison, a cash method partnership (White Tail) purchased farmland in 1979 and in 1980. Each acquisition was financed with loans obtained for that purpose from an unrelated insurance company (John Hancock) and made via wire transfers to the partnership's account. The agreement with respect to the second (1980) loan required the partnership to use a portion of the second loan proceeds to retire the principal balance of first (1979) loan. Of the initial $19 million disbursement under that financing in May 1980, White Tail applied more than $6 million to retire the first John Hancock loan and $227,647 to "pay" accrued interest on that loan.

The second financing called for the partnership to make an interest payment of about $1.5 million January 1, 1981. Under the loan agreement, White Tail had the right to borrow up to one-half of the interest amount if it had insufficient funds from operations to make that interest payment.

By late 1980 it was clear that partnership revenue would not suffice to pay half the amount of interest due in January, 1981, and the parties agreed that John Hancock would advance to the partnership the full amount of the interest payment then due. It did so on by wiring the funds to the partnership on December 30, 1980. The following day, White Tail wired back those funds (plus a small additional payment). After these transactions, the partnership account had a negative balance.

On these facts, Judge Ruwe determined that "[f]undamental and significant factors" restricted White Tail's control over the funds that John Hancock wired to White Tail's account on December 30, 1980, because White Tail had specifically agreed to borrow this amount to satisfy its interest obligation in order to prevent a default. Use of the funds for any other purpose would have breached the terms of its agreement with John Hancock and would have resulted in White Tail's default and a likely end to its business operations.

In Davison, laying the foundation for his decision, Judge Ruwe described the Tax Court's evolving views on lender-borrower circular cash flows. In sustaining deductions under the cash method of accounting for later "payments" of interest to the lender, the earliest of these cases had applied formalistic tests to determine whether a taxpayer had "unrestricted control" over funds borrowed from its lender and deposited to its account.⁶ The Tax Court's analysis in these cases was questioned and expressly rejected by two courts of appeals, which applied less mechanical tests in their analyses. Thus, in Wilkerson v. Commissioner, 655 F.2d 980 (9th Cir. 1981), rev'g and remanding 70 T.C. 240 (1978), the Ninth Circuit (relying on the Fifth Circuit's analysis in Battelstein) denied an interest deduction for a cash method taxpayer because a portion of borrowed loan proceeds was "specifically earmarked" for the purpose of paying the interest due. See Davison, at 47.

In subsequent cases the Tax Court expanded its analysis to consider factors beyond mere physical control over the borrowed funds. Thus, in Menz v. Commissioner, 80 T.C. 1174 (1983), the Tax Court considered significant, in concluding that the borrower did not enjoy unrestricted control over funds advanced from its lender that were later used to "pay" interest to the lender, that a wholly owned subsidiary of the lender was a 1-percent general partner of the borrower and possessed approval power over all the borrower's major transactions.⁷

Against this background, Judge Ruwe concluded in Davison that:

In the case at hand, Taxpayer's circled wire transfers accomplished nothing more than the Battelsteins' circling of checks: each assumed a greater debt to the same lender. The economic consequence also is the same: an effective postponement of payments due. The legal conclusion here must be identical: no "payment" of interest within the meaning of the cash method of accounting.

Taxpayer seeks to distinguish Battelstein on the basis that the debtor there had "limited sources [from which] to pay interest due." The facts of Battelstein, however, were otherwise. The Battelsteins had more than enough other assets with which to pay the interest due.⁸ Similarly, subsequent case law has eroded any distinctions Taxpayer here would make based on the ordering of a borrowing from its lender and a payment of interest to that lender. Thus, in Blitzer v. United States, 684 F.2d 874 (Cl. Ct. 1982) the court stated, "[u]nder the Battelstein rationale a debtor is not recognized as having paid interest on a loan if he borrowed an equivalent sum from the creditor in a transaction closely linked to the payment of the interest, irrespective of the sequence. And it does not matter whether or not the borrower initially had funds of his own upon which he drew for the payment, nor whether or not he was given unrestricted control of the funds he received." Blitzer, at 885.

The thrust of relevant case law, as it has developed, is to focus on the underlying substance of the lender-borrower relationship to determine whether payments of interest purposefully are made via circular cash flows between lender and borrower. In Battelstein and similar circular cash flow cases, there were arms' length relationships between the borrowers and lenders, and the tensions between them were reflected in the facts addressed each case. Those fact patterns allowed courts to infer a taxpayer's purpose with respect to a given loan from the "ring-fenced" nature of a transaction that was largely in form and wholly in substance a circular cash flow.

Where a lender and borrower are related to one another, such ring-fencing is unnecessary to assure a lender that the funds it advances will be used to "pay" the borrower's pre-existing interest obligation to the lender. In related party cases, it is accordingly both necessary and appropriate to apply a heightened level of scrutiny to look past the form of the related parties' transactions with one another and to infer their private intentions from the objective economic hallmarks of their transactions inter se. See, e.g., Matter of Uneco, Inc. v. United States, 532 F.2d 1204, 1207 (8^th Cir. 1976) (quoting Cayuna Realty Co. v. United States, 382 F.2d 298 (Ct. Cl. 1967) ("Advances between parent corporation and a subsidiary or other affiliates are subject to particular scrutiny 'because the control element suggests the opportunity to contrive a fictional debt'"). See also P.M. Fin. Corp. v. Commissioner, 302 F.2d 786, 789 (3^rd Cir. 1962) (sole shareholder-creditor's control of corporation "will enable him to render nugatory the absolute language of any instrument of indebtedness") and Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3^rd Cir. 1968).

The Tax Court recognized this in Davison, formally repudiating the notion (already disavowed by two courts of appeals) that a taxpayer can exercise "unrestricted control" over funds merely by depositing funds borrowed from its lender into its bank account. Davison also makes clear that, in the Tax Court's view, in determining whether the purpose of a lender's advance is to fund a borrower's interest payment, it is necessary to consider the overall substance of the transactions at issue in their broad context, taking into account facts such as whether the failure to make interest payments on an existing obligation would have had significant economic consequences for the borrower (default), or highlighting the practical significance of de facto control exercised via the approval power of a 1-percent partner over the major financial decisions of a borrower-partnership. Where, as here, the borrower is wholly-owned subsidiary of the foreign parent, such control and with it the need for heightened scrutiny of the objective facts exists.

Taxpayer argues here that no specific loan from its foreign parent can be traced to a specific "payment" of interest here at issue -- that the "purpose" of each foreign parent loan is obscure or must relate to all expenditures made by the borrower in a given taxable year. It makes this argument with respect to all three categories of payment identified by the audit team, asserting that in no case is there any verifiable nexus between a loan and a "payment" of interest. For all the following reasons, we conclude that nexus is clear with respect to all claimed payments of interest here at issue.⁹

In the case at hand, when funds are (in form) loaned by the foreign parent to the taxpayer and "paid" back via return wire transfers, the resulting "U-turn" transaction is one that changes neither the economic position of the lender or the borrower. Consider the following example. If, before a U-turn transaction, the taxpayer has an accrued interest obligation payable of $1X on a pre-existing loan of $20X from its foreign parent, it has at that time an economic liability to its parent of $21X dollars. After the taxpayer borrows, in form, an additional $1X at or about the time its interest payment on the pre-existing loan is due and "pays" the interest out of the proceeds of the New Note, the taxpayer still has a liability of $21X to the foreign parent. Correspondingly, the parent, too, has not changed its economic position vis-à-vis the taxpayer: It retains accounts receivable of $21X, now reflected by an old note for $20X and a new subordinated and long-term note for $1X. The taxpayer has in essence "paid" with an IOU. What it has not done is made a payment within the meaning of the cash method of accounting, since a promise to pay is not a payment within either the common-sense meaning of the term or the cash method of accounting.

In this case, Taxpayer, in each taxable year at issue, has identified various sources of cash for its varied types of expenses. Funds from all sources are pooled in its "general account" and all its expenses are paid therefrom. In both Year 1 and Year 2, Taxpayer's foreign parent borrowings substantially increased. To the extent of such increases, the Taxpayer's need for cash demonstrably exceeded its income from all sources.

It is equally clear that all of the expenses Taxpayer paid to unrelated persons from its general account -- including its current obligations to third parties, employees, for equipment, physical plant and so on -- were paid with cash. No third party here accepted scrip -- IOU's -- from the Taxpayer as "payment" for its services or products, and Taxpayer has not meaningfully suggested otherwise.¹⁰

On the facts here at issue, only the foreign parent accepted such Taxpayer promises to pay in the future in lieu of cash payments. In form foreign parent received wire transfers in "payment" of claimed interest expense but, because of the further advance of further funds to the taxpayer, in substance actually achieved no economic change in position. And only the foreign parent has a relationship with the debtor, by virtue of its equity interest, which reflects its willingness to indefinitely defer realization and recognition of the fruits of its investment in Taxpayer.¹¹

The tracing of overall annual increases in debt owed by the Taxpayer to the foreign parent and Taxpayer's claimed "payments" of interest is, we believe, reflected in and evidenced by other facts here present and Taxpayer's overall pattern of conduct during the Tax Years in Issue. In particular, pertinent facts include evidence of specific loans that are unquestionably tied to specific claimed payments (Category (1) and Category (2) Payments). Such evidence lends weight to our conclusion that the Category (3) Payments here at issue are similarly closely linked to other foreign parent loans, as identified upon examination.

Also, we note that Taxpayer did not merely encounter shortfalls in its ability to make claimed "payments" of interest during the Tax Years in Issue only because of temporary and unforeseeable adverse business conditions, or because of Circumstances A. Rather, the artificiality of these transactions are demonstrated by foreign parent's decision to "leverage up" Taxpayer by an additional $Amount A during this audit cycle, which includes periods of substantially diminished demand for Taxpayer's core products. This additional leveraging was unaccompanied by any infusion of capital.¹² In assessing Taxpayer's ability to service such a large and significant advance, a third party lender would have closely considered Taxpayer's ability to make payments of interest thereon as an additional burden on Taxpayer's cash flow, which was already constrained by its obligation to pay interest on its other debts and also by diminishing demand for Taxpayer's core products. Taxpayer cannot, in light of such considerations, plausibly argue that the foreign parent's advances during the Tax Years in Issue were not meaningfully and "purposefully" related to its claimed payments of interest. Taxpayer and foreign parent both knew, or should have known, that Taxpayer might (and in the event, did) have insufficient cash available from all sources to make cash payments to its foreign parent all of the interest it was obligated to pay on the Year 1 Advance and otherwise during the Tax Years in Issue without incurring additional loans. The foregoing evidence, in total, is compelling. Taxpayer's claimed interest "payments" at issue should be traced to increases in foreign parent debt during the Tax Years in Issue.

In each taxable year here at issue, claimed payments of interest that were formally and nominally cast as payments of "cash" via wire transfers, in substance were funded by foreign parent advances made in each such year. Under these circumstances and applying the Tax Court's analysis in Davison, we conclude that "the borrowed funds were, in substance, the same funds used to satisfy the interest obligation" and that the real and underlying "purpose of the loan[s]" here at issue was to substantiate (albeit superficially and in form only) a deduction for an amount claimed to be a "payment" within the meaning of the cash method of accounting. Thus, under these facts, Taxpayer may not claim a deduction for interest so "paid."

The logic of this conclusion applies equally with respect to all three categories of "payments" identified by Exam in this case. As noted above, Taxpayer has not argued, in response to the audit team's proposed adjustments, that the team has improperly linked one or more of the Category (3) Payments here in issue to a particular foreign parent advance or proposed specific criteria for doing so. In light of this fact and the nature of our analysis, Counsel believes that it is unnecessary to address here whether, under different circumstances or in response to different Taxpayer contentions, any particular purported Category (3) Payment of interest would be linked to a particular foreign parent loan under other grounds or analyses, or to address Taxpayer's arguments concerning the possible pro rata allocation of foreign parent loans during the Tax Years in Issue to all Taxpayer expenditures.

Under the cash receipts and disbursements method of accounting, an amount is includible in gross income when actually or constructively received. Treas. Reg. § 1.451-1(a).

For a cash method taxpayer, "[t]he mere delivery of a promissory note to satisfy an interest obligation, without an accompanying discharge of the note, is a mere promise to pay and not a payment in a cash equivalent." Smoker v. Commissioner, T.C. Memo 2013-56 (citations omitted). However, the issuance of a promissory note can be a payment of interest under the cash method if the note is a cash equivalent. A promise to pay is the equivalent of cash and taxable as if a cash payment had been made if (1) it is a promise of a solvent obligor, (2) is unconditional and assignable, (3) not subject to set-offs, and (4) is of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of money. Cowden v. Commissioner, 289 F.2d 20 (5th Cir. 1961).

Taxpayer has provided no evidence that the New Notes meet the four requirements of Cowden so as to be considered cash equivalent. They certainly do not appear to be of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the prevailing premium for the use of money. Therefore, the New Notes cannot be a cash equivalent includible in income when received by the foreign parent under Cowden.

As the New Notes are not cash equivalents, then the foreign parent did not receive payments includible in its income upon their receipt.

Counsel has concluded that notes issued by Taxpayer to the foreign parent and the subject of this advice are not includible in the foreign parent's gross income under the cash method of accounting. This conclusion fully disposes of the need to further address Taxpayer's regulatory construction argument in the present case.

This writing may contain privileged information. Any unauthorized disclosure of this writing may undermine our ability to protect the privileged information. If disclosure is determined to be necessary, please contact this office for our views.

Please call * * * if you have any further questions.

cc:

Furthermore, in some instances loans were made to members of Taxpayer's consolidated return group and not in form to the common parent of the U.S. consolidated group followed by a subsequent loan within the group to the member. Throughout this advice, where loans are referred to as made to "Taxpayer," that term sometimes incorporates loans made in form to such subsidiaries.

² The treatment of the amount of Year 2 claimed interest payments in excess of $Amount E is not contested.

³ To the extent that during the Tax Years in Issue advances under a third party line of credit were in fact used to fund payments of interest on foreign related party debt, these amounts already should be reflected as decreases in the total amounts owed by Taxpayer to its foreign parent and Taxpayer will have appropriately deducted or capitalized have interest on the unrelated party loans. Therefore, the existence and use of such lines of credit during the Tax Years in Issue should not alter the analysis herein.

⁴ The court of appeals stated in part:

⁶See Burgess v. Commissioner, 8 T.C. 47 (1947), and other Tax Court cases discussed in Davison, at 43-46.

⁷ Even though the 1-percent partner lacked signatory authority over the bank account into which the borrowed funds were deposited, the Tax Court found that the borrower lacked unrestricted control because that partner was itself controlled by the lender and could have terminated the borrower's existence if it had failed to use the borrowed funds to satisfy interest obligations owed to the lender. Thus, the court concluded, the "1-percent partner's control over the future of the partnership was too fundamental and significant to conclude that the partnership's control over the funds in its account was unrestricted." Menz, at 1192.

⁸See Battelstein, supra (Circuit Judge Politz, dissenting), at 1187 ("[I]n each of the [challenged] instances of payment . . . the Battelsteins had ample assets to cover taxes and interest payments independent of the subsequent loan proceeds. . . . It cannot be disputed that the Battelsteins had more than adequate funds to pay the quarterly interest, independent of any monies received on later advances from Gibraltar.")

⁹ Although the following analysis applies equally to all three categories of payments identified by the audit team in this matter, Counsel emphasizes that in the case of a Category (1) Payment (a "payment" made via a "netted" foreign parent advance) and a Category (2) Payment (in which a portion of a foreign parent advance was "earmarked" as relating to a subsequent interest "payment"), evidence of the "purpose" for such loans is beyond question. See, e.g., the Ninth Circuit's consideration of "earmarking" in Wilkerson v. Commissioner, supra, and the Tax Court's discussion of that decision in Davison, at 47.

¹⁰ Taxpayer observed that it had accrued (but not been required to pay in cash) interest expense with respect a line of credit from a third party lender during the Tax Years in Issue. Taxpayer appeared in so doing to imply that the acceptance of such interest "payments" amounted to "payments" to a third party with IOU's and that Taxpayer's "payments" to its foreign parent of interest with notes should be treated as deductible in the same manner as payments to third parties when accrued (but not paid).

Counsel notes that while the borrowings under third party lines of credit are inherently self-policing (because a third party creditor will not carry amounts that it suspects are unlikely to be repaid), amounts loaned by persons related to the borrower are subject to a heightened degree of scrutiny, and that the cash method of accounting must be used with respect to claimed interest to related foreign lenders, precisely because such self-policing is absent in the relationship between a foreign parent and its U.S. subsidiaries (among other relationships specified in section 267(b)).

Taxpayer may also have implied that it could have used such borrowings to "pay" (within the meaning of the cash method of accounting) such amounts to its foreign parent. As noted in footnote 3 above, all such cash method "payments" will have been fully reflected in the amounts by which the balances owed by the Taxpayer to its foreign parent at each year's end have risen; Taxpayer will already have received full credit to the extent that it has "borrowed from Peter" (i.e., by means of a third party loan, interest accruing on which is not subject to disallowance under section 267(a)(3)) "to pay Paul" (its foreign parent). The amounts here at issue accordingly are "net" of such third party borrowings.

¹¹ Moreover, Taxpayer and its foreign parent alike were well aware that the failure to make timely interest payments on related party debt has led the Service to challenge the debt characterization of related party advances, and so was strongly motivated to make such payments, if only in form, to avoid falling into arrears and possible default on these obligations. These considerations must be taken into account in determining the underlying "purpose" of foreign parent advances used fund such "payments." See Laidlaw Transportation, Inc., v. Commissioner, T.C. Memo 1998-232, at 74 (evidence introduced at trial regarding the source of interest payments for purposes of a debt-equity analysis also relied upon by Commissioner to argue applicability of section 267(a)(3)).

¹² Because the characterization of Year 1 Advance is in dispute, consequential adjustments to the amounts of claimed deductions for interest expense that are the subject of this advice may be necessary if those payments are hereafter characterized in whole or in part as payments of dividends (not subject to deferral, if treated as paid, under section 267(a)(3)).