SERVICE APPLIES SUBSTANCE-OVER-FORM PRINCIPLES TO DETECT REPATRIATION OF CFC'S EARNINGS TO U.S. SHAREHOLDER.

Rev. Rul. 89-73

ISSUE

Whether the purchase of debt obligations by the issuing domestic corporation's controlled foreign corporation, which mature and are repaid shortly before the end of the controlled foreign corporation's taxable year, followed by the purchase of new debt obligations issued by the domestic corporation shortly after the beginning of the controlled foreign corporation's succeeding taxable year, will constitute an investment of earnings in U.S. property under section 956(a) of the Internal Revenue Code of 1986.

FACTS

EXAMPLE (1)

Corporation X, a domestic corporation, issues to the public debt obligations during 1987 and 1988. CFC, a subsidiary of X and a controlled foreign corporation as defined in section 957 of the Code, is not engaged in U.S. business activity and does not earn income effectively connected with a U.S. trade or business. Both X and CFC report income on a calendar year basis. CFC has accumulated earnings and profits of $1000x as of December 31, 1987 and has never invested its accumulated profits in United States property as defined in section 956(b) prior to the 1987 taxable year.

On February 5, 1987, CFC purchased $200x of debt obligations issued by X that matured and were repaid on November 15, 1987. CFC purchased $225x of debt obligations issued by X on January 15, 1988 and sold the obligations to an unrelated third person on November 10, 1988.

EXAMPLE (2)

The facts are the same as in Example (1) except for CFC's purchases of obligations issued by X. On February 1, 1987, CFC purchased $200x of debt obligations issued by X. The obligations matured and were repaid on June 30, 1987. On January 15, 1988, CFC purchased $225x of obligations issued by X and sold the obligations to an unrelated third person on November 15, 1988.

LAW AND ANALYSIS

Section 951(a)(1)(B) of the Code provides that every person who is a United States shareholder under section 951(b) owning stock in a controlled foreign corporation on the last day of the foreign corporation's taxable year shall include in gross income a pro rata share of the corporation's increase in earnings invested in United States property for such year as determined under section 956(a)(2). The term "United States property" generally includes obligations issued by a United States shareholder of the controlled foreign corporation.

The House Report of the Revenue Act of 1962, which adopted section 956, stated that an objective of that section was "to prevent the repatriation of income to the United States in a manner which does not subject it to U.S. taxation. This objective also accounts for some of the features of this provision, which deny tax deferral where funds are brought back and invested in the United States in a manner which does not otherwise subject them to U.S. taxation." H.R. Rep. No. 1447, 87th Cong., 2d Sess., (1962), at 58, 1962-3 C.B. 405, 462.

The application of section 956 is concerned with the substance of a transaction, not its form. In Gregory v. Helvering, 293 U.S. 465 (1935), the Court stated that "the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended." More recently, in Houchins v. Commissioner, 79 T.C. 570, 589 (1982), the Court in discussing economic substance stated that "labels, semantic technicalities, and formal written documents do not necessarily control the tax consequences of a given transaction. Rather we are concerned with economic realities and not the form employed by the parties."

Courts have previously applied a form versus substance analysis to distinguish loans from dividends. See, e.g., Meyer v. Commissioner, 45 B.T.A. 228, 238-40 (1941); Tollefson v. Commissioner, 52 T.C. 671 (1969), aff'd, 431 F.2d 511 (2d Cir. 1970), cert. denied, 401 U.S. 908 (1971). However, the application of section 956 is not limited to the standard enunciated in these cases for treating an advance to a shareholder as a dividend, because section 956 is intended to prevent the tax-free repatriation of earnings even in circumstances that would not otherwise constitute a dividend distribution. 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. If a controlled foreign corporation lends earnings to its U.S. shareholder interrupted only by brief periods of repayment which include the last day of the controlled foreign corporation's taxable year, there exists, in substance, a repatriation of the earnings to the U.S. shareholder within the objectives of section 956. Because the substance of such a transaction must control the tax consequences, the lending of the controlled foreign corporation's earnings to the U.S. shareholder is a repatriation of earnings of a type which constitutes an investment in U.S. property under section 956. Such a repatriation will be treated as outstanding at the close of a controlled foreign corporation's taxable year for purposes of computing the amount of earnings invested in U.S. property under section 956(a)(1)-(A). This repatriation results in an investment in U.S. property under section 956 even though the two loans may be treated as separate obligations for other purposes of the Code, such as section 1001. in the case of a brief period of disinvestment in the obligations of a U.S. shareholder, the amount of the investment in U.S. property as of the last day of the CFC's taxable year is equal to the lesser of the amount of the investment in U.S. property in the CFC's first taxable year or the amount of the reinvestment in the next succeeding taxable year. Other factors in addition to the period of disinvestment may be indicative of a repatriation of earnings of the controlled foreign corporation that should be taken into account for section 956 purposes.

HOLDING

In Example (1), the brief period of time between the termination of CFC's investment in U.S. property on November 15, 1987 and the reinvestment in obligations of X on January 15, 1988 will be disregarded in determining whether there is an investment in U.S. property as of the close of CFC's 1987 taxable year. The investment by CFC in obligations issued by X and the reinvestment by CFC in X obligations will, therefore, be considered together as a $200x investment in U.S. property in 1987 under section 956.

In Example (2), the period of time between CFC's termination of the investment in U.S. property on June 30, 1987 and its reinvestment in U.S. property on January 15, 1988 is not brief compared to the overall period the debt obligations are outstanding. The debt obligations are not, therefore, considered to represent an investment in U.S. property by CFC in 1987.

These holdings do not provide a taxpayer the right to compel the Internal Revenue Service to disregard the form of its transactions for Federal income tax purposes. See Commissioner v. Alfalfa Dehydrating & Milling 417 U.S. 134 (1974).

DRAFTING INFORMATION

The principal author of this revenue ruling is John F. Dean of the Office of the Associate Chief Counsel (International). For further information regarding this revenue ruling, contact John F. Dean at 202-377-9493 (not a toll-free number).