Rev. Rul. 86-6

1986-1 C.B. 286, 1986-4 I.R.B. 4.

TAX ON INCOME OF FOREIGN CORPORATIONS NOT CONNECTED WITH UNITED STATES

BUSINESS

Published: January 27, 1986

Section 881.-Tax on Income of Foreign Corporations not connected with United States business

(Also Section 871:1.871-1)

  Tax on income of foreign corporations not connected with United States business. A domestic corporation that owns all of the stock of a Netherlands Antilles corporation may withdraw a portion of its paid in capital contribution such that the subsidiary's debt-to- equity ratio is increased from 3-to-1 to 5- to-1 without jeopardizing the subsidiary's separate corporation status.

ISSUE:

  If a domestic corporation owns 100 percent of the stock of a corporation organized under the laws of the Netherlands Antilles (Antilles) and if the domestic corporation withdraws a portion of its equity capital invested in the Antilles subsidiary and thus increases the subsidiary's debt-to-equity ration from 3 to 1 to 5 to 1, does this course of action jeopardize the subsidiary's separate corporate status for purposes of section 127(g)(3) of the Tax Reform Act of 1984 (the Act), 1984-3 (Vol. 1) C.B. and the principles set forth in the rulings cited therein.

FACTS

  P is a domestic bank holding company. In 1980, P organized S in the Netherlands Antilles for the purpose of raising funds in the Eurodollar market for P. S is a controlled foreign corporation (CFC).

  S sold 15 million dollars of notes (Euronotes), denominated in Unites States dollars, to foreign investors during 1981. These notes were unconditionally guaranteed by P, and all of the net proceeds from the sale of the Euronotes were loaned to P by S in exchange for notes from P. The notes from P had the same terms as, and a slightly higher interest rate than, the Euronotes issued by S.

  Prior to the Euronote issue, P contributed equity in the form of 5 million dollars to S such that immediately following the Euronote issue the debt to equity ratio of S was no more than 3 to 1 (that is, the face amount of S's outstanding Euronote obligations was no more than three times the equity of S). S then placed this equity contribution in short term bank deposits with Y, an unrelated domestic corporation. Neither P nor any of its affiliates have any loans outstanding with Y.

  In November 1984, in order to meet further cash requirements, P withdrew 2 million dollars of its previously contributed equity from S. S's remaining equity capital, measured by the amount of P's capital, contribution of United States dollars that was being held in short term bank deposits in the United States, was 3 million dollars, and at no time was this capital contribution less than one-fifth of the face amount of S's outstanding Euronote obligations.

LAW AND ANALYSIS

  Sections 871(a)(1)(A) and 881(a)(1) of the Internal Revenue Code, except as provided in the portfolio interest exemption in section 871(h) and 881(c), respectively (added to the Code by section 127 of the Act), generally impose a

30 percent tax on any interest received by non-United States persons from sources within the United States, to the extent such interest is not effectively connected with the conduct of a trade or business within the United States. Section 1441(a) and 1442(a) provide generally that such tax is to be deducted and withheld at the source of the income.

  A special grandfather rule in section 127(g)(3)(A) of the Act provides that, for purposes of the Code, payments of interest on a United States affiliate obligation to an applicable CFC in existence on or before June 22, 1984, shall be treated as payments to a resident of the country in which the CFC is incorporated.

  Sections 127(g)(3)C)(i) and 121(b)(2)(D) of the Act provide that the term  

'applicable CFC' means any controlled foreign corporation (within the meaning of section 957) which was in existence on the date of interest payment and the principal purpose of which or such date consisted of the issuing of CFC obligations or the holding of short-term obligations and lending the proceeds of such obligations to affiliates.

  Section 957 of the Code provides, in part, that the term 'controlled foreign corporation' means any foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned by United States shareholders on any day during the taxable year of such foreign corporation.

  Sections 127(g)(3)(C)(ii) and 121(b)(2)(F) of the Act provide that the term  

'United States affiliate obligation' means any obligation of (and payable by) a United States affiliate which was issued before June 22, 1984.

  Section 121(b)(2)(E) of the Act defines the term 'United States affiliate' to mean any United States person that is an affiliate (that is, any person that is a related person within the meaning of section 482 of the Code) of the

'applicable CFC.'

  Section 127(g)(3)(B) of the Act provides that section 127(g)(3)(A) shall not apply to any 'applicable CFC' which did not meet requirements which are based on the principles set forth in Rev. Rul. 69-377, 1969-2 C.B. 231; Rev. Rul. 69-

501, 1969-2 C.B. 233; Rev. Rul. 70-645, 1970-2 C.B. 273; and Rev. Rul. 73-110,

1973-1 C.B. 454. The four rulings concerned the Interest Equalization Tax (IET) and were revoked by Rev. Rul. 74-464, 1974-2 C.B. 46, when the IET expired

(June 30, 1974).

  Rev. Ruls. 69-377, 69-501, and 70-645 all concerned whether debt obligations issued by domestic or foreign subsidiaries of domestic parent corporations were bona fide. Under the facts of each of these revenue rulings, the bona fide nature of the debt obligations was generally dependent on the subsidiary maintaining a debt-to-equity ratio of no more than 5 to 1.

  Rev. Rul. 73-110 concerned a domestic parent corporation that purchased all of the capital stock of its foreign financing subsidiary for United States dollars in an amount equal to 20 percent of the principal amount of the total debt obligations to be issued by the subsidiary. The parent made additional contributions in dollars to the subsidiary's equity capital each time the latter incurred additional indebtedness so that the subsidiary's capital would remain at least 20 percent of the principal amount of its outstanding indebtedness.

  The subsidiary received Swiss francs in return for its debt obligations. During a taxable year, the financing subsidiary reduced the amount of its principal indebtedness and the domestic parent withdrew part of its equity capital contribution to maintain a five to one debt-to-equity ratio. The reduction in equity capital was computed on the basis of the currency exchange rate in existence at the time the principal debt of the subsidiary was incurred. Fluctuations in the value of the United States dollar relative to the Swiss franc resulted in an increase in the value of the Swiss franc. Thus, when computed on the basis of the actual currency exchange rate prevailing at the time of the withdrawal, the debt-to-equity capital ration was, after the withdrawal by the parent, greater than five-to-one.

  Rev. Rul. 73-110 held that in determining whether the aggregate face amount of the subsidiary's outstanding indebtedness never exceeds five times the amount of its equity capital, the ratio must be periodically recomputed on the basis of the currency exchange rate in existence at the time of any of the following occurrences: (1) additional borrowings by the financing subsidiary's and/or (2) withdrawals from the subsidiary's equity capital by its parent for any reason, such as a reduction in the subsidiary's indebtedness.

  In order to meet its cash requirements and because of the passage of section

127(g)(3) of the Act, P decided to reduce its equity contribution to S by 2 million dollars. This reduction increased S's debt-to-equity ration from 3 to 1 to 5 to 1.

  Rev. Rul. 73-110 contemplated that periodic adjustments may be made to a financing subsidiary's equity capital. Neither Rev. Rul. 73-110 nor the other revenue rulings cited above indicated that the debt of a financing subsidiary could be recharacterized as the debt of the parent merely on the grounds that the subsidiary's debt-to- equity ration had increased from 3 to 1 to 5 to 1 and was maintained at a ratio of 5 to 1.

  For the limited purpose of measuring S's debt-to-equity ratio to determine if that ratio meets the requirements of section 127(g)(3) of the Act, the dollar denominated Euronotes of S are taken into account at face value in accordance with Rev. Rul. 73-110. The equity capital of S, for this same limited purpose, is the amount of United States dollars contributed as equity to S to the extent that this dollar equity contribution has not subsequently been withdrawn from S.

  In the present situation, P withdrew 2 million dollars of its original 5 million dollar capital contribution, leaving S with an equity capital amount of

3 million dollars. Because S's liabilities are computed at face value, they remained at 15 million dollars. Thus, after the transaction, S had a debt-to- equity ratio that did not exceed 5 to 1.

HOLDING

  P may withdraw equity capital from S without jeopardizing S's separate corporate status or the bona fide nature of S's indebtedness under section

127(g)(3) of the Act and the principles set forth in the revenue rulings cited therein, provided that immediately following the withdrawal of a portion of S's equity capital S's indebtedness does not exceed five times the remaining equity capital.

Rev. Rul. 86-6, 1986-1 C.B. 286, 1986-4 I.R.B. 4.