Conduit financing arrangements.

On October 11, 1994, the IRS issued the first part of proposed regulations on conduit financing arrangements under IRC section 7701(l). The proposed regulations provide rules under which an IRS district director may disregard the participation of one or more persons in certain multiple-party financing

arrangements in applying sections 871, 881, 1441 and 1442, relating to the 30% tax on U.S.-sourced income received by foreign persons. IRC section 7701(l) authorizes the IRS to issue regulations to recharacterize certain multipleparty transactions to prevent tax avoidance. These new conduit rules will be effective for payments made after 30 days from the date final regulations are published.

The Tax Court first addressed the conduit problem in Aiken Industries, Inc. v. Commissioner (56 TC 925 [1972]) when it reclassified interest payments made by Aiken, a U.S. corporation, to a related entity resident in a treaty country. The court ruled the related entity did not retain the necessary dominion and control over the funds to qualify for treaty benefits because it paid matching interest payments to another entity resident in a nontreaty country. The court treated the payments as if Aiken paid them directly to the entity in the nontreaty country; thus, the treaty exemption did nt apply.

In revenue ruling 87-89, which involved three scenarios in which an intermediate entity was not related to the U.S. company making payments, the IRS said it would disregard the intermediary when a loan would not have been made or maintained on the same terms but for the corresponding loan (or deposit) by the ultimate financing entity.

Arrangements the IRS can recharacterize include debt guarantees and equity investments as well as back-to-back loans. However, the regulations generally do not apply when the ultimate financing entity funds the intermediary through an equity investment, except when its legal right to payments from the intermediary is similar to the rights of a creditor. Here, the regulations appear to be less strict than technical advice memorandum 9133004, which involved an equity investment in an intermediate entity by the ultimate financing entity (its parent) as well as back-to-back loans. The intermediate entity paid dividends to the parent of roughly 99% of the cash payments received from the U.S. company. The IRS ruled the intermediate entity lacked the necessary dominion and control and treated the interest as paid by the U.S. company directly to the intermediate entity's parent, subject to the withholding rate prescribed in the parent's treaty.

In general, an intermediate entity will be ignored if its participation reduces the withholding tax imposed under section 881 and its participation is due to a tax avoidance plan. In addition, as in revenue ruling 87-89, participation by an unrelated intermediary will be ignored only if it would not have engaged in the transaction on substantially the same terms but for the involvement of the financing entity. The proposed regulations focus on the motive behind the establishment of the debt structure rather than dominion and control over the income.

Observation: While some practitioners are relieved the regulations are not significantly stricter than existing precedents, others are concerned with the high level of judicial review (abuse of discretion) applicable to the district director's determinations.