CCA 200004011: Related party advances need more facts before interest and withholding adjustments

Plain-English summary

A U.S. corporation recorded advances from foreign related companies as debt but later argued they were equity, which would avoid an imputed interest adjustment. Chief Counsel said the corporation faced a strong proof burden in disavowing its chosen form and that § 385(c) also supported holding it to its debt treatment, while calling for more facts. The memo could not yet determine whether an interest allocation under § 482 was appropriate. If one was made, the resulting deemed interest could create withholding liability under § 1442 for which the corporation would be responsible under § 1461. Financial distress did not automatically bar an interest allocation; the ability to collect and whether related party conduct caused the distress required factual review.

Ruling snapshot

• Question: Can the corporation recast related advances as equity, and could imputed interest lead to withholding despite financial distress?
• Outcome: Advice given: strong proof and § 385(c) weigh against recasting; interest and withholding require more facts.
• Key authorities: IRC §§ 482, 385(c), 1442, 1461, 451; Treas. Reg. § 1.482-2(a).

Full text (IRS public release)

                              DEPARTMENT OF THE TREASURY
                                 I N T E R N AL R E V E N U E S E R V I C E
                                      WASHINGTON, D.C. 20224




Number: 200004011
Release Date: 1/28/2000
CC:INTL:Br.2                                                   October 20, 1999
WTA-N-112718-99
UILC: 482.08-00, 482.08-04,1442.04-00

                        INTERNAL REVENUE SERVICE
                   NATIONAL OFFICE FIELD SERVICE ADVICE

MEMORANDUM FOR:

FROM:

SUBJECT:

       This memorandum responds to your request for Field Service Advice
dated November 30, 1998, on the above-captioned case. Field Service Advice is
not binding on Examination or Appeals and is not a final case determination. This
document is not to be used or cited as precedent.

LEGEND:

A                   =

B                   =
Country X           =
Country Y           =
Year 1              =
Year 2              =

ISSUE(S):

        1. Whether A is precluded from re-characterizing advances it received from
its foreign related entities as equity when it originally classified those funds as debt
on its books and records and its tax returns.

       2. Whether withholding pursuant to sections 1441 and 1442 may be imposed
with respect to deemed interest payments that result from a section 482 allocation
of interest income from A to its foreign related parties.
       3. Whether interest should be imputed to foreign lenders pursuant to section
482 despite the fact that the debtor is financially distressed.


CONCLUSION:

       1. A is subject to the “strong proof” rule articulated by the Tax Court when it
takes a position invoking the substance of a transaction that is contrary to its form.
Based upon the strong proof rule, it would be difficult for A to overcome its burden
of proof in attempting to disavow the form of the transaction it has chosen. Section
385(c) is further support that A should not be allowed to re-characterize its
advances as equity. However, further factual development is recommended.

       2. At present, it cannot be determined whether any allocation of interest
under section 482 from A to its foreign related entities is appropriate. If such
allocations are appropriate, as described below, the withholding tax liability under
section 1442 may arise in connection therewith and A is liable for such tax under
section 1461.

       3. The accrual rules of section 451 (including the doubtful collectibility
exception) do not, as a matter of law, prevent the Service from making an
adjustment under section 482. However, if it is determined that there is no
reasonable expectation of collecting the imputed interest from A and that the
reason for A’s inability to pay is not attributable to non-arm’s length actions by
related parties, then section 482 should not be applied to impute interest on A’s
trade payables.

FACTS:

       The taxpayer, A, is a United States affiliate of a large business system
operating in the United States, Country X, and Country Y. A is 100 percent owned
by B, a Country X corporation.

       A reported losses for year 1 and year 2. A may become a publicly traded
company. Substantial funds have been advanced to A by foreign related entities.
The field has treated all of this debt as inventory related debt. A appears to
concede that A and these foreign related entities are commonly controlled for
purposes of section 482. It is unclear whether these foreign related entities during
the periods in issue engaged in a U.S. trade or business. A recorded the advances
as debt on its books and records and its tax returns. For example, on its trial
balances, the amounts are reflected as trade payables to the foreign related
parties. On its tax returns, the advances are reflected as “Loan from Shareholder”.
No interest has been accrued or actually been paid with respect to these advances.
Further, no promissory notes are known to exist pertaining to these trade accounts
payable. The documentation referencing the intercompany transactions generally
does not state an interest rate.

LAW AND ANALYSIS:



      1. Whether A is precluded from recharacterizing advances it received
from its foreign related entities as equity when it originally classified those
funds as debt on its books and records and its tax returns.

       A argues that the advances are, in substance, capital contributions, and as
such, are not subject to imputed interest under section 482. You have requested
assistance on whether a taxpayer is bound by the form in which it has chosen to
structure the transaction, in this case as debt rather than equity.

      In general, the substance rather than the form of a transaction governs for
federal income tax purposes. Commissioner v. Court Holding Co., 324 U.S. 331
(1945); Gregory v. Helvering, 293 U.S. 465 (1935). Thus, the Commissioner has
been allowed to discount the form of a transaction, and determine the tax
consequences based on its substance. See Gregory v. Helvering; Spector v.
Commissioner, 641 F.2d 376, 381 (5th Cir. 1981), cert. denied, 454 U.S. 868 (1981);
Laidlaw Transportation, Inc. v. Commissioner, T.C. Memo. 1998-232.

       However, the Supreme Court has also long recognized that a taxpayer,
although free to structure his transaction as he chooses, “once having done so, he
must accept the consequences of his choice, whether contemplated or not . . . and
may not enjoy the benefit of some other route he might have chosen to follow but
did not.” Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134,
149 (1974) (citations omitted). Taxpayers have “less freedom than the
Commissioner to ignore the form that they have adopted”, and are ordinarily bound
by the tax consequences that flow therefrom. Illinois Power Co. v. Commissioner,
87 T.C. 1417, 1430 (1986), aff’d 896 F.2d 580 (D.C. Cir. 1990). See also, Nestle
Holdings, Inc. v. Commissioner, 152 F. 3d 83, 87 (2d Cir. 1998); Spector v.
Commissioner, 641 F.2d at 381; Taiyo Hawaii Company, Ltd. v. Commissioner, 108
T.C. 590, 601-603 (1997); Estate of Durkin v. Commissioner, 99 T.C. 561, 572-75
(1992); Little v. Commissioner, T.C. Memo. 1993-281, 65 T.C.M. (CCH) 3025, 3032
(1993), aff’d, 106 F.3d 1445 (9th Cir. 1997). This rule seeks to avoid the uncertainty
that would result from allowing the taxability of a transaction to depend on whether
an alternative form exists under which more favorable tax consequences would
result. National Alfalfa, 417 U.S. at 149; Television Indus., Inc. v. Commissioner,
284 F.2d 322, 325 (2d Cir. 1960).

       The case law recognizes that taxpayers are advantaged by having both the
power to structure transactions in any form they choose and the access to the facts
that reflect the underlying substance. In contrast, the Commissioner is
disadvantaged because he does not have direct access to the facts underlying a
particular transaction. Hence, the Commissioner must be allowed to rely on
representations made by taxpayers in their returns, and must be allowed to
evaluate the resulting tax consequences based on such disclosures. This reliance


is particularly appropriate in the context of a cross border transaction, such as the
present case, where documents, information and witnesses are not readily available
to the Commissioner.

         “The Commissioner is justified in determining the tax effect of transactions on
the basis in which the taxpayers have molded them ....” Television Industries, Inc.
v. Commissioner, 284 F.2d at 325. See also, FNMA v. Commissioner, 90 T.C. 405,
426 (1988), aff'd, 896 F.2d 580 (D.C. Cir. 1990), cert. denied, 499 U.S. 974 (1991).
To allow taxpayers to argue for alternative tax treatment of a transaction upon the
examination of the returns would be tantamount to administering the tax laws based
on a policy that tax consequences flow from the “transaction taxpayers have
chosen or from any other form [of transaction] they might have chosen, whichever
is . . . [more favorable].” City of New York v. Commissioner, 103 T.C. 481, 493
(1994) (quoting Television Industries, Inc. v. Commissioner, 284 F.2d at 325), aff’d,
70 F.3d 142 (D.C. Cir. 1995). For this reason, the courts have generally subjected
taxpayers to a heightened standard of proof before they are permitted to contradict
the form and have the transaction taxed in accordance with substance. Spector v.
Commissioner, 641 F.2d at 382; Estate of Durkin v. Commissioner, 99 T.C. at 572-
75; FNMA v. Commissioner, 90 T.C. at 426; Illinois Power v. Commissioner, 87 T.C.
at 1431; Little v. Commissioner, 65 T.C.M. (CCH) at 3032.

       The courts have articulated this heightened standard of proof differently.
See Spector v. Commissioner, 641 F.2d at 382. For example, in Commissioner v.
Danielson, 378 F.2d 771 (3rd Cir. 1967), cert. denied, 389 U.S. 858 (1967), the
court held that where taxpayers executed a contract containing specific terms,
conditions and allocations, they may not alter or avoid the tax consequences of that
agreement in the absence of fraud, duress, or undue influence. 1 In contrast, the
court in Sonnleitner v. Commissioner, 598 F.2d 464 (5th Cir. 1979), determined that
before a taxpayer may alter or avoid the tax consequences of a contractual
arrangement, the taxpayer must come forth with strong proof that the agreement
lacked economic reality. See also Little v. Commissioner, 65 T.C.M. (CCH) at 3031
(strong proof requires a showing beyond a “preponderance of the evidence that the
terms of the written instrument do not reflect the actual intentions of the contracting
parties”). The strong proof standard has also been adopted by the Tax Court in
adjudicating matters involving debt-equity disputes. Miller v. Commissioner, T.C.
Memo. 1989-153, 57 T.C.M. (CCH) 46, 50-51 (1989) aff’d in an unpublished
opinion, (6th Cir. 1990) (where taxpayers chose to characterize the advances as



       1
           Only certain courts have adopted Danielson. See, e.g., Lane Bryant, Inc. v.
United States, 35 F.3d 1570 (Fed. Cir. 1994); Schatten v. United States, 746 F.2d 319
(6th Cir. 1984); Bradley v. United States, 730 F.2d 718 (11th Cir. 1984), cert. denied, 469
U.S. 882 (1984); Spector v. Commissioner, supra.


debt, the court was unpersuaded by their argument that the substance was equity
when the advances contained both debt and equity characteristics).

       The Tax Court has adopted the strong proof standard and has refused to
apply Danielson outside the circuits that recognize it. See, e.g., Meredith Corp. v.
Commissioner, 102 T.C. 406, 440 (1994); Elrod v. Commissioner, 87 T.C. 1046,
1065-66 (1986). The “strong proof” rule, as applied by the Tax Court, requires a
showing of somewhat more than a preponderance of the evidence and somewhat
less than Danielson. Illinois Power Co. v. Commissioner, 87 T.C. at 1434, n.15
(1986), acq. in result, 1990-2 C.B. 1. The burden upon the taxpayer is “far heavier
when his tax reporting positions and other actions did not consistently reflect the
substance which he later argues should control the form.” Miller v. Commissioner,
57 T.C.M. at 50-51 (citing Illinois Power Co. v. Commissioner, 87 T.C. at 1430).

       The Tax Court in Estate of Durkin v. Commissioner, 99 T.C. at 574-575 held
that, under either a “strong proof” or Danielson standard, the taxpayers could not
disavow the form they chose where:

      (1) taxpayers were seeking to disavow their own tax return treatment of the
      transaction,
      (2) the taxpayers’ reporting position and other actions did not show “an
      honest and consistent respect for the substance of the transaction”,
      (3) the taxpayers were unilaterally attempting to have the transaction treated
      differently after it had been challenged, and
      (4) the taxpayers would have been unjustly enriched if he were permitted to
      belatedly alter the transaction after well-informed negotiations were held with
      the other party to the transaction.

       The taxpayers in Durkin did not prevail in establishing that the transaction, in
substance, was different from that which was initially reported in the tax return as a
purchase of coal properties from their corporation at a price below fair market
value. Upon examination of the returns, the Commissioner determined that the
taxpayers received a constructive dividend for the difference between the price paid
and fair market value of the property. After their returns were challenged by the
Commissioner, the taxpayers argued that their purchase of coal properties were in
substance part of one integrated transaction in which they disposed of their stock
ownership to another shareholder, and thus, the transaction should be taxed as a
redemption. Based on the four factors discussed above, the Tax Court determined
that the taxpayers did not carry their heightened burden to show a substance that is
different than their reporting position. Furthermore, the taxpayers would have been
unjustly enriched if they were permitted to avoid the tax consequences of a
constructive dividend.

      The Ninth Circuit, which governs the present case, has never adopted the
Danielson rule and, as a result, the Tax Court has followed the “strong proof” rule


there. See, e.g., Fountain Valley Transit Mix, Inc. v. Commissioner, T.C. Memo.
1996-244; Salyer Grain and Milling Co. v. Commissioner, T.C. Memo. 1986-165,
aff’d, 815 F.2d 1265 (9 th Cir. 1987).2 These cases rely upon Schmitz v.
Commissioner, 51 T.C. 306, 318 (1968), aff’d sub. nom., Throndson v.
Commissioner, 457 F.2d 1022 (9th Cir. 1972) in which the Tax Court specifically
applied the “strong proof” rule, and the Ninth Circuit affirmed without reaching the
issue of the application of Danielson.3

        Although the Danielson standard and the “strong proof” standard were both
first applied in cases involving covenants not to compete, it is now clear that both
standards cover a much broader range of circumstances. Estate of Robinson v.
Commissioner, 101 T.C. 499, 513 (1993); Coleman, 87 T.C. 178, 202 (1986).
Taxpayers have been held to their characterization of an amount as debt. See
Taiyo Hawaii, Ltd. v. Commissioner, 108 T.C. 590 (1997); City of New York v.
Commissioner, 103 T.C. 481 (1994); Litchfield v. Commissioner, T.C. Memo. 1994-
585, aff’d in an unpublished order, 97-2 USTC ¶ 50, 536 (10th Cir. 1997); Miller v.
Commissioner, T.C. Memo. 1989-153. Significantly, Taiyo Hawaii was decided
under Ninth Circuit precedent.




       2
             In Salyer Grain and Milling Co. v. Commissioner, 815 F.2d 1265 (9th Cir.
1987), the Ninth Circuit simply adopts the Tax Court opinion.
       3
               The Ninth Circuit has used a more stringent rule approaching Danielson.
In Palo Alto Town & Country Village, Inc. v. Commissioner, 565 F.2d 1388, 1390 (9th
Cir. 1977), the taxpayers were challenging provisions in their agreements regarding the
purchase price of two contiguous parcels of land. The court held that taxpayers were
bound by the agreements “knowingly and voluntarily made, with no suggestion of
fraud.” The court noted that “the tax consequences of such an agreement may be
challenged by the Commissioner, but not by the taxpayer.” 565 F.2d at 1390 (citations
omitted). Other Ninth Circuit cases have similarly held that, in an absence of fraud, a
taxpayer could not challenge the form of its transaction. See Baxter, 433 F.2d 757, 759
(9th Cir. 1970). The Tax Court has recognized that the holding of Palo Alto indicates
that the Ninth Circuit may apply a rule that is more stringent than the “strong proof” rule.
See Huestis v. Commissioner, T.C. Memo. 1992-159, 63 T.C.M. (CCH) 2443, 2447
(1992); Chiapetti v. Commissioner, T.C. Memo. 1996-183, 71 T.C.M. (CCH) 2778, 2783
n.8 (1996). However, whether the Tax Court would ever apply the Palo Alto standard is
questionable. In both Huestis and Chiapetti, the Tax Court determined that their
conclusion would be the same under either the “strong proof” or Palo Alto standard.
Huestis, 63 T.C.M. (CCH) at 2447; Chiapetti, 1996 RIA TC Memo ¶ 96, 183 at 1368
n.8. Further, after Palo Alto, the Tax Court has continued to apply the “strong proof”
standard in cases appealable to the Ninth Circuit. See Salyer Grain and Milling Co, 51
T.C.M. (CCH) at 922 n.1.


       The court in Taiyo Hawaii, in holding for the Commissioner that the advances
were debt, found that it was unnecessary under the facts of that case to engage in
a traditional debt-equity analysis. 108 T.C. at 601-604. Working from the
fundamental rule of law enunciated in National Alfalfa that a taxpayer must accept
the tax consequences of its choice of transaction, the court noted that taxpayers
have been permitted to assert substance over form where their “tax reporting and
other actions have shown an honest and consistent respect for” the substance. Id.
at 602 (citing FNMA v. Commissioner, 90 T.C. at 426 and Illinois Power Co. v.
Commissioner, 87 T.C. at 1430). The court found that Taiyo Hawaii failed this
exception. The court stated:

              Petitioner has, for all purposes, treated the advances as loans and
      was instructed by its parent corporation to accrue interest. Under those
      circumstances, we reject petitioner's approach of testing its own choice of
      form with traditional debt versus equity considerations, such as the absence
      of a fixed payment schedule, maturity dates, enforcement, or formal debt
      instruments. We are likewise unpersuaded by petitioner's accountant's . . .
      after-the-fact testimony that, in retrospect, he should have considered the
      advances as equity and reported them as such on petitioner's tax returns.

108 T.C. at 602-603 (citations and footnote omitted).

       In the recent opinion of Norwest Corp. v. Commissioner, 111 T.C. 105
(1998), the Tax Court denied the taxpayer’s attempt to have a transaction taxed in
accordance with its substance, after it was initially reported on the return as a sale
and lease-back of real property. The taxpayer argued that there had been no sale,
and that the entire transaction, in substance, was merely a financing arrangement.
After considering various approaches, the Tax Court concluded that the “taxpayers
cannot elect a specific course of action and then when finding himself in an adverse
situation extricate himself by applying the age-old theory of substance over form.”
Norwest Corp. v. Commissioner, 111 T.C. at 146. A taxpayer’s ability

      to ignore the transactional form that he has adopted . . . is further curtailed if
      . . . [he] attempts to abandon his tax return treatment of a transaction . . .
      [W]hen a taxpayer seeks to disavow his own tax return treatment . . . by
      asserting the priority of substance only after the Commissioner raises
      questions with respect thereto, this Court need not entertain the taxpayer’s
      assertion of the priority of substance . . . [Due to] the tremendous load he
      carries, [the Commissioner] must necessarily rely in the vast majority of
      cases on what the taxpayer asserts to be fact. The burden is on the
      taxpayer to see to it that the form of business he has created for tax
      purposes, and has asserted in his returns to be valid, is in fact not a sham or
      unreal. If in fact it is unreal, then it is not he but the Commissioner who
      should have the sole power to sustain or disregard the effect of the fiction


      since otherwise the opportunities for manipulation of taxes are practically
      unchecked. Id. at 145-146.

       Further, the Tax Court adopted a heightened standard of proof when a
taxpayer attempted to avoid the Commissioner’s interest allocation pursuant to
section 482 based on the argument of substance over form. Cayuga Service, Inc.
v. Commissioner, T.C. Memo. 1975-4, 34 T.C.M. (CCH) 18 (1975). In response to
the taxpayer’s urging that the court disregard the form of intercompany advances as
loans, and find that the advances were investments, the court stated, “[I]f a
taxpayer asserts that the substance is different than the form he used, he must
furnish strong proof that the substance was other than the form indicates,” citing,
inter alia, Ullman v. Commissioner. The court found that “petitioner has failed to
meet its burden of persuading us that the advances were in fact investments and
not loans.” 34 T.C.M. (CCH) at 25.

       The court decided Cayuga Service based on then existing Treas. Reg. §
1.482-2(a), T.D. 6952 (Apr. 16, 1968) and the decision is consistent with
longstanding principles that the Commissioner is allowed to determine the tax
consequences of a transaction based on its substance, while imposing a
heightened standard of proof on taxpayers that argue for a substance different than
the form. These principles are set forth in Treas. Reg. § 1.482-2(a), T.D. 8552 (Jul.
1, 1994), and, unlike the 1968 regulations, are confirmed in Treas. Reg. § 1.482-
2(a)(3)(i), which provides that the substance of the transaction shall be determined,
and that “all the relevant facts and circumstances shall be considered and any law
or rule of law (assignment of income, step transaction, etc.) may apply.”

        We recognize that in some cases involving debt-equity disputes decided
prior to Norwest and Taiyo Hawaii, courts chose to adjudicate the matter by testing
the taxpayer’s chosen form with traditional debt versus equity considerations. For
instance, in Georgia-Pacific Corp. v. Commissioner, 63 T.C. 790 (1975), the
Commissioner argued that the taxpayer was bound by the form in which affiliated
corporations cast advances. The Tax Court, however, believed that such advances
should be “characterized in terms of economic reality for the year at issue” and that
“changing circumstances as time passes may alter the original character of an
advance and transform it into equity.” Id., at 795-796. It is worth noting that when
applying the various debt-equity factors to reach the conclusion that the advances
were debt, a recurring theme relied upon by the Court was the intent of the affiliates
as evidenced by their contemporaneous actions prior to litigation - - the manner in
which the affiliates characterized the advances on their books and records,
reported the advances on their tax returns and reported the advances to unrelated
third parties. Id., at 796-800. The Court concluded that the advances were “clearly
loans at their inception” and the taxpayer had failed to present a “concrete
demonstration of any changed intent.” Id., at 800. In this sense, Georgia-Pacific,
which was decided only one year after National Alfalfa, was a precursor to Norwest
and Taiyo Hawaii. But, to the extent Georgia-Pacific reflects a court’s willingness to


indulge in traditional debt-equity considerations, the Tax Court in Taiyo Hawaii
found the taxpayer’s reliance on Georgia-Pacific unworthy of comment in light of
National Alfalfa and its progeny. 108 T.C. at 601.4

         In this case, we believe it would be difficult for A to overcome its burden of
proof under the “strong proof” rule in attempting to disavow the form of transaction
that it has chosen. A booked the advances as trade payables to the foreign related
parties on its trial balances and recorded the advances as “Loan from Shareholder”
on its tax returns. It is only after an examination by the Service of taxpayer’s
records that A is seeking to disavow its own tax return treatment for the advances it
received. Clearly, A’s financial reporting and tax reporting indicate an inconsistent
treatment for these advances. Further, due to the imposition of additional tax
liability, it appears that A is unilaterally attempting to have the transaction treated
as a contribution to capital after the Service’s challenge. However, we have no
knowledge how the foreign related parties treated the advances for financial
reporting and for tax reporting purposes. For example, it is not known whether the
advances were reflected in any of the foreign related parties’ capital accounts.
Thus, further factual development is necessary to finally determine whether A and
the foreign related lenders took consistent positions with respect to the advances
that A is seeking to disavow, and whether their reporting positions show “an honest
and consistent respect for the substance of the transaction.”

       In the event it is necessary to consider whether the advances constitute debt
or equity, the particular facts and circumstances must be examined. No single
uniform approach has been adopted by the courts in analyzing this particular issue.
The Tax Court looks to whether there was a “genuine intention to create a debt,
with a reasonable expectation of repayment, and . . . [whether] that intention
comport[s] with the economic reality of creating a debtor-creditor relationship.”
Nestle Holdings. Inc. v. Commissioner, T.C. Memo. 1995-441, 70 T.C.M. (CCH)
682, 700 (1995), vacated and remanded on another issue 152 F.3d 83 (2d Cir.
1998) (quoting Litton Business Systems, Inc. v. Commissioner, 61 T.C. 367, 377


      4
              The court in Taiyo Hawaii was likewise unimpressed with the taxpayer’s
reliance on J.A. Tobin Construction Co. v. Commissioner, 85 T.C. 1005 (1985)
(imputation of interest under section 482 rejected, but the Commissioner did not argue
that the taxpayer was held to the form of its transaction); J.A. Maurer, Inc. v.
Commissioner, 30 T.C. 1273 (1958) (advances were contributions to capital); LDS, Inc.
v. Commissioner, T.C.M. 1986-293 (the transfer of land in exchange for a note was
nontaxable capital contribution because the objective factors overwhelmingly outweigh
the taxpayer’s subjective intent that the transaction was to be a sale of land); and
Inductotherm Industries, Inc. v. Commissioner, 48 T.C.M. 167, 186-89 (1984), aff’d.
without published opinion 770 F.2d 1071 (3d Cir. 1985) (advances characterized as
equity but the Commissioner did not argue that the taxpayer was held to the form of its
transaction for such advances) 108 T.C. at 601, n. 9.


(1973). In this regard, the same facts concerning the tax and financial reporting of
A, contemporaneous with the transaction, are very probative of the overall intent of
the parties.

      The courts have enumerated several other factors, in addition to intent, to be
considered in resolving a debt-equity issue. While the following list is not exclusive
and no single factor is determinative, the courts generally look to:

      1.     the name and presence of a written agreement demonstrating
             indebtedness,
      2.     the presence of a fixed maturity date,
      3.     the source of payments, e.g., whether there is anticipated cash flow to
             cover payments,
      4.     the right to enforce payment,
      5.     increased participation in management as the result of the advance,
      6.     subordination,
      7.     thinness of the capital structure in relation to debt,
      8.     the identity of interest between creditor and stockholder,
      9.     the source of interest payments, e.g., from earnings,
      10.    the ability of the corporation to obtain credit from outside sources,
      11.    the use of funds for capital assets or risk involved in making the
             advances, and
      12.    the failure of the debtor to repay.

See Laidlaw Transportation, Inc. v. Commissioner, T.C.M. 1998-232; Nestle
Holdings, Inc. v. Commissioner, 70 T.C.M. at 700; Lansall Company v. United
States, 512 F.Supp. 1178, 1180 (S.D.N.Y. 1981). See also I.R.C. § 385(b) (listing
debt-equity factors which could be taken into account in regulations).

       Further factual development is necessary to determine whether the above
factors have been satisfied.

      It is also your position that section 385(c) precludes A from recharacterizing
the advances as equity.

        In the instant case, A is a domestic corporation that consistently
characterized the advances from related foreign parties as payables on their books
and records and reported them as “Loans from Shareholder” on their federal tax
returns. Only when faced with additional tax liability did A seek to recharacterize
the advances as equity. Under these circumstances, we agree that section 385(c)
is further support to preclude taxpayers from recharacterizing the advances from
debt to equity.


       2. Whether withholding pursuant to sections 1441 and 1442
(“withholding tax”) may be imposed with respect to deemed interest payments
that result from a section 482 allocation of interest income from A to its
foreign related parties.

       Initially, we note that if there were any accounts receivable providing for
interest, and if it is determined both that the accounts receivable’s stated interest is
at an arms length rate within the meaning of Treas. Reg. § 1.482-2(a)(2) and the
accounts receivable provided for payment of interest at maturity, it is possible that
no section 482 adjustment would be appropriate. Section 267(a)(3) puts the
taxpayer on a cash basis with respect to this interest owed to the foreign lender, so
that even if its liability for interest were properly accrued for accounting purposes,
no tax deduction for the interest would be allowable prior to its actual, constructive,
or deemed payment. Because no documentation has thus far been produced, the
balance of this memorandum assumes that no such documentation exists, and that
a section 482 adjustment is appropriate for the period here in issue under the
general rule set forth in Treas. Reg. § 1.482-2(a)(1), during which time no interest
was paid or accrued by the taxpayer in respect of outstanding indebtedness. It is
also assumed for purpose of this discussion that the foreign related lenders do not
have a U.S. trade or business.

       In general, section 881 of the Code imposes a tax of 30 percent of the
amount received from sources within the United States by a foreign corporation as
interest, dividends, rents, salaries, wages, premiums, annuities, compensations,
remunerations, emoluments, and other fixed or determinable annual or periodical
gains, profits, and income (“FDAP”), but only to the extent the amount so received
is not effectively connected with the conduct of a trade or business within the
United States.

       The mechanism for collecting the tax imposed by section 881 is provided in
sections 1441 and 1442. Section 1442 provides that, in the case of foreign
corporations, there shall be deducted and withheld at the source in the same
manner and on the same items of income as is provided in section 1441 a tax equal
to 30 percent thereof. Section 1441 states, in part, that all persons, in whatever
capacity acting, having control, receipt, custody, disposal, or payment of any items
of income specified in [section 871] of any nonresident alien individual or of any
foreign partnership shall deduct and withhold from such items a tax equal to 30
percent thereof. However, an applicable income tax treaty may reduce the rate of
withholding or exempt amounts from withholding; see section 894, Treas. Reg. §
1.1441-6. The United States does not have a treaty with Country X or Country Y.
However, we do not know the lenders country or countries of residence to
determine whether there is an applicable treaty.


      Section 1461 provides, in part, that every person required to deduct and
withhold any tax under sections 1441 and 1442 is liable for such tax and is
indemnified against the claims and demands of any person for the amount of any
payments made in accordance with sections 1441 and 1442.

       Rev. Rul. 82-80, 1982-1 C.B., modified, Rev. Proc. 91-23, 1991-1 C.B. 534,
modified, Rev. Proc. 96-14, 1996-1 C.B. 626, superceded, Rev. Proc. 99-32, 1999-
34 I.R.B.1, in which the Service discussed the application of Rev. Proc. 65-17,
1965-1 C.B. 833, 5 to transactions involving a United States subsidiary and its
foreign parent, also indicates the Service’s position that a constructive, collateral
adjustment required under section 482 may give rise to a section 1442 withholding
tax liability.

       Rev. Rul. 82-80 addresses a United States subsidiary whose taxable income
was increased because of an allocation under section 482. The ruling states that if
Rev. Proc. 65-17 treatment is granted, the original transaction will be treated, for
tax purposes, as if the correct amount, as determined under section 482, had been
paid. Thus, if a United States subsidiary pays more than arm’s length consideration
for services performed by its foreign parent, the parent corporation will not be
considered to have received a dividend to the extent of the greater-than-arm’s
length amount, and the withholding tax provisions of section 1442 will be applied to
the deemed flow of funds necessary to account for the amounts the foreign parent
had, but should not have received, as payments for services.

       The necessary and clear implication of Rev. Rul. 82-80 is that absent Rev.
Proc. 65-17 treatment, a withholding tax liability under section 1442 would have
arisen in connection with the deemed flow of funds from the United States
subsidiary to its foreign parent, and that the tax imposed under section 1442 on
such deemed payment would be collectible from the United States subsidiary, the
withholding agent, under methods appropriate to that section. If a withholding
obligation is deemed to arise under these circumstances (correlative or
consequential adjustments arising in connection with section 482 allocations), it
would appear certain that such obligations also should be treated as arising in
connection with a primary adjustment under section 482 (i.e., the allocation itself).



      5
              Rev. Proc. 65-17 describes the position of the Service, and the
procedures to be followed, in cases in which a United States taxpayer, whose taxable
income has been increased for a taxable year by reason of an allocation under section
482, requests permission to receive payment from, or to, which the allocation of
income, or deductions, was made of an amount equal to a part or all of the amount
allocated, without further income tax consequences. Note that Rev. Proc. 65-17, and
Rev. Rul. 82-80, have been superceded for future years. Rev. Proc. 99-32, 1999-34
I.R.B.1.



       The precise issue of whether a section 482 allocation of U.S. source FDAP to
a foreign entity is subject to section 1442 withholding has not been addressed by a
court. There is, however, case law to support such an approach.

        Interest imputed to a foreign related entity under section 7872 is subject to
withholding. Climaco and Nakamura v. Internal Revenue Service, 96-1 USTC ¶
50,153 (E.D.N.Y. 1996) (unpublished opinion, Jan. 24, 1996). In Climaco, one
plaintiff was a shareholder of a foreign corporation who received a no-interest loan
from the corporation; he used the no-interest loan to purchase a United States
residence, apparently for himself and his wife (who appears to be the second
named plaintiff in the case). Plaintiffs reported the imputed interest payments
foregone by the foreign corporation on the loan pursuant to section 7872, and
claimed a corresponding deduction for those payments. The plaintiffs also filed
annual withholding tax returns pursuant to section 1442. Subsequently, however,
the plaintiffs sought to have such withholding taxes refunded, asserting that in the
absence of actual interest payments to a foreign payee, withholding was not
required.

       The District Court held that plaintiffs were required to withhold and pay a
portion of the imputed interest under section 7872 despite the fact that the plaintiffs
did not actually make any interest payments on their loan. The court could discern
no reason why plaintiffs should not, on these facts, be required to make withholding
payments. Had the foreign corporation lent money at the market rate, the court
reasoned, the plaintiffs clearly would have been required to withhold at the
appropriate rate on the stated interest under section 1442. To hold otherwise, the
court reasoned, would mean that the foreign corporation, by structuring the
transaction as an interest-free loan, could avoid payment of the tax altogether. In
addition, the court found persuasive the Government’s reliance on Casa de Jolla
Park, Inc. v. Commissioner, 94, T.C. 384 (1990) and Central de Gas de Chihuahua
v. Commissioner, 102 T.C. 515 (1994).

       Casa de la Jolla addressed the following fact pattern. Petitioner, a domestic
corporation, was organized by Marshall, a nonresident alien and citizen of Canada,
to market condominium time-share units in a La Jolla (California) property.
BankCal, a domestic (California) bank, collected the proceeds of condominium unit
sales for petitioner. Marshall, petitioner's sole shareholder and director, held an
interest-bearing promissory note from the petitioner.

     Royal, a Canadian bank, had made substantial loans to Marshall, some in
connection with the earlier acquisition and development of that property by a
second domestic corporation wholly-owned by Marshall. As collateral for such


loans, Royal held both Marshall’s stock in the petitioner and his shares in another
(Canadian) corporation, Blake Resources.6

       When Blake Resources entered the Canadian equivalent of Chapter 11
bankruptcy proceedings, Royal sought further assurances of collection of Marshall’s
debts. Accordingly, Marshall, as sole shareholder and director of the petitioner,
authorized BankCal to remit to Royal directly the proceeds from the sales of
petitioner’s time-share units that otherwise were due and payable to the petitioner.
Royal immediately applied the payments it received pursuant to these
arrangements to Marshall’s personal loan accounts.

       At issue was whether petitioner was responsible under section 1441 for
withholding tax on Marshall’s interest income.7 Petitioner contended that it never
possessed or controlled Marshall’s interest income. Petitioner also argued that
Marshall had never "received" any income from which petitioner could withhold.
Respondent, in turn, contended that Marshall had constructively received the
interest income, because pursuant to petitioner’s instructions, the monthly net
proceeds from condominium sales otherwise payable to it were applied to Royal’s
outstanding loans to Marshall. Respondent also argued that petitioner had control
of the time-share proceeds from which withholdings could have been made.

       The Tax Court concluded that petitioner did have control over funds from
which withholding could be made. The court also rejected petitioner’s contention
that withholding responsibility under section 1441(a) requires actual payment and
receipt, noting that "payment" is merely one of several terms (control, receipt, etc.)
that are described in section 1441(a) in the disjunctive. Moreover, the court found
that the doctrine of constructive receipt applies "for purposes of section 1441."
(Emphasis supplied.) This language may be read to support the view that
whenever a payment of United States-source FDAP is constructively received by a
foreign person, there is necessarily a corresponding deemed payment of the
amount that may trigger withholding tax liability under section 1441(a).

       Central de Gas de Chihuahua addressed the following fact pattern. Central,
a foreign (Mexican) corporation, processed, transported, and distributed liquified
natural gas throughout Mexico. Central rented a fleet of tractors and trailers to
Hidro, a sister corporation (also Mexican), but did not receive any rental payments.
The fleet was used to transport gas products within the United States and in
Mexico. As here relevant, the Service imputed to Central the fair rental value of


      6
             Additional collateral held by the bank is not described.
      7
              Also at issue was whether such interest income was effectively connected
with a United States trade or business, and so exempt from section 1441 withholding.
The latter issue, resolved in the government’s favor, is not discussed herein.


Hidro’s use of the fleet, arguing that such income was taxable in its hands under
section 881.

       In responding to this argument, the taxpayer contended in part that in order
for section 881(a) to apply, there must be an actual payment of the income item
and that the allocation of rent to petitioner from Hidro under section 482 does not
satisfy that requirement. The Service, in response, cited Casa de la Jolla Park for
the proposition that there is no requirement of actual payment under section 881,
and that the allocation of rent to petitioner under section 482 provides a sufficient
basis for imposing the 30 percent tax under section 881.

       The Tax Court held that an allocation under section 482 results in a deemed
payment that constitutes "an amount received" under section 881. The court found
that there is no requirement of actual payment under section 881 and that the
allocation of rent to petitioner under section 482 provides a sufficient basis for
imposing the 30 percent tax under that section.

         The court in Central de Gas de Chihuahua expressly did not reach the issue
of whether actual payment is required for withholding under sections 1441 and
1442. The court distinguished between section 881, which it found imposes a
liability for tax, and sections 1441 and 1442, which provide the method for
collecting that tax, commenting that the former section and the latter section serve
distinctly separate purposes. However, the case is nonetheless support for
imputing interest under section 482 and subjecting such interest to withholding.
Because the case holds that a section 482 allocation amount is deemed to be
received by the foreign entity, it follows that withholding is the collection mechanism
for the section 881 tax liability. In our view, to separate the tax liability from the
collection mechanism for the tax would render ineffective the triggering of the
section 881 liability. The Tax Court touched on this concern when it observed that
"[a] holding that actual payment is required could significantly undermine the
effectiveness of section 482 where foreign corporations are involved. Such a view
would permit such corporations to utilize property in the United States without
payment for such use and thereby avoid any liability under section 881." Id. at 520.
Similarly, Rev. Rul. 92-85, 1992-2 C.B. 69, holds that deemed dividend distributions
under section 304(b)(2) by domestic acquiring or domestic acquired/issuing
corporations to foreign controlling corporations give rise to tax under section
881(a)(1), and that the acquiring corporation (whether foreign or domestic) is
responsible for withholding under section 1442 with respect of such deemed
dividends.

       Finally, we note that recently-issued final regulations under section 1441
(Treas. Reg. § 1.1441-2(e)(2)) specifically provide that an allocation of income
subject to withholding under section 482, as well as income arising as a result of a
secondary adjustment made in conjunction with a reallocation of income from a
foreign person to a related U.S. person, is subject to withholding under section


1441. While this regulation is not yet effective and hence does not apply to the
taxable years here in issue, based on the foregoing and on the absence of any
indication in this regulation and its preamble that it was intended to reflect a change
of Service position, we view the new regulation as clarifying currently applicable law
on this point.

      3. Whether interest should be imputed to foreign lenders pursuant to
section 482 despite the fact that the debtor is financially distressed.

       Assistance has been requested about whether interest should be imputed on
A’s outstanding balances of intercompany obligations under section 482 because of
doubtful collectibility. In particular, you have proposed to argue that the general
accrual rules of section 451, including the “doubtful collectibility” exception, do not
override the more specific rules of the section 482 regulations. Your request is in
response to A’s argument that interest may not be imputed due to doubtful
collectibility.

       In Johnson v. Commissioner, T.C. Memo. 1982-517, 44 T.C.M. (CCH) 1076,
1083, the Tax Court held that a corporation did not have to accrue interest imputed
under section 482 on an advance to a commonly controlled sister corporation,
which originally characterized the advances as loans. Because the facts indicated
that the corporation had no reasonable expectancy of collecting the advances or
any interest on the advances, the court concluded that the corporation was not
required to accrue interest imputed pursuant to section 482. The court based its
conclusion on the “narrow exception” to the general rule of accrual for
circumstances where “it is reasonably certain that the income will not be collected
in the tax year or within a reasonable time thereafter . . . .” 44 T.C.M. at 1083,
citing Corn Exchange Bank v. United States, 37 F.2d 34 (2d Cir. 1930).

       Notwithstanding the application in Johnson of the “doubtful collectibility”
exception to the general rule of accrual, you have suggested that the Service can
challenge the Johnson decision based on a rationale analogous to a secondary
rationale underlying the conclusion in TAM 9538007.

       TAM 9538007 considered whether the “doubtful collectibility” exception to the
general accrual rules should apply in the case of original issue discount (“OID”)
interest accrual under section 1272. The TAM pointed out that the accrual of OID
differs from the accrual of non-OID interest in advance of receipt because OID is
included in income in lieu of receipt. The OID interest is deemed paid to the holder,
who in turn is deemed to lend the same amount back to the issuer. At the same
time, the holder’s basis in the instrument increases by an equivalent amount. In
addition, the TAM cited Weis v. Commissioner, 94 T.C. 473 (1990), and Williams v.
Commissioner, 94 T.C. 464 (1990), which held that the general interest accrual
rules of sections 446 and 461 do not trump the more specific imputed interest rules


of section 483. The TAM concluded that to extend the doubtful collectibility
exception to the accrual of OID would contravene the legislative intent of the OID
rules by (1) failing to respect the principle that OID is “deemed” paid as accrued; (2)
creating a mismatch of issuer deductions and holder inclusions; and (3) elevating
general accrual principles over specific statutory provisions. Thus, taxpayers must
continue accruing OID for as long as they hold the instruments, regardless of the
financial condition of the issuer.

        We generally agree that the “doubtful collectibility” exception does not
necessarily preclude the Service from imputing interest under section 482. The
general rule of Treas. Reg. § 1.482-2(a)(1) authorizes the district director to make
appropriate allocations to reflect an arm’s rate of interest on a loan or advance from
one member of a group of controlled entities to another member of the same group.
This rule applies only to bona fide indebtedness between members of a group of
controlled entities and expressly does not apply to an alleged indebtedness that is
in fact a contribution to the capital of a corporation or a distribution by a corporation
with respect to its shares. Payments with respect to an alleged indebtedness are
treated according to their substance. Treas. Reg. § 1.482-2(a)(1)(ii).

       Neither section 482, nor the regulations thereunder, explicitly provide any
exception for a debtor that is unable to pay interest imputed under section 482. We
recognize, however, that the Tax Court applied the exception in Johnson v.
Commissioner, supra, in holding that the lending corporation was not required to
accrue interest income imputed under section 482. In that case, the Service did not
dispute, and the Tax Court did not discuss, whether that the exception applied to
the imputation of interest under section 482. The Service argued that the taxpayer
in that case had not established the lack of any reasonable expectation of collecting
the interest.

       The Service’s position in Johnson is similar to its position in the earlier case
of Pitchford’s, Inc. v. Commissioner, T.C. Memo. 1975-75, 34 T.C.M. (CCH) 384.
There, the Service expressly conceded that an accrual basis taxpayer need not
report otherwise accrued interest income where there is not a reasonable
expectancy of repayment. In addressing this issue, the court stated:

      We express no views on the question whether allocation of interest
      income under section 482 is indeed precluded where there would not
      have been a reasonable expectancy of collection of such interest. For
      purposes of this case only, we accept respondent’s concession on this
      point.

34 T.C.M. at 386.

      Although the Service conceded in Pitchford’s that the doubtful collectibility
exception would preclude the accrual of interest imputed under section 482, the


accrual rules of section 451 (including the doubtful collectibility exception) do not,
as a matter of law, prevent the Service from making an adjustment under section

482. One of the factors to be weighed in determining whether to make a
discretionary adjustment under section 482 should be the financial condition of the
related debtor. However, once it has been determined that a section 482 allocation
is proper, section 451 and the case law thereunder cannot frustrate such an
allocation.

       In Procacci v. Commissioner, 94 T.C. 397, 415-417 (1990), the Tax Court
considered whether an allocation of rental income to a lessor under section 482 is
precluded where the lessee lacks available funds after payment of other expenses
to pay the rent. The court began its analysis with the acknowledgment that a
determination under section 482 is “intensely factual” and focuses on “what would
have transpired between uncontrolled parties dealing at arm’s length.” 94 T.C. at
412-413. In discussing the holdings in Pitchford’s and Johnson, the court explained
that those cases did not establish a per se rule, as urged by the petitioners in
Procacci. Rather, the court viewed each case as having been decided on its own
peculiar facts and explained the significance of the cases as follows:

             At best these cases merely apply a practical, facts and
      circumstances approach to the question of whether the amounts of
      interest income imputed under section 482 would have actually been
      paid in an arm’s-length situation. That is the import of the “reasonable
      expectancy” exception to the general rule of accrual accounting.
      Finding that a taxpayer has no reasonable expectancy of receiving a
      payment means that the taxpayer would not have received the
      payment from an unrelated party in the same condition as the
      controlled one.

94 T.C. at 417. The court summarized its view of the application of section 482 as
follows:

             Thus, section 482 requires that we trace a hypothetical arm’s-
      length path, using as parameters the facts and circumstances of the
      particular case as shown by the record and determine its
      consequences. And, because the determination is so fact-specific,
      prior cases with materially different facts are of limited guidance to us.
      In other words, in a case like this, there are no per se rules or bright-
      line tests.

94 T.C. at 420.

      In our view, the doubtful collectibility exception to the general accrual rules
does not per se preclude an allocation of interest under Treas. Reg. § 1.482-2(a).
However, we believe the Procacci court’s explanation of the interaction between


section 482 and the doubtful collectibility principle points out a practical limitation
inherent in the overall purpose of section 482. Although the doubtful collectibility
exception to the accrual rules does not control whether the Service can make a
section 482 adjustment imputing interest on related-party debt, the debtor’s ability
to pay is a factor to consider in determining whether such an adjustment is
appropriate. As suggested by the Procacci court, the underlying goal of section
482 is to place related parties in the same position as unrelated parties acting at
arm’s length. Because an unrelated creditor may be able to invoke the doubtful
collectibility rule where the facts demonstrate the debtor’s total inability to pay
interest, a related creditor can be expected to argue that section 482 should not
place it in a worse position than an unrelated creditor under an arm’s-length
transaction.

       Accordingly, in light of Procacci, we would expect the Tax Court not to permit
imputed interest under section 482 where an unrelated creditor would not have to
accrue such interest under the doubtful collectibility exception. However, even if
facts indicate that a controlled debtor is unable to pay interest to a related creditor,
the totality of the facts surrounding the lending transaction may establish that the
reason for controlled debtor’s inability to pay is attributable to other non-arm’s
length actions by the related parties. Accordingly, after consideration of all the
relevant facts, the court may conclude that imputed interest under section 482 is
appropriate. Therefore, further factual development is necessary in this case.




      If you have any further questions, please call Kate Y. Hwa at (202) 622-3840.

                                         PHYLLIS E. MARCUS
                                         Chief, Branch 2
                                         Office of Associate Chief Counsel
                                                (International)