CCA 200031023: Hedged swap treated as foreign subsidiaries' loans to U.S. parent

Plain-English summary

Chief Counsel reviewed a U.S. parent's arrangement with foreign subsidiaries and banks, documented as a long-term notional principal contract with assigned future cash flows. The parent wanted access to a subsidiary's accumulated foreign earnings while avoiding a current U.S. tax inclusion. The memo concluded that prearranged assignments and offsetting hedges stripped the transaction of meaningful economic risk, making it a series of loans from the foreign subsidiaries to the U.S. parent. Those loans were investments in U.S. property under section 956 and could create a current income inclusion for the relevant U.S. shareholder. It also treated funds routed through another foreign subsidiary as an indirect investment when the funding came from the earnings-rich subsidiary and the routing was designed to avoid section 956. The advice noted that some aspects of the step-transaction analysis required further factual development.

Ruling snapshot

• Question: Should the purported swap and assignments be treated as loans, and would those loans be investments in U.S. property?
• Outcome: Advice given. Recharacterize the arrangement as loans and apply section 956, subject to factual development noted in the memo.
• Key authorities: IRC §§ 951, 956, 957, and 958; Treas. Reg. §§ 1.956-1T(b)(4) and 1.956-2.

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



                                                                  April 28, 2000
Number: 200031023
Release Date: 8/4/2000

TL-N-8774-97/CC:INTL:B2

UILC: 956.00-00

 INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE


MEMORANDUM FOR


FROM:




SUBJECT:



This Field Service Advice responds to your memorandum dated November 5, 1999.
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

Corp A
Corp B
Sub C
Sub D
Sub E
Bank M
Bank N
Bank O
Date 1
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Date 2
Date 3
Year F
Year G
Year H
Notional Amount P
Notional Amount Q
Notional Amount R
Sum U
Sum V
Sum W
Sum X
Sum Y
Sum Z
Country A
Area B



                                    ISSUES

1.   Should the entire transaction described below, which took the form of a
     notional principal contract between the U.S. parent and an unrelated foreign
     bank followed by the assignment of some of the contract’s cash flows to two
     foreign subsidiaries of the U.S. parent, be recharacterized as a set of loans
     from the foreign subsidiaries to the U.S. parent on the ground that the
     transaction lacks economic substance?

2.   If the transaction described below is recharacterized as a set of loans from
     the foreign subsidiaries to the U.S. parent, do such loans constitute an
     investment in U.S. property under section 956 of the Internal Revenue Code?

                                CONCLUSIONS

1.   The transaction should be recharacterized as a set of loans from the foreign
     subsidiaries to the U.S. parent on the ground that it lacks economic
     substance.

2.   Such recharacterized loans constitute an investment in U.S. property under
     section 956.
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                                       FACTS

A.    Tax Planning Background

       Corp A, a domestic corporation, owns indirectly all of the stock of Corp B,
also a domestic corporation. Corp B owns directly all of the stock of Sub C, which
owns directly all of the stock of Sub D, which owns directly all of the stock of Sub E.
Sub C, Sub D, and Sub E are all Country A corporations.

      In general, Sub C generated substantial earnings from its foreign
manufacturing operations, none of which was subject to current U.S. taxation under
subpart F of the Code. In contrast, the second- and third-tier Country A
subsidiaries, Sub D and Sub E, traded mostly with affiliates and generated a small
amount of income, all of which was subject to current U.S. taxation under Subpart F
and thus constituted previously taxed income (“PTI”) under section 959 of the
Code. All of Sub D’s and Sub E’s earnings were distributed to Sub C as PTI.

      Corp A’s treasury department in the United States provided cash
management services to Corp A, Corp B, and the Country A subsidiaries.
Management in Country A had only minimal authority over the operating budgets of
the Country A subsidiaries.

       A significant portion of Sub C’s earnings were transferred to Sub E, which
held them in bank accounts in the United States. As of Date 1, Sum W had been
transferred to Sub E. These transfers were booked as intercompany advances
from Sub C to Sub E, but were designated on the balance sheet included with
Forms 5471 on Corp A’s tax returns as increases in “trade accounts
payable/receivable.” They were not evidenced by any notes, no interest was paid,
and they were not disclosed on schedule M of the Forms 5471. Corp A explains
these discrepancies by claiming that these transactions were actually capital
contributions to Sub D, which were disguised to avoid liability for the Country A
stamp tax on capital contributions.

       The issues in this case arise because Corp A wanted to “unlock” Sub C’s
non-PTI earnings and have use of these funds for its own operations without
incurring any adverse tax consequences. (Non-PTI earnings of Sub C could not be
made directly available to Corp A ( i.e., through a dividend distribution or a loan)
without triggering an inclusion in Corp A’s income under either section 61 (in the
case of a dividend) or section 956 (in the case of a loan).) At strategic planning
meetings in Years F, G, and H, numerous discussions were held to identify ways to
repatriate cash out of Country A “on a tax-free basis.” In this regard, Corp A was
approached by Bank M. Corp A had a close relationship with Bank M,
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                                                                               Bank M
offered Corp A a “solution” that, if successful, would achieve Corp A’s goals. Corp
A was to engage in a transaction with a third party that would be documented as a
notional principal contract but would result in Sub C’s available cash being
transferred to Corp A without it being taxed immediately to Corp A as either an
actual dividend or a deemed distribution under section 951(a)(1)(B). For purposes
of illustrating the effect of the transaction, the promotional materials assumed that
the interest rates used to compute payments under the notional principal contract
would be 10% “floating” payments for 10% fixed payments. The promotional
materials thus focused on the benefits derived from repatriation of the cash and
assumed that potential differences in interest rates were irrelevant. Further
analysis by Corp A also focused on the benefits of cash repatriation and ignored
the potential hedging benefits that could have been derived from the transaction.

       Sometime on or around the end of Year F, Corp A agreed to adopt Bank M’s
proposal. As part of this agreement, Corp A agreed to pay Bank M an engagement
fee in the amount of Sum U. There is also an indication that Corp A and Bank M
may have negotiated a fee based on the expected tax savings derived by Corp A
from of the proposed transaction, although it is not clear whether such a
negotiation, if it occurred, resulted in an agreement between the parties.

B.    The Transaction 1

       On Date 2, as per the plan presented by Bank M, Corp A entered into a
twenty-year basis swap with a notional principal amount of Sum V with Bank N.
While the charts in the promotional materials used by Bank M in its presentation
reflected fixed rate payments in exchange for floating rate payments, Corp A and
Bank N ultimately agreed to exchange similar floating rate payments ((LIBOR in the
case of Corp A and federal funds in the case of Bank N) semi-annually on the
notional principal amount. It was contemplated from the outset that this swap
would be broken into its component parts and, rather than a single confirmation for
the swap in the amount of Sum V, there were several confirmations in various
amounts in anticipation of the subsequent assignment of portions of the swap to
related and unrelated parties. In fact, the agreement between Corp A and Bank N
specifically anticipated and permitted the assignment of portions of the swap to
some of Corp A’s foreign affiliates.




      1
       Corp A actually engaged in two of these transactions. For purposes of brevity,
only one is described herein.
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       At the core of the plan was Corp A’s anticipated assignment in year 1 of the
receiving leg of the swap for years 6 to 20 (i.e., a stream of payments starting in
year 6 and ending in year 20) to Sub C in exchange for an immediate lump-sum
payment. Corp A, however, had to ensure that it could support the validity of the
pricing set for the assignment. In addition, except to the extent of Sub C’s PTI,
Corp A wanted to ensure that Sub C would not appear to be the originator of the
funds used to make the lump sum payment.

         To inject the appearance that the transaction was priced at market, Corp A
initially assigned the right to receive payments with respect to Notional Amount P of
the receiving leg of the swap for years 6 through 20 to Bank O, an unrelated party,
in exchange for Sum X. With this “market price” in hand, Corp A assigned the right
to receive payments with respect to Notional Amount Q of the receiving leg of the
swap for years 6 through 20 to Sub C in exchange for Sum Y, and it assigned the
right to receive payments with respect to Notional Amount R of the receiving leg of
the swap for years 6 through 20 to Sub D in exchange for Sum Z.

        Sum Y and Sum Z were obtained by Sub C and Sub D, respectively, from
the funds that Sub C had earlier “advanced” to Sub E as increases in Sub E’s
accounts payable and which Sub E held in U.S. bank accounts. The transfer of
Sum Y, which amount approximated Sub C’s PTI, by Sub E to Sub C was booked
as a decrease in Sub E’s accounts payable to Sub C. The transfer of Sum Z by
Sub E to Sub D was booked first as a decrease in amounts payable by Sub E to
Sub C and then as an increase in accounts payable by Sub D to Sub C. These
transfers appear to have been intended to move cash funds of Sub C to Sub D, an
entity that had no earnings and profits.

C.    Corp A’s Tax Return Position

       During the first five years of the swap, Corp A treated the net amount of the
swap payments as an adjustment to interest expense. It did not report as income
any portion of Sums Y and Z during those years. Instead, in years 6 through 20,
Corp A treated these amounts in the same manner as a prepayment on a notional
principal contract. Relying on Notice 89-21, 1989-1 C.B. 651, which provides that a
swap prepayment must be amortized over the life of the swap in some reasonable
manner, Corp A amortized the receipt of Sum Y and Sum Z over years 6 through

20. The transaction, therefore, gave Corp A the use of a significant amount of its
foreign subsidiary’s revenues in year 1 of the swap and allowed it to defer tax on
that income until years 6 through 20 of the swap.
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D.    Elimination of Economic Risks.

       The transaction engaged in by Corp A, Sub C, Sub D, Bank N, and Bank O
had the potential of putting Corp A, its affiliates, and the participating banks at risk.
The parties, however, engaged in further activities and took certain positions in
order to eliminate such risk. Corp A entered into a series of mirror swaps with Bank
M to eliminate any market risk associated with the basis swap. Bank N also
entered into a mirror swap with Bank M in order to eliminate its market risk
associated with the basis swap. As a result, neither Corp A nor Bank N could incur
any losses from the notional principal contract, regardless of how interest rates
moved during the life of the swap.

       Bank N also had to protect itself against credit risk. In this regard, the
agreement provided that if Corp A’s credit rating fell below a threshold level, or if
Corp A failed to make a payment, Bank N would have the right to terminate the
transaction. Although these rights were supposed to be suspended with respect to
any “permissible assignee” of Corp A’s rights under the basis swap, Bank N’s view
was that the occurrence of either event was grounds for dissolution of the swap,
regardless of whether some or all of Corp A’s rights were assigned to its
subsidiaries. In other words, following the assignments, Bank N continued to view
Corp A as the obligor under the notional principal contract. This view was reflected
in both the original credit proposal and in internal Bank N memoranda written after
the swap agreement was executed.

       Corp A’s own actions were consistent with Bank N’s view that Corp A was
ultimately the obligor under the notional principal contract. The original agreement
provided for the netting of payments unless Corp A assigned any of its rights under
the swap to a “permissible assignee.” In such a case, payments were to be made
on a gross basis (i.e., the assignee’s right to receive its payments from Bank N
were independent of Corp A’s obligation to perform). In order to be able to net the
swap payments on its balance sheet, Corp A took the position that the assignments
did not affect its right of offset on the ground that the assignees were entitled to
require Corp A to repurchase the assigned rights at any time at current market
value without the consent of Bank N. The assumption implicit in this position is that
the decision as to whether to assign the rights back to Corp A would be made by
Corp A’s treasury department in the United States.

       As was the case with Bank N, Bank O had to be protected from both market
and credit risks in connection with its purchase of the right to receive payments with
respect to Notional Amount P of the receiving leg of the swap. This was
accomplished by ensuring that Bank O never actually received any of the payments
for years 6 through 20 from Bank N. Specifically, Bank N held a call option on the
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portion of the basis swap purchased by Bank O effective in year 3 of the swap, and
Bank O was given a put option on the purchased portion effective in year 5 of the
swap. The evidence in the record shows that the parties contemplated that Bank O
would be cashed out prior to that time so that “consequently the underlying
transaction would never take place.”

E.    Rewards Limited to Fees

       Corp A claims that it engaged in the transaction for dual purposes. With
respect to the basis swap, Corp A states that its purpose for entering into this part
of the transaction was to hedge against the interest rate risk attributable to the
differences in the commercial paper rates of its domestic debt versus the LIBOR
rates earned on its overseas cash (which amounts were held primarily by Sub E).
According to Corp A, the basis swap was an appropriate means of accomplishing
this goal for at least two reasons. First, although LIBOR rates historically had
exceeded Corp A’s commercial paper rates, the spread between these rates had
narrowed during Years F, G, and H. Corp A claims that it entered into the basis
swap out of concern that the spread might turn negative. Documents generated by
Corp A contemporaneous to the transaction, however, do not reflect this concern.
Specifically, although there is evidence that the taxpayer analyzed interest rate
movements in general in connection with the swap, it did not prepare an analysis of
the impact of the swap as an interest rate hedge.

        Another reason given by Corp A for its decision to enter into this particular
basis swap, notwithstanding the fact that its debt consisted primarily of short-term
obligations, was its “tendency to enter into long-term deals” and because “the
length of the swap helped in the creation of the financial asset with one leg,” i.e.,
the longer the swap, the greater the value of the asset that was to be sold to Sub D.
Corp A apparently did not analyze the cost of terminating the swap if changes in
interest rates rendered the swap uneconomical. Moreover, it acknowledged that at
the time it entered into the swap it was aware that no liquid secondary trading
market for derivatives like the swap existed. According to Corp A, these issues
were irrelevant, since Corp A fully intended to continue the swap throughout its 20-
year life.

        With respect to the assignments, Corp A acknowledged that the sole reason
for this part of the transaction was to repatriate cash, and that the transfer of
ownership of the receiving leg of the swap from Corp A to its Country A subsidiaries
had no economic significance apart from the transfer of cash.

       In the case of the banks, all three received accommodation fees for their
participation in the transaction. Bank M, which initially presented the transaction to
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Corp A and which provided the hedges to the various parties, was paid an
engagement fee of Sum U (and possibly other fees) by Corp A. Bank N, which
entered into the swap with Corp A and hedged its exposure by entering into a mirror
swap with Bank M, was allowed to lock in a 10 basis point spread between the
basis swap and its hedge. Bank O, which agreed to establish the “market price” for
the assigned portions of the swap by purchasing the right to receive payments with
respect to Notional Amount P of years 6 through 20 of the receiving leg of the
swap, was to receive a 15 basis point fee over the life of its transaction.

                                        LAW

A.    Substance Over Form Principles

      1.     General

       As a general rule, taxpayers have the right to arrange their affairs in order to
minimize their taxes Gregory v. Helvering, 293 U.S. 465, 469 (1935). The key
question in analyzing a tax-motivated transaction is “whether what was done, apart
from the tax motive, was the thing the statute intended.” Id. In Gregory, the Court
disregarded the potential tax consequences of a corporate reorganization despite
the fact that the taxpayer had complied with all statutory requirements because the
transaction had no valid economic purpose and on its face lay outside the intent of
the statute. Subsequent to its decision in Gregory, the Court held that to be
respected for federal income tax purposes, a transaction must have economic
purpose beyond a tax reduction. Knetsch v. U.S., 364 U.S. 361 (1960). In Frank
Lyon Co. v. U.S., 435 U.S. 561 (1978), the Court looked to objective realities rather
than form. In that case, however, the Court found that the taxpayer had a business
purpose sufficient to justify a sale-leaseback. The Court found this to be “a
genuine multiparty transaction with economic substance that was compelled by
regulatory considerations, and not shaped solely by tax avoidance features that had
meaningless labels attached.” Id. at 583-584. The Court stressed that the taxpayer
had a downside risk of loss and the possibility of a significant return.

      Transactions that lack economic substance have been routinely struck down
by the lower courts. As stated by the Seventh Circuit in Saviano v. Commissioner,
765 F.2d 643, 654 (7th Cir. 1985), aff’g. 80 T.C. 955 (1983):

      The freedom to arrange one’s affairs to minimize taxes does not include the
      right to engage in financial fantasies with the expectation that the Internal
      Revenue Service and the courts will play along. The Commissioner and the
      courts are empowered, and in fact duty-bound, to look beyond the contrived
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      forms of transactions to their economic substance and to apply the tax law
      accordingly.

See also, Compaq Computer Corporation v. Commissioner, 113 T.C. No. 17 (1999).

      2.     Economic Substance

       In evaluating the validity of a transaction, the courts typically attempt to
determine, first, whether it genuinely occurred or whether it was merely “papered” in
order to generate unwarranted tax benefits. Transactions that are determined to be
factual shams are, of course, disregarded. See, e.g., Malden Knitting Mills v.
Commissioner, 42 T.C. 769 (1964); Empire Press, Inc. v. Commissioner, 35 T.C.
136 (1960).

        A transaction that is determined to have genuinely occurred is analyzed next
in terms of its economic substance. Generally, the courts have developed a two-
pronged approach to the economic substance analysis that looks to the subjective
business purpose and the objective profit potential of the transaction. See Rice’s
Toyota World, Inc. v. Commissioner, 81 T.C. 184, aff’d in relevant part, 752 F.2d 89
(4th Cir. 1983); United Parcel Service of America, Inc. v. Commissioner, T.C.
Memo. 1999-268 (Aug. 9, 1999). These aspects of the inquiry do not constitute a
rigid two-step test, but represent related factors in the analysis of “whether the
transaction had sufficient substance, apart from its tax consequences, to be
respected for tax purposes.” ACM Partnership v. Commissioner, 157 F.3d 231, 247
(3rd Cir. 1998), aff’g in relevant part 73 T.C.M. 2189 (1997).

       Various articulations of the subjective prong of the economic substance
analysis have been set forth by the courts. See, e.g., ACM, 73 T.C.M. at 2217
(whether the transaction is “rationally related to a useful nontax purpose . . . in light
of the taxpayer’s economic situation and intentions.”); ACM, 157 F.3d at 253
(whether the transaction was intended to serve any “useful non-tax purpose”);
Rice’s Toyota World, 752 F.2d at 91 (whether “the taxpayer was motivated by no
business purpose other than obtaining tax benefits in entering in the transaction”);
Friendship Dairies, Inc. v. Commissioner, 90 T.C. 1054, 1062 (1988) (same). See
also Yosha v. Commissioner, 861 F.2d 494, 501 (7th Cir. 1988) (“Judges can’t peer
into people’s minds or ’weigh’ motives.... Rather, the usual approach is to focus the
analysis on whether any non-tax goals or functions were or plausibly could have
been served by the action.”). The common thread of these articulations, however,
is whether the transaction has a business purpose other than obtaining tax benefits.

       Like the subjective prong of the economic substance analysis, the phrasing
of the objective test has varied among the different courts. For example, the Tax
Court in ACM articulated the objective prong as requiring that there be "a
reasonable expectation that the non-tax benefits would be at least commensurate
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with the transaction costs.” 73 T.C.M. at 2217. The Third Circuit, on appeal of the
same case, repeatedly searched for "any practical economic effects" of a
transaction other than the creation of income tax benefits by examining the
taxpayer's financial condition before and after the transaction. 157 F.3d at 248-

252. Under the Fourth Circuit’s expression of the objective prong in Rice’s Toyota
World, a transaction has no economic substance where “no reasonable possibility
of a profit exists.” 752 F.2d at 91. See also Friendship Dairies, 90 T.C. at 1062.
Cf. Killingsworth v. Commissioner, 864 F.2d 1214, 1218 (5th Cir. 1989) (objective
analysis involved examination of “profit making potential”). While the specific
articulation of the objective prong has differed among the courts, the fundamental
principle is that a transaction must have real and practical economic effects other
than the creation of income tax benefits in order to satisfy the objective aspects of
the sham analysis. 2 Central to this notion is that where profit derived from the
transaction is “infinitesimally nominal and vastly insignificant when considered in
comparison with the claimed [tax benefit],” the fact of the profit does not
automatically preclude a finding that the transaction failed the objective prong of the
economic substance analysis. See, e.g., Sheldon v. Commissioner, 94 T.C. 738,
768 (1990).

      3.     Step Transaction.

         In contrast to transactions that have no substance and that can be
disregarded as shams, others do have substance but are disguised, typically
through the interposition of meaningless steps. These steps, however, are to be
ignored, for “[a] given result at the end of a straight path is not made a different
result because reached by following a devious path.” Minnesota Tea Co. v.
Helvering, 302 U.S. 609, 613 (1938). In the context of a sale of property, the
Supreme Court has stated:

      The incidence of taxation depends upon the substance of a transaction. The
      tax consequences which arise from gains from a sale of property are not
      finally to be determined solely by the means employed to transfer legal title.
      Rather, the transaction must be viewed as a whole, and each step, from the
      commencement of negotiations to the consummation of the sale, is relevant.
      A sale by one person cannot be transformed into a sale by another by using
      the latter as a conduit through which to pass title. To permit the true nature
      of a transaction to be disguised by mere formalisms, which exists solely to


      2
        See Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir. 1988), cert. denied
488 U.S. 824 (1988) (objective and subjective factors are considered in determining
“whether the transaction had any practical economic effects other than” generating tax
benefits); Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir. 1989); Chapman v.
Commissioner, 73 T.C.M. 2405, 2414 (1997).
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      alter tax liabilities, would seriously impair the effective administration of the
      tax policies of Congress.

Commissioner v. Court Holding, 324 U.S. 331, 334 (1945). See also, Security
Indus. Ins. Co. v. U.S., 702 F.2d 1234, 1244 (5 th Cir. 1983) (“The step-transaction
doctrine is a corollary of the general principle that the incidence of taxation depends
upon the substance of a transaction rather than its form.”).

       The step-transaction doctrine is invoked when a taxpayer interposes
economically meaningless steps in an otherwise economically significant
transaction in order to avoid certain tax consequences, and can result in the
recharacterization of the transaction according to its true substance. “The step-
transaction doctrine ... treats a series of formally separate ‘steps’ as a single
transaction if such steps are in substance integrated, interdependent, and focused
toward a particular result.” Penrod v. Commissioner, 88 T.C. 1415 (1987). As
noted in Penrod, courts have used any one of three different tests to apply the
step-transaction doctrine:

      The narrowest alternative is the ‘binding commitment’ test, under which a
      series of transactions are collapsed if, at the time the first step is entered
      into, there was a binding commitment to undertake the later step. ...

      At the other extreme, the most far-reaching alternative is the ‘end result’ test.
      Under this test, the step transaction will be invoked if it appears that a series
      of formally separate steps are really pre-arranged parts of a single
      transaction intended from the outset to reach the ultimate result. ... The end
      result test is based upon the actual intent of the parties as of the time of the
      merger.... [I]n contrast to the binding commitment test, the end result test is
      flexible and bases tax consequences on the substance of the transactions,
      not on the formalisms chosen by the participants. ...

      The third test is the ‘interdependence’ test, which focuses on whether ‘the
      steps are so interdependent that the legal relations created by one
      transaction would have been fruitless without a completion of the series.’ ...
      This test concentrates on the relationship between the steps, rather than on
      their ‘end result’. However, since the interdependence test requires a court
      to find whether the individual steps had independent significance or whether
      they had meaning only as part of the larger transaction, the court may be
      called upon to determine the result the participants hoped to achieve. Thus,
      the interdependence test is a variation of the end result test.” (Citations
      omitted.)

88 T.C. at 1429-1430.
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        The substance over form doctrine has also been applied in some cases in
which the courts were asked to recharacterize what purported to be sales
transactions as loans. The cases involved primarily taxpayers that, for various
reasons, wished to accelerate income and who would “sell” future cash flows in
exchange for an immediate discounted lump sum payment. Courts that have
recharacterized the sales as loans have relied in large part on the minimization of
risk and the lack of the usual benefits associated with ownership of property, the
virtual certainty that the lender would be paid back, that the borrower was not free
to dispose of the proceeds as it wished, that the lender was only to receive a sum
certain at an interest rate approximating the standard prevailing rate. Generally,
the courts also took note of the fact that the transactions at issue were tax
motivated. See Mapco Inc. v. U.S., 556 F.2d 1107 (Ct. Cl. 1977).

B.    Investments in U.S. Property3

       During the taxable years at issue, section 951(a)(1)(B) provided, in part, that
 a U.S. shareholder of a controlled foreign corporation (“CFC”) must include in
 income currently its pro rata share (determined under section 956(a)(2)) of the
 CFC’s increase in earnings invested in U.S. property for such year. Section
 956(a)(2) provided, in part, that a United States shareholder’s pro rata share of
 the CFC’s increase for any taxable year in earnings invested in United States
 property was the amount determined by subtracting the United States
 shareholder’s pro rata share of the amount of the CFC’s earnings invested in
 United States property at the close of the preceding taxable year (reduced by
 certain amounts under section 959), from the amount of the CFC’s earnings
 invested in United States property at the close of the current taxable year.
 Section 956(a)(1) provided that the amount of earnings of a CFC invested in
 United States property at the close of any taxable year is the aggregate amount
 of such property held, directly or indirectly, by the CFC at the close of the taxable
 year, to the extent such amount would have constituted a dividend if it had been
 distributed to the CFC’s shareholders.

       The term “controlled foreign corporation” means any foreign corporation if
 more than 50 percent of the total combined voting power of all classes of its stock
 or more than 50 percent of the total value of its stock is owned by United States
 shareholders on any day during the taxable year of such foreign corporation.
 Section 957(a). The term “United States shareholder” means any United States
 person (as defined in section 957(c)) who owns (within the meaning of section
 958) 10 percent or more of the total combined voting power of all classes of stock
 entitled to vote of such foreign corporation. Section 951(b). A United States


      3
      All references to the Internal Revenue Code in this section are to the Internal
Revenue Code as in effect during the years at issue.
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person is defined as including a domestic corporation. Sections 957(c),
7701(a)(30)(C).

      Section 956(b)(1)(C) defined the term “United States property” as including
an obligation of a United States person. The term does not include, however,
obligations of domestic corporations that are unrelated to the CFC making the
investment. Section 956(b)(2)(F). See also Treas. Reg. § 1.956-2(b)(1)(viii). For
purposes of this rule, a domestic corporation is considered unrelated to the CFC
making the investment if it is neither a United States shareholder of the CFC, nor
a corporation 25 percent or more of whose total combined voting power of all
classes of stock entitled to vote is owned or is considered as owned (within the
meaning of section 958(b)) by a United States shareholder of the CFC. Treas.
Reg. § 1.956-2(b)(1)(viii). The term “obligation” is defined, generally, as including
any bond, note, debenture, certificate, bill receivable, account receivable, note
receivable, open account, or other indebtedness, whether or not issued at a
discount and whether or not bearing interest. Temp. Reg. § 1.956-2T(d)(2).

      Temp. Reg. § 1.956-1T(b)(4)(i) provides that a CFC will be considered to
hold indirectly investments in United States property acquired by any foreign
corporation that is controlled by the CFC, if one of the principal purposes for
creating, organizing, or funding (through capital contributions or debt) such other
foreign corporation is to avoid the application of section 956 with respect to the
CFC. For purposes of this rule, a foreign corporation is considered to be
controlled by a CFC if the CFC owns more than 50% of the total combined voting
power of all classes of stock of the foreign corporation. Temp Reg. § 1.956-
1T(b)(4)(i).

                                     ANALYSIS

      Bank M’s plan called for a complex structure that would disguise Corp A’s
true purpose, which was to repatriate cash from its foreign subsidiaries and avoid
the consequences of section 956. This plan required Corp A to enter into a basis
swap with an unrelated party and then to assign a portion of its right to receive
income under the swap to several of its foreign subsidiaries in exchange for an
upfront cash payment. Corp A argues that the tax accounting rules in existence
at the time of the transaction allowed it to defer recognition of the payment until a
period beginning five years after the year in which it received the payment. In
effect, Corp A is arguing that it is entitled to complete tax free use of the payment
for the first five years of the basis swap and substantial deferral for the remaining
15 years. Corp A’s position is dependent on full recognition being given to all
parts of the transaction that generated the upfront cash payment. This
recognition is not warranted, since the facts indicate that no tax-independent
considerations underlay the plan. Corp A has acknowledged that a principal
purpose of the transaction, and the sole purpose of the assignment portion of the
                                        14
TL-N-8774-97

transaction, was to repatriate cash tax-free from its foreign subsidiaries. As will
be discussed below, several theories support recharacterization of the transaction
as a set of loans from the foreign subsidiaries to the U.S. parent on the ground
that the transaction lacks economic substance.

A.   The Transaction Lacks Economic Substance.

      It appears from the facts currently available that the transaction was not a
factual sham. Fund transfers actually occurred, and the transaction cannot be
characterized as fictitious. The next step, therefore, is to determine whether the
transaction lacked economic substance. As the Third Circuit noted in ACM, 157
F.3d at 247, a transaction must have either a subjective non-tax purpose or
objective economic consequences in order to survive a challenge on the ground
of a lack of economic substance. Corp A concedes that the basis swap
transaction was tax motivated, particularly the assignment portion of the
transaction. However, it argues that it entered into the swap portion of the
transaction for a legitimate business purpose, namely the hedging of its short
term domestic debt. Corp A’s claim cannot be sustained under either the
subjective prong or the objective prong of the economic substance analysis.
Moreover, the transaction is subject to step transaction principles.

     1.     Lack of Non-Tax Purpose.

      Corp A claims that it entered into the swap portion of the transaction
specifically to hedge its short-term domestic liabilities. According to Corp A,
historical differences between the LIBOR rates earned on its overseas cash and
the commercial paper rates paid by it on its domestic liabilities had provided
consistent positive arbitrage opportunities for Corp A. In the years immediately
preceding the taxable years in issue, however, these rates had been narrowing
and, in Corp A’s view, were in danger of becoming reversed. Corp A claims that
it entered into the basis swap in order to hedge its liabilities in the event the
spread turned negative.

        Corp A’s arguments are contestable on several grounds. First, and most
significantly, Corp A’s argument is belied by the fact that any hedging benefit
achieved by Corp A as a result of entering into the basis swap was effectively
nullified by the mirror swaps between it and Bank M, the promoter of the basis
swap transaction. Thus, the swap, once fully hedged, became a meaningless
product with no economic substance, much like a riskless straddle. “That would
clearly be the case where the broker guaranteed the investor that the only
consequences of the straddles would be tax consequences; there would be no
market risks, downside or upside. Straddles that involve no market risks are not
economically substantial straddles and hedges; they are artifices created by
                                         15
TL-N-8774-97

accomplices in tax evasion, the brokers.” Yosha v. Commissioner, 861 F.2d at
500.

      Another factor contradicting Corp A’s purported hedging motivation is Corp
A’s choice of a long-term (i.e., 20-year) instrument to hedge short-term liabilities.
Such a mismatch between instruments effectively exposed Corp A to potential
interest rate risk once the hedged liabilities expired or were disposed of. This
potential for such market risk was further exacerbated by the absence of a liquid
secondary trading market for derivative instruments like the basis swap, a fact
that Corp A knew before it entered into the transaction.

      Third, all of the promotional material prepared by Bank M, as well as
documentation prepared by Corp A during its consideration of Bank M’s proposal,
were directed at achieving a single goal -- the tax-free repatriation of cash -- and
ignored other aspects of the swap, such as its potential hedging benefits. See
Heltzer v. Commissioner, 62 T.C.M. 518 (1991) (promotional materials focused
only on tax benefits, and taxpayer did not investigate brokerage firm's profit
record). For example, the schedules prepared by Corp A, which were circulated
among key members of the accounting and treasury departments, only analyzed
the impact of the repatriation of the cash, not the “hedging” potential of the swap.
In these studies, the impact of the differing legs of the swap was assumed away.

      Fourth, every aspect of the transaction (i.e., the basis swap portion, the
assignment portion, and the offsetting hedges) was meticulously pre-arranged to
avoid subjecting any of the participants to economic risk and to ensure that the
only change to any of their economic positions was either the payment of fees (in
the case of Corp A), the receipt of fees (in the case of Bank M, Bank N and Bank
O), or the cash flows from Sub C and Sub D (in the case of Corp A). The
intentional elimination of all economic risk strongly supports the proposition that
Corp A lacked any non-tax purpose for this transaction.

     Finally, some documentation exists that suggests Corp A and Bank M may
at one time have discussed basing a portion of Bank M’s fee on the expected tax
savings derived by Corp A from the proposed swap transaction. Such a fact, if
established, strongly suggests that Corp A’s sole purpose in entering into the
transaction was tax-related.

     2.     Lack of Objective Economic Consequences.

      In general, courts have declined to recharacterize or otherwise disregard a
transaction on the ground of lacking economic substance if the transaction had
real and practical economic effects other than the creation of income tax benefits.
See, e.g., ACM, 157 F.3d at 248-252. From the facts presented, the basis swap
transaction entered into by Corp A had no real and practical economic effects
                                        16
TL-N-8774-97

other than the creation of income tax benefits. As described above, the swap
between Corp A and Bank N was fully hedged resulting in an economic nullity.
Indeed, when the substantial transaction costs of sum U are taken into account,
the transaction lacked, from the outset, any reasonable prospect of profit.
Moreover, while the dynamic nature of the hedges might generate some fortuitous
gain, such amount would likely be de minimis relative to the tax benefits achieved
by the transaction overall. In this regard, any such gain would not materially
affect this analysis. Sheldon, 94 T.C. at 768. Accordingly, the basis swap
transaction fails the objective prong of the economic substance analysis.

     3.     Step-Transaction.

       Corp A followed a prearranged plan to reach its stated goal of repatriating
Sub C’s available cash. It disguised a self-amortizing loan from Sub C as a
notional principal contract, the economic impact of which it hedged, through an
assignment of the receiving leg of years 6 through 20 of the swap to Sub C in
exchange for a lump sum payment from Sub C in year 1 of the swap. Bank N
became the accommodation party through which the principal and interest
payments from Corp A were routed. To further disguise its tax planning, part of
the receiving leg of the swap was assigned to Sub D rather than Sub C, the
affiliate that held the cash. To make its lump sum payment to Corp A, Sub D had
to obtain the needed cash from Sub C. In this case, therefore, Bank N was acting
as the accommodation party for the principal and interest payments from Corp A,
while Sub D was acting as the accommodation party that received the loan
principal on behalf of Such C. These unneeded steps were added to disguise the
true substance of the transaction and must be ignored.

     The facts presented indicate that the various steps of the transaction at
issue were entered into as part of an overall plan for Sub C to make a self-
amortizing loan to Corp A. The facts presented suggest that the parties were
committed to this overall plan from the outset. Thus, it appears that the binding
commitment test could be met. However, further factual development is
necessary.

      “[T]he end result test is flexible and bases tax consequences on the real
substance of the transactions, not on the formalisms chosen by the participants.”
Penrod, 88 T.C. at 1430. The facts reflect that the parties had a single goal, a
single end result, in mind. All the steps of these transactions were planned in
order to reach Corp A’s stated goal to repatriate Sub C’s cash and avoid subpart
F. The series of formally separate steps – the swap, the assignment to Bank O,
the assignment to Sub C and Sub D – were pre-arranged parts of a single
transaction intended from the outset to reach the ultimate result sought after.
See Penrod, 88 T.C. at 1429-1430, and cases cited therein.
                                        17
TL-N-8774-97

      The charts from the various presentations made by Bank M focused on a
single goal: the repatriation of the cash held by Sub C. If the primary purpose of
the swap was to hedge an interest rate risk, the presentation would have focused
on those particular rates. Instead, the presentation assumed away the economic
impact of changes in interest rates by assuming each leg of the swap paid the
same rate. The number of confirmations for the swap confirm the intent of the
parties. Rather than a single swap confirmation, several were prepared, each in
the amount of the anticipated assignments to Bank O, Sub C and Sub D. Finally,
the fact that Corp A and Bank N hedged the positions resulting from the swap
establishes that nothing other than the repatriation of cash from Corp A’s foreign
subsidiaries was contemplated.

      An analysis under the interdependence test, which looks to the relationship
between each of the steps of the transaction, also supports its recharacterization.
Each step in the transaction, by itself, would have been meaningless. If the
assignment of years 6 through 20 had not been made, the entire swap would
have been an economic sham with no substance. This is because the entire
swap was hedged, and thus its potential economic impact was nullified.
Moreover, the assignment of Notional Amount P of years 6 through 20 of the
swap to Bank O was to be quickly nullified through the exercise of the options
granted to the parties. Similarly, the advances from Sub C to Sub D were not
meaningful: Sub D did not need the cash. Rather, that step was merely an
intermediate step, and was to be immediately followed by the transfer of the cash
to Corp A.

      The participation of third parties does not affect the conclusions reached
herein. The transactions cannot be characterized as “genuine multi-party
transaction[s]”, as was done Frank Lyons, supra. Here, the third parties
participated in the tax avoidance promotion in exchange for a fee. They did not
have a stake in the transaction’s outcome and were fully insulated from risk. The
courts have repeatedly held that the insertion of a third-party straw man that acts
as a conduit between related parties can be ignored under the step-transaction
doctrine. Del Commercial Properties, Inc. v. Commissioner, T.C. Memo 1999-411
(1999); Gaw v. Commissioner, T.C. Memo. 1995-531, aff’d without published
opinion 111 F.3d 962 (D.C. Cir. 1997); Kuper v. Commissioner, 533 F.2d 152 (5th
Cir. 1976).

     It should also be noted that, while the cases such as Mapco, supra, that
examine the difference between sales of future cash flows and loans support the
economic substance theories, an analysis under the doctrines described herein is
more appropriate. This is because, rather than attempting to sell a genuine future
cash flow, the parties created a cash flow from a transaction lacking economic
substance and assigned part of it to foreign related parties. Under these
circumstances, it is appropriate to ignore the components of the transaction that
                                         18
TL-N-8774-97

are properly characterized as economic shams and eliminate the unnecessary
steps undertaken by the parties under the step-transaction doctrine. The
application of these principles reveals the true nature of the transaction: a self-
amortizing loan.

B.   Because the Transaction Lacks Economic Substance, It Can Be
     Recharacterized as a Series of Loans from the Foreign Subsidiaries to the
     U.S. Parent.

       Under economic substance and step transaction principles, the transaction
at issue should be recharacterized to reflect its true economic nature. The swap
followed by the assignment of portions of the receiving leg to Subs C and D
effectively resulted in a self-amortizing loan disguised as the purchase price for
the sale of the swap leg. In other words, Corp A borrowed sums Y and Z from
Subs C and D, respectively, when it “sold” its right to receive payments under the
swap. To repay this loan, a third-party intermediary ( i.e., Bank N) was engaged
to receive periodic principal and interest payments from Corp A (disguised as
swap payments) and to forward such payments to Subs C and D based on their
“purchase” of the swap cash flows. Although the transaction was structured to
hide the loan through the use of different floating rates in the basis swap, the use
of hedges to negate this difference reveals the true nature of the transaction.
Specifically, the use of the hedges enabled Bank N to effectively convert the
amount of cash it received from Corp A under the basis swap to equal the amount
of cash it was obligated to pay Subs C and D under the assignment. Thus, the
differing interest rates set forth in the swap agreement does not negate the use of
economic substance principles to recharacterize this transaction as a loan.
                                         19
TL-N-8774-97

                ³     Original swap payments                  ´ Economic effect of the
                                                                    planned structure


                      Corp A                                               Corp A
                                                     Disguised
                                                     repayment of
                                                     principal &
     Floating                                        Interest
     Rate                                            labeled as a
                                                     swap
                    Floating                         payment                     Disguised
                    Rate                                                         loan labeled
                                                                                 as a sale of
  Bank N                                       Bank N                            the right to
                                               (used a conduit)                  receive swap
                                                                                 payments in
                                                                                 years 6-20


                                                          Disguised
                                                          repayment of
                                                          principal &
                                                          Interest
                                                          labeled as a
                                                          swap
                                                          payment
                                                                             Sub C




      Presumably to further disguise the source of the funds for the loans from
Sub C to Corp A, Sub D was inserted as a second entity through which the loans
were made. This was accomplished through the “advance” of substantially all of
Sub C’s non-PTI cash to Sub D through the accounts of Sub E (which were used
by Sub D to “purchase” its portion of the assignment). Such advances had no
economic substance as they were not evidenced by any notes, no interest was
paid and they were not disclosed on Schedule M of the Forms 5471 filed by Corp
A. The diagram below shows that if (1) the parties were required to made
periodic payments on an arm’s length basis and (2) if the unnecessary
intermediaries were eliminated, the transaction was nothing other than a loan
from Sub C to Corp A.
                                                 20
TL-N-8774-97



                                   Corp A                           Funds advanced by Sub
                                                                    C and loaned to Corp A
           Principal & Interest                                     disguised as the
           payments disguised                                       purchase of the right to
           as swap payments                                         receive swap payments
                                                                    in years 6-20
                                  Principal & Interest
                                  payments disguised
                                  as swap payments
     Bank N                                                              Sub D
                                      Principal & Interest
                                      that would have
                                      been payable on
                                      advance made at
                                      arm’s length

                                                             Sub C funds
                                                             “advanced” and
                                                             economically used
                                                             by Sub D as
                                   Sub C                     principal on its
                                                             loan to Corp A




C.    The Loans from the Foreign Subsidiaries to the U.S. Parent Constitute
      Investments in U.S. Property under Section 956.

      1.      General.

      If the transaction is recharacterized as a loan from Sub C to Corp A, the
next issue that arises is whether such “loan” is an investment in U.S. property
under section 956. Corp B is a United States shareholder within the meaning of
section 951(b), since it is a domestic corporation that owns directly 100% of the
stock of Sub C. Sub C is a CFC within the meaning of section 957(a), since
100% of its stock was owned by Corp B, a U.S. shareholder, during all of the tax
years at issue. Accordingly, if Sub C’s loan to Corp A constitutes U.S. property
within the meaning of section 956(b)(1). Corp B will be required to include in
income currently its pro rata share of Sub C’s increase in earnings invested in
that U.S. property.

      Because Sub C’s loan to Corp A constitutes indebtedness of Corp A, a
domestic corporation, such loan constitutes U.S. property within the meaning of
section 956(b)(1) unless it falls within the exception in section 956(b)(2)(F). That
section provides that the term “U.S. property” does not include obligations of
domestic corporations that are unrelated to the CFC making the investment. For
purposes of this rule, a domestic corporation is considered unrelated to the CFC
making the investment if it is neither a United States shareholder of the CFC, nor
                                         21
TL-N-8774-97

a corporation 25 percent or more of whose total combined voting power of all
classes of stock entitled to vote is owned or is considered as owned (within the
meaning of section 958(b)) by a United States shareholder of the CFC. Treas.
Reg. § 1.956-2(b)(1)(viii). This definition thus requires that a domestic
corporation must meet two requirements if it is to be considered unrelated to a
CFC holding its obligation: it must not be a U.S. shareholder with respect to the
CFC, and no more than 25% of its total combined voting power of all classes of
its stock entitled to vote can be owned by a United States shareholder of the
CFC. For purposes of the application of the exception in section 956(b)(2)(F),
Corp A is considered to own 100% of Sub C’s voting stock. See Treas. Reg. §
1.958-2(c)(1)(iii). Thus, it qualifies as a United States shareholder with respect to
Sub C for purposes of section 956(b)(2). See section 951(b). Accordingly, for
each of the tax years in issue, Corp B is required to include in its income currently
its pro rata share of Sub C’s earnings invested in United States property.

     2.     Sub D’s “Loan” to Corp A

      In an apparent effort to hide the fact that Sub C was the originator of the
cash to be repatriated, Corp A assigned a large portion of the receiving leg of the
swap (Notional Amount R) for years 6 through 20 to Sub D. Sub D in turn
obtained the funds it needed to purchase Notional Amount R from Sub C through
an advance from Sub C that was booked as an increase in Sub D’s accounts
payable to Sub C. Corp A now seeks to recharacterize these transfers as equity
contributions to Sub D .

      Corp A’s attempt to recharacterize as an equity contribution the amount
received from Sub C and used to purchase Sub D’s assignment does not affect
the analysis under section 956. As described above, Temp. Reg. §1.956-1T(b)(4)
provides that a CFC (such as Sub C) will be considered to hold indirectly
investments in U.S. property acquired by another foreign corporation controlled by
the CFC (such as Sub D) if the funding (whether through capital contributions or
debt) for such investment originated from the CFC and was designed to avoid the
application of section 956. Sub D is controlled by Sub C, since Sub C owns
100% of Sub D’s stock. Temp. Reg. § 1.956-1T(b)(4)(i). Moreover, as was the
case with Sub C’s loan to Corp A, Sub D’s loan to Corp A constitutes an
investment in U.S. property within the meaning of section 956(b)(1) and Treas.
Reg. § 1.956-2T(d)(2) by Sub C. The various bookkeeping entries indicate that
the ultimate source of the funds used by Sub D to purchase its share of the
assignment was Sub C, an entity that generated substantial non-subpart F
revenues. Whether Sub C transferred these funds to Sub D as either equity or
debt is irrelevant, since Treas. Reg. § 1.956-1T(b)(4) expressly contemplates both
types of funding. Accordingly, Sub C will be considered to hold indirectly Sub D’s
investment in U.S. property if a principal purpose for transferring the funds to Sub
D was to avoid the application of section 956. Such a purpose need not comprise
                                         22
TL-N-8774-97

the sole purpose for engaging in the transaction as long as it is one of the
principal purposes. See The Limited v. Commissioner, 113 T.C. 169 (1999). The
facts, as developed thus far, strongly suggest that such a purpose was present.
In particular, Corp D had no earnings and profits while Corp C had substantial
non-PTI earnings and profits. If Corp C had made a loan directly to Corp A, such
a loan would clearly have qualified as an investment in U.S. property under
section 956. In contrast, if Corp D had made the loan, there would have been no
investment in U.S. property because Corp D had no earnings and profits. The
documents underlying this transaction are replete with references to
accomplishing the tax-free repatriation of Sub C’s revenues to Corp A. In an
attempt to accomplish this goal, Sub D was interposed into the transaction in
order to make it appear that the funds were derived from an entity with no
earnings and profits.

D.   Inapplicability of Notice 89-21.

      Corp A relies upon Notice 89-21, 1989-1 C.B. 651, to support its treatment
of the basis swap transaction. The notice addresses the proper method of
accounting for a notional principal contract with respect to the years at issue.
Because we believe that the basis swap substantively is not a notional principal
contract, we believe that Notice 89-21 does not apply to the transaction.

       Economic substance and step transaction principles apply before application
of any technical rules in the Notice. It is well established that compliance with the
literal terms of a statute or regulation will not insulate a taxpayer from the
requirement that its transactions have economic substance. A transaction must
have a bona fide commercial purpose as a condition precedent to the receipt of
any tax benefits associated with the transaction except in the rare instance where
a tax motivated transaction is “unmistakably within the contemplation of
Congressional intent.” Fox v. Commissioner, 82 T.C. 1001, 1020-1021 (1984).
Thus, as with statutes and regulations, an economic substance and step
transaction analysis precedes consideration of the technical rules in Notice 89-21.

     As the Third Circuit stated in Weller v. Commissioner:

            Thus, the principle laid down in the Gregory case is not
            limited to corporate reorganizations, but rather applies to
            the federal taxing statutes generally. The words of these
            statutes which describe commercial transactions are to be
            understood to refer to transactions entered upon for
            commercial purposes and "not to include transactions
            entered upon for no other motive but to escape taxation."
                                       23
TL-N-8774-97

270 F.2d 294, 297 (3d Cir. 1959), aff’g. 31 T.C. 33 (1958). This principle was
recently confirmed by the Tax Court in ACM, which held that “[o]nly after we
conclude that a transaction has economic substance will we consider the
transaction’s tax consequences under the Code.” 73 T.C.M. at 2217. See also
Leema Enterprises Inc. v. Commissioner, T.C. Memo 1999-18 (January 28,
1999).




     If you have any questions, please call (202) 622-3870 or (202) 622-3840.

     Jeffrey Dorfman                        Phyllis E. Marcus
     Chief, Branch 5                        Chief, Branch 2