The final conduit regulations

Overview

On August 11, 1995, the U.S. Department of Treasury issued the final conduit regulations under section 7701(l) of the Internal Revenue Code.(1*) This article summarizes the regulations and provides some clarifying comments.(2)

The conduit regulations are aimed at the,follow core transaction: a foreign company wants to lend more to a U.S. company, in a situation where the interest payments on the loan, if made directly to the lender, would be subject to withholding tax at a 30-percent rate (in the absence of a treaty) under section 881 of the Internal Revenue Code. To minimize the withholding liability, however, the lender and borrower may have engaged in "treaty shopping" by routing the loan through a third party located in a country where lenders are entitled by treaty to a reduced withholding rate.(3) Section 7701(l) was enacted to authorize the Internal Revenue Service to address this issue.

Scope of the Final Regulations

Like the proposed regulations, the final regulations are basically limited to the taxes and withholding requirements under sections 871, 881, 1441, and 1442 of the Code, though section 7701(l) clearly authorizes a broader approach. The substantive provisions are all contained in new Treas. Reg. [sections] 1.881-3, which cross references the other Code sections. The recordkeeping requirements are set forth in Treas. Reg. [sections] 1.881-4, and the withholding requirements in Treas. Reg. [subsections] 1.1441-3 and 1.1441-7.

Definitions

The regulations begin with definitions of some, but not all, of the terms used in stating the substantive rules. A "financing arrangement" is defined as a series of at least two "financing transactions" in which a lender advances money or other property, and a borrower receives money or other property, if the advance and receipt are brought about through one or more intermediate entities (IE) and there are financing transactions linking the lender, each IE, and the borrower.(4) The definition of a financing arrangement is mechanical; a financial structure can be a financing arrangement without regard to whether there is a tax-avoidance plan.

Because there can be no financing arrangement unless the parties are connected by a chain of financing transactions, the IRS was concerned that two related parties could transfer funds through means other than a financing transaction, thus breaking the chain and defeating the purpose of the regulations. This concern was so great that it is dealt with at two different places in the final regulations. A provision added to the definition of a financing arrangement states that two related persons that would form part of a financing arrangement "but for" the absence of a financing transaction between them can be treated as a single IE (thereby eliminating the need to examine the transaction between them) if one of the principal purposes for the structure "is to prevent the characterization of such arrangement as a financing arrangement."(5)

This is not the same tax-avoidance rule encountered later in the regulations. It deals with one specific bad purpose: avoiding a definition in the regulations. Since such an intent could not have been formed until the regulations appeared, at least in proposed form, this rule has a built-in grandfather clause for previously constructed structures.

In their second attack on the problem, the regulations include what is described in the preamble as "another more general anti-abuse rule." This again authorizes the IRS to treat related IE's as a single entity if one of the principal purposes for their involvement is (i) to prevent characterization as a conduit; (ii) to reduce the portion of a payment subject to withholding taxes (under a formula that is part of the regulations); or (iii) "otherwise to circumvent the provisions [not the "purposes"] of this section."(6) Once again, the provision is intended to defeat an intention that could not have existed prior to issuance of the regulations. (These rules should be distinguished from the more general rule that a structure with multiple unrelated IE's may be a financing arrangement if each of the entities qualifies as a conduit under the usual rules.(7))

The term "financing transaction" means (i) debt; (ii) stock with certain characteristics (or similar interests in partnerships or trusts); (iii) any lease or license; or (iv) any other transaction "pursuant to which a person makes an advance of money ... to a transferee who is obligated to repay or return a substantial portion of the money...."(8) Equity interests constitute financing transactions if (i) the issuer is required to redeem the stock or similar interest; (ii) the issuer has the right to redeem the stock or similar interest, but only if, as of the issue date, such redemption is more likely than not to occur; or (iii) the owner of the stock or similar interest has the right to require a person related to the issuer (or any other person acting pursuant to a plan or arrangement) to acquire the stock or similar interest or make a payment with respect to the stock or similar interest.(9) Thus, ordinary common stock and "perpetual" preferred stock are apparently excluded from the definition of financing transactions under the final regulations, even though the Treasury and IRS rejected suggestions that the regulations provide an explicit safe harbor for these instruments.(10)

The final regulations provide, however, that a person will not be considered to have a right to force a redemption or payment if the right is derived solely from ownership of a controlling interest in the issuer, except when control arose from a default or other contingency under the instrument.(11) A guarantee is not a financing transaction,(12) nor is a transfer of money or other property in satisfaction of a repayment obligation." The definition of a financing transaction is also mechanical: a financing framework can constitute a financing transaction even in the absence of a tax-avoidance plan.

The definition of "related" is very broad. It includes the relationships described in section 267(b) or 707(b)(1), plus entities subject to common control within the meaning of section 482. In determining relationships, the attribution rules of section 318 or 267(c), whichever is broader, will be applied.(14)

Disregarding the Participation of a Conduit

Whether an IE is or is not a "conduit" is determined on the basis of the rules set forth in the following parts of the regulations. Once an IE is determined to be a conduit (called a "conduit entity" in the regulations), the IRS then has discretion to determine whether the conduit's participation in a conduit financing arrangement "should be disregarded for purposes of section 881."(15) If the conduit is disregarded, "the financing arrangement is recharacterized as a transaction directly between the remaining parties to the financing arrangement (in most cases, the financed entity and the financing entity) for purposes of section 881."(16) In such a case, "a portion of each payment made by the financed entity . . . shall be recharacterized as a transaction directly between the financed entity and the financing entity."(17) It is these payments that would be subject to tax -- or subject to a higher tax -- under section 881.

In determining the character of the payments (e.g., interest, dividend, royalty, etc. , a payment made by a borrower will be characterized by reference to the character of the payments made by the conduit to the lender. The nature of the conduit itself (i.e., type of entity), however, does not apply to change the "character" of the borrower. For example, assume the lender makes a bank deposit with a conduit bank, which then advances the money to a U.S. party that is not a bank. The character of the payments by the borrower is interest, since that is the character of the payments made by the conduit bank to the lender. The payments by the borrower, however, do not constitute bank interest, and thus do not qualify for exemption under section 881(i).(18)

The disregarded conduit is ignored for purposes not only of section 881 but also for applying income tax treaties. Thus, the conduit may not claim the benefits of a tax treaty between its country of residence and the United States with respect to payments made by the U.S. borrower to the conduit. The lender may, however, be able to claim the benefits of a treaty between its country and the United States, since the recharacterized payments will be regarded as being made directly from the United States to the lender.(19)

General Standard for Conduit Treatment

An IE is a conduit if (i) its participation reduces the tax imposed by section 881; (ii) its participation in the financing arrangement is pursuant to a tax-avoidance plan; and (iii) either (a) the IE is related to the lender or the borrower or (b) the IE would not have participated in the financing arrangement on substantially the same terms but for the fact that the lender engaged in the financing transaction with the IE.(20)

The general standard contains four tests. The first -- whether there is a reduction of tax -- is largely mechanical, involving a comparison of the aggregate tax imposed under section 881 on payments made on financing transactions making up the financing arrangement, with the tax that would have been imposed if the financing transaction existed directly between the borrower and the lender.(21) The second test is whether the IE is related to the lender or the borrower. The other two tests -- whether there is a tax-avoidance plan and whether the IE would not have entered into the transaction without the financing provided by the lender(22) -- are more involved and require some explanation.

Tax-Avoidance Plans: The Four-Factor Analysis

The IE's participation is pursuant to a tax-avoidance plan if one of the principal purposes of such participation is the avoidance of tax under section 881.(23) (The regulations make the obvious point that the tax-avoidance plan must have been in existence by the last date that any of the relevant financing transactions were entered into. Like the proposed regulations, the final regulations use four non-exclusive factors and one rebuttable presumption to determine whether the participation of the IE is pursuant to such a purpose.

The first factor is whether there is a "significant" reduction in the tax that would have been imposed under section 881. The reduction in tax may be significant whether the reduction is large in absolute or relative terms. That an intermediate entity is a resident of a country that has an income tax treaty with the United States that significantly reduces the section 881 tax is not sufficient evidence, by itself, to establish the existence of a tax-avoidance plan.(24)

The second factor is whether the IE had sufficient available money or other property of its own to have made the advance to the borrower without the advance of money or other property to the IE by the lender.(25)

The third factor is the time period between the financing transactions, making a "tracing" rule relevant to a conduit analysis. A short period of time is evidence of a tax-avoidance plan. Example 16 concludes that a one-year span between a loan by a lender and a loan by an IE to a borrower is a short period of time.(26)

The fourth factor, if applicable, is evidence against a tax-avoidance plan. It applies if the parties to the financing transaction are related and the financing transaction occurs in the ordinary course of the active conduct of complementary or integrated trades or businesses engaged in by the related entities. To be considered in the ordinary course of business, the loan must be a trade receivable or the parties to the transaction must be actively engaged in a banking, insurance, financing, or similar business that consists predominantly of transactions with customers who are not related persons.(27)

In addition, there is a rebuttable presumption that the Ie's participation is not pursuant to a tax-avoidance plan if the IE is related either to the lender or the borrower and the it performs significant financing activities with respect to the financing transactions forming part of the financing arrangement. This favorable presumption can be rebutted only if the IRS establishes that the participation of the IE is pursuant to a tax-avoidance plan.(28)

The definition of "significant financing activities" initially seems complex. As applied to specific cases, however, most of the rules are intuitive -- the goal is to describe a real financing business carried on by the entity in question. The favorable presumption arises if there is a corporation that performs a cash-management function for other members of a group of related corporations (in tax parlance, a "mixer" subsidiary), though other kinds of substantial financing businesses can also qualify. In either case, in order for the IE to qualify for the presumption, (i) its participation must be reasonably expected to produce savings for the group; (ii) within the treaty country or in the country in which the IE is organized, its officers and employees must actively conduct the financing business without material participation (other than general supervision) by any of the other related corporations; (iii) the IE must actively manage "market risks," such as currency and interest-rate fluctuations, and the short-term investment of working capital;(29) and (iv) the IE must actively participate in arranging its own role in the relevant financing transactions, unless the IE is simply performing a cash-management function with respect to trade payables and receivables generated by other members of the group.(30)

All these requirements relate to an ongoing financing operation. Even if an IE does have an ongoing cash management activity that meets all the requirements, the presumption does not protect a separate financing arrangement that is unrelated to the cash management function.(31) A different definition of significant financing activities applies if the IE is performing financing activities with respect to leases and licensees. Here, the regulations incorporate a definition of an active business from Subpart F.(32)

The favorable presumption for significant financing activities applies only to related IES, not to unrelated IE's. This may seem counterintuitive, but the distinction is intentional. The preamble explains that actions by an unrelated IE are based on different considerations, such as regulatory matters and the interests of the owners of the IE; an unrelated IE will not be a conduit unless the IE fails the "but for" test,(33) discussed in the next section.

"But For" Test; Guarantees

An unrelated IE cannot be treated as a conduit unless it would not have participated in the financing arrangement on substantially the same terms "but for" the financing transaction between the lender and the IE. The regulations decline to provide bright-line definitions for the concepts "substantially the same terms" or "but for." In an audit or litigation, however, the facts-and-circumstances test makes both factual and opinion evidence relevant. The opinion evidence presumably would be expert testimony on the kinds of financing transactions a similarly situated IE would enter into, in the presence or absence of financing similar to that provided by the financing entity under review.

The definition of a "guarantee" is consistent with the definition used in connection with the earnings stripping rules.(34) It is clear that a guarantee is not, in itself, a financing transaction. If there is a financing transaction between the lender and the IE -- and at the time of the transaction some entity (not necessarily the lender or a party related to the lender) has guaranteed that the borrower's debt to the IE will be paid -- the IRS may presume that the IE would not have participated in the financing arrangement but for the financing transaction between the lender and the IE. To rebut this presumption, the taxpayer must produce clear and convincing evidence that the IE would, in fact, have participated in the financing arrangement on substantially the same terms, even in the absence of the financing transaction with the lender."' This burden of proof seems harsh in the context of guarantees by unrelated commercial entities that may be routine in the particular context. Indeed, the existence of a guarantee by an unrelated party would tend to prove lack of reliance on the lender by the IE.

Amount to Be Recharacterized

If an IE is a conduit, the IRS may disregard the conduit and recast the financing arrangement as a transaction directly between the lender and the borrower. Acknowledging that a complex financing arrangement may involve a number of IEs and the amount financed may not be the same at each step, the regulations look at the smallest link in the chain of transactions by recharacterizing only the smallest financing amount common to all of the transactions. This amount equals the amount of money advanced, or the fair market value of property advanced or transferred, measured in U.S. dollars, as of the close of business on the last day on which the chain is complete.(36)

Recordkeeping and Withholding; Effective Date

In a piece of good news, the final regulations eliminate the extensive reporting requirements outlined in the proposed regulations. The final regulations set out much more specific requirements for keeping records relevant to determining whether the entity in question is a party to a financing arrangement and whether the arrangement is a conduit financing arrangement. Where the parties are related, the records should also show the nature of the relationship.(37)

In an improvement over the proposed regulations, the final regulations provide examples of the application of the rules in the withholding context.(38) Withholding by the borrower is required only if the borrower knows (or has reason to know) of facts establishing that the financing arrangement is a conduit arrangement, including that the Ie's participation is pursuant to a tax-avoidance plan. Knowledge of the transactions only -- in the absence of knowledge of a tax-avoidance plan or of the IE's inability to participate in the financing arrangement without financing from a lender in another country -- will not be enough to trigger the withholding requirement.(39) Taxpayers should keep in mind, however, that a party other than the borrower could be a withholding agent with sufficient knowledge to be responsible for the payment of tax.

Withholding is required with respect to a financing arrangement that includes a conduit, whether or not the IRS has asserted that the conduit should be disregarded, and whether or not any such IRS assertion has been sustained upon review. Furthermore, the amount to be withheld is determined as though the borrower were making payments directly to the lender. The borrower may not take into account any tax treaty between the IE's country and the United States, but may take advantage of a treaty between the lender's country and the United States.(40)

In at least one situation, the regulations create a problem requiring the careful drafting of indemnification provisions. Under the regulations, a lender is not subject to tax under section 881 if it is unrelated to both the borrower and the IE and does not know (or have reason to know) of facts sufficient to establish the existence of a conduit and the necessary tax-avoidance plan. This provision protects only the lender, however, since the duty to withhold depends on the knowledge of the borrower or other withholding agent, not the lender. If the withholding agent has the requisite guilty knowledge, it must withhold, and the fact that the lender owes no tax does not give any party the right to a refund of any withheld tax.(41)

The general effective date provision imposes liability for withholding tax on payments made on or after September 11, 1995, with an exception for a special category of interest payments covered by section 127(g)(3) of the Tax Reform Act of 1984, and for interest payments on certain other debt obligations issued prior to October 15, 1984.(42) The record maintenance requirement is also effective on September 11, 1995.(43) Thus, the final regulations are retroactive in the sense that they apply to interest and other payments made pursuant to financings entered into prior to the final regulations, the proposed regulations, or the enactment of section 7701(l).

In addition to the overall effective date, two rules contain built-in grandfather rules because the rules apply only to transactions designed to defeat the regulations -- an intent that could not have been formed before publication of the regulations.(44)

Other Potential Applications

Treasury has restricted the effect of the final regulations to certain taxes on payments by a U.S. borrower to a foreign lender. In 1994, Treasury and the IRS considered expanding the scope of the regulations to include section 956(45) and the DISC and FSC provisions.(46) In contrast, the preamble to the final regulations refers only to possible future rules under sections 871, 881, 1441 and 1442.(47)

The possibility of a wider use of section 7701(l) was reflected, however, in Notice 95-53,48 where certain multiparty transactions known as "lease strips" were characterized as improperly separating deductions from the corresponding income. The IRS described these transactions as the arrangement of a service or property agreement to permit one party to report deductions from the transaction and another party to realize rental or other income from the transaction. The IRS announced its intent to recharacterize the transactions or reallocate items under its available authority, including new regulations to be issued under section 7701(l).

Conclusions

The proposed regulations generally struck a good balance between specific and lengthy rules that are almost impenetrable to a non-specialist (such as the limitation of benefits article in the Netherlands-United States Income Tax Treaty) and general regulations that provide inadequate guidance. The final regulations retain that sense of balance, though not every change in the regulations is in the direction of greater clarity.

In developing the final regulations, Treasury reviewed many comments from the public criticizing the draft rules as violative of our treaty commitments. Treasury clearly holds the opposite view, and it is apparent that the IRS will vigorously defend taxpayer challenges to the conduit regulations on this score.

Another disputed issue has been whether the taxpayer should be required to prove an abuse of discretion in order to defeat conduit treatment. In fact, a decision by the IRS to treat an IE as a conduit is subject to the many rules discussed in this article. In view of the history of litigation under sections 269 and 482 (which are comparable but broader provisions), great taxpayer concerns over the burden of proof does not seem warranted. (*) Footnotes appear on page 48.

Notes

(1) References to "sections" are to the Internal Revenue Code of 1986; references to "regulations" are to the related Treasury Regulations. (2) The conduit regulations were published in proposed form in the October 14, 1994, issue of the Federal Register, 59 Fed. Reg. 52110 ff, and in final form in the August 11, 1995, issue, 60 Fed. Re 4997 ff. The regulations implement section 7701(l) of the C e which authorizes the Treasury to "prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any 2 or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by [Title 26]." Section 7701(l) is a special grant of authority to the Treasury rather than a rule of substantive tax law. Section 7701(l) was added by section 13238 of the Omnibus Budget Reconciliation Act of 1993, Pub. L. No. 103-66, 107 Stat. 311.

For a discussion of the proposed regulations, see E.J. Hawkins, S. Black,. and M.S. Thompson, The Conduit Regulations: A Primer, 46 Tax Executive 492 (November-December 1994). That article also analyzed the prior quarter-century of IRS attempts to combat this form of treaty shopping. The final regulations represent the culmination of many years of IRS efforts to attack conduit financing. (3) The regulations obscure this not-very-subtle arrangement by referring to the lender and borrower in polysyllabic terms -- financing entity" and "financed entity" -- that are almost identical. In this article, the terms "Lender" and "borrower" are used. The regulations also give the middleman an eight-syllable moniker -- intermediate entity -- which is hereinafter abbreviated IE." The IRS itself finds its polysyllabic approach confusing; in one case, the regulations use "financed entity" where financing entity' was meant. See Treas. Reg. [sections] 1.881-3(a)(3)(ii)(b) (last sentence). (4) Treas. Reg. [sections] 1.881-3(a)(2)(i). (5) Treas. Reg. [sections] 1.881-3(a)(2)(i)(b). (6) Treas. Reg. [sections] 1.881-3(a)(4)(ii)(b). (7) Treas. Reg. [sections] 1.881-3(a)(4)(ii)(a) (8) Treas. Reg. [sections] 1.881-3(a)(2)(ii)(a). (9) Treas. Reg. [sections] 1.881-3(a)(2)(ii)(b)(1). (10) 60 Fed. Reg. 41000. (11) Treas. Reg. [sections] 1.881-3(a)(2)(ii)(b)(2)(i). (12) Treas. Reg. [sections] 1.881-3(e), Ex. 1. A guarantee, however, can give rise to an adverse presumption that an intermediate entity would not have otherwise participated in a financing arrangement. Treas. Reg. [sections] 1.881-3(c)(2). (13) See Treas. Reg. [sections] 1.881-3(a)(2)(i)(a). (14) Treas. Reg. [sections] 1.881-3(a)(2)(v). (15) Treas. Reg. [sections] 1.881-3(a)(2)(iii). (16) Treas. Reg. [subsections] 1.881-3(a)(3)(i) & (ii)(a). (17) Treas. Reg. [sections] 1.881-3(d)(1)(i). (18) Treas. Reg. [sections] 1.881-3(a)(3)(ii)(b). Note that the tenth word from the end of this paragraph should be "financing" and not "financed." (19) Treas. Reg. [sections] 1.881-3(a)(3)(ii)(c). (20) Under the operating rules quoted in the text, if an IE is a conduit, the IRS can disregard it and treat the related flows of interest (or dividends, royalties, etc.) as paid directly to the lender, with an attendant increase in U.S. tax under section 881. (21) Treas. Reg. [subsections] 1.881-3(a)(4)(i)(A) & (d)(1)(i). (22) Treas. Reg. [subsections] 1.881-3(b) & (c). (23) Treas. Reg. [sections] 1.881-3(b)(1). (24) Treas. Reg. [sections] 1.881-3(b)(2)(i). (25) Treas. Reg. [sections] 1.881-3(b)(2)(ii). (26) Treas. Reg. [subsections] 1.881-3(b)(2)(iii) & (e), Ex. 16. (27) Treas. Reg. [sections] 1.881-3(b)(2)(iv). (28) Treas. Reg. [sections] 1.881-3(b)(3)(i). (29) Treas. Reg. [sections] 1.881-3(b)(2)(ii)(b). The preamble notes that the term market risks' has replaced the term "business risks" used in the proposed regulations in order to exclude from consideration such factors as credit risks. 60 Fed. Reg. 41002. (30) Treas. Reg. [sections] 1.881-3(b)(3)(ii)(b)(3). (31) See Treas. Reg. [sections] 1.881-3(e), Ex. 22, [paragraph] (ii). (32) Treas. Reg. [sections] 1.881-3(b)(3)(ii)(a). See I.R.C. [sections] 954(c)(2)(a), which contains,an exception from the definition of "foreign personal holding company income." (33) 60 Fed. Reg. 41002. (34) I.R.C. [sections] 1636)(6)(D)(iii). (35) Treas. Reg. [sections] 1.881-3(c). (36) Treas. Reg. [sections] 1881-3(d)(1). (37) Treas. Reg. [subsections] 1.881-4(b) & (c). (38) Treas. Reg. [sections] 1.1441-7(d)(2)(ii). (39) Treas. Reg. [sections] 1.1441-7(d)(2)(i). (40) Treas. Reg. [subsections] 1.881-3(a)(2)(iii) & (iv); Treas. Reg. [sections] 1.1441-30)(1). (41) Treas. Reg. [sections] 1.1441-30)(1). (42) Treas. Reg. [sections] 1.881-3(f). (43) Treas. Reg. [sections] 1.881-4(d). (44) See text accompanying notes 5-7 supra. The rules are set forth at Treas. Reg. [subsections] 1.881-3(a)(2)(i)(b) (a)(4)(ii)(b). (45) See Proposed Conduit Rules Could Apply to Other Transactions, IRS Official Says, 202 Daily Tax Rep. G-5 (Oct. 21, 1994) (Statement by IRS Associate Chief Counsel (International) Robert Culbertson); IRS Looking at Expanding Scope of Conduit Regulations, Official Says, 240 Daily Tax Rep. G-4 (Dec. 16, 1994) (Statement by Michael Pfeifer, Special Assistant, Office of IRS Associate Chief Counsel (International). (46) See Statement by Associate Chief Counsel (International), supra note 45. (47) 60 Fed. Reg. 40998. (48) 1995-44 I.R.B. 21.

EDWARD J. HAWKINS and SAM BLACK are partners in the Washington, D.C., office of Squire, Sanders & Dempsey. Mr. Hawkins has served as Chief Tax Counsel and, when control of the Senate changed in 1981, Minority Tax Counsel of the Senate Finance Committee. Mr. Black works extensively in the international tax field.

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