105 T.C. No. 22
UNITED STATES TAX COURT
NORTHERN INDIANA PUBLIC SERVICE COMPANY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24468-91. Filed November 6, 1995.
P, a domestic utility company, formed F as a subsidiary corporation in the Netherlands Antilles. F's only activity was to borrow money by issuing Euronotes and then lend the proceeds to P at an interest rate that was 1 percent greater than the rate on the Euronotes. Sec. 1441, I.R.C., generally requires a domestic taxpayer to withhold a 30-percent tax on interest paid to nonresident aliens. However, payments to Netherlands Antilles corporations were exempted from this tax pursuant to treaty. R determined that F was a mere conduit or agent of P, that P should be treated as having paid interest directly to the Euronote holders, and that P is therefore liable for the withholding tax.
Held: F engaged in the business activity of borrowing and lending money. F was not a mere conduit or agent. The treaty exemption applies. P is not liable for the withholding tax. - 2 -
Lawrence H. Jacobson, David C. Jensen, and Michael L. Brody,
for petitioner.
Elsie Hall, Reid M. Huey, and Monique I.E. van Herksen,
for respondent.
RUWE, Judge: Respondent determined deficiencies in
petitioner's Federal income taxes as follows:
Year Deficiency
1982 $3,785,250 1983 3,785,250 1984 3,785,250 1985 3,785,250
The sole issue for decision is whether petitioner was required,
pursuant to section 1441,1 to withhold tax on amounts of interest
paid to nonresident aliens. If the answer is yes, petitioner is
liable for the tax pursuant to section 1461.2
1 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. 2 In Northern Ind. Pub. Serv. Co. v. Commissioner, 101 T.C. 294 (1993), we denied petitioner's motion for partial summary judgment and held that the special 6-year period of limitations contained in sec. 6501(e)(1) applies where the income subject to withholding tax under sec. 1441 is understated by an amount in excess of 25 percent of the amount of gross income stated on Form 1042. - 3 -
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts, second, third, and fourth stipulations
of facts, and attached exhibits, respectively, are incorporated
herein by this reference.
Petitioner is an Indiana corporation with its principal
office in Hammond, Indiana. Petitioner's wholly owned foreign
subsidiary, Northern Indiana Public Service Finance N.V.
(Finance), was incorporated on August 21, 1981, in Curacao under
the Commercial Code of the Netherlands Antilles for an unlimited
term. Finance had 20 shares of stock issued and outstanding, all
of which were acquired by petitioner for $20,000 cash. Finance's
sole managing director throughout its existence was Curacao
Corporation Company N.V. Finance's books and records were
maintained by its managing director in the Netherlands Antilles.
Article 2 of Finance's articles of incorporation provides:
The purpose of the company is to finance directly or indirectly the activities of the companies belonging to * * * [petitioner] * * *, to obtain the funds required thereto by floating public loans and placing private loans, to invest its equity and borrowed assets in the debt obligations of one or more companies of * * * [petitioner], and in connection therewith and generally to invest its assets in securities, including shares and other certificates of participation and bonds, as well as other claims for interestbearing debts however denominated and in any and all forms, as well as the borrowing and lending of monies.
Specifically, Finance was organized for the purpose of obtaining - 4 -
funds so that petitioner could construct additions to its utility
properties. To accomplish this, Finance was to issue notes in
the Eurobond market. The Eurobond market has been aptly
described in a 1984 Senate Finance Committee report as follows:
A major capital market outside the United States is the Eurobond market. It is not an organized exchange, but rather a network of underwriters and financial institutions that market bonds issued by private corporations (including but not limited to finance subsidiaries of U.S. companies), foreign governments and government agencies, and other borrowers.
In addition to individuals, purchasers of the bonds include institutions such as banks (frequently purchasing on behalf of investors with custodial accounts managed by the banks), investment companies, insurance companies, and pension funds. There is a liquid and well-capitalized secondary market for the bonds with rules of fair practice enforced by the Association of International Bond Dealers. Although a majority of the bond issues in the Eurobond market are denominated in dollars (whether or not the issuer is a U.S. corporation), bonds issued in the Eurobond market are also frequently denominated in other currencies (even at times when issued by U.S. multinationals). [S. Prt. 98-169 (Vol. I), at 417 (1984).]
On August 28, 1981, petitioner filed a petition with the
Public Service Commission of Indiana for a certificate of
authority and an order approving and authorizing petitioner to:
(1) Issue a note or notes in an amount not to exceed $75 million
to Finance; (2) pay all expenses of issuance of its notes and the
Euronotes connected therewith; and (3) apply the net cash
proceeds from the loan of the Euronote proceeds as requested in
the petition. Essentially, the petition provided that the - 5 -
proceeds were to be added to petitioner's working capital for
ultimate application to the cost of its construction project,
including the payment of short-term borrowings made to provide
funds for the construction project. Petitioner also stated the
following in its petition to the Public Service Commission of
Indiana:
It is believed that the Notes issued in conjunction with the Finance Subsidiary's issue and sale of the Euronotes, could be issued at a relatively favorable interest rate compared to domestically issued, unsecured long-term debt of petitioner and would allow petitioner additional flexibility in funding its construction program.
On September 25, 1981, the Public Service Commission of
Indiana issued a certificate of authority providing that
petitioner was authorized to borrow the proceeds of the Euronote
issue and, in return, was authorized to issue its note in an
amount not to exceed $75 million to Finance, at an interest rate
which would be 1 percent greater than that borne by the
Euronotes. The certificate of authority also provided that
petitioner could unconditionally guarantee the amount of
principal, interest, and premium, if any, on the Euronotes in the
event of a default by Finance and that the guaranty would be a
direct unsecured obligation of petitioner and would rank equally
and ratably with all other unsecured senior debt of petitioner.
On October 6, 1981, Finance was authorized by its managing
director to issue and sell $70 million of guaranteed notes that - 6 -
would be due October 15, 1988. This same day, petitioner's
executive and finance committee authorized and approved the
issuance of a $70 million note to Finance.
On October 15, 1981, Finance issued notes in the Eurobond
market in the amount of $70 million, at an interest rate of 17-
1/4 percent. The notes were listed on the stock exchange of the
United Kingdom and the Republic of Ireland. The timely payment
of the principal amount and the interest was unconditionally
guaranteed by petitioner, and the notes contained a call option
in 1985 for a 1.5-percent premium, and in 1986 for a .75-percent
premium. Also on October 15, 1981, petitioner issued a $70
million, 18-1/4 percent note due on October 15, 1988, to Finance,
and pursuant thereto, Finance remitted the net proceeds of the
Euronote offering of $68,525,000 to petitioner.3
Petitioner and Finance issued a prospectus in connection
with the Euronote offering that was dated October 7, 1981. The
prospectus provided that prior to the Euronote issuance,
petitioner was to contribute to Finance "cash or property in an
aggregate amount sufficient to bring total stockholder's equity
to $28,000,000."
3 Finance's Euronotes were issued at a discount of $1,475,000, which Finance amortized over the term of the notes. The discount consisted of $875,000 (1.25 percent) original issuance discount, $262,500 (.375 percent) broker/manager commission, $262,500 (.375 percent) underwriter commission, and $75,000 for broker/manager out-of-pocket legal fees and expenses. - 7 -
In connection with the issuance of the Euronotes,
petitioner, Finance, and the Irving Trust Co. entered into an
Indenture Agreement on October 15, 1981. This agreement
elaborates on the form and terms of the Euronote issuance and on
the responsibilities of the respective parties. The agreement
provides, inter alia, that Finance's net worth will not be
reduced to an amount that is less than 40 percent of the
aggregate amount of its outstanding indebtedness.
Also in connection with the Euronote offering, Eichhorn,
Eichhorn & Link issued a legal opinion letter dated October 7,
1981. Based upon certain representations by petitioner, the
opinion letter stated that the Euronote holders would not be
subject to U.S. income tax upon receipt of interest income from
Finance, unless the holders were engaged in a U.S. trade or
business. For purposes of this opinion letter, petitioner
represented, inter alia, that the equity capital of Finance at
the time of issuance of the Euronotes would not be less than $28
million, consisting of accounts receivable to be assigned to
Finance, and that Finance's net worth would not at any time be
reduced to an amount less than 40 percent of the aggregate amount
of its outstanding indebtedness, so as to maintain at all times a
debt-to-equity ratio not in excess of 2-1/2 to 1.
On October 15, 1981, petitioner and Finance executed a
document captioned "Assignment of Accounts Receivable". This
assignment was authorized by petitioner's board of directors on - 8 -
September 22, 1981. The assignment document provides that
petitioner assign all its "right, title and interest in and to
the accounts receivable" of five of petitioner's largest
customers: United States Steel Corp.; Inland Steel Co.; Jones &
Laughlin Steel Corp.; Bethlehem Steel Corp.; and Midwest Steel
Corp., a division of National Steel Corp. The assignment
document also provides that petitioner will act as a collection
agent for Finance with respect to the above accounts and that the
above accounts
do now and at all times will aggregate in excess of $28,000,000, and in the event a decline in the value of one or more of the accounts would cause the aggregate amount to be less than $28,000,000, * * * [petitioner] will promptly assign additional customer accounts sufficient that the aggregate of all assigned accounts will be in excess of $28,000,000.
On October 15, 1981, Eichhorn, Eichhorn & Link issued a
second legal opinion reaffirming its letter dated October 7,
1981, and stating that in its opinion, Finance was capitalized as
set forth in the prospectus.
Petitioner did not change the manner in which it recorded
sales and accounts receivable information as a result of
executing the assignment document. The moneys petitioner
collected on the accounts receivable that were listed in the
assignment document were not set aside in a special account, but
were placed in petitioner's general corporate funds.
Petitioner's audited financial statements covering September 1981 - 9 -
through September 1986 included the accounts receivable that were
listed in the assignment document.
Petitioner did not send a letter notifying the account
debtors of the execution of the assignment document, nor did
petitioner file financing statements, as that term is defined in
the Uniform Commercial Code. During the period the Euronotes
were outstanding, petitioner engaged in no borrowing transactions
in which any of its accounts receivable were pledged to an
unrelated third party or otherwise subject to a security interest
of an unrelated third party. The balance of the accounts
receivable at all times relevant herein exceeded $28 million.
Finance received annual interest payments in 1982, 1983,
1984, and 1985 in the amount of $12,775,000 from petitioner.
Finance made annual interest payments in the amount of
$12,075,000 in 1982, 1983, 1984, and 1985 to the holders of the
Euronotes. Finance's aggregate income on the spread between the
Euronote interest and the interest on petitioner's note was
$2,800,000. In addition, Finance earned interest income on its
investments (exclusive of interest paid by petitioner on its
note).
On October 10, 1985, petitioner repaid its note plus accrued
interest and early payment premium to Finance. The payment
consisted of $70 million in principal, $12,775,000 in interest
for the period ending October 15, 1985, and a $1,050,000 call
premium. On October 15, 1985, Finance redeemed the Euronotes by - 10 -
paying $70 million in principal, $12,075,000 in interest, and a
$1,050,000 call premium to the Euronote holders.
On September 22, 1986, Finance was liquidated. The
distribution of Finance's assets to petitioner was completed
sometime during 1987.
Petitioner timely filed Forms 1042 (U.S. Annual Return of
Income Tax to be Paid at Source) for each of the years at issue.
Petitioner also filed Forms 1042S (Foreign Person's U.S. Source
Income Subject to Withholding) for all the payments reported on
the Forms 1042. The interest payments made by Finance to the
Euronote holders were not reported in petitioner's Forms 1042 and
1042S or on any schedule or statement attached to such returns.
OPINION
Section 871(a)(1) generally imposes a tax on nonresident
aliens of 30 percent of the amount of interest received from
sources within the United States. Section 1441(a) and (b)
generally requires persons who pay such interest to deduct and
withhold a tax equal to 30 percent of the amount thereof.
Section 1461 makes the payor liable for this withholding tax.
Section 894 provides that to the extent required by any
treaty obligation of the United States, income of any kind shall
be exempt from taxation and shall not be included in gross
income. See Tate & Lyle, Inc. v. Commissioner, 103 T.C. 656, 664
(1994). During the tax years at issue, article VIII of the - 11 -
income tax treaty between the United States and the Netherlands,
as extended to the Netherlands Antilles (Treaty), provided the
following:
(1) Interest on bonds, notes, debentures, securities, deposits or any other form of indebtedness * * * paid to a resident or corporation of one of the Contracting States shall be exempt from tax by the other Contracting State. [Convention with Respect to Taxes, Apr. 29, 1948, U.S.--The Neth., art. VIII, 62 Stat. 1757, 1761, supplemented by Protocol, Oct. 23, 1963, 15 U.S.T. 1900, modified by Supplementary Convention, Dec. 30, 1965, 17 U.S.T. 896, 901.]
In light of this Treaty provision, if petitioner's interest
payments are recognized as having been paid to Finance, Finance
would not be liable for the tax imposed by section 871(a)(1), and
petitioner would be under no obligation to withhold tax pursuant
to section 1441.
Respondent determined that petitioner was required to
withhold taxes pursuant to section 1441 on the interest payments
to the Euronote holders. Respondent's position is based on the
proposition that Finance should be ignored and that petitioner
should be viewed as having paid interest directly to the Euronote
holders. Respondent argues that Finance was a mere conduit or
agent in the borrowing and interest-paying process.
Petitioner formed Finance for the purpose of borrowing money
in Europe and lending money to petitioner. Normally, a choice to
transact business in corporate form will be recognized for tax
purposes so long as there is a business purpose or the - 12 -
corporation engages in business activity. As stated by the
Supreme Court:
The doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity. * * * [Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438-439 (1943); fn. refs. omitted.]
The alternative requirements of business purpose or business
activity have been restated many times. With respect to the
latter requirement, the quantum of business activity may be
rather minimal. Hospital Corp. of America v. Commissioner, 81
T.C. 520, 579 (1983). Even where a corporation is created with a
view to reducing taxes, if it in fact engages in substantive
business activity, it will not be disregarded for Federal tax
purposes. Bass v. Commissioner, 50 T.C. 595, 601 (1968). This
is true even if the primary reason for the corporation's
existence is to reduce taxes. As we stated in Nat Harrison
Associates, Inc. v. Commissioner, 42 T.C. 601, 618 (1964):
Whether the primary reason for its existence and conduct of business was to avoid U.S. taxes or to permit more economical performance of contracts through use of native labor, or a combination of these and other reasons, makes no difference in this regard. Any one of these reasons would constitute a valid business purpose for its existence and conduct of business as - 13 -
long as it actually conducted business.[4] * * *
Considering these principles and the fact that Finance engaged in
the business activity of borrowing and lending money at a profit,
it would seem that Finance should be recognized as the recipient
of interest paid to it by petitioner.
Of course, a corporate entity can act as an agent for its
sole shareholder rather than for its own account. But these
instances have been rather narrowly restricted to situations
where the corporation's role as an agent is made clear; e.g.,
where the agency relationship is set forth in a written
agreement, the corporation functions as an agent, and the
corporation is held out as an agent in all dealings with third
parties related to the transaction. Commissioner v. Bollinger,
485 U.S. 340 (1988).5 The facts before us do not fit this mold.
4 See also Ross Glove Co. v. Commissioner, 60 T.C. 569, 588 (1973). 5 In Bass v. Commissioner, 50 T.C. 595, 601 (1968), we observed:
Long ago, the Supreme Court held that when a corporation carries on business activity the fact that the owner retains direction of its affairs down to the minutest detail makes no difference tax-wise, observing that "Undoubtedly the great majority of corporations owned by sole stockholders are 'dummies' in the sense that their policies and day-to-day activities are determined not as decisions of the corporation but by their owners acting individually." National Carbide Corp. v. Commissioner, supra at 433; see Chelsea Products, Inc., 16 T.C. 840, 851 (1951), affd. 197 F.2d (continued...) - 14 -
Respondent does not deny the corporate existence of Finance.
Respondent's reason for treating Finance as a mere conduit or
agent is that Finance was "not properly capitalized". The
explanation of adjustments in the notice of deficiency states:
It has been determined that your 100% owned foreign subsidiary, incorporated in the Netherlands Antilles, was not properly capitalized, therefore the interest paid by that subsidiary on debt obligations (Euronotes) is treated as being paid directly by you. Consequently, you are liable for the 30% withholding which was not withheld on interest payments made to the holders of the Euronotes * * * [Emphasis added.]
Respondent's argument that Finance was inadequately
capitalized, and that this should result in ignoring it for tax
purposes, appears to be based on Rev. Rul. 69-377, 1969-2 C.B.
231; Rev. Rul. 69-501, 1969-2 C.B. 233; Rev. Rul. 70-645, 1970-2
C.B. 273; and Rev. Rul. 73-110, 1973-1 C.B. 454. These revenue
rulings basically recognize the validity of the debt obligation
of wholly owned foreign financing subsidiaries in situations
identical to the instant case, if the amount borrowed by the
financing subsidiary does not exceed five times its equity
capital.6 Respondent would agree that petitioner is not liable
5 (...continued) 620 (C.A.3, 1952). 6 In Rev. Rul. 74-464, 1974-2 C.B. 47, respondent indicated that the mere existence of a 5-to-1 debt-to-equity ratio could no longer be relied upon by taxpayers.
(continued...) - 15 -
for the withholding tax if Finance's debt-to-equity ratio does
not exceed 5 to 1.7
Petitioner argues that its assignment of accounts receivable
in an amount of at least $28 million was an equity investment in
Finance that brings Finance well within the debt-to-equity ratio
of 5 to 1. Respondent argues that this assignment was not an
equity investment because actual ownership of the accounts
receivable was never transferred. Before we launch any inquiry
into the true nature of the assignment of petitioner's accounts
receivable, we will first inquire into the legal basis for
respondent's reliance on alleged inadequate capitalization as a
6 (...continued) In light of the inseparability of the IET [Interest Equalization Tax] and the five to one debt to equity ratio and resultant Federal income tax consequences, the expiration of the IET on June 30, 1974, eliminated any rationale for treating finance subsidiaries any differently than other corporations with respect to their corporate validity or the validity of their corporate indebtedness. Thus, the mere existence of a five to one debt to equity ratio, as a basis for concluding that debt obligations of a finance subsidiary constitute its own bona fide indebtedness, should no longer be relied upon. [Id.]
7 As more fully discussed infra, sec. 127(g)(3) of the Deficit Reduction Act of 1984 (DEFRA), Pub. L. 98-369, 98 Stat. 652, provides a "safe harbor" from taxation for interest paid to a controlled foreign corporation if the requirements of the above-mentioned revenue rulings are met. At trial, respondent's counsel acknowledged that the specific capital requirements of the revenue rulings outlined above were not based on statute or case law, except to the extent that compliance with them is required to come within the "safe harbor" provisions of DEFRA sec. 127(g)(3). - 16 -
reason for treating Finance as a conduit.
Revenue rulings represent "merely the opinion of a lawyer in
the agency and must be accepted as such", and are "not binding on
the * * * courts." Stubbs, Overbeck & Associates, Inc. v. United
States, 445 F.2d 1142, 1146-1147 (5th Cir. 1971); see Halliburton
Co. v. Commissioner, 100 T.C. 216, 232 (1993), affd. without
published opinion 25 F.3d 1043 (5th Cir. 1994). Accordingly, "a
ruling or other interpretation by the Commissioner is only as
persuasive as her reasoning and the precedents upon which she
relies." Halliburton Co. v. Commissioner, supra at 232. The
aforementioned revenue rulings contain no legal analysis
supporting their debt-to-equity requirement. At trial, we asked
respondent's counsel to explain the legal foundation and
rationale upon which respondent's debt-to-equity position was
based. Except for referring to the aforementioned revenue
rulings, counsel was unable to provide an explanation at that
time. In respondent's opening brief, respondent cited no legal
authority supporting a debt-to-equity requirement.
Petitioner takes the position that a debt-to-equity ratio is
irrelevant to whether a corporation is acting as a conduit or
agent. In respondent's reply brief, she addresses petitioner's
argument that the debt-to-equity ratio is irrelevant by
attempting to distinguish the cases petitioner cited on the
ground that they did not deal with the type of
conduit/withholding transaction presented in this case. - 17 -
Respondent's reply brief then states that
in the case at bar, we are dealing with the question of debt to equity ratio in the context of a controlled foreign corporation, a financing subsidiary. The requirement of adequate capitalization serves as a major assurance that there is financial reality and substance to the transaction in the post Moline Properties, supra, era. [Fn. ref. omitted.]
However, respondent cites no authority for this proposition, nor
does she explain what factors should be used in determining the
existence of "adequate capitalization" in this situation. It
would appear that this is an issue of first impression.
There is nothing in Moline Properties, Inc. v. Commissioner,
319 U.S. 436 (1943), upon which respondent can rely. In that
case, the taxpayer corporation was created and owned by an
individual who had previously purchased real estate that he had
mortgaged. The investment proved unprofitable, and in order to
avoid losing the property, the individual owner was required by
his creditors to transfer title to the newly formed corporation
and place the corporate stock in trust as collateral. See Moline
Properties, Inc. v. Commissioner, 45 B.T.A. 647 (1941), revd. 131
F.2d 388 (5th Cir. 1942), affd. 319 U.S. 436 (1943).
In Moline Properties, Inc. v. Commissioner, supra, the
Supreme Court upheld the Commissioner's position that the
corporate entity to which the real estate was transferred must be
recognized and pay tax on the profit realized when it sold the
real estate. There is nothing in Moline Properties that suggests - 18 -
that the Supreme Court placed any significance on the ratio of
debt to equity. Indeed, from the facts presented in Moline
Properties, one would suspect that the creditors required the
transfer of real estate to the newly formed corporation, because
the individual debtor/stockholder had insufficient equity to
satisfy the creditors that the debts would be repaid.
Moline Properties, Inc. v. Commissioner, supra, stands for
the general proposition that a choice to do business in corporate
form will result in taxing business profits at the corporate
level. Neither party has directed our attention to precedent
that conditions this proposition on a ratio of debt to equity.
This does not mean that the relationship of debt to equity is
necessarily irrelevant in cases where there is a challenge to a
corporation's role. But if the relationship of debt to equity is
to be a significant factor for tax purposes, it seems to us that
it must also have economic significance to the transaction being
challenged.
In the instant case, if petitioner had invested sufficient
equity capital in Finance to bring the debt-to-equity ratio to 5
to 1, respondent would have conceded. Petitioner could have
achieved this debt-to-equity ratio by contributing an additional
$14 million to Finance.8 But since Finance's only business
8 As previously noted, petitioner argues that it did achieve a 5-to-1 debt-to-equity ratio when it assigned at least $28 million of accounts receivable to Finance. - 19 -
purpose was to borrow money in Europe and lend money to
petitioner--and petitioner obviously needed the $14 million9--one
would naturally expect that a $14 million capital contribution
received by Finance would have been lent right back to
petitioner. This would have presumably satisfied respondent's
debt-to-equity ratio, and respondent would not have characterized
Finance as a mere conduit.10 In reality, however, nothing of
economic significance would have occurred with respect to
Finance's issuance of Euronotes. The financial stability of
Finance and the position of the Euronote holders would have been
substantially unchanged. Both would have ultimately remained
dependent upon petitioner's ability to pay its notes to Finance,
so that Finance could in turn pay off the Euronotes.
The legislative history of DEFRA describes the manner in
which domestic corporations accessed the Eurobond market:
In general, debt securities in the Eurobond market are free of taxes withheld at source, and the form of bond, debenture, or note sold in the Eurobond market puts the risk of such a tax on the issuer by requiring the issuer to pay interest, premiums, and principal net of any tax which might be withheld at source (subject to a right of the issuer to call the obligations in the
9 The whole purpose of Finance was to facilitate petitioner's borrowing $70 million. 10 Respondent did not contend on brief that a financing subsidiary would be lacking in substance if it lent its capital back to its parent, and nothing in respondent's revenue rulings indicates the manner in which a financing subsidiary is required to invest its capital. - 20 -
event that a withholding tax is imposed as a result of a change in law or interpretation occurring after the obligations are issued). Because the Eurobond market is generally comprised of bonds not subject to withholding tax by the country of source, an issuer may not be able to compete easily for funds in the Eurobond market solely on the basis of price if its interest payments are subject to a substantial tax. U.S. corporations currently issue bonds in the Eurobond market free of U.S. withholding tax through the use of international finance subsidiaries, almost all of which are incorporated in the Netherlands Antilles.
Finance subsidiaries of U.S. corporations are usually paper corporations, often without employees or fixed assets, which are organized to make one or more offerings in the Eurobond market, with the proceeds to be relent to the U.S. parent or to domestic or foreign affiliates. The finance subsidiary's indebtedness to the foreign bondholders is guaranteed by the U.S. parent (or other affiliates). Alternatively, the subsidiary's indebtedness is secured by notes of the U.S. parent (or other affiliates) issued to the Antilles subsidiary in exchange for the loan proceeds of the bond issue. Under this arrangement, the U.S. parent (or other U.S. affiliate) receives the cash proceeds of the bond issue but pays the interest to the Antilles finance subsidiary rather than directly to the foreign bondholders. [S. Prt. 98-169 (Vol. I), at 418 (1984).]
The above description closely corresponds to the manner in which
petitioner sought access to the Eurobond market.
Petitioner wanted to take advantage of favorable Eurobond
interest rates. However, prospective lenders did not want to be
liable for the 30-percent tax imposed by section 871(a)(1).
Prospective lenders were willing to lend money to Finance because
it was a Netherlands Antilles corporation whose notes would not
be subject to tax under section 871(a)(1). The business purpose
of Finance was to borrow money in Europe at a favorable rate and
lend money to petitioner. For its involvement, Finance would - 21 -
derive a profit equal to 1 percent of the amount lent to
petitioner; i.e., the difference between 17-1/4 percent and 18-
1/4 percent interest. Obviously, the Euronote purchasers were
willing to buy Finance's notes without requiring that any
additional equity capital be invested in Finance. Therefore,
regardless of how petitioner's assignment of accounts receivable
is characterized, petitioner's equity investment in Finance was
"adequate" to carry out Finance's business purpose.11
Respondent relies almost exclusively on Aiken Indus., Inc.
v. Commissioner, 56 T.C. 925 (1971). In Aiken Indus., a domestic
corporation (U.S. Co.) borrowed $2,250,000 at an interest rate of
4 percent on April 1, 1963, from a Bahamian corporation
(Bahamian). Bahamian owned 99.997 percent of U.S. Co.'s parent,
also a domestic corporation, which in turn wholly owned U.S. Co.
On March 30, 1964, Bahamian's wholly owned Ecuadorian subsidiary
incorporated Industrias Hondurenas S.A. de C.V. (Industrias) in
the Republic of Honduras. On March 31, 1964 (which appears to be
1 day before U.S. Co.'s first interest obligation to Bahamian was
due), Bahamian assigned U.S. Co.'s note to Industrias in exchange
for nine promissory notes ($250,000 each), which totaled
$2,250,000 and bore interest of 4 percent. Because of this
11 Cf. Bradshaw v. United States, 231 Ct. Cl. 144, 683 F.2d 365, 374 (1982) (citing Gyro Engg. Corp. v. United States, 417 F.2d 437, 439 (9th Cir. 1969); Piedmont Corp. v. Commissioner, 388 F.2d 886, 890 (4th Cir. 1968), revg. T.C. Memo. 1966-263; Sun Properties, Inc. v. United States, 220 F.2d 171, 175 (5th Cir. 1955)). - 22 -
assignment, U.S. Co. made its 4-percent interest payments to
Industrias, and Industrias made its 4-percent interest payments
to Bahamian. Prior to the assignment, U.S. Co.'s interest
payments to Bahamian would have been subject to the withholding
provisions of section 1441. But after the assignment, because
there was an income tax treaty between the United States and the
Republic of Honduras, U.S. Co. claimed exemption from the
withholding provisions.
In Aiken Indus., Inc. v. Commissioner, supra, we held that
the corporate existence of Industrias could not be disregarded.
However, we also held that the interest payments in issue were
not "received by" Industrias within the meaning of the article of
the United States-Honduras Income Tax Treaty that exempted
interest from tax. Id. at 933. In Aiken Indus., Inc. v.
Commissioner, supra at 933-934, we stated:
The words "received by" refer not merely to the obtaining of physical possession on a temporary basis of funds representing interest payments from a corporation of a contracting State, but contemplate complete dominion and control over the funds.
The convention requires more than a mere exchange of paper between related corporations to come within the protection of the exemption from taxation * * *, and on the record as a whole, the * * * [taxpayer] has failed to demonstrate that a substantive indebtedness existed between a United States corporation and a Honduran corporation.
* * * Industrias obtained exactly what it gave up in a dollar-for-dollar exchange. Thus, it was committed to pay out exactly what it collected, and it made no profit on the * * * [exchange of the notes] - 23 -
* * *
In these circumstances, where the transfer of * * * the notes * * * left Industrias with the same inflow and outflow of funds and where * * * [all involved] were * * * members of the same corporate family, we cannot find that this transaction had any valid economic or business purpose. Its only purpose was to obtain the benefits of the exemption established by the treaty for interest paid by a United States corporation to a Honduran corporation. While such a tax-avoidance motive is not inherently fatal to a transaction, see Gregory v. Helvering, * * * [293 U.S. 465, 469 (1935)], such a motive standing by itself is not a business purpose which is sufficient to support a transaction for tax purposes. See Knetsch v. United States, 364 U.S. 361 (1960); Higgins v. Smith, 308 U.S. 473 (1940); Gregory v. Helvering, supra.
The fact that the transaction was entirely between related
parties was important to our conclusion that it was void of any
"economic or business purpose." Aiken Indus., Inc. v.
Commissioner, supra at 934. In contrast, Finance borrowed funds
from unrelated third parties (the Euronote holders) who were
willing to enforce their rights over both Finance and petitioner.
The Euronote holders would not have lent money to petitioner.
Finance was therefore created to borrow money in Europe and then
lend money to petitioner in order to comply with the requirements
of prospective creditors, a business purpose of the kind
recognized by the Supreme Court in Moline Properties, Inc. v.
Commissioner, 319 U.S. 436 (1943).
The instant case is also distinguishable from Aiken Indus.,
because Finance's borrowing and lending activity was a business
activity that resulted in significant earnings for Finance. - 24 -
Petitioner was required to pay interest at 18-1/4 percent,
whereas Finance issued the Euronotes at 17-1/4 percent.
Finance's aggregate income on the spread between the Euronote
interest and the interest on petitioner's note was $2,800,000.
In addition, Finance earned interest income on its investments
(exclusive of interest received from petitioner) during its
existence.12
Moreover, in Aiken Indus., this Court did not rely upon, or
even mention, lack of adequate capitalization as a reason for
treating Industrias as a conduit. Since respondent's
determination was based on her finding that Finance was "not
properly capitalized," respondent's reliance on Aiken Indus. is
misplaced.
Respondent next argues that
in 1984 Congress had the option of retroactively grandfathering all foreign subsidiaries and eliminating all withholding tax on bond interest had it chosen to do so. Instead, it opted for the safe harbor provision contained in section 127(g)(3) which expressly referenced the rulings requiring a debt equity ratio of no more than five-to-one for financing subsidiaries utilized prior to the effective date of the Act. The intent of Congress, as reflected in this safe harbor
12 Compare Morgan Pac. Corp. v. Commissioner, T.C. Memo. 1995-418, in which the taxpayer conceded, based on Aiken Indus., Inc. v. Commissioner, 56 T.C. 925 (1971), that a Netherlands Antilles corporation should be treated as a conduit. The transactions in Morgan Pacific are distinguishable from those in the instant case. Among other things, the interest payments received and paid by the Netherlands Antilles corporation in Morgan Pacific were identical and the transactions did not involve parties unrelated to petitioner. - 25 -
provision, is consistent with respondent's scrutiny of petitioner's debt to equity ratio and should be carried out. [Emphasis added.]
The Deficit Reduction Act of 1984 significantly modified
withholding requirements with respect to "interest received by
foreigners on certain portfolio investments." DEFRA sec. 127, 98
Stat. 648. These provisions essentially provided U.S. taxpayers
direct tax-free access to the Eurobond market. The amendments
made by DEFRA section 127 generally applied to "interest received
after the date of the enactment of this Act with respect to
obligations issued after such date, in taxable years ending after
such date." DEFRA sec. 127(g)(1), 98 Stat. 652. However, DEFRA
section 127(g)(3), 98 Stat. 652-653, established safe harbor
rules applicable to certain controlled foreign corporations in
existence on or before June 22, 1984:
(A) In General.--For purposes of the Internal Revenue Code of 1954, payments of interest on a United States affiliate obligation to an applicable CFC in existence on or before June 22, 1984, shall be treated as payments to a resident of the country in which the applicable CFC is incorporated.
(B) Exception.--Subparagraph (A) shall not apply to any applicable CFC which did not meet requirements which are based on the principles set forth in Revenue Rulings 69-501, 69-377, 70-645, 73-110.
Thus, respondent argues that for the safe harbor rules to apply,
the controlled foreign corporation must have met the 5-to-1 debt-
to-equity ratio as set forth in Rev. Rul. 69-377, 1969-2 C.B. - 26 -
231; Rev. Rul. 69-501, 1969-2 C.B. 233; Rev. Rul. 70-645, 1970-2
C.B. 273; and Rev. Rul. 73-110, 1973-1 C.B. 454.
Petitioner agrees that in order to fall within the safe
harbor provisions, Finance had to meet the debt-to-equity ratios
as set forth in the above revenue rulings. Petitioner
nevertheless contends that "there is nothing in the 1984 Act, as
amended, or the accompanying legislative history, which suggested
that compliance with this safe harbor was the only method a
United States corporation could utilize in claiming an exemption
from U.S. withholding tax or interest paid to controlled foreign
finance subsidiaries." Accordingly, petitioner contends that
irrespective of the capital requirements set forth in the
rulings, if the situation before us falls within the terms of the
Treaty, it is not liable for the withholding tax. We agree.
The legislative history of DEFRA describes in some detail
the practice of U.S. corporations seeking access to the Eurobond
market. The legislative history notes that the offerings by
finance subsidiaries (mostly all of which were incorporated in
the Netherlands Antilles) "involve difficult U.S. tax issues in
the absence of favorable IRS rulings." S. Prt. 98-169 (Vol. I),
at 419 (1984). Indeed, the legislative history outlined the
arguments supporting the position taken by taxpayers and the
arguments supporting the Government's position with respect to
these "difficult U.S. tax issues".
Notwithstanding this, no conclusion was drawn regarding the - 27 -
merits of either position. In fact, the legislative history
states that "these finance subsidiary arrangements do in form
satisfy the requirements for an exemption from the withholding
tax and a number of legal arguments would support the taxation of
these arrangements in accordance with their form." S. Prt. 98-
169 (Vol. I), at 419 (1984). Lastly, the legislative history
states:
No inference should be drawn from this rule regarding the proper resolution of other tax issues. The conferees do not intend this provision to serve as precedent for the U.S. tax treatment of other transactions involving tax treaties or domestic tax law. [H. Conf. Rept. 98-861, at 938 (1984), 1984-3 C.B. (Vol. 2) 1, 192; emphasis added.]
See also S. Prt. 98-169 (Vol. I), at 418 n.1 (1984).
The fact that Congress made the safe harbor provisions of
DEFRA section 127(g)(3) contingent on meeting the requirements of
preexisting revenue rulings does not mean that such requirements
must be met in order for the legal substance of these financing
transactions to be recognized. Congress was presumably trying to
provide a safe harbor for taxpayers who had complied with the
revenue rulings. As already indicated, Congress did not intend
DEFRA section 127(g)(3) to be the exclusive means by which a
taxpayer could claim exemption from the 30-percent withholding
tax. Moreover, Congress drew no conclusions regarding the
respective positions taken by taxpayers and the Government on
whether these transactions would qualify for exemption from - 28 -
withholding tax. Based on this, we are not convinced that
Congress was attempting to impart legitimacy to the debt-to-
equity ratio that was required by the revenue rulings.13
13 In Rev. Rul. 84-153, 1984-2 C.B. 383, the Commissioner took the position that a Netherlands Antilles financing subsidiary was a mere conduit for interest payments to foreign bondholders even though the subsidiary was adequately capitalized. The facts in Rev. Rul. 84-153, supra, are essentially as follows: (1) P, a corporation organized under the laws of the United States, owned 100 percent of the stock of S, an Antilles corporation; (2) to upgrade the production facilities of P's wholly owned domestic subsidiary, R, S sold bonds to foreign persons in public offerings outside the United States on Sept. 1, 1984; (3) S lent the proceeds from the bond offerings to R at a rate of interest that was 1 percentage point higher than the rate payable by S on the bonds; (4) R made timely payments to S and S made timely payments to its bondholders; (5) S's excess revenue after expenses was retained by S; (6) neither P, R, nor S was thinly capitalized. The revenue ruling does not mention any debt-to-equity ratio, nor does it explain the meaning of "thinly capitalized". The revenue ruling concludes:
In substance, S, while a valid Antilles corporation, never had such dominion and control over R's interest payments, but rather was merely a conduit for the passage of R's interest payments to the foreign bondholders. The primary purpose for involving S in the borrowing transaction was to attempt to obtain the benefits of the Article VIII(1) interest exemption for interest paid in form by R, a domestic corporation, to S, an Antilles corporation, thus, resulting in the avoidance of United States tax. This use of S lacks sufficient business or economic purpose to overcome the conduit nature of the transaction, even though it can be demonstrated that the transaction may serve some business or economic purpose. See Gregory v. Helvering, 293 U.S. 465 (1935), and Aiken Industries, Inc., v. Commissioner, supra. * * * [Rev. Rul. 84- 153, 1984-2 C.B. at 384.]
It is clear from this that the Commissioner would treat a Netherlands Antilles finance corporation as a conduit, regardless (continued...) - 29 -
Based on the facts and circumstances before us, we hold that
Finance did not act as a conduit or agent with respect to the
transactions in issue. It follows that petitioner was not
required to withhold tax on interest payments to the Euronote
holders.14
Decision will be entered
13 (...continued) of whether it was adequately capitalized. However, Rev. Rul. 84- 153, supra, was modified by Rev. Rul. 85-163, 1985-2 C.B. 349, as follows:
Pursuant to the authority contained in section 7805(b) of the Internal Revenue Code, the holdings of * * * Rev. Rul. 84-153 will not be applied to interest payments made in connection with debt obligations issued prior to October 15, 1984, the date that * * * Rev. Rul. 84-153 [was] published * * *
Finance issued its Euronotes on Oct. 15, 1981, approximately 3 years prior to the effective date of Rev. Rul. 84-153, as modified by Rev. Rul. 85-163.
14 As a result of our conclusion, we need not address petitioner's alternative argument that Finance met the capital requirements of DEFRA sec. 127(g)(3) by virtue of the assignment of petitioner's accounts receivable.