The Service generally has three years after a return is filed to assess any tax due for that year.1 There are a number of exceptions to this general rule, such as where a taxpayer files a false return or omits more than 25 percent of its gross income from the return. There are no exceptions, however, that would allow the Service to keep the statute of limitations open indefinitely with respect to an amount actually received in the current year, but constructively received in a prior year with respect to which the statute of limitations is now expired. Notwithstanding the lack of any statutory support, the Service has attempted within the cross-border setting to take two proverbial bites of the apple in such cases.
Section 956 and Constructive Dividends, in General
In general, U.S. shareholders of foreign corporations, like U.S. shareholders of domestic corporations, are taxable on the earnings and profits (E&P) of such corporations only when that E&P is distributed in the form of a dividend. If the corporation is classified as a “controlled foreign corporation” or “CFC,” however, any U.S. shareholders owning 10 percent or more of the voting power of the CFC (“U.S. Shareholders”) are taxable annually on their pro rata shares of (1) the CFC’s “Subpart F income” and (2) the CFC’s earnings invested in U.S. property (“Section 956 inclusions”).
Regarding Section 956 inclusions, Section 956 requires that the lesser of (i) the average quarterly balance of U.S. property held by a CFC for that year, less any amounts previously included and therefore excepted from inclusion when actually distributed under Section 959(c)(1)(A) or (ii) the applicable share of E&P of the CFC, generally is taxable to the U.S. Shareholders of such CFC each tax year. For this purpose, U.S. property includes loans from the CFC to its U.S. Shareholders, among many other items.2
When Section 956 applies, the amount determined under Section 956 is treated as a “constructive distribution” to the U.S. shareholders of the CFC.3 According to case law and leading commentary, where Section 956 otherwise applies in a particular tax year, and thus a constructive distribution is triggered in that year, this constructive distribution occurs regardless of whether the taxpayer actually includes and pays tax on the Section 956 “inclusions” for that year.4 In other words, it is the includability of such amounts that causes the constructive distribution, not their actual inclusion.
Statute of Limitations Concerns
A question that sometimes arises in the cross-border context is whether, when a CFC makes a loan to its U.S. Shareholder but the U.S. Shareholder does not report a Section 956 inclusion on its return for the relevant year, if the CFC later cancels or forgives the loan after the statute of limitations on the relevant year has run, how is this cancellation treated for U.S. federal income tax purposes? Assuming sufficient E&P, the question is whether that cancellation should be treated as a taxable constructive distribution to the U.S. Shareholder in the year the debt is extinguished or, rather, should not be taxable in the later year, due to the expired statute of limitations. Is it enough that the amounts were includable under Section 956, even though they were not actually included and taxed?
It is clear that the cancellation of a debt of a shareholder by a corporation generally is treated as a distribution of property where the corporation is not a CFC.5 Assuming a valid debt, there is no statute of limitations concern in such cases, as there is only one year in which it is possible to argue for inclusion, and that is the year of cancellation. Where the corporation is a CFC, though, the situation is different and additional policy concerns are raised. As discussed below, in these cross-border situations the correct result should be that, where the statute of limitations is closed on the year in which a Section 956 inclusion would have been proper, the later cancellation of the debt cannot be a taxable event. Any other result would seem to render the statute of limitations meaningless in such cases.
The Tax Court has considered similar cases in the past. In McCulloch, the taxpayer, a U.S. corporation, had a Canadian subsidiary that was a CFC (the “CFC”). The CFC made a series of loans to the taxpayer. The first loan was made in tax year 1970, but was not repaid until tax year 1971. The taxpayer did not report any inclusion under Section 956 for 1970. Four other loans were made in succeeding tax years, but those loans were in each case repaid before the end of the tax year in which the loan was made.
During 1974, the Service audited the taxpayer for years 1970 through 1973. By that time, the statute of limitations had run on tax year 1970. The Service argued that the series of loans between the CFC and the taxpayer should be viewed as a single loan, not repaid until 1974, and that the Service could apply Section 956 to tax these amounts since they had not yet been taxed. The taxpayer, on the other hand, argued that these were separate loans, and that each loan was closed out before the end of the tax year such that there was no includible loan balance at the end of any tax year, other than 1970. Thus, in the taxpayer’s view, 1970 would have been the only possible year for a Section 956 inclusion, since that was the only year in which there was a year-over-year increase in the loan balance. As to 1970, however, the statute of limitations was closed and thus no Section 956 inclusion was possible.
The taxpayer thus argued that, although the taxpayer had never actually included the Section 956 amounts in income, there was no way for the Service to tax them after the statute of limitations had expired. The Tax Court agreed, stating that, “if an adjustment under section 956 is appropriate at all, the adjustment should have first been made [in] the first taxable year … 1970.”
The fact that the taxpayer had not included the amounts in 1970, which was now time-barred by the statute of limitations, did not change the analysis or the result in McCulloch.
The Service has agreed with and followed McCulloch in its published guidance. In 1996 FSA Lexis 277, in which the Service cited McCulloch, the Service advised that:
The issue in this case is how to measure the increase in earnings invested in U.S. property for a year when the U.S. shareholder failed to include in gross income, under section 951(a)(1)(B), its pro rata share of such an increase for the preceding year and the statute of limitations for that preceding year has now run. . . . The regulations under section 956 make clear that for purposes of determining a U.S. shareholder’s pro rata share of the CFC’s increase in earnings invested in U.S. property, the determination of the amount of earnings invested in U.S. property for the preceding year is made irrespective of the amount actually included in the U.S. shareholder’s gross income in that preceding year.
This language confirms the Service’s view that whether the taxpayer actually includes the Section 956 amounts in income in the year a loan initially is made (or increased) is not relevant to subsequent year Section 956 computations.
Thus, where a CFC makes a loan to its U.S. parent company or other U.S. Shareholder, the newly-created balance of the intercompany receivables account is includible in the U.S. Shareholder’s income for that year. In any subsequent year in which the balance of the intercompany receivables account increases, assuming the CFC has sufficient E&P to support the additional inclusions, the increase in balance generally triggers a Section 956 inclusion to the U.S. Shareholders. Importantly, if there is no increase in the balance of the receivables for a particular tax year, there generally should be no Section 956 inclusion for that year (assuming no other Section 956 items for that year). And based on the case law discussed above, the Section 956 inclusions arise and trigger constructive dividends to the taxpayer in the relevant years even if the taxpayer does not actually report and pay tax on those amounts.
Additional case law illustrates the related, important point that if a Section 956 inclusion should have been made in a previous closed year, but such amounts were never included by the taxpayer or assessed by the Service, these amounts cannot be taxed in a later year when they are actually received. For example, the Court of Appeals for the First Circuit has held that
[i]f a taxpayer actually receives income that was constructively received in a prior year and the statute of limitations precludes its assessment and collection in respect of the prior year, the income is still not includable in the taxpayer’s income in the year it is actually received.”6
The Tax Court also has acknowledged and agreed with this position in Lewis v. Commissioner, citing Ross v. Commissioner.7
Based on Ross and Lewis, if the Service is not able to reach closed years under Section 956 to argue for inclusion of any annual increases in intercompany receivables, the Service would seem to be prohibited from assessing such amounts later, in the year of cancellation. Where the cancelled amounts are the same amounts that already were constructively received pursuant to Section 956, in order for the statute of limitations to be given effect, inclusion of the same amounts should be time-barred in the later year of cancellation.
A potential alternative argument in the taxpayer’s favor in such cases can be made under Section 959(a). Section 959 deals with a U.S. Shareholder’s exclusion from income of previously taxed E&P that was included by the shareholder in a prior year under Section 951(a) (such income is known as “previously taxed income” or “PTI”). The taxpayer in Lewis, for example, made an alternative argument that certain intercompany receivables balances that were includible in income in prior years under Section 956 (but were never actually included by the taxpayer in those earlier years) represented PTI, and therefore such amounts were excludible from his income under Section 959 when they were later distributed for the taxpayer’s benefit. The Tax Court in that case held against the taxpayer, but did so on other grounds, i.e., that there was no valid debt. What was interesting about the court’s reaction to this argument is that the court did not dismiss the argument itself as incorrect. The language of Section 959(a) seems to require an actual inclusion (“amounts which are, or have been included in the gross income of….”) in order for the relevant income to be classified as PTI. If the court agrees with this reading, however, it did not specifically say so in Lewis.
As illustrated above, the cancellation of debt in a cross-border setting raises concerns that are not implicated in the domestic setting. The statute of limitations is typically not an issue in purely domestic cases. When a CFC makes a loan to its U.S. Shareholder, however, and that loan is subsequently forgiven after the statute of limitations has expired on the original year in which inclusion was proper, a significant statute of limitations issue arises. In these cases, allowing the Service to assert a constructive distribution in the year of cancellation gives rise to serious concerns about the ability of the Service to circumvent the statute of limitations that Congress has clearly defined in Section 6501(a).
1 Section 6501(a).
2 Section 956(a) and (c)(1)(C).
3 See, e.g., P.L. 99-514, 99th Cong., H.R. 3838 (May 4, 1987) at p. 54; H. Rept. 99-426, 99th Cong., 1st Sess., H.R. 3838 (December 7, 1985) at p. 65; Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders,15.62[a].
4 See McCulloch Corp. v. Commissioner, T.C. Memo. 1984-422; See also Rhoades & Langer, U.S. International Taxation and Tax Treaties, Section 4.01[c][i], Example 3 and surrounding text.
5 Treas. Reg. Section 1.301-1(m).
6 Ross v. Commissioner, 169 F.2d 483, 492 (1st Cir. 1948).
7 See Lewis v. Commissioner, T.C. Memo 1992-391.