Planning around the CFC netting rule.

• Author: Roth, Joseph
• Position: Controlled foreign corporation

If a U.S. parent company borrows externally and in turn makes a loan to its controlled foreign corporation (CFC), it may be subject to the CFC netting rule under Regs. Sec. 1.861-10(e). If applicable, the CFC netting rule requires a direct allocation of the U.S. parent company's third-party interest expense against foreign-source interest income received from the CFC when computing the foreign tax credit (FTC) limitation. The impetus behind the CFC netting rule was to curtail a perceived abuse that had U.S. taxpayers generating low-taxed foreign-source income to use excess FTCs; the effect is a reduction in foreign-source income and the FTC, which results in a higher U.S. tax liability.

The applicability of the CFC netting rule in any given year will depend on whether the taxpayer has both "excess related group indebtedness" (ERGI) and "excess U.S. shareholder indebtedness" (ESI). ERGI equals the amount by which related group indebtedness (average current year loans to CFCs) exceeds allowable related group indebtedness (generally, the average current year assets of CFCs multiplied by the average of the previous five years' ratios of average loans to CFCs to their average assets). ESI is correspondingly the amount by which the U.S. parent company's unaffiliated indebtedness exceeds allowable unaffiliated indebtedness (generally, the average current year assets of the U.S. shareholder multiplied by the average of the previous five years' ratios of average unaffiliated loans to average assets of the U.S. shareholder). (There are certain safe harbor provisions and elections available to mitigate the impact of the CFC netting rule; however, they are beyond the scope of this discussion.)

If ERGI and ESI are both present, the U.S. parent company's third party interest expense is allocated against interest income from CFCs using the following formula:

Interest income Lesser of ERGI from related or ESI group x Related group indebtedness indebtedness As a possible way to eliminate (or at least minimize) the impact of the CFC netting rule, the U.S. shareholder could (in lieu of making direct loans to its CFCs) capitalize an intermediary finance subsidiary in a tax haven with sufficient cash and have that subsidiary lend to the applicable CFCs. It may also be possible to contribute existing direct loans to the finance subsidiary, provided gain under Sec. 367 could be avoided or minimized. By structuring internal financing in this manner, the interest...