The conduit regulations: a primer.

• Author: Hawkins, Edward J.

Overview

The Revenue Reconciliation Act of 1993 added section 7701(l) to the Internal Revenue Code. The new provision consists of a single sentence that authorizes the Department of the Treasury to issue regulations "recharacterizing any multiple-party financing transaction as a transaction directly among any two or more of such parties" where the Internal Revenue Service determines that this is necessary to prevent tax avoidance.

The statutory language is very broad, but the legislative history described the particular situations intended to be addressed solely in terms of international transactions, primarily loans where an intermediate entity is inserted between the lender and the borrower for treaty-shopping purposes.

The typical treaty-shopping situation arises when interest payments to the "real" lender would be subject to the 30-percent U.S. withholding tax but interest payments to the intermediate entity would be protected from all or most of the U.S. withholding tax by a tax treaty between its country and the U.S. Assuming that the intermediate entity can avoid tax in its own country on the interest it receives by deducting the interest it pays to the real lender, the tax savings can be substantial.

On October 14, 1994, the Internal Revenue Service promulgated proposed regulations under the new conduit provision. The regulations are reasonably restrained in most respects and generally limited to the "treaty shopping" problem described in the legislative history.(1) Taxpayers should be aware, however, that the conduit rules are rather aggressive in two respects--their retroactivity and their effect on tax treaties.

As promulgated, the conduit regulations are to be applied to payments made after 30 days from the time they are published in final form. This effective date would be retroactive in the sense that the regulations would apply to deny the expected benefits of lower U.S. withholding rates for future interest payments on hundreds of existing financings, even if the financings were entered into before the publication of the proposed regulations or even before the enactment of section 7701(l).(2)

Modern U.S. tax treaties contain provisions specifically dealing with treaty shopping. If these anti-treaty shopping provisions are satisfied, the treaty benefits should be available. Under the proposed regulations, however, a new and rigoroous set of requirements must be met. The question whether this constitutes an improper override of treaties is discussed at the end of this article.

Basic Framework of Proposed Regulations

The proposed regulations focus exclusively on the use of back-to-back financings designed to avoid tax liability under section 881, which imposes U.S. tax on foreign entities receiving interest and dividend income from U.S. sources.(3) The scope of the regulations could clearly have been broader. Indeed, the legislative history of section 7701(l) refers to section 956, dealing with loans by controlled foreign corporations to a related U.S. borrower, but the conduit regulations do not extend to section 956 or any other section of the Code not related to the taxation of U.S. source income. Lest too much comfort be drawn from the limitation to section 881 and the related sections, the preamble to the regulations states that the IRS and Treasury are considering the circumstances under which the recharacterization provided for in the regulations should be extended to other Code sections.

Because the substantive rules generally refer only to section 881, incorporating the related sections simply by reference, the proposed regulations are primarily located in Prop. Reg. [sections] 1.881-3, with some recordkeeping and reporting requirements in Prop. Reg. [sections] 1.881-4. New paragraphs have also been added to the withholding regulations at Prop. Reg. [sections][sections] 1.1441-3(j) and 1.1441-7(d), and conforming changes made to regulations under other related sections. Of particular interest in Prop. Reg. [sections] 1.881-3(f) is a set of 16 examples illustrating the operation of the new substantive rules.

The basic case to which the regulations refer is a relatively simple three-party transaction. The first party is a foreign "financing entity" that is the source of the financing. The second party is an "intermediate entity," which receives funds from the financing entity and then lends funds to the third party, a U.S. entity referred to as the "financed entity" in the regulations but as the "borrower" in this article.

The chief purpose of the regulations is to define the circumstances when, in the basic case or one of its variations, the intermediate entity is a conduit. "Conduit," as used in the regulations, refers only to an intermediate entity whose participation in the transaction is to be disregarded. In such cases, the interest paid by the borrower is considered to be paid directly to the financing party. That interest, therefore, is subject to a U.S. withholding tax that would have been wholly or in part avoided if the interest were considered to be paid to the conduit, which is typically located in a country with a favorable tax treaty.

The decision whether an intermediate party is a conduit is made by the IRS, applying the standards in the regulations.(4) The preamble to the regulations states that this decision will be subject to judicial review under an abuse of discretion standard. In determining tax liability, the conduit regulations can only be used by the IRS and cannot be invoked affirmatively by the taxpayer to overturn the form of its transactions, though a taxpayer may comply with the regulations in order to avoid the imposition of interest and penalties.(5)

Standards to Be Applied

Generally speaking, the proposed regulations provide that, where the intermediate party is related to one or both of the other parties, the IRS may treat the intermediate party as a conduit if the participation of the intermediate party in the financing arrangement (i) reduces the tax imposed by section 881, and (ii) is pursuant to a tax avoidance plan.(6) The term "financing arrangement" means two or more financing transactions pursuant to which the financing entity advances money to an intermediate party, and the intermediate party advances money to the borrower. It also covers cases where there are multiple intermediate entities, or "any other series of steps" that achieve substantially the same result.(7)

Since the regulations do not apply unless there is a financing arrangement, and there is no financing arrangement without two financing transactions, the definition of financing transaction operates as a substantive...