The final conduit regulations.

• Author: Hawkins, Edward J.

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.

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