The New York State Bar Association’s Tax Section has recently published a report highlighting that, in a variety of commonplace circumstances where a controlled foreign corporation (CFC) engages in certain routine treasury center and hedging activities, the application of existing subpart F rules can frequently lead to tax results that are inconsistent with the CFC’s economic position.
These inconsistencies stem from the treatment of currency gains as subpart F income. The report explores whether the relevant existing rules can be interpreted under current law to minimize unpredictable or adverse consequences or, alternatively, how the rules might be modified to reduce the likelihood of unpredictable or unreasonable tax consequences.
After analyzing tax and economic inconsistencies, the Report concludes by requesting that the Internal Revenue Service clarify the application of existing subpart F exceptions to currency gains.
Certain results inconsistent with the US owner’s economic position
The Report describes in detail three specific instances that result in subpart F income and appear to be inconsistent with the economic position of the US owner of the CFC:
- a CFC that is a member of a US multinational group, performing treasury functions via acting as a financing entity for other group members by borrowing from banks in various currencies and on-lending those amounts to other group members (a TCFC)
- a CFC that hedges its exposure to certain property held by a qualified business unit (QBU) of the CFC that operates in a different functional currency from that of the parent CFC and
- a CFC that hedges its investment in a subsidiary CFC that operates in a different functional currency from that of the parent CFC, which is referred to as a net investment hedge or a Hoover hedge.
I. A TCFC borrows funds from banks in various currencies and on-lends these funds to other group members with functional currencies different from the TCFC
The definition of a “dealer in securities” under Internal Revenue Code Section 475(c)(1) and Section 954(c)(2)(C) triggers inconsistent results between a TCFC’s borrowing and lending function.
The Report details that the TCFC is considered a “dealer in securities” within the meaning of Section 475(c)(1), but will not be considered a dealer in securities within the meaning of Section 954(c)(2)(C). Under Section 475, a taxpayer that regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business is a “dealer in securities”. Conversely, a “dealer in securities” for purposes of Section 954 is a CFC that purchases property from and sells property to customers that are not related persons. Therefore, because a TCFC’s “customers” are generally related affiliates, it is not a “dealer in securities” under Section 954 (but is for purposes of Section 475.1
Under Section 475, a “dealer in securities” is required to mark-to-market its lendings at the end of the taxable year, but is not permitted to mark-to-market the borrowing. Any gain or loss with respect to the lending (stemming from the mark-to-market) is likely to be treated as subpart F foreign personal holding company income under Section 954; however, pursuant to a “special rule” under Section 1.954-2(g)(2)(iii) pertaining to interest-bearing liabilities (the Currency Gain / Loss Allocation Rule), any currency gain or loss with respect to the borrowing will be allocated between the TCFC’s subpart F and non-subpart F income in the same manner as interest expense associated with the borrowing.
The result is that the TCFC will realize annual subpart F currency gain or loss with respect to the lending, but the TCFC will not realize any currency gain or loss with respect to the borrowing until the loan maturity date (other than with respect to payments of interest).
Therefore, there is a mismatch in timing of subpart F recognition. It should be noted that, upon maturity, the currency gain or loss on the borrowing will be allocated between subpart F and non-subpart F income under the rules for allocating interest expense (similar to recognition on borrowings).
Suggestions to resolve the mismatch
The Report suggests that one way to resolve the mismatch is to ensure that the currency gain or loss is excluded from the computation of subpart F income. To achieve this, the Report proposes the expansion of the “Business Needs Exception.” This exception excludes from subpart F income any currency gain or loss attributable to any transaction directly related to the business needs of a CFC.2 A transaction by a CFC that is a regular dealer in property is generally treated as directly related to the business needs of such CFC.3 The Report notes that because a TCFC is not defined as a “dealer in securities” for 954(c)(2)(C) purposes, its hedges cannot be deemed entered into in the ordinary course of business and, therefore, such transactions do not qualify for the Business Needs Exception.
The Report advocates regulatory clarifications or amendments to expand the Business Needs Exception to (1) treat a TCFC as a “dealer in securities” under Section 954(c)(2)(C), ensuring that the TCFC’s activities are considered as directly related to its business needs under Section 1.954-2(g)(2)(ii)(C)(1); or (2) specify that the aforementioned borrowing and lending are both subject to the Business Needs Exception and explicitly provide that the Gain / Loss Allocation Rule is inapplicable to liabilities that qualify for the Business Needs Exception.
Alternatively, the Report proposes a regulatory clarification that the borrowing can be treated as a hedge of the lending under Section 475 (and, therefore, is eligible to be marked-to-market), and to provide that the gain or loss from the borrowing is not subject to the Gain / Loss Allocation Rule to the extent such gain or loss is recognized from the hedged Section 475 security.
The Report also proposes an alternative regulatory clarification or amendment which would permit the TCFC to bifurcate a non-functional currency borrowing into a functional currency borrowing and a “currency swap.” The currency swap would be treated as a Section 475 security, and could be marked-to-market, and thus matched with the associated non-functional currency lending. The Report also discusses and dismisses as inadequate other proposed regulatory clarifications and amendments to solve the TCFC transactions mismatch.
II. CFC hedging its exposure to ordinary property held by a Section 987 QBU of the CFC that operates in a different functional currency from that of the parent CFC
Section 987 generally addresses the computation of foreign branch taxable income and recognition of its remittances to its owner, and mandates the use of the profit and loss method of computing foreign branch income.4
A foreign subsidiary owned by a CFC may be considered a Section 987 QBU if it meets the following conditions:
- the foreign subsidiary utilizes a different functional currency from the CFC
- the foreign subsidiary has elected to be disregarded as a separate entity for US tax purposes via a check-the-box election and
- the foreign subsidiary keeps separate records and books from the CFC.
The Report highlights several areas where it is not clear whether the application of Section 987 rules would prevent a CFC’s use of the Business Needs Exception for hedging transactions.
The Business Needs Exception excludes from subpart F income the gains and losses that stem from bona fide hedging transactions (Business Needs Hedges).5 A bona fide hedge transaction, and its resulting currency gains and losses, is excluded from the computation of subpart F income if it:
- is entered into in the normal course of the CFC’s business
- does not itself give rise to subpart F income other than foreign currency gains and losses
- is not a forward contract or similar transaction and
- includes a currency exposure.
The CFC must clearly demonstrate that the gains and losses are derived from the bona fide hedging transaction.6 A transaction that hedges the liabilities or assets of a related person or that is entered into to reduce risks of a related person is not a bona fide hedge.7
Should the Business Needs Exception apply?
While the Report contends that under current law it is likely appropriate for the CFC to exclude a QBU’s hedging currency gains or losses from the computation of subpart F income under the Business Needs Exception, it goes on to identify gray areas in this regard. For example, the Report poses the following questions:
(1) Is a foreign branch a “related person” with respect to the CFC for these purposes, such that the CFC could not hedge its branch’s inventory in a bona fide hedge transaction?8
(2) Would certain hedging transactions that would otherwise meet the requirements fail to qualify due to the application of the Section 987 rules categorizing the transaction as a hedge of tax attributes rather than of Business Needs Property?
(3) Is a currency gain or loss under this fact pattern rendered not “clearly determinable” from the books and records of the CFC as a consequence of the Section 987 regime, precluding qualification for the Business Needs Exception?
In analyzing these circumstances, the Report contends that under current law the Business Needs Exception should apply. However, when a position is incorrectly identified as a hedge, or when it is inappropriately not identified as a hedge, there can be severe consequences, and the Report, noting this, calls for further regulatory clarifications.
III. A CFC hedging its investment in a subsidiary CFC that operates in a different functional currency from that of the parent CFC
Where a CFC hedges its investment in a foreign subsidiary operating in a different functional currency, the transaction is often called a net investment hedge or a Hoover hedge. The landmark Tax Court case Hoover Company v. Comm’r9 held that these transactions are not appropriately characterized as “hedging transactions” for US tax purposes. This is because the foreign subsidiary is considered a “related person” and not an extension of the CFC, which would be the case if the subsidiary was a disregarded entity.10 These Hoover hedges may result in currency gains or losses as a result of the appreciation or depreciation of the subsidiary’s functional currency in regards to the CFC’s own functional currency.
Under current law, it is unlikely that these gains or losses could be excluded from subpart F income. The Hoover hedges do not meet the Business Needs Exception because they are not considered hedges.
The Report calls for a complete overhaul of the treatment of a Hoover hedge, or a modification to the Business Needs Exception, to allow for the exclusion of Hoover hedge gains or losses from subpart F income. Because this would be a significant undertaking, the Report proposes a modification to the Business Needs Exception to include Hoover hedge gains and losses as qualifying under the Business Needs Exception, thereby excluding such gains and losses from the computation for subpart F income.
IV. Need for a policy decision
The Report concludes that a policy decision must be made as to whether and how broadly to clarify or expand the Business Needs Exception from subpart F income with respect to currency gain and loss.
The various scenarios described in the Report are not unusual and apply to many international businesses today. Until further clarifications are provided, the potential inconsistent and unpredictable tax implications can pose a trap for the unwary. The full Report is available at www.nysba.org.