On January 11, 2007, the IRS issued guidance on the application of section 954(c)(6) (the “CFC look-through rule”). Section 954(c)(6), which is generally effective from 2006 through 2008, grants an exclusion from Subpart F income for certain dividends, interest, rents, and royalties received or accrued by one CFC from another related CFC. The purpose of the CFC look-through rule is to allow taxpayers to reinvest their active foreign earnings without triggering Subpart F income. Notice 2007-9 resolves several technical issues that have arisen under the statute in a way that is generally favorable to taxpayers and consistent with legislative intent. The Notice also lists several categories of transactions that the IRS considers contrary to the purposes of the CFC look-through rule and therefore not entitled to the benefits of section 954(c)(6). The Notice does not explicitly articulate a rationale for distinguishing such abusive transactions from non-abusive transactions and, as a result, taxpayers may face some uncertainty when evaluating arrangements not described in the Notice.

Dividends

The Notice clarifies that, for purposes of section 954(c)(6), the term “dividends” includes amounts treated as dividends under section 302 or section 304. The application of the CFC look-through rule to section 304 transactions was unclear prior to the Notice, and this is a welcome clarification. The Notice also provides that the CFC look-through rule will apply to gains treated as dividends pursuant to sections 964(e) and 356(a)(2). Certain deemed dividends arising by application of section 367(b) are not, however, considered dividends for purposes of the CFC look-through rule. Additionally, dividends that are attributable to effectively connected income (“ECI”) are not eligible for look-through treatment.

To qualify for look-through treatment, the CFC paying the dividend and the CFC receiving the dividend must be related persons at the time the dividend is received. The Notice clarifies that, for this purpose, it is irrelevant whether the earnings and profits were accumulated during a period that the payor constituted a CFC, or during a period when recipient qualified as a related person.

Partnerships and Attribution Rules

The Notice generally applies an aggregate theory for payments by or made to a partnership. Thus, interest, rents, and royalties paid by a partnership having one or more CFC partners are generally entitled to the benefits of the CFC look-through rule. This result is consistent with the result under the “Brown Group regulations” that apply the section 954(c)(3) same-country exception in the partnership context. Similarly, dividends, interest, rents, and royalties received by a partnership with one or more CFC partners are also generally entitled to the benefits of the CFC look-through rule. The Notice provides rules to determine the extent to which interest, rents, and royalties are attributable or allocable to income that is neither Subpart F income nor ECI, such that they do not give rise to Subpart F income under the CFC look-through rule.

Anti-Abuse Rules

The Notice lists four categories of abusive transactions that are ineligible for the benefits of the CFC look-through rule. This list is not exclusive, however, and the Notice declares the government’s intention to provide additional anti-abuse rules in the future. In the meantime, the listed examples provide little explicit guidance as to basic principles or themes for distinguishing legitimate transactions from those that are “abusive of the purposes of section 954(c)(6).” The guidance applies to two of the categories as of the start of 2006, and to the other two as of the start of 2007.

The first category of abusive transactions involves the reduction of income from the U.S. tax base without a corresponding inclusion of subpart F income, where such inclusion would have resulted in the absence of section 954(c)(6). In the example, a U.S. shareholder claims a loss in the context of the factoring of receivables of one CFC by another related CFC. The second category of abusive transactions involves dividends that reduce the applicable earnings of a CFC under section 956 and that consequently reduce the income inclusion that would otherwise arise as a result of the CFC’s investment of earnings in U.S. property.

These two categories of transactions involve the use of the CFC look-through rule to result in an immediate reduction in a U.S. shareholder’s taxable income (subpart F or otherwise). The anti-abuse rules apply to these categories of transactions as of the start of 2006.

The third and fourth categories of abusive transactions involve attempts to change the character of income earned or accrued by a CFC so that it qualifies for favorable treatment under the CFC look-through rule. The third category involves the use of options to cause a foreign corporation to become a CFC payor in order to qualify for the benefits of the CFC look-through rule. The final example involves the use of a conduit CFC where direct payment would have resulted in subpart F income. The anti-abuse rules apply to these categories of transactions as of the start of 2007 and only if the principle purpose of the arrangement is to qualify payments for the CFC look-through rule. Thus, for example, if an option arrangement is put into place to avoid the application of the PFIC rules pursuant to section 1297(e), perhaps the anti-abuse rule would not apply to deny the benefit of the CFC look-through rule.

Taxpayers should consider the application of the anti-abuse rules when entering or making use of arrangements a significant purpose of which is to use the CFC look-through rule. This is particularly the case where the CFC look-through rule could be considered to result in an immediate reduction in a U.S. shareholder’s taxable income (subpart F or otherwise), if a CFC’s equity structure involves options, warrants, or other stock rights that implicate the constructive ownership rules, or if principles such as those of Treas. Reg. § 1.881-3 could be applied to subsequent payment of the look-through proceeds to other persons.

Conclusion

Notice 2007-9 is the most recent of several developments in the Subpart F area. Given the temporary nature of section 954(c)(6), taxpayers may not receive further clarification in the form of regulations. With such little guidance, taxpayers should operate with care when pursuing planning that relies upon the CFC look-through rule.

For further information, please contact any of the following lawyers:

Marc Gerson, mgerson@milchev.com, 202-626-1475

Rocco Femia, rfemia@milchev.com, 202-626-5823

Layla Asali, lasali@milchev.com, 202-626-5866

Kimberly Majure

The information contained in this communication is not intended as legal advice or as an opinion on specific facts. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. For more information, please contact one of the senders or your existing Miller & Chevalier lawyer contact. The invitation to contact the firm and its lawyers is not to be construed as a solicitation for legal work. Any new lawyer-client relationship will be confirmed in writing.

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