Swap Recharacterized for Lack of Business Purpose

Field Service Advice (FSA) 200031023 illustrates several missteps in tax planning. In an attempt to repatriate foreign earnings without incurring tax, a taxpayer entered into a swap and then sold income rights under the swap to its foreign subsidiaries. The taxpayer claimed that it had entered into the swap to hedge interest rate risk, but was unable to substantiate its business purpose. The IRS recharacterized the swap as a loan from the foreign subsidiaries, thus treating the taxpayer as having repatriated foreign earnings under Sec. 956.

In FSA 200031023, the taxpayer's foreign subsidiaries had earnings that had not been subjected to tax under subpart F. The taxpayer wished to repatriate these earnings without incurring tax. It was approached by a bank that was aware of the taxpayer's predicament. The bank suggested a way to repatriate earnings by entering into a 20-year swap transaction and then selling income rights for years six through 20 to the foreign subsidiaries. The payments by the foreign subsidiaries in exchange for these income rights would repatriate the untaxed earnings. The taxpayer treated the payments as prepayments under the swap and deferred them until later years. To support this treatment, it made an advantageous interpretation of Notice 89-21, which provided guidance at that time on notional principal contracts.

Following ACM Partnership, 157 F3d 231 (3d Cir. 1998), the Service applied both the economic substance doctrine and the step-transaction doctrine to disregard the swap. It recharacterized the transaction as a loan made by the foreign subsidiaries to the taxpayer. The IRS treated the taxpayer's payments under the swap as servicing the debt, and treated the swap counter-party as merely an accommodation party. By recharacterizing the transaction as a loan, the Service was able to treat the taxpayer as having repatriated foreign earnings under Sec. 956. (Note: Recharacterizing the transaction as a loan may not be entirely correct, given that there was no sum certain that the taxpayer would have to pay under the transaction.)

The taxpayer argued that it had a business purpose for entering the swap. It claimed it was hedging interest rate risk for its commercial paper. It acknowledged that the sales of income rights to the foreign subsidiaries were wholly motivated by tax planning, but argued that the swap itself had a business purpose and should be respected. The IRS built a heavily factual case to cast doubt on the taxpayer's claimed business purpose. It obtained promotional materials provided by the bank; these materials discussed only repatriation strategies and made no mention of using the strategy to hedge interest rate risk. The taxpayer's in-house analysis also discussed only tax concerns; it never crunched numbers to determine whether the swap made good business sense. The taxpayer had also undermined its business purpose by entering into a "mirror" swap to eliminate its risk under the original swap. In addition, it did not have a plausible reason why it would hedge its short-term borrowings with what appeared to be a highly illiquid, long-term swap. Finally, the Service placed significance on the possibility that the taxpayer had been charged a fee based on expected tax savings.

The transaction would have been less susceptible to attack had the taxpayer planned more carefully. To improve the transaction, the promotional materials should have provided nontax business reasons, and the taxpayer should have documented the transaction to support its business purpose. Finally, the taxpayer could have assigned income rights under an existing swap that it had entered into in connection with its business, or at least tried to match the swap with the items that it claimed to be hedging. Using an "old and cold" swap would have made it harder for the IRS to disregard the transaction.

From Helen S. Yanchisin, J.D., and Alan B. Munro, J.D., LL.M., CPA, Washington, DC