The Limited, Inc., and Consolidated Subsidiaries v. Commissioner , 113 T.C. No. 13 ( 1999 )

113 T.C. No. 13UNITED STATES TAX COURT
THE LIMITED, INC., AND CONSOLIDATED SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 26618-95. Filed September 7, 1999.
P’s subsidiary, D, a domestic corporation, is a
credit card bank, issuing private label credit cards to
customers of P. F1 is a controlled foreign corporation
with respect to P. F2 is a foreign subsidiary of F1.
F1 funded F2, which purchased certificates of deposit
(CDs) from D.
Held: The CDs are U.S. property within the
meaning of sec. 956(b)(1), I.R.C., and not deposits
with persons carrying on the banking business within
the meaning of sec. 956(b)(2)(A), I.R.C. Held,
further, the CDs are attributed to F1 pursuant to sec.
1.956-1T(b)(4), Temporary Income Tax Regs., 53 Fed.
Reg. 22163, 22165 (June 14, 1988). Held, further, P
must include the increase of investment in U.S.
property in gross income pursuant to sec. 951(a)(1)(B),
I.R.C.
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Joel V. Williamson, Roger J. Jones, Frederic L. Hahn,
Daniel A. Dumezich, Russel R. Young, Neil B. Posner, James P.
Fuller, Kenneth B. Clark, Ronald B. Schrotenboer, William F.
Colgin, Jr., and Patricia A. Yurchak, for petitioner.
Christine A. Roth, James E. Kagy, Donald K. Rogers, and
John Budde, for respondent.
HALPERN, Judge: Petitioner is the common parent corporation
of an affiliated group of corporations making a consolidated
return of income (the affiliated group). By notice of deficiency
dated September 29, 1995 (the notice), respondent determined
deficiencies in Federal income tax for the affiliated group for
its taxable years ended February 1, 1992, and January 30, 1993
(1992 and 1993, respectively), in the amounts of $72,040,547 and
$95,836,934, respectively. Many of the adjustments giving rise
to the deficiencies determined in the notice have been settled,
and this report addresses only whether certain transfers during
1993 were investments in U.S. property for purposes of those
provisions of the Internal Revenue Code dealing with controlled
foreign corporations.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue.
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FINDINGS OF FACT
Introduction
Some of the facts have been stipulated and are so found.
The stipulations of facts filed by the parties, with accompanying
exhibits, are incorporated herein by this reference. Petitioner
has its principal place of business in Columbus, Ohio.1
Business of Petitioner
Petitioner is one of the largest specialty retailers in the
United States. During the years at issue, it sold its
merchandise both in its own stores and by catalog. Among the
well-known stores owned by petitioner (the stores) were The
Limited, Lane Bryant, Lerner New York, Victoria’s Secret, and
Abercrombie & Fitch. Petitioner earned its income primarily from
the sale of garments. A foreign subsidiary of petitioner
manufactured many of those garments or contracted with others for
their manufacture.
Payments by Customers
Merchandise sold by petitioner is paid for with cash, by
check, or by credit card. Petitioner accepts two types of credit
cards: (1) petitioner’s private-label credit card, which is
1
In the stipulations, the parties have adopted the convention
of referring to the affiliated group as “petitioner”; hereafter,
we will use the term “petitioner” to refer both to the affiliated
group and to any member, so long as specific identification of
that member is unnecessary.
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honored only in one or more of petitioner's stores, and (2) a
credit card issued by a third-party bank or other financial
institution and honored by many merchants.
Petitioner’s Private-Label Credit Cards
Prior to 1982, petitioner issued no credit cards.
In 1982, petitioner acquired two retailers of women’s
clothing that had preexisting open-end credit plans: i.e.,
credit plans providing for repeated extensions of credit with no
fixed dates for repayment. Petitioner organized two new
subsidiary corporations to take over the operation of those
credit plans. Those two corporations were Limited Credit
Services, Inc. (Limited Credit), a Delaware corporation, and
World Financial Network, Inc. (WFN), also a Delaware corporation.
Limited Credit administered petitioner's open-end credit
operations. WFN funded the consumer credit associated with the
open-end credit systems through a receivables financing facility.
Eventually, Limited Credit and WFN came to operate credit plans
for some of petitioner's other stores.
The credit plans operated by Limited Credit were established
under the retail installment sales acts enacted in each of the
50 States, the District of Columbia, and Puerto Rico. Limited
Credit was required to comply on a State-by-State basis with
varying limitations on interest rates, minimum finance charges,
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delinquency charges, uncollectible check fees and methods for
calculating the average daily balance of accounts.
Organization of World Financial Network National Bank
In 1986, Ralph E. Spurgin (Spurgin) joined petitioner’s
organization and became president of Limited Credit. Spurgin
believed that petitioner could increase the profitability of its
credit card operations if it could avoid the various States'
retail installment sales acts. In particular, he believed that,
if petitioner could avoid setting interest rates on a State-by-
State basis, and charge a uniform rate, it could earn an
additional $10 million dollars in revenue. Spurgin believed that
a way to avoid the States' retail installment sales acts was, in
some manner, to employ a national bank to extend credit to
customers of the stores (a bank that would not be subject to the
various States' retail installment sales acts).2
2
A national banking association is permitted to charge
interest for any extension of credit at the rate permitted by the
State in which it is located or, alternatively, a rate 1 percent
greater than the 90-day discount rate in effect in the Federal
Reserve district in which the national banking association is
located, whichever is higher. 12 U.S.C. sec. 85 (1994),
12 C.F.R. sec. 7.4001 (1999); Marquette Natl. Bank v. First of
Omaha Serv. Corp., 439 U.S. 299 (1978). Prior to the decision in
Marquette, the majority of analysts assumed that a national bank
was not permitted to export the interest rate permitted by the
State in which it was located, but, rather, was subject to the
usury restrictions imposed by each of the States in which its
credit card customers resided.
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The Bank Holding Company Act of 1956 (BHCA), ch. 240, 70
Stat. 133, currently codified at 12 U.S.C. secs. 1841-1850
(1994), concerns the ownership of banks. In general, BHCA
prohibits companies that own banks from engaging in any business
other than banking or a business closely related to banking. See
12 U.S.C. sec. 1841 (1994). In 1987, in part to deal with the
problem of “nonbank banks” (institutions regulated as banks but
exempt from key provisions of BHCA because of their failure to
meet the definition of a bank under BHCA), Congress amended BHCA.
See the Competitive Equality Banking Act of 1987 (CEBA), Pub. L.
100-86, sec. 1004(b), 101 Stat. 552, 659.3 CEBA broadened the
3
S. Rept. 100-19 (1987) accompanied S. 790, 100th Cong. 1st
Sess. (1987), which, substantially as passed by the Senate,
became Pub. L. 100-86, 101 Stat. 552 (Competitive Equality
Banking Act of 1987 (CEBA)). See H. Conf. Rept. 100-261 (1987).
Immediately prior to CEBA, the Bank Holding Company Act of 1956
(BHCA), ch. 240, 70 Stat. 133, currently codified at 12 U.S.C.
secs. 1841-1850 (1994), defined a “bank” as an institution that
both accepted demand deposits and made commercial loans. 12
U.S.C. 1841(c)(1) and (2) (1982). The Senate Comm. on Banking,
Housing, and Urban Affairs (the Committee) believed that that
definition created a loophole (the “nonbank loophole”) for a bank
that refrained from one of those two activities and, thus, was
not considered a bank for purposes of BHCA. For instance, the
Committee believed that a nonbank bank could offer interest
bearing NOW accounts rather than demand deposits and escape
regulation under BHCA. S. Rept. 100-19, supra at 5-6. The
Committee found:
The impetus for nonbank banks stems primarily from
large diversified companies wanting to invade the
banking business while avoiding the regulatory
restraints of the Bank Holding Company Act. Thus some
of the nation’s largest retailing, securities, and
(continued...)
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definition of a bank for purposes of BHCA but excluded from that
definition institutions engaging only in credit card transactions
(credit card banks).4 Thus, a company like petitioner, which was
engaged in neither banking nor a banking related business, could
own a credit card bank without violating BHCA. CEBA cleared the
3
(...continued)
insurance companies have been able to enter the banking
business through the nonbank loophole while banks are
prevented from entering those businesses by the Bank
Holding Company Act.
Id. at 6. The Committee believed that a failure to close the
nonbank loophole would cause a number of problems in the banking
system, including creating new competitive inequalities for bank
holding companies, whose activities, under BHCA, must be closely
related to banking. Id. at 7-9. To close the nonbank loophole,
Congress expanded the definition of the term “bank” in BHCA to
include any bank whose deposits are insured by the Federal
Deposit Insurance Corp., as well as any institution that
(1) accepts demand deposits or deposits that the depositor may
withdraw by check or similar means for payment to third parties
and (2) engages in the business of making commercial loans. See
12 U.S.C. sec. 1841(c)(1) (1994), as amended by CEBA, sec. 101,
101 Stat. 554-557. Congress maintained certain express
exclusions from the definition of the term “bank” and provided
certain, additional limited exceptions for, among other
institutions, credit card banks. See 12 U.S.C. sec. 1841(c)(2)
(1994); S. Rept. 100-19 supra at 11. An institution qualifies as
a credit card bank if it (1) engages only in credit card
operations, (2) does not accept demand deposits or deposits that
the depositor may withdraw by check or similar means for payment
to third parties or others, (3) does not accept any savings or
time deposits of less than $100,000 (except for certain deposits
held as collateral), (4) maintains only one office that accepts
deposits, and (5) does not engage in the business of making
commercial loans. 12 U.S.C. sec. 1841(c)(2)(F) (1994).
4
See supra note 3.
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way for petitioner to own a bank that could charge a uniform rate
of interest on credit card sales.5
As of March 15, 1989, World Financial Network National Bank
(WFNNB) was organized under the National Bank Act, see 12 U.S.C.
sec. 24 (1994). On May 1, 1989, the Comptroller of the Currency
issued a charter certificate to WFNNB authorizing it to commence
the business of banking as a National Banking Association. The
articles of association of WFNNB (the articles) state that the
association is organized to carry on the business of banking
under the laws of the United States. The articles incorporate in
full the CEBA credit card institution restrictions. See supra
note 3. In pertinent part, Article THIRD provides:
The association
(i) will engage only in credit card operations;
(ii) will not accept demand deposits or deposits that
the depositor may withdraw by check or similar
means for payment to third parties or others;
(iii) will not accept any savings or time deposit of less
than $100,000;
(iv) will maintain no more than one office that accepts
deposits;
(v) will not engage in the business of making commercial
loans; * * *
Petitioner subscribed to 175,000 shares of the common stock of
WFNNB (par value $17.5 million). In consideration of receipt of
those shares, petitioner contributed all of the stock of Limited
5
In 1986, Ralph E. Spurgin believed that the Comptroller of
the Currency had put a moratorium on the organization of nonbank
banks that would issue credit cards.
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Credit and WFN to WFNNB, which corporations were thereafter
liquidated and dissolved. WFNNB is a wholly owned subsidiary
corporation of petitioner.
Credit Operations of World Financial Network National Bank
Upon receipt of its charter, WFNNB entered into agreements
(the merchant agreements) with the stores. The merchant
agreements concerned credit cards to be issued by WFNNB to
customers of the stores and embodied the contractual relationship
between WFNNB and the stores with respect thereto. Among other
things, the merchant agreements entitled WFNNB to issue credit
cards bearing the name and logo of each store to customers of
that store.
Also upon receipt of its charter, WFNNB sent notices (change
of terms notices) to holders of the credit cards previously
issued under the credit plans operated by Limited Credit and WFN.
The change of terms notices, among other things, informed such
credit card holders that WFNNB would be the extender of credit on
their account and, for credit card holders in certain States,
there would be an increase in the interest rate on their
accounts.
As of January 30, 1993, WFNNB had opened 12.9 million credit
card accounts, and it had outstanding credit card loans in excess
of $757 million.
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WFNNB: Capitalization and Liquidity Needs
WFNNB had cash (liquidity) needs that could not be met
without borrowing. Limited Service Corp. (Limited Service),
another member of the affiliated group, performed the “treasury
function” for WFNNB. That function included assisting WFNNB in
meeting its liquidity needs. Limited Service had access to funds
generated by petitioner’s sale of its commercial paper.
Initially, WFNNB’s liquidity needs were met from within the
affiliated group. On May 1, 1989, Limited Service granted WFNNB
a line of credit in the amount of $500 million. On December 1,
1993, Limited Service increased to $1 billion the line of credit
it granted to WFNNB. At various times, WFNNB obtained funds from
Limited Service pursuant to various other long- and short-term
loan agreements. WFNNB also borrowed money from, and was granted
lines of credit by, various unrelated, outside lenders. On
December 4, 1992, WFNNB was granted a $280 million line of credit
by a syndicate of 17 banks. WFNNB never drew on that line of
credit because it could obtain funds less expensively from
Limited Service.
Certificates of Deposit
WFNNB first issued (sold) a certificate of deposit (CD) on
May 1, 1989. That CD was sold to Limited Service for $100,000,
the minimum acceptable time deposit pursuant to the CEBA
restrictions incorporated in the articles.
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On November 19, 1992, by letter agreement (the letter
agreement), WFNNB appointed Merrill, Lynch, Pierce, Fenner &
Smith, Inc. (Merrill Lynch), as its agent for its customers who
desired to purchase CDs. The letter agreement provided that the
CDs would be sold in denominations of $100,000 or integral
multiples thereof.
During December 1992 and January 1993, WFNNB, acting through
its agent, Merrill Lynch, sold 17 CDs, receiving $26.3 million.
Those 17 CDs comprised 263 “transferable individual time deposit
accounts” of $100,000 each. Each of those accounts was insured
by the Federal Deposit Insurance Corp.
MFE (Netherlands Antilles) N.V. (MFE N.V.), is a Netherlands
Antilles corporation. On January 28, 1993, MFE N.V. purchased
eight CDs from WFNNB in the total amount of $174.9 million (the
MFE N.V. CDs). Each MFE N.V. CD was for a term of 1 year, showed
an annual interest rate of 3.1 percent (annual yield of
3.14 percent), and provided that it was a “non-negotiable and
non-transferable time deposit”. Each also provided: “This Time
Deposit shall renew automatically for a like term unless and
until notice of withdrawal is presented at the Bank within * * *
seven calendar days after the maturity date”.
Reduction of Indebtedness to Limited Service
On January 28, 1993, WFNNB transferred the $174.9 million
received from MFE N.V. on the sale of the CDs to Limited Service
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to reduce the balance outstanding under the line of credit
extended to WFNNB by Limited Service.
Petitioner’s Indirect Ownership of MFE N.V.
MFE N.V. is a fourth tier subsidiary of petitioner. The
relationship of MFE N.V. to petitioner, as well as the
relationship of WFNNB, Limited Service, and the stores to
petitioner is shown in the following diagram.
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Simplified Corporation Organizational Structure
January 1993
The Limited, Inc.
(US)
100% 100%
100%
100%
World Financial Mast
Limited Services Store Divisions
Network National Holding
Corporation (US) many
Bank (US) Corporation
“Limited Service” (US)
“WFNNB” (US)
100%
Mast Industries Inc.
“MII”
100%
Mast Industries
(Far East) Ltd.
(Hong Kong)
“MFE”
100%
MFE (Netherlands
Antilles) N.V.
(Netherlands Antilles)
“MFE N.V.”
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Organization and Operation of MFE and MFE N.V.
In 1970, Mast Industries, Inc. (MII) organized Mast
Industries (Far East) Ltd. (MFE) as a Hong Kong corporation. At
all times here pertinent, MFE had its headquarters and principal
place of business in Hong Kong. MFE is a “controlled foreign
corporation” (of petitioner) within the meaning of section
957(a).
MFE is a contract manufacturer for petitioner. It operates
throughout Asia, manufacturing or contracting for the manufacture
of garments to be sold by petitioner's stores.
MFE declared no significant dividends from the early 1980s
through 1993, resulting in accumulated earnings and profits in
excess of $330 million at the end of 1993.
On January 12, 1993, the directors of MFE resolved to
organize and capitalize MFE N.V. Among the stated purposes were:
“engaging in group financing activities and providing for a means
of investing and reinvesting liquid assets and funds.” The
directors of MFE further resolved to make a capital contribution
to MFE N.V. of $175 million. MFE N.V. had no employees during
January 1993. On January 28, 1993, MFE transferred $175 million
by wire to MFE N.V. That $175 million was used to purchase the
MFE N.V. CDs.
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OPINION
I. Introduction
World Financial Network National Bank (WFNNB), a national
banking association, is a wholly owned subsidiary of petitioner.
In 1989, WFNNB was organized (and today operates) as a credit
card bank to issue credit cards to customers of petitioner’s
stores. Mast Industries (Far East), Ltd. (MFE), a Hong Kong
corporation, also is a wholly owned subsidiary of petitioner.
MFE is a controlled foreign corporation within the meaning of
section 957 and, with respect to MFE, petitioner is a U.S.
shareholder within the meaning of section 951(b). MFE
(Netherlands Antilles) N.V. (MFE N.V.), a Netherlands Antilles
corporation, is a wholly owned subsidiary of MFE. On January 28,
1993, MFE N.V. purchased eight certificates of deposit (CDs) from
WFNNB in the total amount of $174.9 million (the MFE N.V. CDs).
We must determine whether, as a result of those purchases,
petitioner must include $174,127,665 in gross income under
section 951(a)(1)(B) on account of the investment by MFE of its
earnings in U.S. property.6 See sec. 956.
6
The record does not explain the discrepancy between the
$174.9 million purchase price and the $174,127,665 adjustment to
gross income.
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II. Internal Revenue Code and Regulations
The principal provisions of the Internal Revenue Code at
issue are sections 951 and 956. Sections 951 and 956 are found
in subpart F of part III, subchapter N, chapter 1 of the Internal
Revenue Code (subpart F). Subpart F concerns itself with
controlled foreign corporations. The term “controlled foreign
corporation” is defined in section 957(a).7 Section 951 provides
that each U.S. shareholder of a controlled foreign corporation
shall include in gross income certain amounts, including “his pro
rata share (determined under section 956(a)(2)) of the
corporation’s increase in earnings invested in United States
property”.
In pertinent part, section 956 provides:
(a) General Rules.--For purposes of this subpart--
(1) Amount of investment. The amount of
earnings of a controlled foreign corporation
7
Sec. 957(a) provides:
General Rule.--For purposes of this subpart, the term
“controlled foreign corporation” means any foreign
corporation if more than 50 percent of--
(1) the total combined voting power of all classes
of stock of such corporation entitled to vote, or
(2) the total value of the stock of such
corporation,
is owned (within the meaning of section 958(a)), or is
considered as owned by applying the rules of ownership
of section 958(b), by United States shareholders on any
day during the taxable year of such foreign
corporation.
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invested in United States property at the
close of any taxable year is the aggregate
amount of such property held, directly or
indirectly, by the controlled foreign
corporation at the close of the taxable year,
to the extent such amount would have
constituted a dividend (determined after the
application of section 955(a)) if it had been
distributed.
(2) Pro rata share of increase for year.
* * *
* * * * * * *
(b) United States property defined.--
(1) In general.--For purposes of subsection
(a), the term “United States property” means any
property acquired after December 31, 1962, which
is--
(A) tangible property located in the
United States;
(B) stock of a domestic corporation;
(C) an obligation of a United States person;
or
(D) any right to the use in the United
States of--
(i) a patent or copyright,
(ii) an invention, model, or design
(whether or not patented),
(iii) a secret formula or process, or
(iv) any other similar right,
which is acquired or
developed by the controlled
foreign corporation for use
in the United States.
(2) Exceptions.--For purposes of subsection (a),
the term “United States property” does not include--
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(A) obligations of the United States,
money, or deposits with persons carrying on
the banking business;
(B) property located in the United
States which is purchased in the United
States for export to, or use in, foreign
countries;
(C) any obligation of a United States
person arising in connection with the sale or
processing of property if the amount of such
obligation outstanding at no time during the
taxable year exceeds the amount which would
be ordinary and necessary to carry on the
trade or business of both the other party to
the sale or processing transaction and the
United States person had the sale or
processing transaction been made between
unrelated persons;
(D) any aircraft, railroad rolling
stock, vessel, motor vehicle, or container
used in the transportation of persons or
property in foreign commerce and used
predominantly outside the United States;
(E) an amount of assets of an insurance
company equivalent to the unearned premiums
or reserves ordinary and necessary for the
proper conduct of its insurance business
attributable to contracts which are not
contracts described in section 953(a)(1);
(F) the stock or obligations of a
domestic corporation which is neither a
United States shareholder (as defined in
section 951(b)) of the controlled foreign
corporation, nor a domestic corporation, 25
percent or more of the total combined voting
power of which, immediately after the
acquisition of any stock in such domestic
corporation by the controlled foreign
corporation, is owned, or is considered as
being owned, by such United States
shareholders in the aggregate;
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(G) any movable property (other than a
vessel or aircraft) which is used for the
purpose of exploring for, developing,
removing, or transporting resources from
ocean waters or under such waters when used
on the Continental Shelf of the United
States;
[Emphasis added.]
In pertinent part, section 1.956-1T(b)(4), Temporary Income
Tax Regs. 53 Fed. Reg. 22163, 22165 (June 14, 1988), provides:
Treatment of certain investments of earnings in United
States property. (i) Special Rule. For purposes of
1.956-1(b)(1) of the regulations [which, as pertinent,
paraphrases section 956(a)(1)], a controlled foreign
corporation will be considered to hold indirectly * * *
at the discretion of the District Director, investments
in U.S. property acquired by any other foreign
corporation that is controlled by the controlled
foreign corporation, if one of the principal purposes
for creating, organizing, or funding (through capital
contributions or debt) such other foreign corporation
is to avoid the application of section 956 with respect
to the controlled foreign corporation. * * *
III. Summary of Arguments of the Parties
A. Respondent’s Arguments
MFE controls MFE N.V., and respondent argues that a
principal purpose for creating, organizing, or funding MFE N.V.
was to avoid the application of section 956. Thus, respondent
would exercise his discretion to consider MFE as owning
(indirectly) any investment in U.S. property acquired by MFE N.V.
See sec. 1.956-1T(b)(4), Temporary Income Tax Regs. Respondent
considers the MFE N.V. CDs to be U.S. property within the meaning
of section 956(b)(1)(C) (U.S. property). Thus, respondent
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concludes that (1) MFE, a controlled foreign corporation,
increased its earnings invested in U.S. property and
(2) petitioner, the sole U.S. shareholder of MFE, must include
$174,127,665 in gross income pursuant to section 951(a)(1)(B).
Respondent has numerous arguments why the MFE N.V. CDs are
not deposits with persons carrying on the banking business within
the meaning of section 956(b)(2)(A) (sometimes, section 956
deposits). Principally, respondent argues that (1) to be in the
banking business for purposes of section 956(c)(2)(A), an
institution must first be a “bank” within the meaning of section
581 (definition of bank for purposes of rules of general
application to banking institutions), and (2) since WFNNB does no
more than operate a private label credit card business, its
activities are too narrow to put it into “the banking business”.
Respondent also argues that the MFE N.V. CDs did not constitute
deposits as that term is used in section 956(b)(2)(A).
Alternatively, respondent argues that, because, in
substance, the MFE NV CDs are the repatriation of earnings of a
controlled foreign corporation, they should be treated as such no
matter what steps petitioner took to color them as something
else.
B. Petitioner’s Arguments
Petitioner denies that MFE N.V. was created, organized, or
funded to avoid the application of section 956. Moreover,
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petitioner argues that the MFE N.V. CDs do not constitute U.S.
property since they qualify for an exception to that term as
“deposits with persons carrying on the banking business” pursuant
to section 956(b)(2)(A). Petitioner argues that the term "the
banking business" has no special meaning and that WFNNB was
organized as a bank, is operated as a bank, is regulated as a
bank, and is considered a bank by various experts in banking,
finance, and economics. Petitioner likewise argues that the term
“deposits” has no special meaning and the MFE N.V. CDs are
deposits both in form and substance.
IV. Discussion
A. Introduction
As will be explained below, the provisions of subpart F here
in question were enacted to tax as dividends the repatriated
earnings of controlled foreign corporations. An exception was
made for deposits with persons carrying on the banking business.
Given the limited purpose of WFNNB (to issue credit cards to
customers of the stores), we find that the MFE N.V. CDs are not
“deposits with persons carrying on the banking business”, as
Congress used those words in section 956(b)(2)(A). We
independently reach the same conclusion based on the
relationships between and among petitioner, WFNNB, MFE, and MFE
N.V. Therefore, we find that the $174,127,665 in question was
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invested in U.S. property. The details of our reasoning are as
follows.
B. Deposits With Persons Carrying on the Banking Business
In arguing whether the MFE N.V. CDs constitute section 956
deposits, the parties expend considerable effort addressing
whether WFNNB is a bank. Respondent would have us define the
term “bank” as it is defined in section 581, and argues that
WFNNB cannot qualify under that definition since taking deposits
from unrelated parties does not constitute a substantial part of
its business. Petitioner’s argument is somewhat more elaborate.
Petitioner argues that, since banks are in the business of
banking, and WFNNB is a bank, WFNNB must be in the business of
banking. Petitioner supports its minor premise (WFNNB is a bank)
by showing that WFNNB was organized to carry on the business of
banking, is authorized by the Comptroller of the Currency to do
business as a national banking association, and derives its
authority from, and is governed by, the National Bank Act
(currently codified in Title 12 U.S.C.). Petitioner points out
that WFNNB may not legally engage in any activity but the
business of banking. Petitioner concludes: “The language
enacted by Congress is unambiguous. WFNNB is a bank. It is
therefore a priori engaged in the banking business. As a matter
of law, it can do nothing else.”
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We do not accept either party’s argument that we can
determine whether WFNNB is in the banking business simply by
determining whether WFNNB is a bank. The question is not whether
WFNNB is a bank. Congress did not provide an exception for
deposits with “banks”; it provided an exception for “deposits
with persons carrying on the banking business”. Congress did not
define the term “banking business”, and, although petitioner
presented expert testimony with respect to banks and banking,
none of petitioner’s experts claim that the term “banking
business” is a term of art or has a well-defined meaning.
Indeed, petitioner’s expert, Robert L. Clarke, Comptroller of the
Currency from December 1985 through February 1992, testified:
“During the time I served as Comptroller of the Currency, the
issues of what it means to be a ‘bank’ and exactly what
constitutes the ‘banking business’ regularly confronted the
Office of the Comptroller of the Currency [OCC], Congress and the
court system, including the Supreme Court.” We conclude that the
term “deposits with persons carrying on the banking business” is
ambiguous.8 Cf. NationsBank, N.A. v. Variable Annuity Life Ins.
8
The parties dispute not only the meaning of the term
“deposits with persons carrying on the banking business” but also
the meanings of the subordinate terms “deposits” and “banking
business”. We conclude that the subordinate term “banking
business” is ambiguous. That is sufficient for us to conclude
that the superior term, “deposits with persons carrying on the
banking business”, is ambiguous.
- 24 -
Co., 513 U.S. 251, 258, n.2 (1995) (determining that Comptroller
of the Currency may determine what is an “incidental powe[r] * *
* necessary to carry on the business of banking” for purposes of
12 U.S.C. sec. 24: “We expressly hold the ‘business of banking’
is not limited to the enumerated powers in § 24 Seventh and that
the Comptroller therefore has discretion to authorize activities
beyond those specifically enumerated.”)
C. Court’s Function in Interpreting the Internal Revenue
Code
This Court's function in interpreting the Internal Revenue
Code is to construe the statutory language to effectuate the
intent of Congress. See United States v. Am. Trucking
Associations, 310 U.S. 534, 542 (1940); Merkel v. Commissioner,
109 T.C. 463, 468 (1997); Fehlhaber v. Commissioner, 94 T.C.
863, 865, affd. 954 F.2d 653 (11th Cir. 1992); U.S. Padding Corp.
v. Commissioner, 88 T.C. 177, 184 (1987), affd. 865 F.2d 750 (6th
Cir. 1989). Both a textual analysis of the statute and a
consideration of Congress’ purpose in enacting Subpart F are
warranted and appropriate to determine whether deposits with
WFNNB, whose activities were predominantly limited to credit card
transactions, and which is a wholly owned subsidiary of
petitioner, are section 956 deposits. See Public Citizen v.
United States Dept. of Justice, 491 U.S. 440 (1989). We begin by
considering Congress' purpose in enacting subpart F.
- 25 -
D. Tax Reform Acts of 1962 and 1976
Subpart F was added to the Internal Revenue Code of 1954 by
section 12 of the Revenue Act of 1962, Pub. L. 87-834, 76 Stat.
960. H.R. 10650, 87th Cong., 2d Sess. (1962) (H.R. 10650), is
the bill that, when enacted, became the Revenue Act of 1962. The
committee reports accompanying H.R. 10650, both in the House of
Representatives (the House) and in the Senate, discuss the
impetus for subpart F: to wit, to end the “tax deferral”
resulting from the failure of our income tax system to tax the
foreign source income of American controlled foreign corporations
until such income is distributed to the corporation’s American
shareholders as dividends. H. Rept. 1447, 87th Cong., 2d Sess.
(1962), 1962-3 C.B. 405, 461; S. Rept. 1881, 87th Cong., 2d Sess.
(1962), 1962-3 C.B. 707, 784. The committees did not attempt to
eliminate such tax deferral completely, but they did address
certain “tax haven” devices. See S. Rept. 1881, supra, 1962-3
C.B. at 784. With respect to that portion of subpart F dealing
with investments in U.S. property (the repatriation provision),
the Committee on Finance said: “Generally, earnings brought back
to the United States are taxed to the shareholders on the grounds
that this is substantially the equivalent of a dividend being
paid to them.” S. Rept. 1881, supra, 1962-3 C.B. at 794; accord
H. Rept. 1447, supra, 1962-3 C.B. at 469. With respect to the
exceptions to U.S. property for section 956 deposits (which both
- 26 -
tax writing committees referred to as “bank accounts”) and the
other items contained in section 956(b)(2), the Committee on
Finance explained: “The exceptions * * * however, are believed
to be normal commercial transactions without intention to permit
the funds to remain in the United States indefinitely (except in
the case of the last category where full U.S. corporate tax is
being paid).”9 S. Rept. 1881, supra, 1962-3 C.B. at 794; accord
H. Rept. 1447, supra, 1962-3 C.B. at 469.
Because U.S. property was defined to include, in general,
all tangible and intangible property located in the United
States, the scope of the repatriation provision proved too broad
for Congress, which, in 1976, limited it. See Tax Reform Act of
1976, Pub. L. 94-455, sec. 1021(a), 90 Stat. 1525 (adding section
956(b)(2)(F) and (G)). H.R. 10612, 94th Cong., 2d Sess. (1975),
is the bill that, when enacted, became the Tax Reform Act of
1976. The committee reports accompanying H.R. 10612, both in the
House and the Senate, state the committees’ views that the scope
of the repatriation provision is too broad. H. Rept. 94-658
9
As originally enacted, sec. 956(b)(2) contained only the
exceptions set out as secs. 956(b)(2)(A) through (E) plus an
exception for assets of the controlled foreign corporation equal
to certain accumulated earnings and profits already subject to
income taxation in the United States (i.e., the “last category”
referred to in the quoted language from the report of the
Committee on Finance). The exception set out as sec.
956(b)(2)(F) was added by the Tax Reform Act of 1976, Pub. L. 94-
455, sec. 1021(a), 90 Stat. 1520.
- 27 -
(1975), 1976-3 C.B. (Vol. 2) 701, 908; S. Rept. 94-938 (1976),
1976-3 C.B. (Vol. 3) 57, 226. Both reports state that the
repatriation provision may have encouraged foreign corporations
to invest their profits abroad, with a detrimental effect upon
the U.S. balance of trade: “For example, a controlled foreign
corporation looking for a temporary investment for its working
capital is, by this provision, induced to purchase foreign rather
than U.S. obligations.” H. Rept. 94-658, supra, 1976-3 C.B.
(Vol.2) at 908; S. Rept. 94-938, supra, 1976-3 C.B. (Vol. 3) at
226.
The Committee on Finance explained:
In the committee’s view a provision which acts to
encourage, rather than prevent, the accumulation of
funds offshore should be altered to minimize any
harmful balance of payments impact while not permitting
the U.S. shareholders to use the earnings of controlled
foreign corporations without payment of tax.
In the committee’s view, since the investment by a
controlled foreign corporation in the stock or debt
obligations of a related U.S. person or its domestic
affiliates makes funds available for use by the U.S.
shareholders, it constitutes an effective repatriation
of earnings which should be taxed. The classification
of other investments in stock or debt of domestic
corporations as the equivalent of dividends is, in the
committee’s view, detrimental to the promotion of
investments in the United States. Accordingly, the
committee’s amendment provides that an investment in
U.S. property does not result when the controlled
foreign corporation invests in the stock or obligations
of unrelated U.S. persons.
S. Rept. 94-938, supra, 1976-3 C.B. (Vol. 3) at 226; see also,
H. Rept. 94-658, supra, 1976-3 C.B. (Vol. 2) at 908. By the Tax
- 28 -
Reform Act of 1976, Congress added subparagraph (F) to section
956(b)(2).10 Subparagraph (F) of section 956(b)(2) provides that
U.S. property does not include stock or debt of a domestic
corporation (unless the corporation is itself a U.S. shareholder
of the foreign controlled corporation) if the U.S. shareholders
of the controlled foreign corporation have less than 25-percent
control of the domestic corporation.
E. Analysis
1. The Banking Business
The repatriation provision was enacted in 1962 on the theory
that the repatriation of previously untaxed (by the United
States) earnings by a controlled foreign corporation was
substantially the equivalent of a dividend being paid to the U.S.
shareholders of that corporation (dividend equivalency theory).
Excepted were a group of transactions that the tax writing
committees believed were “normal commercial transactions without
intention to permit funds to remain in the United States
indefinitely”. S. Rept. 1881, supra, 1962-3 C.B. at 794; accord
H. Rept. 1447, supra, 1962-3 C.B. at 469. One such exception is
for “deposits with persons carrying on the banking business”.
The phrase “carrying on the banking business” is a phrase
10
Congress also added subparagraph (G) to sec. 956(b)(2),
which deals with certain oil drilling rigs used on the U.S.
continental shelf and is not relevant to our discussion.
- 29 -
modifying (and, thus, describing or limiting) the noun “persons”.
The phrase expresses an action required of such persons. That
action is to carry on “the banking business”. Congress' use of
the definite article “the” to modify the subordinate term
“banking business” indicates a purpose to particularize the
activity or activities required of such persons. Such persons
must do something in particular: They must carry on (i.e.,
conduct) a business. Not any business, but the banking business;
not a banking business (which would suggest a variety of
businesses that would qualify) but the banking business. Our
textual analysis convinces us that Congress did not intend that
the term "persons carrying on the banking business" apply to
every person that is conducting one or more of the activities
that are considered to be part of a banking business by any
statute, agency, or industry. Therefore it is not sufficient for
petitioner to prove that the activities and business that WFNNB
carried on were a banking business. Rather, the issue is whether
WFNNB was “carrying on the banking business”, as those terms are
used in section 956(b)(2)(A). (Emphasis added.)
From the context of the term “the banking business” we infer
that Congress meant a group of activities carried on to aid the
domestic business activities of controlled foreign corporations.
For example, section 956(b)(2)(B) and (C) except, from the
definition of U.S. property, property that is purchased for
- 30 -
export and loans to U.S. sellers or processors of the controlled
foreign corporation's property. We believe that a person
carrying on the banking business, for purposes of section
956(b)(2)(A), must, at the very least, provide banking services
useful to a controlled corporation engaging in business
activities in the United States. Our conclusion that Congress
had a group of business-facilitating activities in mind is
bolstered by the tax writing committees’ stated belief that the
exceptions to the definition of U.S. property were for “normal
commercial transactions without intent to permit the funds to
remain in the United States indefinitely”. Both tax writing
committees used the term “bank accounts” to describe the deposits
exception. A dictionary definition of the term "bank account"
is: "an account with a bank created by the deposit of money or
its equivalent and subject to withdrawal of money (as by check or
passbook)". Webster's 3d New International Dictionary (1993)
(similar in second edition, 1934) 172. While not dispositive of
Congressional intent, the use of the term "bank accounts", as
defined in the dictionary for many years, is yet another
indication that the deposit exception was meant to encompass
banking functions (e.g., the ability to write checks) that would
facilitate the controlled foreign corporation’s business.
- 31 -
In H. Rept. 1447, the Committee on Ways and Means reported:
“Certain exceptions * * * [to the House's definition of U.S.
property] are made but these apply only where the property
located within the United States is ordinary and necessary to the
active conduct of the foreign corporation's business or
substantially the same trade or business”. H. Rept. 1447, supra,
1962-3 C.B. at 469 (emphasis added). H.R. 10650 as passed by the
House (the House bill) dealt more strictly with a controlled
foreign corporation’s investment of its earnings than did the
provision substituted by the Senate (which substitute was
accepted by the House). To escape tax, the House bill would have
required earnings invested outside of the United States (and the
few exceptions for domestic investments) to be invested in money
or property “ordinary and necessary for the active conduct of a
qualified trade or business” (the active conduct restriction).
H.R. 10650, 87th Cong., 2d Sess., sec. 13(a) (1962). The Senate
eliminated that restriction. It retained virtually unchanged,
however, the language of the House bill describing the few
permitted domestic investments. Since the House undoubtedly
understood that language to describe investments satisfying the
active conduct restriction, it can be inferred by the Senate's
nearly verbatim adoption of the same language that it also
understood that language to describe investments satisfying the
active conduct restriction, notwithstanding its elimination of
- 32 -
that restriction with respect to all foreign investments and
U.S. investments of earnings that had been subjected to
U.S. taxation.
We are mindful that the exceptions to the definition of U.S.
property provided in section 956(b)(2)(A) include an exception
for "obligations of the United States", which, of course, could
include a long-term investment, such as a 30-year Treasury bond.
This fact does not alter our conclusion that Congress intended to
limit section 956(b)(2)(A), in general, and the section 956
deposit exception, in particular, to business facilitating
activities. It was only natural for Congress to encourage any
form of deposit of offshore earnings with the U.S. Government.
Given our conclusion as to the meaning of the term “the
banking business”, we are satisfied that the activities of WFNNB
do not satisfy it. WFNNB's articles of association significantly
limit its banking activities:
The association
(i) will engage only in credit card operations;
(ii) will not accept demand deposits or deposits that
the depositor may withdraw by check or similar
means for payment to third parties or others;
(iii) will not accept any savings or time deposit of less
than $100,000;
(iv) will maintain no more than one office that accepts
deposits;
(v) will not engage in the business of making commercial
loans; * * *
WFNNB is a special purpose institution that is not of much
use to a foreign business customer seeking banking services to
- 33 -
aid its domestic business activities, except as the issuer of a
private-label credit card or as the recipient of large deposits
of funds that are not needed immediately. Those are insufficient
services for us to conclude that WFNNB was “carrying on the
banking business” as Congress used that phrase in section
956(b)(2)(A).
2. Dividend Equivalence
As originally enacted, in 1962, the repatriation provision
classified as U.S. property virtually all investments by a
controlled foreign corporation of its earnings in the United
States. There was little, if any, reason for Congress to include
a related-party restriction in the exception for section 956
deposits.11 By 1976, however, the tax writing committees of
11
From the enactment of the Bank Holding Company Act of 1956
(BHCA), Pub. L. 91-607, ch. 240, 70 Stat. 133, currently codified
at 12 U.S.C. secs. 1841-1850 (1994), until its amendment by the
Bank Holding Company Act Amendments of 1970 (BHCA 1970
Amendments), Pub. L. 91-607, 84 Stat. 1760, a bank holding
company was defined as a company having control over two or more
banks. The BHCA would, thus, not have impeded a nonbanking
company, such as petitioner, from owning a single bank.
Nevertheless, petitioner has failed to show us that, in 1962
(when subpart F was enacted), that possibility was any more than
theoretical. See S. Rept. 91-1084 (1970), 1970 U.S.C.C.A.N.,
p. 5519, 5522 (accompanying H.R. 6778, which was enacted as BHCA
1970 Amendments, and describing "the theoretical freedom of a
one-bank holding company to engage in any business, or acquire
anything it desires (subject to antitrust laws)"; Conf. Rept. 91-
1747 (1970), 1970 U.S.C.C.A.N., p. 5561, 5562 (also accompanying
H.R. 6778 and stating that, “[i]n the late 1960's”, nonbank
corporations began acquiring one bank, “thus mixing banking and
nonbanking in complete contravention of the purpose of both
(continued...)
- 34 -
Congress had recognized that the repatriation provisions had
discouraged investments that would be favorable to the U.S.
balance of payments. Congress addressed that problem by adding
two additional exceptions to the definition of U.S. property:
subparagraphs (F) (certain stock or debt investments) and
(G) (certain oil drilling rigs). The subparagraph (F) exception
is limited to stock or debt of unrelated domestic corporations.
The Committee on Finance cautioned that it did not wish the law
to be changed to permit the U.S. shareholders of a controlled
foreign corporation to use the earnings of the corporation
without payment of tax. H. Rept. 94-658, supra. S. Rept. 94-
938, supra. Congress did not amend the section 956 deposit
exception to except only deposits with unrelated persons. That
is understandable, however, since BHCA prohibited nonbank holding
companies from owning banks.12 Petitioner has offered no policy
reason why Congress would permit deposits (particularly deposits
for an indefinite period) with a related bank but prohibit
investments in a related corporation. In response to
11
(...continued)
Federal banking laws going back to the 1930's and the Bank
Holding Company Act of 1956.”)
12
Undoubtedly, Congress believed that it had foreclosed that
possibility in 1970 when it enacted BHCA 1970 Amendments. See
supra note 11. By 1987, nonbank companies had found a loophole
(the nonbank loophole) in BHCA, which Congress enacted CEBA to
close. See supra note 3. Commercial firms, however, did not
begin to exploit the nonbank loophole until the early 1980s.
- 35 -
petitioner's argument that the phrase "deposits with persons
carrying on the banking business" has a plain meaning (an
argument we reject), we note that, when the adherence to the
"plain meaning" of a statute produces an unreasonable result
"plainly at variance with the policy of the legislation as a
whole", it is proper to follow that purpose, rather than the
literal words. United States v. Am. Trucking Associations, Inc.,
310 U.S. 534, 543-544 (1940)(internal quotation omitted); see
also United States v. Ron Pair Enter., 489 U.S. 235, 242 (1989).
Further, "[w]e may then look to the reason of the enactment and
inquire into its antecedent history and give it effect in
accordance with its decision and purpose, sacrificing, if
necessary, the literal meaning in order that the purpose may not
fail." U.S. Padding Corp. v. Commissioner, 88 T.C. at 184(quoting Ozawa v. United States, 260 U.S. 178, 194 (1922)). We
believe that a related party prohibition is implicit in the
exception for section 956 deposits. Such a prohibition is
necessary to give effect to the dividend equivalence theory that
underlies the repatriation provision.13 If we find that the
13
Petitioner argues that a limitation of the sec. 956 deposits
exception to unrelated-party deposits would render that exception
"superfluous" in light of sec. 956(b)(2)(F). According to
petitioner, because sec. 956(b)(2)(F) permits a controlled
foreign corporation's earnings to escape U.S. taxation when
invested in the obligations of an unrelated U.S. corporation, it
would serve no purpose to interpret the sec. 956 deposits
(continued...)
- 36 -
purchase of the MFE N.V. CDs amounts to the use of the earnings
of a controlled corporation by a U.S. shareholder, we believe
that such purchase must be regarded as an increase of earnings
invested in U.S. property (and not a section 956 deposit).
On January 28, 1993, MFE N.V. purchased the (eight) MFE N.V.
CDs from WFNNB for $174.9 million, Each CD was for a term of
1 year, showed an annual interest rate of 3.1 percent, and
provided that it was a “nonnegotiable and nontransferable time
deposit”. Each also provided: “This Time Deposit shall renew
automatically for a like term unless and until notice of
withdrawal is presented at the Bank within * * * seven calendar
days after the maturity date". On January 28, 1993, WFNNB
13
(...continued)
exception as accomplishing the same result with respect to
obligations in the form of deposits with a domestic corporation
carrying on the banking business. The sec. 956(b)(2)(A)
exception, however, applies to "deposits with persons carrying on
the banking business", whereas the sec. 956(b)(2)(F) exception
applies to "obligations of a domestic corporation." A person
carrying on the banking business need not be a corporation. See,
e.g., Mass. Gen. Laws Ann. ch. 167, sec. 1 (1997) defining "Bank"
to include "any individuals, association, partnership or
corporation * * * doing a banking business in the commonwealth";
see also N.D. Cent. Code sec. 6-01-02 (1995) defining the terms
"banking association" and "state banking association" to include
"limited liability companies, partnerships, firms, or
associations whose business in whole or in part consists of the
taking of money on deposit". Although our interpretation of the
sec. 956 deposits exception narrows its scope, we conclude that
it cannot be interpreted to permit deposits by controlled foreign
corporations with a related person carrying on the banking
business to go untaxed and still remain consistent with the clear
overall legislative intent to tax investments in related U.S.
persons.
- 37 -
transferred the $174.9 million received from MFE N.V. to Limited
Services to reduce the balance outstanding under a line of credit
extended to WFNNB by Limited Services.
WFNNB is a wholly owned subsidiary of petitioner, and,
therefore, the reduction of WFNNB’s line of credit balance to
Limited Service directly benefited petitioner. As we shall
explain in the next section of this report, we find that
respondent did not abuse his discretion in attributing the MFE
N.V. CDs to MFE. We therefore view the purchase of the MFE N.V.
CDs as a repatriation of the earnings of MFE. Because that
repatriation made the earnings of MFE (a controlled foreign
corporation) available for use by its only U.S. shareholder
(petitioner), we find that the repatriation was substantially the
equivalent of a dividend being paid by MFE to petitioner. The
purchase of the MFE N.V. CDs was an investment in U.S. property.
The exception for section 956 deposits is unavailable.
F. Section 1.956-1T(b)(4), Temporary Income Tax Regs.
Section 1.956-1T(b)(4), Temporary Income Tax Regs., 53 Fed.
Reg. 22165 (June 14, 1988), empowers respondent to attribute to
MFE the MFE N.V. CDs if one of the principal purposes for
creating, organizing, or funding MFE N.V. was to avoid the
application of section 956 with respect to MFE.
Petitioner argues that the purpose of organizing MFE N.V.
was to inject an additional corporate layer between MFE and the
- 38 -
deposits to WFNNB “to improve the efficacy of the deposits as
protection against expropriation” by the People’s Republic of
China, which was scheduled to take over Hong Kong in 1997. That
was the testimony of Kenneth B. Gilman, petitioner’s executive
vice president-finance and chief financial officer. When asked,
however, why that was the case, Mr. Gilman replied that he was
not exactly sure. Timothy B. Lyons is and, during the years in
issue, was petitioner’s vice president-tax. His responsibilities
include compliance, tax planning, and administration of the tax
function at petitioner. He is intimately familiar with the
business activity of MFE. Like Mr. Gilman, he also testified
that the purpose of forming MFE N.V. was to protect against
expropriation. Indeed, he testified that it was the “sole”
purpose for organizing MFE N.V. On cross-examination, Mr. Lyon
was asked why no consideration had been given to forming a
domestic (United States) subsidiary of MFE to protect against
expropriation. He responded: “It didn’t really accomplish
anything from the asset protection side * * * but * * * there is
no question it would have been deemed a dividend or something at
that point.”14 Further, petitioner decided to invest MFE’s funds
14
It is possible that Mr. Lyon's concern related to sec.
956(b)(1)(B), pursuant to which MFE's increase in earnings
invested in the stock of a domestic corporation would have
resulted in subpart F income to petitioner to the extent of such
increase.
- 39 -
in WFNNB before MFE N.V. was organized. Whether MFE N.V. was
organized for asset protection purposes we need not say. We do
believe, however, that that was not the sole purpose of
organizing MFE N.V. We believe that a principal purpose of
organizing and funding MFE N.V. was to avoid having the $174.9
million capital contribution result in subpart F income pursuant
to section 956. Further, we believe that another principal
purpose was to limit any subpart F income imposed pursuant to
section 956 to MFE N.V.'s earnings and profits, which were
negligible. Thus, we find that a principal purpose for creating,
organizing, and funding MFE N.V. to purchase the MFE N.V. CDs,
rather than using a domestic corporation or having MFE purchase
the CDs directly, was to avoid the application of section 956.
Mr. Lyon's testimony supports that conclusion. Accordingly, the
MFE N.V. CDs are attributed to MFE pursuant to section 1.956-
1T(b)(4), Temporary Income Tax Regs., supra.
G. Conclusions
At the close of 1993, MFE held the MFE N.V. CDs. The MFE
N.V. CDs were U.S. property and not section 956 deposits.
V. Conclusion
To the extent respondent determined a deficiency in tax on
the basis that petitioner must include $174,127,665 in gross
- 40 -
income under section 951(a)(1)(B), that deficiency in tax is
sustained.
An appropriate order
will be issued.