In their continued effort to crackdown on offshore activity, the IRS and Treasury released proposed regulations yesterday that target debt held by foreign partnerships.  These regulations provide that debt held by foreign partnerships will be treated as an obligation of the partnership’s U.S. partners for purposes of the controlled foreign corporation rules (Section 956).  The allocation of debt to the partners would be based on the partners’ interests in the partnership’s profits.

What is the reason for this change?  If a controlled foreign corporation loans money to its U.S. parent or shareholder, the loan may be treated as a deemed dividend under Section 956, resulting in taxation of the earnings parked offshore.  To avoid this deemed dividend treatment, taxpayers are inserting a foreign partnership between the controlled foreign corporation and the U.S. parent or shareholder, and having the controlled foreign corporation loan the money to the foreign partnership.   The proposed regulations are designed to shut down this loophole.

An exception to this new rule would be available in cases where neither the lending controlled foreign corporation or any person related to the lending controlled foreign corporation is a partner in the partnership.