A loan from — or an A/P to — your foreign sub can trigger US tax

In the world of multinational business, complying with transfer pricing rules often means US companies meticulously book invoices for services rendered or goods provided by their foreign subsidiaries. But what happens when those intercompany accounts payable linger on the books? An unpaid invoice, a simple loan, or a guarantee can all unintentionally trigger a complex and costly US tax event known as a §956 inclusion.

This rule can effectively treat these transactions as a taxable "deemed dividend," even though no cash dividend was formally declared. Understanding this anti-abuse rule is critical for any US business with overseas operations.

What is a §956 inclusion?

The purpose of Internal Revenue Code §956 is to prevent the tax-free repatriation of a Controlled Foreign Corporation's (CFC's) earnings. While US tax on a CFC's active foreign earnings could be deferred, a §956 inclusion is triggered when those earnings are made available for use in the US.

The rule states that a US shareholder of a CFC must include in gross income their pro-rata share of the CFC's earnings invested in "US property". The inclusion amount is the lesser of the shareholder's share of the US property investment or their share of the CFC's "applicable earnings".

What is US property?

The term "US property" is broadly defined under §956(c) and includes four main categories:

• Tangible property located in the United States.
• Stock of a domestic corporation.
• An obligation of a United States person.
• The right to use certain intellectual property in the United States.

Key exceptions: what is NOT US property?

The law provides several important exceptions. A CFC can hold certain US assets without triggering an inclusion, including:

• Obligations of the US government, money, and certain bank deposits.
• Stock or debt of unrelated domestic corporations (i.e. portfolio investments).
• Property purchased in the US for export to a foreign country.
• Short-term loans: an obligation of a US person that is collected within 30 days is generally excluded, provided the CFC doesn't hold similar short-term loans for 60 or more days during the tax year.

Accounts receivable: a common pitfall

An "obligation of a US person" includes accounts receivable. An important exception exists for receivables that arise in the ordinary course of business from the sale of property or services. If the receivable and its payment terms are standard for the industry, it is generally not considered US property.

However, a receivable that is not settled within normal commercial terms can lose this protection and become a taxable investment in US property. This is a significant risk for companies that are compliant with transfer pricing by booking intercompany invoices but are lax in settling the actual cash payments.

Beyond direct loans: the pledges and guarantees trap

The reach of §956 extends beyond direct loans. A CFC is also considered to hold an obligation of a US person if it is a pledgor or guarantor of that obligation. If your CFC pledges its assets or stock to secure a loan taken by its US parent from a third party, this action is treated as an investment in US property and can trigger a §956 inclusion.

The last day test: a critical timing rule

The amount of a CFC's investment in US property is measured based on the average of the amounts held at the close of each quarter. However, a US shareholder is only required to have an income inclusion if they own the CFC's shares on the last day of the CFC's taxable year.

This is a key distinction from other anti-deferral rules. For instance, the recent OBBBA legislation shifted the income inclusion for Subpart F or NCTI (currently GILTI) to an "any day" of the year test. The fact that the "last day" rule was specifically retained for §956 makes year-end planning and monitoring of intercompany loans and other US investments absolutely critical.

What if you had Previously Taxed Income (PTI)?

A crucial element in any §956 analysis is the CFC's PTI. A §956 inclusion is only taxable to the extent the calculated amount exceeds the CFC's PTI balances related to §956. Under IRC §959, distributions from a CFC are sourced first from PTI. This means a CFC with a significant PTI balance (from prior Subpart F or GILTI/NCTI inclusions) can often make loans or other investments in US property without triggering additional US tax, as the deemed distribution is treated as a tax-free return of already-taxed income.

Mini case study

"US-Corp," a US parent company, owns 100% of "Foreign-Co," a CFC with $2 million in earnings, of which $1.2 million is PTI from prior NCTI inclusions. On 1 March, Foreign-Co lends US-Corp $750,000.

• Scenario A — long-term loan with PTI shield: the loan remains outstanding all year. On the last day of the year, US-Corp has a potential §956 inclusion of $750,000. However, because this amount is less than Foreign-Co's PTI balance of $1.2 million, the deemed distribution is treated as a tax-free return of PTI. Result: no additional US tax is due.
• Scenario B — loan exceeding PTI: if the loan was for $1.5 million, the §956 inclusion would exceed the $1.2 million PTI balance by $300,000. Result: US-Corp must include $300,000 in its taxable income.
• Scenario C — short-term loan: if the $750,000 loan was repaid on 25 March (within 30 days), it could qualify for the short-term obligation exception, avoiding a §956 inclusion for that quarter.

Where this leaves you

Navigating the rules for intercompany financing and avoiding unexpected deemed dividends under §956 requires careful, proactive planning. The team at AlignMyTax can help you structure your group strategies while staying compliant with your tax obligations in the US.