T.C. Memo 1999-411
UNITED STATES TAX COURT
DEL COMMERCIAL PROPERTIES, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1887-98. Filed December 20, 1999.
Val J. Albright, for petitioner.
George E. Gasper, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
SWIFT, Judge: For 1990 through 1993, respondent
determined deficiencies in petitioner’s Federal income taxes and
additions to tax as follows:
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Additions to Tax
Year Deficiency Sec. 6651(a)(1) Sec. 6656
1990 $ 5,823 $ 1,456 $ 582
1991 136,238 34,060 13,624
1992 479,445 119,861 47,945
1993 265,732 66,433 26,573
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
After concessions, the issues for decision are whether,
under sections 894, 1441, and 1442 and under a treaty between the
United States and Canada, interest paid by petitioner is subject
to withholding tax and whether petitioner is liable for additions
to tax for failure to timely file withholding tax returns and for
failure to make deposit of withholding taxes.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
At the time the petition was filed, petitioner’s principal
place of business was located in Ontario, Canada. Petitioner
(Del Commercial) was incorporated in the State of Illinois. Del
Commercial invested in and owned industrial real property located
in the United States and leased the property to tenants.
In 1990, Del Commercial participated in a series of related
and essentially simultaneous financial transactions with a number
of its affiliated foreign corporations. As set forth in the
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chart below, Del Commercial was a fourth-tier subsidiary of the
affiliated group of corporations. For each of the affiliated
corporations reflected in the chart below, we indicate the name
of the corporation and in parentheses the place of incorporation.
Unless qualified in the footnote to the chart, each arrow
reflects 100-percent ownership and voting control of each lower
level corporation.
* With regard to Delcom Properties, Inc., Rayel Construction Ltd., and Tridel
Corp., the evidence suggests the possibility of some minority ownership. For
1991 and subsequent years, Rayel Construction Ltd. owned 63.5 percent of La
Habra Developments Ltd., and Delcom Holdings Ltd. owned the remaining 36.5
percent.
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Tridel Corp. (Tridel) provided overall management and
planning for all of the affiliated corporations.
In 1990, Del Commercial needed funds to refinance and to make
improvements to some of its real property located in the United
States. In order to obtain the necessary funds, officers of
Tridel, acting on advice of an accounting firm, initiated and
planned the following essentially simultaneous transactions.
On July 18, 1990, the Royal Bank of Canada (Royal Bank), an
independent Canadian commercial bank, lent $14 million1 to Delcom
Financial Ltd. (Delcom Financial) at an interest rate based on a
specified bank prime interest rate plus one-half percent per
annum, payable in 20 approximately equal quarterly installments
due in full on July 15, 1995 (Royal Bank loan).
On July 18, 1990, Delcom Financial purportedly made an
unsecured loan to Delcom Holdings Ltd. (Delcom Holdings) in the
principal amount of $14 million at the same bank prime interest
rate plus five-eights percent per annum. Delcom Holdings issued
a promissory note to Delcom Financial in exchange for the
purported loan.
On July 18, 1990, Delcom Holdings purportedly contributed $14
million to Delcom Cayman Ltd. (Delcom Cayman) in exchange for
common shares of stock in Delcom Cayman. Delcom Cayman then
purportedly contributed $14 million to Delcom Antilles N.V.
1
All references to dollars are to U.S. dollars.
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(Delcom Antilles) in exchange for common shares of stock in
Delcom Antilles, and Delcom Antilles purportedly contributed $14
million to Del Investments Netherlands B.V. (Del Netherlands) in
exchange for common shares of stock in Del Netherlands. Del
Netherlands also executed a written guaranty that guaranteed
repayment of the $14 million Royal Bank loan.
Del Netherlands maintained a small office in Barbados with
one part-time officer who did not have any substantive duties or
responsibilities. Other than a few purported loans to members of
the affiliated group of corporations, Del Netherlands conducted
minimal business activity and had negligible assets and
consequently had no independent credit standing outside the
affiliated group of corporations.
On July 19, 1990, as an integral part of and dependent upon
the above transactions that occurred on July 18, 1990, Del
Netherlands purportedly lent $14 million to Del Commercial. This
purported loan was reflected by a demand promissory note of Del
Commercial in favor of Del Netherlands with stated interest at a
specified bank prime interest rate plus 1½ percent per annum,
payable in 20 quarterly installments and due in full on July 15,
2015.2 As part of this transaction, a security agreement and a
2
Del Commercial’s promissory note indicates that some
interest was to be paid monthly.
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general assignment of rents were entered into between Del
Commercial and Del Netherlands.
Also as security for the $14 million Royal Bank loan, Del
Commercial executed a document labeled "Undertaking" which
reflected Del Commercial’s obligation to allow Royal Bank to
place a mortgage on Del Commercial’s real property located in the
United States, and it required Del Commercial to provide to Royal
Bank annual financial statements, to insure its real property, to
assign the insurance policies to Royal Bank, to defer paying
dividends to shareholders, and to pay to Royal Bank on the $14
million Royal Bank loan proceeds from sale of any of Del
Commercial’s real property.
On January 1, 1991, Del Commercial began making payments on
the $14 million loan Del Commercial purportedly had received from
Del Netherlands. In each year from 1991 to 1993, Del Commercial
made the following total payments on the $14 million loan it had
received:
Year Principal Interest Total Payments
1991 $ 28,062 $ 881,938 $ 910,000
1992 442,329 3,153,283 3,595,612
1993 866,998 1,683,002 2,550,000
Del Commercial and Del Netherlands recorded the loan payments on
their respective books and records as having been made by Del
Commercial to Del Netherlands.
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For 1991 through June 1992, Del Netherlands transferred the
funds received from Del Commercial either to Delcom Holdings or
to Delcom Financial. The funds were used to pay principal and
interest owed on the $14 million Royal Bank loan.
In July of 1992, because of concern of Royal Bank over
payments due on its $14 million loan, Del Commercial began to
make the loan payments due on the loan it had purportedly
received from Del Netherlands directly to Delcom Financial,
bypassing Del Netherlands and Delcom Holdings, and Delcom
Financial then forwarded funds to Royal Bank in payment on the
Royal Bank loan. On Del Commercial’s books and records, those
loan payments were still recorded as having been made to Del
Netherlands.
On December 4, 1992, Delcom Financial and Royal Bank amended
the terms of the original $14 million Royal Bank loan. The
amendment, among other things, increased the interest rate
charged on the loan by 1 percent. Also, under the amended loan
agreement, Tridel added its guaranty on the Royal Bank loan.
For 1990 through 1993, Del Commercial did not file U.S.
Federal withholding tax returns with respect to the interest
payments in issue.
On audit, respondent determined that the substance of the $14
million loan to Del Commercial reflected a loan not from Del
Netherlands, but from Delcom Financial, and therefore that the
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interest payments Del Commercial made on the loan should be
treated as having been made by Del Commercial to Delcom Financial
and as subject to withholding tax.
OPINION
Under section 881(a), foreign corporations which receive
interest income from U.S. payors (that is not effectively
connected with conduct of a trade or business within the United
States) are liable for a tax of 30 percent of the interest
received. U.S. taxpayers who pay the interest to the foreign
corporations generally are required to withhold the 30-percent
tax from interest payments made to the foreign corporations. See
secs. 1441 and 1442. U.S. taxpayers who are required to withhold
the 30-percent tax and who fail to do so become personally liable
for the withholding tax. See sec. 1461.
Under section 894, U.S. treaty provisions may modify the
Internal Revenue Code, including the withholding tax provisions.
For the years at issue, under a treaty between the United States
and Canada (U.S.-Canada Treaty), interest payments made by U.S.
taxpayers to Canadian corporations are subject to tax at a rate
not exceeding 15 percent if the Canadian corporations are the
beneficial recipients and owners of the interest income. See
Convention on Taxes on Income and Capital, Sept. 26, 1980, U.S.-
Can., art. XI, T.I.A.S. No. 11087.
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Also, under a treaty between the United States and the
Netherlands (U.S.-Netherlands Treaty), interest payments made by
U.S. taxpayers to Netherlands corporations are exempt from tax by
the United States. See Supplementary Convention on Taxes on
Income and Other Taxes, Dec. 30, 1965, U.S.-Neth., art. VI, 17
U.S.T. 896, 901.
U.S. tax laws and treaties, however, do not recognize as
valid for tax purposes sham transactions or transactions that
have no economic substance. See Gregory v. Helvering, 293 U.S.
465, 470 (1935); Johansson v. United States, 336 F.2d 809, 813
(5th Cir. 1964). Even legitimate corporations may engage in sham
transactions. See Knetsch v. United States, 364 U.S. 361, 366
(1960).
Also, under various applications of the step-transaction
doctrine, a series of formally separate steps may be collapsed
and treated as a single transaction. See Penrod v. Commissioner,
88 T.C. 1415, 1428 (1987). A series of steps may be collapsed
and treated as one if at the time the first step was entered into
there was a binding commitment to undertake the later step
(binding-commitment test), if separate steps constitute
prearranged parts of a single transaction intended to reach an
end result (end-result test), or if separate steps are so
interdependent that the legal relations created by one step would
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have been fruitless without a completion of the series of steps
(mutual-interdependence test). See id. at 1429-1430; Custom
Chrome, Inc. v. Commissioner, T.C. Memo. 1998-317, on appeal
(9th Cir., Nov. 9, 1998).
We have applied the step-transaction doctrine to disregard
the use of intermediaries and conduits for Federal tax purposes.
See Packard v. Commissioner, 85 T.C. 397, 420 (1985); D’Angelo
Associates, Inc. v. Commissioner, 70 T.C. 121, 129 (1978); Gaw v.
Commissioner, T.C. Memo. 1995-531, affd. without published
opinion 111 F.3d 962 (D.C. Cir. 1997).
Back-to-back loans similar to those involved herein between
U.S. corporations and related foreign corporations and between
the foreign corporations and their indirect foreign parent
corporations have been held to represent mere conduits for the
passage of interest payments, and in such situations we have
imposed withholding tax liability on the U.S. corporate payors.
See Aiken Indus., Inc. v. Commissioner, 56 T.C. 925, 934 (1971).
Respondent argues that in substance the interest payments in
issue made by Del Commercial were paid to Delcom Financial, a
Canadian taxpayer, with regard to the $14 million Royal Bank loan
and therefore that Del Commercial, under the U.S.-Canada Treaty,
is liable for a 15-percent withholding tax on the interest
payments.
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Del Commercial argues that the interest payments were made to
Del Netherlands, a Netherlands corporation, and therefore that
under the U.S.-Netherlands Treaty the interest payments are
exempt from U.S. withholding tax.
Regardless of which theory is used under the step-transaction
doctrine, the facts in this case result in the same conclusion.
The facts reflect a step transaction created simply to bypass
U.S. withholding tax. Del Netherlands had minimal assets, and
Del Netherlands had only transitory possession of and no control
over the $14 million loan proceeds as the proceeds were passed
from Delcom Financial to Del Commercial. Apart from the
purported $14 million loan to Del Commercial, Del Netherlands
engaged in minimal business activity, and the Barbados branch of
Del Netherlands had no officer with any substantive duties or
responsibilities.
Royal Bank, the independent third-party lender which
ultimately provided the $14 million, exacted guaranties from Del
Commercial and mortgages or deeds of trust on Del Commercial’s
U.S. real property, establishing the link between the loan
payments Del Commercial made and the Royal Bank loan. Del
Netherlands passed on the loan payments received from Del
Commercial to its affiliated Canadian corporations in order to
service the $14 million Royal Bank loan. After July of 1992, Del
Commercial bypassed Del Netherlands completely and made the loan
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payments directly to Delcom Financial. Del Netherlands acted as
a mere shell or conduit with respect to the interest payments Del
Commercial made. In substance, Del Commercial received the $14
million loan from Delcom Financial and made the loan payments to
Delcom Financial, a Canadian corporation. Del Commercial
therefore is liable for the withholding taxes determined by
respondent.
Northern Ind. Pub. Serv. Co. v. Commissioner, 105 T.C. 341
(1995), affd. 115 F.3d 506 (7th Cir. 1997), on which Del
Commercial relies, is distinguishable. That case involved a loan
to a U.S. corporation from a foreign subsidiary corporation using
funds obtained from unrelated parties on the Eurobond market. In
the transaction at issue in the instant case, the participation
of Del Netherlands had no purpose other than avoidance of
withholding tax. Even the interest-rate spread that Del
Netherlands was to earn was eliminated in 1992 when the interest
rate of the Royal Bank loan was increased to 1½ percent.
Northern Ind. Pub. Serv. Co. provides no support for Del
Commercial.
Under section 6651(a)(1), an addition to tax is imposed for
failure to file a tax return, and under section 6656, an addition
to tax is imposed for failure to timely deposit a tax due in a
Government depository, unless it is shown that such failures were
attributable to reasonable cause and not to willful neglect. Del
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Commercial has not presented any credible argument that the
failure to file and the failure to timely deposit withholding
taxes due on interest paid on the $14 million loan were
attributable to reasonable cause. Respondent’s determinations of
the additions to tax are sustained.
To reflect the foregoing,
Decision will be entered
under Rule 155.