A SALE-LEASEBACK transaction aimed at enabling a corporation to use expiring foreign tax credits was shot down by the IRS.

The taxpayer was the parent company of a domestic, deconsolidated subsidiary corporation with foreign tax credits that were about to expire. After consulting with its lawyers and a bank about how best to take advantage of the credits, the taxpayer implemented a transaction in which the deconsolidated subsidiary and one of the taxpayer’s consolidated subsidiaries entered into mirror sale-leaseback transactions with affiliates of a bank. The consolidated subsidiary sold some of its used computer equipment to one of the bank’s affiliates, who immediately leased the equipment back to the subsidiary. Meanwhile, the deconsolidated subsidiary purchased used computer equipment that was located in another country and immediately leased it back to another affiliate of the bank.

Within a month of entering into the leases, both lessees prepaid all the rent due over the 3-year terms of their respective leases. The prepayment made by the consolidated subsidiary perfectly offset the prepayment received by the deconsolidated subsidiary. Three months later, the lessors swapped titles to the computer equipment so that the taxpayer’s original computer equipment wound up back in its own hands. Because the ability to use foreign tax credits is tied to the amount of foreign source income a company has — the more foreign source income, the more foreign tax credits it may use — the leases were designed to create foreign source income for the taxpayer’s subsidiary without creating any meaningful gain or loss for any of the parties involved. The prepaid rents were foreign-source income to the deconsolidated subsidiary because the leased property was located overseas.

The IRS called the transaction a “sham.” In addition to disallowing the credits, the national office also urged its field agents to pursue negligence penalties against the taxpayer.

The IRS released a “field service advice” about the transaction in December. The number is FSA 200203053.

Keith Martin