## Facts

- In June 1963, Daniel K. Ludwig entered into an agreement with Phillips Petroleum Co. to purchase 1,340,517 shares of Union Oil Co. stock for $75 per share (about $100.5 million).
- The sale required approval from the Department of Justice Antitrust Division and court approval in pending litigation in the U.S. District Court for the Southern District of California; the required approvals were obtained.
- Ludwig financed the acquisition by borrowing the full purchase price from three banks (with Chase Manhattan Bank acting as agent), and the lenders required collateral.
- As collateral, the banks took a pledge of (1) the Union Oil shares being acquired and (2) 1,000 shares of Oceanic Tankships, S.A., a Panamanian corporation; the 1,000 shares represented all outstanding Oceanic stock.
- Oceanic had accumulated earnings and profits in 1963 of about $5,092,318, and its overall value was reported at roughly $200 million, much of which stemmed from Oceanic’s ownership of all stock of Universe Tankships, Inc., a Liberian corporation.
- As part of the lending arrangement, Ludwig agreed to restrictive negative covenants limiting actions by Oceanic and Universe, including prohibitions on borrowing, pledging assets, guaranteeing debts, merging, selling major assets, transferring subsidiary shares, or paying money to Ludwig (including dividends).
- Ludwig later sold the Union Oil stock in 1965, realizing a gain of a little over $45 million, which he reported.
- The Commissioner determined an income tax deficiency for 1963 of $4,438,086.75. After concessions, the remaining dispute focused on whether Oceanic’s role in the financing arrangement triggered current income to Ludwig under Subpart F.
- The Commissioner’s theory was that Oceanic, a controlled foreign corporation wholly owned by Ludwig, effectively “guaranteed” Ludwig’s bank debt (because the lenders could reach Oceanic’s value through the pledged stock and restrictions), creating an inclusion under I.R.C. §§ 951 and 956.

## Issues

1. Whether Oceanic Tankships, S.A., a controlled foreign corporation wholly owned by Ludwig, was a “guarantor” of Ludwig’s bank obligations within the meaning of I.R.C. § 956(c), causing Ludwig to have a Subpart F income inclusion under I.R.C. § 951 for 1963.

## Decision

- The Tax Court held that Oceanic was not a “guarantor” of Ludwig’s obligations within the meaning of I.R.C. § 956(c) based solely on the pledge of Oceanic stock and the negative covenants imposed in the financing arrangement.
- Because Oceanic was not treated as guaranteeing the bank loans, the arrangement did not result in an investment in “United States property” that would trigger a current inclusion under I.R.C. § 951 for 1963 on the Commissioner’s theory.
- The Commissioner’s deficiency determination was not sustained to the extent it depended on treating Oceanic as a § 956(c) guarantor of Ludwig’s debt.

## Legal Principles

- For purposes of I.R.C. § 956(c), a controlled foreign corporation is treated as a “guarantor” only when the corporation (or its property in the statutory sense) undertakes a guarantee-like obligation; mere economic support or indirect protection to a lender is not enough.
- A U.S. shareholder’s pledge of stock in a controlled foreign corporation is generally a pledge of the shareholder’s property interest (the shares), not a pledge by the corporation of its own assets and not, by itself, a corporate guarantee of the shareholder’s personal debt.
- Contractual restrictions (negative covenants) that limit a shareholder’s ability to cause a controlled foreign corporation to borrow, pledge assets, or make distributions may protect lender collateral value, but they do not, without more, create a guarantee obligation by the corporation for § 956(c) purposes.
- Subpart F inclusion under I.R.C. § 951 based on § 956 requires that the statutory conditions for treating the controlled foreign corporation as investing in “United States property” be met; labeling a transaction as “functional” support is insufficient if the legal relationship does not match § 956(c).

## Conclusion

In *Daniel K. Ludwig and Gertrude V. Ludwig v. Commissioner*, the Tax Court rejected the IRS’s attempt to treat a controlled foreign corporation as a § 956(c) guarantor where the U.S. shareholder pledged all of the corporation’s stock as collateral and accepted restrictive covenants limiting the corporation’s actions; absent a direct guarantee-type obligation by the corporation, the court found no § 956(c) guarantee and therefore no Subpart F income inclusion under § 951 for 1963 on that ground.


Daniel K. Ludwig and Gertrude V. Ludwig v. Commissioner, 68 T.C. 979 (1977)