Sec. 304: IRS reconsiders "foreign subsidiary stock transfer" rulings.

Recently, an IRS official informally stated that thought has been given to reconsidering the Service's position on Rev. Ruls. 91-5 and 92-86 (both dealing with Sec. 304 cross-chain transfers) and Letter Rulings 9131059 and 9325040, which expanded on the revenue rulings. The Service is concerned about the availability of Sec. 902 foreign tax credits (FTCs) in certain Sec. 304 cross-chain transfers of stock in a foreign subsidiary by a U.S. subsidiary of a foreign parent to a foreign subsidiary of the same foreign parent. In the meantime, the two revenue rulings remain in effect; however, the official indicated that the IRS will no longer issue rulings on Sec. 959 (distributions of previously taxed income) or Sec. 961 (basis adjustments of previously taxed income) within the parameters of Sec. 304.

Although Sec. 304 was originally enacted to prevent the conversion of ordinary income into capital gain from the sale of stock to a related party, in the international area Sec. 304 has become a popular vehicle for repatriating cash from a foreign subsidiary back into the United States without incurring any foreign withholding tax. This is important because when earnings are repatriated in the form of dividends, they generally bear a withholding tax of 5% or more. When these taxes are added to the foreign corporate tax rate, the combined taxes generally amount to more than 35% (the current top U.S. corporate rate). Furthermore, as the U.S. FTC system allows an offset for foreign taxes only up to the U.S. rate on the foreign-source income, the withholding tax in effect becomes a bottom line cost to the company. In addition, if the total amount of foreign taxes imposed exceeds the creditable amount allowed by the U.S. FTC system, the benefit of the excess credits can be carried forward or carried back.

Generally, Sec. 304 applies to recast a sale of shares of one controlled (acquired) corporation to an affiliated (acquiring) corporation as a redemption of shares by the acquiring corporation from the controlling (selling) corporation.

Example: A domestic parent (P) owns all the shares of a domestic corporation (Dx) and a foreign corporation (Fx). Dx owns all the shares of a second foreign corporation (Fy). P and Dx file a consolidated return. Dx sells all its Fy shares to Fx at their fair market value, such price also being equal to the combined earnings and profits (E&P) of the two foreign corporations.

The sale is a transaction described in Sec. 304(a)(1) and, therefore, is treated as a distribution to Dx in redemption of the shares of Fx. Since the redemption does not satisfy any of the tests of Sec. 302(b), the rules under Sec. 301 apply. In determining the amount of the distribution considered a dividend under Sec. 301, first the E&P of the acquiring corporation (Fx) and then the E&P of the acquired corporation (Fy) are considered. To the extent Sec. 301 applies, the shares of the acquired corporation are deemed to be contributed to the acquiring corporation's capital by the selling corporation. In this example, based on the amount of combined E&P of Fy and Fx, the full amount of the proceeds is considered a dividend to Dx.

Sec. 902 generally permits a corporation to claim an FTC for taxes deemed paid if the shareholder owns at least 10% of the voting shares of the distributing corporation. Until Rev. Rul. 91-5 was issued, there was uncertainty as to whether the 10%-or-more ownership requirement could be satisfied through attribution under Sec. 318 (i.e., does Dx own the requisite percentage of Fx?). However, Rev. Rul. 91-5 held that Dx will be considered to satisfy the ownership requirement under Sec. 902, and thus Dx is allowed to claim a deemed paid credit for taxes paid by Fx. The deemed paid crediton taxes paid by Fy were not in question because of Dx's direct ownership interest. Note that the amount of deemed paid taxes must be included in income under Sec. 78.

The unique aspect of this transaction is that the "dividend" treatment of the sale makes the technique a valuable planning tool despite the fact that funds retained overseas are subject to many risks and are potentially vulnerable (e.g., to hyperinflationary economies).

Also, despite the fact that several rulings have been issued on this topic, the number of lingering details appears to be growing with the issuance of each new ruling. However, it appears that immediate planning opportunities are still available with regard to Sec. 304 cross-chain transfers; the IRS has only alluded to the fact that it is reconsidering its position in relation to these rulings and has not yet issued any contrary authority.