Unraveling the mysteries of Sec. 304 in international tax planning.

U.S.-Based Multinationals Using This Tax-Efficient Method to Repatriate Foreign Subsidiary Profits Still Face Hurdles

With the release of Rev. Ruls. 91-5(1) and 92-86,(2) U.S.-based multinationals have a heightened awareness of the benefits of Sec. 304 in international tax planning. Sec. 304 can provide an extremely tax efficient means of repatriating foreign subsidiary profits back into the United States. For example, U.S.-based multinationals often use Sec. 304 as a means of repatriating cash from a foreign subsidiary to the United States without incurring local country witholding tax. Further, the Sec. 304 transaction can be used as a means to infuse debt into the foreign subsidiary and create interest deductions for local tax purposes. In addition, Sec. 304 transactions can be used to repatriate earnings when there are foreign capital or other statutory restrictions that could prevent the payment of an actual dividend. Finally, Sec. 304 is an important consideration in any postacquisition restructuring of foreign operations.

This article will review the operation of Sec. 304, analyze the conclusions reached in Rev. Ruls. 91-5 and 92-86, and explore some of the opportunities and issues presented to international tax practitioners by Sec. 304. As will be shown below, recent published rulings have resolved one critical issue in the international tax area but leave several important issues unresolved.

Background

Sec. 304 transactions, in their simplest form, involve a situation in which a person controls each of two corporations and sells stock of one corporation to the other corporation.

Example 1: A U.S. parent (USP) owns 100% of the stock of both A, a country X corporation, and B, a country Y corporation. Y imposes a 15% withholding tax on any dividends paid to USP.

USP would like to repatriate B's earnings to the United States without incurring any Y withholding tax. In addition, USP would like to obtain a deemed paid credit under Sec. 902 on taxes actually paid by B. To accomplish this result, B acquires 100% of the stock of A from USP.(3)

Rather than treating the transaction as a straight sale of stock by USP to B, Sec. 304 splits the transaction into two parts. Although the order of the two parts is not entirely clear, it appears that first there is a contribution by USP to the capital of B (the acquiring corporation) of the purchased shares. Then there is a distribution by B in redemption of the stock deemed issued to USP on the contribution of capital.(4) The distribution would be treated as a dividend under Sec. 302(d). The amount and source of the dividend is determined by Sec. 304(b)(2). Accordingly, the distribution is treated as a dividend to USP from B to the extent of B's earnings and profits (E&P) and then from A (the issuing corporation) to the extent of A's E&P.

As USP own 100% of both A's and B's stock immediately before the transaction, under Sec. 902, to the extent the distribution is treated as a dividend, USP will be deemed to have paid any foreign taxes actually paid by A and B. Assuming Y treats the transaction as a purchase and does not impose any withholding tax on the distribution, USP will have achieved its objective.

There are several important collateral consequences of the transaction: * The distribution reduces A's and B's E&P to the extent the distribution is deemed paid from the respective companies.(5) * USP's basis in B is increased by USP's basis in A, which is deemed to be contributed to B's capital by USP.(6) * B takes a carryover basis (from USP) in the A stock received from USP.(7) * The contribution to B's capital is a Sec. 351 out-bound transfer of stock covered under Sec. 367, which may require a gain recognition agreement under Notice 87-85(8) and Temp. Regs. Sec. 1.367(a)-3T(g). The issue of whether a gain recognition agreement should always be required is explored below in some detail.

Foreign Tax Credit Consequences

In Example 1, USP owned 100% of the stock of both A (the issuing corporation) and B (the acquiring corporation). It is clear in this situation that USP can claim a deemed paid foreign tax credit (FTC) under Sec. 902 on the part of the distribution that comes from A and B, respectively.(9) However, before Rev. Rul. 91-5 was issued, the result of a Sec. 304 transaction in which the seller did not directly own the stock of both the acquiring and issuing corporation was far from clear. Probably the single most important issue was whether the seller (transferor corporation) was entitled to a deemed paid credit under Sec. 902 on the "dividend" received under Sec. 304 when it did not directly own any shares in the acquiring corporation. Rev. Rul. 91-5 confirmed that, under certain circumstances, a U.S. subsidiary is entitled to a deemed paid FTC under Sec. 902 on a Sec. 304 distribution from a foreign subsidiary in which the U.S. subsidiary has no direct ownership.

* Rev. Rul. 91-5

The facts of Rev. Rul. 91-5 involved the structure shown in Flowchart 1, on page 170. P owns 100% of the stock of both DX, a domestic corporation, and FX, a country U corporation. DX owns 100% of the stock of FY, another U corporation. Of the outstanding stock of FX, 50% by value is voting stock and 50% by value is nonvoting stock.

The fair market value (FMV) of the FY stock is $200x. The FMV of the FX voting and nonvoting stock is also $200x.

DX sold all of its FY stock to FX for $200x. The transaction is, of course, covered by Sec. 304 DX directly controls FY by its ownership of FY stock, and indirectly controls FX through the attribution rules of Sec 318(a)(3)(C) (relating to the constructive ownership by a corporation of stock owned by its parent corporation). Under Sec. 304(a)(1), the $200x received by DX is treated as a distribution in redemption of the FX stock, even though the cash goes straight to DX and not to P, the actual FX shareholder. The redemption results in a dividend from FX directly to DX.

Under Sec. 304(b)(1), the determination of whether the distribution is to be treated as a payment in exchange for stock or as a dividend is made by reference to the FY stock. Since DX directly owned all of the FY stock before the transaction and constructively owns all of the FY stock after the transaction, none of the provisions of Sec 302(b) apply and the redemption is treated as a distribution of property to which Sec. 301 applies. Under Sec. 304(b)(2), the distribution received by DX is taxable as a dividend first to the extent of FX's E&P and then to the extent of FY's E&P.

According to the ruling, DX is entitled to claim an FTC under Sec. 902 for the taxes paid by FY (the issuing corporation) "[b]ecause DX owned the FY stock as required by section 902(a)." This position is consistent with the IRS's position in private letter rulings issued after the changes made to Sec. 304(b)(2) by the Tax Reform Act of 1084.(10)

The critical issue resolved is that a Sec. 902 credit is available to DX on the distribution from FX even though DX does not directly own any of the FX stock.

* Reconciliation of Rev. Rul. 91-5 with Sec. 902

Although this result seems to be equitably correct and was generally well received by taxpayers, the technical basis for the conclusion is somewhat vague and should be reconciled with the general requirements of Sec. 902. Sec. 902(a) allows an FTC for foreign taxes paid by a foreign corporation and deemed paid by a domestic corporate shareholder only when the domestic corporation directly owns at least 10% of the voting stock of the distributing foreign corporation. The tax Court followed this requirement in First Chicago Corp.,(11) holding that direct ownership is required for purposes of Sec. 902 and that the ownership of several members of an affiliated group could not be aggregated to reach the 10% threshold.

The obvious question is how this holding is reconciled with the conclusion in Rev. Rul. 91-5, which allowed a Sec. 902 credit without direct ownership.(12) Apparently, the IRS is following the fiction of Sec. 304, which allows a dividend to be paid to a nonshareholder, and has given DX a direct ownership interest in FX for purposes of Sec. 902.

Rev. Rul. 91-5 provided that, consistent with the legislative history of Sec. 304(b)(2), DX is considered to own at least 10% of the voting stock of FX for purposes of Sec. 902(a) and is therefore entitled to claim the benefits of Sec. 902. The legislative history under Sec. 304(b)(2) provides that the FTC should be allowed to the selling corporation "to the same extent as if the distribution had been made directly by the corporation which is treated as having made the distribution."(13)

The reference in the ruling to the legislative history of Sec. 304(b)(2) does not provide a clear technical basis for allowing a Sec. 902 credit on the dividend from the acquiring corporation. The language of the legislative history appears to address issues relating to the characterization of the distribution (dividend or capital gain) and the source of the dividend (U.S. or foreign) in a Sec. 304 transaction.

Further, in Letter Ruling 8515041,(14) issued after the 1984 legislation, the IRS said that the seller must hold at least a 10 direct ownership in the acquiring corporation to obtain the benefits of Sec. 902 in a Sec. 304 context. Thus, Rev. Rul. 91-5 clearly represents a change in thinking by the IRS and should overrule this letter ruling. Effect of relative values: One reading of Rev. Rul. 91-5 is that the IRS reached its technical conclusion for allowing the Sec. 902 credit on the dividend from FX based on the percentage, by value, of stock deemed held by DX immediately before the redemption Under this theory, DX would be deemed to receive FX shares based on the relative value of the FY shares compared to the combined value of FX and FY. FX would then redeem the shares DX received on the contribution of the FY shares to FX.

Since the values of FX and FY are equal, DX would own, albeit momentarily, 50% of FX ($200x /($200x + $200x)) Although this example ignores the added complication caused by FX having both voting and nonvoting shares, DX should obtain at least a 10% voting interest in FX.

If the relative values of FX and FY were not equal, the valuation issue would become more apparent. For example, if the value of the FY shares were $10x and the value of the FX shares were $190x, DX would be deemed to hold, by virtue of Sec.. 304, only a 5% interest in FX on the contribution of the FY shares ($10x / ($190x + $10x)). Under this theory, it could be argued that DX would not be entitled to a Sec. 902 credit on the distribution from FX as DX would not have the required 10% interest in FX.

Fortunately, the effect of the relative values of the issuing and acquiring corporation on the Sec. 902 credit was addressed by the Service in Rev. Rul. 92-86.

* Rev. Rul. 92-86

Rev. Rul. 92-86 was issued to amplify and clarify Rev. Rul. 91-5. The facts in Rev. Rul. 92-86 are similar to those in Rev. Rul. 9-5 with one very important distinction: the FMV of the FY stock is less than 10% of the combined FMVs of FX and FY.

Under the facts of Rev. Rul. 92-86, as in Flowchart 11, P, a domestic corporation, owns all of the outstanding stock of DX, a domestic corporation, and FX, a U corporation. DX owns all of the outstanding stock of FY, a U corporation. Of the outstanding FX stock, 90% by value is voting stock and 10% by value is nonvoting stock. P and DX are members of a consolidated group.

The FMV of the FY stock owned by DX is $40x, and DX has a basis of 20x in the FY stock. FY has accumulated $30 of post-1986 undistributed earnings and has paid post-1986 foreign income taxes of $10x. The FMV of the voting and nonvoting stock of FX owned by P is $500x. FX has accumulated post-1986 undistributed earnings of 30x and has post-1986 income taxes of $10X. DX sells all of its FY stock to FX for $40x.

The transaction is covered by Sec. 304. As in Rev. Rul. 9-5, Rev. Rul. 92-86 said that a Sec. 902 credit is available on the distribution from FX, the acquiring corporation. Again, consistent with Rev. Rul. 91-5, the ruling cited as authority the legislative history to Sec. 304(b)(2).

Significantly, the ruling also stated that for purposes of the 10% ownership requirement of Sec. 902(a), DX is considered to own the stock of FX that DX actually or constructively owns under Sec. 304(c). Sec. 304(c) refers to Sec. 38 for purposes of determining constructive ownership. Under Sec. 38(a)(3)(C), DX would constructively own 100% of the stock of FX.

Thus, the fact that DX would be considered to own only 74% ($40x / ($40x + $500x)) of the value of the FX shares as a result of the deemed contribution to capital is not relevant in determining the deemed paid credit. The key to the holding is Sec. 304(c).

Unresolved Issues

Regrettably, these rulings leave several critical issues open. For example, could the contribution to capital ever fall under the Sec. 367(b) regulations so as to avoid a gain recognition agreement under Sec. 3679a) and Notice 87-85? Also, could the transferor corporation ever obtain any basis in the acquiring corporation from the contribution to capital?

* Sec. 367 implications

One issue that has not been resolved by Rev. Ruls. 91-5 and 92-86 is whether the outbound transfer of stock from DX to FX should come under Sec. 367(a) or (b) in situations that qualify as both Sec. 351 transactions and Sec. 368(a)(1)(B) reorganizations. The current Sec. 367 regulations treat a transaction that qualifies under both Sec. 351 and 368(a)(1)(B) as falling under the Sec. 367(b) regulations, which do not require a gain recognition agreement.

Under sec. 304(a)(1), the FY stock transfered by DX is treated as having been received by FX as a capital contribution. Sec. 367(c)(2) treats a capital contribution of property to a foreign corporation by persons who own at least 80% of the total combined voting power of the foreign corporation as an exchange of property for stock of a foreign corporation. Through the Sec. 38 attribution rules, DX owns 100% of the total combined voting power of the FX stock. Thus, DX is considered to have transferred the FY stock to FX in exchange for FX stock.

The contribution of the FY stock to FX also qualifies as a Sec. 351 transfer to a controlled corporation. Under Regs. Sec. 1.1502-34, DX is considered to own the stock owned by other members of the consolidated group of which DX is a member. Thus, DX is considered to control FX for purposes of Sec. 351. Rev. Ruls. 91-5 and 92-86 concluded that because DX is a U.S. person and FX is a foreign corporation, the transfer under Sec. 351 is subject to Sec. 367(a). Following the regulations under Sec. 367(a) and Notice 87-85, DX would be required to execute a gain recognition agreement under Temp. Regs. Sec. 1.367(a)-3T(g). Based on the facts in the rulings, the gain recognition agreement would be for a 10-year period as DX is deemed to own 100% of the stock of FX.(15) As a result, should FX sell FY at any time before the expiration of the period for the gain recognition agreement, DX would be required to file an amended return for the year of the initial transfer and recognize the gain realized but not recognized at the time of such initial transfer.(16) Interest would be required to be paid on any tax deficiency calculated on the amended return.(17)

A B reorganization occurs when one corporation acquires at least 80% control of another corporation solely in exchange for voting stock. Rev. Ruls. 91-5 and 92-86 both involved situations in which the acquiring corporation had outstanding voting and nonvoting stock. If FX had only one class of voting stock, the deemed exchange of stock under Sec. 367(c)(2) could possibly be treated as an exchange qualifying as both a Sec. 351 transfer and a reorganization under Sec. 368(a)(1)(B). The critical question is whether or not the constructive issuance of stock under Sec. 367(c)(2) could satisfy the solely voting stock requirement of Sec. 368(a)(1)(B).

The Tax Court held in Lessinger(18) that the exchange requirements of Sec. 351 were met when a sole stockholder transferred property to a wholly owned corporation even though no stock or securities were issued. Even though the statutory language of Sec. 351 requires a transfer solely in exchange for stock or securities, the Second Circuit, which agreed on this point while ultimately reversing the Tax Court's holding, noted that "[i]ssuance of new stock in this situation would be a meaningless gesture." It appears to be a logical extension to apply Lessinger-type reasoning in the B reorganization context. Issuance of new shares by the transferee corporation in a contribution to capital transaction that would otherwise qualify as a B reorganization should also be a meaningless gesture and therefore not a required step to qualify the transaction as a B reorganization.

The IRS had vacillated on this issue(19) until IRS Letter Ruling 9035061,(20) which appears to allow the deemed issuance of shares in exchange for stock to qualify as a B reorganization. In the letter ruling, the U.S. shareholder transferred 100% of its shares (representing about 99% of the total shares outstanding) in a foreign subsidiary to Newco, a newly organized foreign subsidiary. Newco acquired the shares solely in exchange for Newco voting stock. Under the facts of the ruling, depending on the local law requirements, Newco may or may not issue additional shares of its one class of voting stock. This ruling permits the deemed issuance of Newco voting shares to qualify the transaction as a B reorganization, as it does not require that additional shares be issued.

Although not discussed in the ruling, the U.S. shareholder, as in Lessinger, actually owned 100% of the voting stock of Newco prior to the contribution of capital. This fact could have significance in determining whether a Sec. 367(c)(2) transaction could be considered a B reorganization. Perhaps then a distinction could be made for Sec. 304 transactions in which the selling shareholder actually owns stock in the acquiring corporation, as opposed to the Rev. Rul. 92-86 situation in which the selling shareholder has no actual ownership in the acquiring corporation.

Assuming the transaction could satisfy the solely voting stock requirement necessary to be classified as a B reorganization, why should the result of a Sec. 351/B overlap transaction arising as part of a Sec. 304 transaction be different from the result of a Sec. 351/B overlap transaction that does not arise through Sec. 304? The current Sec. 367 regulations do not require a gain recognition agreement in the typical Sec. 351/B overlap (outside of the Sec. 304 context). Further, it does not appear that a gain recognition agreement is even necessary to protect the United States fisc if the transaction were treated as a B reorganization (or would have been treated as a B reorganization if voting stock had actually been issued). In the Rev. Rul. 992-86 fact pattern, the gain derived by the foreign transferee on a subsequent disposition of the transferred stock would be treated as subpart F income and taxed to the U.S. shareholder.(21)

Although not yet in effect, the proposed regulations under Sec. 367, released in August 199, would subject such a Sec. 351/B transaction to both Sec. 367(a) and (b) and would require a gain recognition agreement. Thus, taxpayers willing to brave these somewhat unchartered waters may have a window of opportunity until the proposed Sec. 367 regulations are issued in final form to enter into certain Sec. 304 transactions and avoid a gain recognition agreement.

* Disappearing basis - impact on postacquisition

restructuring

Another issue that was not addressed by Rev. Rul. 91-5 or 92-86 was the disappearing basis issue raised by Rev. Rul. 70-496.(22) In Rev. Rul. 70496, corporation X owned 100% of the stock of corporation Z and 70% of the stock of corporation Y. Y owned 100% of the stock of corporation S. Z acquired 100% of S's stock from Y. The IRS said that "since the transferor (Y) had no direct stock ownership interest in the acquiring corporation (Z) before or after the transaction, the basis of the S stock surrendered by Y disappears and cannot be used to increase the basis of any other asset of Y." Had the transaction been treated as an actual sale rather than a dividend under Sec. 304, Y would have been able to reduce its gain on the sale of S by its basis in S.

The implications of the disappearing basis issue for postacquisition restructuring of foreign operations can be quite serious.

Example 2: A U.S. purchaser (USP) has recently purchased F2, a country Y corporation, which owns F3, a country X corporation. USP made a Sec. 338 election for F2 and F3. For X tax reasons, USP establishes a new subsidiary (F1) to acquire the stock of F3 from F2. The purchase price of F3 is the FMV of F3 on the date of the initial acquisition of F2. See Flowchart 2 on page 174.

This is a typical Sec. 304 cross-chain acquisition. Under Sec. 304(b)(2), F2 would have dividend income to the extent of F1's and F3's E&P. As F1 was just formed. F1 has no E&P. Due to the Sec. 338 election, F3's E&P was eliminated as of the date of the acquisition of F2.(23) (Assume further that there is no intervening E&P from the date of the acquisition of F3 through the end of F3's year.) Thus, there is no dividend income to F2. Under Sec. 30(c)(2), the distribution is then treated as a return of capital to the extent of F2's basis in F1. As F2 has no basis in F1, there can be no return of capital and the transaction is treated as a sale or exchange of the F1 stock deemed held by F2. The capital gain on the sale of F3 will be passive basket(24) subpart F income(25) to F2 and would be includible in USP'a gross income, subject to the high-taxed exception of Sec. 954(b)(4). The indirect credit received by USP under Sec. 960 will consist of a portion of the foreign taxes in F2's passive pool of post-1986 foreign income taxes, which are likely to be negligible.

In other words, even though USP made a Sec. 338 election for F@ and F3, and F2 has an FMV basis in F3, because the "sale" is treated as a Sec. 304 transaction and not as a sale of F3 stock for U.S. tax purposes, F2 will have a capital gain for U.S. tax purposes equal to the "sales price" of F3. Arguably, F2 should have basis in F1 equal to the basis of the deemed capital contribution of the F3 stock made by F2 to F1 under Sec. 34(a). However, this is clearly not the result in Rev. Rul. 70-496.

It does seem to follow that since Rev. Rul. 92-86 deems the transferor corporation to hold the 10% ownership in the acquiring corporation necessary to obtain the Sec. 902 deemed paid credit, the transferor corporation should have constructive ownership for basis purposes as well. Unfortunately, Rev. Rul 92-86 does not address the issue and taxpayers will continue to be forced to restructure before the Sec. 304 sale to avoid the otherwise disastrous results.

Taxpayers have avoided this disappearing basis issue by restructuring before the Sec. 304 sale so that the transferor corporation owns both the acquiring and the acquired corporation. Arguably, in the above fact pattern, if the transferor corporation (F2) owns even one share of the acquiring corporation (F1), F2 would be able to avoid the entire capital gain on the Sec. 304 sale. Regs. Sec. 1304 2(a) provides that the transferor's basis in the stock of the acquiring corporation will be increased by the basis of the stock surrendered by him. Thus, returning to the facts in Example @, assuming F2 owned one share of F1 before the Sec. 304 transaction, F2 would be able to increase its basis in F1 by its basis in F3. Due to the Sec. 338 election, F2 has an FMV basis in F3. Therefore, the entire distribution under Sec. 304 should be a return of capital to F2.

The IRS blessed this type of pre-Sec. 304 sale restructuring in Letter Ruling 8826033.(26) There, the transferor corporation acquired 10% of the stock of the acquiring corporation before a Sec. 304 sale. (It is obviously no coincidence that the 10% interest was also the amount needed to ensure the ability to claim the Sec. 902 credit.(27))

Application of Sec. 304 With Sec. 291 Funds

Proposed regulations under Sec. 29,(28) dealing with the passive foreign investment company (PFIC) rules, may have extremely adverse consequences to U.S. taxpayers who use Sec. 304 transactions to restructure foreign subsidiaries. The proposed Sec. 129 regulations may not limit the amount of excess distribution coming from a PFIC in a Sec. 304 transaction in the same manner as an excess distribution coming from a PFIC in a non-Sec. 304 transaction. A detailed analysis of the PFIC rules is beyond the scope of the present discussion. Therefore, only a general explanation of the issues is presented below.

In general, a PFIC is a foreign corporation that in any tax year ending after 1986 earns passive income equal to 75% or more of its gross income or has passive income generating assets equal to 50% or more of its total assets.(29)

When a U.S. shareholders of a PFIC receives an "excess distribution" from a PFIC or disposes of the PFIC stock, the shareholders must pay U.S. tax on the deferred income amount allocable to post-1986 tax years, plus an interest charge.(30) An excess distribution from a PFIC is normally the portion a distribution made by the PFIC for the three preceding years.(31) The amount of the excess distribution is not limited to the E&P of the PFIC.(32)

Under Porp. Regs. Sec. 1.129-2(b)(3), the amount of excess distribution from the issuing corporation in not reduced by the 125% of prior-year distributions in Sec. 304 transaction. Instead, the entire amount is treated as an excess distribution.

There is a conflict between the text and the preamble of the proposed regulations involving Sec. 304 transactions in which the PFIC is the acquiring company. Prop. Regs. Sec. 1.1291-2(b)(3) states that any amount paid by the acquiring corporation will be treated as a distribution to the transferor corporation. This language indicates that the normal rules for determining the amount of an excess distribution will apply. The preamble to the proposed regulations states that the entire amount paid by the PFIC would be an excess distribution. U.S. multinationals should be aware of the inconsistency as the proposed regulation could be modified to conform to the preamble.(33)

As a result of this different definition of excess distributions in the proposed Sec. 1291 regulations for Sec. 304 transactions, taxpayers have yet another potential trap to avoid in structuring Sec. 304 sales.

Conclusion

Sec. 304 is clearly gaining a prominent role in international tax planning. With the release of Rev. Ruls. 91-85 and 92-86, taxpayers have much greater certainty as to the result in cross-border Sec. 304 transactions. However, many unanswered questions remain. Further, with the release of the proposed Sec. 1291 regulations, tax practitioners now have an additional hurdle to clear in implementing any Sec. 304 transactions.

(1) Rev. Rul. 91-5, 1991-1 CB 4. (2) Rev. Rul. 92-86, 1992-2 CB 199. (3) While the immediate benefit to USP is the same whether or not A and B are located in the same country, USP must also considered the consequences of having B,a country Y corporation, own A, a country X corporation. Over the past several years, the more common Sec. 304 transaction involved two foreign subsidiaries located in the same country. However, the Sec. 304 transaction will not always achieve the desired results if both foreign subsidiaries are located in the same country (i.e., Canada). Thus, the use of third countries may become more common); see e.g., IRS Letter Ruling 921042 12/12/91). (4) It appears from Regs. Sec. 1.304-2(a) that the contribution to capital would occur before the distribution in redemption. The seller is able to increase his basis in the acquiring corporation by the amount of his basis in the issuing corporation in order to determine the extent of any return of capital distribution. (5) H. Rep. No.98-861, 98th Cong.,2d Sess. 1223 (1984) hereinafter referred to as the "Conference Report"). See also Sec. 312(a). (6) Regs. Sec. 1.304-2(a). (7) Sec. 362(a) provides that the basis of property acquired by a corporation as a contribution to capital will be the same as the basis in the hands of the transferor, increased by the amount of gain recognized by the transferor on such transfer. However, there is no increase in basis on account of the dividend realized by the transferor (Regs. Sec. 1.304-2(c), Example (4)). (8) Notice 87-85, 1987-2 CB 395. (9) See, e.g., IRS Letter Rulings 8514081 (1/10/85), 8826033(4/4/88) and 8929064 (4/28/89). (10) Id. (11) First Chicago Corp., 96 TC 421 (1991), involved only the payment of a regular cash dividend. Sec. 304 was not considered. (12) See Conference Report, at 1223. (13) Id. (14) IRS Letter Ruling 851504 (1/11/85). (15) Notice 87-85, note 8. (16) Temp. Regs. Sec. 1.367(a)-3T(g)(3). (17) Id. (18) Sol Lessinger, 872 F2d 519 (2d Cir. 1989)(63 AFTR2d 89-1055, 89-1 USTC para. 9254), rev'g 85 TC 824 (1985). (19) In Letter Ruling (TAM) 8625006 (3/14/86), the IRS would not treat a deemed contribution to capital transaction as a B reorganization when no additional stock was issued by the transferee corporation. However, the IRS revoked this letter ruling in Letter Ruling (TAM) 9008002 (10/31/89) without indicating its reasoning for the revocation. (20) IRS Letter Ruling 903506 (6/5/90). (21) The subpart F income would likely be subject to little, if any, foreign tax and would be passive basket income. Thus, the U.S. shareholder may not be able to shield the subpart F income with any deemed paid FTCs. This result may ultimately prove more onerous to the U.S. transferor than if a gain recognition agreement were entered into. Assuming the transaction were covered by Sec. 367(a), a sale of FX by FY within the period covered under the gain recognition agreement could generate active basket Sec. 1248 dividend income to USP, which could be sheltered by deemed-paid FTCs. (22) Rev. Rul.70-496, 1970-2 CB 74. (23) All historical tax attributes of the target corporation, including E&P, are eliminated as of the date of acquisition when a regular Sec. 338(g) election is made. (24) Sec. 904(d)(2)(A). (25) Sec. 954(c)(1)(B). (26) IRS Letter Ruling 8826033, note 9. (27) See also IRS Letter Ruling 921003 (12/0/91). As an alternative to obtaining shares in the acquiring corporation, the transferor could consider retaining a small interest in the issuing corporation and then selling the retained shares to an unrelated third party to generate a capital loss. Under Regs. Sec. 1.302-2(c), the basis of the shares retained in a redemption transaction should be increased by the basis of the shares that have been transferred. A subsequent sale of the retained shares to a third party would likely generate a capital loss that would offset the capital gain from the initial Sec. 304 transaction. (28) Prop. Secs. 1.1291-1 through-10 (proposed 4/1/92). (29) Sec. 1296(a). (30) Sec. 129(a). (31) Sec. 129(b0. (32) Id. (33) For a more detailed discussion by the proposed PFIC regulations, see Tuerff, Renfroe and Gordon, "Unpleasant Surprises: Life in the Section 1291 Ditch," Tax Notes International. 11/23/92, at 1105.