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Application of AET to foreign-owned U.S. corporations.

The accumulated earnings tax (AET) imposed by Sec. 531 was designed as a penalty tax on a corporate taxpayer unreasonably accumulating earnings, rather than distributing them as dividends (which would subject them to shareholder level tax).

A question exists as to the applicability of the AET when a shareholder would not be subject to U.S. tax on the corporation's accumulated earnings; i.e., the shareholder in question is a foreign person not engaged in a trade or business in the United States, and whose only U.S. tax liability on receipt of the U.S. corporation's accumulated earnings is a withholding tax. IRS Letter Ruling 9229025 addressed this question and held the A.ET was essentially moot when there could not possibly be any avoidance of shareholder level tax for the AET.

Letter Ruling 9229025 involved a foreign corporation (FC) not engaged in a U.S. trade or business. Each of FC's shareholders, two foreign corporations, owned 50% of FC. Neither these foreign corporations nor their ultimate shareholders were U.S. citizens or residents, and they were not engaged in any U.S. trade or business. FC's only involvement in the United States was its ownership of all of the stock of a U.S. parent corporation (PC), which in turn wholly owned a U.S. subsidiary (SC). Both PC and SC owned and operated real estate in the United States and may have accumulated earnings beyond their business needs.

The taxpayer requested a ruling that PC and SC were not subject to the AET on the grounds that, since no shareholder level tax was being avoided, Sec. 531 should not apply. The IRS agreed and stated that no liability under Sec. 531 could arise because no domestic or foreign corporation had been formed or availed of to avoid the imposition of income tax on its shareholders.

The ruling also discussed the potential imposition of U.S. withholding tax on the payment of a U.s.-source dividend by FC. The Service indicated that since both PC and SC appeared to be U.S. real property holding companies (Sec. 897(c)(2)), any earnings generated by FC on a sale of the shares of PC would be treated as income effectively connected with a U.S. trade or business. Therefore, such earnings would be from sources within the United States that might give rise to an AET liability should FC fail to pay sufficient distributions of U.s.-source income. However, under the provisions of the income tax treaty between the United States and FC's country of incorporation (presumed to be Australia), such a "second tier" U.S. withholding tax could not be applied. Thus, the ruling again held that the AET was inapplicable.

The important point of this letter ruling is that when the express purpose of a law is to prevent an event that cannot in fact occur (e.g., the avoidance of shareholder level tax), the law may not have any application. The ruling may have practical implications in situations in which a foreign-owned U.S. corporation has sold off many of its assets and has retained liquid assets to generate income to offset existing net operating losses (NOLs). These corporations may have been concerned about the AET since they may generate current earnings and profits despite their accumulated NOLs. This ruling should help to quell those fears.
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Title Annotation:accumulated earnings tax
Author:Lehmann, Paul G.
Publication:The Tax Adviser
Date:Jul 1, 1993
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