How corporations can reduce their foreign tax burden - impact of IRS PLR 8929059. (private letter ruling)by McGowan, John R.
Application of Sec. 355/1248(f) Under Notice 87-64
Under Sec. 355, if a corporation distributes the stock or securities of a corporation which it controls immediately before the distribution, the recipient of tile distribution will not realize any gain or loss if: 1) the transaction was not used to distribute E&P of either corporation; 2) the active business requirements of Sec. 355(b) are satisfied; and 3) the distributing corporation distributes either all, or a controlling amount, of stock in the controlled corporation.
Qualification of the distribution under Sec. 355 has important implications for the distributing corporation. Sec. 311(a) provides nonrecognition treatment for the distributing corporations. Moreover Sec. 311(b) would not apply to a Sec. 355 transaction because the distribution is not subject to Secs. 301-307 (i.e., "Subpart A").
If the IRS rules that Sec. 355 does not apply, a distribution of appreciated stock is generally treated as a sale pursuant to Sec. 311(b). As such, it will also be treated as a sale for purposes of Sec. 1248(a). (Rev. Rul. 87-96.) Sec. 1248, added to the IRC in 1962, generally recharacterizes gain recognition by a U.S. shareholder on the disposition of stock in a CFC as a dividend to the extent of earnings attributable to the U.S. shareholder's ownership interest in the CFC. Prior to 1962, shareholders could sell the stock of a CFC and recognize a capital gain. This induced shareholders to avoid the repatriation of foreign E&P as an actual dividend distribution, subject to tax at ordinary income rates. Sec. 1248(f)(1) applies to Sec. 311 distributions unless relief is available under Sec. 1248( (2) to recognize dividend income to the extent of earnings and profits attributable to the period in which the described corporation was a CFC, notwithstanding any other provision in the IRC (e.g., Sec. 311(a), Sec. 1248(f)(2) provides that Sec. 1248(f)(1) will not apply to any distribution of stock to a domestic corporation if the distributee corporation is treated as holding the stock of the foreign corporation for the period for which the stock was held by the distributing corporation.
Notice 87-64 states that Sec. 1248(f)(1) applies to Sec. 355 spinoffs, without relief under Sec. 1248(f)(2). However, future regulations under Sec. 1248(f) may limit the application of Sec. 1248(f)(1) to those situations in which either the CFC is no longer a CFC after the distribution, or one or more of the distributees are not "U.S. shareholders" under Sec. 951(b) after the distribution. it is this principle which is utilized in PLR 8929059. The notice also indicates that future regulations will contain provisions to ensure that, subsequent to a Sec. 355 distribution not subject to Sec. 1248(f)(1), the amount of Sec. 1248 dividend resulting from a later disposition of the CFC stock will include the Sec. 1248 earnings attributable to the CFC stock as of the date of the Sec. 355 distribution.
Application of Secs. 311(b) and 1248(a) in the Consolidated Return Context Under Rev. Rul. 87-96
The facts of Rev. Rul. 87-96 are as follows: P, a U.S. corporation, owns all the stock of S, also a U.S. corporation, which in turn owns all the stock of FX, a CFC as defined in Sec. 957. P and S file a consolidated tax return on a calendar year basis. The fair market value of the FX stock currently exceeds S's basis in such stock.
As part of a corporate restructuring, it is contemplated that S will distribute, on December 31, 1987, all of its FX stock to P; thus, following the distribution P will own all of the stock of both S and FX. As of December 31, 1987, FX will have post- 1 962 earnings and profits (E&P) that will not have been previously taxed under Subpart F.
In this ruling, the IRS disqualified the transaction as a tax-free spin-off under Sec. 355. While no reason for such disqualification was given, presumably the non-applicability of Sec. 355 resulted from actual circumstances. Since Sec. 355 was inapplicable, Sec. 301 applied to the transaction. Moreover, Sec. 311(b) then triggered gain to the extent that the appreciated stock transferred by S to P exceeds basis in such stock.
Application of Secs. 311(b) and 1248(a) in an Unconsolidated Return Context Under Rev. Rul. 87-47
The facts of Rev. Rul. 87-47 are as follows: P, a U.S. corporation, owned all the stock of S, also a U.S. corporation. On January 1, 1983, S purchased, in a transaction in which gain or loss was recognized, all the stock of FX, a CFC. On January 1, 1986, S contributed for no consideration all of the FX stock to HC, an existing wholly-owned U.S. subsidiary, of S. HC's only asset is the stock of FX. On December 31, 1986, S distributed to P all the shares of the HC stock. On the date of this distribution the fair market value of the HC stock exceeded the adjusted basis of such stock in the hands of S. P, S and HC did not file a consolidated return.
This transaction failed to qualify as a Sec. 355 tax-free spinoff because the five-year active business requirement was not satisfied. Thus, the distribution was taxable as a dividend under Sec. 301. Moreover, the distribution of the HC stock by S was taxable under Sec. 311(b), which treats the distribution of the HC stock as if the stock had been sold at the time of the distribution. Both of these rulings indicate that gain recognition resulted from factual considerations, leaving open the possibility of nonrecognition treatment where the tenets of Sec. 355 are otherwise satisfied.
This PLR is a good example of how the IRS applies Notice 87-64 and of how corporations can restructure and reduce this overall foreign tax burden with current U.S. tax cost. In this ruling, the IRS held that a distribution by a second tiered CFC to a U.S. corporation qualified for nonrecognition treatment under Sec. 311(a). Moreover, the IRS ruled that Sec. 355(a)(1) applies to the receipt of the stock by. a U.S. corporation. Finally, a number of the temporary regulations were applied from IRC Reg. Sec. 7.367.
The facts of PLR 8929059 are as follows: DP, a U.S. parent engages in business J through U.S. and foreign subsidiaries. DP owns all the stock of DS, a U.S. corporation which engages in business J in various foreign countries. DS in turn, owns all the stock of FD, a Country M corporation engaged in business J. FD owns all the stock of FC, a Country N corporation engaged in business J. There is intercorporate debt between FD and FC which arises and is discharged in the normal course of business.
The current corporate structure of the DS/FC operations costs DP a high Country, N tax burden. First, the distribution of dividends from FC to DS through FD incurs excessive Country N withholding taxes. Under the U.S.-Country, N income tax treaty dividends paid by a Country N corporation to a U.S. corporation qualify for a reduced withholding tax rate. This treaty does not apply, however, where the dividends are paid to a non-U.S. shareholder, such as FD, and the dividends incur a higher withholding rate. Country M counsel has advised that if FD were eliminated as FC's shareholder, FC could make dividend distributions which would qualify for the reduced withholding tax rate of the U.S.- Country N income tax treaty. DP expects to have substantial savings in foreign taxes after the proposed spin-off due to its significant excess foreign tax credits. These savings in foreign taxes will result in actual net dollar savings for DP.
Second, Country N counsel has advised that if FC were owned by a Country N holding company along with DP's other Country N affiliates, it would be possible for FC and other DP affiliates to save Country N taxes by taking advantage of the Country N tax grouping laws. Because the holding company would itself be a Country N company, FC would continue to be eligible for the reduced withholding tax benefits of the U.S.- Country N income tax treaty.
In order to achieve these tax savings, FD will distribute all of FC's outstanding shares to DS. As a result, DS will own all the outstanding shares of FD and FC. ks soon as it is practicable after that, DS will transfer all the shares of FC to FX, a Country N holding company, in a transaction described in Sec. 351(a). Concurrently with this drop-down, DP will transfer to FX all the outstanding shares of other DP Country N affiliates in a transaction described in Sec.351. As a result, DP and DS will own all of FS's outstanding stock.
The IRS ruled that FD's distribution of the FC stock will be accorded non-recognition under Sec. 311(a). The receipt by DS of the FC stock will also be accorded non-recognition under Sec. 355(a)(1). Next, the IRS held that, if the requirements of Temp. Reg. Secs. 7.367(b)-1(c), (d) and 7.367(b)-4 through 7.367(b)-12 are met, and if FX, FD, and FC are corporations within the meaning of Sec. 7701(a)(3), and if DP and DS file an agreement under Temp. Reg. Sec. 19367(a)-3T(g), then FD and FC will be considered corporations for purposes of the distribution of the FC stock to DS, pursuant to Sec. 367(b)(1) and Temp. Reg. Sec. 7.367(b)- 10.
These sections of the IRC state that corporations realizing gain pursuant to Sec. 367(b) must file a notice of such transaction with the district director, and that adequate records must be kept to make any required adjustments to earnings and profits. Finally, Temp. Reg. Sec. 1.367(a)3T(g) states generally that a transfer of stock of securities shall not be subject to Sec. 367(a) if such transferor agrees to recognize gain upon any subsequent disposition by the transferee.
Finally, the IRS ruled that Temp. Reg. Secs. 7.367(b)-10(a) and (c) and 7.367C)-1 apply to the exchange resulting from FD's distribution of the FC shares to DS. Moreover, 367(a)(1) will not apply to the transfer of FC stock to FX if DP and DS file an agreement under Temp. Reg. 1.36- (a)3T(g), effective for 10 years, to recognize gain on a subsequent disposition.
The Sec. 1248 amount, the Sec, 1248(c)(2) amount, the earnings and profits amount, and the additional earnings and profits amount of FC including those amounts previously attributed to FC's stock) will be attributed to FX's stock received by DS as a consequence of the proposed transaction, in accordance with the principles of Reg. Secs. 1.1248-2 and 1,1248-3, pursuant to Temp. Reg. Sec. 1.367(b)-9(b)(1). Reg. Sec. 1.1248-2 covers the manner of computation of earnings and profits attributable to a block of stock in simple cases, while Reg. Sec. 1.1248-3 covers the manner of computation of earnings and profits attributable to a block of stock in complex cases.
The facts of a recent PLR largely parallel the provisions of 87-64. Unlike Rev. Ruls. 87-64 and 87-96 where Sec. 355 did not apply PLR 8929059 did apply Sec. 355. Similarly, Notice 87-64 indicated that when Sec. 355 applies to a distribution of stock that Sec. 1248(f) may require immediate gain recognition and recharacterization. This PLR applied Sec. 355 to a transaction in which Sec. 1248(f) did not trigger immediate gain. Instead, the IRS stated that the Sec. 1248 amount and the Sec. 1248(c) amount would he attributed to the new holding company which holds the stock. This letter ruling illustrates how corporations can reduce their foreign tax burden by taking advantage of favorable tax treaties with tax grouping laws within certain countries.
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