Rev. Rul. 92-85 postulates two situations, the first of which involves a parent corporation (FP) with two wholly owned subsidiaries (DX and FX). FX owned all the outstanding stock of a second-tier subsidiary (FY). FP was organized under the laws of foreign country A, which has an income tax convention with the U. S. that is identical to the 1981 draft U.S. model treaty. FX and FY were both organized under the laws of foreign country Z, which has a similar treaty with the U.S., except that the U.S.-Z treaty provides a higher withholding tax rate on dividends than that of the U.S.-A treaty. DX was a U.S. corporation.

The ruling analyzes the Federal income tax consequences of a sale by FX of all the FY stock to DX in exchange for a cash payment. IRC Sec. 304(a)(1) applied to the transaction, because FX controlled both FY and DX before the sale occurred. (FX directly owned all of the outstanding stock of FY, and FX was deemed to own all the outstanding stock of DX by operation of the attribution rule of IRC Sec. 318(a)(3)(C). Thus, the cash payment received by FX was treated as a distribution in redemption of DX stock.

Continuing the analysis, FX directly owned all the outstanding stock of FY before the transaction and, by reason of the attribution rules of IRC Sec. 318(a)(2)(C) and (3)(C), was also deemed to own all such stock immediately thereafter. Accordingly, the IRS concluded that none of the provisions of IRC Sec. 302(b) applied to treat the deemed distribution as a payment in exchange for stock. Therefore, the deemed distribution was, subject to IRC Sec. 301.

Under IRC Sec. 304(b)(2), the deemed distribution was treated as a dividend from DX to the extent of DX's earnings and profits and, thereafter, as a dividend from FY to the extent of FY's earnings and profits.

Because DX was a U.S. corporation, the deemed dividend from DX was held to constitute U.S. source income subject to tax under IRC Sec. 881 and withholding under IRC Sec. 1442. A reduction in the withholding tax rate on dividends was available under the U.S.-Z treaty, and the DX stock that was attributed to FX for IRC Sec. 304 purposes under IRC Sec. 318(a)(3)(C) was treated as being owned by FX for purposes of determining the withholding tax rate available under the treaty. The deemed ownership by FX of more than 10% of the voting stock of DX caused the deemed dividend from DX to qualify for a favorable withholding tax rate. The deemed dividend from FY was considered foreign source income, not subject to Federal income tax or withholding.

Underwithholding Exposure

In discussing the amount treated as a distribution, the IRS implied that the rationale of Rev. Rul. 72-87, 1972-1 CB 274, may sometimes be relevant to the type of restructuring transaction under consideration. Broadly speaking, Rev. Rul. 72-87 requires that a U.S. corporation withhold tax by reference to the full amount of any ordinary distribution to a foreign person, notwithstanding that some or all of the distribution may ultimately be treated as gain under IRC Sec. 301(c)(3)(A). Because Rev. Rul. 92-85 does not specify under what circumstances the IRS would so apply that rationale, there may be some degree of exposure to an underwithholding challenge by the IRS in situations where taxpayers do not withhold on the full amount paid pursuant to such a transaction. If successful, such a challenge could result in liability for interest and penalties. The greatest exposure to such a challenge in connection with the type of restructuring transaction under consideration would appear to be presented where the transaction occurs substantially before the end of the taxable year of the participating domestic corporation (DX, on the facts presented). Taxes overwithheld in response to concern about Rev. Rul. 72-87 could be recovered by filing a refund claim with the IRS.

The IRS also implied that the rationale of Rev. Rul. 84-152, 1984-2 C.B. 381, and Rev. Rul. 84-153, 1984-2 C.B. 383, which concern withholding tax with respect to certain interest payments on back-to-back loans, might have applied had the withholding tax rate on dividends under the U.S.-Z treaty been lower than that under the U.S.-A treaty. However, the IRS did not articulate any basis for predicting when such a challenge would likely to occur with respected to the type of restructuring transaction in question.

The second situation presented in Rev. Rul. 92-85 concerns a foreign corporation (FP) with two wholly-owned subsidiaries (FS1 and FS2) owned all the outstanding stock of a U.S. subsidiary (DS). FS1 ad FS2 were each organized under the laws of a foreign country that does not have a tax treaty with the U.S.

The ruling analyzes the Federal income tax consequences of a sale by FS2 all the DS stock to FS1, in exchange for a cash payment. IRC Sec. 304(a)(1) applied to the transaction, because FS2 controlled DS and FS1 before the sale occurred. FS2 directly owned all the outstanding DS stock and was deemed under IRC SEc. 318(a)(3)(C) to own all the outstanding FS1 stock. Thus, the cash payment received by FS2 was treated as a distribution in redemption of FS1 stock.

FS2 directly owned all the outstanding stock of DS before the transaction and was deemed under IRC Sec. 318(a)(2)(C) and (3)(C) to own all of such stock immediate thereafter. Accordingly, the IRS concluded that none of the provisions of IRC Sec. 302(b) applied, and that the deemed distribution was subject to IRC Sec. 301. The deemed distribution was treated under IRC Sec. 304(b)(2) as a dividend from FS1 to the extent of FS1's earnings and profits and, thereafter, as a dividend from DS to the extent of DS's earnings and profits.

Because FS1 was organized outside of the U.S., the amount treated as a dividend from FS1 was foreign source income to FS2. Therefore, U.S. withholding tax did not apply to that portion of the payment. However, the deemed dividend from DS (a U.S. corporation) was U.S. source income subject to withholding tax. As the payor, FS1 was treated by the IRS as a withholding agent, notwithstanding its status as a foreign corporation. In other words, the IRS required FS1 to withhold tax on the portion of its payment to FS2 that was treated as a dividend from DS.

In discussing the amount subject to withholding tax in this type of situation, the IRS stated that a payment will generally be treated as a distribution from the foreign acquiring corporation (FS1, on the facts presented), and thus not subject to withholding tax, only to the extent that the corporation's earnings and profits can be clearly determined. The remaining amount will be deemed paid by the domestic issuer, here DS, and subject to withholding to the extent of that corporation's earnings and profits. If this requirement is strictly applied, it may have a harsh impact where a foreign corporation utilizes accounting methods that do not readily lend themselves to the calculation of earnings and profits. This might occur where a corporation is organized in a jurisdiction that requires the application of accounting principles that vary substantially from GAAP.