Sec. 304 Anti-Avoidance Rule Modified

Editor: Rick Klahsen, CPA

The IRS recently released temporary and proposed regulations (T.D. 9477) that modify and strengthen regulations previously issued under Temp. Regs. Sec. 1.304-4T. The regulations apply to certain transactions otherwise subject to Sec. 304 but entered into with the principal purpose of avoiding the statute’s application. The original version of Temp. Regs. Sec. 1.304-4T issued in 1988 (T.D. 8209) targeted transactions designed to avoid Sec. 304 treatment of a corporation that controls the acquiring corporation or deemed acquiring corporation. The new regulations restate the original rule and contain a similar rule that targets transactions designed to avoid Sec. 304 for a corporation that is controlled by the issuing corporation or deemed issuing corporation.

Background

Sec. 304 was designed to ensure dividend treatment on related-party stock transactions that are in substance a dividend from earnings and profits (E&P). Under Sec. 304(a)(1), if a brother and sister corporation are under common control and the brother (the acquiring corporation) acquires the stock of the sister (the issuing corporation), the proceeds will be treated as received in redemption of the acquiring corporation. The redemption will generally result in dividend treatment under Sec. 302 because both acquiring and issuing corporations are under common control. The dividend is treated as if first distributed by the acquiring corporation to the extent of its E&P and then distributed by the issuing corporation to the extent of its E&P.

Example 1: D, a domestic corporation, wholly owns two foreign corporations, C1 and C2. In D’s hands, the basis and fair market value (FMV) of the C1 stock is $100. C1 has substantial E&P. C2 has accumulated E&P of $200. D wants to own all its foreign corporations in a direct chain and causes C2 to acquire the C1 stock for $100.

Under Sec. 304(b)(2), D will be treated as receiving a distribution, to which Sec. 301(c)(1) applies, first out of the E&P of the acquiring corporation (C2) and only then from the issuing corporation (C1). As a result, D will receive a taxable dividend of $100 from C2’s E&P. D will also include a deemed paid foreign tax credit (under Sec. 902) for the underlying taxes attributed to the E&P distributed.

Original Regulation

The original Temp. Regs. Sec. 1.3044T targeted transactions that sought to circumvent the E&P of the acquiring corporation (C2 above) through the use of a newly formed intermediary.

Example 2: D, a domestic corporation, wholly owns two foreign corporations, C1 and C2. In D’s hands, the basis and FMV of the C1 stock is $100. C1 has substantial E&P and is located in Country X, a high-tax jurisdiction. C2 has accumulated E&P of $200 and is located in Country Y, a low-tax jurisdiction. D wants to own all its foreign corporations in a direct chain. To avoid a dividend distribution from C2’s low-tax E&P and to avoid Y approval for the sale, D causes C2 to form a new Y corporation, C3. C2 contributes $100 to C3, and C3 then acquires the C1 stock from D for $100.

Under Sec. 304, D would be treated as receiving a dividend first from the E&P of C3 (none), then from the E&P of C1 (high tax). The original regulation gave the IRS discretion to treat C2 as the deemed acquiring corporation and thus force a dividend from its low-tax E&P rather than C1’s high-tax E&P. Although D’s gross income is not affected by the recharacterization, it would reduce the deemed paid foreign tax credit available to D to offset the resulting taxes.

The anti-avoidance rule would apply if the IRS determined under audit that the taxpayer had entered into the transaction with a principal purpose of avoiding the application of Sec. 304 by forming and funding C3. The transaction’s purported business purpose—e.g., alignment of D’s foreign group or local government approval—would not prevent the IRS from applying the rule.

Current Regulation

The new regulations update the deemed acquirer rule described above and add a new deemed issuer rule that targets another variation of the cross-chain stock sale. The new rule eliminates a perceived loophole in the original regulation because only the identity of the acquirer was previously considered.

Example 3: D, a domestic corporation, wholly owns two foreign corporations, C1 and C2. In D’s hands, the basis and FMV of the C1 stock is $100. C1 has no E&P and has $100 cash at its disposal. The basis and FMV of the C2 stock is also $100, and C2 has E&P of at least $100. D creates C3 and contributes all the C2 stock in exchange for all the C3 stock. D then transfers all the C3 stock to C1 in exchange for $100 cash in a Sec. 304 transaction.

In this example, neither the acquiring corporation (C1) nor the issuing corporation (C3) has E&P. As a result, D would report the $100 received in the redemption as a return of basis under Sec. 301(c)(2). Under the new regulations, C2 would be considered the deemed issuing corporation if the transaction was entered into with a principal purpose of avoiding the application of Sec. 304. In that case, D must report the $100 as a dividend from the C2 E&P, the deemed issuing corporation.

The other major revision to the regulations is that the anti-avoidance rules are self-executing and no longer apply only at the discretion of the IRS. They now apply if a transaction was undertaken with a principal purpose of avoiding the application of Sec. 304 to the deemed acquiring corporation or the deemed issuing corporation. As before, the taxpayer cannot escape application of the rule with a bona fide business purpose. The new regulations also clarify that the funding of the Sec. 304 proceeds may come from a borrowing, including a third-party borrowing. The new regulations are effective for transactions occurring on or after December 29, 2009.

What’s Next?

The new regulations are presumably part of a tax policy initiative to address transactions in which a U.S. multinational repatriates foreign earnings in a dividend-like transaction with little or no U.S. tax consequence. The new Sec. 304 regulations eliminate a perceived loophole for issuing corporations. Another perceived loophole is the all-cash D reorganization using a U.S.-owned foreign corporation whose stock has no built-in gain.

The basic Sec. 304 transaction described in Example 1 becomes a basic all-cash D reorganization if, following the stock sale, D causes C1 to check the box to be treated as a disregarded entity (assuming C1 is an eligible entity under Regs. Sec. 301.7701-3). The election results in the deemed liquidation of C1, which stepped together with the stock sale would result in the transaction being treated as a Sec. 368(a)(1)(D) reorganization. The proceeds are now subject to Sec. 356 rather than Sec. 304. Under the “boot within the gain” rule of Sec. 356(a)(2), D would not report any income or gain on the transaction. The Obama administration has proposed to exclude such acquisitions of foreign corporations from the boot within the gain rule.

The debate will continue about whether this is a Sec. 356(a)(2) loophole that needs closing, but as the new Sec. 304 regulations demonstrate, the government will continue to address transactions in which U.S. taxpayers repatriate foreign earnings paying little or no U.S. tax.

EditorNotes

Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or rick.klahsen@rsmi.com.