As implementation of the Organisation for Economic Co-operation and Development's guidelines on cross-border taxation moves forward and legislation is enacted in many countries, multinational groups are reevaluating their holding structures. Foreign organizations may be considering transfers of U.S. subsidiaries within the corporate group, and for reasons other than U.S. income tax, these transactions could be structured as sales of U.S. stock among foreign affiliates.
Example: P, a foreign parent corporation, may transfer all of the stock of S, its wholly owned U.S. subsidiary, to B, a foreign wholly owned subsidiary of P, in exchange for cash.
In general, gain from the sale of stock of a U.S. subsidiary by its foreign parent should not be subject to U.S. federal income tax unless the U.S. subsidiary's assets consist predominantly of U.S. real estate property (see the Foreign Investment in Real Property Tax Act rules of Sec. 897). However, if the subsidiary's stock is sold to an affiliated corporation rather than a third party, Sec. 304 may apply to the transaction, resulting in adverse and often unintended tax consequences. Namely, Sec. 304 may cause the proceeds received by P to be treated as a U.S.-source dividend subject to fixed or determinable, annual or periodical (FDAP) withholding under Sec. 1442 and require B to act as the withholding agent.
Redemption treatment under Sec. 304
Sec. 304 is an anti-abuse provision designed to prevent avoidance of dividend treatment by controlling shareholders that withdraw money from their corporate subsidiaries by selling stock of one subsidiary to another affiliate company in exchange for cash, promissory notes, or other property. Before the enactment of Sec. 304, shareholders could receive corporate funds from the acquiring subsidiary with the benefit of a lower taxable base (i.e., the ability to reduce the taxable portion of the proceeds by their basis in the stock transferred) and a lower tax rate (in the form of the capital gains rate instead of the dividends rate). The latter incentive—a lower capital gains rate—was eliminated for individual shareholders with the Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27, which provided for a qualified dividend rate matching the long-term capital gains rate. On the other hand, corporate shareholders do not receive a preferred rate for capital gains.
While it may appear that much of Sec. 304's original intent as an anti-avoidance rule has been rendered unnecessary, the section remains largely relevant and is frequently considered today in the context of outbound international tax planning. In the first place, the deemed dividend treatment provides a tax-efficient way of transferring assets, earnings and profits (E&P), and foreign tax pools among foreign subsidiaries with the opportunity to claim foreign tax credits. In addition, since foreign jurisdictions would normally respect the sale treatment, a sale transaction has been consistently used as an alternative to traditional dividends to sidestep local restrictions on corporate distributions or avoid foreign withholding tax.
Another reason this provision remains highly relevant is its potential to trigger unintended tax consequences when intercompany reorganizations are not carefully planned. An example of a particularly harsh and easily overlooked result is the application of Sec. 304 in an inbound context, in which a U.S. subsidiary is transferred within a foreign group.
Under its general mechanics, Sec. 304 operates to recharacterize the proceeds from the related-party sale of stock as a distribution in redemption of the stock of the acquiring corporation. First, the transferor is deemed to have transferred the target's stock to the acquiring corporation in exchange for the acquiring corporation's stock in a Sec. 351(a) contribution; then, the acquiring corporation is deemed to have transferred the property (i.e., the sale proceeds) back to the transferor in redemption of the very stock that the acquiring corporation was deemed to have issued.
To the extent the distribution can be traced to the E&P of the acquiring corporation or the target corporation, the proceeds will be treated as a dividend in the transferor's hands.
In the example, P's transfer of all of the stock of S to B in exchange for cash would fall within the scope of Sec. 304. P would be treated as if it contributed S's stock to B under Sec. 351(a) in exchange for newly issued stock of B. Immediately thereafter, P would be deemed to receive a cash distribution in redemption of the fictional stock of B.
Deemed U.S.-source dividends subject to withholding
Under the general rules of Sec. 301, a shareholder recognizes a dividend to the extent a distribution is paid out of corporate E&P. In the fictional scheme of a Sec. 304 transaction, a dividend can be traced to the E&P of both the acquiring corporation and the target corporation (Sec. 304(b)(2)). In general, in determining the amount and the source of the dividend, the distribution is treated as made first out of the E&P of the acquiring corporation and then out of the E&P of the target.
Thus, it might at first glance appear that as long as B has sufficient E&P, the only result of Sec. 304 would be to recast a foreign-source capital gain into a foreign-source dividend, nonetheless exempt from U.S. federal income tax.
However, certain perceived abuses resulted in the enactment of the rules of Sec. 304(b)(5), which were specifically designed to address situations where the acquiring corporation is a foreign corporation. These rules turn off the ability to trace the dividends to the foreign E&P of the acquiring affiliate except where the foreign acquiring company is or has been a controlled foreign corporation, or dividends out of the E&P would otherwise be subject to U.S. tax (Sec. 304(b)(5)(B)).
Accordingly, in the example, B's E&P may not support a dividend. If none of the acquiring corporation's E&P can be applied to the distribution, all of the dividend will be deemed paid out of the E&P of the target corporation, S. The result in the example is that P is deemed to receive a U.S.-source dividend, even though B, a foreign corporation, actually makes the payment. As a consequence, U.S. FDAP tax withholding of 30% would apply, and B would be considered the withholding agent for purposes of Sec. 1442. Rev. Rul. 92-85, which confirms this treatment, also notes that if B qualifies as a resident of a treaty country, the treaty provision addressing withholding on dividends may be relied on to reduce or eliminate the statutory withholding (Regs. Sec. 1.1441-6(a)).
Avoiding an undesirable result
The application of Sec. 304 to inbound reorganizations may result in the imposition of U.S. tax withholding on foreign affiliates acquiring U.S. subsidiaries, complicating what would otherwise seem to be linear sales of U.S. stock. This result seems particularly harsh where, as in the example discussed, there is no movement of assets outside the U.S. corporation. In this case, it is difficult to understand the rationale for the imposition of tax withholding intended for outbound payments of U.S.-source income. Nonetheless, taxpayers should adopt appropriate planning alternatives to stay clear of undesirable tax withholding obligations.
Mark Heroux is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.