Allocating previously taxed income in a Sec. 355 tax-free distribution

By Kyle Colonna, J.D., LL.M., and Julie Allen, CPA, Washington, D.C.

Editor: Annette B. Smith, CPA

In general, if a corporation (Distributing) distributes appreciated property to its sole shareholder with respect to its stock, Sec. 311(b) requires Distributing to recognize gain as if Distributing had sold the property to its shareholder at its fair market value (FMV). Because there was a distribution of property made by a corporation to its shareholder with respect to its stock, Sec. 301(a) generally applies to the shareholder. Distributing's earnings and profits (E&P) are adjusted pursuant to Secs. 312(a) and (b). If the appreciated property is stock of one or more of the controlled corporate subsidiaries (Controlled) of Distributing, then Sec. 355 generally applies — which affords tax-free treatment to Distributing and its shareholders on the distribution and receipt of Controlled stock, respectively — provided that a number of requirements are satisfied and restrictions do not apply.

To the extent Sec. 355 applies, Sec. 312(h)(1) requires a proper allocation, in accordance with the regulations, with respect to the E&P of Distributing and Controlled. If, however, all or a portion of the E&P of Distributing and Controlled also is previously taxed income (PTI) under Sec. 959, it is uncertain how the PTI is treated because there is a lack of guidance on the allocation, if any, of PTI between Distributing and Controlled.

This discussion explores the allocation of E&P in a distribution to which Sec. 355 applies, PTI under Sec. 959, and various proposed and final versions of the regulations under Secs. 959 and 367, in an effort to analyze the allocation, if any, of PTI with respect to a distribution to which Sec. 355 applies.

Allocations of E&P in a Sec. 355 distribution

As noted, Sec. 312(h)(1) requires a proper allocation, in accordance with the regulations, with respect to the E&P of Distributing and Controlled in connection with a distribution or exchange to which Sec. 355 applies. Under Regs. Sec. 1.312-10, such an allocation is required in two situations:

  • A Sec. 355 distribution preceded by a reorganization under Sec. 368(a)(1)(D) (a D reorganization), that is, if Distributing transfers part of its assets to Controlled in a transaction to which Sec. 368(a)(1)(D) applies and, immediately thereafter, the stock of Controlled is distributed in a distribution or exchange to which Sec. 355 applies; and
  • A Sec. 355 distribution not preceded by a D reorganization.

First situation: For a distribution preceded by a D reorganization, Regs. Sec. 1.312-10(a) provides that the E&P of Distributing immediately before the transaction is allocated between Distributing and Controlled. Regs. Sec. 1.312-10(a) specifies that when Controlled is formed as a new corporation in connection with the transaction, the allocation of E&P between Distributing and Controlled generally is made in proportion to the FMV of the business or businesses (and interests in any other properties) retained by Distributing and held by Controlled immediately after the transaction (the FMV method). Generally, the FMV method applies unless there is a "proper case" to apply the net basis method, which provides that the allocation between Distributing and Controlled generally is made in proportion to the net basis of the assets transferred and of the assets retained, or by such other method as may be appropriate under the facts and circumstances of the case.

Second situation: For a Sec. 355 distribution that is not preceded by a D reorganization, the E&P of Distributing is decreased by the lesser of the following amounts:

  • The amount by which the E&P of Distributing would have been decreased if it had transferred the stock of Controlled to a new corporation in a D reorganization and, immediately thereafter, distributed the stock of that new corporation; or
  • The net worth of Controlled (Regs. Sec. 1.312-10(b)).

Calculations: In addition, Regs. Sec. 1.312-10(b) provides that two calculations must be made before the E&P of Controlled can be determined. If the E&P of Controlled immediately before the transaction is less than the amount of the decrease in the E&P of Distributing (including a case in which Controlled has a deficit), then the E&P of Controlled after the distribution is equal to the amount of that decrease. Conversely, if the E&P of Controlled immediately before the transaction is more than the amount of the decrease in the E&P of Distributing, the E&P remains unchanged.

Sec. 959 and PTI

Neither Sec. 312 nor Regs. Sec. 1.312-10 refers to PTI or makes a distinction between PTI and untaxed E&P. In general, Sec. 959 governs the treatment of PTI. Sec. 959(a) provides that when a foreign corporation distributes E&P that is attributable to PTI of a U.S. shareholder (as defined in Sec. 957), those amounts are not included again as income of the U.S. shareholder. In addition, similar to Sec. 959(a), the other provisions of Sec. 959 merely refer to E&P.

A tax-free distribution under Sec. 355, however, is not a distribution of E&P. Instead, a transaction qualifying as a tax-free distribution under Sec. 355 is a tax-free distribution of stock of Controlled by Distributing to the shareholders of Distributing. Although Sec. 312 requires a proper allocation of E&P with respect to Distributing and Controlled, a tax-free distribution under Sec. 355 does not result in a recognition event such that amounts would be included in the gross income of a U.S. shareholder. Therefore, on its face, Sec. 959 does not appear to dictate the treatment of PTI in a tax-free distribution under Sec. 355.

Current regulations under Sec. 959 are silent on PTI in the context of a tax-free distribution under Sec. 355. Proposed regulations under Sec. 959 address adjustments of PTI; however, those regulations make no reference to Sec. 355. The preamble to the proposed regulations under Sec. 959 (REG-121509-00) acknowledges:

  • Shareholder-level accounting of PTI;
  • That there are unresolved issues in the context of a Sec. 355 distribution and that "comments are requested on whether rules should be provided to address the proper allocation of PTI after a transaction described in section 355"; and
  • That guidance is required on how the Sec. 959 principles apply to a Sec. 367(b) transaction.

Regarding how Sec. 959 principles apply to a Sec. 367(b) transaction, the preamble states that "[t]he IRS and Treasury Department invite comments regarding the proper extension of the principles in these proposed regulations (including shareholder-level accounting of PTI and the PTI sharing rules) to [Prop. Regs. Secs.] 1.367(b)-3 and -7, as well as Prop. [Regs. Sec.] 1.367(b)-8."

Notably, Prop. Regs. Sec. 1.959-3(e)(2)(ii) provides that PTI is reduced by the amount of previously taxed E&P distributed to the covered shareholder (i.e., a U.S. shareholder with a PTI account) during the year with respect to that stock. Thus, the question arises whether a Sec. 355 distribution itself constitutes E&P distributed to a covered shareholder. However, there currently is no guidance on treating a transaction that qualifies as a tax-free distribution under Sec. 355 as a distribution of E&P for purposes of Sec. 959.

Further, as previously mentioned, a tax-free distribution under Sec. 355 is merely a tax-free distribution of Controlled stock. Treating a tax-free distribution of Controlled stock as a distribution of E&P appears inconsistent with the legislative intent of Sec. 355. In particular, while the concept of E&P is intended to measure a corporation's ability to pay taxable dividends to its shareholders, Sec. 355 expressly permits a tax-free distribution of Controlled stock to the shareholders of Distributing. Consequently, Sec. 959 and its regulations do not seem to provide meaningful guidance regarding the treatment of PTI in a tax-free distribution under Sec. 355.

Sec. 367 and PTI

Proposed regulations issued in November 2000 under Sec. 367(b) address the allocation of E&P in a Sec. 355 transaction, but those regulations reserved future guidance with respect to PTI (REG-116050-99; Prop. Regs. Sec. 1.367(b)-8(d)(4)). Further, the allocation of E&P and foreign income taxes in certain foreign corporate separations are expressly reserved under the final regulations (Regs. Sec. 1.367(b)-8). In addition, Regs. Sec. 1.367(b)-3, which was amended in 2006 by adding paragraph (f) (carryover of E&P), addresses carryover of E&P of a foreign acquired corporation in the context of Sec. 381 transactions (i.e., Sec. 332 liquidations and certain reorganizations under Sec. 368) but not Sec. 355 transactions. The current regulations under Sec. 367(b) reserve on PTI (Regs. Sec. 1.367(b)-3(f)(2)).

The preamble to the final and temporary regulations under Sec. 367 acknowledges that the rules regarding carryover or separation of a foreign corporation's E&P do not adequately consider the international aspects of the Code, most notably, the foreign tax credit. In addition, the preamble states that "[u]ntil the IRS and Treasury promulgate such regulations, taxpayers should use a reasonable method (consistent with existing law and taking proper account of the purposes of the foreign tax credit regime) to determine the carryover and separation of earnings and profits and related foreign taxes" (T.D. 8862). The preamble does not indicate that the method used must be the "most reasonable" or that it be "as reasonable" as any other available method.

Reasonable allocation method

There currently is a lack of guidance on the allocation of PTI in a Sec. 355 transaction under Sec. 312, 367, or 959, and as acknowledged by the IRS and Treasury. Until specific guidance is issued on the allocation of PTI in a Sec. 355 transaction, taxpayers should heed the current position of the IRS and Treasury by applying a reasonable method that is consistent with existing law and takes into account the purposes of the foreign tax credit regime.

EditorNotes

Annette B. Smith, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@pwc.com.

Contributors are members of or associated with PricewaterhouseCoopers LLP.

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