Section 1248 and Dispositions of CFC Stock. CITE Subpart F Planning Seminar Chicago, Illinois August 8, 2011

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1 Section 1248 and Dispositions of CFC Stock CITE Subpart F Planning Seminar Chicago, Illinois August 8, 2011 William R. Skinner, Esq. Fenwick & West LLP (650) Last Updated January 18, 2013 This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (expressed or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, Fenwick & West LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. The views expressed herein are those of the author, and are not necessarily the views of CIRCULAR 230 DISCLOSURE To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice in this communication is not intended or written by Fenwick & West LLP to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. 1

2 TABLE OF CONTENTS 1. Overview of Section Determining When 1248 Applies to a Transaction... 4 a. Basic Rule and Conditions for Application of b. Application of the Five Year Look-Back... 4 c. Stock Held Through Partnerships... 4 d. Types of Transactions... 5 e. U.S. Holding Company Rule... 6 f. Conditions for Applying 1248 to Lower-Tier Foreign Corporations... 7 g. Rev. Rul , Explained by GCM (Jan. 20, 1983) Calculation of the 1248 Dividend... 8 a. Computation of the 1248 Deemed Dividend and Foreign Tax Credit... 8 b. Simple Case Method Conditions to Application... 9 c. Simple Case Method Amount of the Foreign Corporation s 1248 E&P... 9 d. Simple Case Method Allocation of E&P to Block of Stock e. Rev. Rul f. Examples of Simple Case Method g. Complex Case Method (Treas. Reg ) Overview h. Complex Case Method Determination of E&P i. Complex Case Method Allocation, Step 1 Tentative Ratable Shares j. Complex Case Method Allocation, Step 2 From Tentative Ratable Shares to Ratable Shares k. Complex Case Method Earnings of Lower-Tier Foreign Corporations l. E&P Substantiation & Reporting Other Rules Governing 1248 Stock Sales a. Sales of Lower-tier CFC Stock Section 964(e) b. PTI Consequences of c. Distributions in the Year of Sale d. Treatment of the 1248 Deemed Dividend for Other Purposes Considerations for Sale of CFC Stock a. Section 338 Elections for a Foreign Target b. 338 Elections With Respect to CFCs General Rules c. Foreign Taxes d. Effect on the 1248 Amount e. End of Taxable Year Issues f. Section 901(m) g. Sales of Lower-Tier CFCs Special Topics Under a. Treas. Reg (finalized July 2007 by TD 9345)

3 b. Cash D Reorganizations & Effect on the 1248 Amount c. 1248(i) d. 1248(f) e. Partnerships Holding CFC Stock Overview of Section 1248 Section 1248 was originally enacted as an anti-avoidance measure as part of subpart F in It serves to subject the accumulated earnings of a foreign corporation to tax as if they were distributed as a dividend to the shareholder. Where there is lower rate on capital gains vs. dividend income, 1248 prevents a U.S. shareholder from accumulating earnings in a foreign corporation and converting the ordinary income into capital gains re-characterizes a gain on the sale of stock as a dividend to the extent of the E&P attributable to the stock. Foreign tax credits are available under 902 to the same extent as if the earnings had actually be distributed. Consistent with this purpose, 1248 allows an individual shareholder to reduce the tax due under 1248 to the extent of the amount relief that would have been available had the shareholder been eligible for From a corporate taxpayer s perspective, 1248 generally is quite helpful. In a taxable disposition of CFC stock, a corporate taxpayer generally will want to maximize the 1248 amount, so as to increase foreign source general basket income and the available foreign tax credits under may be a harmful provision where (1) the U.S. corporation has expiring capital loss carry-forwards and wants to use capital gains from the sale of stock to offset those gains, and (2) tax-free reorganizations and restructurings, in which case, the 367(b) regulations may cause an otherwise tax-free transaction to become taxable to the extent of the shareholder s 1248 amount in the CFC s stock. While foreign tax credits are generally available under 1248, there are important computational differences between 1248 s deemed dividend and an actual dividend or deemed distribution under 302 or 304. In the case of either an external stock sale or internal restructuring, it is important to understand 1248 s operation to maximize the 902 credits that may be available. 1 See 1248(b)(1). 3

4 2. Determining When 1248 Applies to a Transaction. a. Basic Rule and Conditions for Application of (a) provides that 1248 applies where the following conditions are met: i. A United States person sells or exchanges stock in a foreign corporation. ii. The United States person owns under 958(a), or is considered as owning under 958(b), at least 10% of the total voting power of stock of the foreign corporation at any time during the five-year period ending on the date of the sale or exchange when the foreign corporation was a CFC. If these two conditions are met, then 1248 treats the gain recognized on the sale as a dividend to the extent of iii. The earnings and profits of the foreign corporation attributable to the stock sold that were accumulated during a period when 1. the United States person held the stock and 2. the foreign corporation was a CFC. As noted above, there is both a five-year look-back and application of constructive ownership rules of subpart F. The ownership test for applying 1248 is the same as the test that determines whether a U.S. person constitutes a United States shareholder of a CFC under 951(g). b. Application of the Five Year Look-Back. Treas. Reg (a)(5), Example 1. Foreign corporation F has 100 shares of stock outstanding. From January 1, 1963 to June 30, 1965, F is a CFC, but not any time thereafter. Brown, a U.S. person owns 15 shares of F from January 1, 1963 until December In December 1965, Brown sells 7 of the shares. Although F is not a CFC in December 1965, 1248 nonetheless applies because of the five-year look-back rule. Id., Example 2. Assume that on January 1, 1970, Brown sells his remaining 8 shares in F. Again, 1248 applies to the sale because during the five years preceding the sale, Brown held the shares and was a 10% or greater shareholder in F while it was a CFC. c. Stock Held Through Partnerships. The Service has taken a mixed entity / aggregate approach to the application of 1248 to sales of stock by partnerships. If the partnership is a United States person under 7701, then the partnership is treated as an entity and a 1248 shareholder 4

5 of the CFC. 2 If, on the other hand, the partnership is not a U.S. person, then 1248 applies on a look-through basis as if each partner sold its proportionate share of the CFC s stock held by the partnership. 3 Thus, a partner that owns 10% or more of the foreign corporation s stock can qualify for 1248 benefits on the partnership s sale of stock. d. Types of Transactions. i. 1248(a)(2) provides that 1248 applies to any transaction in which the shareholder is treated as realizing gain from the sale of stock. However, the regulations generally turn off 1248 in the case of non-recognition transactions. Thus, subject to 1248(f) and 367(b), 1248 only applies to the extent the shareholder recognizes gain from the sale or exchange. 4 ii. Deemed sales or exchanges. For 1248 purposes, a sale or exchange of stock includes a number of transactions in which subchapter C treats a corporation or shareholder as selling or exchanging property, such as under 302(a), 311, 331(a) or 351. Recent temporary regulations (TD 9444, Feb. 10, 2009) clarified that 1248 also applies to gain the shareholder is treated as recognizing under 301(c)(3). iii. Installment sales. If the shareholder sells stock for a deferred payment under 453, each payment that is treated as gain under the installment method is treated as a 1248 dividend to the extent of the 1248 E&P. That is, the 1248 dividend and capital gains are not prorated between each payment. 5 The amount of E&P available to support the 1248 dividend is determined on the date of the original sale under the normal rule. iv. Deferred intercompany transactions. 1. In Rev. Rul , the IRS addressed a case where a domestic subsidiary, S, distributed stock of a CFC to its parent, P, in a taxable 311 transfer. The Service held that this deemed sale was subject to 1248, but also was a deferred intercompany transaction under the predecessor to current Treas. Reg The ruling provided a complex rule to integrate the deferred intercompany transaction rules with the calculation of the 1248 amount See Rev. Rul , C.B Treas. Reg (a)(4). Treas. Reg (c). See Treas. Reg (f). 5

6 2. Treas. Reg (c)(7), Example 15. The current rules defer the 1248 calculation until the CFC stock is sold outside the group. Under single entity principles, the 1248 amount is calculated at the time of the sale outside the group, and that attribute determines the first member s 1248 dividend. For example, assume S sells FC stock to B at a gain of $40 when FC s E&P is $40. Assume FC has a deficit in E&P during B s holding period of ($10) and B sells the stock for a gain of $60. In this case, the group s total 1248 dividend is $30 and capital gain is $30. S sell recognizes all of the $ dividend. The remaining $ dividend of S, on a separate entity basis, is re-characterized as capital gain under the matching rule. The Example also has alternative fact patterns. v. Ordinary income transactions, etc., excluded only applies to recharacterize long-term capital gains as dividends. Thus, 1248 does not apply to an amount that already is treated as (i) a dividend, (ii) ordinary income, or (iii) gain from the sale of an asset held less than 12 months also does not apply to boot in an exchange governed by The apparent reason is that boot will already be re-characterized as a dividend to the extent of the Target s earnings under 356(a)(2). In T.D (July 2007), the IRS and Treasury cited 1248(g)(2) as supporting the position that 1248 does not apply to a U.S. partner s sale of an interest in a partnership that holds CFC stock. Since the gain is treated as ordinary income under 751, the IRS and Treasury reason that 1248 does not apply. The same issue could also arise in certain other cases where a Code provision outside of 1248 treats CFC stock as an ordinary income asset for example, due to COD-related attribute reduction under e. U.S. Holding Company Rule. 1248(e) provides that sale of stock in a U.S. corporation holding stock in a CFC will be treated as a sale or exchange of stock in the CFC where the domestic corporation was formed or availed of principally for the holding of stock in a CFC. In Notice 87-64, the IRS noted that the 1986 Tax Reform Act had eliminated the capital gains rate differential for corporate taxpayers, so that the primary effect of 1248 was to re-characterize sales proceeds as a dividend carrying foreign tax credit. Accordingly, the IRS announced that it would 6 7 Section 1248(g)(2); Treas. Reg (e). Treas. Reg (e)(2). 8 See Mindy Herzfeld and John Kennedy, Debt Modifications International Tax Considerations for U.S. Multinationals, International Tax Journal (July / August 2010). 6

7 promulgate regulations suspending the operation of 1248(e) for any period in which there is no capital gains rate differential. f. Conditions for Applying 1248 to Lower-Tier Foreign Corporations. 9 Where a U.S. person sells stock in a CFC, the E&P included in the 1248 dividend also includes the E&P of certain lower-tier foreign corporations. (Where a CFC sells stock in a lower-tier CFC, separate 1248 rules apply in accordance with 964(e), as discussed below). The conditions for including the E&P of lower-tier foreign corporations in the 1248 dividend are as follows i. The U.S. person is treated under 958(a)(2) as owning stock in the lower-tier foreign corporation by reason of owning the stock in the first-tier CFC; and ii. The U.S. person owned stock under 958(a), or was considered as owning under 958(b), a 10% or greater voting interest in the lower-tier foreign corporation when the lower-tier corporation was a CFC during the five-year period ending on the date of the sale of stock in the first-tier CFC. If these conditions are satisfied, then the U.S. person takes into account so much of the E&P of the lower-tier foreign corporation as was iii. Attributable to the stock in the lower-tier CFC which such person owned indirectly under 958(a)(2) by reason of ownership in the first-tier CFC on the date of the sale or exchange of stock in the upper-tier CFC (or on the date of any sale or exchange of stock in the lower-tier CFC by the upper-tier CFC during the five-year look-back period, but only to the extent not otherwise taken into account under and not in excess of the gain in such lower-tier CFC s stock that was sold or exchanged); and iv. Was accumulated by the lower-tier foreign corporation during years when 1. The lower-tier corporation was a CFC; and 2. The U.S. person owned stock in such lower-tier corporation under 958(a). The simple case and complex case method regulations, discussed in the following Section, determine how to calculate the amount of the lower-tier CFC s earnings that are included in the 1248 dividend. For 1248(c)(2) to apply, the upper-tier corporation must be a CFC at the time of sale or at some time in the five year look-back period. In the 9 10 See 1248(c)(2)(A) through (D). This parenthetical predates the 1997 enactment of 964(e). 7

8 relatively unusual set of facts where the U.S. person indirectly holds an interest in a lower-tier CFC through a higher-tier foreign corporation that is not a CFC, 1248 will not apply to the sale unless the first-tier corporation is turned into a CFC prior to the sale. g. Rev. Rul , Explained by GCM (Jan. 20, 1983). USP owned all of the stock in two CFCs, FS1 and FS2, for a number of years. In an outbound transfer not subject to tax under 367, USP transferred all of the stock of FS2 to FS1. Subsequently, FS1 was sold in a transaction to which 1248(a) applied. The issue was whether, under 1248(c)(2)(D)(ii), the 1248 E&P of the lower-tier corporation included E&P accumulated during the shareholder s holding period, but before FS2 was contributed to FS (c)(2)(D)(ii) as then drafted literally included in the 1248(c)(2) calculation only the E&P accumulated during the period in which the U.S. person owned within the meaning of 958(a)(2) stock in FS2. The Service took a non-literal interpretation of 1248 to include the E&P of FS2 that accumulated during both the period of P s direct and indirect ownership. This issue was resolved legislatively in the 133(c) of the 1984 Deficit Reduction Act. Now, this sort of fact pattern would also implicate Treas. Reg Calculation of the 1248 Dividend. a. Computation of the 1248 Deemed Dividend and Foreign Tax Credit. The 1248 deemed dividend is generally the lesser of two amounts (1) the gain recognized by the shareholder, and (2) the E&P that is attributable to the stock that is sold. Thus, the E&P included in the 1248 dividend is limited to a pro rata amount of E&P that accumulated during the shareholder s holding period of the stock. Where the shareholder owns multiple blocks of stock with different bases or holding periods, the 1248 amount must calculated separately with respect to each block of stock. 11 Treas. Reg (d) provides that foreign tax credits are available with the 1248 deemed dividend provided that the U.S. person meets the 902 stock ownership requirement on the date of the sale. Further, Treas. Reg (d)(1)(ii) states that, if on the date of sale, the upper-tier CFC owns at least 50% of the stock in a lower-tier CFC, 902 applies to taxes paid by the lower-tier CFC in the same manner as if the lower-tier CFC had distributed the portion of its earnings included in 1248 dividend to the first-tier CFC prior to the recognition of the deemed dividend under If the amount included as a dividend under 1248 is less than the E&P attributable to the stock being sold, then, for foreign tax credit 11 Treas. Reg (a)(5). 8

9 purposes, the 1248 dividend is deemed paid by each CFC in proportion to the amount of its earnings that are attributable to the stock sold. 12 Note Treas. Reg (d)(1)(ii), by stating that the first-tier CFC must own at least 50% of the lower-tier CFC for foreign tax credits to be available, appears not to reflect later statutory amendments to 902(b) made in 1971 by PL , 1, or the subsequent amendments to the definition of qualified group for foreign tax credit purposes. b. Simple Case Method Conditions to Application. 13 Treas. Reg provides a set of rules for determining the E&P attributable to a block of stock in simple cases that meet the certain criteria. If the simple case method does not apply, then the separate set of rules in Treas. Reg for complex cases must be used for the block of stock. The simple case method requires the following conditions to be met i. On each day in which the U.S. person held the block of stock, the foreign corporation was a CFC and was not an FPHC or FIC; ii. The foreign corporation had only one class of stock and the same number of shares outstanding during every day in the U.S. person s 1248 holding period of the stock; iii. The foreign corporation was not a less developed country corporation; iv. During the U.S. person s holding period, the foreign corporation did not make any distributions out of its earnings and profits, other than distributions that are considered under 316, as modified by 959, to be made out of its earnings and profits accumulated during the U.S. person s holding period when the foreign corporation was a CFC; v. In respect of any lower-tier CFCs, the four conditions in (i) (iv) above are satisfied and the U.S. person owns, within the meaning of 958(a)(2), the same percentage of shares of the lower-tier corporation during each day in its holding period of the upper-tier corporation s stock. c. Simple Case Method Amount of the Foreign Corporation s 1248 E&P. Under the simple case method, the first step is to determine the E&P of the foreign corporation accumulated in any taxable year included the U.S. person s holding period. Generally, this is equal to the E&P of the foreign corporation determined under 964 for each year in the shareholder s holding period, reduced by any Treas. Reg (d)(3). See Treas. Reg (c). 9

10 distributions from such E&P. However, 1248 E&P does not include amounts that have already been subject to U.S. tax as ECI. 14 The simple case method assumes as a condition to its application that all distributions are considered under 316 and 959 to be made out of E&P accumulated during the U.S. person s holding period. Thus, accumulated E&P for the relevant years is simply reduced by the amount of distributions to determine the E&P for each year. For a discussion of year-of-sale distributions and Rev. Rul , see below. d. Simple Case Method Allocation of E&P to Block of Stock. Under the simple case method, the calculation of 1248 E&P is made by (1) taking the sum of the CFC s accumulated E&P for the taxable years during the shareholder s holding period and (2) multiplying this sum by the percentage of the CFC s stock held by the U.S. person during its holding period. 15 If the U.S. person holds stock for less than an entire year, the E&P taken into account for the 1248 calculation for that year is prorated based on the number of days in the year in which the U.S. person holds stock in the CFC. 16 The E&P included in the 1248 calculation must also be reduced to reflect the CFC s earnings that have been previously taken into account under subpart F. 17 In simple cases, Treas. Reg (e)(3) provides that, if the U.S. person included an amount under 951 during its holding period of the block stock, the amount of 1248 E&P attributed to the block is reduced by the following amount: (1) the E&P other attributed to the block of stock without taking into account any subpart F inclusions, minus the excess of (2) the amount included by the shareholder under 951 with respect to the block during the holding period, over (3) the distributions previously excluded by the shareholder pursuant to 959. The amount of this reduction generally should equal the amount of the CFC s earnings and profits that are attributable to undistributed PTI included by that U.S. shareholder under Section 1248(d)(4); Treas. Reg (d)(2)(i). Treas. Reg (e)(1). Treas. Reg (e)(2). Section 1248(d)(1). 10

11 e. Rev. Rul The U.S. shareholder included an amount of subpart F income under 951(a)(1)(A). Subsequently, the CFC made an investment in U.S. property subject to 956. The U.S. shareholder excluded the 956 investment from income under 959(a)(2). The issues were (1) whether the exclusion of the 956 investment from income under 959 triggered a reduction in basis under 961(b) (answer no), and (2) whether the E&P attributable to the PTI exclusion claimed under 959(a)(2) were included in the shareholder s 1248 amount. With respect to the 1248 issue, the Service ruled that the Treas. Reg (e)(3)(ii) E&P calculation reduces the exclusion of subpart F income from the 1248 amount only for actual distributions of PTI, not for deemed distributions of PTI as a result of a 956 investment. Thus, the E&P previously taxed as subpart F income continued to be excluded from 1248 E&P after it was re-classified from the 959(c)(2) PTI account to the 959(c)(1) PTI account. f. Examples of Simple Case Method. Treas. Reg (e)(4), Example 1: On May 26, 1965, Green, a United States person, purchases at its fair market value a block of 25 of the 100 outstanding shares of the only class of stock of controlled foreign corporation F. He sells the block on January 1, In respect of the block, Green did not include any amount in his gross income under section 951. F uses the calendar year as its taxable year and does not own stock in any lower tier corporation referred to in paragraph (c)(5)(i) of this section. All of the conditions of paragraph (c) of this section are satisfied in respect of the block. The earnings and profits accumulated by F (computed under paragraph (d) of this section) are $10,000 for 1965, $13,000 for 1966, and $11,000 for The earnings and profits of F attributable to the block are $7,500, determined as follows: Sum of earnings and profits accumulated by F during period block was held: For 1965 (219/365 x $10,000) $6,000 For 1966 $13,000 For 1967 $11, Sum $30,000 Multiplied by: Number of shares in block (25), divided by total number of shares outstanding (100) 25%

12 Earnings and profits attributable to block $7,500 ====== 12

13 Treas. Reg (e)(4), Example 2 (U.S. shareholder has subpart F inclusion): Assume the same facts as in example (1) except that in respect of the block Green includes in his gross income under section 951 the total amount of $2,800 for 1965 and 1966, and because of such inclusion the amount of $2,300 which was distributed to Green by F on January 15, 1967, is excluded from his gross income under section 959(a)(1). Accordingly, the earnings and profits of F attributable to the block are $7,000, determined as follows: Earnings and profits attributable to the block, as computed in example (1) $7,500 Minus: Excess of amount included in Green s gross income under section 951 ($2,800), over portion thereof which resulted in an exclusion under section 959(a)(1) ($2,300) $ Earnings and profits attributable to block: $7, The Example appears to contain an error in that it does not reduce the $7,500 of accumulated earnings and profits during the shareholder s 1248 holding period by the $2,300 distribution of PTI. An example in the 1962 Senate Finance Committee Report, illustrating the application of the predecessor to 1248(d)(1), indicates that PTI that is distributed causes a reduction in the amount of the CFC s 1248 E&P. See S. Rep. No. 1881, 87th Cong., 2d Sess. 305 (1962). 13

14 Treas. Reg (e)(4), Example 3 (lower-tier foreign corporation): Assume the same facts as in example (1) except that on each day beginning on January 1, 1966 (the date controlled foreign corporation G was organized) through January 1, 1968, F owns 80 of the 100 outstanding shares of the only class of G stock. Since, by reason of his ownership of 25 shares of F stock, Green owns within the meaning of section 958(a)(2) the equivalent of 20 shares of G stock (25/100 of 80 shares), G is a lower tier corporation referred to in paragraph (c)(5)(i)(a) of this section. If Green had sold the 20 shares of G stock on January 1, 1968, the date he actually sold the block of F stock, the conditions of paragraph (a)(2) of would be satisfied in respect of the G stock, and, accordingly, the conditions of paragraph (c)(5)(ii) of this section must be satisfied. Assume further that such conditions are satisfied, that G uses the calendar year as its taxable year, and that the earnings and profits accumulated by G (computed under paragraph (d) of this section) are $19,000 for 1966 and $21,000 for The earnings and profits of F and of G attributable to the block are $15,500, determined as follows: Sum of earnings and profits accumulated by G for period Green owned G stock within the meaning of section 958(a)(2) ($19,000 plus $21,000) $40,000 Multiplied by: Number of G shares deemed owned within the meaning of section 958(a)(2) by Green (20), divided by total number of G shares outstanding (100) 20% Earnings and profits of G attributable to block $8,000 Earnings and profits of F attributable to block, as determined in example (1) $7, Total earnings and profits attributable to block $15,000 14

15 g. Complex Case Method (Treas. Reg ) Overview. If any of the conditions for applying the simple case method are absent, then the E&P attributable to the block of stock must be determined under the complex case method. Under this method, E&P of the foreign corporation is determined on an annual basis and allocated to the shareholder based on the shareholder s weighted average percentage ownership of the CFC during the year. The same process is then repeated so as to tier up the E&P of lower-tier foreign corporations. This annual calculation is necessary to take into account fluctuating levels of ownership of the CFC. Two examples illustrate the year-by-year nature of the calculation of E&P. The following example shows the year-by-year calculation with both first-tier and lower-tier CFCs: Treas. Reg (a)(7), Example 2. Assume the same facts as in example (1), except that in respect of X there are lower tier corporations Y and Z to which the provisions of paragraph (f) of this section apply. Brown s ratable shares of the earnings and profits of X, Y, and Z attributable to the block under steps 1 and 2 for each taxable year of X are as follows: Ratable shares Taxable year of X X Y Z Total $100 $40 $20 $ Sum $350 $120 $80 $550 As discussed below, the tentative ratable share of E&P for a foreign corporation can be negative for a year. In the Example, the deficit of one corporation in the chain for the year is used to offset the positive E&P of another corporation in the chain for calculating the 1248 amount for year. Cf. 952(c)(1)(C) (qualified chain deficit rule in computing subpart F income). 15

16 h. Complex Case Method Determination of E&P. The complex case method, like the simple case method, begins with the foreign corporation s E&P as determined under 964. However, the regulations note that the E&P of the foreign corporation for a taxable year for purposes of applying the complex case method may differ from E&P under 316 or the simple case method in its treatment of distributions. Under Treas. Reg (b)(2)(i), the foreign corporation s E&P is adjusted to remove any income taxable as ECI under 882. Further adjustments are made to reduce the accumulated E&P for the year by any distributions made during the year, whether the distributions are made from current E&P or from accumulated E&P in prior years. 19 For purposes of the complex case method, a distribution in excess of current E&P will result in an E&P deficit for the year in which the distribution is made. For example: Treas. Reg (b)(3)(ii), Example 1. X Corporation, which uses the calendar year as its taxable year, was organized on January 1, 1965, and was a controlled foreign corporation on each day of The amount of X s earnings and profits accumulated for 1965 (computed under this paragraph without regard to the adjustment for distributions under this subparagraph) is $400,000, of which $100,000 is distributed by X as dividends during The amount of X s earnings and profits accumulated for 1965 (computed under this paragraph) is $300,000 (that is, $400,000 minus $100,000). The result would be the same even if X was not a controlled foreign corporation on each day of Treas. Reg (b)(3)(ii), Example 2. Assume the same facts as in example (1). Assume further that the amount of X s earnings and profits accumulated for 1966 (computed under this paragraph without regard to the adjustment for distributions under this subparagraph) is $150,000, and that X distributes the amount of $260,000 as dividends during Since $150,000 of the distribution is from earnings and profits accumulated for 1966 (computed without regard to the adjustment for distributions under this subparagraph), and since $110,000 is from earnings and profits accumulated for 1965, the earnings and profits of X accumulated for 1966 are a deficit of $110,000 (that is, $150,000 minus $260,000). However, the earnings and profits accumulated for 1965 are still $300,000 for purposes of computing in the manner prescribed in paragraph (c) of this section a person s tentative ratable share. 19 See Treas. Reg (b)(3). 16

17 As discussed below, a distribution during the year of sale can also reduce 1248 E&P and the seller s 1248 amount. i. Complex Case Method Allocation, Step 1 Tentative Ratable Shares. Under the complex case method, the allocation between shares is made in two steps by determining the tentative ratable share and ratable share. Treas. Regs (c) and (d) provide different rules depending on whether the E&P for the year determined under Treas. Reg (b) is positive or negative. If E&P for the year is positive, then a shareholder s tentative ratable share of E&P for each share of stock held during the year is determined by the following formula: E&P / number of shares outstanding * percentage of total days in the year when the U.S. person held the share while the corporation was a CFC In cases where the number of shares outstanding changes during the year, the total is adjusted to reflect the total of days each share is outstanding to arrive at an average number of shares outstanding during the year. If the CFC has multiple classes of stock, accumulated E&P is first allocated among the classes of stock under the principles of Treas. Reg (e)(3), which assumes that the CFC distributed all of its earnings among its shareholders in accordance with their distribution rights. Then, the complex method is applied separately to each of the classes of stock that have a share of earnings and profits See Treas. Reg (c)(4). 17

18 Treas. Reg (e)(3), Example 2. On December 31, 1964, X Corporation, a controlled foreign corporation which uses the calendar year as its taxable year, had 100 shares of one class of stock outstanding, 15 of which were owned by T. T s 15 shares were redeemed by X on March 14, On December 31, 1965, in addition to the remaining 85 shares, 10 new shares of stock (which were issued on May 26, 1965) were outstanding. Thus, during 1965, 15 shares were outstanding for 73 days, 10 for 219 days, and 85 for 365 days. The earnings and profits (computed under paragraph (b) of this section) accumulated for X s taxable year ending on December 31, 1965, are $18,800. T s tentative ratable share with respect to one share of stock is $40, computed as follows: Earnings and profits accumulated for taxable year $18,800 Divided by: Number of shares deemed outstanding each day of 1965: 15 for 73 days (15x73/365) 3 10 for 219 days (10 x 219/365) 6 85 for 365 days (35 x 365/365) 85 ==== Total number of shares deemed outstanding each day of Earnings and profits accumulated per share $200 Multiplied by: Number of days in 1965 T held his share while X was a controlled foreign corporation (73), divided by number of days in 1965 (365) 20% T s tentative ratable share per share of stock $40 18

19 If earnings and profits are negative for the year, then a deficit that is attributable an operating deficit is allocated between shareholders in the same manner as an amount of positive earnings for the year. 21 A deficit attributable to a distribution, however, may arise from the distribution of earnings accumulated before the foreign corporation was a CFC or before the U.S. person owned stock. To correct for this, Treas. Reg (d)(3) provides that only a deficit attributable to distributions from earnings accumulated during the shareholder s holding period when the foreign corporation was a CFC are allocated as a negative tentative ratable share. Other deficits arising from distributions are disregarded. For purposes of this allocation, distributions from accumulated earnings and profits are deemed to be made from the most recent E&P first. 22 Treas. Reg (d)(5), Example 2 provides a good illustration of the mechanics of this rule. Note that a distribution made after the foreign corporation ceases to be a CFC may nonetheless create a deficit to the extent it results in distribution of E&P accumulated during the shareholder s 1248 holding period. j. Complex Case Method Allocation, Step 2 From Tentative Ratable Shares to Ratable Shares. After the tentative ratable shares have been determined, these amounts must be adjusted to reflect the subpart F inclusions by the shareholder. Treas. Reg (e)(2) provides for essentially the same rule for subpart F income as under the simple case method : 1248 E&P is reduced by the excess of (1) prior subpart F inclusions by the shareholder (or another shareholder whose holding period is tacked to the current shareholder s holding period under 1223) over (2) the PTI exclusions claimed by the shareholder. Treas. Reg (e)(6) provides a rule applicable where a successor-ininterest to a PTI account receives a distribution of earnings and profits out of the predecessor s PTI. Under Treas. Reg (b)(3) and -3(d), the distribution is treated as reducing 1248 E&P in the year in which made, not the year of the underlying 951 inclusion. To the extent that the current shareholder s 1223 holding period does not include the underlying subpart F income, then the Treas. Reg (d)(2). See Treas. Reg (d)(4). 19

20 k. Complex Case Method Earnings of Lower-Tier Foreign Corporations. 23 Earnings of lower-tier foreign corporations ( LTFCs ) are included in the 1248 amount with respect to the stock sold in the first-tier CFC if three conditions are met: i. The U.S. person satisfies the 10% ownership test in the first-tier foreign corporation at a time when the first-tier corporation is a CFC; ii. The U.S. person is treated as owning stock in the LTFC under 958(a)(2) by reason of its ownership in the first-tier corporation; and iii. The U.S. person would have satisfied the 10% ownership test in the LTFC at a time when the LTFC was a CFC, if it had sold its indirect interest in the LTFC at a time when the LTFC was a CFC. Earnings of LTFCs are included using a formula similar to the formula for the first-tier CFC, but modified to take into account the different taxable years, ownership changes at the lower-tier level, etc. Specifically, the E&P of the LTFC for the year that is attributed to the share of the upper-tier CFC is equal to the product of the following amounts: 1. The E&P of the LTFC divided by the total number of shares outstanding (or deemed outstanding 24 ) in the first-tier CFC, times 2. The number of days in the taxable year of the first-tier CFC in which the U.S. person indirectly, through the first-tier CFC, owned a share in the LTFC while it was CFC, divided by the total number of days during the year, times 3. The percentage of the outstanding shares of the LTFC that were owned by the first-tier CFC during the taxable year, times 4. The percentage of the taxable year of the LTFC included in the taxable year of the first-tier CFC. Note that the amount of E&P attributed up from the LTFC is not limited to the gain inherent in the LTFC s stock. 23 See Treas. Reg (f). 24 In cases where the number of shares outstanding changes, the number of outstanding shares is calculated using a weighted average under the same rule that applies at the first-tier CFC level. See Treas. Reg (f)(2)(i)(B). 20

21 Curiously, Treas. Reg (f), governing attribution of the LTFC s earnings, does not contain a rule for multiple classes of stock. In the case of a first-tier corporation or LTFC with multiple classes of stock, the regulations literally seem to require an allocation based on the number of outstanding shares without regard to their legal entitlements. Perhaps this is a case, as in Rev. Rul , where the regulation should be interpreted non-literally to avoid an absurd result. 21

22 Example of Lower-tier Calculation Treas. Reg (f)(3), Example 1. In a year subsequent to 1969, Brown, a United States person, sells 5 of his shares of stock in X Corporation in a transaction as to which the provisions of this paragraph apply. Brown had purchased the 5 shares prior to On each day of 1969 X Corporation actually had 100 shares of one class of stock outstanding. On each such day X Corporation directly owned all of the shares of stock in Y Corporation, and Y Corporation directly owned all of the shares of stock in Z Corporation. Z Corporation on each such day was a controlled foreign corporation. Both X and Z use the calendar year as the taxable year. Z s earnings and profits accumulated for 1969 (computed under paragraph (b) of this section) are $2,000. Brown s tentative ratable share of the earnings and profits accumulated by Z attributable to the 1969 calendar year of X is $20 per share, computed as follows: (i) Z s earnings and profits for 1969 ($2,000), divided by the number of shares in X deemed outstanding each day of 1969 (100) $20 Multiplied by: (ii) Since on each day of 1969 Brown (by reason of owning directly his shares in X) owned, within the meaning of section 958(a)(2), stock in Z while Z was a controlled foreign corporation, the percentage determined under subparagraph (2)(ii) of this paragraph equals 100% Multiplied by: (iii) Since on each day of 1969 X owned 100 percent of the stock of Y while Y owned 100 percent of the stock in Z, the percentage determined under sub- paragraph (2)(iii) of this paragraph equals 100% Multiplied by: 22

23 (iv) Since X and Z each use the same taxable year, the percentage deter-mined under subparagraph (2)(iv) of this paragraph equals 100% Total $20 23

24 As in the case of the first-tier corporation, the LTFC s deficits for a taxable year must be adjusted to remove any deficits created by the distribution of earnings accumulated during a year when the LTFC either was not a CFC or when the shareholder did not hold an interest in the LTFC. l. E&P Substantiation & Reporting. 1248(h) provides that it is the taxpayer s responsibility to establish the amount of the CFC s E&P and, otherwise, it will be assumed that the entire gain is a dividend. The taxpayer also must establish the amount of foreign taxes claimed as a 902 credit in accordance with the normal procedures in Treas. Reg In this regard, Treas. Reg requires the taxpayer to attach a schedule to its tax return for the year of sale providing detailed information about the 1248 computation. 4. Other Rules Governing 1248 Stock Sales. a. Sales of Lower-tier CFC Stock Section 964(e). Enacted in as part of the 1997 Tax Reform Act, 964(e) extends the principles of 1248 to a CFC s sale of stock in a lower-tier CFC. 964(e)(1) provides that 1248 applies to CFC s sale of stock in the lower-tier CFC in the same manner as if the CFC were a U.S. person. 964(e) also applies to deemed sales of stock in a lower-tier CFC, such as 311(b) gain resulting from a first-tier CFC s distribution of stock in the lower-tier CFC. Prior to 2004, the primary effect of 964(e) was to convert the gain from the sale of the lower-tier CFC s stock from capital gain treated as passive FPHC income into general basket dividend income. See 964(e)(3) (providing that deemed 1248 dividend under 964(e) did not qualify for same country exception). However, in Notice , the IRS interpreted the 954(c)(6) look-through rule to apply to all deemed dividends, including those created under 964(e). Thus, to the extent of the 1248 amount, the gain from the sale of the lower-tier CFC generally will be excluded from subpart F income under 954(c)(6). b. PTI Consequences of i. To the Seller. As stated above in the discussion of the simple and complex methods, PTI is generally excluded from the 1248 amount. However, solely for purposes of 25 See Treas. Regs (c) and (d)(2). 24

25 calculating exchange gain or loss under 986(c), the Service treats the PTI as distributed immediately before the 1248 event. See Notice 88-71, 2(c) and Example 6. The gain or loss then adjusts the shareholder s basis in the CFC stock. The rationale of this rule is that, since PTI is not deemed distributed under 1248, the Notice provides for a deemed dividend to make sure that 986(c) gain or loss arising during the Seller s ownership is taxable to the Seller. 26 ii. To the Buyer. In a sale of CFC stock for which no 338 election, the Buyer will acquire the CFC stock along with any PTI accounts inherent in the stock. 27 Further, gain re-characterized as dividend income under 1248 gives rise to PTI that may be used by the Buyer to shelter post-transaction distributions. See 959(e) and 1248(j). If a 338 election is made, the new target would not inherit any of the old target s tax attributes. Thus, its E&P (including PTI) would be eliminated by the sale transaction. However, the Target would initially have zero E&P, so the distributions may constitute a return of capital. c. Distributions in the Year of Sale. i. Rev. Rul , Modified by Rev. Rul The Service addressed the effect of a distribution in the year of sale on the calculation of the CFC s E&P in a simple case. In the ruling, A owned 90% of the stock of Z, a controlled foreign corporation as defined in section 957(a) of the Code, Z files its income tax returns on the basis of the calendar year. A acquired the stock prior to 1963 and sold such stock on June 30, 1966 to B, an unrelated buyer, in a transaction which resulted in a recognized gain to A of 1,000x dollars. Pursuant to section 1248(g) of the Code A established that Z had accumulated earnings and profits for years 1963, 1964, and 1965 of 50x dollars, 100x dollars, and 150x dollars respectively. For the year 1966, it was further established that Z had 300x dollars earnings and profits before any distribution in such year. On September 15, 1966, Z paid a dividend to B of 200x dollars. For the year 1966, Z s E&P under the simple case method was the normal $300 for the year, reduced by any distributions therefrom. The Service s 26 See Field Service Advice (Mar. 1, 1999) (re-released April 29, 2005). 27 See Treas. Reg (d), Example (purchaser of interest in a CFC from shareholder that had included PTI entitled to inherit the PTI). 25

26 primary holding in Rev. Rul was that the distributions referred to in the regulations included the post-sale distribution to the buyer in The net accumulated E&P for 1966 (after the distribution was taken into account) was prorated between the pre- and post-sale periods according to number of days in each period. Thus, A s share of Z s 1248 E&P was 90% * $300 E&P for and 90% of $49.85 ($100 E&P after distributions prorated based on the number of days before the sale during the year). Although the ruling involved the simple case method, the same rule would also apply under the complex case method. See (b)(1) (reduction of E&P for distributions during the taxable year of the corporation). In the ruling the Service also stated that the 1248 deemed dividend does not reduce the CFC s earnings and profits. This latter holding proved more controversial. ii. GCM (1980). The National Office considered and rejected a proposed revenue ruling which would have held, in reliance on Rev. Rul and the legislative history of 1248, that E&P and related foreign tax credits are not reduced by a deemed dividend under iii. Rev. Rul The IRS suspended Rev. Rul with respect to the reduction of the CFC s E&P to reflect the amount of a distribution during the year of sale. It indicated this issue would be addressed through further action of the IRS or Congress. iv Tax Reform Act, Enacting 959(e). Congress enacted 959(e) to provide that amounts deemed to be distributed under 1248 give rise to PTI. In the House Report, Congress stated that the 1248 dividend does not result in the distribution of E&P, only in the re-characterization of those amounts as a dividend and as PTI. v. Rev. Rul Based on 959(e), the IRS concluded that the effect of a 1248 inclusion on the CFC s earnings and profits was resolved legislatively. It read 959(e) to provide that: if a transferor shareholder includes an amount in gross income as a dividend under section 1248 of the Code, the earnings and profits of the controlled foreign corporation are not reduced at the time of the recognition of the dividend amount. Instead, under section 959(e), an account under section 951(a)(1)(A) in the amount of the dividend is established on behalf of the transferee shareholder as if that amount had been included in gross income under section 951(a)(1)(A). However, there remains some confusion surrounding the ordering of a distribution and 1248 dividend in the same year, as evidenced by the following private rulings: 26

27 vi. FSA # (Oct. 9, 1997). This FSA involved an internal restructuring that resulted in a 1248 inclusion. Following the 1248 event and in the same year, the CFC distributed cash to the new shareholder. Under Rev. Rul and Reg (d)(1), the National Office held that the distribution reduced E&P taken into account under However, the taxpayer also argued that the distribution was treated as PTI. The National Office rejected this argument because the E&P had never been previously taxed (because of the reduction to the 1248 amount). The IRS distinguished Rev. Rul as holding only that amounts deemed to be distributed under 1248 reduce E&P, and as not as prescribing that 1248 deemed dividends are taken into account before actual dividends. vii. TAM Parent sold stock in its CFC on Date D during the year. On Date B, Parent received a distribution from CFC and on Date E, the purchaser received a distribution. The Date B and Date E distributions exceeded the CFC s earnings and profits, and eliminated the 1248 dividend. Parent sought to treat the Date E dividend as not reducing E&P the 1248 amount on the argument that 959(e) gave priority to the 1248 dividend over 301 distributions during the year. Since 959(e) treats the 1248 amount as a subpart F inclusion under 951(a)(1)(A), the normal 959 ordering rule (subpart F inclusions before dividends) arguably should apply. The IRS rejected this argument and reiterated the position in Rev. Rul that distributions during the year of sale reduce the 1248 amount. The existing regulations were not inconsistent with the statute because 959(e) did not change the way that a 1248 dividend is calculated. The TAM stands as a warning to the seller to make sure to negotiate contractual provisions to ensure that any 1248 dividend (and related foreign tax credits) are protected by not allowing the purchaser to declare a dividend (above a specified amo9999unt) in the year of sale. viii. Effect of Subpart F Inclusions or 956 Investments in the Year of the 1248 Event. 28 Amounts of subpart F income inclusions under 951(a)(1)(A) are not taken into account again as a deemed dividend under See 1248(d)(1). However, it is not entirely clear how to coordinate between a subpart F inclusion and a 1248 deemed dividend in the same year. 28 The subpart F ordering rules, including the effect on any 1248 dividend, receive a complete treatment in Doernberg, et al., Ordering Rules Make Your Head Spin? Here s Some Aspirin, 92 Tax Notes 833 (July 23, 2001). 27

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