Most tax practitioners are familiar with the redemption provisions under Section 302 which provide whether a selling shareholder must treat the purchase of its stock in a controlled corporation as a sale or exchange, generally resulting in long term capital gain or loss, or instead as the equivalent to a dividend and taxable as such to the extent of the deemed redeeming corporation’s earnings and profits. Where stock is sold to an unrelated third party, the rules under Section 302 are not directly implicated unless the purchaser of the stock is related or affiliated to the seller, i.e, a shareholder sells part of its stock in a parent corporation to a subsidiary or a "sister" controlled corporation purchases the stock of a "brother" controlled corporation . In such instances, the rules under Section 304 are first applied.
Where a shareholder owning a controlling interest for purposes of Section 304(c) of stock in a parent corporation sells shares of parent stock to a controlled subsidiary, Section 304(a)(2), recharacterizes the form of the transaction to conform with its economic substance. In such instance the subsidiary is viewed as having made a distribution to its parent of the funds or other property used to purchase the stock succeeded by the parent’s redemption of its own stock from the selling shareholder. At this point, application of Section 302 is required and if Section 302(b) does not treat the redemption as a sale or exchange, dividend treatment is required under Section 301(c) to the extent of the earnings and profits of the subsidiary and parent.
Where a controlled corporation purchases the stock of another controlled corporation under common ownership, Section 304(a)(1) provides that the consideration paid for the stock is moved over to the issuing corporation which is then treated as having first exchange its stock for the stock it purchased in a deemed Section 351 transaction, received the consideration paid and is recast as the acquiring corporation, and then is viewed as having redeemed its own stock sold by its shareholder which deemed Section 302 redemption is then tested for dividend equivalence under Section 302(b). The result in many cases is that the consideration received is treated as a dividend for purposes of Section 301(c)(1).
Section 304 overrides the normal characterization sequence of stock sales to third parties as well as to parent and affiliate corporations. It was enacted by Congress to override several losses previously suffered by the Commissioner before the courts. As mentioned, Section 304(a)(1) applies to stock sales between brother-sister corporations. Section 304(a)(2) applies to so-called downstream stock sales of parent stock by its subsidiary. The latter provision has priority in the event of overlap. In addition, Section 304 does not address upstream stock sales where lower-tier subsidiary stock is sold to upper-tier members. While regulations to Section 304 had been in place for many years, a set of new regulations reflecting changes to the brother-sister related party stock sale under Section 304(a)(1) were proposed in January 2009. Such regulations became final later that year, effective December 30, 2009, when the Service simultaneously published final and temporary regulations (T.D. 9477) to address related party sales designed by tax advisers to avoid Section 304(a)(1).
When the Bush Tax 2001 tax rate reductions reduced the dividend rate for qualifying domestic dividends from as much as 35% to 15%, much of the "bite" of Section 304 was reduced although its application is was required for testing essential for dividend equivalence and sourcing of earnings and profits. Moreover, dividend equivalence, despite the substantially lower tax rate, would preclude the tax-free recovery of stock basis until all earnings and profits were eliminated. Still, with the fiscal cliff pushing ordinary dividend rates up to 39.6% couple with a potential Medicare Contribution Act add-on tax of 3.8% to subject individuals under Section 1411, the potential for Section 304 to now regain its "bite" is quite apparent, and might it be added with "bigger and sharper teeth". Where Congress to finally reach a compromise and retain Section 1(h)(11) perhaps at a higher rate, together with the 3.8% tax under Section 1411, would yield higher tax rates on dividend equivalent redemptions described under Section 304 that under EGTRRA.
Section 304, particularly the brother-sister rule contained in Section 304(a)(1), has spawned the need for much guidance and re-thinking by the IRS and the Treasury on sales and exchanges of stock in a controlled corporation to another controlled corporation which is also described in Section 367(a) or Section 367(b).
Section 304 Anti-Avoidance Regulations Finalized
On December 21, 2012, in T.D. 9606, effective for stock acquisitions occuring on or after December 29, 2012, the Treasury finalized without changes the temporary regulations which expanded the anti-avoidance rule for stock sales between related corporations, applying such rule to issuing corporation as well as to acquiring corporations and making the rule "self-executing" instead of being subject to IRS discretion. The expansion of the anti-avoidance rule, contained in Treas. Reg. §1.304-4, is designed to prevent domestic corporations from repatriating cash tax free by having one or more related foreign subsidiaries engage in stock sales in a way that permits the domestic parents to avoid dividend treatment. The Service was indeed aware that some corporations have repatriated cash tax free by using a structured transaction, purposely designed to trigger application of Section 304. Section 304 recasts a cash payment from a controlled foreign corporation to its domestic parent from engaging in a straight-forward sale or exchange of stock of a controlled affiliate whereby the domestic parent corporation would likely end up paying capital gains tax on the excess of the amount realized over the adjusted basis) into a redemption transaction.
The Preamble to the new rule-making highlights the deemed abusive transaction involving purchases of foreign stock of a controlled foreign subsidiary described in Section 304(a)(1).
Consider P as the domestic parent corporation and CFC1 and CFC2 as two controlled foreign corporations. P has CFC1 acquire by purchase all of the stock of CFC2 for cash. Section 304(a)(1) treats the sale as a deemed Section 351 exchange between the two CFCs and then a deemed Section 302 redemption of CFC stock by P for the cash. If the deemed redemption produces a "dividend equivalent" outcome under Section 302(d) which in this case it would, then under Section 301(c)(1), the deemed redemption is treated as a dividend to the extent of earnings and profits. The excess is used to reduce the adjusted basis of the stock, and the remainder is treated as capital gain. Taxpayers with no earnings and profits but high basis stock, could treat the disposition as a recovery of stock basis under Section 301(c)(2) and avoid dividend income as well as gain under Sections 302(c)(3) and Section 1248(a).
The IRS stated that it had became aware that some taxpayers with earnings and profits accumulated in the "CFC2s" were also designing Section 304(a)(1) redemptions as "repatriation of earnings" transactions. This would be achieved through the deemed redemption outcome of dividend income per Section 301(c)(1). Still yet some P companies were creating newly formed corporations funded with sufficient levels of cash but still without earnings and profits with a view to avoid any tax on their Section 304 repatriation transactions . In 1988 the Service, invoking Treas. Reg. §1.304-4T, stated that P could not have the new FC2 if you will acquire stock in CFC1 from P to avoid or minimize dividend treatment to P. The first version of the anti-avoidance regulation was not self-executing, it applied only "at the discretion of the District Director" -- what today is called the director of field operations. The new final regulations under Treas. Reg. §1.304-4 are effective on December 26, 2012 and apply to acquisitions of stock occurring on or after December 29, 2009.
In late December, 2009, in T.D. 9477, the Service and the Treasury Department issued final and temporary regulations under Section 304 with respect certain transactions described within Section 304 that have as a principal purpose the avoidance of Section 304 to a corporation that is controlled by the issuing corporation in the transaction, or with a principal purpose of avoiding the application of Section 304 to a corporation that controls the acquiring corporation in the transaction. The IRS and Treasury Department in the rule-making announced that an anti-avoidance rule similar to Treas. Reg. § 1.304-4T, but that applies in the case of a transaction entered into with a principal purpose of avoiding the treatment of a corporation as the issuing corporation is appropriate for transactions such as the one described above. Accordingly, the 2009 regulations amend Treas. Reg. § 1.304-4T to provide that for purposes of determining the amount of a property distribution that is a dividend (and the source thereof) under Section 304(b)(2), the acquiring corporation shall be treated as acquiring for property the stock of a corporation (deemed issuing corporation) that is controlled by the issuing corporation, if, in connection with the acquisition for property of stock of the issuing corporation by the acquiring corporation, the issuing corporation acquired stock of the deemed issuing corporation with a principal purpose of avoiding the application of Section 304 to the deemed issuing corporation. The rule-making further modified Treas. Reg. §1.304-4T of the regulations to make the anti-avoidance rule self-executing rather than only invoked at the discretion of the District Director or other authorized delegate. A further change in wording from the 1988 version of -4T of the Section 304 transaction in question have as "one of the principal purposes" for avoiding application of Section 304 to simply having "a principal purpose" for avoidance of Section 304. Both modifications were not viewed as involving substantive changes. Finally, and as noted above, current Treas. Reg. § 1.304-4T applies if one of the principal purposes for creating, organizing, or funding the acquiring corporation, through capital contributions or debt, is to avoid the application of section 304 to the deemed acquiring corporation. The regulations included in this document clarify that this rule may apply in cases where the funding is from an unrelated party. For example, the regulations may apply when the deemed acquiring corporation facilitates the repayment of an obligation incurred by the acquiring corporation (even if such obligation is with respect to a borrowing from an unrelated party) to acquire the stock of the issuing corporation. The 2009 regulations apply to acquisitions occurring on or after December 29, 2009. No inference is intended as to the potential applicability of other Code or regulatory provisions or judicial doctrines (including step transaction or substance over form) to transactions described in the regulations.
Notice 2012-15: Overlap Between Section 304 and Section 367: the Government’s "Flip" in Positions Previously Taken in Regulatory Guidance
Last Winter the Service issued guidance in Notice 2012-15 under Sections 367(a) and (b) for certain transfers of stock to foreign corporations in exchange for property under Section 304(a)(1). In the Notice, the Treasury and the IRS announced it would later amend the Section 367 rules to incorporate the guidance.
In 2006 the IRS published final regulations (T.D. 9250) providing that Section 367(a) and (b) do not apply to certain transfers of stock of a foreign or domestic corporation to a foreign acquiring corporation to which a deemed Section 351 applies by application of Section 304(a)(1). In response to comments, the Service next issued temporary regulations in 2009 (T.D. 9444) which modified the treatment of Section 304 transactions provided by the 2006 regulations. The 2009 regulations did retain the general rule that a deemed Section 351 exchange would override application of both Sections 367(a) and 367(b). Still, the 2009 regulations set forth an exception, in which case Section 367 would apply, where a U.S. person reduces its basis under Section 301(c)(2) in its stock of the foreign acquiring corporation other than the stock deemed issued to the U.S. person in the deemed Section 351 exchange. The U.S. person would then recognize gain under Section 367(a)(1) equal to the amount by which the gain realized exceeds the amount treated as a dividend under Section 301(c)(1). The 2009 regulations also provided that a U.S. person will not be able to avoid gain under Section 367(a) and Section 367(b) by entering into a gain recognition agreement ("GRA"). can't avoid the gain by entering into a gain recognition agreement.
Notice 2012-15 next appears and reverses the prior rule-makings that Section 304 will generally trump application of Section 367. Effective for acquisitions occurring on or after February 10, 2012, the Treasury and the IRS have decided to revise the approach to the interaction of Sections 367 and 304 by providing that Sections 367(a) and (b) apply fully to the deemed Section 351 exchange and deemed Section 302 redemption. The Notice states that they will amend the Section 367 rules to provide that a deemed Section 351 exchange (and deemed Section 302 redemption) that is deemed to occur in a Section 304(a)(1) transaction is subject to section 367(a) and (b) in the manner described under Notice 2012-15.
Notice 2012-15 provides that to the extent that under section 304(a)(1), a U.S. person is treated as transferring stock of a domestic or foreign corporation to a foreign corporation in a deemed section 351 exchange, the transfer is subject to section 367(a) and the applicable rules, including applicable exceptions described in Treas. Regs. §§ 1.367(a)-3(b)(1) and 1.367(a)-3(c)(1). A transferor involved as the seller of stock in a Section 304 transaction that is a U.S. person may in some cases be allowed to enter into a GRA in accordance with Treas. Reg. § 1.367(a)-8 to defer gain recognition under Section 367(a)(1). Notice 2012-15 also provides that to the extent that under Section 304(a)(1), a foreign corporation acquires the stock of a foreign corporation in a deemed Section 351 exchange, the exchange is subject to Section 367(b) and the applicable rules, including Treas. Reg. §1.367(b)-4.