Enactment of Section 304(b)(5)(B) in 2010

In The Education Jobs and Medicaid Assistance Act (P.L. 111-226, August 10, 2010), Congress amended §304(b)(5) by adding, in §304(b)(5)(B), to deny dividend reduction from earnings and profits  for a purchase of stock by a controlled foreign corporation through a chain of ownership that “hopscotches” over the U.S. person under §951(b). While §304 is itself an substance over form provision to avoid dividend inclusion, U.S. corporations have structured brother-sister or parent-subsidiary stock purchases to avoid foreign withholding taxes that would have otherwise been imposed on a direct dividend distribution and to also obtain deemed paid foreign tax credits under §902.  Congress, in 1996 and now recently in the Education Jobs Act last year, has tried to put a stop on “gaming” the withholding and controlled foreign corporation dividend impacts by stock purchases between a non-CFC or U.S. shareholder of a CFC.

Redemptions of Stock Through Related Corporations: Section 304

As a starting point, §304(a) provides that where a “related corporation” (other than a subsidiary, i.e., two corporations in which one or more persons are in control, as defined, of both, and in return for property, one of the corporations acquires stock in the other corporation from the person or person in “control” of both, then (unless §304(a)(2) applies), such property received is treated as a distribution in redemption of the stock of the corporation acquiring such stock. To the extent the described distribution is taxable as a dividend under §301, the transferor and the acquiring corporation shall be treated as if the transferor had transferred the stock so acquired in exchange for to the acquiring corporation in exchange for stock of the acquiring corporation in a transaction controlled by §351(a), and then the acquiring corporation redeemed the stock it treated as having issued in the transaction.

Under §304(a)(2), which applies to the acquisition of stock in a related corporation by a subsidiary, where in return for property the stock of a parent corporation is acquired by a controlled subsidiary, then such property is treated as a distribution in redemption of the stock of the issuing (parent) corporation. If a subsidiary corporation (the controlled or acquiring corporation) acquires stock of its parent (the issuing corporation) from a shareholder of the parent, § 304(a)(2) provides that for purposes of § 302 or § 303, any “property” paid for the stock must be treated as a distribution in redemption of the parent corporation's stock.

The definition of the term “property” for purposes of § 304 is the same as for purposes of § 302.  Since the definition includes everything of value other than the corporation's own stock or stock rights, it normally causes little confusion; however, in the context of a parent-subsidiary redemption, the issue can arise as to which party is “the corporation,” particularly since § 304(a)(2) states that the transaction will be treated as a redemption of the stock of the issuing corporation. The Tax Court has held that a shareholder's transfer of parent stock to a subsidiary in exchange for stock of the latter is not a § 304 distribution of “property,” because it is a distribution of stock of the corporation referred to by § 317(a), the subsidiary in this case. See. Bhada, 89 TC 959 (1987) , aff'd sub nom. Caamano v. Comm’r, 879 F2d 156 (5th Cir. 1989) , and Bhada v. Comm’r, 892 F2d 39 (6th Cir. 1989). Section 304(a)(2) transmutes a sale of the parent's stock to the controlled subsidiary into a deemed redemption of the stock  by the parent but not for purposes of applying the non-equivalent tests under §302(b). The subsidiary's basis in the purchased parent stock is its cost basis under § 1012 regardless of whether the transaction is treated as a sale or a dividend to the selling shareholder. Where  the selling shareholder is treated as having received a §301 distribution, its basis in the parent corporation’s stock will generally be added to the basis of remaining shares.

Section §304(b) sets forth special rules for making sale or exchange determination under §302(b). Under §304(b)(1), where stock of a corporation is acquired under §304(a), whether the distribution is in part or full payment in exchange for the stock is made by looking at the “before” and “after” impacts by reference to the stock of the issuing corporation.  In applying the constructive ownership rules in §318 with respect to §302(b), §§318(a)(2)(C) and 318(a)(3)(C) are applied without regard to the 50%  limitation contained in those provisions.

The amount and source of the “dividend” portion of the redemption proceeds, i.e., in an acquisition of stock described under §304(a), is determined “as if the property were distributed” by the acquiring corporation to the extent of its earnings and profits and then by the issuing corporation to the extent of its earnings and profits. In applying the §351 construct in §304(a), unless otherwise provided, §304(a) (and not §351 and §§357 and 358 as they related to §351), shall apply to any property received in a distribution described in subsection (a) . To the extent the dividend is sourced from the earnings and profits of the acquiring corporation, the transferor is considered to receive the dividend directly from the acquiring corporation. Commentors have referred to this as “hopscotching” since the dividend essentially bypasses any intermediary shareholders, which in the context of this note would be a U.S. shareholder under §951(b). See H.R. Rep. No. 98-861 (1984) (Conf. Rep.), 1222-1224; Rev. Rul. 80-189 , 1980-2 C.B. 106. Other applicable rules with respect to liability assumptions, distributions incident to the formation of a bank holding company and treatment of certain intragoup transactions.

The Taxpayer Relief Act of 1997 Addressed Sales of CFC Stock Abuse

Section 304(b)(5) was enacted by Congress in 1997,  and shortly thereafter amended, in an effort to limit certain earnings and profits of a foreign acquiring corporation from being  taken into account for §304 purposes. The target of abuse of that legislation was to prevent a U.S. corporation from claiming a §902 foreign tax credit for taxes paid by a foreign acquiring corporation in instances where  an actual dividend paid by the foreign acquiring corporation would have been received by a foreign parent corporation and no foreign tax credit would have been available to the U.S. corporation. For example, if a foreign-controlled domestic corporation sells the stock of a subsidiary to a foreign sister corporation, the domestic corporation may claim it can  credit the foreign taxes that were paid by the foreign sister corporation. See Rev. Rul. 92-86, 1992-2 C.B. 199 ; Rev. Rul. 91-5, 1991-1 C.B. 114 . Where the foreign sister corporation actually distributed its earnings and profits to the common foreign parent, no foreign tax credits would have been available to the domestic corporation.

Under the Taxpayer Relief Act of 1997, P.L. 105-34 (8/5/97) bill, the earnings and profits of the acquiring foreign corporation, i.e., a CFC,  that are taken into account in applying §304. Such earnings and profits taken into account by the CFC will not exceed the portion of such earnings and profits that (1) is attributable to stock of such acquiring corporation held by a corporation or individual who is the transferor (or a person related thereto) and who is a U.S. shareholder (within the meaning of § 951(b)) of such corporation, and (2) was accumulated during periods in which such stock was owned by such person while such acquiring corporation was a controlled foreign corporation. For purposes of this rule, except as otherwise provided by the Secretary of the Treasury, the rules of §1248(d) (relating to certain exclusions from earnings and profits) would apply. See also §1442 which  generally requires a 30-percent gross basis tax to be withheld on dividend payments to foreign persons unless reduced or eliminated pursuant to an applicable income tax treaty.

Prior to the Education Jobs Act, enacted in 2010, a CFC group could repatriate the earnings and profits of the CFC group free from U.S. income tax where the acquiring corporation, the CFC, purchased the stock of the issuing corporation that resulted in a deemed distribution from the CFC directly to the foreign shareholder. This could occur, for example, if a CFC group which included a US holding company and a subsidiary CFC purchased  stock of its subsidiary CFC, a purchase by the CFC of stock of the issuing corporation held by a non-CFC foreign corporation in a transaction described §304(a)(1). This strategy resulted in a  dividend that bypassed the U.S. holding company and avoided the U.S. income tax that would have been otherwise payable by the U.S. holding company. In addition, because the dividend was treated as a distribution out of the earnings and profits  of acquiring, a foreign corporation, the constructive redemption resulted in a distribution of foreign source dividend income when paid to the foreign parent or other tax indifferent foreign member that was not subject to U.S. withholding tax. The earnings of an Issuing U.S. member of a foreign controlled group could also be constructively distributed to a foreign parent or  a tax indifferent entity in a constructive redemption. In that case, however, to the extent the dividend was deemed to be from the earnings of the domestic issuing corporation, it was generally be subject to U.S. withholding tax (at 30%, or for a lower rate under applicable treaty). Note the inapplicability of §367(a)(outbound transfers of property, including inventory from the U.S.) or §367(b)(foreign to foreign transfers) to §351 type transactions that are part of a deemed redemption under §304(a)(1).

“The Problem” Which Resulted in Passage of Section 304(b)(5)(B): A Hypothetical

Assume that FHC is a publicly traded foreign corporation and, by definition, is not a CFC. Assume further that  FHC does not maintain a U. S. trade or purpose directly but owns all the stock of US Sub. US Sub is the parent of a wholly owned foreign subsidiary, FS. All of FS’s earnings and profits are not previously taxed, i.e., earnings and profits described in §959(c)(3) that would also be described in §304(b)(5) and §304(b)(5)(A). FHC sells part of its share holdings in US Sub. to FS for cash in an amount equal to FS’s earnings and profits.

The “problem”  transaction is described in §304(a)(2) with the acquiring corporation being FS and the issuing corporation US Sub., and the shareholder of the issuing corporation FHC. Prior to the Act, FHC, per §304(b)(2)(A), would maintain its receipt of a dividend from FS for the full amount of cash received as a direct dividend from FS to FHC and not through US Sub. FHC would therefore contend it had no U.S. tax liability resulting from the deemed dividend, i.e., the dividend sourced from FS’s earnings would “hopscotch” over US Sub. But see §902 (for direct chain of ownership dividends from a CFC to its US parent corporation). After the transaction, FS would own stock of USP that generally would be a cost basis investment in U.S. property for purposes of §956 . This potentially could result in an income inclusion to US Sub. under §951(a)(1)(B) as the U.S. shareholder (per §951(b) ) of FS, a CFC. However, were FS’s earnings and profits eliminated in the stock purchase from FHC, the income inclusion under the CFC to US Sub. would be substantially reduced.

Enactment of Section 304(b)(5)(B) in 2010 Education Jobs Act

For §304 redemptions occurring after July 8, 2010, The 2010 Education Jobs Act, P.L. 111-226, under amended §304(b)(5)(B) imposes an additional limit on the earnings and profits of a foreign acquiring corporation that may be taken into account in determining the amount (and source) of a distribution treated as a dividend in a constructive redemption. Under the Act earnings and profits of an acquiring foreign corporation in a.§304(a) related party stock purchase are not taken into account in determining the amount treated as a dividend under §304(b)(2)(A) if more than 50% of the dividends arising in connection with the acquisition would neither (i) be subject to U.S. income tax for the year in which the dividends arise, §304(b)(5)(B)(i); or (ii) be included in earnings and profits of a CFC, per §957, without regard to §953(c) (§304(b)(5)(B)(ii)).  The limitation generally applies when more than 50% of the issuing corporation is acquired from a foreign person that is not a CFC, in which case none of the foreign acquiring corporation's earnings and profits is taken into account and just the target corporation’s earnings and profits are so accounted for in computing the amount of the dividend. The new provision effectively prevents the foreign acquiring corporation's earnings and profits from permanently escaping U.S. taxation by being deemed to be distributed directly to a foreign person (i.e., the transferor) without an intermediate distribution to a domestic corporation in the chain of ownership between the acquiring corporation and the transferor corporation. Generally, if the transferor is a foreign corporation (and not a CFC) and the acquiring corporation is a CFC, it is not relevant whether the target corporation is a domestic or a foreign corporation. However, if the target is a U.S. corporation, the 30-percent gross basis withholding tax applies to the amount constituting a dividend from the target, unless reduced or eliminated by treaty.

Revisiting the Hypothetical “Problem” After Passage of Section 304(b)(5)(B)

In applying §304(b)(5)(B) to the “Problem”, i..e, the stock sale occurred after August 10, 2010, then none of the FS’s earnings and profits would be used to fund a deemed dividend per §304(b)(2)(A). The requirements for §304(b)(5)(B) would be met, i.e., more than 50% of the dividends arising from such acquisition (without regard to §304(b)(5)(B)) would neither be subject to U.S. income tax either directly or through the CFC provisions. The gain FHC recognizes would not be subject to US tax.

Postscript. Regulations are expected to be issued that will provide a series of anti-avoidance provisions, including through the use of partnerships, options, or other arrangements to cause a foreign corporation to be treated as a CFC. The provision applies to transactions occurring after thedate of enactment, August 10, 2010.