Section 304 provides provides generally that, for purposes of §§302 and 303, if one or more persons are in control of each of two corporations and one such corporation (the “acquiring corporation”) acquires in exchange for property stock of the other corporation (the “issuing corporation”) from the person (or persons) so in control, then, unless §304(a)(2) applies, the property is treated as received in redemption of the stock of the acquiring corporation.
Section 304(a)(2) provides generally that, for purposes of §§302 and 303, if in exchange for property the acquiring corporation acquires stock of the issuing corporation from a shareholder of the issuing corporation and the issuing corporation controls the acquiring corporation, then the shareholder shall be treated as receiving the property in redemption of the stock of the issuing corporation.
“Control” for purposes of §304 means the ownership of stock possessing at least 50% of the total combined voting power of all classes of voting stock or at least 50% of the total value of shares of all classes of stock. With certain modifications, the constructive ownership rules of §318 are applied.
Under section 304(b)(2), the determination of the amount of the property distribution that is a dividend (and the source thereof) is made 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. If the acquiring corporation is foreign, §304(b)(5) limits the amount of earnings and profits of the acquiring corporation that are taken into account for this purpose.
Where and to the extent that the dividend is sourced from the E&P of the acquiring corporation, the transferor is considered to receive the dividend directly from the acquiring corporation;this outcome has been referred to by tax practitioners as “hopscotching” because the dividend bypasses any intermediary shareholders.
Special rules apply if the acquiring corporation is foreign under §304(b)(5). For purposes of determining the amount of the dividend to the transferor, the foreign acquiring corporation's E&P that is required to be taken into account is limited to the portion of such E&P that: (i) is attributable to stock of the foreign acquiring corporation held by a corporation or individual who is the transferor (or a person related thereto) of the target corporation and who is a U.S. shareholder per §951(b) of the foreign acquiring corporation and (ii) was accumulated while such stock was owned by the transferor (or a person related thereto) and while the foreign acquiring corporation was a controlled foreign corporation (“CFC”).
Where the redemption treated as a dividend is made with respect to stock held by a non-U.S. person, 30% withholding under §1441 is generally required on the dividend unless and to the extent that a treaty is applicable and provides for a lower rate of withholding.
Revision to Section 304.
Under the recent revision to §304 made in the Medicaid Assistance bill, an additional limitation on the E&P of a foreign acquiring corporation is taken into account in determining the amount (and source) of the distribution that is treated as a dividend. In particular, where more than 50% of the dividends arising from acquisition would (without taking into account the provision) not be: (i) subject to U.S. tax in the year in which the dividend arises, or (ii) includible in the E&P of a CFC per §957 (but without taking into account §953(c)), the E&P of the foreign acquiring corporation is not taken into account for this purpose. The new special rule generally applies if more than 50% of the target corporation is acquired from a foreign corporation which is not a controlled foreign corporation.
Where the special rule applies, none of the foreign acquiring corporation's E&P is taken into account. In such case, the only E&P that is taken into account to determine the amount constituting a dividend is the target corporation's E&P. The provision is aimed to prevent the foreign acquiring corporation's E&P from permanently escaping U.S. taxation by being deemed to be distributed directly to a foreign person (i.e., the transferor) without “hopschotching” over” 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. See §1442. Regulations are to provide rules to prevent circumvention of the provision through the use of partnerships, options, or other arrangements to cause a foreign corporation to be treated as a CFC.
The revision applies to redemptions occurring after the date of enactment (8/10/2010).
Temporary Regulations setting forth anti-abuse rules to §304 were issued last year. See Treas. Reg. §1.304-4T.