The anti-avoidance regulation at Treasury Regulation Section 1.304-4 was finalized over a year ago to prevent circumvention of Section 304, which governs stock redemptions using controlled corporations. The explicitly targeted transactions involve multinational groups - a context where the need for proper corporate distribution planning is most acute. The regulation prevents redemption treatment (akin to a sale) and instead seeks to ensure dividend treatment for certain de facto distributions.


The normal corporate distribution environment has disparate tax treatments for situations containing only subtle differences. The classic distribution is, of course, a dividend under Section 301(c)(1) where a corporation with sufficient earnings and profits pays an equal portion of the profits to each shareholder, pro rata. This rule requires the accounting system for earnings and profits under the tax system as a general guide to the extent of a corporation’s profitability. Recipient shareholders take the dividend as ordinary income (with special rates for individuals receiving qualified dividends and for corporations receiving the dividends received deduction).

When a corporation pays out an equal distribution to all shareholders, yet has insufficient earnings and profits, the excess over profits is no longer income but a return of basis under Section 301(c)(2). The Code has adjudged that this is not income but something more akin to the principal of an investment, which implies that the corporation has begun to cannibalize itself by the distribution. Yet this is often a useful tax outcome, particularly for those holding shares with a high basis that are able to take the income without federal income tax.

Once a taxpayer has used up all the basis in shares, then a distribution is treated as capital gain under Section 301(c)(3). Together, Sections 301(c)(2) and (3) mimic the treatment of a sale of the shares, with gain only to the extent the amount realized in distributions exceeds basis of the stock.

In contrast to the dividend-like distributions is the redemption or sale of stock to the corporation itself. A redemption, particularly with either a put or a call option, is a common tactic in business deals, particularly popular in the venture capital space (e.g., to provide liquidity to shareholders pre-IPO, or to clear the cap table of difficult or inactive shareholders). In the tax context, a redemption is a non-pro rata distribution from the corporation to a shareholder, followed by surrendering of shares that results in a substantial diminution of the recipient shareholder’s stake in the company. The shareholder, who may be partially or wholly redeemed, receives capital gain sale treatment, the same as if selling the shares to a third party. A sole shareholder  effectively receives only pro rata distributions, even in the case of a redemption, since his ownership of the stock remains at 100%. A dominant (e.g., >80%) shareholder can technically have a non-pro rata distribution, but only with the loss of 80% control (which may have business or tax consequences, e.g., loss of affiliated group status).

It is certainly tempting for a taxpayer to make use of these varying treatments by selecting the most advantageous one, even though the tax treatment is nominally not elective. Without Section 304 it would be simple for corporate groups to elect into sale treatment by having a related corporation buy the stock of a sister corporation from the parent corporation. The substance of this transaction would be that the parent corporation sold the stock to itself (through the vehicle of a controlled subsidiary) and moved cash from a subsidiary to its own coffers while retaining the right of control. Sale treatment does not align with the economic substance of the transaction.

This sort of game-playing between related taxpayers is not allowed by Section 304 on redemptions through controlled corporations. The provision forces sales to related parties to be analyzed as redemptions under Section 302. If there is no substantial diminution of control, the sale to a related party is simply a Section 301 distribution subject to dividend treatment (or return of basis or capital gain treatment). Under Section 304(b)(2), the earnings or profits of the acquiring corporation and the issuing corporation can both be used to support dividend treatment for the distribution.

Treasury Regulation Section 1.304-4

Prior to the proposal of Treasury Regulation Section 1.304-4, the creation of new subsidiaries allowed taxpayers to use a different tax strategy with distributions, despite the Section 304 check. Specifically, by creating a new subsidiary to purchase the stock of a related corporation, the parent could use an entity that had no earnings and profits and so elect out of dividend treatment. Such a transaction was especially appealing to the parent of a multinational group as a method to distribute cash from a foreign subsidiary without dividend tax. The regulation at Section 1.304-4 prevents this strategy by disregarding the new entity and deeming its parent as the acquirer.

For example: US Parent has two subsidiaries, S1 and S2. If S2 simply buys stock of S1 from Parent, then Section 304 forces a Section 302 analysis on the transaction. It cannot be a Section 302 redemption because the sole owner has no diminished ownership, so we must look to Section 301 for the distribution’s tax consequences. The purchase of S1 stock from Parent counts as a contribution of S1 stock from Parent to S2, followed by a distribution from S2 to Parent that will be taxed based on the availability of earnings and profits or basis of Parent’s S2 stock. If S2 has plenty of earnings and profits, then what is formally structured as a sale becomes a taxable dividend.

In an attempt to avoid application of Section 304, Parent might try to create a subsidiary, S3, under S2. The new subsidiary has no earnings and profits, so when it engages in a purchase of S1 stock from Parent, the Sections 304 and 302 analysis dictates that the ending point will be a return of basis (or capital gain) rather than a taxable dividend. However, Section 1.304-4 comes into play and disregards S3, provided that one of the principal purposes of the transaction was avoidance of Section 304. If S3 is disregarded, then the deemed acquiring corporation is its  parent S2, negating the use of a new subsidiary to sidestep S2’s earnings and profits.

Because Section 304 draws earnings and profits from both the acquiring corporation and the issuing corporation, Section 1.304-4 can create a deemed issuing corporation as well as a deemed acquiring corporation. If Parent had created S4 under S1 and S2 purchased the S4 stock (with a principal purpose of Section 304 avoidance), then Section 1.304-4 would disregard S4 and deem S1 the issuing corporation for earnings and profits purposes.


Treasury Regulation Section 1.304-4 primarily creates a limitation for multinational corporate groups who have the need to make repatriating distributions and are not able to rely on the dividends received deduction. While such multinational groups should engage in thoughtful tax planning, this finalized regulation limits the use of new subsidiaries simply to evade the earnings and profits rules.