In a recent private letter ruling,15 the IRS addressed whether a wholly-owned subsidiary could be included in its parent’s affiliated group, even though the subsidiary’s shares were subject to a proxy agreement entitling the proxy holders to exercise exclusive control over the subsidiary’s management.
The IRS concluded that, although the parent company lacked voting rights, the ownership requirements of Section 1504(a) of the Code were met and the subsidiary could join in the filing of the group’s consolidated return. The IRS also ruled that the parent could even transfer the subsidiary’s stock to another member of the affiliated group, with the same result, so long as the acquiring corporation would also be bound by the proxy agreement.
By way of background, the subsidiary whose shares were subject to the proxy agreement was an indirect subsidiary of a foreign corporation. The subsidiary was engaged in providing services to the U.S. government, requiring it to maintain various security clearances. However, in order to effectively insulate the subsidiary from foreign ownership, control, or influence — a prerequisite to retaining its security clearances — the foreign corporation and subsidiary, as well as each of the interposed domestic corporations, were required to enter into a proxy agreement.
The proxy agreement vested control of the subsidiary’s management in the proxy holders. Under the terms of the proxy agreement, the proxy holders were required to: 1) be resident U.S. citizens; 2) have no prior contractual, financial, or employment relationships with the foreign corporation or entities controlled by the foreign 18 PLR 201306007 (Feb. 8, 2013). corporation; 3) certify their willingness to accept various security responsibilities; 4) be eligible for the requisite security clearance; and 5) be approved by the U.S. government. Central to the IRS’s ruling, however, was the fact that the proxy holders held no economic interest in the subsidiary.
As part of the proxy agreement, the proxy holders became directors of the subsidiary. In their capacity as directors, the proxy holders were entitled to act on behalf of the subsidiary. Even so, they could not authorize certain fundamental corporate transactions, such as: 1) the sale or disposal, in any manner, of capital assets or business of the subsidiary; 2) pledging, mortgaging, or encumbering the subsidiary’s assets for purposes other than obtaining working capital or funds for capital improvements; 3) the merger, consolidation, reorganization, or dissolution of the subsidiary; 4) selling, transferring, pledging, or otherwise encumbering the subsidiary’s stock; and, 5) the filing or making any petition under the federal bankruptcy laws or any similar law or statute of any state or foreign country.
Consistent with their role as directors of subsidiary, the proxy holders were required to act in good faith and, because of the nature of the subsidiary’s business, in the national interest. The proxy holders held limited terms, and they could only be removed as specified in the proxy. Finally, the proxy agreement was for a five-year term. The proxy agreement could, however, be terminated before the end of the five-year period, but only by the U.S. government and only under certain circumstances.
In light of these facts, the IRS found that, as long as the proxy agreement (or a successor agreement) was in place, ownership of the subsidiary would constitute beneficial ownership and, as such, direct ownership for purposes of the consolidated return rules and Section 1504(a) of the Code. Accordingly, the subsidiary would be a member of the affiliated group and would be permitted to join in the filing of a consolidated federal income tax return with its parent’s affiliated group. Furthermore, a transfer of the subsidiary’s stock to another member of the parent corporation’s affiliated group would also constitute direct ownership, as long as the acquiring corporation became subject to the proxy agreement.