Double Taxing Sandwiches

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By James J. Tobin, Esq.

Ernst & Young LLP, New York, NY 

Some tax questions take a little time to percolate before they get answered. Of course, the delay doesn't necessarily correlate with complexity; it may simply be because the question hasn't been asked a lot. I think that's the case with the issue of how the dividends received deduction (DRD) applies in the Subpart F context.

Now most would agree that U.S. sandwich structures – U.S. Parent owns controlled foreign corporation (CFC) owns U.S. Subsidiary – are fairly unusual and are really undesirable from a tax perspective.  They create the potential for double taxation through a host of provisions, including §956 and Subpart F more generally and the U.S. dividend withholding tax. This kind of structure is seen most often in an acquisition context where the foreign target has U.S. subsidiaries, although in most cases it should be possible to restructure out of the sandwich and its potentially bad consequences through a §338 election if the sandwiched CFC is in a foreign country that has a participation exemption. But sometimes taxpayers get trapped in the sandwich either because of gain that would be taxable in the foreign country or because they are unable to make a §338 election.  So it's not just a neat theoretical question, but also a slice of real life.

Probably because the structure is so troublesome and therefore generally avoided, the question of whether a DRD is available to the sandwiched CFC and to the ultimate U.S. parent largely has been relegated to speculation. But it has been on the minds of practitioners on and off for decades. I recall a pretty robust debate in the tax press about 20-25 years ago on how the DRD should operate in a sandwich structure.

The question of whether a DRD applies in the context of dividends flowing from a U.S. subsidiary to a CFC to an ultimate U.S. parent is not too hard, but the question of what level of DRD is somewhat harder. And these questions require navigating one's way through the Subpart F rules and §§243 and 245, which are neighborhoods of the Code one doesn't usually visit on the same trip.

The IRS recently provided answers to both questions in PLR 200952031, but didn't provide much of a roadmap as to how they got to those answers.

The distilled facts in the PLR are pretty simple: at the end of the day, U.S. Parent wholly owns CFC which wholly owns U.S. Subsidiary — and earnings are moving up the chain from U.S. Subsidiary to U.S. Parent. The IRS concluded that a §243 DRD could be taken into account for purposes of determining Subpart F income of CFC, but only at the 80% level. The IRS came to a similar result with respect to the repatriation of the earnings back to the United States – U.S. Parent could take into account an 80% DRD under §245 with respect to dividends from CFC. However, the IRS did not elaborate in the ruling why it is that an 80% DRD applied at each level instead of a 100% DRD.

Let's start off by looking at the math that results from the 80%/80% position in the ruling. After all, 80% sounds pretty good. And 80% twice sounds even better. Unfortunately, it leaves room for a significant amount of double tax. And here we're talking about double U.S. taxation, not the kind of international double taxation where the foreign tax credit offers some relief.

Assume U.S. Subsidiary pays a dividend of 100 to CFC, which immediately distributes that dividend up to U.S. Parent.  On the first dividend, CFC would have 100 of gross Subpart F income and would deduct 80 under the 80% DRD, resulting in 20 of net Subpart F income to U.S. Parent. When U.S. Parent then receives 100 as a cash dividend from CFC, it would exclude 20 from its income under §959 as previously taxed income. The remaining 80 would be eligible for another 80% DRD, leaving 16 of taxable dividend. Thus, in total, 36 of the 100 dividend from U.S. Subsidiary would be subject to double tax – real double U.S. taxation (taxed at the U.S. Subsidiary level and at the U.S. Parent level). Presumably the cascading 20% double tax leakage would further escalate if U.S. Subsidiary were owned not by a first-tier CFC but rather through a chain of CFCs.  For those taxpayers that are caught in a U.S. sandwich structure as a result of a foreign acquisition, I could well imagine a multi-decker sandwich problem, particularly if, heaven forbid, the check-the-box rules were ever to fade into history.

The double tax problem would be further exacerbated if the full 100 dividend from U.S. Subsidiary were not immediately paid up through CFC as a dividend — for example, if CFC reinvested the 100 or used it to pay down liabilities. In that case, CFC would still have 100 of additional E&P. The ownership of the shares of U.S. Subsidiary would constitute an investment in U.S. property under §956, up to the basis in such shares. Because 20 has already been included in income under Subpart F, only an additional 80 inclusion would be required by reason of §956. However, because a §956 inclusion is not a dividend, presumably no DRD at all would be available with respect to that inclusion. Thus, there would be double tax on the full 100 of dividend from U.S. Subsidiary, 20 directly from the dividend itself and 80 from the resulting §956 inclusion. The obvious advice to a company in this situation (after the initial advice of avoiding being in this structure in the first place) would be to always pay the full dividend all the way through to U.S. Parent immediately.  However, that may be easier said than done if CFC has other income or costs, which could complicate the tax calculations with respect to a payment of the dividend on to U.S. Parent in the same year received from U.S. Subsidiary.

So, given that this 80%/80% approach turns out not to produce such a great result, I ask myself whether this is the right technical and policy answer. From a tax policy perspective, I would conclude that it clearly is not the right answer. There seems to be no reason to impose a significant double tax burden within a wholly owned group with respect to fully taxed U.S. operating profits.  But even good policy objectives are constrained by statutory and regulatory rules. Which means the more important question is whether 80%/80% is the right technical answer. While I can understand how one could reach the 80%/80% result, my view here is that one also can get to the better policy result under the applicable rules. There appears to be ample support under the statutory and regulatory rules to reach a 100% DRD result for the Subpart F inclusion. With respect to the dividend distribution from CFC to U.S. Parent, it is a bit more of a challenge under the statutory language to get to the 100% DRD result that I would posit is the appropriate answer. However, as described below, I think the IRS could stretch a bit to get there.  And if they did, I doubt they would be accused of overreaching – certainly, I can promise I wouldn't criticize them.

Let's look at this from the bottom up, starting with the dividend from U.S. Subsidiary to CFC.

Existing regulations for determining a foreign corporation's gross income and taxable income for Subpart F purposes require the foreign corporation to be treated as if it were a domestic corporation. Regs. §1.952-2(a) provides, in general, that the gross income of a foreign corporation for any taxable year is determined by treating the foreign corporation as a domestic corporation taxable under §11 and by applying the principles of §61. Similarly, Regs. §1.952-2(b)(1) provides that the taxable income of a foreign corporation for any taxable year shall, subject to the special rules of Regs. §1.952-2(c), be determined by treating such foreign corporation as a domestic corporationtaxable under §11 and by applying the principles of §63. There are exceptions to the general rule, but they do not apply in this case.

So what does that mean? Under §243(a)(3), a domestic corporation is allowed a 100% DRD for so-called qualifying dividends. A qualifying dividend is defined in §243(b) as any dividend that is received by a domestic corporation that is in the same affiliated group as the distributing corporation. (Note that §243(c) provides for an 80% DRD for dividends received from a 20%-owned domestic corporation in situations where the 100% DRD is not available.)

Because the §952 regulations explicitly say that a CFC should be treated as a domestic corporation for purposes of determining gross income and taxable income and because the DRD is relevant to the determination of taxable income, it seems logical that §243(a)(3) and (b) would apply in this case. In the PLR's facts, if CFC is treated as a domestic corporation, it would be a member of the same affiliated group as the U.S. subsidiary below it, which is the domestic corporation paying the dividend in question.  Thus, the 100% DRD should apply to the dividend.

It seems that the IRS view in the PLR was that CFC was not a domestic corporation for all purposes; the IRS view seems to have been that CFC was just a pretend domestic corporation for some purposes but not others. So it was considered to be a domestic corporation for purposes of being entitled to a DRD in the first place.  But it was not domestic enough to be considered a member of the same affiliated group with U.S. Subsidiary, which it wholly owned. I've tried reading the words backwards, but I can't find that distinction in the §952 regulations.

In this regard, consider §243(e), which treats a dividend from a foreign corporation as a dividend from a domestic corporation for purposes of the §243 DRD in circumstances involving earnings accumulated by a domestic corporation. Section 243(e) provides treatment as a domestic corporation but it doesn't separately explicitly provide treatment as a member of the same affiliated group as the dividend recipient. If the domestic corporation treatment that is provided under the §952 regulations, just as it is provided under §243(e), isn't a ticket into affiliated group treatment (where the prerequisites for that treatment would otherwise be met), then does that mean that §243(e) and its domestic corporation treatment would never get you to a 100% DRD? It's very hard for sure to see a basis or rationale for the "domestic but not affiliated despite 100% ownership" position that is needed to get to an 80% DRD here, and none is expressed by the IRS in the ruling.

It's interesting to think about the situation where the business of U.S. Subsidiary were instead conducted as a branch of CFC. Clearly all the U.S. taxable income principles would apply in computing CFC's U.S. branch taxable income, just as are supposed to apply in computing its Subpart F taxable income. But in the branch case no double tax would arise — a result one could get to in the case of a U.S. subsidiary instead of a U.S. branch simply by applying a 100% DRD instead of just 80%. So I think the first 80% holding is wrong both technically and policy-wise, and the IRS could have ruled that a 100% DRD applied to the dividend from U.S. Subsidiary to CFC for purposes of computing Subpart F income.

Next, let's take a look at whether U.S. Parent should get a 100% DRD when CFC distributes the dividend it received up the chain.

This issue involves the interaction of §§243(a), 243(b), 243(e), 245(a), and 245(b). I must admit that as an international guy I don't get to spend a lot of time in this neighborhood of the Code and fortunately my clients don't generally find themselves having to choke down this flavor of sandwich. So I did have to spend a bit of time discerning just how these provisions weave together. And as an aside, I'd like to note that §§243 and 245 are not a model of clarity in statutory drafting (lack of clarity in statutory drafting being a condition with which I am well familiar as an international guy). But anyway, here goes. Sections 243(a) and (b), taken together, provide that a dividend from a wholly owned domestic corporation that is a member of the same affiliated group is eligible for a 100% DRD.  Section 245(a) generally deals with DRDs for dividends from foreign corporations that have U.S. businesses. Section 245(b) provides a 100% DRD in the case where the dividend-paying foreign corporation is wholly-owned directly or indirectly and all of its income for the year is effectively connected with a U.S. trade or business. Section 243(e) provides that for purposes of §243 a dividend from a foreign corporation will be treated as a dividend from a domestic corporation to the extent the E&P was accumulated by a domestic corporation.  At a minimum, this would seem to cover the situation of an outbound reorganization where the foreign corporation in question had previously been a domestic corporation and had accumulated E&P at the time of the reorganization.

So let's consider how these rules might apply to a hypothetical fact pattern. Say a U.S. corporation (USP) owns 100% of the stock of a foreign holdco (FH), which owns 100% of the stock of a U.S. subsidiary (USS) and 100% of the stock of a foreign subsidiary (FS) that has only U.S.-source effectively connected income.  It seems to me that if FS pays a dividend to FH which pays it on to USP, a 100% DRD would be available based on §245(b) because FS is directly or indirectly wholly owned by USP. It also seems to me that if USS were to liquidate under §332 into FH (ignoring the §367 consequences), then, to the extent of the old E&P of USS, a dividend from FH would be eligible for the 100% DRD based on §243(e). Therefore, it would seem an odd policy gap if an actual dividend that is paid from USS to FH and then paid on to USP, assuming FH had no other E&P for the year, would not also receive the 100% DRD benefit.

To get to the right result — which I would posit is 100%/100% — in the ruling, I would think the IRS either could have used the direct or indirect concept in §245(b), which admittedly is a stock ownership concept in the statutory language, to get to the conclusion that CFC indirectly had earned U.S. effectively connected income with respect to its dividend from U.S. Subsidiary, or could have construed the dividend received from CFC as constituting E&P that had been accumulated by a domestic corporation under §243(e).  It seems odd to me that operating as a U.S. subsidiary would be treated less favorably than operating as a foreign affiliate with a U.S. branch.

At the end of the day, we now have a ruling confirming that the DRD is available at 80%/80%, and that's a really good start. It at least gives a positive answer to a very old question.  It just would be nice if the IRS would think a little harder about this question and maybe get to an even better (and, in my view, more appropriate) answer. And maybe they could do it before all us international tax people forget again where those DRD rules are in the Code.

This commentary also will appear in the May 2010 issue of the Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Maule, 503 T.M., Deductions: Overview and Conceptual Aspects, Yoder, 926 T.M., Subpart F — General, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.