Regs. §1.304-4T Broadens Anti-Avoidance Rule

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By Lowell D. Yoder, Esq.

McDermott Will & Emery LLP, Chicago, IL 

A transaction used for restructuring the ownership of foreign subsidiaries is for a U.S. parent (USP) to sell the stock of one foreign subsidiary to another foreign subsidiary. This transaction can avoid foreign restrictions on cash distributions from the foreign subsidiaries to USP, as well as minimize foreign and U.S. tax costs.

The above transaction is recast for U.S. tax purposes under §304. For example, assume that USP owns all of the stock of two controlled foreign corporations (CFCs), CFCT and CFCA, and that CFCA owns the stock of several other CFCs. CFCA acquires for value all of the stock of CFCT from USP for $1,000 in cash. CFCA has $800 of earnings and profits with associated foreign taxes of $800, and CFCT has $500 of earnings and profits with associated foreign taxes of $50.

Under §304(a)(1), USP is treated as first transferring the stock of CFCT to CFCA in exchange for $1,000 of CFCA stock in a tax-free §351 transaction.1 Section 367(a) generally does not apply to the deemed outbound transfer of the CFCT stock to CFCA.2

Second, CFCA is treated as redeeming for $1,000 its stock deemed issued to USP. This redemption is treated as a distribution subject to §301.3 Under §304(b)(2), the determination of the amount of the property distribution that is a dividend and the source of such dividend 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.4 In the parlance of §304, CFCA is the acquiring corporation and CFCT is the issuing corporation. Therefore, in the above example the deemed distribution is treated first as a dividend out of CFCA's earnings and profits in the amount of $800 (with $800 of foreign taxes), and then as a dividend of $200 out of the earnings and profits of CFCT (with $20 of foreign taxes).5 Accordingly, USP would report $1,000 of dividend income with $820 of foreign tax credits, and generally pay no U.S. tax on the transaction.

Restructuring through a sale of one CFC to another CFC also can be used when the U.S. parent has substantial basis in the stock of the target and neither the acquirer nor the target have a material amount of earnings and profits.6 For example, assume the facts above, except that neither CFCT nor CFCA has any earnings and profits, and USP has a basis in the CFCT stock of $900 and a basis in the CFCA stock of $2,000. The $1,000 paid by CFCA to USP is treated first as a return of basis of the CFCA stock deemed issued ($900), and then as gain under §301(c)(3) ($100).7 If USP instead takes the position that its basis in the existing CFCA shares should also be taken into account in determining its return of basis and gain from the deemed redemption under §304 (which would result in no gain recognition for CFCA from the redemption),8 then the $100 of gain realized with respect to the CFCA stock deemed issued would be subject to U.S. taxation under §367(a).9

Regs. §1.304-4T published in 1988 ("the 1988 temporary regulations") provided a rule that, under certain circumstances, treats a corporation other than the acquirer as the acquiring corporation in a §304 transaction. Specifically, for purposes of determining the amount of a property distribution constituting a dividend and the source thereof under §304(b)(2), the District Director (now known as the Director of Field Operations) is permitted to consider another corporation as the acquiring corporation if such corporation controls the corporation that in fact acquires the issuing corporation and if one of the principal purposes for creating, organizing, or funding the actual acquiring corporation (through capital contributions or debt) is to avoid the application of §304 to the funding corporation.  The 1988 temporary regulations did not contain an anti-avoidance rule that applied to the issuing (target) corporation.

Regs. §1.304-4T was recently modified and expanded ("the 2010 temporary regulations"). They specify additional funding arrangements that may cause the anti-avoidance rule to deem another corporation as the acquiring corporation ("deemed acquiring corporation"). In addition, they add an anti-avoidance rule that, under certain circumstances, treats a corporation other than the actual issuer (target) as the issuing corporation ("deemed issuing corporation"). The application of these rules can impact the amount of the distribution that is treated as a dividend, the amount of deemed-paid taxes associated with the deemed dividend, and the amount of basis taken into account in the §304 transaction.10

Deemed Acquiring Corporation

The 2010 temporary regulations that deem another corporation as the acquiring corporation apply to additional funding arrangements. The 1988 temporary regulations appeared to be limited to situations where another corporation funded the acquiring corporation by capital contributions or loans, whereas the 2010 temporary regulations can apply where another corporation funds the acquirer "by any means." The 2010 temporary regulations list capital contributions and debt merely by way of illustration.

The Preamble to the 2010 temporary regulations states that the anti-avoidance rule may apply in cases where the acquirer receives funds for the acquisition from an unrelated party. For example, a corporation can be considered as a deemed acquiring corporation where such corporation facilitates the repayment of an obligation incurred by the acquiring corporation to acquire the stock of the issuing corporation. No additional guidance is provided concerning the situations in which a corporation will be considered to be facilitating the repayment of an obligation.

For example, assume the facts in the second example above (where CFCA and CFCT have no earnings and profits), except that CFCA borrows $1,000 from a bank to acquire the stock of CFCT. Subsequently, CFCA borrows $1,000 from a related CFC, CFCF, and repays the bank loan. Under the 2010 temporary regulations, CFCF may be treated as the acquiring corporation for purposes of applying §304 if a principal purpose of the CFCF loan is to avoid the application of §304 to CFCF. If CFCF is treated as the acquiring corporation, the amount treated as a dividend, the deemed-paid taxes, and the basis results would be determined as if CFCF had acquired the stock of CFCT.

The 2010 temporary regulations provide no additional guidance concerning when the principal purpose test is satisfied or when cash received by the acquiring corporation is treated as having "funded" the §304 acquisition. Arguably, a principal purpose for avoiding the application of §304 to the acquiring corporation is lacking where the acquiring corporation has other sources of cash to fund the acquisition. In addition, cash is fungible, and without a specific factual connection to the funding of the acquisition, it is not clear when cash or funds received by the acquiring corporation should be considered as funding the §304 acquisition.

There also is no guidance concerning what other funding arrangements might be subject to the anti-avoidance rule.  Query whether there may be circumstances where a dividend from a subsidiary to the acquiring corporation might be considered as funding the acquisition under the 2010 temporary regulations, causing the subsidiary to be the deemed acquiring corporation. This should not be the case, however, where the dividends are not paid for a principal purpose of funding the acquisition. In addition, a dividend from the acquired corporation should not be subject to this rule.

The above changes to Regs. §1.304-4T in the 2010 temporary regulations fundamentally expand the potential application of the anti-avoidance rule set forth in the 1988 temporary regulations. Nevertheless, the IRS might seek to apply the new concepts to prior years, as the Preamble refers to these modifications as "clarifications."

The 1988 temporary regulations applied at the discretion of the District Director. This was changed by the 2010 temporary regulations, which make the anti-avoidance rule self-executing. 

The 1988 temporary regulations also applied when "one of the principal purposes" was to avoid the application of §304 to the funding corporation. The 2010 temporary regulations apply when "a principal purpose" of the transaction is to avoid the application of §304. The IRS and Treasury do not view this modification as a substantive change.

Deemed Issuing Corporation

The 2010 temporary regulations contain a new anti-avoidance rule that applies to the issuing corporation when, in connection with the §304 transaction, the issuing corporation acquires stock of another corporation with a principal purpose of avoiding the application of §304 to the other corporation. Under these circumstances, the acquiring corporation is treated as acquiring the stock of the other corporation (deemed issuing corporation) rather than the stock of the actual issuing corporation. This rule applies for purposes of determining the amount of property distribution that is a dividend and the source thereof under §304(b)(2).

For example, assume that USP is a domestic corporation that wholly owns CFC1 (organized in country X) and CFC2 (organized in country Y). The CFC1 stock has a basis of $1,000. CFC1 has substantial earnings and profits and CFC2 has no earnings and profits. USP desires to own all of its foreign corporations in a direct chain and to repatriate cash of CFC2. USP first transfers the stock of CFC1 to newly formed CFC3, and then CFC2 acquires the stock of CFC3 for $1,000. The transfer of CFC1 to CFC3 was to avoid country Y restrictions and to avoid the application of §304 to CFC1. For purposes of determining the character of the distribution and source, the 2010 temporary regulations treat CFC2 as acquiring the stock of CFC1 (and thus disregard CFC3, at least for purposes of §304). Accordingly, the distribution is treated as paid out of CFC1's earnings and profits.11

This example shows that the presence of an important foreign business purpose for the transaction will not avoid application of the anti-avoidance rule if there is also a principal purpose to avoid §304 applying to the deemed issuing corporation. It also indicates that certain transactions seeking to isolate earnings and profits of a subsidiary of the issuing corporation may not be respected for purposes of applying §304.

The expansion of the anti-avoidance rules that apply to acquiring corporations and the addition of an anti-avoidance rule applying to issuing corporations materially limits the opportunities for affirmatively using §304 to obtain particular tax results.  Nevertheless, under certain circumstances, the use of a transaction subject to §304 can still be beneficial, e.g., as an effective repatriation of high-tax earnings and profits that avoids foreign restrictions and costs on payments of dividends.12

This commentary also will appear in the April 2010 issue of the Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Gross, Doloboff, Koutouras and Tizabgar, 768 T.M., Stock Sales Subject to Section 304, and Davis, 919 T.M., U.S.-to-Foreign Transfers Under Section 367(a),  and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.



 1 This construct applies because USP directly owns 100% of CFCT before the transaction and indirectly owns 100% of CFCT after the transaction.


 2 Regs. §1.367(a)-3(a); seeRegs. §1.367(b)-4(a) (§367(b) also does not apply).  See also T.D. 9444, 74 Fed. Reg. 6824 (2/11/09).


 3 §302(d).


 4 Where the acquiring corporation is foreign, §304(b)(5) imposes certain limits on the amount of earnings and profits of the acquiring corporation that are taken into account in determining the amount of the deemed dividend.


 5 See Rev. Rul. 91-5, 1991-1 C.B. 114, and Rev. Rul. 92-86, 1992-2 C.B. 199, for the application of the deemed-paid foreign tax credit rules to §304 transactions.


 6 SeeYoder, "CFC Purchase of Stock in a Related CFC: Code Sec. 304 vs. D Reorganization Treatment," 34 Int'l Tax J. 3 (Mar.-Apr. 2008).


 7 See Regs. §1.1248-1T(b) (§1248 applies to gain recognized under §301(c)(3)).


 8 Proposed regulations would provide that all of the basis USP has in the stock of CFCA is taken into account, which could result in the entire $1,000 being treated as a return of basis. Prop. Regs. §1.304-2, REG-143686-07, 74 Fed. Reg. 3509 (1/21/09).


 9 Regs. §1.367(a)-9T. See Yoder, "New Code Sec. 367(a) Regulations Apply to International Code Sec. 304(a)(1) Transactions," 35 Int'l Tax J. 3 (May-June 2009). 


 10 T.D. 9477, Regs. §1.304-4T.


 11 Regs. §1.304-4T(c) Ex. 2.


 12 The IRS has respected the affirmative use of §304 by taxpayers to achieve the tax treatment provided by that section. See Notice 2007-9, 2007-5 I.R.B. 401 (§304 dividends eligible for the look-through exception under §954(c)(6)); Notice 2005-64, 2005-2 C.B. 471 (§304 dividends eligible for the dividends received deduction under §965). Indeed, one might imply from the expansion of the anti-abuse rules that the affirmative use of §304 to create dividends must be respected, because the expanded rules only apply to recast transactions designed to reduce or avoid dividend treatment under §304.