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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
Recently issued final regulations provide that §1248 applies to gain recognized under §301 by a "United States shareholder" (hereinafter simply "U.S. shareholder") in connection with a distribution of property received from a controlled foreign corporation (CFC).1 This would appear to expand the scope of §1248 to apply where there is no actual transfer of stock in a CFC.
By way of background, generally gain recognized on the sale or exchange of stock in a corporation is capital gain.2 Section 1248 modifies this rule with respect to gain recognized by a U.S. shareholder that "sells or exchanges stock in a foreign corporation." Such gain is recharacterized as ordinary dividend income to the extent of the earnings and profits (sometimes referred to herein simply as "earnings") of the foreign corporation derived while it was a CFC and attributable to the shares sold (including earnings of lower-tier CFCs). Deemed-paid foreign taxes accompany the §1248 amount in the same manner as if the earnings had been distributed as a dividend.3
Section 301(c) specifies the treatment of a corporation's distribution to its shareholders. A distribution is a dividend to the extent of the corporation's earnings and profits (not including earnings of subsidiaries). A distribution in excess of earnings is applied against and reduces the basis in the shareholder's stock (and is not subject to taxation). The portion of the distribution that is not a dividend, to the extent it exceeds the shareholder's basis in the stock, "shall be treated as gain from the sale or exchange of property."
Absent the final regulations, it would not seem that §1248 would apply to a §301 distribution. First, §1248 expressly does not apply to amounts treated as dividends.4 In addition, §1248 does not apply to a distribution that is a non-taxable return of basis because no gain is recognized. Finally, §1248 did not appear to apply to a distribution in excess of basis because there is no sale or exchange of the stock of the CFC, i.e., the U.S. shareholder does not transfer any of its CFC stock.5
Under the final regulations, however, gain recognized as a result of a distribution by a foreign corporation to a U.S. shareholder in excess of basis is subject to §1248. Therefore, the §301(c)(3) gain is recharacterized as ordinary dividend income to the extent of the earnings and profits of the distributing foreign corporation and its subsidiaries that were derived while the foreign corporations were CFCs and that are attributable to the shares owned by the U.S. shareholder. As the CFC making the distribution would not have any earnings and profits under such circumstances, the new regulation has the effect of taxing the earnings and profits of lower-tier CFCs.6
Example. Assume that U.S. Parent (USP) owns Foreign HoldCo, a CFC, which in turn owns Foreign OpCo, also a CFC. USP has a basis of $6 million in the stock of Foreign HoldCo. Assume Foreign HoldCo has no earnings and profits and Foreign OpCo has $25 million of earnings and profits derived while it was a CFC and while owned indirectly by USP. Foreign HoldCo borrows $10 million and distributes it to USP. Under §301, USP would receive $6 million as a non-taxable return of basis and would recognize $4 million of gain. Under the final regulations, the gain would not be capital gain, but USP would include in income $4 million of the earnings and profits of Foreign OpCo. 7
A CFC's earnings and profits are not reduced by the amount of a §1248 inclusion, but are reclassified as previously taxed income (PTI). Section 959(e) provides that any amount included in gross income under §1248 shall be treated as an amount included in gross income under §951(a)(1)(A) (i.e., as Subpart F income) for purposes of §959. As a result, subsequent distributions of earnings that were subject to tax pursuant to the application of §1248 are excluded from the gross income of the U.S. shareholder.
Accordingly, in the above example, the $4 million inclusion in the income of USP under §1248 should result in $4 million of the earnings of Foreign OpCo being reclassified as PTI. A subsequent distribution of such amount up through Foreign HoldCo to USP is excluded from the income of USP under §959.8
When a U.S. shareholder includes an amount in gross income under §951 as Subpart F income or as an investment in U.S. property of a first-tier or lower-tier CFC, its basis in the stock of the first-tier CFC is increased by the same amount under §961. The basis is reduced when the PTI resulting from the inclusion is distributed to the U.S. shareholder. An amount received by a U.S. shareholder out of PTI that exceeds its basis in the stock of the CFC is taxable to the U.S. shareholder. Specifically, §961(b)(2) provides that, to the extent that the amount excluded from gross income under §959(a) exceeds the adjusted basis of the stock or other property with respect to which it is received, the amount is treated as "gain from the sale or exchange of property."
In the above example, the $10 million distribution would result, pursuant to §301(c)(2), in USP's basis in the stock of Foreign HoldCo being reduced to zero. Does USP increase its basis in the stock of Foreign HoldCo as a result of the inclusion of the $4 million of Foreign OpCo's earnings and profits in its income under §1248 (which are reclassified as PTI)?
Example. Assume in a subsequent year Foreign OpCo distributes its $4 million of PTI to Foreign HoldCo, and Foreign HoldCo distributes the same amount to USP. The amount received by USP would be excluded from the income of USP under §959, i.e., as PTI. If USP increased its basis in the stock of Foreign HoldCo for the $4 million of Foreign OpCo's earnings reclassified as PTI as a result of taxation under §1248, the current distribution of $4 million of PTI would not result in taxable gain to USP under §961(b)(2). On the other hand, if USP does not step up its basis under §961 for such amount of PTI, it would recognize $4 million of gain under §961(b)(2) when it receives the PTI from Foreign HoldCo in the subsequent year.
Whether §961 provides a basis step-up for the §1248 inclusion when there is no transfer of the CFC's stock does not appear to be clearly stated. The Code and regulations provide for a basis increase for amounts included in a U.S. shareholder's income under §951, but do not expressly address §1248 inclusions. In addition, while §959 treats §1248 inclusions as §951 inclusions for purposes of the PTI rules, there is no similar rule for purposes of §961. It would seem appropriate in the above example for USP to increase its basis in the stock of Foreign HoldCo for the $4 million of PTI resulting from the §1248 inclusion (which is the effective result when §1248 applies to an actual sale of stock in the CFC, i.e., the purchaser takes a fair market value basis in the stock).9
If USP does not get a basis step-up and recognizes gain on the distribution of the $4 million of PTI, the next question is whether §1248 applies to such gain? The final regulations do not expressly reference §961(b)(2).
However, the language in that section providing for gain is the same language that is in §301(c)(3). Nevertheless, in the absence of a specific reference, it is not clear whether such gain would be subject to §1248 under the final regulations.
What if §961(b)(2) gain were subject to §1248? In such case, the subsequent distribution of the $4 million of PTI to USP would result in an additional $4 million of Foreign OpCo's earnings and profits becoming subject to taxation to USP. This seems a bit odd.
It is noted that the final regulations can apply to any transaction that is treated as a §301 distribution. For example, the final regulations can apply to dividend-equivalent redemptions under §302 and sales of stock to related corporations under §304 where gain is recognized under §301(c)(3). Such application would result in recharacterizing such gain as a dividend to the extent of the earnings and profits of the acquiring corporation's subsidiaries.
Under final regulations, taxpayers now are required to apply §1248 to §301 distributions received by a U.S. shareholder from a foreign corporation in excess of its stock basis. This rule converts capital gain into ordinary dividend income when the distributing foreign corporation owns subsidiaries with earnings and profits. Earnings of lower-tier CFCs subject to this rule are reclassified as PTI that generally is excluded from the income of the U.S. shareholder when subsequently distributed. Nevertheless, it will be important to consider the implication of the basis adjustment rules under §961, which are unclear.
This commentary also will appear in the August 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, Lyon, and Noren, 926 T.M., CFCs-General Overview, and Yoder & Kemm, 930 T.M., CFCs-Sections 959-965 and 1248, and in Tax Practice Series, see ¶7150, U.S. Persons-Worldwide Taxation.
1 Regs. §1.1248-1(b), T.D. 9585, 77 Fed. Reg. 24380 (4/24/12) (effective for distributions that occur on or after Feb. 10, 2009, based on the date the temporary regulatios were issued in T.D. 9444).
3 Regs. §1.1248-1(d).
4 §1248(g)(2)(A) and (B); Regs. §1.1248-1(e)(3).
5 See Regs. §1.367(a)-8(b)(1)(iii), (n)(2), and (q)(2), Ex. 17 (coordination of §301 rules with §367 gain recognition rules).
6 Earnings distributed during the year are not taken into account for §1248 purposes. Regs. §1.1248-2(d)(1). There are a number of complexities that can arise in determining the amount of earnings attributable to shares held by a CFC when the shares were purchased at different times. Regs. §1.1248-3(a)(3).
7 The Administration's FY 2013 Budget proposes to not permit a distribution to be treated as a reduction of basis under §301(c)(2) under certain circumstances. If applicable, USP's basis in Foreign HoldCo's stock would be ignored for purposes of applying §301, and the entire $10 million distribution would be treated as gain. See Department of the Treasury, General Explanations of the Administration's Fiscal Year 2013 Revenue Proposals (February 2012); Joint Committee on Taxation, Description of Revenue Provisions Contained in the President's Fiscal Year 2013 Budget Proposal, at pp. 417-22 (June 2012). See also Yoder, "Obama Administration's FY 2013 Budget Targets Return-of-Basis Distributions," 38 Int'l Tax J. 3 (May-June 2012).
8 See §986(c) (exchange gain or loss is recognized on a distribution of PTI).
9 Proposed regulations may provide for a basis step-up. Prop. Regs. §1.961-1(b)(1), REG-121509-00, 71 Fed. Reg. 51155 (8/29/06).
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