Final Regs. §1.304-4: Broad Anti-Avoidance Rules

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By Lowell D. Yoder, Esq.  

McDermott Will & Emery LLP, Chicago, IL

Recently finalized §304 regulations provide anti-avoidance rules with their primary focus on transactions involving controlled foreign corporations (CFCs).1 The expanded rules limit the ability of taxpayers to affirmatively use §304 to achieve certain tax planning objectives.

Illustration of the Application of §304  

As background, §304 recasts for tax purposes a sale of stock in a related corporation to a related corporation, treating the purchase price as a distribution made by the acquiring corporation. Section 304 was designed to prevent individual shareholders from bailing out "cash" of controlled corporations through a stock sale, but is regularly used affirmatively by corporate shareholders for tax planning purposes, particularly where foreign corporations are involved.

To illustrate, assume that a U.S. parent (USP) owns all of the stock of two 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.2 Section 367(a) generally applies to the deemed outbound transfer of the CFCT stock to CFCA, and the underlying regulations require a five-year gain recognition agreement (GRA) to avoid recognizing gain on the CFCT stock.3

Second, CFCA is treated as redeeming for $1,000 its stock deemed issued to USP. This redemption is treated as a distribution subject to §301.4 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 (target) corporation to the extent of its earnings and profits.5

In the above example, the deemed distribution of $1,000 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).6 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.7

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 has a material amount of earnings and profits.8 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. Under one approach, pursuant to §301(c) the $1,000 paid by CFCA to USP is treated first as a return of basis in the CFCA stock deemed issued ($900), and then as gain ($100).9

If USP instead takes the position that its basis in the existing CFCA shares should also be taken into account in applying §301(c) to the deemed redemption under §304 (and there is good support for this position), no gain should be recognized as a result of the deemed redemption.10 In addition, the $100 of gain with respect to the CFCT stock would not be recognized under §367(a) upon USP's deemed §351 contribution to CFCA, provided a GRA is filed.11

Final Regs. §1.304-4  

The application of §304 to sales of CFCs can be further complicated by the recently finalized anti-avoidance rules. Final Regs. §1.304-4 is generally intended to prevent the avoidance of §304 dividend treatment through the use of a controlled corporation with little or no earnings and profits. It provides a rule that, under certain circumstances, treats a corporation other than the acquirer as the acquiring corporation in a §304 transaction ("deemed acquiring corporation"). In addition, the final regulations contain an anti-avoidance rule that, under certain circumstances, treats a corporation other than the actual issuer (target) as the issuing corporation ("deemed issuing corporation").12

The anti-avoidance rules apply for purposes of determining the amount of a property distribution constituting a dividend and the source thereof under §304(b)(2). This can affect the amount of taxable dividend income, the amount of deemed-paid taxes associated with the deemed dividend, and the amount of basis taken into account in the §304 transaction.

Deemed Acquiring Corporation  

The first anti-avoidance rule can apply to treat another corporation as the acquiring corporation. For this rule to apply, the other corporation must control the actual acquiring corporation.13

This anti-avoidance rule applies only if "a principal purpose for creating, organizing, or funding the acquiring corporation by any means (including through capital contributions or debt) is to avoid the application of section 304 to the deemed acquiring corporation." The final regulations appear to expand-beyond prior temporary regulations promulgated in 1988-the funding situations that can result in the application of this anti-avoidance rule. While the prior temporary regulations applied where the acquiring corporation was funded by a loan or capital contribution, the final regulations can apply where another corporation funds the acquirer "by any means." Capital contributions and debt are listed merely by way of illustration.

The Preamble to the temporary regulations stated 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.14

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 final regulations, CFCF might be treated as the acquiring corporation for purpose 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 taken into account would be determined as if CFCF had acquired the stock of CFCT.

The final 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.  It is conceivable that a dividend from a subsidiary to the acquiring corporation might be considered as funding the acquisition under the final regulations, causing the subsidiary to be the deemed acquiring corporation. This should not be the case, however, if the payment of the dividend does not have a principal purpose to fund the acquisition.15 In addition, a dividend from the acquired corporation should not be subject to this rule.

Deemed Issuing Corporation  

The final regulations contain a second anti-avoidance rule that applies to the issuing (target) corporation when, in connection with a §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 the property distribution that is a dividend and the source thereof under §304(b)(2).

For example, assume that USP is a U.S. 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 $1000. 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 final regulations treat CFC2 as acquiring the stock of CFC1 (and thus disregard CFC3, at least for purposes of applying §304). Accordingly, the distribution is treated as paid out of CFC1's earnings.16

This example shows that the presence of an important foreign business purpose for a transaction will not prevent the application of the anti-avoidance rule if there is also a principal purpose to avoid the application of §304 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.

In sum, the expansion of the anti-avoidance rule that applies to acquiring corporations and the addition of an anti-avoidance rule applying to issuing corporations limit 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, 17 such as in the first example above, where the transaction may facilitate the repatriation of high-tax earnings in a way that avoids foreign restrictions and costs that would apply with a payment of a dividend.18

This commentary also will appear in the April 2013 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 T.D. 9606, 77 Fed. Reg. 75844 (12/26/12).

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

  3 Notice 2012-15, 2012-9 I.R.B. 424. This notice is discussed in Yoder, "GRA Now Necessary for All Outbound Code Sec. 304 Transactions," 38 Int'l Tax J. (Sept.-Oct. 2012). Section 367(b) also would apply, but generally should not have any consequences with respect to the transactions discussed herein.

  4 §302(d).

  5 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.

  6 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.

  7 USP would calculate the tax consequences as follows (assuming it can fully use foreign tax credits): {[$1,000 (dividend) + $820 (§78 gross-up)] x .35 = $637 (preliminary U.S. tax liability)} - $637 (FTCs); USP would have excess foreign tax credits of $183 ($820 - $637).

  8 See Yoder, "CFC Purchase of Stock in a Related CFC: Code Sec. 304 vs. D Reorganization Treatment," 34 Int'l Tax J. 3 (March-April 2008).

  9 See Regs. §1.1248-1(b) (§1248 applies to gain recognized under §301(c)(3)). Yoder, "The Application of §1248 to §301 Distributions," 41 Tax Mgmt. Int'l J. 409 (8/10/12).

  10 Proposed regulations would provide that all of the basis USP has in the stock of CFCA is taken into account on a pro rata, share-by-share basis.  Prop. Regs. §1.304-2, REG-143686-07, 74 Fed. Reg. 3509 (1/21/09).

  11 Notice 2012-15, supra.  Prior Regs. §1.367(a)-9T required that the $100 of realized gain be recognized (i.e., no GRA could be filed to avoid recognizing the gain). 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).

  12 The final regulations adopt (without change) temporary regulations that were issued in 2009. Regs. §1.304-4T, T.D. 9477, 2010-1 C.B. 385. The temporary regulations issued in 2009 revised temporary regulations issued in 1988. T.D. 8209, 1988-2 C.B. 174. For an analysis of the changes made by the 2009 temporary regulations, see Yoder, "Regs. §1.304-4T Broadens Anti-Avoidance Rule," 39 Tax Mgmt. Int'l J. 222 (4/9/10). The final regulations apply to acquisitions of stock occurring after December 29, 2009.

  13 "Control" means the ownership of stock possessing at least 50% of the total voting power or value of all classes of stock (taking into account direct, indirect, and constructive ownership). §301(c); Regs. §1.304-5.

  14 The IRS has issued rulings that address when circular flows of cash will be disregarded. See Rev. Rul. 83-142, 1983-2 C.B. 68; Rev. Rul. 80-154, 1980-1 C.B. 68; Rev. Rul. 78-397, 1978-2 C.B. 150; Rev. Rul. 78-330, 1978-2 C.B. 147; Rev. Rul. 79-250, 1979-2 C.B. 147.

  15 In general, a dividend to the acquiring corporation should not implicate the principal purpose test, because the dividend would increase the earnings and profits of the acquiring corporation and thus increase the amount of the §304 dividend. But in unusual circumstances (e.g., where the acquiring corporation has a current deficit in earnings and profits following the dividend), Regs. §1.304-4 may need to be considered.

  16 Regs. §1.304-4(c), Ex. 2.  This rule points out that only earnings and profits of the acquiring corporation and issuing corporation are taken into account under §304, absent application of the anti-avoidance rule. But see Regs. §1.1248-1(b) (§1248 recharacterizes gain recognized under §301(c)(3) as dividend income taking into account certain earnings and profits of subsidiaries).

  17 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 infer 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.

  18 Section 304 transactions may also be used to effectively hopscotch high-tax earnings and profits over low-tax earnings and profits in intermediate CFCs (e.g., by causing a lower-tier, high-tax CFC to be the acquiring corporation). Cf. §960(c).

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