IRS Finalizes §304 Anti-Avoidance Regulations

By Joseph Calianno, Esq., CPA, and Brad Rode, CPA  

Grant Thornton LLP, Washington, DC and BDO USA LLP, Chicago, IL, respectively

1  

The IRS and Treasury (hereinafter, "IRS") recently finalized regulations under §304 (the "2012 Final Regulations")2 addressing certain §304 transactions that are structured with a principal purpose of re-designating the issuing corporation or acquiring corporation in the transaction.  Specifically, the 2012 Final Regulations adopt without change the 2009 temporary regulations (the "2009 Temporary Regulations")3 that expanded the anti-avoidance rule of prior Regs. §1.304-4T4 and made the anti-avoidance rules self-executing.5 These anti-avoidance rules under the §304 regulations are intended to address certain transactions that the IRS believes could have the effect of repatriating cash or other property from a foreign subsidiary of a U.S. parent to the U.S. parent without the corresponding consequences that the IRS believes should follow under §304 from the transaction.6 In the Preamble to the 2009 Temporary Regulations, the IRS provided insight into the changes made by the 2009 Temporary Regulations to prior Regs. §1.304-4T. This commentary references the Preamble to the 2009 Temporary Regulations where relevant in discussing the 2012 Final Regulations.

By way of background, §304(a)(1) generally provides that, for purposes of §§302 and 303, if one or more persons are in control (as defined in §304(c)) of each of two corporations and, in return for property, one of the two corporations (the acquiring corporation) acquires stock in the other corporation (the issuing corporation) from the person (or persons) so in control, then, unless §304(a)(2) applies, the property will be treated as a distribution in redemption of the stock of the acquiring corporation.  To the extent that §301 applies to the distribution, the transferor and the acquiring corporation are treated as if: (1) the transferor transferred the stock of the issuing corporation to the acquiring corporation in exchange for stock of the acquiring corporation in a transaction to which §351(a) applies; and (2) the acquiring corporation then redeemed the stock that it is deemed to have issued.  The determination of the amount of the property distribution that is a dividend (and the source thereof) is made under §304(b)(2) as if the property is distributed by the acquiring corporation to the extent of its earnings and profits (E&P), and then by the issuing corporation to the extent of its E&P. Section 304(a)(2) provides rules relating to certain acquisitions by subsidiaries.  Several definitions and special rules in §304 give further guidance on the application of the provision (e.g., §304(b)(5), which may limit the E&P of a foreign acquiring corporation taken into account under §304(b)(2) in certain instances).

This commentary first provides a discussion of the §304 anti-avoidance regulation prior to the change in the regulation made by the 2009 Temporary Regulations7 and then provides a discussion of the 2012 Final Regulations, incorporating as relevant a discussion of the Preamble to the 2009 Temporary Regulations (given that the 2012 Final Regulations adopt the 2009 Temporary Regulations without change).

Regs. §1.304-4T (Prior to Modification by 2009 Temporary Regulations)  

Regs. §1.304-4T  (before its amendment by the 2009 Temporary Regulations) was an anti-avoidance regulation that was issued in 1988 in T.D. 8209.8 This regulation was designed to prevent the circumvention of the proper application of §304. Specifically, former Regs. §1.304-4T(a) read as follows:At the discretion of the District Director, for purposes of determining the amount constituting a dividend, and source thereof, under section 304(b)(2), a corporation (deemed acquiring corporation) will be considered to have acquired for property the stock of a corporation (issuing corporation) acquired for property by another corporation (acquiring corporation) that is controlled by the deemed acquiring corporation, if one of the principal purposes for creating, organizing, or funding the acquiring corporation, through capital contributions or debt, is to avoid the application of section 304 to the deemed acquiring corporation….

Former Regs. §1.304-4T also included the following example illustrating its application:P, a domestic corporation, owns all of the stock of CFC1, a controlled foreign corporation with substantial accumulated earnings and profits. CFC1 is organized in Country X, which imposes a high rate of tax on CFC1's income. P also owns all of the stock of CFC2, another controlled foreign corporation, which has accumulated earnings and profits of $200x. CFC2 is organized in Country Y which imposes a low rate of tax on CFC2's income. P wishes to own all of its foreign corporations in a direct chain and to effectuate a repatriation of CFC2's cash to P. In order to avoid having to obtain Country X approval for the acquisition of CFC1 (a Country X corporation) by CFC2 (a Country Y corporation) and to avoid a dividend to P out of CFC2's earnings and profits that would otherwise occur as a result of the application of section 304, P causes CFC2 to form RFC as a Country X wholly-owned subsidiary and to contribute $100x to RFC.  RFC will purchase, for $100x, all of the stock of CFC1 from P. Because one of P's principal purposes for having CFC1 owned by RFC is to avoid section 304, under §1.304-4T(a), CFC2 is considered to have acquired the stock of CFC1 for $100x for purposes of determining the amount constituting a dividend (and source thereof) for purposes of section 304(b)(2).

A mechanical application of §304(b)(2) (absent the rule provided in former Regs. §1.304-4T(a)) would have operated to look first to the E&P of RFC, and then to the E&P of CFC1, for the purpose of determining the amount of the property distribution constituting a dividend pursuant to §301(c)(1), and the source thereof. Absent some other Code or regulatory provision or judicial doctrine altering this result, this mechanical application of §304(b)(2) (absent the rule provided in former Regs. §1.304-4T(a)) would have resulted in the entire $100x received by P being treated as a dividend from CFC1. However, because one of P's principal purposes for creating, organizing, or funding RFC was to avoid the application of §304 to CFC2, the example applied the anti-avoidance rule of §304 and concluded that CFC2 is considered as the deemed acquiring corporation for purposes of determining the amount constituting a dividend, and the source thereof, under §304(b)(2). The example in this case makes clear that, even though other reasons existed for RFC's creation and role in the transaction other than the avoidance of any U.S. tax consequences, CFC2 could be treated as the deemed acquiring corporation because one of the principal purposes for creating RFC was to avoid the application of §304 to CFC2.

The actual language of former Regs. §1.304-4T (prior to the change made by the 2009 Temporary Regulations) stated that the anti-avoidance rule was applied at the discretion of the District Director (i.e., requiring an affirmative assertion of the rule by the IRS). Perhaps one is expected to infer in the example above that the District Director did in fact assert the anti-avoidance provision in the regulation, given the facts of the transaction, even though the example did not specifically state such an assertion.  Additionally, the former Regs. §1.304-4T(b) also provided a rule stating that nothing in the regulation could be construed to provide a taxpayer the right to compel the IRS to disregard the form of its transaction for federal income tax purposes.

Although former Regs. §1.304-4T provided that the form of the transaction could be disregarded by the IRS in the case of an acquiring corporation created to avoid the application of §304 to the deemed acquiring corporation, no specific rule existed in the §304 regulations at the time addressing the creation of a new issuing corporation to alter the consequences of a §304 transaction.9 As discussed below, under the 2009 Temporary Regulations (and now the 2012 Final Regulations), these types of transactions are specifically addressed by the §304 regulations.

The 2012 Final Regulations  

Specifically, Regs. §1.304-4(a) and (b) read as follows:(a) Scope and purpose. This section applies to determine the amount of a property distribution constituting a dividend (and the source thereof) under section 304(b)(2), for certain transactions involving controlled corporations. The purpose of this section is to prevent the avoidance of the application of section 304 to a controlled corporation.

(b) Amount and source of dividend. For purposes of determining the amount constituting a dividend (and source thereof) under section 304(b)(2), the following rules shall apply:

(1) Deemed acquiring corporation.  A corporation (deemed acquiring corporation) shall be treated as acquiring for property the stock of a corporation (issuing corporation) acquired for property by another corporation (acquiring corporation) that is controlled by the deemed acquiring corporation, 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.  See paragraph (c) Example 1 of this section for an illustration of this paragraph.

(2) Deemed issuing corporation. The acquiring corporation shall be treated as acquiring for property the stock of a corporation (deemed issuing corporation) controlled by the issuing corporation if, in connection with the acquisition for property of stock of the issuing corporation by the acquiring corporation, the issuing corporation acquired stock of the deemed issuing corporation with a principal purpose of avoiding the application of section 304 to the deemed issuing corporation. See paragraph (c) Example 2 of this section for an illustration of this paragraph.

Some important observations relating to the 2012 Final Regulations (as well as the 2009 Temporary Regulations that they replace) are worth noting when comparing them to Regs. §1.304-4T as it existed prior to the issuance of the 2009 Temporary Regulations.

First, the 2012 Final Regulations have a specific rule for deemed issuing corporations. In the Preamble to the 2009 Temporary regulations, the IRS included a statement that it had become aware of certain transactions that are subject to §304 but are entered into with a principal purpose of avoiding the treatment of a corporation as the issuing corporation. The Preamble included an illustration of a situation in which a new target corporation was formed by a taxpayer immediately prior to a §304 transaction with a principal purpose of avoiding a deemed dividend resulting from a corporation that otherwise would have been the issuing corporation in the §304 transaction. In that particular example, the U.S. parent was seeking to alter who the foreign issuing corporation was in order to receive the cash in the §304 transaction as a return of basis under §301(c)(2) rather than a deemed dividend.10 Commenting on that type of transaction, the IRS stated that it believes that such a transaction should be subject to an anti-avoidance rule. In essence, the IRS views this type of transaction as a repatriation of a particular corporation's E&P without the corresponding U.S. tax consequences. The 2012 Final Regulations (as well as the 2009 Temporary Regulations) specifically include an example in the regulations illustrating how this rule applies in this context (see example below). Importantly, this rule can apply even if other valid business purposes exist for the restructuring prior to the §304 transaction.

Second, the 2012 Final Regulations (like the 2009 Temporary Regulations) revise the anti-avoidance rule in the case of a deemed acquiring corporation to specifically address cases where the acquiring corporation may receive third-party funding for the acquisition of the issuing corporation. Specifically, Regs. §1.304-4T prior to its amendment by the 2009 Temporary Regulations applied when "one of the principal purposes for creating, organizing, or funding the acquiring corporation, through capital contributions or debt, is to avoid the application of §304 to the deemed acquiring corporation." The regulation now provides that the anti-avoidance measure applies when "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 §304 to the deemed acquiring corporation." (Emphasis added.) In the Preamble to the 2009 Temporary Regulations, the IRS stated that this change is intended to clarify that the rule may apply in cases where the funding is from an unrelated party. Specifically, the IRS provided in the Preamble to the 2009 Temporary Regulations, "For example, the regulations may apply when the deemed acquiring corporation facilitates the repayment of an obligation incurred by the acquiring corporation (even if such obligation is with respect to a borrowing from an unrelated party) to acquire the stock of the issuing corporation."

Finally, the 2012 Final Regulations (like the 2009 Temporary Regulations) make the application of the anti-avoidance rule self-executing. In the Preamble to the 2009 Temporary Regulations, the IRS stated: Current Temp. Reg. §1.304-4T applies at the discretion of the District Director. The IRS and Treasury Department believe the anti-avoidance rule of current §1.304-4T should be self-executing. Thus, current §1.304-4T is amended accordingly. [Emphasis added.]

As we mentioned in our article discussing the 2009 Temporary Regulations, the self-executing nature of Regs. §1.304-4 could be troubling for some taxpayers. For instance, when does a taxpayer have a principal purpose of creating, organizing, or funding an acquiring corporation to avoid the application of §304 to another corporation (i.e., a "deemed acquiring corporation")? Neither the 2009 Temporary Regulations nor the 2012 Final Regulations address how this determination should be made, except for providing two examples illustrating situations in which the anti-avoidance rule applies. Nevertheless, this is not the first time that the phrase "a principal purpose" has been used in a Code section or regulatory provision in the context of an anti-avoidance/anti-abuse rule. In fact, it is used quite frequently, e.g., §382(l), §751(b)(3), and Regs. §1.701-2.11 Therefore, taxpayers need to undertake an evaluation of certain types of §304 transactions to determine whether the self-executing anti-avoidance rule of Regs. §1.304-4 applies.

Application of the Anti-Avoidance Rule  

The 2012 Final Regulations (like the 2009 Temporary Regulations) contain the following two examples illustrating the application of these rules: Example 1 (see attached diagram)

Facts. P, a domestic corporation, wholly owns CFC1, a controlled foreign corporation with substantial accumulated earnings and profits. CFC1 is organized in Country X, which imposes a high rate of tax on the income of CFC1. P also wholly owns CFC2, a controlled foreign corporation with accumulated earnings and profits of $200x. CFC2 is organized in Country Y, which imposes a low rate of tax on the income of CFC2. P wishes to own all of its foreign corporations in a direct chain and to repatriate the cash of CFC2.  In order to avoid having to obtain Country X approval for the acquisition of CFC1 (a Country X corporation) by CFC2 (a Country Y corporation) and to avoid the dividend distribution from CFC2 to P that would result if CFC2 were the acquiring corporation, P causes CFC2 to form CFC3 in Country X and to contribute $100x to CFC3. CFC3 then acquires all of the stock of CFC1 from P for $100x.

Result. Because a principal purpose for creating, organizing, or funding CFC3 (acquiring corporation) is to avoid the application of section 304 to CFC2 (deemed acquiring corporation), §1.304-4(b)(1), for purposes of determining the amount of the $100x distribution constituting a dividend (and source thereof) under section 304(b)(2), CFC2 shall be treated as acquiring the stock of CFC1 (issuing corporation) from P for $100x. As a result, P receives a $100x distribution out of the earnings and profits of CFC2 to which section 301(c)(1) applies.

Example 2 (see attached diagram)  

Facts. P, a domestic corporation, wholly owns CFC1, a controlled foreign corporation with substantial accumulated earnings and profits. The CFC1 stock has a basis of $100x. CFC1 is organized in Country X. P also wholly owns CFC2, a controlled foreign corporation with zero accumulated earnings and profits. CFC2 is organized in Country Y. P wishes to own all of its foreign corporations in a direct chain and to repatriate the cash of CFC2. In order to avoid having to obtain Country X approval for the acquisition of CFC1 (a Country X corporation) by CFC2 (a Country Y corporation) and to avoid a dividend distribution from CFC1 to P, P forms a new corporation (CFC3) in Country X and transfers the stock of CFC1 to CFC3 in exchange for CFC3 stock. P then transfers the stock of CFC3 to CFC2 in exchange for $100x.

Result. Because a principal purpose for the transfer of the stock of CFC1 (deemed issuing corporation) by P to CFC3 (issuing corporation) is to avoid the application of section 304 to CFC1, under §1.304-4(b)(2), for purposes of determining the amount of the $100x distribution constituting a dividend (and source thereof) under section 304(b)(2), CFC2 (acquiring corporation) shall be treated as acquiring the stock of CFC1 from P for $100x. As a result, P receives a $100x distribution out of the earnings and profits of CFC1 to which section 301(c)(1) applies.

The 2012 Final Regulations apply to acquisitions of stock occurring on or after December 29, 2009.12

Conclusion  

As discussed above, the 2012 Final Regulations adopt without change the revisions made to the anti-avoidance rules under §304 in the 2009 Temporary Regulations-expanding the scope of the original anti-avoidance rule as set forth in T.D. 8209 and making the rules self-executing.

Given that the IRS has made the anti-avoidance rules of §304 self-executing, query whether the IRS intends to make similar changes to other anti-avoidance/anti-abuse regulations that are not self-executing (e.g., Regs. §1.956-1T(b)(4)).

This commentary also will appear in the March 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 in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation.


  1 Joseph Calianno is a Partner and International Technical Tax Practice Leader in the Washington National Tax Office of Grant Thornton LLP. He currently serves as a Vice-Chair of teh ABA's Foreign Activities of U.S. Taxpayers Committee and previously served as the Chair of the AICPA's International Tax Technical Resource Panel. Brad Rode is a Partner with BDO USA LLP in the International Tax Services practice in Chicago, Illinois.  The views expressed in this commentary are their views and not necessarily those of Grant Thornton LLP or BDO USA LLP. This commentary is not intended and should not be construed to serve as tax advice.

  2 T.D. 9606.

  3 See T.D. 9477 for the 2009 Temporary Regulations.

  4 See T.D. 8209.

  5 For a discussion of the 2009 Temporary Regulations, see Calianno and Rode, "Navigating the IRS's Attack on Perceived Repatriation Transactions," 39 Tax Mgmt. Int'l J. 197 (4/9/10).

  6 It is worth noting that, although §304 is considered an anti-abuse provision, §304 often is used affirmatively by taxpayers to achieve certain results. For instance, a U.S. corporation may use §304 to access the foreign tax pools of its foreign subsidiaries under §902 while avoiding foreign withholding tax that otherwise might result if a foreign subsidiary simply paid a dividend.

  7 The 2009 Temporary Regulations applied to acquisitions of stock occurring on or after Dec. 29, 2009.  See former Regs. §1.304-4T(d).

  8 Also included in that regulation package was Regs. §1.956-1T(b)(4), which provided the following:For purposes of §1.956-1(b)(1) of the regulations, a controlled foreign corporation will be considered to hold indirectly (A) the investments in United States property held on its behalf by a trustee or a nominee or (B) at the discretion of the District Director, investments in U.S. property acquired by any other foreign corporation that is controlled by the controlled foreign corporation, if one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) such other foreign corporation is to avoid the application of section 956 with respect to the controlled foreign corporation. For purposes of this paragraph (b), a foreign corporation will be controlled by the controlled foreign corporation if the foreign corporation and the controlled foreign corporation are related parties under section 267(b). In determining for purposes of this paragraph (b) whether two or more corporations are members of the same controlled group under section 267(b)(3), a person is considered to own stock owned directly by such person, stock owned with the application of section 1563(e)(1), and stock owned with the application of section 267(c).

T.D. 8209 also contained examples illustrating the application of the amended regulations. To date the IRS has not amended this regulation to make it self-executing in a manner similar to the manner it modified the §304 regulations.

  9 In discussing the changes made by the 2009 Temporary Regulations which expanded the anti-avoidance rule of the §304 regulations to include the concept of a deemed issuing corporation, the IRS stated in the Preamble to the 2009 Temporary Regulations that no inference was intended as to the potential applicability of other Code or regulatory provisions or judicial doctrines (including step transaction or substance over form) to transactions described in the regulations.

  10 Specifically, the IRS cited the following transaction as an example:

[A] domestic corporation (USP) wholly owns two foreign corporations (F1 and F2). The basis and fair market value of the F1 stock is $100x. F1 does not have positive earnings and profits (or its earnings and profits for purposes of section 304(b)(2) are limited by section 304(b)(5)) but has at least $100x cash. The basis and fair market value of the F2 stock is $100x and F2 has earnings and profits of at least $100x.  USP forms a new foreign corporation (F3) and contributes the stock of F2 to F3 in exchange for F3 stock. In a transaction subject to section 304(a)(1), USP then transfers the stock of F3 to F1 in exchange for $100x cash. Because neither F1 (the acquiring corporation) nor F3 (the issuing corporation) has positive earnings and profits, USP reports the $100x cash received in redemption of the shares deemed issued by F1 under section 304(a)(1) as a return of basis under section 301(c)(2).

  11 The phrase "a principal purpose" is used extensively throughout the Code and regulations. Contrast the use of the phrase "a principal purpose" with a different phrase, "the principal purpose," as used, for example, in §269. (Emphasis added.)

  12 Regs. §1.304-4(d).