Recent Ruling Eases Indigestion from Sandwich Structure(1)

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Dirk J.J. Suringa, Esq.

Covington & Burling LLP, Washington, DC 

The IRS in a recent ruling endorsed a type of debt pushdown in which a newly acquired domestic corporation continues as a foreign corporation in an outbound F reorganization.1 The insertion of debt without a dividend when the target was acquired allowed the target, once it became a foreign corporation, to repatriate funds without U.S. taxation. In conjunction with the F reorganization, the now-foreign target contributed its U.S. assets to a U.S. Newco to mitigate a U.S. corporate-level tax on the deemed outbound asset transfer in the F reorganization.2 Nevertheless, the outbound F reorganization plus the drop of U.S. assets into U.S. Newco did create a "sandwich" structure, in which the U.S. Parent company owns U.S. Newco through a controlled foreign corporation (CFC).

This type of "foreign sandwich" can lead to unfavorable tax treatment of income subsequently earned by U.S. Newco. In addition to the corporate-level tax paid by U.S. Newco on its income, U.S. withholding tax may apply to dividends from U.S. Newco to the CFC.3 U.S. Newco dividends may be subject to foreign tax upon receipt by the CFC if it is resident in a credit jurisdiction rather than an exemption jurisdiction.  The dividends also meet the definition of gross foreign personal holding company income in the hands of the CFC and thus are potentially taxable currently to U.S. Parent.4 A Subpart F inclusion consisting of U.S. Newco dividends would not provide any foreign-source income to help credit foreign taxes.5 A subsequent, actual distribution of U.S.-source earnings from CFC to U.S. Parent would not carry foreign tax credits.6 A foreign sandwich thus can give rise to significant heartburn.

A more recent letter ruling from the IRS explains how the dividends received deduction (the "DRD") can alleviate some of the symptoms of this condition.7 Somewhat surprisingly, this ruling appears to be the first piece of IRS guidance directly addressing the interaction between the DRD and Subpart F.

In PLR 200952031, U.S. Parent acquired U.S. target corporation, which converted into a foreign corporation in an outbound F reorganization. Immediately thereafter, the converted foreign corporation, now a CFC, contributed a portion of its assets and liabilities to U.S. Newco, a newly formed domestic corporation, in exchange for all its stock. Noting that U.S. Newco expected to generate U.S. earnings and profits after the transaction, the ruling addressed the treatment of future dividend distributions by U.S. Newco to the CFC and then by the CFC to U.S. Parent. The ruling cited Regs. §1.952-2(b)(1) for the proposition that the taxable income of a CFC generally is determined by treating the CFC as if it were a domestic corporation.  Section 243(a) and (c) generally allow an 80% DRD to a 20% corporate shareholder of a domestic corporation. The ruling applied those provisions and concluded that the CFC would be allowed an 80% DRD in computing its Subpart F income. Assuming no other deductions, 20% of the dividend from U.S. Newco to the CFC would be Subpart F income currently includible by U.S. Parent.

If the CFC really is treated as a domestic corporation for purposes of computing the DRD, one could argue that the 100% DRD in §243(a)(3) should be available for computing Subpart F income.  The 100% DRD is available if the recipient is a member of the same §1504 affiliated group, which generally excludes foreign corporations.8 However, if the CFC is treated as a domestic corporation, perhaps it should be treated as eligible for affiliation as well. As discussed below, the effect of reducing the DRD from 100% to 80% is to expose U.S. Parent to income taxation on 36% of U.S. Newco's dividend, as the 20% haircut cascades through the ownership chain. The ruling does not discuss the 100% DRD, but presumably the IRS position is that a CFC only determines its income under the same recognition and timing rules as a domestic corporation, not that an item in the hands of a CFC is always classified the same as in the hands of a domestic corporation. Moreover, if CFCs generally were treated as affiliated group members for purposes of computing Subpart F income, certain CFC-CFC sales arguably would produce deferred intercompany gain rather than Subpart F income, which hardly seems an intended result.9

In any event, the ruling went on to consider the treatment of subsequent distributions from the CFC to U.S. Parent.  Section 245(a) generally allows an 80% DRD on the U.S.-source portion of a dividend paid to a 20% corporate shareholder by a qualified 10%-owned foreign corporation. U.S. Parent owned 100% of the stock of the CFC and therefore met the ownership tests required for an 80% DRD on the U.S.-source portion of a dividend from the CFC. The U.S.-source portion of the dividend is determined based on the amount of the CFC's post-1986 undistributed earnings that consist of U.S.-source earnings and profits.  Under §245(a)(5)(B), U.S.-source earnings and profits include dividends from an 80%-owned domestic corporation, like U.S. Newco.  Therefore, the ruling determined, U.S. Parent would be entitled to an 80% DRD on dividends from the CFC attributable to dividends received by the CFC from U.S. Newco.

The ruling further explained that the earnings to which the CFC had succeeded under §381(c) when it converted from a U.S. corporation would not be taken into account in computing the U.S.-source portion of the dividends distributed to U.S. Parent.  If those earnings were counted, they could affect the portion of dividends entitled to the DRD in the hands of U.S. Parent.10

The DRD at the U.S. Parent level is important because, as the ruling confirms, the earnings and profits of the CFC are not decreased by the amount of the DRD taken into account in computing the CFC's Subpart F income.11 Thus, a later distribution from the CFC to U.S. Parent out of the untaxed portion of the dividend from U.S. Newco would be potentially includible to U.S. Parent as a dividend. The U.S.-source portion of the dividend to U.S. Parent would bring with it no direct or indirect foreign tax credits,12 and it generally would be U.S.-source income for purposes of the foreign tax credit limitation.13

The 20% of the dividend not offset by the DRD, unless otherwise offset by CFC-level deductions, would be includible currently to U.S. Parent as Subpart F income. Although not addressed by the letter ruling, this portion of the dividend should be previously taxed income and should generate a basis increase in the stock of the CFC until distributed.14 When distributed, it would retain its U.S.-source for purposes of the foreign tax credit limitation15 but, in contrast to an actual dividend from the CFC, the Subpart F inclusion apparently could bring up a deemed-paid foreign tax credit.

Thus, assuming no other income, the ruling appears to provide for immediate taxation of 20% of the U.S. Newco dividend to CFC and for an 80% DRD on the remaining 80% of the U.S. Newco dividend once distributed to U.S. Parent. In round numbers, a $100 dividend from U.S. Newco to CFC would give rise to Subpart F income of $20 at CFC after its DRD, and a subsequent distribution of $100 to U.S. Parent would bring up $20 of PTI and taxable dividend of $80, for which U.S. Parent would get a DRD of $64. U.S. Parent would pay tax on $36 if all distributions are made in the same year. This result raises the question of whether a debt pushdown that creates a foreign sandwich still would be worth the heartburn that remains after the DRD treatment.

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 Maule, 503 T.M., Deductions — Overview and Conceptual Aspects,  and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.


Copyright©2010 by The Bur

 1 See PLR 200930030 (1/15/09).


 2 See Regs. §1.367(a)-3(d)(2)(vi)(B).


 3 See §1442.


 4 See §954(c).


 5 See §904(h)(1)(A)(i).


 6 See §245(a)(8), discussed below.


 7 PLR 200952031 (12/24/09)). The facts stated in the text are slightly simplified from those of the ruling. It is unclear from the text of this ruling whether it involves the same taxpayer as PLR 200930030. The facts are very similar. See §245(a)(8).  Other symptoms can be cured by migrating the target to the right foreign jurisdiction. An ideal foreign jurisdiction would have no anti-deferral regime that taxes the active earnings of U.S. Newco before distribution, a participation exemption that bars foreign taxation of U.S. Newco's earnings once distributed, and a tax treaty with the United States that provides an exemption from U.S. and foreign dividend withholding taxes.


 8 See §§243(b)(2)(A), 1504(b)(3).


 9 See generally GCM 39367 (12/31/84) ("United States consolidated return principles do not apply to foreign corporations.").


 10 The ruling reserved on the application of §243(e) to dividends received by U.S. Parent from the CFC.  Under §243(e), dividends from a foreign corporation out of earnings and profits accumulated by a domestic corporation during a period when the domestic corporation was subject to U.S. taxation is treated as a dividend from a domestic corporation. If this provision applies, U.S. Parent would be entitled to an 80% DRD for dividends from the CFC attributable to the U.S. target earnings and profits succeeded to by the CFC pursuant to §381 as a result of the outbound reorganization.  The 100% DRD would not appear to be available here because the earnings and profits were not accumulated while U.S. Parent and CFC were members of the same affiliated group. See §243(b)(1)(B).  The dividend out of such earnings and profits would remain U.S.-source (see §861(a)(2)(C), Regs. §1.861-3(a)(4)), and it might not support an indirect foreign tax credit, cf. §906(b)(5) (disallowing a §902 credit with respect to effectively connected earnings and profits). The IRS appears to take the position that such a dividend would not be out of post-1986 earnings and profits and that it could be subject to a U.S. withholding tax. See Preamble to REG-116050-99, 65 Fed. Reg. 69146 (11/15/00).


 11 See, e.g.,  Dileo v. Comr., 96 T.C. 858, 888 (1991), aff'd, 959 F.2d 16 (2d Cir.), cert. denied, 506 U.S. 868 (1992).


 12 See §245(a)(8).


 13 See §245(a)(9).  If U.S. Parent qualifies for the benefits of a tax treaty with a re-sourcing rule, U.S. Parent may be able to elect to treat the dividend as foreign-source income, but it would be subject to its own separate limitation. See §245(a)(10).


 14 See §§959, 961(a).


 15 See §904(h)(1)(A)(i) and (h)(10)(A)(ii).

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