Temporary Regulations Issued on Use of Controlled Corporations to Avoid Application of §304

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The IRS explained that, under §304(a)(1), for §§302 and 303 purposes, if one or more persons are in control of each of two corporations and one of the corporations (the acquiring corporation) acquires in exchange for property stock of the other corporation (the issuing corporation) from the person or persons in control, then—unless §304(a)(2) applies—the property is treated as received in redemption of the acquiring corporation's stock. Under §304(a)(2), the IRS explained, for §§302 and 303 purposes, an acquisition, for property, by an acquiring corporation of issuing corporation stock from a shareholder of an issuing corporation that controls the acquiring corporation results in the shareholder's receipt of property in redemption of issuing corporation stock.
Under §304(b)(2), the IRS continued, the determination of the amount of the property distribution that is a dividend (and the source thereof) is made as if the acquiring corporation distributed the property to the extent of its earnings and profits, and then as if the issuing corporation distributed the property to the extent of its earnings and profits. The IRS noted that if the acquiring corporation is foreign, §304(b)(5) limits the amount of earnings and profits of the acquiring corporation that are taken into account.
The IRS also explained that in 1988 it issued an anti-avoidance rule, Regs. §1.304-4T (T.D. 8209), to permit the Director of Field Operations to consider a corporation (deemed acquiring corporation) as having acquired for property the stock of the issuing corporation that, in fact, the acquiring corporation acquired for property, if the deemed acquiring corporation controls the acquiring corporation and if one of the principal purposes of creating, organizing, or funding (through capital contributions or debt, including when funding is from an unrelated party) the acquiring corporation is to avoid the application of §304 to the deemed acquiring corporation.
The temporary regulations are amended to extend application of the anti-avoidance provisions to transactions that are subject to §304 but that are entered into with a principal purpose of avoiding the treatment of a corporation as the issuing corporation. As an example of the perceived abuse, the preamble describes a domestic corporation (USP) that wholly owns foreign corporations F1 and F2. The basis and fair market value of the F1 stock is $100,000. F1 does not have positive earnings and profits (or its earnings and profits are limited by §304(b)(5)) but has at least $100,000 cash. The basis and fair market value of the F2 stock is $100,000, and F2 has earnings and profits of at least $100,000. USP forms foreign corporation F3 and contributes the stock of F2 and F3 in exchange for F3 stock. USP then transfers the stock of F3 to F1 in exchange for $100,000 cash in a transaction subject to §304(a)(1). Because neither the acquiring corporation (F1) nor the issuing corporation (F3) has positive earnings and profits, USP reports the $100,000 cash received in redemption of the shares deemed issued by F1 under §304(a)(1) as a return of basis under §301(c)(2).
To address this type of transaction, Regs. §1.304-4T is amended to provide that for purposes of determining the amount of a property distribution that is a dividend (and the source thereof) under §304(b)(2), the acquiring corporation shall be treated as acquiring for property the stock of a corporation (deemed issuing corporation) that is controlled by the issuing corporation if, in connection with the acquiring corporation's acquisition for property of issuing corporation stock, the issuing corporation acquired stock of the deemed issuing corporation with a principal purpose of avoiding application of §304 to the deemed issuing corporation.

This Treasury decision also makes Regs. §1.304-4T self-executing (rather than applied at the Director's discretion).

The regulation as amended applies to acquisitions occurring on or after December 30, 2009.


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