Sec. 304 anti-avoidance rule modified.

• Author: Klahsen, Rick

The IRS recently released temporary and proposed regulations (T.D. 9477) that modify and strengthen regulations previously issued under Temp. Regs. Sec. 1.304-4T. The regulations apply to certain transactions otherwise subject to Sec. 304 but entered into with the principal purpose of avoiding the statute's application. The original version of Temp. Regs. Sec. 1.304-4T issued in 1988 (T.D. 8209) targeted transactions designed to avoid Sec. 304 treatment of a corporation that controls the acquiring corporation or deemed acquiring corporation. The new regulations restate the original rule and contain a similar rule that targets transactions designed to avoid Sec. 304 for a corporation that is controlled by the issuing corporation or deemed issuing corporation.

Background

Sec. 304 was designed to ensure dividend treatment on related-party stock transactions that are in substance a dividend from earnings and profits (E&P). Under Sec. 304(a)(1), if a brother and sister corporation are under common control and the brother (the acquiring corporation) acquires the stock of the sister (the issuing corporation), the proceeds will be treated as received in redemption of the acquiring corporation. The redemption will generally result in dividend treatment under Sec. 302 because both acquiring and issuing corporations are under common control. The dividend is treated as if first distributed by the acquiring corporation to the extent of its E&P and then distributed by the issuing corporation to the extent of its E&P.

Example 1: D, a domestic corporation, wholly owns two foreign corporations, C1 and C2. In D's hands, the basis and fair market value (FMV) of the C1 stock is $100. C1 has substantial E&P. C2 has accumulated E&P of $200. D wants to own all its foreign corporations in a direct chain and causes C1 to acquire the C1 stock for $100.

Under Sec. 304(b)(2), D will be treated as receiving a distribution, to which Sec. 301 (c)(1) applies, first out of the E&P of the acquiring corporation (C2) and only then from the issuing corporation (C1). As a result, D will receive a taxable dividend of $100 from C2's E&P. D will also include a deemed paid foreign tax credit (under Sec. 902) for the underlying taxes attributed to the E&P distributed.

Original Regulation

The original Temp. Regs. Sec. 1.304-4T targeted transactions that sought to circumvent the E&P of the acquiring corporation (C2 above) through the use of a newly formed intermediary.

Example 2: D, a...