Unraveling the mysteries of Sec. 304 in international tax planning.

• Author: Jacobsohn, R. Bruce

U.S.-Based Multinationals Using This Tax-Efficient Method to Repatriate Foreign Subsidiary Profits Still Face Hurdles

With the release of Rev. Ruls. 91-5(1) and 92-86,(2) U.S.-based multinationals have a heightened awareness of the benefits of Sec. 304 in international tax planning. Sec. 304 can provide an extremely tax efficient means of repatriating foreign subsidiary profits back into the United States. For example, U.S.-based multinationals often use Sec. 304 as a means of repatriating cash from a foreign subsidiary to the United States without incurring local country witholding tax. Further, the Sec. 304 transaction can be used as a means to infuse debt into the foreign subsidiary and create interest deductions for local tax purposes. In addition, Sec. 304 transactions can be used to repatriate earnings when there are foreign capital or other statutory restrictions that could prevent the payment of an actual dividend. Finally, Sec. 304 is an important consideration in any postacquisition restructuring of foreign operations.

This article will review the operation of Sec. 304, analyze the conclusions reached in Rev. Ruls. 91-5 and 92-86, and explore some of the opportunities and issues presented to international tax practitioners by Sec. 304. As will be shown below, recent published rulings have resolved one critical issue in the international tax area but leave several important issues unresolved.

Background

Sec. 304 transactions, in their simplest form, involve a situation in which a person controls each of two corporations and sells stock of one corporation to the other corporation.

Example 1: A U.S. parent (USP) owns 100% of the stock of both A, a country X corporation, and B, a country Y corporation. Y imposes a 15% withholding tax on any dividends paid to USP.

USP would like to repatriate B's earnings to the United States without incurring any Y withholding tax. In addition, USP would like to obtain a deemed paid credit under Sec. 902 on taxes actually paid by B. To accomplish this result, B acquires 100% of the stock of A from USP.(3)

Rather than treating the transaction as a straight sale of stock by USP to B, Sec. 304 splits the transaction into two parts. Although the order of the two parts is not entirely clear, it appears that first there is a contribution by USP to the capital of B (the acquiring corporation) of the purchased shares. Then there is a distribution by B in redemption of the stock deemed issued to USP on the contribution of capital.(4) The distribution would be treated as a dividend under Sec. 302(d). The amount and source of the dividend is determined by Sec. 304(b)(2). Accordingly, the distribution is treated as a dividend to USP from B to the extent of B's earnings and profits (E&P) and then from A (the issuing corporation) to the extent of A's E&P.

As USP own 100% of both A's and B's stock immediately before the transaction, under Sec. 902, to the extent the distribution is treated as a dividend, USP will be deemed to have paid any foreign taxes actually paid by A and B. Assuming Y treats the transaction as a purchase and does not impose any withholding tax on the distribution, USP will have achieved its objective.

There are several important collateral consequences of the transaction: * The distribution reduces A's and B's E&P to the extent the distribution is deemed paid from the respective companies.(5) * USP's basis in B is increased by USP's basis in A, which is deemed to be contributed to B's capital by USP.(6) * B takes a carryover basis (from USP) in the A stock received from USP.(7) * The contribution to B's capital is a Sec. 351 out-bound transfer of stock covered under Sec. 367, which may require a gain recognition agreement under Notice 87-85(8) and Temp. Regs. Sec. 1.367(a)-3T(g). The issue of whether a gain recognition agreement should always be required is explored below in some detail.

Foreign Tax Credit Consequences

In Example 1, USP owned 100% of the stock of both A (the issuing corporation) and B (the acquiring corporation). It is clear in this situation that USP can claim a deemed paid foreign tax credit (FTC) under Sec. 902 on the part of the distribution that comes from A and B, respectively.(9) However, before Rev. Rul. 91-5 was issued, the result of a Sec. 304 transaction in which the seller did not directly own the stock of both the acquiring and issuing corporation was far from clear. Probably the single most important issue was whether the seller (transferor corporation) was entitled to a deemed paid credit under Sec. 902 on the "dividend" received under Sec. 304 when it did not directly own any shares in the acquiring corporation. Rev. Rul. 91-5 confirmed that, under certain circumstances, a U.S. subsidiary is entitled to a deemed paid FTC under Sec. 902 on a Sec. 304 distribution from a foreign subsidiary in which the U.S. subsidiary has no direct ownership.

* Rev. Rul. 91-5

The facts of Rev. Rul. 91-5 involved the structure shown in Flowchart 1, on page 170. P owns 100% of the stock of both DX, a domestic corporation, and FX, a country U corporation. DX owns 100% of the stock of FY, another U corporation. Of the outstanding stock of FX, 50% by value is voting stock and 50% by value is nonvoting stock.

The fair market value (FMV) of the FY stock is $200x. The FMV of the FX voting and nonvoting stock is also $200x.

DX sold all of its FY stock to FX for $200x. The transaction is, of course, covered by Sec. 304 DX directly controls FY by its ownership of FY stock, and indirectly controls FX through the attribution rules of Sec 318(a)(3)(C) (relating to the constructive ownership by a corporation of stock owned by its parent corporation). Under Sec. 304(a)(1), the $200x received by DX is treated as a distribution in redemption of the FX stock, even though the cash goes straight to DX and not to P, the actual FX shareholder. The redemption results in a dividend from FX directly to DX.

Under Sec. 304(b)(1), the determination of whether the distribution is to be treated as a payment in exchange for stock or as a dividend is made by reference to the FY stock. Since DX directly owned all of the FY stock before the transaction and constructively owns all of the FY stock after the transaction, none of the provisions of Sec 302(b) apply and the redemption is treated as a distribution of property to which Sec. 301 applies. Under Sec. 304(b)(2), the distribution received by DX is taxable as a dividend first to the extent of FX's E&P and then to the extent of FY's E&P.

According to the ruling, DX is entitled to...