Redemption Distributions of PTE

Letter Ruling 9802018 could have broad implications for common restructuring techniques and, in certain cases, result in double taxation of previously taxed earnings (PTE) of a controlled foreign corporation (CFC). The ruling involved a Sec. 302 redemption by a CFC of shares held by another CFC; the redeeming CFC was wholly owned indirectly by two U.S. corporations that were members of the same U.S. consolidated group. The ruling held that only a portion of the redeeming CFC's PTE distributed (as a dividend) in the redemption will be excluded from the recipient CFC's gross income under Sec. 959.

The simplified facts in the letter ruling are as follows: U.S. Parent A owns 100% of domestic corporation B, which owns 100% of domestic corporation C. A files a consolidated tax return with B and C. B and C together own 100% percent of the shares of CFC H, which owns 100% percent of the shares of CFC I. In addition, C owns 100% CFCs of G and J. Together G, J and I own 100% of CFC L. All of L's earnings and profits (E&P) have been previously taxed under Sec. 951(a).

Prior to a redemption of L shares held by G, J will increase its percentage ownership of L through a capital contribution. Accordingly, the percentage ownership of L held by G and I will be reduced. This transaction will have the effect of shifting a portion of the indirect ownership of L from B to C. Under Secs. 302, 301 and 316, the subsequent redemption distribution from L to G will be characterized as a dividend to the extent of L's E&P. All of L's E&P will be distributed to G in the redemption distribution.

Holding

The ruling held that the portion of the redemption distribution attributable to amounts previously included in C's gross income under Sec. 951(a) is determined based on the percentage of C's indirect ownership of L stock under Sec. 958(a), measured at the time of the redemption distribution. As a consequence, only a portion of the total distribution, to the extent characterized as a dividend, will be excluded from G's gross income, even though all of L's E&P were previously taxed. The ruling does not state how the remainder of the distribution to G should be treated.

Comments: The ruling seems to recharacterize a portion of L's PTE as untaxed E&P, the amount of which would be determined based on C's indirect ownership of L at the time of the redemption distribution. The amount included in G's gross income presumably would be treated as a dividend and constitute subpart F income to G. Accordingly, C, the first U.S. shareholder in G's ownership chain, would be required under Sec. 951(a) to include in gross income a portion of L's E&P that apparently was taxed previously to B under Sec. 951(a).

The rationale for the holding seems to be an attempt to match the distribution of L's PTE with the U.S. shareholder that originally included such earnings in gross income under Sec. 951(a). However, the ruling's approach leaves room for mismatching, because it determines the PTE exclusion percentage at the time of the redemption distribution, rather than at the time the earnings were originally included in the U.S. shareholder's gross income under Sec. 951(a).

Implications for Sec. 304
Transactions

In a cross-chain Sec. 304 sale of a CFC owned indirectly (i.e., through another CFC) by several members of an affiliated U.S. group, one question is whether a distribution of PTE can be excluded from the gross income of the selling CFC. If a U.S. shareholder of the selling CFC does not own all of the shares of the acquiring CFC (directly or indirectly through other CFCs), Letter Ruling 9802018 would appear to cause the U.S. affiliated group to be taxed twice on the distributed PTE.

Example: A domestic corporation, P, owns 100% of the shares of S, also a domestic corporation. P and S file a consolidated return. P also owns 100% percent of the shares of R, a CFC. All of R's earnings are PTE. S owns 100% of the shares of D, a CFC, which owns 100% of the shares of J, another CFC. R acquires all of J's shares from D in a Sec. 304 transaction.

Letter Ruling 9802018 seems to suggest that the deemed distribution from R to D (to the extent treated as a dividend) would not be considered as made entirely from R's PTE, but rather would be considered attributable to the same percentage of R's PTE as corresponds to the percentage of R stock owned by S at the time of the distribution. Because S would indirectly own a portion of the R shares (as a result of the deemed issuance of R shares to D under Sec. 304), a portion of the dividend would be attributable to R's PTE and excluded from D's gross income. However, the portion of the distribution attributable to P's ownership of R would not be excluded from D's gross income as PTE and apparently would be taxed twice in the hands of the consolidated group.

1998 Legislation

Sec. 304(b)(6), as enacted by the Internal Revenue Service Restructuring and Reform Act of 1998, may help certain taxpayers with future distributions of PTE. Sec. 304(b)(6) instructs the IRS to provide rules to prevent multiple inclusions of income items and to provide appropriate basis adjustments, including rules modifying the application of Secs. 959 (exclusion from gross income of PTE) and 961 (adjustments to stock basis in CFCs and other property) for Sec. 304 transactions.

Sec. 304(b)(6) generally is effective for distributions or acquisitions after June 8, 1997. However, it is not clear how future regulations under Sec. 304(b)(6) will deal with the potentially adverse consequences of PTE distributions in the Sec. 304 context. Moreover, these regulations presumably would not apply to transactions not subject to Sec. 304, such as the Sec. 302 redemption in Letter Ruling 9802018. Thus, taxpayers should consider that, at this point, the consequences of transactions involving PTE distributions under Secs. 302 and 304 are uncertain. Taxpayers should structure their transactions accordingly to minimize any potential exposure.

From Jordan W. Bacon, CPA, and Michael V. Lukacs, J.D., LL.M., Washington, DC