“Check-the-Box” Election Avoided FPHCI Taint

It would appear that Dover Corp., 122 TC No. 19 (2004), is the first opportunity that a court has had to opine on the effect and interplay of the “check-the-box” regulations and Sec. 954(c)(1)(B)(iii) (foreign personal holding company income (FPHCI)).

Facts

Dover is the common parent of an affiliated group of corporations filing a consolidated return. It is a Delaware corporation that maintains its principal place of business in New York. During and before 1997, the group’s business activities were divided into five groups, one of which was Dover Elevator. Dover Elevator was managed by Dover Elevator International, Inc. (DEI), a domestic corporation. In 1997, DEI’s United Kingdom (U.K.) elevator business was conducted by Hammond & Champness Limited (H&C), a U.K. corporation that installed and serviced elevators. H&C was wholly owned by a U.K. holding company, Dover U.K. Holdings Limited (Dover U.K.), which was wholly owned by a Delaware Corporation, Delaware Capital Formation (DCF), which, finally, was wholly owned by Dover.

On June 30, 1997, Dover U.K. and Dover entered into an agreement with Thyssen Industrie Holdings U.K. PLC (Thyssen), a German corporation registered in England and Wales, and its German parent, for the sale by Dover U.K. to Thyssen of the entire issued share capital of H&C. The agreement provided that all documents would be held in escrow until July 11, 1997. Dover U.K. agreed to carry on the H&C business “in the normal course without any interruption” between June 30 and July 11, 1997. On July 11, 1997, the deal closed and Dover received the purchase price for H&C.

On Dec. 3, 1998, Dover sought relief from the IRS, under Regs. Sec. 301.9100-1(c) and -3, for an extension for H&C to file a retroactive election to be treated as a disregarded entity for Federal income tax purposes. Dover specifically requested this for U.S. tax purposes, also asking that the election be effective immediately before the sale of H&C stock to Thyssen.

Initially, the IRS was reluctant to grant the request, partly because it did not want the election to allow the sale to escape FPHCI taxation under the subpart F provisions. Finally, on March 31, 2000, it granted the relief and allowed H&C to be treated as a disregarded entity effective June 30, 1997. However, it added a caveat to the requested ruling: “[N]o inference should be drawn from this letter that any gain from the sale of [H&C’s] assets immediately following its election to be disregarded as an entity separate from its owner gives rise to gain that is not foreign personal holding company income as defined in section 954(c) (1)(B)….”

H&C filed Form 8832, Entity Classification Election, on or about Oct. 10, 1999. The form specified that the election was to be effective on June 30, 1997.

The IRS wanted to deem the gain on the sale of H&C as stock sale gain, which would be subject to the subpart F provisions and taxed immediately in the U.S. as FPHCI. Dover wanted to cast the transaction as the sale of trade or business assets, which Dover U.K. owned and was deemed to operate and, thus, not subject to subpart F.

IRS’s Argument

Sec. 954(c)(1)(B)(iii) provides that FPHCI is the portion of gross income that consists of gains over losses from the sale or exchange of property which does not give rise to any income. Further, under Regs. Sec. 1.954-2(e)(3):

Except as otherwise provided in this paragraph (e)(3), for purposes of this section, the term property that does not give rise to income includes all rights and interests in property (whether or not a capital asset) including, for example, forwards, futures and options. Property that does not give rise to income shall not include—

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(ii) Tangible property (other than real property) used or held for use in the controlled foreign corporation’s trade or business that is of a character that would be subject to the allowance for depreciation under section 167 or 168 and the regulations under those sections (including tangible property described in 1.167(a)-2);

(iii) Real property that does not give rise to rental or similar income, to the extent used or held for use in the controlled foreign corporation’s trade or business;

(iv) Intangible property (as defined in section 936(h)(3)(B)), goodwill or going concern value, to the extent used or held for use in the controlled foreign corporation’s trade or business.

Further, Regs. Sec. 1.954-2(a)(3)(i) provides:

In general. Under paragraphs (e), (f), (g) and (h) of this section, transactions in certain property give rise to gain or loss included in the computation of foreign personal holding company income if the controlled foreign corporation holds that property for a particular use or purpose. The use or purpose for which property is held is that use or purpose for which it was held for more than one-half of the period during which the controlled foreign corporation held the property prior to the disposition.

Based on the facts and the above provisions, the IRS argued that the deemed sale of H&C’s operating assets was not a sale of property used, or held for use, in Dover U.K.’s business. Thus, the property was not excludible from the definition of property “which does not give rise to any income” and, as a result, it also triggered FPHCI subject to immediate U.S. taxation.

Taxpayer’s Argument

Dover argued that its deemed sale of H&C’s assets qualified as a sale of property used in Dover U.K.’s trade or business and, thus, was not FPHCI. In support, Dover relied on the check-the-box regulations and previously issued revenue rulings.

Regulations: Dover argued, citing Regs. Sec. 301.7701-2(a), that the check-the-box regulations impose continuity of business enterprise as a consequence of a disregarded entity election. According to that regulation, if a business entity with only one owner is disregarded, its activities are treated in the same manner as a sole proprietorship, branch or division of the owner.

Dover contended that as a consequence of that regulation, there was as a matter of law and under the IRS’s own check-the-box regulations, a continuing business use of H&C’s assets, which were deemed to be a branch or division of Dover U.K.

Rev. Ruls.: Dover also contended that the Service’s position was “wholly inconsistent with” that contained in Rev. Ruls. 75-223 and 77-376, which, under principles derived from the Sec. 381(c) attribute carryover rules applicable to Sec. 332 liquidations, “unequivocally attribute the trade or business of a subsidiary that is liquidated under section 332 to its parent.” Thus, because H&C’s disregarded entity election involved a deemed Sec. 332 liquidation of H&C, Dover concluded that the IRS’s position violated the principle of Rauenhorst, 119 TC 157 (2002), that “taxpayers should be entitled to rely on revenue rulings in structuring their transactions, and they should not be faced with the daunting prospect of the Commissioner’s disavowing his rulings in subsequent litigation.”

Based on these revenue rulings, for most practical purposes, the parent, after a subsidiary’s liquidation, is viewed as if it has always operated that subsidiary’s business.

IRS’s Response

The Service acknowledged that the check-the-box election constituted a deemed Sec. 332 liquidation, with the result that H&C became a branch or division of Dover U.K. The issue was whether Dover U.K. succeeded to the business history of H&C, with H&C’s trade or business assets subsequently constituting assets used in Dover U.K.’s trade or business.

The undisputed tax consequences of the disregarded entity election are as follows:

• Dover recognized neither gain nor loss on its deemed receipt of H&C’s assets;
• Dover received a carryover basis in H&C’s assets;
• Dover could tack on H&C’s holding period to Dover  U.K.’s holding period.

However, the IRS argued that Dover U.K. had to use, or hold for use, such assets for the requisite period of time in its trade or business before it could exclude from FPHCI the gain from the deemed sale of H&C’s assets. The Service stated that Dover U.K. had a separate identity and business from H&C. In addition, Dover U.K. never intended to use H&C’s assets in an elevator business. The transaction was structured solely to try to avoid the subpart F provisions.

Tax Court’s Findings

According to the Tax Court, the parties’ arguments on whether to deem Dover U.K. to have succeeded to H&C’s business history centered on Sec. 381, which provides that the acquiring corporation in a Sec. 332 liquidation succeeds to the various tax attributes, in Sec. 381(c), of the distributing corporation. The court stated that although Sec. 381(c) does not list “business history” as a carryover attribute, it agreed with Dover that the Service’s position was inconsistent with previously issued revenue rulings and a number of letter rulings. Thus, it held that the deemed sale of H&C’s assets was a sale of property used in Dover U.K.’s trade or business and was not FPHCI; thus, the sale gain was not subject to immediate U.S. tax under the subpart F provisions.

This was a very favorable decision.

From Robert E. Whittall, ACA, CPA, MAT, Cohen & Company, Ltd., CPAs, Mentor, OH