Conflict over PTI

In Letter Ruling (TAM) 200141003, the IRS treated the entire previously taxed income (PTI) pool of a controlled foreign corporation (CFC) as a distribution to a fractional U.S. shareholder on the shareholder's sale of its interest in the CFC's to its wholly owned foreign subsidiary in a Sec. 304 transaction. The TAM may have implications for taxpayers engaging in international restructuring transactions.

PTI Rules—In General

Under the subpart F and other rules, certain CFC earnings are taxed to the CFC's U.S. shareholders, whether or not distributed. To prevent double taxation on the actual receipt of the CFC's earnings, Sec. 959 allows the U.S. shareholders to exclude such earnings from gross income. Although the purpose of the PTI rules (the avoidance of double taxation) is plain, their application can be difficult, such as when applied to Sec. 304 transactions.

Sec. 304 Transactions

Sec. 304 prevents a taxpayer from using a sale of stock of one related corporation to another related corporation to withdraw corporate earnings as capital gains and return of capital, thereby avoiding the ordinary income tax on dividends. To achieve its anti-bailout purpose, Sec. 304 recasts such sales into another fictional transaction, which typically gives rise to dividend treatment.

For example, if a U.S. corporation sells, under Sec. 304, all the shares of its wholly owned foreign subsidiary to another wholly owned foreign subsidiary, the sale would be treated as (1) a Sec. 351 contribution by the U.S. corporation of all of the first subsidiary's shares to the acquiring corporation, in exchange for additional shares of that corporation and (2) a cash distribution by the acquiring corporation to the U.S. corporation in redemption of the acquiring corporation's shares. Because the distribution qualifies as a distribution of property under Secs. 301 and 302(d), the U.S corporation will be treated as receiving a dividend distribution from the acquiring corporation to the extent of (1) the acquiring corporation's earnings and profits (E&P) and (2) the first subsidiary's E&P.

If the distribution exceeds the acquiring corporation's and the first subsidiary's available E&P, the excess will apply against and reduce the basis of the acquiring corporation's stock deemed issued to the selling corporation (although some tax practitioners believe that it may be applied against and reduce the selling corporation's legacy basis in the acquiring corporation as well). To the extent that the excess is greater than the relevant basis, it is treated as gain from the sale or exchange of property.

The Recent TAM

In the recent TAM, two U.S. corporations owned all the shares of a foreign corporation. One of the U.S. corporations sold all of its interest in the foreign corporation to its wholly owned foreign subsidiary. The other U.S. corporation, which owned all the selling corporation's shares, retained the remaining interest in the foreign corporation.

Similar to the example, the sale was characterized as an equity contribution followed by a Sec. 301/302(d) distribution. Additionally, the acquiring corporation and the foreign corporation had sufficient E&P to characterize such distribution as a dividend distribution, with no amount being treated as a return of basis or capital gain.

While none of the acquiring corporation's E&P had previously been subject to U.S. income tax, a portion of the foreign corporation's E&P was subject to U.S. income tax previously under subpart F rules. With little analysis, the Service treated the foreign corporation's entire PTI pool as a distribution to the selling corporation, even though a portion of the pool likely arose as a result of U.S. income taxes paid by the other corporate shareholder. Accordingly, the selling corporation may have been entitled to an undue benefit (i.e., tax-free income) at the expense of the other corporate shareholder, which may have paid U.S. income tax on E&P that it may never receive.

The Conflict

In contrast, in Letter Ruling 9802018, the IRS concluded that only a portion of a CFC's E&P, 100% of which had been subject to U.S. income tax previously under subpart F rules, was excludable PTI when distributed to an intermediate CFC. The IRS took great pains to trace the CFC's previously taxed E&P to the relevant U.S. shareholder that originally included such amount in gross income under subpart F rules. Although seemingly well reasoned, the result in the letter ruling appears unfair. By excluding only a portion of the distributing CFC's E&P as PTI, the remaining PTI was dividend income to the intermediate CFC and thus subpart F income subject to U.S. income tax a second time, in the hands of the intermediate CFC's U.S. shareholders.

Interestingly, prior to issuance of Letter Ruling 9802018, the Service took positions consistent with the conclusion reached in the TAM, but contrary to the position espoused in Letter Ruling 9802018; see Letter Rulings 9131059 and 9210031.

Conclusion

The IRS has not adopted a consistent position in the Sec. 304/PTI arena. Congress recognized this problem and, through the Congressional mandate embodied in Sec. 304(b)(6), has given the IRS authority to issue regulations to prevent a multiple inclusion of an item in income and provide appropriate basis adjustments, including rules modifying the application of Sec. 959 in Sec. 304 transactions. Until such regulations are issued, taxpayers are left to decipher the confusing and inconsistent array of authorities in this area.

From Mary Lim, CPA, Washington, DC