Global Tax Alert | 8 November 2013

US IRS rules on effect of Section 302(a) redemption on post-1986 E&P and foreign income tax pools

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Executive summary

On 30 September 2013, the Internal Revenue Service (IRS) issued a Chief Counsel Advice Memorandum 2013-006 (the CCM) addressing the issue of whether a foreign corporation’s post-1986 foreign income taxes should be reduced when a minority shareholder’s stock in the foreign corporation is redeemed pursuant to Section 302(a) and, as a result of such redemption, the post-1986 undistributed earnings of the foreign corporation are reduced pursuant to Section 312(a) and Section 312(n)(7). In the CCM, the IRS concludes that there should be a reduction in a controlled foreign corporation’s post-1986 foreign taxes corresponding to the reduction in earnings resulting from the stock redemption.

Detailed discussion

The CCM examines the consequences to a controlled foreign corporation’s post-1986 foreign income tax pool where the foreign corporation’s earnings and profits have been reduced by reason of a Section 302(a) redemption in the context of the following fact pattern:

  • US parent (USP) owns 60% of the stock of a controlled foreign corporation (CFC). An unrelated foreign party (UFP) owns the other 40%. CFC does not earn any subpart F income.
  • In Year 1, CFC redeems all of UFP’s stock in exchange for a cash distribution. Under Section 302(a), the redemption is treated as a distribution in full payment in exchange for the stock. The distribution in Year 1 reduces the post-1986 undistributed earnings of CFC under Section 312(a). Section 312(n)(7) limits this reduction to an amount equal to UFP’s pro-rata share of CFC’s post-1986 undistributed earnings.
  • In Year 2, when USP owns 100% of the stock of CFC, CFC pays its entire remaining post-1986 undistributed earnings to USP as a dividend and USP claims a Section 902 deemed paid foreign tax credit equal to CFC’s total post-1986 foreign tax pool.

The IRS Office of Chief Counsel concludes in the CCM that Section 902 and its regulations require a proportionate reduction of the post-1986 foreign income taxes of the CFC to correspond with the reduction in earnings and profits arising from the Year 1 redemption of the UFP stock by the CFC, thereby reducing the foreign tax credits that USP may claim as a result of the dividend in Year 2.

The key provision discussed in the CCM is Treas. Reg. Section 1.902-1(a)(8)(i), which defines post-1986 foreign income taxes and provides, in part, that foreign taxes deemed paid by a foreign corporation on or with respect to earnings that were “distributed or otherwise removed” are eliminated from a corporation’s post-1986 tax pool. The CCM discusses the history and purposes of Section 902 and of this regulatory provision in order to determine whether the earnings “otherwise removed” language should be read to reach a reduction in earnings and profits arising through the operation of Section 312(a) and (n)(7).

For purposes of calculating the deemed paid credit, Section 902 provides that the amount of a foreign corporation’s foreign income taxes deemed to have been paid is equal to the same proportion of the corporation’s post-1986 foreign income taxes that the amount of the dividend bears to the corporation’s post-1986 undistributed earnings. The CCM acknowledges that the statutory language of Section 902(c)(2), which defines post-1986 foreign income taxes for these purposes, specifically refers to reductions to post-1986 foreign income taxes for foreign taxes attributable to “dividends” distributed. The CCM points, however, to the grant of regulatory authority in Section 902(c)(8) providing such regulations as may be necessary or appropriate to carry out the provisions of Section 902. The IRS focuses on the second sentence of Treas. Reg. Section 1.902-1(a)(8)(i)1 and argues that the reference in that sentence to earnings “otherwise removed” is sufficiently broad to cover reductions of earnings related to redemptions that are treated as a sale or exchange transaction under Section 302(a).

The CCM notes that the pooling rules of Section 902 and its regulations represent Congress’ attempt to ensure that the amount of a taxpayer’s indirect foreign tax credit is determined based on the average effective rate of foreign tax associated with foreign earnings over time, concluding that “if there is no corresponding reduction to post-1986 foreign income taxes for taxes associated with post-1986 undistributed earnings that have been eliminated, there will be a distortion in the average effective rate of tax associated with the remaining earnings, thereby frustrating a principal goal of the pooling rules.”

In the CCM, the IRS also explicitly addresses the argument made by certain taxpayers that this interpretation of the “otherwise removed” language is improper, taking into consideration the context of the regulatory paragraph in which that language is located. As described in the CCM, taxpayers have argued that, in light of other language in the paragraph referring to “dividends distributed to, or earnings otherwise included” and amounts “distributed or deemed distributed,” the “otherwise removed” language should be read to be limited to earnings removed by dividends or deemed distributions or inclusions. In the IRS’s view, that other language in the regulation is not intended to be limiting, but to merely set forth examples of the operation of the rule and, therefore, should not affect the scope of the “otherwise removed” language. As such, the IRS concludes that the broader interpretation of “otherwise removed” is not only permissible, but also is more consistent with the intent and text of the regulation, and the principles and purpose of the Section 902 rules.

Implications

The CCM conclusion is consistent with the proposed legislation in the administration’s fiscal 2013 budget proposal reducing the amount of foreign taxes paid by a foreign corporation if a transaction results in the elimination of a foreign corporation’s earnings and profits. The CCM puts taxpayers on notice regarding the IRS’s interpretation of Section 902 and the related Treasury regulations as they apply to such transactions under present law.

Endnote

1. This sentence of the regulation states:

“Except as provided in paragraph (b)(4) of this Section, foreign taxes paid or deemed paid by a foreign corporation on or with respect to earnings that were distributed or otherwise removed from post-1986 undistributed earnings in prior post-1986 taxable years shall be removed from post-1986 foreign income taxes regardless of whether the shareholder is eligible to compute an amount of foreign taxes deemed paid under Section 902, and regardless of whether the shareholder in fact chose to credit foreign income taxes under Section 901 for the year of the distribution or inclusion.” (Emphasis added)

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax Services, Washington, DC
  • Natan Leyva
    +1 202 327 6798
    natan.leyva@ey.com
  • Maria Martinez
    +1 202 327 8055
    maria.martinez@ey.com
Ernst & Young LLP, International Tax Services, New York
  • Karen Petrosino
    +1 212 773 0375
    karen.petrosino@ey.com
  • Ben Orenstein
    +1 212 773 4485
    benjamin.orenstein@ey.com

EYG no. CM3945