Rev. Rul. 70-373

Advice has been requested whether a domestic corporate shareholder is entitled to a credit under section 902 of the Internal Revenue Code of 1954 for foreign income taxes paid by its foreign subsidiary corporations under the circumstances set forth below.

The domestic corporation, X, owned all the outstanding voting stock of foreign corporation Y which, in turn, owned all the outstanding voting stock of foreign corporation Z. Y was not a less developed country corporation as defined in section 902(d) of the Code. Y acquired all the assets of Z in a distribution in complete liquidation within the meaning of section 332 of the Code, in which the basis of the assets carried over under section 334(b)(1) of the Code. The acquisition of the assets of Z by Y is a transaction described in section 381(a)(1) of the Code. As required by section 367 of the Code, X established to the satisfaction of the Commissioner of Internal Revenue before the liquidation that the acquisition of the assets of Z by Y was not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax. Subsequent to that acquisition and unrelated thereto, a dividend was paid to X by Y from the accumulated earnings and profits that included earnings and profits Z had accumulated prior to its liquidation. Prior to its complete liquidation Z had paid or accrued taxes to the foreign country in which it was incorporated.

Section 381(c)(2) of the Code provides that an acquiring corporation (such as Y) in a transaction to which section 381(a) of the Code applies shall succeed to and take into account the earnings and profits of the transferor corporation (such as Z) as of the close of the date of the transfer. See also section 1.381(c)(2)-1 of the Income Tax Regulations.

If a domestic corporate shareholder (such as X) receives dividends in any taxable year from a foreign corporation (first-tier corporation) in which the shareholder owns at least 10 percent of the voting stock, the credit for foreign income taxes allowed by section 901 of the Code includes the foreign taxes deemed to have been paid by such domestic shareholder for such year under section 902 of the Code. Section 902(a)(1) of the Code and section 1.902-3(a)(2) of the regulations provide that to the extent dividends are paid by a first-tier corporation to its domestic shareholder out of accumulated profits of a taxable year for which such first-tier corporation is not a less developed country corporation, the domestic shareholder shall be deemed to have paid the same proportion of any foreign income taxes paid or deemed to be paid by such first-tier corporation on or with respect to such accumulated profits for such year which the amount of such dividends bears to the amount by which such accumulated profits exceed the amount of such taxes (other than those deemed to be paid).

Section 902(b)(1) of the Code and section 1.902-3(b)(2) of the regulations provide that a first-tier corporation which is not a less developed country corporation for its taxable year in which it receives dividends from its second-tier corporation (meaning a foreign corporation in which the first-tier corporation owns at least 50 percent of the voting stock), shall be deemed to have paid for such year the same proportion of any foreign income taxes paid or accrued by its second-tier corporation on or with respect to the accumulated profits for the taxable year of the second-tier corporation from which such dividends are paid which the amount of such dividends bears to the amount by which such accumulated profits of the second-tier corporation exceed the taxes so paid or accrued. This rule applies whether or not the second-tier corporation is a less developed country corporation for its taxable year.

Section 1.902-3(c)(1) of the regulations defines the accumulated profits for any taxable year of a first-tier corporation which is not a less developed country corporation for such year to be the sum of the earnings and profits of such corporation for such year and the foreign income taxes imposed on or with respect to the gains, profits, and income to which such earnings and profits are attributable. This definition of accumulated profits also applies to a second-tier corporation of such first-tier corporation even though such second-tier corporation is a less developed country corporation for such year. See section 1.902-3(c)(3) of the regulations.

Under section 1.902-3(c)(1) of the regulations a correlation exists between earnings and profits, accumulated profits, and foreign income taxes. Since a qualified domestic corporate shareholder may obtain a foreign tax credit under section 902 of the Code with respect to distributions from the earnings and profits of a second-tier corporation and since a first-tier corporation may succeed to and take into account under section 381(c)(2) of the Code the earnings and profits of a second-tier transferor corporation in a transaction covered by section 381(a)(1) of the Code, it is proper to allow the first-tier transferee corporation to succeed to and take into account the accumulated profits and foreign income taxes of the second-tier corporation imposed on the income to which the earnings and profits are attributable. However, such accumulated profits and foreign income tax "inherited" by the first-tier corporation must be segregated with respect to (1) the amount of foreign income taxes that were paid or accrued by the second-tier corporation for each of the taxable years, and (2) the amount of accumulated profits for each of such years.

Accordingly, with respect to the dividend paid to X after liquidation of Z out of the accumulated profits of Y and Z for the respective taxable years prior to the date of Z's liquidation, X will be deemed to have paid a proportionate part of the foreign income taxes paid or accrued by both Y and Z on their respective accumulated profits for such taxable years and is entitled to a credit with respect thereto under section 902 of the Code.