Rev. Rul. 80-154

ISSUE

Does section 305(a) of the Internal Revenue Code apply to a distribution by a foreign corporation to its shareholders, who are two United States corporations, under the circumstances described below?

FACTS

X and Y, both of which are United States manufacturing corporations, owned all of the outstanding stock (common) of Z, a business entity organized under the law of M, a foreign country, as an M limited liability corporation and classified as an association taxable as a corporation for federal income tax purposes. It is engaged in the manufacturing business in M. X owns 80 percent of the Z stock and Y owns 20 percent. Under M law the shareholders of an M limited liability corporation declare dividends or otherwise direct the disposition of the profits of the corporation. Furthermore, under M income tax law, corporate profits of a business year that are not capitalized and are not distributed to shareholders are taxed to the corporation at a higher rate than if they are capitalized. The capitalized profits are taxed under M capital yield tax law to the shareholders as dividends. In 1978, X and Y directed Z, pursuant to written resolution, to increase its capital by the amount of its previous year's profits and to distribute this amount. The resolution stated that "the payment will be made in cash without any delay" and that "the dividend shall be utilized to cover a new share" that will "participate in the profit earned by the company beginning with the current business year." No cash or shares of stock or certificates of participation were distributed by Z to X or Y. Accounting entries recorded the reduction of undistributed profits and the increase in the capital of Z.

LAW AND ANALYSIS

Section 305(a) of the Code provides that gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock, except as otherwise provided in section 305. Section 305(b)(1) provides that section 305(a) does not apply and that the distribution will be treated as a distribution of property to which section 301 applies, if the distribution is, at the election of any of the shareholders (whether exercised before or after the declaration thereof), payable either in stock or in property.

A resolution declaring a cash dividend raises the presumption that a cash dividend is intended. However, this presumption is rebutted when the corporate resolution ties up the "cash" dividend so effectively that the shareholders never receive it, never exercise any control with respect to it, and the dividend is used to pay for additional stock. See Maverick-Clarke Litho Company v. Commissioner, 11 T.C. 1087 (1948), acq., 1949-1 C.B. 3, aff'd., 180 F.2d 587 (5th Cir. 1950), and Teehan v. United States, 25 F.2d 884 (D. Mass. 1928). In the instant case, the dividend declared was for the sole purpose of capitalizing the profits of Z and could not be taken out in cash at the option of X or Y. Thus, the capitalization of the profits of Z had the effect of a stock dividend.

Furthermore, the fact that X and Y could have initially directed Z to distribute its profits to them in cash or other property rather than have Z capitalize this amount is not an election within the meaning of section 305(b)(1) of the Code. This choice is not provided by corporate action but instead is a result of M law which provides that the shareholders of an M limited liability corporation declare dividends or otherwise direct the disposition of the profits of the corporation. Once the initial choice to capitalize was made, X and Y could not elect to receive cash or other property.

The distribution by Z to X and Y represents a distribution by Z of its common stock to its shareholders, X and Y, with respect to the Z common stock held by X and Y, and section 305(b)(1) is not applicable.

HOLDING

Under the facts described, section 305(a) of the Code is applicable to the distribution by Z to X and Y. Consequently, the distribution is not includible in X or Y's gross income.