CORPORATION'S DISTRIBUTION OF APPRECIATED CFC STOCK TO PARENT WILL BE TREATED AS SECTION 1248(a) SALE; GAIN WILL BE DEFERRED.

Rev. Rul. 87-96

ISSUES

If a domestic corporation that files a consolidated return with its parent distributes to the parent the appreciated stock of a controlled foreign corporation in a transaction characterized as a sale by section 311(b) of the Internal Revenue Code of 1986:

(1) Will the transaction be treated as a sale for purposes of section 1248(a)?

(2) When will the domestic subsidiary take its section 311(b) gain into income?

(3) How will section 1248 apply to the section 311(b) gain?

FACTS

P, a domestic corporation, files a consolidated federal income tax return with S, its wholly owned domestic subsidiary corporation. S owns all of the stock of FX, a controlled foreign corporation as defined in section 957(a) of the Code. FX's functional currency is the United States dollar. The fair Market value of the FX stock held by S exceeds S's basis in the stock.

On December 31, 1987, as part of a corporate restructuring, S distributed all of its FX stock to P as an intercorporate dividend in a transaction to which section 355 of the Code did not apply. Following this distribution, P owned all of the stock of both S and FX. On December 31, 1987, FX had post-1962 earnings and profits that had not been previously taxed under subpart F. P and S file their tax returns on a calendar year basis.

LAW AND ANALYSIS

ISSUE 1

Section 301 of the Code describes the tax treatment of the distribution of property by a corporation with respect to its stock, and applies to the distribution of the FX stock by S to P. Section 311(b) provides that, if a corporation distributes property to a shareholder in a transaction to which section 301 applies and the fair market value of the property exceeds its adjusted basis in the hands of the distributing corporation, then gain is recognized by the distributing corporation as if the property distributed had been sold to the distributee at its fair market value. For purposes of section 311(b), the transaction will be treated as if S had sold the FX stock to P at its fair market value.

Section 1248(a) of the Code provides that, if a United States person sells stock in a foreign corporation and the ownership requirements of section 1248(a)(2) are satisfied, the gain recognized on the sale will be included in the seller's gross income as a dividend to the extent of certain earnings and profits of the foreign corporation. Section 1248(f) provides that, if, in a transaction to which section 311, 336, or 337 applies, a domestic corporation distributes, sells, or exchanges stock in a foreign corporation and the ownership requirements of section 1248(a)(2) are satisfied, the excess of the fair market value of the stock over its adjusted basis in the hands of the transferor will be included in the transferor's gross income as a dividend to the extent of certain earnings and profits of the foreign corporation.

The legislative histories of section 1248(f) of the Code and section 311(d) of the Internal Revenue Code of 1954 (the predecessor to current section 311(b)) indicate that section 1248(a) is intended to apply to transactions in which gain is recognized under other sections of the Code (including section 311(b) and its predecessor), and that a transaction treated as a sale for purposes of section 311(b) is also to be treated as a sale for purposes of section 1248(a). Section 1248(f) is intended to apply to transactions in which gain would not otherwise be recognized. See S. Rep. No. 938, 94th Cong., 2d Sess., 263-64, 270 (1976), 1976-3 (Vol. 3) C.B. 301- 02, 308; H.R. Rep. No. 861 (Conf. Rep.), 98th Cong., 2d Sess. 823 (1984), 1984-3 (Vol. 2) C.B. 77. In accordance with this legislative history, section 1248(a) and not section 1248(f) applies to the gain realized by S on its distribution of FX stock to P.

ISSUE 2

Section 1.1502-11(a) of the Income Tax Regulations provides that consolidated taxable income for any year is determined by taking into account the separate taxable income of each member of the group for that year. Section 1.1502-12 of the regulations provides that the separate taxable income of a member is computed in accordance with the provisions of the Code prescribing the determination of the taxable income of corporations generally, subject to certain modifications.

Sections 1.1502-13 and 1.1502-14 of the regulations provide that one such modification is the deferral of income or loss with respect to certain intercompany transactions. Section 1.1502-14 provides that the inclusion in income of any gain recognized by a distributing corporation in certain intercompany distributions (including any amount treated as gain under section 311) will be deferred until one of the triggering events described in section 1.1502-13(f) occurs.

Therefore, pursuant to section 1.1502-14(c)(1) of the regulations, S will defer the section 311(b) gain on its distribution of FX stock to P until the occurrence of a triggering event. Section 1248(a) will not apply until that time.

ISSUE 3

In order to determine the application of section 1248(a) to the section 311(b) gain that S will include on the occurrence of a triggering event, S will maintain a separate account on its books reflecting the potential section 1248 recharacterization. Initially, this account will equal the amount of the earnings and profits of FX equal to the portion of S's section 311(b) gain that would have been recharacterized as a dividend at the time of the distribution of the FX stock to P had P and S not filed consolidated returns. FX's earnings and profits will not be reduced by the earnings included in the section 1248 recharacterization account. In addition, earnings included in the section 1248 recharacterization account will not be treated as previously taxed income ("PTI") in the hands of FX pursuant to section 959(e) because such earnings are not included in income under section 1248 prior to the inclusion of the deferred gain on the FX stock on the occurrence of a triggering event described in section 1.1502-13(f).

Any dividend distributions by FX to P out of earnings and profits that have been included in the section 1248 recharacterization account will be treated as having been received from FX by S and then distributed to P by S. As a result, the section 1248 recharacterization account will be reduced by the amount of any such distributions. Similarly, any increase in earnings of FX invested in United States property under section 956 that would result in a section 951(a)(1)(B) inclusion in P's income will, to the extent that the inclusion relates to the earnings and profits included in the section 1248 recharacterization account, be treated as a section 951(a)(1)(B) inclusion to S and a distribution from S to P. The section 1248 recharacterization account will be reduced by the amount of the section 951 inclusion by S.

FX's earnings and profits will be reduced by the amount of any dividends, including those dividends that reduce S's section 1248 recharacterization account. FX will treat the earnings and profits included under section 951 that reduce S's section 1248 recharacterization account as PTI pursuant to section 959(e). Post- 1987 deficits in FX's earnings and profits will not affect the section 1248 recharacterization account.

When a triggering event described in section 1.1502-13 occurs, S will include in its income the amount of deferred gain required by the consolidated return regulations. An amount of that gain equal to any remaining section 1248 recharacterization account will be characterized as a dividend by section 1248(a) at that time. FX's earnings and profits become PTI under section 959(e) to the extent of the amount taken into account under section 1248.

For purposes of the foreign tax credit, as S's section 1248 recharacterization account is reduced by distributions or section 951 inclusions, S will take into account an appropriate amount of the total foreign tax credit for foreign taxes paid with respect to the earnings and profits in such account, adjusted as necessary under section 905(c). The calculation of such foreign tax credit will be made as of the time that S's section 1248 recharacterization account is reduced, and by taking into account all the applicable provisions of the Code, including the rules of section 902 and 904 relating to the ordering and characterization of such earnings and profits.

HOLDINGS

(1) A transaction characterized as a sale under section 311(b) will also be treated as a sale for purposes of section 1248(a).

(2) The domestic subsidiary will defer its section 311(b) gain on the distribution and the resulting section 1248 recharacterization until the occurrence of one of the triggering events enumerated in the consolidated return regulations.

(3) Section 1248(a) will apply to the deferred section 311(b) gain in the manner described in this revenue ruling.