DOMESTIC CORPORATION MAY COMPUTE FOREIGN TAXES DEEMED PAID UNDER SECTION 902 ON DIVIDENDS DEEMED RECEIVED IN STOCK SALE.

Rev. Rul. 91-5

ISSUES

May a domestic corporation compute foreign taxes deemed paid under section 902 of the Internal Revenue Code with respect to a deemed dividend distribution from a foreign corporation in a transaction under section 304(a)(1)?

Does section 367(a) of the Code apply to the capital contribution described below?

FACTS

P, a domestic corporation, owns all of the outstanding stock of DX, a domestic corporation, and FX, a Country U corporation. DX owns all of the outstanding stock of FY, a Country U corporation. Of the outstanding stock of FX, one-half by value is voting stock and one- half is non-voting stock. FX and FY were incorporated in 1987. P and DX are members of a consolidated group. The functional currency of FX and FY under section 985(b) is the U.S. dollar.

The fair market value of the FY stock owned by DX is $200x, and DX has a basis of $100x in the FY stock. FY has accumulated $110x of post-1986 undistributed earnings, and has paid post-1986 foreign income taxes of $25x. See section 902(c) of the Code. The fair market value of the voting and non-voting FX stock owned by P is $200x. FX has accumulated post-1986 undistributed earnings of $90x, and has paid post-1986 foreign income taxes of $20x.

DX sells all of its FY stock to FX for $200x.

LAW AND ANALYSIS

The sale of the FY stock by DX to FX for $200x is a transaction described in section 304(a)(1) of the Code. Section 304(a)(1) provides that, if one or more persons are in control of each of two corporations and, in return for property, one of the corporations acquires stock in the other corporation from the person (or persons) so in control, then such property shall be treated as a distribution in redemption of the stock of the corporation acquiring such stock. DX directly controls FY by its ownership of FY stock, and indirectly controls FX through the attribution rule of section 318(a)(3)(C). See section 304(c)(1) and (3)(A).

Thus, the $200x received by DX is treated as a distribution in redemption of the stock of FX. The determination as to whether the distribution is treated as in part of full payment in exchange for stock is made by reference to the FY stock. See section 304(b)(1) of the Code. Because DX directly owned all of the FY stock before the transaction, and indirectly owned all the FY stock after the transaction pursuant to the attribution rules of section 318(a)(2)(C) and (a)(3)(C), none of the provisions of section 302(b) apply to treat the distribution as in part or full payment in exchange for stock. Accordingly, the redemption is treated as a distribution of property to which the rules of section 301 apply.

The distribution received by DX is taxable as a dividend to the extent of the earnings and profits of FX and FY. See sections 301(c)(1), 316 and 304(b)(2) of the Code. The amount and source of the portion of the distribution that is treated as a dividend is determined as if the property were distributed by FX to the extent of its earnings and profits, and then by FY to the extent of its earnings and profits. The distribution received by DX is a dividend of $200x. The source of the dividend is FX, to the extent of $90x, and FY, to the extent of $110x. The dividend is considered paid by FX and FY directly to DX, and, accordingly, the earnings and profits of FX and FY are reduced by the portion of the dividend distribution attributable to each corporation. See H.R. Rep. No. 98-861 (Conf. Rep.), 98th Cong. 2d. Sess. 1223 (1984), 1984-3 (Vol. 2) C.B. 477; section 312(a).

A domestic corporation that owns 10 percent or more of the voting stock of a foreign corporation from which it receives dividends in any taxable year is deemed to have paid the same proportion of such foreign corporation's post-1986 foreign income taxes as the amount of such dividends (determined without regard to section 78 of the Code) bears to such foreign corporation's post-1986 undistributed earnings. See section 902(a).

Section 902(a) of the Code permits the computation of foreign taxes deemed paid only where the domestic corporation owns at least ten percent of the voting stock in the distributing foreign corporation. See Rev. Rul. 85-3, 1985-1 C.B. 222. Because DX owned the FY stock as required by section 902(a), and because all of FY's earnings and profits are considered distributed, DX may compute foreign taxes deemed paid of $25x with respect to the dividend that is considered received from FY. See H.R. Rep. 98-861 supra. If DX computes foreign taxes deemed paid with respect to the dividend from FY, then DX must include the $25x income as a dividend. See section 78.

When Congress amended section 304(b)(2) of the Code in 1984 to clarify the characterization and sourcing rules, it indicated that the foreign tax credit should be allowed "to the same extent as if the distribution had been made directly by the corporation which is treated as having made the distribution." See H.R. Rep. No. 98-861 supra. Consistent with this legislative history, and in view of the facts presented in this ruling, DX shall be considered to own at least 10 percent of voting stock of FX for purposes of section 902(a). DX may compute foreign taxes deemed paid of $20x with respect to the dividend that is considered received from FX. If DX computes foreign taxes deemed paid with respect to the dividend from FX, then DX must include the $20x in income as a dividend. See section 78.

The FY stock is treated as having been transferred by DX, and having been received by FX, as a capital contribution. See section 304(a)(1) of the Code.

A capital contribution of property to a foreign corporation by persons who own, directly or indirectly, within the meaning of section 318 of the Code, at least eighty percent of the total combined voting power of the foreign corporation is treated by section 367(c)(2) as an exchange of such property for stock of the foreign corporation. DX is considered to have transferred the FY stock to FX in exchange for FX stock under section 367(c)(2) because DX owns, directly or indirectly, at least eighty percent of the total combined voting power of all classes of FX stock. Moreover, DX is considered to "control" FX within the meaning of section 368(c), and the contribution of the FY stock to FX, therefore, qualifies as a transfer to a controlled corporation under section 351(a). See section 1.1502-34 of the Income Tax Regulations. Because DX is a United States person and FX is a foreign corporation, the transfer under section 351 is also subject to section 367(a). See the regulations under section 367(a) and Notice 87-85, 1987-2 C.B. 395, for requirements applicable to such transfers.

HOLDING

DX may compute foreign taxes deemed paid under section 902 on the dividends from FX and FY.

DX's transfer of FY stock to FX is a section 351 exchange that is subject to section 367(a).

DRAFTING INFORMATION

The principal author of this revenue ruling is Charles P. Besecky of the Office of the Associate Chief Counsel (International). For further information regarding this revenue ruling contact Mr. Besecky on (202) 566-6442 (not a toll-free call).