SUBSIDIARY MAY COMPUTE FOREIGN TAXES DEEMED PAID ON DEEMED DIVIDEND DISTRIBUTION.

Rev. Rul. 92-86

ISSUES:

(1) May a domestic corporation compute foreign taxes deemed paid under section 902 of the Internal Revenue Code of 1986 with respect to a deemed dividend distribution from a foreign corporation in a transaction described in section 304(a)(1) under the facts below?

(2) 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, 90 percent by value is voting stock and 10 percent by value 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 $40x, and DX has a basis of $20x in the FY stock. FY has accumulated $30x of post-1986 undistributed earnings, and has paid post-1986 foreign income taxes of $10x. See section 902(c) of the Code. The fair market value of the voting and non-voting stock of FX owned by P is $500x. FX has accumulated post-1986 undistributed earnings of $30x, and has paid post-1986 foreign income taxes of $10x.

DX sells all of its FY stock to FX for $40x.

LAW AND ANALYSIS

The sale of the FY stock by DX to FX for $40x is a transaction described in section 304(a)(1) of the Code. Under section 304(a)(1), 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, the receipt of the property is treated for purposes of sections 302 and 303 as a distribution in redemption of the stock of the corporation acquiring such stock. DX directly controls FY through 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, for purposes of section 302 of the Code, DX's receipt of the $40x is treated as a distribution in redemption of the stock of FX. The determination whether the distribution is treated as in part or full payment in exchange for stock is made by reference to the FY stock. See section 304(b)(1). DX directly owned all of the FY stock before the transaction, and constructively owns all of the FY stock after the transaction under the attribution rules of section 318(a)(2)(C) and (a)(3)(C). Thus, 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 section 301 applies.

The distribution received by DX is taxable as a dividend by reference to 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 $40x. The dividend is deemed to come out of FX's earnings and profits to the extent of $30x, and out of FY's earnings and profits to the extent of $10x. The dividend is considered paid by FX and FY directly to DX, and the earnings and profits of FX and FY are reduced by $30x and $10x, respectively. 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 directly 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 allows a foreign tax credit for foreign taxes paid by a foreign corporation and deemed paid by a domestic corporate shareholder only where the domestic corporation directly owns at least 10 percent of the voting stock of the distributing foreign corporation. See Rev. Rul. 85-3, 1985-1 C.B. 222. In First Chicago Corp. v. Commissioner, 96 T.C. 421 (1991), the Tax Court held that direct ownership is required for purposes of section 902 and thus the ownership of several members of an affiliated group could not be aggregated to reach the 10 percent threshold.

When Congress amended section 304(b)(2) of the Code in 1984 to clarify the characterization and sourcing rules under section 304, it indicated that the foreign tax credit should be allowed to the selling corporation "to the same extent as if the distribution had been made directly by the corporation that is treated as having made the distribution." See H.R. Rep. No. 98-861, supra. In Rev. Rul. 91- 5, 1991-1 C.B. 114, under the facts presented, it was held that the selling corporation was entitled to a section 902 credit in a section 304(a) transaction on a deemed dividend distribution from the acquiring corporation.

Under section 304 of the Code, FX is treated as having made a dividend distribution to DX. Consistent with the legislative history, DX is considered to own, for purposes of section 902(a), the stock of FX that DX owns actually or constructively under section 304(c) in determining whether DX controls FX. Therefore, DX is considered to own 100 percent of the voting stock of FX. DX may therefore compute foreign taxes deemed paid of $10x with respect to the dividend that is considered received from FX (10x foreign tax x 30x dividend/30x undistributed earnings). If DX computes foreign taxes deemed paid with respect to the dividend from FX, then DX must include the $10x in income as a dividend. See section 78.

Also, for purposes of section 902(a) of the Code, FY is treated as having made a dividend distribution to DX with respect to the FY voting stock actually owned by DX, and DX is entitled to a credit for foreign taxes deemed paid on the dividend that it is considered to receive from FY. See H.R. Rep. No. 98-861, supra. The amount of the credit computed under section 902(a) is $3.33x (10x foreign tax x 10x dividend/30x undistributed earnings). If DX computes foreign taxes deemed paid with respect to the dividend from FY, DX must include the 3.33x in income as a dividend. See section 78.

The FY stock transferred by DX is treated as having been received by FX as a capital contribution. See section 304(a)(1) of the Code. Section 367(c)(2) treats 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 80 percent of the total combined voting power of the foreign corporation as an exchange of property for stock of the foreign corporation. DX indirectly owns at least 80 percent of the total combined voting power of all classes of FX stock pursuant to section 318(a)(2)(C) and (a)(3)(C). Thus, under section 367(c)(2), DX is considered to have transferred the FY stock to FX in exchange for FX stock.

Moreover, for purposes of section 351(a) of the Code, DX is considered to own the stock owned by other members of the consolidated group of which DX is a member. Section 1.1502-34 of the Income Tax Regulations. Thus, DX is considered to "control" FX for purposes of section 351, and the contribution of the FY stock to FX qualifies as a transfer to a controlled corporation under section 351(a). 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 requirement applicable to such transfers.

HOLDING

(1) DX may compute foreign taxes deemed paid under section 902 of the Code on the dividends from FX and FY. See H.R. Rep. No. 98- 861, supra; Rev. Rul. 91-5, 1991-1 C.B. 114.

(2) DX's transfer of FY stock to FX is a section 351 exchange for purposes of section 367(c)(2) of the Code and is a transfer that is subject to section 367(a). Section 1.1502-34, Income Tax Regulations.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 91-5 is modified and amplified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Caren Silver Shein of the Office of the Associate Chief Counsel (International). For further information regarding this revenue ruling contact Ms. Shein on (202) 622-3850 (not a toll-free call).