Distributions by CFCs with wholly-owned foreign subsidiaries

Treas. Reg. §1.1248-1T(b) provides that distributions from a foreign corporation that are treated as gains to a Section 1248 shareholder under Section 301(c)(3) of the Internal Revenue Code (the Code) will be treated as dividends to the extent of the earnings and profits (E&P) of the distributing corporation’s controlled foreign corporation subsidiaries under Section 1248(c)(2).

Gain on sale of CFC stock

A US person who holds at least 10 percent of the stock of a controlled foreign corporation (CFC), will be considered to be a Section 1248 shareholder for US tax purposes. A CFC is defined as a foreign corporation that is owned more than 50 percent by one or more US shareholders. The definition of a US shareholder is exactly the same as that of a Section 1248 shareholder. Section 1248 requires that any gain recognized on the sale or exchange of the stock of a CFC be treated as a dividend to the Section 1248 shareholders to the extent of the E&P of the CFC. The E&P of the CFC includes any foreign subsidiaries of the CFC that would independently qualify as a CFC through indirect ownership.

For example, a US corporation (US corp.) owns all of the stock of a foreign corporation (CFC 1). Assume the US corp. has a basis of $100 in the CFC 1 stock; and CFC 1 has E&P of $500. The US corp. is treated as both a US shareholder of CFC 1 and as a Section 1248 shareholder of CFC 1, because it owns at least 10 percent of the stock of CFC 1. If the US corp. sells the stock of CFC 1 to a third party purchaser for $1,000, $500 of the $900 gain on the sale will be treated as a deemed dividend to the US corp. because the US corp. is a Section 1248 shareholder of CFC 1. The remaining $400 would be treated as a capital gain from the sale or exchange of CFC 1 stock. Section 1248(c)(2) further provides that on the sale of CFC 1 described above, any E&P of subsidiary CFCs owned by CFC 1 would also be included in the amount of the deemed dividend to the US corp.

For example, if CFC 1 also owns all of the stock of a second foreign corporation (CFC 2), and CFC 2 has E&P of $100 on the date of the sale of the stock of CFC 1, that $100 would also be included in the income of US corp. as a deemed dividend. Thus, of the $1,000 of gain realized on the sale of CFC 1 stock by the US corp., $600 ($500 of E&P attributed to CFC 1 stock and $100 of E&P attributed to CFC 2 stock) would be treated as a deemed dividend to the US corp., and $300 would be treated as a capital gain from the sale or exchange of the CFC 1 stock.

Distributions of property

Under Section 301 of the Code, a dividend is included in the gross income of the shareholder of the corporation making the distribution, to the extent of the distributing corporation’s E&P. If the fair market value of the property distributed by the corporation exceeds the E&P of the distributing corporation, the excess fair market value of the property is treated as a reduction in the shareholder’s basis in the stock of the distributing corporation. In the event that the fair market value of the property distributed exceeds both the E&P of the distributing corporation and the shareholder’s basis in the stock of the distributing corporation, Section 301(c)(3) of the Code provides that the excess amount is treated as gain from the sale or exchange of the stock of the distributing corporation.

For example, assume the same facts as above, except here the US corp. is owned 100 percent by an individual US tax resident (the US shareholder). Further assume that the US shareholder has a basis of $100 in the US corp. stock, and that the US corp. has E&P of $500. Instead of selling the stock of CFC 1, the US corp. distributes the stock of CFC 1 to the US shareholder. The fair market value of the distributed CFC1 stock is $1,000. The distribution is first treated as a dividend to the US shareholder to the extent of the E&P of the US corp., which in this case is $500. In addition, $100 of the distribution would be treated as a reduction in the US shareholder’s basis in the stock of the US corp.. Finally, applying Section 301(c)(3) of the Code, the remaining $400 of fair market value attributed to the distribution of CFC 1 stock would be treated as gain from the sale or exchange of the stock of the US corp. by the US shareholder.

Application of final regulations

The regulations finalized under Notice 2012-15 treat any gain in excess of E&P and basis of a distributing foreign corporation that qualifies as a CFC as a dividend to the extent of the E&P of any CFCs owned by the distributing foreign corporation.

For example, assume that the US corp. in the examples above is a CFC instead of a domestic company (CFC Parent) and that all the stock of CFC Parent is owned by a single US shareholder. Further assume that CFC Parent owns two foreign corporations that are also considered to be CFCs (CFC 1 and CFC 2). The fair market value of the CFC 2 stock is $1,000. CFC Parent has E&P of $500 and CFC 1 has E&P of $100. If CFC Parent distributes the stock of CFC 2 to the US shareholder of CFC Parent, the distribution will be treated: 1) as a dividend to the extent of the E&P of CFC Parent ($500); 2) as a reduction of or a return of the basis of the stock of CFC Parent held by the US shareholder ($100); and finally 3) as a sale or exchange of the stock of CFC Parent that is held by the US shareholder ($400 of capital gain). Applying the final regulations, an additional $100 representing the E&P of CFC 1 must be included in the US shareholder’s income as a dividend because of the application of Section 1248(c)(2). Application of this rule would result in the inclusion of the E&P of any of CFC Parent’s subsidiary CFCs when a distribution by CFC Parent is treated as a sale or exchange of CFC Parent’s stock. Note that there would not be any gain recognition on the distribution of the stock of CFC 2 because CFC 2 would still considered to be a CFC after the distribution to the US shareholder under the principles of Section 367(b).

These examples are only meant to provide a very basic description of how the Section 1248 rules apply in the context of distributions by a CFC. Please always consult with your Baker Tilly advisor when distributing or selling the stock of a CFC or former CFC, as there are hidden traps that can easily be avoided with proper planning.