Acquisitive companies may often find themselves with necessities of an internal restructuring after acquiring multiple entities. Many restructuring transactions involve a sale of stock, owned through one chain of corporations, to another subsidiary owned through another chain. For U.S. federal income tax purposes, this "sale" may be treated as a transaction in which the seller (or its shareholder) may receive dividend income, rather than capital gain, due to the application of Section 304.1
This article provides a general discussion of the application of Section 304, with a focus on one of two transactions described in Section 304, a brother-sister transaction.2 The application of Section 304 could take taxpayers by surprise by treating a stock sale transaction as a stock redemption transaction.
Consider the following simplified example (see Figure 1 and 2): Japanese Corporation (JP) owns directly all the stock of two US corporations (US1 and US2). For valid business reasons, JP plans to combine US1 and US2 in a parent-subsidiary relationship. JP wants to effect the combination by selling the stock of US1 to US2 for cash which is equal to its fair market value.
JP's sale of the US1 stock to US2 for cash is subject to Section 304. Section 304 prevents a taxpayer from, in effect, withdrawing earnings and profits (E&P) as capital gain and a return of basis through the use of related-party stock sales and, thus, treats such a related-party stock sale as a redemption transaction. By treating the stock sale as a redemption transaction, Section 304 treats the sales proceeds as though they were received in a distribution, which generally results in dividend income to the seller to the extent of E&P of the target (or "sold") company and the acquiring company.
The deemed redemption is treated as a distribution through a complex set of rules constructing a two-step fictional transaction (see Figure 3 and 4). First, the seller (JP) is deemed to contribute the stock of the target (US1) that was "sold" to the acquiring corporation (US2) in exchange for fictional stock of acquiring (US2) (the "Fictional Shares"). This deemed transfer generally results in nonrecognition treatment and JP takes a tax basis in the Fictional Shares equal to its basis in the US1 stock.3 In the example, the deemed transfer is an "inbound" transfer of the US1 stock (from JP to US2). As a result, US2's basis in the US1 stock will equal the lesser of the JP's basis in the US1 stock or the fair market value of that stock.4 Second, the acquiring (US2) is deemed to redeem the Fictional Shares from the seller (JP) in exchange for the cash proceeds. As a result, if US1 and US2 in aggregate have sufficient E&P (current or accumulated), the cash proceeds paid by US2 to JP for the stock of US1 are treated as dividend income to JP.
Dividend income to JP could result in a withholding tax to JP at either 30% or a reduced rate under the US-Japan Tax Treaty (unless JP satisfies the requirements to be exempt from a withholding tax under the Treaty).5 To the extent that the cash proceeds received by JP exceed the E&P of US1 and US2, the excess cash amount is treated as a return of capital and thus reduces the basis of the stock of US2 held by JP.6 The amount of cash, if any, that exceeds the basis of the stock of US2 is treated as a capital gain to JP.7 Capital gain recognized by JP, a foreign corporation without a trade or business in the US, is not taxable for US federal income tax purposes, assuming the capital gain is not taxable under the FIRPTA.8, 9
Without Section 304, JP would not have triggered any dividend income resulting in a withholding tax and have recognized only capital gain or loss on its sale of the stock of US1 to US2. Such gain or loss would have resulted in no tax to JP for US federal income tax purposes assuming JP does not have a trade or business in the US and it is not subject to FIRPTA. In this respect, JP may be adversely affected with the application of Section 304, assuming a zero withholding tax rate is inapplicable.
Section 304, in part, provides that for purposes of Section 302, if one or more persons are in "control"10of each of two corporations and, in return for property, one of the corporations acquires stock in the other corporation from the person so in control, then such property will be treated as a distribution in redemption of the stock of the corporation acquiring such stock.11 "Control" is defined to mean the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote, or at least 50 percent of the total value of shares of all classes of stock, taking into account constructive ownership of stock.
For purposes of determining "control", constructive ownership rules under Section 318(a) are applied with certain modifications.12 In cases involving a complex ownership structure, applying the constructive ownership rules to determine whether the "control" requirement is met for Section 304 serves to further complicate the analysis.
Consider the following simplified example (See Figure 5 and 6): Japanese Corporation (JP) owns directly all of the stock of another Japanese Corporation (JP1) as well as a US corporation (US1). JP1 in turn owns 100% of the stock of a US corporation, US2. For valid business reasons, JP plans to combine US1 and US2 in a parent-subsidiary relationship. JP wants to effect the combination by causing JP1 to sell the stock of US2 to US1 for cash equal to the fair market value of the stock of US2.
JP1's sale of the US2 stock to US1 for cash is subject to Section 304 because JP1 is considered to be directly or constructively in control of each of US2 and US1, and, in return for property, US1 acquires stock in US2 from JP1. JP1 is constructively in control of US1, even though it does not directly or indirectly own any US1 stock, because of the application of constructive ownership rules under Section 318(a).13
As a result, if US2 and US1 in aggregate have sufficient E&P (current or accumulated), the cash proceeds paid by US1 to JP1 for the stock of US2 are treated as dividend income to JP1. In contrast to the prior example, the seller (JP1 in this case) does not actually own any of the acquiring corporation's stock. Nevertheless, for purposes of applying a treaty exception to the 30 percent withholding tax rate, JP1 may be able to rely on the US1 stock attributed to it and obtain a lower rate.14
Finally, consider the following simplified example (see Figure 7 and 8): Japanese Corporation (JP) owns directly all of the stock of another Japanese Corporation (JP1), which owns 100% of a US corporation (US1). US1 in turn owns 100% of the stock of a Mexican subsidiary (MX1). For valid business reasons, JP plans to cause US1 to sell the MX1 stock to JP1 in exchange for cash which is equal to the fair market value of the stock of MX1.
Interestingly, US1's sale of the MX1 stock to JP1 for cash is not subject to Section 304. Generally, due to a complex set of constructive ownership rules, an upstream sale of a subsidiary's stock such as the one in this example is excluded from the application of Section 304.15,16 We recommend that a transaction which involves an intercompany sale or exchange of stock be reviewed closely prior to the transaction so that a determination of whether Section 304 applies can be made. In a situation where Section 304 applies to a transaction, there may be a potential opportunity to structure the transaction in a more tax favorable manner.
If you have any questions about this article, please contact your KPMG tax engagement team or Hiroko Kitayama (email@example.com).
1. Unless otherwise stated, all references to the "IRC§" or "Section" are to the Internal Revenue Code of 1986, as amended, and all references to the "Regulations" or to "Treas. Reg." are to the Treasury Regulations promulgated thereunder.
2. Section 304 contains complex rules and, depending on the particular facts, several other provisions, such as Section 1059 and Section 1248, may also need to be considered. A discussion of these other provisions, however, is beyond the scope of this article. Please also note that Section 304 does not apply to any acquisition of stock of a corporation in an intercompany transaction within a U.S. consolidated group under Treas. Reg. Section 1.1502-80(b).
3. Sections 351(a) and 358(a).
4. Sections 362(a) and (e)(1).
5. Article 10 of the US-Japan Income Tax Treaty.
6. Section 301(c)(2). Under current law it is unclear whether the distribution would first apply to reduce the basis in the redeemed Fictional Shares, or whether it would apply to all of JP's shares of US2 stock. Proposed regulations under Section 304, would resolve this uncertainty by treating the redemption as a distribution made pro rata with respect to each share of common stock, including the Fictional Shares, owned or deemed owned by the seller. The proposed approach treats dividend equivalent transactions, such as the one resulting from Section 304, consistent with an actual dividend distribution. It is important to note that, whichever approach applies under existing or proposed law, it is possible that distributions with respect to certain shares results in recognition of gain even while stock basis remains unrecovered in other shares.
7. Section 301(c)(3).
8. Section 881.
9. The Foreign Investment of Real Property Tax Act of 1980 (FIRPTA) generally treats all gain or loss from the sale of a U.S. real property interest as effectively connected to a U.S. trade or business under Section 897(a)(1). A U.S. real property interest includes, but is not limited to, any interest in a domestic corporation which was at any time a US real property holding corporation (defined under Section 897(c)(2)) during the 5-year period ending on the date of disposition.
10. Section 304(c).
11. Section 304(a)(1).
12. Section 318(a)(3)(C), as modified by Section 304(c)(3)(B)(ii)(I) and (II), provides that if a person owns directly or indirectly 5 percent or more in value of the stock in a corporation, such corporation shall be considered as owning the stock owned, directly or indirectly, by or for such person, however, if the person owns less than 50% in value of the stock in a corporation, the corporation is considered as owning the stock owned by such person in such proportion. Subject to certain exceptions, under Section 318(a)(5)(A) stock constructively owned by a person by reason of the application of paragraph (1), (2), (3), or (4) of Section 318(a) generally will, for purposes of applying paragraphs (1), (2), (3), and (4) of Section 318(a), be considered as actually owned by such person.
13. Section 318(a)(3)(C), as modified by Section 304(c)(3)(B)(ii)(I). As 100 percent in value of the stock in JP1 is owned directly by JP, JP1 should be considered as owning the stock of US1 owned directly by JP.
14. Revenue Ruling 92-85, 1992-2 C.B. 69. In determining the ownership requirement for reduced withholding tax rates under the US-Japan Treaty, the constructive ownership should be applied by reason of the application of Section 304. In this example, JP1 is considered to own 100% of US1 for purposes of determining the applicable withholding tax rate. Note, however, that this ruling does not address the holding period for the attributed stock, and therefore cannot be relied upon to satisfy a holding period requirement under a treaty.
15. Revenue Ruling 74-605, 1974-2 CB 97. Under this ruling, X, Y, Z and S were connected vertically through a 100% ownership chain (X owned Y, which owned Z which then owned S) and Z sold S stock to its direct parent Y. Due to the application of Sections 318(a)(2)(C) and 318(a)(3)(C), Z would be considered to be in control of both Y and S, making Section 304 applicable. However, due to the application of Section 318(a)(3)(C), if Z were treated as controlling Y, Z could also betreated as owning its own stock, which is prohibited under Treas. Reg. Section 1.318-1(b)(1). The IRS ruled that Section 304 did not apply to the purchase by Y of the S stock from Z because Z was not considered to be in control of Y within the meaning of Section 304(c)(1).
16. Even though Section 304 does not apply to this transaction, other tax rules may produce unanticipated results. For example, the capital gain recognized by US1 may be treated as dividend income to the extent of the E&P of MX1 due to the application of Section 1248. The laws of the target subsidiary's country (Mexico in this case) also should be considered to determine whether they impose any taxes on the transfer of the subsidiary.
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