Chief Counsel Advice
201640018
Released September 30, 2016
Advice
RIC distribution routing does not produce foreign-dividend deduction
Apply this to your situation
This page covers one taxpayer's ruling from 2016, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.
Not precedent. Under 26 U.S.C. § 6110(k)(3), this written determination may not be used or cited as precedent. It resolved one taxpayer's situation on its specific facts, and identifying details were redacted by the IRS before release. The official IRS release (linked on this page as a PDF) is the authoritative source.
About this page: The plain-English summary and ruling snapshot below were written by Ezel based on the official IRS release. The full text is the IRS's own document.
View official IRS release (PDF)
Plain-English summary
A consolidated corporate group routed investment funds and returns from a domestic regulated investment company through a controlled foreign corporation. The structure was designed to convert interest and capital-gain returns into dividends for which a domestic subsidiary claimed an 80 percent deduction under section 245. Chief Counsel advised that the deduction was unavailable because section 854 would have blocked a dividends-received deduction if the domestic subsidiary had received the RIC distributions directly. The consolidated-return anti-avoidance rule required the income to be characterized consistently with a transfer between divisions of one corporation. Chief Counsel also concluded that the routing lacked economic substance, that the foreign corporation acted as a conduit under substance-over-form and step-transaction principles, and that a group member should include the foreign corporation's subpart F income under section 951.
Ruling snapshot
- Question: Could a domestic subsidiary claim the section 245 dividends-received deduction for RIC-derived funds routed through a controlled foreign corporation?
- Outcome: Advice that the deduction was unavailable and the transaction should instead produce a section 951 inclusion.
- Key authorities: IRC §§ 243, 245, 854, 951, 1502, 7701(o); Treas. Reg. § 1.1502-13(h).
Full text (IRS public release)
Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 201640018
Release Date: 9/30/2016
CC:CORP:B05 Third Party Communication: None
POSTU-131660-15 Date of Communication: Not Applicable
UILC: 243.00-00, 301.01-07, 854.00-00, 1502.13-03, 245.00-00
date: May 23, 2016
to: Senior Counsel (Large Business & International)
from: Senior Counsel (Corporate)
subject: Application of Section 245 to the Transaction
This Chief Counsel Advice responds to your request for assistance. This document
should not be used or cited as precedent.
LEGEND
Common Parent = --------------------------------
Sub B = -----------------------------------
Sub C = ----------------------------
Sub D = ------------------------------------------
Sub E = --------------------------------------
Sub 1 = ------------------------------------
Sub 2 = ----------------------------------------
Sub 3 = ---------------------------------------------
Sub 4 = ---------------------------------------------
Sub 5 = -------------------------------
POSTU-131660-15 2
Sub 6 = -----------------------------------------------
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Sub 7 = ---------------------------
Sub 6 RIC = ------------------------------------------------
F-DE = --------------------------------------------------
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Bank 1 = -------------------------
Bank 2 = ---------------------------------------
Agency 1 = ---------------------------------------------------------------
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Agency 2 = --------------------------------------
Person 1 = ----------------------------------------
Person 2 = ---------------------------------------------------------------
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Business N = ----------------------
Business O = ----------
Document 1 = ---------------------------------------------------------------
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State S = ----------
State T = ------------
Country U = ---------------------------
Country V = ----------------
Year W = ------
Year X = ------
Year Y = ------
Year Z = ------
Year AA = ------
Year BB = ------
Date 2(W) = ---------------------------
Date 4 = ------------------
Date 5 = ------------------
Date 7(W) = --------------------------
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POSTU-131660-15 4
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Date 20(X) = ----------------
Date 22(X) = -----------------
Date 23(Y) = ---------------------
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Date 40(Y) = ---------------------
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ISSUE
Whether Sub 3 is eligible for a dividends received deduction (“DRD”) under section 245
of the Code1 (the “section 245 DRD”) with respect to the funds distributed from a
regulated investment company within the meaning of section 851 (“RIC”) to Sub 3 via
Sub 4 during Year Y?
CONCLUSION
No. Sub 3 is not eligible for the section 245 DRD with respect to the funds distributed
from the RIC to Sub 3 via Sub 4 during Year Y.
FACTS
I. Ownership Structure and Business Operations
Common Parent is a State T corporation and the common parent of an affiliated
group of corporations that file a consolidated U.S. federal income tax return (“US Group”
or “Taxpayer”). Common Parent is a publicly-traded company. Its taxable year ends
Date 4. Common Parent owns numerous entities, some of which are described in this
memorandum. US Group generally engages in Business N.
Certain members of US Group, including Sub C, engage in Business O
(collectively, the “Business O Entities”). In connection with this business, the Business
O Entities --------------------------------------------------------------------------- (“Customer Funds”),
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1
Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, title 26 of
the United States Code, as amended, and as in effect during the years at issue.
POSTU-131660-15 9
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----------------------------------------------------------------------------.
Business O is subject to regulatory requirements administered by Agency 1 and
Agency 2. Pursuant to Agency 1 regulations, the Business O Entities must invest the
Customer Funds in high-grade, domestic liquid assets (“Business O Eligible
Investments”) and cannot invest the funds in dividend-paying stock of unrelated
corporations. Accordingly, the Business O Eligible Investments generally produce
interest income, and, to a lesser extent, capital gain or loss.
Taxpayer began planning the transaction that is the subject of this memorandum
(the “Transaction”) prior to Year X. During Year X, Common Parent directly held all of
the stock of Sub B, which directly held all of the stock of Sub C, which directly held all of
the stock of Sub D, and Sub E. Sub E directly held all of the stock of Sub 1. Sub 1 held
all of the stock of Sub 2, which in turn, held all of the stock of Sub 3, which held all of
the stock of Sub 4. Sub 1, Sub 2, Sub 3, and Sub 4 were all State T corporations. Sub
4 directly held all of the membership interests in Sub 5 and Sub 6. Sub 5 and Sub 6
were State T limited liability companies that were treated as corporations for U.S.
federal income tax purposes. Sub C, Sub D, Sub E, Sub 1, Sub 2, Sub 3, Sub 4, Sub 5,
and Sub 6 were all members of US Group. See Diagram One for the pre-transaction
ownership structure at the beginning of Year W.
POSTU-131660-15 10
Diagram One Diagram Two
Common Common
Parent Parent
Sub B Sub B
Sub C Sub C
Sub D Sub E Sub D Sub E
Sub 1 Sub 1
Sub 2 Sub 2
Sub 3 Sub 3
Sub 4
Sub 4 Country U
Sub 5 F-DE
Sub 5 Sub 6 RIC
Country U Country U
Sub 6 RIC
In furtherance of the Transaction, Common Parent caused certain US Group
members to deconsolidate from US Group. Specifically, Sub 4 and Sub 5 re-domiciled
into Country U and Sub 6 became a RIC. See Diagram Two.
II. Taxpayer’s Planning of the Transaction
A. Intent of the Transaction
POSTU-131660-15 11
Common Parent planned the Transaction with the stated principal goal of
increasing US Group’s after-tax return on the Business O Eligible Investments by
claiming an 80 percent DRD with respect to income attributable to the interest and
capital gain derived from the investments. As reflected in its planning documents,
Taxpayer calculated that the post-Transaction yield on the investments would be 130
percent of the pre-Transaction yield,2 with the increased yield due to a decrease in
Taxpayer’s U.S. federal income tax liability. The Transaction would result in a better
after-tax return only if the DRD were allowed; if the DRD were not allowed, Taxpayer’s
after-tax return would decrease because of the costs associated with the Transaction.3
B. Taxpayer’s Expected U.S. Federal Income Tax Treatment of Transaction
Prior to commencing the Transaction, Taxpayer anticipated the treatment of the
Transaction for U.S. federal income tax purposes as follows:
1. Sub 6 (hereinafter referred to as “Sub 6 RIC” during the period after its
conversion to a RIC) would not pay U.S. federal income tax. Sub 6 RIC
would invest in Business O Eligible Investments (similar to investments
purchased by US Group in years prior to Year X) and make distributions to its
sole shareholder, Sub 4, during Year Y.4 Thus, Sub 6 RIC would not pay
U.S. federal income tax on its interest or capital gain income because its
income would be offset by a dividends paid deduction (“DPD”). Sections
852(b)(2)(D)5 and 852(b)(3)(A).6
2. Sub 4 would not pay U.S. federal income tax. Sub 4 would not be subject to
U.S. federal income tax on the distributions that it received from Sub 6 RIC,
and Sub 6 RIC would not be required to withhold tax on its distributions to
Sub 4 during Year Y. Sections 871(k) and 881(e).7
2
Document 2.
3
Id.
4
Pursuant to the Transaction, the taxpayer interposed F-DE, a foreign entity that was disregarded as an
entity separate from its owner for U.S. federal income tax purposes, between Sub 4 and Sub 6 RIC.
5
When a RIC meets certain requirements, section 852(b)(2)(D) allows the RIC a deduction in computing
its investment company taxable income for dividends paid (as defined in section 561), but the amount of
dividends with respect to which the deduction applies is computed without regard to capital gain dividends
and exempt-interest dividends. Net capital gains are separately excluded from the definition of
investment company taxable income. Section 852(b)(2)(A).
6
Section 852(b)(3)(A) imposes on a RIC a tax, determined as provided in section 1201(a), on the excess,
if any, of the net capital gain over the deduction for dividends paid (as defined in section 561) determined
with reference to capital gain dividends only.
7
Section 881(a) generally imposes a 30 percent tax on certain income received from sources within the
United States by a foreign corporation, unless otherwise excepted. Except as otherwise provided, section
POSTU-131660-15 12
3. Sub 3 would not pay U.S. federal income tax. Sub 3 would not have an
inclusion under section 951(a)(1) (a “section 951 inclusion”) with respect to
Sub 4 as a result of the distributions from Sub 6 RIC.8 The Sub 6 RIC
distributions received by Sub 4 would constitute foreign personal holding
company income (within the meaning of section 954(c)) and, thus, would be
subpart F income (within the meaning of section 952(a)). However, Sub 3
would not have a section 951 inclusion with respect to Sub 4 in Year Y
because Sub 3 would dispose of its Sub 4 stock before the close of Sub 4’s
taxable year ending in Year Y and Sub 4 would remain a CFC after the
disposition. Section 951(a)(1).
4. Sub 2 would pay, at most, a small amount of U.S. federal income tax. Sub 2
would have a section 951 inclusion with respect to Sub 4 in Year Y because
Sub 2 would hold all of the stock of Sub 4 on the last day of Sub 4’s taxable
year. However, Sub 2’s pro rata share of Sub 4’s subpart F income would be
reduced by the amount of Sub 4’s distribution to Sub 3 during Year Y.
Section 951(a)(2)(B).
5. Sub 3 would claim an 80 percent DRD. Sub 4 would distribute the amounts
that it received from Sub 6 RIC to Sub 3 during Year Y before Sub 3 disposed
of its Sub 4 stock. Sub 3 would include the distribution in income as a
dividend, and treat the entire amount as a U.S.-source dividend for purposes
of section 245. Thus, Sub 3 would offset the dividend income with an 80
percent DRD. Sections 245(a) and 861(a)(2)(B).
6. Sub 4 would change its taxable year at the outset of the Transaction so that
its taxable year would differ from US Group’s taxable year.
7. In Date 15(X) and Year Y, Sub 6 RIC would distribute its Year X and Year Y
income to Sub 4, and, in turn, Sub 4 would distribute the funds to Sub 3.
Thus, by changing Sub 4’s taxable year to a year different from US Group’s
taxable year, US Group would be able to defer including the income
attributable to Sub 6 RIC’s Year X earnings in US Group’s income until Year
Y.9
881(e) provides an exception to the tax imposed by section 881(a) for any interest-related dividend (as
defined in section 871(k)) from a RIC.
8
If a foreign corporation is a controlled foreign corporation (“CFC”) for an uninterrupted period of 30 days
or more during any taxable year, section 951(a) generally imposes a tax on every person who is a U.S.
shareholder (as defined in section 951(b)) of such corporation and who owns (within the meaning of
section 958(a)) stock in such corporation on the last day, in such year, on which such corporation is a
CFC.
9
The propriety of US Group’s deferral of tax on income attributable to Business O Eligible Investments by
investing through a captive RIC rather than making these investments directly is beyond the scope of this
memorandum, and no inference should be drawn as to the U.S. federal income tax treatment of that
POSTU-131660-15 13
III. Transaction Steps
After preliminary restructuring steps,10 US Group undertook the following steps in
connection with the Transaction:
1. On Date 9(W), Sub 6 changed its name. In anticipation of becoming a RIC, Sub
6 sold all of its assets prior to Date 11(W), so that it only held cash on Date
11(W).11
2. Effective Date 11(W), Sub 4 and Sub 5 converted from State T corporations to
Country U corporations, thereby deconsolidating from US Group. On Date
11(W), Sub 5 had approximately $b of investments.
3. On Date 11(W), Sub 4 formed F-DE, a wholly-owned Country U subsidiary, which
made an election to be disregarded as an entity separate from Sub 4 for U.S.
federal income tax purposes effective as of the date of its formation. Sub 4
contributed all of its Sub 6 shares to F-DE.
4. On Date 11(W), Sub 6 registered as an investment company under the
Investment Company Act of 1940 (“Investment Company”). Effective Date 13(X),
Sub 6 elected to be taxed as a RIC for its Year X taxable year.
5. Effective Date 13(X), Sub 4 and Sub 5 each changed its taxable year end to Date
5 from Date 4.
6. On Date 18(X), Sub 1 directly wired $d to Sub 6 RIC. Common Parent treated
this transfer, in relevant part, as a contribution of $d by Sub 3 to Sub 4, and then
by Sub 4 (through F-DE) to Sub 6 RIC. (Common Parent stated that due to
internal control restrictions, Sub 1 directly wired the cash to Sub 6 RIC’s deposit
account at Bank 2. Common Parent reflected its treatment of the contributions
through accounting entries.)
7. On Date 20(X), Sub 6 RIC entered into an agreement with Bank 1, authorizing
Bank 1 to act as placement agent for the private sale of Sub 6 RIC notes due in
Year Y, one year from issuance. On Date 22(X), Sub 6 RIC issued notes with a
aspect of the Transaction, or any other aspect of the Transaction not addressed in this memorandum.
10
As part of the preliminary restructuring, on Date 7(W), Sub 4 (while still a member of US Group)
distributed its entire interest in Sub 7 to Sub 3. Effective on Date 7(W), Sub 7 elected to be disregarded
as an entity separate from its owner for U.S. federal income tax purposes.
11
Sub 6 held $e on Date 11(W).
POSTU-131660-15 14
principal amount of approximately $e. Taxpayer directed Bank 1 to issue Sub 6
RIC’s notes to more than 100 investors, at least one of which was not a “qualified
purchaser.”12 Sub 6 RIC paid Bank 1 $f for the placement of the notes.
8. During Year Y, one or more members of US Group transferred an additional $q to
Sub 6 RIC in a transaction that Common Parent treated, in relevant part, as a
contribution of $q by Sub 3 to Sub 4, and then by Sub 4 (through F-DE) to
Sub 6 RIC.
9. During Year X, Sub 6 RIC purchased Business O Eligible Investments. [During
Year X, Sub 6 RIC derived interest income and capital gains from the
investments in the amount of $p. During Year Y, Sub 6 RIC derived interest
income and capital gains from the investments in the amount of $y.]
10. During Year Y, Sub 6 RIC distributed $k to Sub 4 as follows:
Date Amount
Date 30(Y) $h13
Date 40(Y) $l14
Date 50(Y) $m
Date 60(Y) $o
11. During Year Y, Sub 4 distributed $aa, an amount in excess of $k, to Sub 3 as
follows:
Date 23(Y) $bb
Date 45(Y) $cc
Date 55(Y) $dd
12. On Date 57(Y), Sub 3 distributed all of its shares in Sub 4 to Sub 2.
12
Taxpayer caused the notes to be issued in this manner in order to treat Sub 6 RIC as an Investment
Company, which requires Sub 6 RIC to register with the U.S. Securities and Exchange Commission
(“SEC”) as an Investment Company.
13
Taxpayer takes the position that the dividend of $h paid on Date 30(Y) was a “time certain” dividend
deemed to have been paid on December 31 of Year X for purposes of Sub 6 RIC’s DPD. Sub 6 RIC
declared the dividend on Date 14(X).
14
Taxpayer treated the dividend of $l paid on Date 40(Y) as having been paid in Year X for purposes of
Sub 6 RIC’s DPD. Section 855(a). For tax years beginning before December 22, 2010, a dividend to
which a RIC elects to apply section 855(a) must be declared by the due date of the RIC’s return (with
extensions), and paid within 12 months.
POSTU-131660-15 15
IV. Taxpayer’s Treatment of the Transaction
A. Sub 6 RIC
Sub 6 RIC reported income and deductions related to the Transaction for Year X
and Year Y as follows:
(i) Year X. On its U.S. federal income tax return for its Year X taxable year,
Sub 6 RIC reported income as follows:
Ordinary income (net of expenses): $r15
Long and short-term capital gains: $s16
_____________
Total taxable income before DPD: $p
Sub 6 RIC deducted $p as a DPD for its Year X taxable year, but did not
distribute any of the amount until Year Y.17 Sub 6 RIC made two distributions during
Year Y totaling $p, which RIC treated as having been paid during Year X for purposes
of Sub 6 RIC’s DPD.
(ii) Year Y. On its U.S. federal income tax return for its Year Y taxable year,
Sub 6 RIC reported income as follows:
Ordinary income (net of expenses): $w18
Long and short-term capital gains: $x19
______________
Total taxable income before DPD: $y
15
Sub 6 RIC reported $u of interest income and $t of dividends on its Year X Form 1120-RIC.
16
Sub 6 RIC reported $ v in short term capital gain on its Year X Form 1120-RIC.
17
Sub 6 RIC distributed only a separate amount, $g, to Sub 4 in Year X. In one document, it
characterized this distribution as a return of capital. In another, it stated that this amount constituted a
dividend of Sub 6’s undistributed income for the period Date 11(W) through Date 12(W), a period prior to
Sub 6 becoming a RIC. Common Parent reported that the distribution qualified for an 80 percent DRD.
The amounts used in this memorandum are taken from several different documents. Any discrepancies
between the amounts of the distributions as stated in this memorandum and Taxpayer’s tax filings do not
impact the legal analysis in this memorandum.
18
Sub 6 RIC reported $ss of interest income and $tt in dividends on its Year Y Form 1120-RIC.
19
Sub 6 RIC reported $uu of gain offset by capital loss of $vv on its Year Y Form 1120-RIC.
POSTU-131660-15 16
Sub 6 RIC deducted $y as a DPD for its Year Y taxable year.
B. US Group
On the US Group’s amended Form 1120X for taxable year Year Y, Common
Parent reported that Sub 3 had U.S.-source dividend income of $ee, which was reduced
by an 80 percent DRD of $ii. This deduction gave rise to a tax savings of $jj. The Form
1120 also reported a section 951 inclusion for Sub 2 but did not report a section 951
inclusion for Sub 3. Common Parent asserts that Sub 3 did not have a section 951
inclusion with respect to Sub 4 because it did not hold any Sub 4 stock on the last day
of Sub 4’s Year Y taxable year. In addition, Common Parent takes the position that Sub
2 was able to reduce the amount of its section 951 inclusion with respect to Sub 4 by
the amount of Sub 4’s distributions to Sub 3 during Year Y.
V. Additional Facts
A. Taxpayer’s Asserted Business Purpose for the Transaction
Common Parent maintains that the predominant purpose for creating and
implementing the Transaction was to invest in, and earn a return on, investment
securities. In addition, Common Parent states that one of its objectives was to reduce
expenses relating to the investment, including tax expenses. Thus, Common Parent
states that it used “tax planning” to reduce its expenses.
B. Sub 6 RIC
Common Parent asserts that Sub 6 RIC is properly treated as a RIC under the
Code. Common Parent notes that a RIC offers advantages over non-RIC investment
entities: (i) a RIC receives preferable tax treatment under the Code relative to a
non-RIC corporation provided it distributes nearly all of its earnings annually; and (ii)
certain investors that are concerned about misinformation and fraud are more likely to
invest in a RIC than a non-RIC because a RIC is subject to SEC oversight.
Sub 6 RIC did not have any employees. Sub D, a member of US Group and a
registered investment advisor, acted under an asset management agreement as the
investment advisor to Sub 6 RIC. Sub D directed Sub 6 RIC’s investment portfolio in
accordance with the guidelines for certain of US Group’s investments, as it did for other
members of US Group. Bank 2 provided accounting, custody, and transfer agent
services to Sub 6 RIC.
Common Parent indirectly maintained beneficial ownership and complete control
of Sub 6 RIC. Although at least two of Sub 6 RIC’s directors were required to be
independent, Common Parent, through Sub 4, had the right to remove the directors.
POSTU-131660-15 17
The information memorandum provided to prospective Sub 6 RIC note holders stated
that: Quote 7.20
As evidenced by its accounting practices, US Group did not derive the customary
benefits of using a RIC, such as pooling of funds and obtaining the Investment
Company’s professional investment management services. Under generally accepted
accounting principles (“GAAP”), a RIC generally is required to file audited financial
statements on a stand-alone basis with the SEC. However, Common Parent
determined that it was not required to use the specialized accounting required for an
Investment Company, and, instead, consolidated Sub 6 RIC’s financials with those of
US Group on Common Parent’s financial statements.21 Common Parent based this
decision on the definition of an investment company for GAAP purposes as an “entity
that pools shareholders’ funds to provide the shareholders with professional
management.” Common Parent concluded that Sub 6 RIC did not meet the definition of
an Investment Company under GAAP because Quote 8.22
Sub 6 RIC elected to be disregarded as an entity separate from its owner for U.S.
federal income tax purposes effective Date 100(BB), and filed a final U.S. federal
income tax return for its year ended Date 90(BB). In addition, Sub 6 RIC filed Form N-
8F with the SEC to deregister its status as a RIC on Date 110(BB).
C. Sub 4
Taxpayer’s planning Document 1 states that Sub 4, Sub 5, and F-DE would
conduct all of their operations in the United States and that their only contacts with
Country U would be to satisfy certain statutory requirements (e.g., maintaining a
registered office/agent). For all other purposes, these entities would do business only in
the United States and would maintain their books and records in the United States.23
Common Parent provided the following reasons for causing Sub 4 to become a
Country U corporation:
1. For a variety of political, regulatory, and tax reasons, it is easier and cheaper to
attract investment capital from non-U.S. investors for certain types of investments by
using an entity organized in Country U rather than in the United States.
20
When entities act as a group, as defined in Section 13(d)(3) of the Securities and Exchange Act, they
are required to separately file a Schedule 13D pursuant to Rule 13d-1. The following entities filed as
“group members” and each was designated as a beneficial owner of all of the RIC shares: Sub 4, Sub 3,
Sub 1, Common Parent, Sub B, and Sub C.
21
See Document 3.
22
Id. at p. 10.
23
Document 1 at p. 11.
POSTU-131660-15 18
2. An investment in Country U may be viewed more favorably by some non-U.S.
investors because the investors would not be subject to withholding tax on interest
payments made by an entity formed in Country U but would be subject to U.S.
federal withholding tax if they invested in debt of U.S. entities.
3. Non-U.S. investors, who often invest funds obtained from international sources, may
prefer to invest relatively less in the United States and relatively more in other
jurisdictions for political and reputational reasons. Common Parent states that, in
previous transactions, non-U.S. investors have specifically requested that Common
Parent use a foreign subsidiary for these reasons.
4. Non-U.S. investors prefer to invest in an entity formed in Country U rather than the
United States because they would be treated more favorably if Common Parent
declared bankruptcy. For example, if Common Parent declared bankruptcy in the
United States, Common Parent’s creditors in the United States would have more
difficulty reaching the assets of a subsidiary in Country U than reaching the assets of
a domestic subsidiary.
5. Another significant benefit of having a subsidiary in Country U instead of State T is
that the government of Country U provided a “binding undertaking” that any entities
formed by the US Group in Country U would not be taxed by Country U for at least
20 years. State T did not offer similar tax relief.
D. Taxpayer Noted Disadvantages of the Transaction
Common Parent’s planning documents for the Transaction noted that the
Transaction structure had several disadvantages:
1. The assets of Sub 6 RIC could not be pledged;
2. In the event that Sub 6 RIC’s assets were sold at a loss, the losses would not
pass through to the Sub 6 RIC shareholders;
3. If the Transaction was successfully challenged by the Internal Revenue
Service (IRS), the Taxpayer’s investment return would be lower than if it had
not engaged in the Transaction, due to the costs of the Transaction; and
4. The Transaction would create a risk to Common Parent’s reputation due to
adverse publicity for engaging in “tax arbitrage.”
E. Taxpayer’s Correspondence with Agency 1
As noted above, Sub C is engaged in Business O, is subject to Agency 1’s rules,
and must invest only in Business O Eligible Investments. Under Agency 1’s guidelines,
Sub 4 and Sub 6 RIC only could make investments that Sub C could make directly.
POSTU-131660-15 19
Taxpayer maintained that it did not need formal approval from Agency 1 to
implement the Transaction because Sub 6 RIC would hold only Business O Eligible
Investments and Common Parent had received prior approval from Agency 1 to
establish operating subsidiaries to hold the assets. Nonetheless, in Year W, prior to
engaging in the Transaction, Common Parent informed Agency 1 that Sub 6 RIC would
not be Quote 1 and asked for a determination that Quote 2.24
In seeking assurances from Agency 1, Taxpayer told Agency 1 that Sub C
planned to make an indirect investment in a closed-end diversified fund that would
principally hold Quote 4. At the time of the communication, Sub C planned to make the
RIC investment through an entity organized in Country V that was treated as a pass-
through entity for U.S. federal income tax purposes.25 Taxpayer assured Agency 1 that
the Country V entity would limit its activities to holding the RIC shares, which Sub C was
permitted to hold directly.26 In a follow-up communication, Common Parent informed
Agency 1 that it changed the transaction structure, stating that: Quote 5.
Taxpayer told Agency 1 that Sub 4’s principal office would be located at Address
1 in State S, and that all of its activities would be in the United States. Further,
Taxpayer stated that all of Sub 4’s officers and directors would be United States
residents and employees of Common Parent, a U.S.-based affiliate of Common Parent,
or another domestic entity. Sub 4’s only contact with Country U, other than its
incorporation and appointment of a resident agent, would be annual meetings held in
Country U, which could be carried out by proxy granted to the resident agent. Common
Parent further noted that Sub 4’s annual meetings could be limited to the authorization
of a one page filing required by Country U law. Moreover, Common Parent would
indirectly provide funds to Sub 6 RIC on behalf of Sub 4. Although Sub 4 did not
receive funds, because they were wired directly from a member of US Group to Sub 6
RIC, Taxpayer advised Agency 1 that Sub 4’s use of the funds was limited to
purchasing interests in F-DE, which would, in turn, purchase interests in Sub 6 RIC.
Sub 6 RIC’s use of the funds was limited to acquiring Business O Eligible Investments.
F. Taxpayer’s Transaction Costs
Common Parent incurred significant costs in connection with the Transaction,
including planning costs, and costs for setting up the Transaction structure and
maintaining Sub 6 RIC. Common Parent estimated that an initial investment in Sub 6
RIC of $ff, with a minimum investment by Sub 6 RIC in Business O Eligible Assets of
24
Date 2(W) e-mail from Person 2, of Common Parent, to Person 1, of Agency 1.
25
Id.
26
Id. This e-mail states that Sub C would Quote 3.
POSTU-131660-15 20
$gg, was necessary in order for the U.S. federal income tax savings to be greater than
the costs of implementing and maintaining the Transaction structure. In Year X, the
cost to register and maintain Sub 6 RIC was $mm, and the amount of a payment to
Bank 1 in connection with Sub 6 RIC’s note issuance was $kk. In Year X, Sub 6 RIC
claimed expenses of $hh (including $oo in interest to noteholders). In Year Y, Sub 6
RIC claimed expenses of $pp (including $qq in interest to noteholders).
G. Taxpayer’s Potential Claims for the DRD in Subsequent Tax Years
On Date 65(Y) and Date 72(Z), Sub 6 RIC made distributions to Sub 4, the total
of which was $ww. Taxpayer reported this amount in income under Section 951.
On Date 75(Z) and Date 80(AA), Sub 6 RIC made distributions to Sub 4, the total
of which was $yy.
Prior to the end of Sub 4’s Year AA tax year, Sub 2 distributed the stock of Sub 4
to Sub 1. Taxpayer reported that Sub 2 received dividends from Sub 4 in Year AA and
reported the U.S. source portion was $zz. It is our understanding that Taxpayer intends
to have Sub 2 claim an 80 percent DRD of $aaa at a future date. This deduction would
result in a tax savings of $bbb.
On Date 85(BB) and Date 90(BB), Sub 6 RIC made distributions to Sub 4, the
total of which was $ccc.
Prior to the end of Sub 4’s Year BB tax year, Sub 1 distributed the stock of Sub 4
to Sub E. Taxpayer reported that Sub 1 received dividends from Sub 4 in Year BB and
reported the U.S. source portion was $ddd. It is our understanding that Taxpayer
intends to have Sub 1 claim an 80 percent DRD of $ eee at a future date. This
deduction would result in a tax savings of $ fff.
Adding the amounts for Years AA and BB to the amounts for Year Y, discussed
above, Taxpayer’s claim and potential future claims from this transaction give rise to an
aggregate DRD of $ggg and an aggregate tax savings of $hhh.
TAXPAYER’S POSITION
Taxpayer asserts that its U.S. federal income tax reporting position is consistent
with the form of the Transaction and the literal language of the Code. Taxpayer states
that its business purpose for the Transaction was to maximize the return on its
investments. As discussed in greater detail in the FACTS section of this memorandum,
Taxpayer maintains that it used Sub 4, an entity formed under the laws of Country U, in
the Transaction in order to attract non-U.S. investors and because Country U agreed
not to tax any entities formed in Country U for a twenty-year period.
LAW AND ANALYSIS
POSTU-131660-15 21
I. Statute
Section 245 allows a corporation a DRD on dividends received from a qualified
foreign corporation. Section 316(a)(1) generally defines the term “dividend” as any
distribution of property (as defined in section 317) made by a corporation to its
shareholders out of earnings and profits (“E&P”). Treas. Reg. § 1.312-6(b) provides
that income exempted from taxation by statute is included in E&P. Sub 4 increased its
E&P by the amount of the distributions it received from Sub 6 RIC. Taxpayer argues
that Sub 4’s distributions to Sub 3 were dividends within the meaning of section 316(a)
because the distributions were made out of E&P accumulated after February 28, 1913,
or out of the current taxable year, and asserts that the dividends qualify for the section
245 DRD.
Section 245(a)(1) limits the amount of the section 245 deduction to an “amount
equal to the percent (specified in section 243 for the taxable year) of the U.S. source
portion of such dividends.” The “U.S. source portion” of any dividend is any amount
which bears the same ratio to such dividends as the post-1986 undistributed U.S.
earnings bears to the total post-1986 undistributed earnings.27 Section 245(a)(3).
During the years that Taxpayer engaged in the Transaction, section 245 did not
contain an explicit limitation that would have prevented distributions from a RIC from
being taken into account in determining the “U.S.-source portion” of a dividend paid by a
“qualified 10-percent owned foreign corporation.” Section 326 of the Protecting
Americans from Tax Hikes Act of 2015 (Public Law 114-113, 129 Stat. 2242) (the
“PATH Act”) added section 245(a)(12) to provide that, with respect to dividends
received on or after December 18, 2015, for purposes of the definition of post-1986
undistributed U.S. earnings in section 245(a)(5)(B), a domestic corporation does not
include a RIC or a real estate investment trust. Accordingly, distributions from Sub 4
attributable to distributions from Sub 6 RIC explicitly would not be eligible for the section
245 DRD under the revised statute. Consistent with the indication in section 326(c) of
the PATH Act, the Joint Committee on Taxation states that, “[n]o inference is intended
with respect to the proper treatment under section 245 of dividends received from RICs
or REITs before such date.”28
27
Section 245(a)(4) defines the term “post-1986 undistributed earnings” as having the same meaning
given to such term by section 902(c). Section 902(c) defines the term as “the amount of earnings and
profits of the foreign corporation (computed in accordance with sections 964(a) and 986) accumulated in
taxable years beginning after December 31, 1986 – (A) as of the close of the taxable year of the foreign
corporation in which the dividend is distributed, and (B) without diminution by reason of dividends
distributed during such taxable year.” Section 964(a) provides that the earnings and profits of a foreign
corporation are calculated according to rules substantially similar to those applying to domestic
corporations except as otherwise provided.
28
Technical Explanation of the Protecting Americans from Tax Hikes Act of 2015, House Amendment #2.
POSTU-131660-15 22
Section 245(a)(5) limits the definition of “post-1986 undistributed U.S. earnings”
to:
(A) income of the … foreign corporation which is effectively connected with
the conduct of a trade or business within the United States and is subject
to tax under this chapter, or
(B) any dividend received (directly or through a wholly-owned foreign
corporation) from a domestic corporation at least 80 percent of the stock
of which (by vote and value) is owned (directly or through such wholly
owned foreign corporation) by the qualified 10-percent owned foreign
corporation.
The funds that Sub 4 received from Sub 6 RIC are not “post-1986 undistributed
U.S. earnings” within the meaning of section 245(a)(5)(A) because Sub 4 did not have
income that was effectively connected with the conduct of a trade or business within the
United States, and subject to U.S. federal income tax.29
Pursuant to section 245(a)(5)(B), “post-1986 undistributed U.S. earnings”
includes a “dividend” received from a domestic corporation. Section 854(a) states that a
capital gain dividend received from a RIC “shall not be considered a dividend” for
purposes of determining whether a shareholder is entitled to the DRD under section
243.30
Section 854(b)(1) applies to distributions from a RIC other than those to which
section 854(a) applies. It states that in computing any deduction under section 243,
there shall be taken into account only the portion of such dividend reported by the RIC
as eligible for such deduction in written statements furnished to its shareholders.
The shareholder of a RIC is only eligible for the section 243 DRD with respect to
29
Moreover, Sub 4 did not have fixed or determinable annual or periodic income that was subject to tax.
Section 881(a)(1) generally imposes a 30 percent flat tax on, among other things, interest and dividends.
Under Taxpayer’s analysis, neither Sub 6 RIC nor Sub 4 was subject to U.S. federal income tax on the
interest generated by the Business O Eligible Investments or income attributable thereto, because Sub 6
RIC distributed amounts attributable to the interest to Sub 4, and Sub 4 treated the distribution as exempt
from tax under sections 881(e)(1)(A) and 871(k)(1)(A). Similarly, under Taxpayer’s analysis, neither Sub
6 RIC nor Sub 4 were subject to U.S. federal income tax on any short-term capital gain generated by the
Business O Eligible Investments or income attributable thereto because Sub 6 RIC distributed amounts
attributable to the gain and Sub 4 treated the distribution as exempt from tax under sections 881(e)(2)
and 871(k)(2). However, any capital gain dividend other than a short-term capital gain dividend, although
not effectively connected with a U.S. trade or business, would be subject to tax under section 881(a).
30
Under section 243, certain taxpayers are allowed a deduction for certain dividends received from a
domestic corporation.
POSTU-131660-15 23
those distributions that are designated by the RIC as dividends eligible for such a
deduction. The amount that a RIC designates for a taxable year generally cannot
exceed the amount of dividends the RIC receives from domestic corporations that would
be eligible for the DRD if RICs were permitted to claim the DRD. Sub 6 RIC generally
held only debt instruments and its income therefore consisted of interest and capital
gain rather than dividends.
Sub 6 RIC did not issue a statement to Sub 4 that qualified any of the Sub 6 RIC
distributions as dividends eligible for a DRD. Accordingly, Sub 4 could not claim a
section 243 DRD with respect to Sub 6 RIC’s distributions due to the application of
sections 854(a) and (b). If Sub 3 had directly held the Sub 6 RIC shares, it could not
have claimed the section 243 DRD either. Because Sub 3 would have been precluded
from claiming a DRD under section 243 on direct distributions from Sub 6 RIC,
Taxpayer inserted a foreign corporation between Sub 3 and Sub 6 RIC in order to claim
a DRD under section 245 with respect to dividends attributable to the Sub 6 RIC
distributions. Section 854 does not discuss whether or not RIC distributions are to be
taken into account in calculating the amount of dividends eligible for the DRD under
section 245.
Although the Sub 6 RIC distributions to Sub 4 are not “dividends” eligible for the
DRD under section 243, Sub 4 treats them as “dividends” received from a domestic
corporation in calculating Sub 4’s post-1986 undistributed U.S. earnings for the purpose
of section 245(a)(5)(B). Under Taxpayer’s position, even though a member of US
Group would not have been able to claim a DRD with respect to the interest income and
capital gain derived on the Business O Eligible Investments if it had received it directly,
and likewise would not have been able to claim a DRD if it had received distributions
from Sub 6 RIC attributable to such income, distributions attributable to such income are
dividends eligible for the 80 percent section 245 DRD if funneled through Sub 4.
II. Section 1502 and Treas. Reg. § 1.1502-13(h)
A. Statute and Regulation
Congress enacted the consolidated return regime to levy tax according to the
true net income and invested capital of a single business enterprise, even though the
business is operated through more than one corporation.31 Article 631 of Treas. Reg.
31
See Atlantic City Elec. Co. v. Comm’r, 288 U.S. 152 (1933) (citing Art. 631 of Treas. Reg. No. 45). See
also, S. Rep. No. 960, at 14 (1928), which states “[t]he permission to file consolidated returns by affiliated
corporations merely recognizes the business entity as distinguished from the legal corporate entity of the
business enterprise. The mere fact that by legal fiction several corporations owned by the same
stockholders are separate entities should not obscure the fact that they are in reality one and the same
POSTU-131660-15 24
No. 4532 states in pertinent part:
[w]here one corporation owns the capital stock of another corporation or
corporations, or where the stock of two or more corporations is owned by the
same interests, a situation results which is closely analogous to that of a
business maintaining one or more branch establishments. In the latter case,
because of the direct ownership of the property, the invested capital and net
income of the branch form a part of the invested capital and net income of the
entire organization. When such branches are owned and controlled through the
medium of separate corporations, it is necessary to require a consolidated return
in order that the invested capital and net income of the entire group may be
accurately determined. Otherwise opportunity would be afforded for the evasion
of taxation by the shifting of income through price fixing, charges for services and
other means by which income could be arbitrarily assigned to one or another unit
of the group. In other cases without a consolidated return excessive taxation
might be imposed as a result of purely artificial conditions existing between
corporations within a controlled group.
Congress’ concern about corporate taxpayers avoiding tax also is evidenced in
section 1502, in which Congress grants authority to the Secretary to:
prescribe such regulations as he may deem necessary in order that the tax
liability of any affiliated group of corporations making a consolidated return and of
each corporation in the group, both during and after the period of affiliation, may
be returned, determined, computed, assessed, collected, and adjusted, in such
manner as clearly to reflect the income tax liability and the various factors
necessary for the determination of such liability, and in order to prevent
avoidance of such tax liability. In carrying out the preceding sentence, the
Secretary may prescribe rules that are different from the provisions of chapter 1
that would apply if such corporations filed separate returns.
A legislative regulation is “issued under a specific grant of authority to prescribe a
method of executing a statutory provision.”33 The Supreme Court explained that the
power of an administrative agency to administer a congressionally created program
business owned by the same individuals and operated as a unit… Much of the misapprehension about
consolidated returns will be removed when it is realized that it is only when the corporations are really but
one corporation that the permission to file consolidated returns is given, and that no ultimate advantage in
the tax laws really results.”
32
Regulations relating to the Income Tax and War Profits and Excess Profits Tax under the Revenue Act
of 1918.
33
Dresser Indus. v. Comm’r, 911 F.2d 1128, 1137 (5th Cir. 1990) (internal quotations and citations
omitted).
POSTU-131660-15 25
“‘necessarily requires the formulation of policy and the making of rules to fill any gap
left, implicitly or explicitly, by Congress.’”34 When Congress explicitly leaves a gap for
the agency to fill, there is an express delegation of authority to the agency to elucidate a
specific provision of the statute by regulation. These legislative regulations are given
controlling weight unless they are arbitrary, capricious, or manifestly contrary to the
statute.
The Supreme Court stated that it has “long recognized that considerable weight
should be accorded to an executive department’s construction of a statutory scheme it
is entrusted to administer, and the principle of deference to administrative
interpretations has been consistently followed by this Court.”35 Congress explicitly left a
large gap for the IRS and the Department of the Treasury to fill by regulation in order to
administer the consolidated return regime, and granted explicit authority in section 1502
for the Secretary to issue regulations to prevent tax avoidance.
B. Intercompany Transactions
Treas. Reg. § 1.1502-13 provides rules for taking into account items of income,
gain, deduction, and loss of members derived from intercompany transactions. The
purpose of these rules is to “clearly reflect the taxable income (and tax liability) of the
group as a whole by preventing intercompany transactions from creating, accelerating,
avoiding or deferring consolidated taxable income (or consolidated tax liability).”
An “intercompany transaction” is a transaction between corporations that are
members of the same consolidated group immediately after the transaction. Treas.
Reg. § 1.1502-13(b)(1)(i). “S” is the member transferring property or providing services
and “B” is the member receiving the property or services. Intercompany transactions
include distributions by S to its shareholder, B. In the Transaction, Sub 3’s distribution
of its Sub 4 stock to Sub 2 is an intercompany transaction. Sub 3 is the member
transferring property and Sub 2 is the member receiving property.
Treas. Reg. § 1.1502-13(b)(2) defines “intercompany items” to include, generally,
S’s income, gain, deduction, and loss from an intercompany transaction. Thus, Sub 3’s
gain, if any, from the distribution of its Sub 4 stock to Sub 2 would be its intercompany
gain.
Treas. Reg. § 1.1502-13(b)(2) further provides that “[a]n item is an intercompany
item whether it is directly or indirectly from an intercompany transaction.” Taxpayer
maintains that Sub 3 changed the character of the income derived from Sub 4 from an
34
Chevron, U.S. A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 843-44 (1984)
(quoting Morton v. Ruiz, 415 U.S. 199, 231 (1974)).
35
Id. at 844 (citations omitted).
POSTU-131660-15 26
amount required to be included in income pursuant to section 951 to a dividend that
qualifies for the section 245 DRD because Sub 3 transferred its Sub 4 stock to Sub 2
before the end of Sub 4’s taxable year. Accordingly, although it is not a change with
respect to Sub 3’s gain or loss on the transfer of the Sub 4 stock, this purported change
in the character of Sub 3’s income is the result of the intercompany transaction.
Treas. Reg. § 1.1502-13(a)(2) explains that the participants in an intercompany
transaction, S and B, are treated as separate entities for some purposes, but as
divisions of a single corporation for other purposes. The “amount and location of S’s
intercompany items and B’s corresponding items are determined on a separate entity
basis (separate entity treatment).” However, the “timing, and the character, source, and
other attributes of the intercompany items and corresponding items, although initially
determined on a separate entity basis, are redetermined under this section to produce
the effect of transactions between divisions of a single corporation (single entity
treatment).” Accordingly, although the character of Sub 3’s income from Sub 4 is
initially determined on a separate entity basis, under the general principles of Treas.
Reg. § 1.1502-13(a), it must be redetermined to produce the same effect as though Sub
3 merely transferred the Sub 4 stock from one division to another division of a single
corporation. Thus, all of Sub 3’s and Sub 2’s income from Sub 4 that is attributable to
distributions from Sub 6 RIC is includible in income under section 951.36
C. The Anti-Avoidance Rule
In addition to the general principles set forth in Treas. Reg. § 1.1502-13(a),
Treas. Reg. § 1.1502-13(h), a legislative regulation that addresses Congress’ concerns
about tax avoidance, sets forth an anti-avoidance rule, which states:
If a transaction is engaged in or structured with a principal purpose to avoid the
purposes of this section (including, for example, by avoiding treatment as an
intercompany transaction), adjustments must be made to carry out the purposes
of this section.
Treas. Reg. § 1.1502-13(h)(2) provides several examples of the application of
the anti-avoidance rule. In Example 1, member “S” of a consolidated group owns land
with a $10 basis and $100 value. Instead of selling the land directly to “X” (an unrelated
party) in Year F, S contributes the land to a partnership in exchange for a 10 percent
partnership interest. Section 721 applies to the transfer and the partnership does not
have a section 754 election in effect. S then sells its partnership interest to another
member of its consolidated group, “B,” for $100. As a result, B’s basis in the
partnership interest is $100. S’s $90 gain (or income) is deferred under the
36
The distributions from Sub 4 would be treated as distributions of E&P described in section 959(c)(2)
(“PTI distributions”) to the extent they are included in income pursuant to section 951(a)(1)(A). The PTI
distributions would be excluded from income under section 959(a), and would not be treated as dividends
for purposes of chapter 1 of the Code pursuant to section 959(d).
POSTU-131660-15 27
consolidated return rules. B has net operating losses from separate return years that
are subject to limitation under Treas. Reg. § 1.1502-21(c). The partnership then sells
the land to X in Year G. Under section 704(c), the partnership’s $90 gain is allocated to
B, and B’s basis in its partnership interest increases to $190 under section 705. The
$90 partnership gain would ordinarily increase B’s separate return limitation year
(“SRLY”) limitation. In a later year, B sells its partnership interest to a nonmember for
$100, thereby realizing a $90 loss, which is not subject to limitation under the SRLY
rules. The example disallows the $90 increase in B’s unlimited SRLY loss.
Accordingly, B is not able to offset its $90 gain upon its sale of the partnership interest.
Example 1 states that S’s contribution of property and its sale of its partnership
interest were part of a plan, a principal purpose of which was to achieve a reduction in
consolidated tax liability. If S had directly sold its land to X in Year F, immediately after
the sale:
(1) S would have held $100;
(2) X would have owned the land; and
(3) S would have had $90 of gain (or income) which would have been
includable in the group’s consolidated tax computation.37 S’s $90 profit
would not have been offset by B’s losses.
The rationale underlying the Treas. Reg. § 1.1502-13(h) adjustment in Example 1
is consistent with the rationale underlying such common law doctrines as the step
transaction doctrine and the economic substance doctrine. S likely had a business
purpose for the overall transaction: selling its land. However, rather than sell the land
directly to X in Year F, S engaged in a number of steps so that it indirectly transferred
the land to X in Year G. The extra steps did not increase the group’s profit (other than
the purported tax savings) because X paid only $100 for the land in Year G. Aside from
the tax benefits of the transaction, taking the time value of money into account, and the
costs of planning and engaging in the transaction, S would have been better off selling
the land directly to X for $100 in Year F, and investing the proceeds.
Example 4 of Treas. Reg. § 1.1502-13(h) shows that the tax avoidance aspect of
a transaction is not cured by stretching steps of a transaction out over an extended
period of time, a legitimate business operation, or a third-party participant. In Example
4, two members of a consolidated group, M-1 and M-2, engage in a partnership mixing
bowl transaction in order to shift $100 of basis from M-2’s nondepreciable asset (land)
to M-1’s asset (which could be amortized but had a $0 basis). M-1 contributed an
intangible asset to the partnership and M-2 contributed land. An unrelated third party
contributed cash. The partnership engaged in a legitimate business for over 5 years
before liquidating. In connection with the liquidation, M-1 received the land (which then
had a $0 basis in M-1’s hands) and M-2 received the intangible asset (which then had a
37
The example does not state whether S held the land as inventory or as an investment.
POSTU-131660-15 28
$100 basis in M-2’s hands). The basis exchange does not escape the application of
Treas. Reg. § 1.1502-13(h).
D. Application of Treas. Reg. § 1.1502-13(h) to the Transaction
In the Transaction, as in Example 1 of Treas. Reg. § 1.1502-13(h), instead of
carrying out a direct transaction, a consolidated group carried out a multi-step plan that
included an intercompany transaction in order to alter the group’s consolidated income
tax (“CIT”). In each case, the taxpayer used the combination of steps to get a tax result
that distorted the intended results of the consolidated return regulations.
Taxpayer takes the position that Sub 3 did not own any stock of Sub 4 on the last
day of Sub 4’s Year Y taxable year and that Sub 3’s only inclusions in income with
respect to Sub 4 for Year Y were dividends eligible for the section 245 DRD, rather than
inclusions under section 951. Had Sub 3 held the Sub 4 stock on the last day of Sub
4’s Year Y, Sub 3 would have been required under section 951 to include in income its
pro rata share of Sub 4’s subpart F income, which would have included the distributions
received by Sub 4 from Sub 6 RIC. Had Sub 3 merely moved the Sub 4 stock from one
branch of Sub 3 to another, it would not have changed the character of Sub 3’s income
with respect to Sub 4 from a section 951 inclusion to a dividend eligible for an 80
percent section 245 DRD. Although the consolidated return rules respect Sub 3’s
transfer of the Sub 4 stock to Sub 2, they treat the transfer as between divisions of a
single corporation. Treas. Regs. §§ 1.1502-13(a)(2) and -13(c). Determined
accordingly, the character of Sub 3’s income with respect to Sub 4 is an inclusion under
section 951.
Taxpayer attempted to change the character of Sub 3’s income through the use
of an intercompany transaction: Sub 3’s distribution of its Sub 4 stock to Sub 2.
Taxpayer’s characterization of Sub 3’s income with respect to Sub 4 as taxable
dividends eligible for the section 245 DRD distorts the tax liability of Sub 3. In addition,
as the income of Sub 3 is used to calculate the CIT liability of US Group,38 Taxpayer’s
characterization distorts US Group’s CIT liability. As each member of a consolidated
group is severally liable for the CIT, Taxpayer’s characterization of Sub 4’s distributions
to Sub 3 distorts the tax liability of every member of US Group.39 Taxpayer’s position
does not clearly reflect the taxable income of the group as a whole. Accordingly, as
discussed in Part II.B of the LAW AND ANALYSIS section of this memorandum,
although Sub 3’s income from Sub 4 is initially determined on a separate entity basis, it
then must be redetermined to produce the same effect as though Sub 3 transferred the
stock of Sub 4 from one division to another division of a single corporation.
38
Treas. Reg. § 1.1502-11.
39
Treas. Reg. § 1.1502-6.
POSTU-131660-15 29
III. Common Law Doctrines
A. Overview
Taxpayer asserts that Sub 3 is eligible for an 80 percent section 245 DRD
because the Transaction complied with the literal requirements of the Code. Although
U.S. federal tax law is based on statute, the tax treatment of a transaction is also
subject to common law doctrines, including the economic substance doctrine and the
substance over form doctrine.40
When determining whether a taxpayer is entitled to a deduction or loss, courts
generally review the text and purpose of the applicable statute and analyze whether
mere compliance with the statute is sufficient. Courts generally conclude that a
taxpayer’s formal compliance with a statute is not sufficient if the transaction’s form is
inconsistent with its substance or if the transaction is a sham. One commentator
suggests that common law doctrines may be considered to be a method of statutory
interpretation or that “the legislature assumes that [such doctrines] will be used to
interpret the statutes it enacts.”41 This view is consistent with Judge Learned Hand’s
analysis in Commissioner v. Transport Trading & Terminal Corp.42 Judge Hand stated
that “in construing words of a tax statute which describe commercial or industrial
transactions we are to understand them to refer to transactions entered upon for
commercial or industrial purposes and not to include transactions entered upon for no
other motive but to escape taxation.”43 The proposition that statutory law is applied only
to the extent that it is consistent with the economic substance of an underlying
transaction is also supported by the analysis of the Court of Appeals for the Federal
Circuit in Coltec Industries, Inc. v. United States,44 which treated economic substance
as a prerequisite to the application of any Code provision that provides favorable tax
treatment for a taxpayer.45
40
Wells Fargo & Co. v. United States, 641 F. 3d 1319, 1325 (Fed. Cir. 2011) (“judicial anti-abuse
doctrines ‘prevent taxpayers from subverting the legislative purpose of the tax code’”) (quoting Coltec
Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006)). Although income tax determination is
generally rule based, there are a set of standards that overlay the rules. Some are built into the rules,
such as anti-abuse provisions. Other standards are judicially created.
41
Joseph Bankman, The Economic Substance Doctrine, 74 S. Cal. L. Rev. 5 (2000) (suggesting that
under this latter theory, the common law doctrines have been implicitly adopted as part of the statute).
42
176 F.2d 570 (2d Cir.1949).
43
Id. at 572.
44
454 F.3d 1340 (2006).
45
Id. at 1355-56.
POSTU-131660-15 30
Even if Taxpayer satisfied the literal requirements of section 245 as in effect for
the relevant taxable years, Sub 3 is not entitled to the section 245 DRD with respect to
the dividends that it received from Sub 4 attributable to Sub 6 RIC’s distributions
because moving funds through a Country U corporation lacked economic substance.46
Alternatively, Sub 3 is not entitled to the section 245 DRD under the substance over
form doctrine.
B. Economic Substance Doctrine
Although one of the fundamental principles of taxation is that taxpayers can
structure their transactions to minimize their tax liabilities, the economic substance
doctrine requires a court to disregard a transaction that a taxpayer enters into without a
business purpose in order to claim tax benefits not consistent with the purpose of the
Code or regulations thereunder. -------------------------------------------------------------------------
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--------------------------- .
1. Case Law
The economic substance doctrine is founded in several Supreme Court cases,
including Gregory v. Helvering.47 In Gregory, Mrs. Gregory owned all of the shares of
the United Mortgage Corporation (“Mortgage”) which owned some of the shares of
Monitor Securities Corporation (“Monitor”). If Mortgage sold its Monitor shares, it would
incur a corporate level tax on its significant capital gain and Mrs. Gregory would incur a
shareholder level tax when Mortgage distributed the cash proceeds to her as a
dividend. To reduce her tax liability, she caused Mortgage to transfer the stock of
Monitor to Averill Corporation (a newly formed corporation, wholly owned by Mrs.
Gregory) under an agreement pursuant to which Averill issued all of its stock to Mrs.
Gregory in exchange for the Monitor shares. The transaction satisfied the literal terms of
the reorganization provisions then in effect. A few days after receiving the Averill stock,
Mrs. Gregory caused Averill to dissolve. In connection with its dissolution, Averill
distributed all of its Monitor stock to Mrs. Gregory and she then sold the Monitor stock.
The Court opined that the issue to be determined was “whether what was done, apart
from the tax motive, was the thing which the statute intended.”48 In interpreting the
reorganization statute, the court concluded that the transfer of assets by one
corporation to another required a transfer in pursuance of a reorganization of corporate
46
Taxpayer entered into the Transaction before the effective date of section 7701(o), which codified the
economic substance doctrine. Accordingly, this memorandum does not address the application of section
7701(o) to the Transaction.
47
293 U.S. 465 (1935).
48
Id. at 469.
POSTU-131660-15 31
business. The Court concluded Mrs. Gregory’s transaction was an operation “having no
business purpose,”49 but was instead a mere device to transfer shares to Mrs. Gregory
in the guise of a corporate reorganization. Although the Court acknowledged that Averill
was a valid corporation, it found that Averill was “nothing more than a contrivance” 50 to
accomplish Mrs. Gregory’s plan. The Court denied the transaction reorganization
treatment, stating that to “hold otherwise would be to exalt artifice above reality and to
deprive the statutory provision in question of all serious purpose.”51
---------------------------
In the Eighth Circuit, “under the common law ‘sham transaction’ or ‘economic
substance’ doctrine, ‘even if a transaction is in ‘formal compliance with Code provisions’
a deduction will be disallowed if the transaction is an economic sham.’”52 Under this
analysis, Sub 3’s section 245 DRD is disallowed if the steps in the transaction that result
in the deduction constitute an economic sham, even if the transaction otherwise
satisfies the literal terms of the relevant Code provisions.
Although the Eighth Circuit also traces the origin of the economic substance
doctrine to the Supreme Court’s holding in Gregory, it attributes the current application
of the doctrine to Frank Lyon Co. v. United States.53 In Frank Lyon, a bank wanted to
build a new building for its headquarters. After determining that federal and state laws
and regulations prohibited it from constructing and financing a new building through
more conventional means,54 it entered into a sale-and-leaseback arrangement with
Frank Lyon Company (“Lyon”), an unrelated entity. Lyon was owned by a member of
the bank’s Board of Directors. The bank selected Lyon to enter the arrangement
following a competitive proposal process that involved independent potential investors.55
Lyon obtained construction financing and a mortgage loan from two independent
lenders.56 The lease agreement between Lyon and the bank provided the bank with
49
Id.
50
Id.
51
Id. at 470.
52
WFC Holdings Corp. v. United States, 728 F.3d 736, 742 (8th Cir. 2013) (quoting Dow Chem. Co. v.
United States, 435 F.3d 594, 599 (6th Cir. 2006)) (quoting Am. Elec. Power Co., Inc. v. United States,
326 F.3d 737, 741 (6th Cir. 2003)).
53
435 U.S. 561 (1978).
54
Id. at 563-64.
55
Id. at 564-65.
56
Id.
POSTU-131660-15 32
both a purchase option and a lease renewal option for the building.57 Although Lyon
bore the risk that the bank would default or fail to exercise either of its options, the
agreement terms were such that Lyon would receive payments sufficient to cover its
mortgage payments as well as a return of its initial investment plus 6% interest
compounded on the amount of the investment.58 The IRS disallowed Lyon’s rental
income and expenses for interest and depreciation with respect to the bank building
after determining that Lyon was “not the owner for tax purposes of any portion” of the
building.59 The IRS took the position that the transaction should be disregarded
because it was a sham designed to produce tax deductions. The Supreme Court
disagreed and indicated that a transaction should be respected for tax purposes:
where…there is a genuine multiple-party transaction with economic substance
which is compelled or encouraged by business or regulatory realities, is imbued
with tax-independent considerations, and is not shaped solely by tax-avoidance
features that have meaningless labels attached, the Government should honor
the allocation of rights and duties effectuated by the parties.60
In its 1990 decision in Shriver v. Commissioner,61 the Eighth Circuit applied the
two-part test set forth in Rice’s Toyota World Inc. v. Commissioner,62 but did not adopt
it. Under Rice’s Toyota World, a transaction is a sham if it (1) lacks a business purpose
apart from obtaining tax benefits, and (2) has no economic substance “because no
reasonable possibility of a profit exists.”63 Even though the Eighth Circuit analyzed the
Shriver transaction under both parts of the test, it said in dictum, “[W]e do not read
Frank Lyon to say anything that mandates a two-part analysis.”64 The Eighth Circuit
also considered the economic substance doctrine in IES Industries, Inc. v. United
States65 in 2001. In IES, the court concluded that the transactions at issue had both
economic substance and a business purpose but did not decide whether the doctrine
required a two-part analysis. It noted, however, that Shriver suggests that the failure of
57
Id. at 566.
58
Id. at 567.
59
Id. at 568.
60
Id. at 583-84.
61
899 F.2d 724 (8th Cir. 1990).
62
752 F.2d 89 (4th Cir. 1985).
63
Id. at 91.
64
Id. at 727.
65
253 F.3d 350 (8th Cir. 2001).
POSTU-131660-15 33
one test would result in the conclusion that the transaction in question is a sham for
U.S. federal income tax purposes.66 In WFC Holdings Corp. v. United States,67 a more
recent decision, the Eighth Circuit noted that that the courts of appeals do not have a
consistent approach on the application of the economic substance/sham transaction
doctrine.68 It outlined the following approaches taken by various courts of appeal:
(1) a disjunctive analysis, under which a transaction is valid if it has a business
purpose or has economic substance;
(2) a conjunctive analysis, under which a transaction is valid only if the
transaction has both a business purpose and economic substance beyond tax
objectives;
(3) an analysis under which a lack of economic substance is sufficient to sham a
transaction even if the taxpayer has motives other than tax avoidance; and
(4) an analysis under which the objective and subjective prongs of the two-part
test are factors to consider in determining whether a transaction has any
practical economic effects other than with respect to taxes.
After setting forth the possible ways to apply the doctrine, the court held that the
transaction at issue had neither economic substance nor a business purpose and,
accordingly, noted that it did not need to reach a conclusion about which test to apply.
--------------------------
The Ninth Circuit has explained in case law that the Commissioner’s
determination that a transaction is a sham is presumptively correct and Taxpayers have
the burden of producing evidence to rebut the deficiency determination and the burden
of persuasion to substantiate the deduction.69
The Ninth Circuit’s application of the economic substance doctrine focuses on
both the subjective aspect of whether the taxpayer intended to do anything other than
acquire tax deductions and the objective aspect of whether the transaction had any
66
Id. at 353.
67
728 F.3d 736 (8th Cir. 2013).
68
See id. at 744, n. 3.
69
Reddam v. Comm’r, 755 F.3d 1051, 1059 (9th Cir. 2014) (quoting Sochin v. Comm’r, 843 F.2d 351,
355 n. 9 (9th Cir. 1988)).
POSTU-131660-15 34
economic substance other than the creation of tax benefits. However, Ninth Circuit
case law emphasizes that the economic substance doctrine is not a rigid two-step
analysis. Rather the court focuses holistically on whether the transaction had any
practical economic effects other than the creation of income tax losses.70
----------------------------------------------------------------------------------------------------
In its most recent pronouncement on the economic substance doctrine, the
Federal Circuit reiterated that it follows the disjunctive test for determining whether a
transaction should be disregarded as an economic sham.71 That is, a transaction
should be disregarded if it “lacks objective economic substance or if it is subjectively
shaped solely by tax avoidance motives.”72
With regard to the objective prong, the court stated that a transaction lacks
economic reality if it does not alter “the taxpayer’s economic position in any meaningful
way apart from their tax consequences, typically entailing no risk and no significant
possibility of profit other than as a result of tax consequences.”73 Importantly, the fact
that a transaction lacks the potential for economic profit is not dispositive of the lack of
economic reality. In Salem Financial, Inc. v. United States,74 the court cited the
following characteristics of the transaction to support its finding that it lacked economic
reality: circular cash flows that had no real economic effect other than tax benefits; the
transfer of income producing assets to controlled entities that had no incremental effect
on the taxpayer’s activities; a lack of genuine economic risk; and, an “unlimited capacity
to generate gains, without any additional exposure or commitment of resources.”75
In considering the lack of a business purpose for the transaction, the Salem court
relied on evidence establishing that the transaction had been designed to save taxes
and had been promoted as a prepackaged tax strategy.76 Without incremental profit
potential other than tax benefits and risk other than tax risk, the court found that the
70
Sochin v. Comm’r, 843 F.2d 351, 354 (9th Cir. 1988).
71
Salem Fin., Inc. v. United States, 786 F.3d 932, 942 (Fed. Cir. 2015).
72
Stobie Creek Inv. v. United States, 82 Fed. Cl. 636, 697 (2008).
73
Salem, 786 F.3d at 942.
74
786 F.3d 932 (Fed. Cir. 2015).
75
Id. at 951.
76
Taxpayer maintains that it did not purchase the Transaction that is the subject of this memorandum as
a prepackaged tax strategy. However, this tax strategy has not been limited to Taxpayer’s use; a very
similar transaction is discussed in a Chief Counsel advisory memorandum dated January 18, 2013 (CCA
201320014).
POSTU-131660-15 35
transaction was created “solely” to generate tax savings and therefore lacked a
business purpose.77
As stated by the court in Stobie Creek Investments v. United States,78 “the
disjunctive approach reflects the more flexible and considered approach to the Supreme
Court’s economic substance doctrine as set forth in Frank Lyon.”79
In its overview of the economic substance doctrine in Coltec, the Court of
Appeals for the Federal Circuit explained that over many years, the doctrine has
“required disregarding, for tax purposes, transactions that comply with the literal terms
of the tax code but lack economic reality,”80 and noted that the economic substance
doctrine is a “judicial effort to enforce the statutory purpose of the tax code.”81 It is a
tool “to prevent taxpayers from subverting the legislative purpose of the tax code by
engaging in transactions that … lack economic reality simply to reap a tax benefit.”82
The court stated that the economic substance doctrine incorporates the following
principles:
(1) Although a taxpayer has a right to decrease taxes by means which the law
permits, a taxpayer may not reap tax benefits from a transaction that lacks
economic reality. The Gregory case gives support to disregarding transactions
that do not serve a business purpose, do not vary control, or do not change the
flow of economic benefits. The economic substance doctrine may apply if the
taxpayer’s sole subjective motivation is tax avoidance, even if a transaction has
economic substance; but if a transaction has no economic substance, it may also
be disregarded, even if tax avoidance is not the taxpayer’s sole motive.83
(2) When a taxpayer claims a tax benefit, the taxpayer must prove that the
transaction has economic substance. It is a heavy burden for the taxpayer to
demonstrate that Congress intended to give favorable tax treatment to a
transaction that would not have occurred but for the motive of tax avoidance.84
77
Salem, 786 F.3d at 953.
78
82 Fed. Cl. 636 (2008).
79
Id. at 698.
80
Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1352 (Fed. Cir. 2006).
81
Id. at 1353.
82
Id. at 1354.
83
Id. at 1355.
84
Id. at 1355-56.
POSTU-131660-15 36
(3) “[T]he economic substance of a transaction must be viewed objectively rather
than subjectively.”85 Black & Decker Corp. v. United States86 explains that the
economic substance inquiry requires an “‘objective determination of whether a
reasonable possibility of profit from the transaction existed.’”87
(4) “[T]he transaction to be analyzed is the one that gave rise to the alleged tax
benefit.”88
(5) “[A]rrangements with subsidiaries that do not affect the economic interest of
independent third parties deserve particularly close scrutiny.”89
2. Application of the Economic Substance Doctrine to Taxpayer’s Transaction
a. The Transaction to Be Analyzed
A “preliminary step of the economic substance inquiry is to identify the
transaction to be analyzed.”90 As discussed in Coltec, the economic substance doctrine
should be applied to the transaction steps that gave rise to the alleged tax benefit.
If a member of US Group had invested directly in Business O Eligible
Investments, it would have had to include the resulting interest and capital gain in its
income without any offsetting DRD.91 Similarly, if a member of US Group had invested
85
Id. at 1356.
86
436 F.3d 431, 441-42 (4th Cir. 2006) (explaining that shamming a corporation under Moline Prop. v.
Comm’r, 319 U.S. 436 (1943), is a different analysis than shamming a transaction with a controlled
corporation under the objective prong of the economic substance doctrine).
87
Id. at 441 (quoting Rice’s Toyota World Inc. v. Comm’r, 752 F.2d 89, 94 (4th Cir. 1985)).
88
Coltec, 454 F.3d at 1356. The court describes, as an example, the transaction in Basic Inc. v. United
States, 549 F.2d 740 (Ct. Cl. 1977). In Basic, in anticipation of the sale of its carbon business to a third
party, a parent corporation caused its first-tier subsidiary to distribute the stock of a second-tier subsidiary
to the parent. The parent corporation then sold both subsidiaries to the buyer. As a result of the
distribution, the parent corporation’s tax liability with respect to the sale was lower than it would have
been if the first-tier subsidiary had sold the stock of the second-tier subsidiary to the buyer. The Basic
court did not allow the business purpose for the ultimate sale to justify the intermediate transfer.
89
Coltec, 454 F.3d at 1357.
90
Bank of N.Y. Mellon v. Comm’r, 801 F.3d 104, 115 (2d Cir. 2015).
91
Clearly, a member of US Group could not offset interest and capital gain income through the use of the
section 243 DRD because such income would comprise dividends.
POSTU-131660-15 37
directly in a RIC, such as Sub 6 RIC, it would have had to include its interest-related
dividend distributions and capital gain distributions in income without an offsetting
section 243 DRD.92 Taxpayer treated Sub 3 as contributing funds to Sub 4 and
receiving dividend distributions from Sub 4 in order to avoid the application of section
854, and, instead, claim the section 245 DRD. Taxpayer moved funds through Sub 4 in
order to convert interest and capital gain income into section 316 dividends of U.S.-
source earnings from a foreign corporation that would qualify for an 80 percent DRD
under section 245. In furtherance of its plan to eliminate almost all U.S. federal income
tax on the income from the Business O Eligible Investments, Taxpayer also caused Sub
3 to distribute the stock of Sub 4 to Sub 2 in order to avoid the application of section 951
with respect to most of Sub 4’s subpart F income.
Taxpayer will likely maintain that the Transaction, viewed in its entirety, served
the business purpose of investing in Business O Eligible Investments. Having identified
a business activity, Taxpayer may assert that it should be able to structure this activity
in a manner that is advantageous from a tax savings perspective. Although Taxpayer’s
investments in Business O Eligible Investments produced a profit and served a valid
business purpose, the transaction at issue in this economic substance inquiry is not the
investment activity itself, but rather the “part of a larger series of steps . . . ‘that
generated the claimed deductions.’”93 Elements of the larger series of steps in the
Transaction did not generate any incremental profit other than tax benefits and, being
strictly among controlled entities, entailed no risk other than tax risk.
In order to avoid the application of section 854, invoke the section 245 DRD, and
avoid section 951,Taxpayer (i) re-domiciled Sub 4 to Country U; (ii) funneled investment
funds and the return on investment through a Country U corporation; and (iii) transferred
the Sub 4 stock from Sub 3 to Sub 2 before the end of Sub 4’s Year Y taxable year.
Accordingly, this part of the larger Transaction is analyzed under the economic
substance doctrine. If these elements of the Transaction lack economic substance,
they are not given effect, and Sub 3 does not get the benefit of the section 245 DRD.
In the alternative, Taxpayer will fail to sustain its position that Sub 3 qualifies for
the section 245 DRD if Taxpayer’s use of the Country U corporation to funnel funds
between US Group and Sub 6 RIC in and of itself lacks economic substance. If just this
part of the Transaction lacks economic substance, the Country U corporation’s
participation in the Transaction is not given effect, and accordingly, Sub 3 does not get
the benefit of the section 245 DRD.
92
As discussed in Part III.B.2.d.i of the LAW AND ANALYSIS section of this memorandum, the section
243 DRD would have been precluded under section 854(a).
93
Bank of N.Y. Mellon, 801 F.3d at 115 (quoting Nicole Rose Corp. v. Comm’r, 320 F.3d 282, 284 (2d.
Cir. 2003)).
POSTU-131660-15 38
b. The Economic Substance Test
The objective economic substance prong focuses on whether a transaction has
an effect on a taxpayer’s economic position apart from U.S. federal income tax effects.
Under this prong, a transaction does not have economic substance if there is not a
reasonable possibility of deriving a profit from the transaction.
As discussed in Part I of the FACTS section of this memorandum, one or more
members of US Group historically invested the Customer Funds in Business O Eligible
investments and sought to make a profit on such investments. During certain periods of
time, Business O Eligible Investments produced a very low return. Therefore, Taxpayer
planned to increase its net investment profit by paying less U.S. federal income tax.
Taxpayer’s investment of the Customer Funds in Business O Eligible
Investments had economic substance. However, the transaction, in which Taxpayer
moved Sub 4 to Country U, routed funds through Sub 4, and moved the location of the
Sub 4 stock within US Group, did not provide a potential for increasing US Group’s
investment return other than by the amount of the tax savings attributable to the section
245 DRD. A taxpayer “cannot avoid the requirements of economic substance simply by
coupling a routine economic transaction generating substantial profits with no inherent
tax benefits to a unique transaction that otherwise has no hope of turning a profit.”94
Courts have opined that “transfers of income-producing assets to controlled entities do
not imbue an arrangement with substance if the transfer has no incremental effect on
the taxpayer’s activities.”95
Engaging in the Transaction in order to ultimately invest in Business O Eligible
Investments did not increase Taxpayer’s profit potential on such investments
(independent of tax savings). To the contrary, it reduced profitability by adding
substantial transaction costs. Taxpayer candidly acknowledged that it expected its
profits to be reduced as a result of the multi-step transaction if the IRS disallowed the
deduction because of the costs of creating and implementing the Transaction.
Taxpayer’s contemporaneous documents reflect that it did not have a reasonable
expectation of increasing its pre-tax profit on its Business O Eligible Investments
94
Long Term Capital Holdings v. United States, 330 F.Supp. 2d 122, 183 (D. Conn. 2004).
95
Salem Fin., Inc. v. United States, 112 Fed. Cl. 543, 586 (2013), aff’d in part, rev’d in part, and
remanded by Salem Fin., Inc. v. United States, 786 F.3d 932 (Fed. Cir. 2015). See also Southgate
Master Fund v. United States, 659 F.3d 466, 491-92 (5th Cir. 2010) (disregarding partnership used to
acquire loan receivables); ACM P’ship v. Comm’r, 157 F.3d 231, 249-52 (3d Cir. 1998) (disregarding
returns on Citicorp notes where economic returns on capital were unaffected by the transaction); Zmuda
v. Comm’r, 731 F.2d 1417, 1421 (9th Cir. 1984) (disregarding contribution of income producing assets to
foreign trusts).
POSTU-131660-15 39
because of its indirect investment strategy; Taxpayer’s documents show that the
increase in profit from the Transaction was to result solely from the DRD.
Taxpayer’s indirect investment of Customer Funds in Business O Eligible
Investments through Sub 4 did not provide a reasonable opportunity for economic profit,
other than the profit that would have been earned had Taxpayer invested directly in Sub
6 RIC or directly in the Business O Eligible Investments.
Sub 4 did not provide investment advice with respect to the Business O Eligible
Investments. Rather, Sub D, a member of US Group and a registered investment
advisor, operated as Sub 6 RIC’s investment advisor. Sub D managed Sub 6 RIC’s
investments in accordance with US Group’s investment guidelines. Moreover, the
Business O Eligible Investments continued to be subject to Agency 1’s oversight and
restrictions even though US Group held them indirectly through Sub 4 (a Country U
entity). Taxpayer sought assurances from Agency 1 that the Transaction would not
cause “safety and soundness” issues because Sub C (a member of US Group) needed
to take the Business O Eligible Investments into account in determining whether it
satisfied certain of Agency 1’s requirements. To this end, Taxpayer informed Agency 1
that Quote 6. In addition, Taxpayer informed prospective note holders of Sub 6 RIC that
Quote 7.
The funds used to invest in the Business O Eligible Investments came from one
or more members of US Group. Employees of a member of US Group determined what
investments were to be made. Taxpayer did not increase its profit on the Business O
Eligible Investments by accounting for the funds as if they were routed from US Group
members through Sub 4 on their way to Sub 6 RIC, or by having Sub 4 hold
distributions from Sub 6 RIC for a transitory period before transferring the funds to Sub
3.
We conclude that Taxpayer fails to satisfy the objective prong of the economic
substance test. Moving Sub 4 to Country U, funneling funds through Sub 4 as a
Country U corporation, and moving the Sub 4 stock from Sub 3 to Sub 2, did not give
Taxpayer any reasonable expectation of economic profit over and above the profit it
could expect if a member of US Group directly invested in Business O Eligible
Investments or invested in a RIC that invested in Business O Eligible Investments.
Taxpayer took these steps to avoid the application of section 854, which prevents Sub 3
from offsetting its income attributable to Sub 6 RIC’s distributions with the section 243
DRD and to avoid an inclusion under section 951 with respect to Sub 3.
In the alternative, we conclude that Taxpayer fails to satisfy the objective prong
of the economic substance test with respect to its funneling of investment funds and its
investment returns through a Country U corporation. Taxpayer routed its Customer
Funds and its return on investment through Sub 4 to circumvent the application of
section 854. Routing funds through Sub 4 did not give Taxpayer any reasonable
expectation of economic profit over and above the profit it could expect if a member of
POSTU-131660-15 40
US Group directly invested in Business O Eligible Investments or invested in a RIC that
invested in Business O Eligible Investments.
c. The Business Purpose Test
The subjective business purpose prong of the economic substance test focuses
on whether the taxpayer acted with a business purpose other than tax avoidance. A
sophisticated and well-advised taxpayer is aware of the business purpose prong of the
economic substance doctrine analysis. Likely anticipating a challenge by the IRS,
Taxpayer included a list of purported business purposes for the use of a Country U
corporation in its planning documents.
Taxpayer claims that it used a corporation organized in Country U in the
Transaction for the business purpose of attracting foreign investors. Taxpayer
maintains that foreign investors would be subject to U.S. federal withholding taxes on
distributions from a domestic entity but would not be subject to similar withholding taxes
on payments made by an entity organized in Country U. This justification is
unpersuasive because Taxpayer relied on sections 871(k) and 881(e) to exempt
distributions from Sub 6 RIC to Sub 4 from U.S. federal withholding taxes. Non-U.S.
investors would have likewise been exempt from U.S. federal withholding taxes under
sections 871(k) and 881(e) if they had invested directly in Sub 6 RIC. Thus, there is no
support for Taxpayer’s claim that it was necessary to use a Country U corporation as an
investment vehicle for potential foreign investors in order to reduce U.S. federal
withholding taxes.
Taxpayer presents additional justifications to support its purported business
purpose for using a Country U corporation. Taxpayer suggests that non-U.S. investors
may prefer to invest in U.S. assets indirectly through non-U.S. entities so that they
appear to be investing in a country other than the United States for non-tax personal
reasons. However, there is no evidence that Taxpayer actually sought, or planned to
seek, non-U.S. investors for Sub 4. To the contrary, Taxpayer assured Agency 1 that
Quote 5. Taxpayer would not have made this representation to Agency 1 if it intended
to issue Sub 4 stock to non-U.S. investors.
In addition, Taxpayer claims that non-U.S. investors would prefer to invest in a
corporation organized in Country U because they would be afforded better protection in
the event that Common Parent declared bankruptcy, as the creditors would have more
difficulty reaching assets of a Country U subsidiary. Taxpayer assured Agency 1 that
the assets would be held in the United States. Taxpayer’s continued reliance on the
Business O Eligible Investments for purposes of satisfying the safety and soundness
requirements of Sub C is inconsistent with Taxpayer’s alleged business purpose of
moving the assets out of the reach of U.S. creditors. Accordingly, Taxpayer’s argument
that it used an entity organized in Country U in order to attract non-U.S. investors has
no merit.
POSTU-131660-15 41
Another claimed business purpose for having Sub 3 hold Sub 6 RIC stock
indirectly through Sub 4, rather than holding the stock directly or through another
subsidiary organized in State T, was to avoid tax that State T would have imposed on
distributions received by a State T subsidiary from Sub 6 RIC. Country U had agreed to
not subject Sub 4 to income tax under the laws of Country U for at least twenty years,
but no such agreement had been reached with State T. As planned, by the end of Year
Y, Taxpayer caused Sub 4 to distribute its earnings to Sub 3, a State T corporation.
Thus, income attributable to the Business O Eligible Investments was apparently
subject to State T tax. Taxpayer has not substantiated the difference between the state
tax that Sub 3 would have had to pay had it directly invested in the Business O Eligible
Investments, invested in the stock of Sub 6 RIC through another State T subsidiary, or
directly invested in the stock of Sub 6 RIC, and the amount of state T tax it paid
because it received a distribution from Sub 4. Even assuming that there were State T
tax savings, any savings must be offset by the Transaction costs and, as Taxpayer
noted, the potential loss of valuable public goodwill. Taxpayer’s claimed business
purpose of using a Country U corporation in order to save State T tax is unpersuasive.
It is notable that Taxpayer’s asserted business purposes for using an entity
formed in Country U in the Transaction do not include operating a business in Country
U. In connection with obtaining Agency 1’s approval for the Transaction structure,
Taxpayer, in effect, asked Agency 1 to disregard Sub 4 and look through to Sub 6 RIC
and Sub 6 RIC’s underlying investments. Taxpayer assured Agency 1 that Sub 4 would
conduct only de minimis activities in Country U. In fact, in its correspondence with
Agency 1, Taxpayer referred to Sub 4 as a “domestic operating” subsidiary. 96
The funds used to invest in the Business O Eligible Investments came from one
or more members of US Group. Employees of a member of US Group determined what
investments were to be made. Taxpayer’s transaction planning documents make it
clear that Taxpayer did not intend that Sub 4 itself would benefit from the investment
funds or the investment return on the Business O Eligible Investments. Members of US
Group directly wired the investment funds to Sub 6 RIC; Sub 4 did not have any
opportunity to control the funds before Sub 6 RIC used them to purchase Business O
Eligible Investments in accordance with Taxpayer’s Transaction plan. Before
commencing the Transaction, Taxpayer determined that Sub 4 would distribute the
funds it received from Sub 6 RIC to Sub 3 before the end of Sub 4’s Year Y.97 Taxpayer
96
Taxpayer has not explained its treatment of the corporation organized in Country U as a “domestic
operating” subsidiary in its dealings with Agency 1.
97
Taxpayer claims that Sub 4 received funds from Sub 6 RIC in Year Z and did not distribute them to Sub
2 before the end of Sub 4’s Year Z taxable year. We understand that Sub 2 did not claim a section 245
DRD in Year Z. However, in Year AA and Year BB, Taxpayer carried out the Transaction again. It is our
understanding that in Years AA and BB, Taxpayer intends to have a member of US Group claim the
benefit of the section 245 DRD. The dollar amount of the funds held by Sub 4 in Year Z and included by
Sub 2 as a section 951 inclusion was small compared to the amounts Taxpayer treated and may treat as
dividends qualifying for the 80 percent section 245 DRD in Years Y, AA and BB. Sub 4’s retention of
POSTU-131660-15 42
carried out the Transaction consistent with its plan.
There is evidence to support the inference that Taxpayer’s only purpose for
moving funds from Sub 6 RIC to Sub 4 before returning the funds to a member of US
Group was tax avoidance. Taxpayer’s contemporaneous documents discuss the
deduction that the Transaction was to provide, rather than any increased business profit
or other valid business purpose. The documents evaluate the success of the
Transaction solely in terms of its tax consequences. Taxpayer moved funds through a
foreign corporation in order to create a dividend eligible for a DRD. Taxpayer did not
have a legitimate business purpose for funneling the income derived from the Business
O Eligible Investments through a CFC.
We conclude that Taxpayer fails to satisfy the business purpose prong of the
economic substance test. Taxpayer’s business purpose for the Transaction was to
invest in Business O Eligible Investments so as to maintain the safety and soundness of
Sub C. Taxpayer has not provided a plausible business purpose for moving Sub 4 to
Country U, funneling funds through Sub 4 as a Country U corporation, and moving the
Sub 4 stock from Sub 3 to Sub 2.
Taxpayer also fails to satisfy the business purpose prong of the economic
substance test specifically with respect to its funneling investment funds and its
investment returns through a Country U corporation. Funneling the Customer Funds
and the return on investment through a Country U corporation did not enhance
Taxpayer’s profit potential on the Business O Eligible Investments (other than the tax
savings) and did not serve any other non-tax business purpose.
d. Congressional Intent
The economic substance doctrine does not apply when a taxpayer’s treatment of
an item is consistent with the congressional intent underlying the relevant Code
sections. Thus, in addition to the two-pronged test discussed earlier in this
memorandum, the economic substance doctrine requires an analysis of the
Congressional intent underlying the Code sections at issue. This section of the
memorandum analyzes the Congressional purpose for enacting the DRD provisions, as
well as other Code sections relied on by Taxpayer with respect to its treatment of the
Transaction for U.S. federal income tax purposes.
Prior to the enactment of sections 881(e) and 871(k), which exempt foreign
shareholders from withholding tax on interest-related dividends received from a RIC,
such dividends were subject to withholding tax. As explained below, Congress provided
tax relief to foreign investors in sections 881(e) and 871(k) to encourage them to invest
funds in Year Z, and interest earned on the funds during this time, does not change our economic
substance analysis. Any interest earned by Sub 4 on the funds it received from Sub 6 RIC is dwarfed by
the magnitude of the tax deduction that Taxpayer’s use of Sub 4 was designed to generate.
POSTU-131660-15 43
in the United States. Section 245 gives tax relief to domestic shareholders of foreign
corporations. Congress did not amend section 245 upon enacting sections 881(e) and
871(k) to expressly forbid domestic corporations from using foreign conduits to convert
RIC interest-related and capital gain dividends into dividends eligible for a section 245
DRD. Taxpayer took the lack of such a specific statutory prohibition as permission to do
so. Taxpayer’s DRD should be disallowed under the economic substance doctrine
because, as set forth below, there is clear evidence that Congress did not intend
taxpayers to be able to convert interest income and capital gains into dividends eligible
for the DRD.
i. Section 243 and Subchapter M
RICs are generally subject to taxation under special rules in subchapter M
(sections 851 through 860G). A RIC that satisfies the requirements under section
852(a) is generally able to take a DPD in computing its taxable income.98 Thus, a RIC
can eliminate tax at the entity level by properly distributing its income. RICs generally
make timely distributions to their shareholders in order to take advantage of the DPD.
Corporate earnings are generally subject to two levels of tax: the corporation is
taxed on its earnings and the corporation’s shareholders are taxed on the corporation’s
distributions of its earnings. The taxation of RICs under subchapter M provides an
exception from the corporate level tax on corporate earnings. The DRD provides
another exception from the multiple layers of tax on corporate earnings. When originally
enacted in 1917, the DRD was intended “to eliminate or minimize further multiples of
taxation of corporate earnings as the earnings pass from one corporation to another.”99
Accordingly, as noted upon amendment of the DRD provisions in 1932, “[w]here … the
distributing corporation is exempt from tax, there is no reason why the dividends should
be deducted from the gross income of the stockholder corporation.”100
Section 243(a) generally allows a corporation to take as a deduction an amount
equal to a specified percentage of the amount received as dividends from a domestic
corporation that is itself subject to U.S. federal income tax. However, section 243(d)
states that, for purposes of section 243(a), a dividend received from a RIC is subject to
the limitations prescribed in section 854. The Internal Revenue Code of 1954101 added
section 854, which governs which dividends received from a RIC give rise to a DRD. In
98
Sections 852(b)(2)(D) and 852(b)(3)(A).
99
134 Cong. Rec. H6319-03.
100
H. Rep. No. 708, 72d Cong., 1st Sess., at 12 (1932) (noting also, “[d]ividends received by a
corporation are allowed as a deduction in computing the net income of a corporation, upon the theory that
a corporate tax has already been paid upon the earnings out of which the dividends are distributed.”).
101
Pub. L. No. 83-591 (1954).
POSTU-131660-15 44
enacting this provision, Congress noted that the purpose of the DRD is “to limit the
multiple taxation of intercorporate dividends.”102 Congress was concerned that, under
prior law, a corporate shareholder of a RIC might claim a DRD with respect to a
dividend paid by a RIC attributable to interest that the RIC received on bond
investments. Congress believed that this resulted in tax avoidance because the
corporation that issued the bond received an interest deduction and neither the RIC nor
the corporate shareholder of the RIC paid the full tax on the interest income.103 Section
854 was Congress’ attempt to prevent this abuse by limiting the use of the DRD with
respect to RIC distributions.
In 1984, Congress amended section 854 to further narrow the eligibility of RIC
distributions for the DRD. Under section 854(b) as originally enacted, if at least 75
percent of a RIC’s gross income consisted of dividends from domestic corporations,
then all of the RIC’s distributions were treated as dividends eligible for the DRD. Thus,
up to 25 percent of the RIC’s gross income could consist of interest income.104
Congress was concerned that the original “rules permit a taxpayer to convert interest
income into dividend income. Taxpayers have organized RICs to take advantage of this
conversion opportunity.” 105 Congress explained that a change in the law was
necessary because this opportunity was “unwarranted.”106
To prevent such inappropriate use of the section 243 DRD, Congress amended
section 854 so that a shareholder of a RIC cannot treat any dividend received from the
RIC as a dividend for purposes of the DRD except to the extent that the RIC can identify
the distribution as eligible for the DRD.107 The amount of dividends a RIC can identify
as eligible for the DRD in a taxable year generally is limited to the amount of dividends
that the RIC receives from domestic corporations in that year that would give rise to a
DRD in the hands of the RIC if RICs were permitted to claim the DRD.108
In the instant case, Sub 6 RIC did not receive any dividends that would qualify for
102
S. Rep. No. 1622, 83rd Cong., 2d Sess., at 103 (1954) (emphasis added).
103
Id. at 103-104.
104
Section 854(b) of the 1954 Code.
105
H.R. Rep. No. 432(II), 98th Cong., 2d Sess., at 1183 (1984).
106
Id.
107
Section 854(b)(1)(A). The rule for identifying dividends eligible for a DRD was changed by the
Regulated Investment Company Modernization Act of 2010 (Pub. L. No. 111-325, 124 Stat. 3537 (2010)),
from a designation requirement to a written notice requirement. The limit on the amount of a RIC
dividend that may be treated as a DRD-eligible dividend remains unchanged.
108
See sections 854(b)(2) and (3). Under section 852(b)(2)(C), a RIC is not allowed a DRD.
POSTU-131660-15 45
a DRD if Sub 6 RIC were allowed a DRD, and, therefore, none of Sub 6 RIC’s
distributions were eligible for the DRD. Thus, Sub 6 RIC did not provide notice to its
shareholder that the distributions were dividends eligible for the section 243 DRD.
ii. Portfolio Interest Exception
In the instant case, Taxpayer claims that the distributions from Sub 6 RIC to Sub
4 are exempt from withholding tax under section 881(e). Taxpayer needs to rely on
sections 881(c) and (e) in order to avoid withholding tax on the distribution to Sub 4,
which is necessary to achieve its tax savings on the Transaction. Congress enacted
sections 871(h) and 881(c) in the Tax Reform Act of 1984 (the “Tax Reform Act”),109 to
encourage foreign investors to invest in the United States, to enhance the U.S.
government’s and U.S. business’ access to international capital markets, and to
eliminate the need for U.S. borrowers to use intermediary financing affiliates.110
Prior to 1984, a foreign person that received U.S.-source interest income was
generally subject to U.S. federal income tax on the interest. If the interest was not
connected with the foreign person’s trade or business within the United States, the tax
generally was collected by withholding the amount of tax from the interest when it was
paid to the foreign person.111 The legislative history of the Tax Reform Act indicates
that Congress wanted to allow U.S. businesses and the U.S. government to raise
money through the Eurobond market. Congress determined that the U.S. federal
withholding tax on certain interest paid to foreign lenders impeded access to the
Eurobond market.112 The portfolio interest provisions in the Tax Reform Act eliminated
the 30 percent withholding tax on interest received by nonresident aliens and foreign
corporations with respect to certain debt obligations issued by U.S. corporations or the
U.S. government after July 18, 1984, through the addition of sections 871(h) and 881(c)
to the Code.
In 2004, Congress expanded the portfolio interest exemption with the addition of
sections 871(k) and 881(e),113 which generally exempt interest-related dividends paid to
a foreign person by a RIC from the 30 percent withholding tax.114 In effect, these
109
Pub. L. No. 98-369, 98 Stat. 494 (1984).
110
See S. Rep. No. 169(I), 98th Cong., 2d Sess., at 417-421 (1984).
111
Sections 1441 and 1442.
112
See S. Rep. No. 169(I), 98th Cong., 2d Sess., at 417-421 (1984).
113
American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418 (2004).
114
Section 881(e) provides that, except as otherwise provided, “no tax shall be imposed … on any
interest-related dividend (as defined in section 871(k)(1)) received from a regulated investment company.”
An “interest related dividend” is generally a dividend that the RIC pays out of certain interest income that
would not be subject to tax in the hands of a shareholder that is a foreign corporation or a nonresident
POSTU-131660-15 46
provisions give a foreign investor in a RIC that holds investments that generate U.S.-
source interest the same U.S. federal income tax result as if the investor had directly
invested in the underlying investments. When the foreign investor is a CFC, any
interest-related dividends eligible for the section 881(e) exclusion must be included in
the CFC’s subpart F income without regard to certain exceptions, including the de
minimis exception under section 954(b)(2), and the related party exception under
section 954(c)(3).115 Accordingly, the U.S. shareholders of a CFC generally would have
section 951 inclusions based, in part, on the full amount of the interest-related dividends
received by the CFC. Congress did not intend to allow U.S. taxpayers to be able to
avoid U.S. federal income tax under section 881(e) by investing through a CFC.116
When Congress eliminated tax on portfolio interest paid to foreign persons in
1984, Congress recognized that U.S. persons could attempt to evade U.S. federal
income tax on interest income by buying U.S. bearer obligations on the Eurobond
market, and claiming to be a foreign person or by buying the bonds through the
assistance of a foreign person. If the U.S. person failed to include the interest in its U.S.
return and there was no withholding, the income would not be taxed and the tax
avoidance would likely go unnoticed by the IRS, because the obligations were in bearer
rather than registered form. In order to prevent this tax avoidance, Congress enacted
certain measures, including an expansion of the Department of the Treasury’s authority
to require registration of securities designed to be sold to foreign persons.117
Furthermore, Congress required that the withholding agent receive a statement that the
beneficial owner of the obligation is not a U.S. person,118 and empowered the
Department of the Treasury to make certain determinations that could prevent
taxpayers from engaging in back-to-back transactions.119
alien if the shareholder received it directly. More specifically, section 871(k)(1)(A) exempts any interest-
related dividends that foreign corporations and nonresident aliens receive from RICs from the 30 percent
withholding tax. A RIC must designate an interest-related dividend by written notice provided to its
shareholders. Section 871(k)(1)(C). The amount that a regulated investment company may so designate
is based on the RIC’s “qualified net interest income,” which is the RIC’s “qualified interest income,”
reduced by certain deductions. Section 871(k)(1)(D). “Qualified interest income” is the amount of the
RIC’s U.S. source interest income that would be exempt from the 30 percent withholding tax if the
shareholder received the interest directly. Section 871(k)(1)(E).
115
Section 881(e)(1)(C), which applies the rules of section 881(c)(5)(A) to interest-related dividends.
116
See S. Rep. No. 169(I), 98th Cong., 2d Sess., at 423 (1984).
117
See Staff of Joint Comm. on Taxation, 98th Cong. 2d Sess., General Explanation of the Revenue
Provisions of the Deficit Reduction Act of 1984, at 393 (1984).
118
See section 871(h)(2)(B)(ii)(I).
119
See sections 871(h)(5) and (h)(6).
POSTU-131660-15 47
The exemption from taxation of interest-related dividends received from a RIC
does not apply unless the withholding agent receives a statement similar to that
required under section 871(h), stating that the beneficial owner of the stock is not a U.S.
person.120 It is our understanding that Sub 4 provided a statement to Sub 6 RIC that it
was the beneficial owner of the Sub 6 RIC stock, and, accordingly, that, ostensibly
conforming to the literal requirements of the withholding rules, Sub 6 RIC did not
withhold tax on its distributions to Sub 4.
iii. Subpart F
Taxpayer contends that under section 245(a), Sub 3 is entitled to an 80 percent
DRD to offset the distributions that Sub 3 received from Sub 4, which are “U.S.-source”
dividends within the meaning of section 245(a) because they are attributable to
distributions Sub 4 received from Sub 6 RIC.
Subpart F was added to the Code in 1962 to prevent U.S. persons from
inappropriately deferring U.S. federal income tax on certain income earned by CFCs.121
The subpart F rules provide, in part, that U.S. shareholders of a CFC are taxed currently
on certain types of income (“subpart F income”) earned by the CFC under section 951.
Specifically, a U.S. shareholder that owns stock of a CFC on the last day of the CFC’s
taxable year has a section 951 inclusion with respect to the CFC, which includes the
shareholder’s “pro rata share” of the CFC’s subpart F income. To the extent that the
CFC’s subpart F income is included in the U.S. shareholder’s income as a section 951
inclusion, the CFC’s actual distributions to the U.S. shareholder are excluded from the
U.S. shareholder’s income under section 959 so that the amounts are not included in
the U.S. shareholder’s income twice. Neither the section 951 inclusion nor the tax-free
distribution of earnings and profits attributable to the section 951 inclusion is treated as
a dividend for the purposes of the section 245 DRD, or is otherwise eligible for the
section 245 DRD. 122
If the foreign corporation is a CFC owned by a U.S. shareholder for its entire
taxable year, the U.S. shareholder’s pro rata share of the CFC’s subpart F income is
generally the amount that would have been distributed to the shareholder with respect
120
See section 871(k)(1)(B)(ii); see also sections 871(h)(2)(B)(ii)(I) and (h)(5). The exemption also does
not apply if the interest-related dividend is paid to a person in a foreign country with respect to which the
Secretary has determined that the information exchange between the United States and the foreign
country is inadequate to prevent evasion of U.S. federal income tax by U.S. persons. Sections
871(k)(1)(B)(iii) and (h)(6)(A).
121
As originally enacted, subpart F consisted of section 951 through 964. Section 965 was added to
subpart F in 2004. American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418 (2004).
122
See Rodriguez v. Comm’r, 137 T.C. 174 (2011), aff’d 722 F.3d 306 (5th Cir. 2013); section 959(a) and
(d).
POSTU-131660-15 48
to the stock that it owns (within the meaning of section 958(a)) if the CFC had
distributed its subpart F income for the taxable year. Thus, its “pro rata share” generally
is based on the U.S. shareholder’s percentage of CFC stock ownership (including
certain stock owned indirectly by the U.S. shareholder). Special rules for determining a
U.S. shareholder’s “pro rata share” apply when there is a change in ownership during a
CFC’s taxable year, and the CFC’s status as a CFC is not changed. Under section
951(a)(1), the U.S. shareholder that disposes of its stock prior to the end of a CFC’s
taxable year does not have a section 951 inclusion with respect to the CFC’s
undistributed income. Instead, only the acquiring U.S. shareholder has a section 951
inclusion, assuming the acquiring U.S. shareholder holds the CFC stock on the last day
of the CFC’s taxable year. In addition, under section 951(a)(2), the amount of the
acquiring shareholder’s section 951 inclusion is reduced by all or a portion of any
dividends paid to the disposing shareholder with respect to the transferred shares
during the taxable year.123
The rule requiring a reduction of the section 951 inclusion for the current U.S.
shareholders of a CFC for the same year distributions to the previous owner(s) was
intended to prevent both the current and former shareholders from being subject to tax
with respect to the same amount of the CFC’s subpart F income. Similarly, the rule that
provides that a U.S. shareholder does not have a section 951 inclusion when it transfers
its CFC interest to another U.S. person during the CFC’s taxable year is a rule for
administering the subpart F regime in a year in which two U.S. persons held the same
CFC shares in order to avoid double taxation. Neither rule was intended to allow
taxpayers to structure transactions that avoid subjecting any U.S. shareholder to U.S.
federal income taxation with respect to subpart F income of a CFC.
iv. Section 245
Section 245 provides rules for the deduction of dividends received from certain
foreign corporations. In connection with the promulgation of the Technical and
Miscellaneous Review Act of 1988 (the “1988 Act”), Congress explained that dividends
eligible for the section 245 DRD “are based on the ratio of (a) the foreign corporation’s
post-1986 earnings and profits that have been subject to net-basis U.S. corporate
income tax and that have not been distributed to (b) the corporation’s total accumulated
earnings and profits.”124 The statutory rules include tests for determining when
dividends are attributable to previously-taxed corporate income, and provide rules on
deductibility based in part on the recipient’s level of stock ownership in the payor. In
addition, Congress specifically disallowed the DRD for amounts treated as dividends
123
See section 951(a)(2)(B). The amount of the acquiror’s section 951 inclusion is reduced by the lesser
of the amount of the distributions made to the disposing shareholder and the subpart F income allocable
to the portion of the taxable year for which the CFC’s stock was owned by the previous owner.
124
H.R. Rep. No. 795, 100th Cong., 2d Sess., at 263 (1988) (emphasis added).
POSTU-131660-15 49
under section 1248125 because the deemed section 1248 dividends are “generally
derived from earnings not subject to U.S. corporate income tax.”126
Common Parent likely is familiar with Congress’ clearly articulated intent to allow
the DRD only for earnings that have been subject to net-basis U.S. federal corporate
income tax. Nonetheless, Sub 3 treated its Year Y distributions from Sub 4 (attributable
to distributions from Sub 6 RIC) as section 301(c)(1) dividends that qualified for the 80
percent DRD under section 245(a). Section 245(a) allows a DRD (as specified in
section 243) for that portion of a dividend paid by a “qualified 10-percent owned foreign
corporation” that is equal to the “U.S.-source portion” of the dividend. Common Parent’s
position is that Sub 4 is a qualified 10-percent owned foreign corporation, and that the
“U.S.-source portion” of the distribution was 100 percent. It is anticipated that Common
Parent will argue that section 245 does not specifically state that the DRD is only
available with respect to earnings that have been subject to U.S. federal corporate
income tax.
However, Sub 3 should not be able to treat distributions from Sub 4 attributable
to distributions from Sub 6 RIC as dividends eligible for the section 245 DRD when,
under sections 243 and 854, Sub 3 could not have claimed a DRD if it had directly
received the distributions from Sub 6 RIC. The general policy of section 245 is
consistent with that of section 243: to ensure that only a single level of corporate tax is
imposed on U.S. source income distributed to a corporate shareholder.127 It is
inconsistent with that policy to allow section 245 deductions for distributions attributable
to interest income and capital gains distributed by a RIC (through a foreign
intermediary) that have not borne any U.S. federal corporate-level income tax. That has
been made even clearer by the addition of section 245(a)(12) to the Code in 2015.128
125
Section 245(a)(11).
126
S. Rep. No. 445, 100th Cong., 2d Sess., at 278 (1988).
127
See S. Rep. No. 313, 99th Cong., 2d. Sess., at 375 (1986) (“The committee recognizes that in a two-
tiered tax system such as in the United States, double taxation will occur (one tax at the corporate level
and a second tax at the individual level at the time of distributions). The dividends received deduction is
intended to prevent more than one full corporate level tax on the same earnings.”)
128
Section 245(a)(12) is discussed in Part I of the LAW AND ANALYSIS section of this memorandum. A
Senate Report explanation of an earlier bill that contained a similar provision to that ultimately enacted
explained that, “[a]n IRS chief counsel advisory memorandum concluded that dividends attributable to
interest income of an 80-percent owned RIC are not entitled to be counted in determining the dividends
received deduction under section 245. … The Committee wishes to preclude any remaining potential that
taxpayers might take the position that any RIC or REIT dividends are eligible for the dividends received
deduction under section 245. … No inference is intended with respect to the proper treatment under
section 245 of dividends received from RICs or REITs before the date of enactment. S. Rep. 114-25,
th st
114 Cong., 1 Sess., at 10 (April 14, 2015).
POSTU-131660-15 50
e. Conclusion of Economic Substance Analysis
Taxpayer fails to satisfy the economic substance test with respect to moving Sub
4 to Country U, funneling funds through Sub 4 as a Country U corporation, and moving
the Sub 4 stock from Sub 3 to Sub 2.
In the alternative, we conclude that Taxpayer fails to satisfy the economic
substance test with respect to its funneling investment funds and its investment returns
through a Country U corporation.
In both cases:
(1) These steps did not provide Taxpayer with a realistic possibility of profit
over and above its return on the Business O Eligible Investments, other
than the planned tax savings from the section 245 DRD.
(2) Other than tax savings, Taxpayer did not have a business purpose that
withstands scrutiny.
(3) Taxpayer’s use of the DRD is not consistent with congressional intent.
Thus, Sub 3’s section 245 DRD is disallowed under the economic substance
doctrine, regardless of whether the literal requirements of section 245 and the other
Code sections at issue have been technically satisfied.
C. Substance Over Form Doctrine
A transaction’s tax consequences depend on its substance, not its form.129 Under
this fundamental principle of income taxation, courts have disallowed the tax benefits of
a transaction despite its formal compliance with the Code and its implementing
regulations. Although the form by which a transaction is effected does influence, and in
certain situations, may decisively control the taxation of a transaction, the substance
over form doctrine allows the courts and the IRS to look beyond the superficial
formalities of a transaction to determine its proper tax treatment.130
The Supreme Court described the substance over form doctrine in Commissioner
v. Court Holding Co.,131 in which the Court agreed with the Commissioner’s
129
See, e.g., Comm’r v. Court Holding Co., 324 U.S. 331 (1945); Frank Lyon Co. v. United States, 435
U.S. 561, 572-73 (1978).
130
See Blueberry Land Co., Inc. v. Comm’r, 361 F.2d 93 (5th Cir. 1966).
131
324 U.S. 331 (1945).
POSTU-131660-15 51
determination that the substance of a purported corporate dividend of real property to
shareholders, and subsequent sale by the shareholders of that property to a third party,
was actually a sale by the corporation to the third party directly.132 The Court stated:
The incidence of taxation depends upon the substance of the transaction.
The tax consequences which arise from gains from the sale of property
are not finally to be determined solely by the means employed to transfer
legal title. Rather, the transaction must be viewed as a whole, and each
step, from the commencement of negotiations to the consummation of the
sale, is relevant. A sale by one person cannot be transformed for tax
purposes into a sale by another by using the latter as conduit through
which to pass title. To permit the true nature of a transaction to be
disguised by mere formalisms, which exist solely to alter tax liabilities,
would seriously impair the effective administration of the tax policies of
Congress.133
The substance over form doctrine allows the government to characterize a
transaction based on its actual substance, regardless of its form, and to tax it
accordingly.134 Courts recast transactions where the taxpayer’s form does not comport
with the reality of the transaction.135 The court has never regarded the simple expedient
of drawing up papers as controlling for tax purposes when the objective economic
realities are to the contrary.136 The substance over form doctrine is used to effect the
underlying purpose of a statute.137 The purpose of the substance over form doctrine is
to deny legal effect to transactions that comply with the literal terms of a statute but
contravene the purpose of the statute.138 The substance of a transaction is assessed in
132
Id. at 334.
133
Id. at 333.
134
See also, e.g., Schering-Plough Corp. v. United States, 651 F.Supp.2d 219 (D.N.J. 2009), aff’d sub.
nom. Merck & Co., Inc. v. United States, 652 F.3d 475 (3d Cir. 2011) (substance of purported sales in
interest rate swaps were loans); BB&T v. United States, 523 F.3d 461 (5th Cir. 2008) (substance of
purported lease agreement was financing arrangement, and purported loan was circular flow of funds);
Rogers v. United States, 281 F.3d 1108 (10th Cir. 2002) (substance of purported loan agreement was
sale); Shepherd v. Comm’r, 283 F.3d 1108 (10th Cir. 2002) (substance of purported gift of partnership
interest was a gift of real estate); Sather v. Comm’r, 251 F.3d 1168 (8th Cir. 2001) (describing the
“reciprocal trust doctrine,” a version of substance over form where reciprocal gifts of stock left transferors
in same position as prior to gifts); and, Grojean v. Comm’r, 248 F.3d 572 (7th Cir. 2000) (substance of
purported lending agreement was a guaranty).
135
See Court Holding, 324 U.S. at 334.
136
Merck, 652 F.3d at 481 (quoting Frank Lyon v. United States, 435 U.S. 561 (1978)).
137
Consol. Edison Co. of N.Y. v. United States, 703 F.3d 1367, 1374 (Fed. Cir. 2013).
138
See Stewart v. Comm’r, 714 F.2d 977, 988 (9th Cir. 1983).
POSTU-131660-15 52
light of all the facts and circumstances.139 The substance over form doctrine requires
viewing the transaction as a whole.140
1. Step Transaction Doctrine
a. Overview of the Step Transaction Doctrine
One variation of the substance over form doctrine is the step transaction
doctrine. The step transaction doctrine was developed by the courts to ensure that a
transaction is taxed in accordance with its substance “‘by ignoring for tax purposes,
steps of an integrated transaction that separately are without substance.’”141 The “well-
established” doctrine has been “expressly sanctioned” by the Supreme Court, which has
noted that “interrelated yet formally distinct steps in an integrated transaction may not
be considered independently of the overall transaction.”142
Courts have outlined three basic tests to establish the circumstances under
which the application of the step transaction doctrine applies. Under the narrowest
approach, the “binding commitment” test, the steps are collapsed if, at the first step,
there was a “‘binding commitment to undertake the later step’ in a series of
transactions.”143 The interdependence test focuses on “whether ‘the steps [are] so
interdependent that the legal relations created by one transaction would have been
fruitless without a completion of the series.’”144 It requires a determination of whether
the steps had independent significance or had meaning only as part of a larger
transaction – that is, a transaction with the end result that the taxpayer hoped to
achieve. Accordingly, the interdependence test is sometimes viewed as a variation of
the third test: the “end result” test. Under the end result test, the doctrine is applied if it
appears that “separate transactions were ‘really component parts of a single transaction
intended from the outset to be taken for the purpose of reaching the ultimate result.’”145
139
Grodt & McKay Realty, Inc. v. Comm’r, 77 T.C. 1221 (1981).
140
John Hancock Life Ins. v. Comm’r, 141 T.C. 1 (2013).
141
The Falconwood Corp. v. United States, 422 F.3d 1339, 1349 (Fed. Cir. 2005) (quoting Dietzch v.
United States, 498 F.2d 1344, 1346 (Ct. Cl. 1974)).
142
Comm’r v. Clark, 489 U.S. 726, 738 (1989).
143
Falconwood Corp., 422 F.3d at 1349 (quoting Penrod v. Comm’r, 88 T.C. 1415, 1429 (1987)).
144
Id. (quoting King Enter., Inc. v. United States, 418 F.2d. 511, 516 (Ct. Cl. 1969)).
145
Id. (quoting King Enter., Inc. v. United States, 418 F.2d. 511, 516 (Ct. Cl. 1969)).
POSTU-131660-15 53
b. Step Transaction Doctrine Analysis
The Transaction consisted of a carefully planned and orchestrated series of
steps, as set forth in Part III of the FACTS section of this memorandum, which included,
in part, the following:
(Step 6 and Step 8) One or more members of US Group transferred funds that were to
be invested in Business O Eligible Investments directly to Sub 6 RIC (which Taxpayer
treated as transfers going directly or indirectly to Sub 3, from Sub 3 to Sub 4, and from
Sub 4 to Sub 6 RIC);
(Step 9) Sub 6 RIC purchased Business O Eligible Investments in accordance with the
advice of a member of US Group;
(Step 10) Sub 6 RIC made distributions of its earnings with respect to the Business O
Eligible Investments to Sub 4; and
(Step 11) Sub 4 made distributions of the funds it received from Sub 6 RIC to Sub 3.
Sub 3’s (deemed) transfers to Sub 4, Sub 4’s (deemed) transfers to Sub 6 RIC,
Sub 6 RIC’s transfers to Sub 4, and Sub 4’s transfers to Sub 3, as enumerated above,
should be disregarded. As this memorandum sets forth in the discussion of the
economic substance doctrine, these steps, which served only to route funds through
Sub 4, served no independent business purpose.
Taxpayer planned the entire Transaction before moving funds from one or more
members of US Group to Sub 6 RIC. The Transaction plan required Sub 4 to transfer
the funds to Sub 6 RIC and required Sub 6 RIC to use the funds to invest in Business O
Eligible Investments. Moreover, the plan required Sub 6 RIC to distribute its earnings
on the Business O Eligible Investments back to one or more members of US Group,
routing the funds through Sub 4. Taxpayer carried out the steps in the Transaction in
accordance with the plan.
Application of the Interdependence Test. The interdependence test analyzes the
relationship between the intermediate steps of a complex transaction.146 This test
focuses on whether the intervening steps in a series of steps would have been fruitless
or meaningless if the other steps in the series had not taken place.147
The steps in which Taxpayer moved funds through Sub 4, as enumerated above,
are interdependent and should be disregarded under the interdependence test because
146
Assoc. Wholesale Grocers, Inc. v. United States, 927 F.2d 1517, 1523 (10th Cir. 1991).
147
Penrod v. Comm’r, 88 T.C. 1415, 1430 (1987).
POSTU-131660-15 54
each of the steps would have been “fruitless” in the larger Transaction if the other steps
had not taken place. Sub 3’s contribution of funds to Sub 4 would have been fruitless
unless Sub 4 contributed the funds to Sub 6 RIC so that Sub 6 RIC could invest in the
Business O Eligible Investments. Sub 4’s receipt of distributions from Sub 6 RIC would
have similarly been fruitless unless Sub 4, in turn, distributed the return on investment
back to Sub 3 so that Sub 3 could claim the DRD.
In its application of the interdependence test, the Tax Court, in Barnes Group v.
Commissioner,148 focused its inquiry on whether there was a non-tax business purpose
for each of the separate steps in the transaction.149 As set forth in the discussion of the
economic substance doctrine in Part III.B of the LAW AND ANALYSIS section of this
memorandum, the steps of the Transaction that Taxpayer took to move funds through
Sub 4 did not have an independent business purpose. As in Barnes Group, the lack of
a non-tax business purpose for these steps supports disregarding the routing of funds
through Sub 4. Accordingly, Sub 3 should be treated as directly contributing funds to
Sub 6 RIC and Sub 6 RIC should be treated as making direct distributions to Sub 3, to
which section 243 would not apply as a result of section 854.
Application of the End Result Test. The end result test analyzes whether a
series of steps are prearranged parts of a single transaction that, from the outset, is
designed to achieve a specific end result.150 The test focuses on the parties’ subjective
intent when they structure the transaction.151
Taxpayer’s planning documents reflect that Taxpayer took steps to move funds
through Sub 4 in order to generate a DRD that it could not obtain if one or more
members of US Group directly invested in Business O Eligible Investments or invested
in them through Sub 6 RIC. Taxpayer planned and carried out these steps to achieve
the end result of providing Taxpayer with a return on the Business O Eligible
Investments, avoiding the application of section 854, and ostensibly qualifying for a
section 245 DRD. Under the application of the end result test, these steps should be
disregarded and Sub 3 should be treated as directly contributing funds to Sub 6 RIC
and directly receiving distributions from Sub 6 RIC in Year Y, which were not eligible for
a DRD.
Application of the Binding Commitment Test. As previously discussed, Sub 4 did
not have an independent business purpose, other than tax avoidance, for participating
148
T.C. Memo. 2013-109, aff’d by ruling by summary order, 593 Fed. Appx. 7 No. 13-4298 (Nov. 5, 2014).
149
Id.
150
True v. United States, 190 F.3d 1165, 1175 (10th Cir. 1999).
151
Superior Trading, LLC v. Comm’r, 137 T.C. 70, 89 (2011).
POSTU-131660-15 55
in the acquisition of the Business O Eligible Investments. Common Parent’s control
over Sub 4 resulted in a transaction whose steps were as controlled as any contractual
arrangement. The binding commitment test of the step transaction doctrine is generally
applied when the parties have entered into a binding contract to carry out the
transaction steps. In the instant case, there was no need for the parties to enter into
binding contracts to ensure that each step of the transaction would take place as
planned. There was no risk that Sub 4 would deviate from Taxpayer’s plan. As noted in
the FACTS section of this memorandum, Sub 4 was not an independent actor; it was at
all times controlled by Taxpayer. Sub 4 did not have its own employees; all of its
activities were carried out by employees of members of the US Group. Importantly,
members of US Group directly transferred funds to Sub 6 RIC to invest in the Business
O Eligible Investments. Thus, there was not even the opportunity for Sub 4 to control
the funds on their journey from members of US Group to Sub 6 RIC and divert the funds
for its own use. The outcome of the Sub 6 RIC transaction was even more pre-ordained
than would be the outcome of a transaction pursuant to a contractual arrangement
between unrelated parties. Accordingly, under the binding commitment test Sub 4’s
participation in the Transaction should be disregarded in determining how the
Transaction is taxed.
Moreover, the Transaction deserves “particular scrutiny” because it was carried
out among related parties.152 Even if Sub 4 did not have a binding commitment to move
funds to Sub 6 RIC or make distributions to a member of US Group, there is ample
authority for linking prearranged steps under the interdependence test and end result
test in the absence of a contractual obligation or financial compulsion to follow through
with the steps.153
No statutory or regulatory provisions have been implemented to prevent
application of the step transaction doctrine in the context of the Transaction. A
transaction’s steps may be integrated under the step transaction doctrine unless the
application of the doctrine has been “turned off” by legislative or regulatory mandate.
For example, Congress enacted statutes in response to the Supreme Court’s
application of the step transaction doctrine in Helvering v. Bashford.154
152
In re Uneco, Inc., 532 F.2d 1204, 1207 (8th Cir. 1976) (“Advances between a parent corporation and a
subsidiary or other affiliate are subject to particular scrutiny ‘because the control element suggests the
opportunity to contrive a fictional debt.’”) (quoting Cuyuna Realty Co. v. United States, 382 F.2d 298, 300-
01 (Ct. Cl. 1967)).
153
See, e.g., Kornfeld v. Comm’r, 137 F.3d 1231, 1235-1236 (10th Cir. 1998); McDonald’s Rest. v.
Comm’r, 688 F.2d 520, 525 (7th Cir. 1982).
154
302 U.S. 454 (1938).
POSTU-131660-15 56
A discussion of the Bashford decision, necessitates a preliminary discussion of
Groman v. Commissioner.155 In the Groman case, Glidden corporation formed a new
corporation, “Ohio,” to acquire all of the shares of an unrelated corporation, “Indiana.”
The shareholders of Indiana, including Mr. Groman, received in exchange for their
shares, stock in Glidden, stock in Ohio, and cash. Under the reorganization provision
then in effect, Mr. Groman would not recognize gain to the extent he exchanged his
Indiana shares for shares of a corporation that was a party to the reorganization. The
Commissioner determined Glidden was not “a party to the reorganization” and the Court
agreed. Accordingly, Mr. Groman was taxed on the cash he received and on the
Glidden shares.
The Bashford transaction had facts similar to those in the Groman case. In
Bashford, the “Atlas” corporation wanted to acquire the stock of three of its corporate
competitors. In pursuance of the transaction, Atlas caused the formation of a new
company. The shareholders of the three target corporations received, in exchange for
their shares, stock in the new company, stock in Atlas and cash. The Commissioner
determined that, under the law then in effect, Atlas was not a party to the reorganization
and the shareholders of the target corporations were to be taxed on their receipt of the
Atlas shares. Mr. Bashford, a shareholder of one of the target corporations, attempted
to distinguish his transaction from the Groman transaction. He explained that Atlas
directly acquired the shares of target corporations and Atlas provided all of the
consideration (which included both Atlas shares and shares of the new company).
Accordingly, Mr. Bashford argued Atlas was a party to the reorganization. Only after
acquiring the target stock did Atlas transfer the shares to the new corporation.
The Court applied the step transaction doctrine, disregarding Atlas’ acquisition of
the target corporations because “[a]ny direct ownership by Atlas [of the target
corporations] was transitory and without real substance; it was part of a plan which
contemplated the immediate transfer of the stock or the assets or both of the three
reorganized companies to the new Atlas subsidiary.”156 Accordingly, the Court found
the distinction in form between the Groman transaction and the Bashford transaction
was not of legal significance. To override the effect of the Bashford decision, Congress
enacted section 368(a)(2)(C), which allows transactions otherwise qualifying as
reorganizations not to be “disqualified by reason of the fact that part or all of the assets
or stock which were acquired in the transaction are transferred to a corporation
controlled by the corporation acquiring the assets or stock.” In effect, section
368(a)(2)(C) prevents the application of the step transaction doctrine to the facts of a
transaction such as the one described in Bashford.
155
302 U.S. 82 (1937).
156
Bashford, 302 U.S. at 458. The Court did not specifically state that it was applying the step transaction
doctrine.
POSTU-131660-15 57
There are no statutes or regulations that prevent the application of the step
transaction doctrine to the Transaction. Therefore, under the application of the step
transaction doctrine, Sub 3 is treated as directly acquiring stock in Sub 6 RIC and
receiving distributions from Sub 6 RIC with respect to such stock. Accordingly, Sub 3
does not qualify for a DRD under section 245 or section 243.
c. Conduit Analysis
In the context of the step transaction doctrine, the Ninth Circuit has identified a
“class of cases in which the form of the transaction is particularly suspect. Where a
party acts as a ‘mere conduit’ of funds – a fleeting stop in a predetermined voyage
toward a particular result – [the court has] readily ignored the role of the intermediary in
order appropriately to characterize the transaction.”157 Taxpayer’s moving funds
through Sub 4 had no purpose or effect other than as steps to facilitate Taxpayer’s
reduction of tax through the use of the section 245 DRD.
In Robino v. Commissioner,158 the Ninth Circuit integrated a series of steps to
find that two individuals sold a parcel of land to a developer and that they used their tax-
exempt trusts as conduits to accomplish this result. The individuals, Mr. Filler and Mr.
Schlosberg, purchased the land in 1981 as tenants in common. During that same year,
Mr. Schlosberg was approached by a builder, who wanted to build on the land. Mr.
Schlosberg was the sole trustee and beneficiary of a tax-exempt pension trust that
purchased an option to buy Mr. Filler’s interest in the land. Mr. and Mrs. Filler set up a
similar trust to buy an identical option to purchase Mr. Schlosberg’s interest in the land.
The Fillers and Mr. Schlosberg signed the cross-options in 1981 under which each
would sell for $5,000 an option to buy a half share in the land within two years for
$275,000. Notwithstanding that the Fillers and Mr. Schlosberg granted options to the
trusts, they also offered options to buy the property to a real estate agent working on
behalf of the builder. They agreed to an option price of about $1.3 million. Later that
same year, the trusts exercised their options to buy the parcel of land and a few weeks
later, sold the land to the builder. Filler and Schlosberg each reported gain of
approximately $50,000, the difference between each individual’s basis in the land of
$225,000 and the $275,000 paid by the trust to exercise its option. The IRS determined
that the trusts were merely conduits and thus treated Mr. Filler and Mr. Schlosberg as
selling their respective rights in the land to the builder.
The Ninth Circuit agreed with the Commissioner, finding that Mr. Filler and Mr.
Schlosberg: (i) sold options to the trusts at below market prices; (ii) negotiated the terms
of the builder’s option to purchase the land; (iii) structured the transaction through the
trusts to avoid taxes and had little justification for using the trusts other than tax
157
Brown v. United States, 329 F.3d 664, 672 (9th Cir. 2003).
158
894 F.2d 342 (1990).
POSTU-131660-15 58
avoidance; and (iv) as the transaction was carried out, at each moment retained
complete control over the property. The court, focusing on the realities of the
transaction rather than the refinements of legal title, the verbiage of written instruments,
or the chronological order of formal events, found that, in substance, Mr. Filler and Mr.
Schlosberg directly sold their property interests to the builder.
Under the conduit theory of the substance over form doctrine, the use of an entity
may be disregarded if it is a mere conduit in a transaction. As set forth in the discussion
of the economic substance and step transaction doctrines, Taxpayer planned and
oversaw the entire Transaction in which Sub 4 was a mere intermediary in routing funds
between Taxpayer and Sub 6 RIC. Taxpayer structured the transaction to move funds
through a Country U corporation to avoid taxes by circumventing the application of
section 854 and instead, claiming the section 245 DRD. Taxpayer had little, if any,
justification for moving funds through a Country U corporation other than tax avoidance.
Sub 4’s role in the Transaction, which was predetermined by Taxpayer and under
Taxpayer’s control, had no substantive effect on US Group’s investment in the Business
O Eligible Investments. Moreover, throughout the Transaction, Taxpayer retained
complete control of the funds it held in Sub 4. Thus, Sub 4’s role should be disregarded
as that of a conduit. Sub 3 should be treated as directly contributing funds to Sub 6 RIC
and as directly receiving distributions from Sub 6 RIC in Year Y.
2. Alternative Substance Over Form Analysis
Sub 4 is a CFC and Sub 3 is a U.S. shareholder of Sub 4 within the meaning of
section 951(b). The dividends received by Sub 4 from Sub 6 RIC during Year Y are
foreign personal holding company income (FPHCI), which is a type of subpart F
income.159 However, Taxpayer takes the position that Sub 3 is not required to include in
income its pro rata share of Sub 4’s subpart F income under section 951(a) because
Sub 3 distributed its entire interest in Sub 4 to Sub 2 just prior to the end of Sub 4’s
Year Y taxable year. As noted in Part I of the FACTS section of this memorandum, Sub
C directly owned all of the stock of Sub 1 and indirectly owned the stock of Sub 2, Sub
3, Sub 4, and Sub 6 RIC. Throughout Sub 4’s Year Y taxable year, Sub C used the
Business O Eligible Investments and the income they produced to satisfy its safety and
soundness requirements without regard to whether the Business O Eligible Investments
were held directly or through one or more of its subsidiaries that were members of US
Group or Sub 6 RIC.
Sub C indirectly wholly owned Sub 4 prior to Sub 3’s distribution of Sub 4 shares
to Sub 2, and Sub C continued to own indirectly Sub 4 after the distribution of the
shares to Sub 2. For purposes of subpart F, a U.S. shareholder of a CFC includes a
United States person who is considered as owning 10 percent or more of the total
159
Section 954(c)(1)(A) provides that dividends are a type of FPHCI. None of the exceptions to FPHCI
apply to the dividends received by Sub 4 from Sub 6 RIC during Year Y.
POSTU-131660-15 59
combined voting power of all classes of stock entitled to vote by applying the rules of
ownership of section 958(b), which incorporates the constructive ownership rules of
section 318 subject to certain exceptions not relevant here. Accordingly, as members of
a 100 percent-owned chain of domestic corporations, Common Parent and each
intervening domestic subsidiary in the US Group, including each of Sub C, Sub 1, and
Sub 2, was a U.S. shareholder of Sub 4 throughout Year Y (and during Year Z and Year
BB) for subpart F purposes, because each was considered under sections 951(b) and
958(b) as owning 100 percent of the total combined voting power of Sub 4.160 Unlike
cases in the subpart F area in which parties varied voting rights in order to avoid U.S.
shareholder status, in this case it is undisputed that all corporations of US Group in the
chain of ownership of Sub 4 were U.S. shareholders under subpart F and potentially
subject to section 951 inclusions.
In order to avoid the double counting of income inclusions in a chain of
corporations, subpart F limits the income inclusion to only those corporations in the
chain that own interests in the CFC on the last day of the CFC’s taxable year directly or
through foreign entities.161 But when a chain of 100 percent U.S. shareholders holds
the CFC on every day of the taxable year, these statutory provisions were not intended
to result in the exclusion of all subpart F income merely by manipulating which U.S.
shareholder in the chain owned a direct interest in the CFC on the last day of the year,
as Taxpayer did in the Transaction. If Sub 3 had owned the stock of Sub 4 on the last
day of Sub 4’s Year Y taxable year, it would have had an income inclusion under
section 951(a) because Sub 3 owned 100 percent of Sub 4’s stock within the meaning
of section 958(a).162 That income inclusion would have been based on the full amount
of Sub 4’s subpart F income because Sub 3 would have owned the stock on every day
of Sub 4’s Year Y taxable year. Instead, Sub 3 transferred its interest in Sub 4 to Sub 2
days before the end of Sub 4’s Year Y taxable year and claimed that it did not have a
subpart F inclusion because it did not hold the stock on the last day of the taxable year.
Sub 3 did so in order to change the character of the income that it derived with respect
to Sub 4 during Year Y from a section 951 inclusion that was not eligible for a section
245 DRD to a dividend, which Taxpayer claims is eligible for a section 245 DRD.
If Sub C, or any other U.S. shareholder in US Group, had directly owned the
stock of Sub 4 every day of Sub 4’s Year Y taxable year, it would have been required to
include in income amounts under section 951 with respect to all of Sub 4’s income that
160
See Schering-Plough Corp. v. United States, 651 F. Supp. 2d 219, 225, aff’d sub. nom. Merck & Co.,
Inc. v. United States, 652 F. 3d 475 (3d Cir. 2011) (“Schering-Plough (through its domestic subsidiaries)
was a United States shareholder within the meaning of I.R.C. §§ 951(b) and 958(a)”).
161
Sections 951(a) and 958(a).
162
See the discussion of the subpart F rules described in Part III.B.2.d.iii of the LAW AND ANALYSIS
section of this memorandum.
POSTU-131660-15 60
was attributable to the Business O Eligible Investments.163 Sub C and these other
members were U.S. shareholders of Sub 4 for subpart F purposes throughout the year,
yet other than a small section 951 inclusion reported by Sub 2, none of these U.S.
shareholders included amounts in income under section 951 with respect to the subpart
F income earned by Sub 4. Taxpayer’s structuring ensured that no single member of
US Group that was a U.S. shareholder of Sub 4 owned, within the meaning of section
958(a), all of the stock of Sub 4 on every day of Sub 4’s Year Y taxable year. However,
each member of US Group that was a U.S. shareholder of Sub 4, including Sub 3,
retained ownership (within the meaning of section 958(b)) of voting power with respect
to Sub 4 at all times during Sub 4’s Year Y taxable year. Moving the stock of a CFC
between related U.S. shareholders at the end of the CFC’s taxable year to avoid a
section 951 inclusion is contrary to the purposes of subpart F, which require amounts to
be included in income under section 951(a) when U.S. shareholders control a foreign
corporation.
Although there are no cases that address the avoidance of section 951 with the
same facts as those in the Transaction, courts have rejected schemes devised to avoid
section 951 inclusions since the enactment of subpart F. As early as 1961, taxpayers
contrived to avoid section 951 inclusions by transferring nominal voting power to
“friendly” foreign persons, and then arguing that the foreign corporation did not meet the
definition of a CFC under section 957 because more than half the voting control of the
corporation was held by foreign persons.164 The courts ignored these transfers for
purposes of determining whether the foreign corporation was a CFC because it was
clear that the U.S. shareholders, in substance, continued to control the voting power of
the stock nominally held by foreign persons.165 Further, the courts rejected the
taxpayers’ arguments that the statute provided a mechanical test. Instead, the courts
concluded that mere technical compliance with the statute was not sufficient, and that
the rules in the statute would be applied to the substance of the transaction, rather than
the form of the transaction.
Similarly, U.S. shareholders have tried to avoid section 951 inclusions
attributable to loans from their wholly-owned CFCs by engaging in transactions that, in
form, were outside the scope of section 956. In Jacobs Engineering v.
163
Sub 4’s subpart F income subject to inclusion by such U.S. shareholder would not have been reduced
by a DRD because Sub 4’s income is calculated as if it were a domestic corporation. See Treas. Reg. §
1.952-2. Therefore, Sub 4 would not have been able to claim a DRD under section 243 due to the
application of section 854.
164
Garlock, Inc. v. Comm’r, 58 T.C. 423 (1972), aff’d., 489 F.2d 197 (2d Cir. 1973). See also Kraus v.
Comm’r, 59 T.C. 681 (1973), aff’d, 490 F.2d 898 (2d Cir. 1974); Weiskopf Est. v. Comm’r, 64 T.C. 78
(1975), aff’d per curiam, 538 F.2d 317 (2d Cir. 1976); Koehring Co. v. United States, 583 F.2d 313 (7th
Cir. 1978).
165
See supra note 165.
POSTU-131660-15 61
Commissioner,166 a U.S. shareholder frequently borrowed and repaid funds from its
wholly-owned CFC, with only short periods of time between repayments and new
borrowings. The taxpayer carefully ensured that the loans were never outstanding on a
section 956 measuring date, which would have resulted in a section 951 inclusion.167
The court observed that under the substance over form doctrine, “the Commissioner
may deny legal effect to a transaction if the sole purpose of the transaction was to avoid
tax,” and the court must simply decide whether the facts of the case “fall within the
intended scope of the Internal Revenue Code provision at issue.”168 The court
concluded that the series of loans was, in substance, a single loan outstanding for the
entire year, notwithstanding that the loans were not, in form, outstanding on a section
956 measurement date.169
Furthermore, in Schering-Plough v. United States,170 the taxpayer tried to avoid a
section 951 inclusion attributable to a loan from its wholly-owned CFC by arranging a
series of circular interest rate swaps with the CFC and a third party. The court noted
that when applying the substance over form doctrine, “transactions between related
parties merit extra scrutiny.”171 The court held that the interest rate swaps were, in
substance, a loan from the CFC that resulted in a section 951 inclusion to the U.S.
shareholder and found that the third party, a large unrelated bank, was a mere conduit
between the U.S. parent and the CFC in the tax avoidance scheme.172
In all of these cases, the courts recognized that the statutory rules in the subpart
F regime are not purely mechanical. Instead, the courts applied the Gregory principle to
determine whether the subject transaction met both the terms and intent of the statute.
In each of the cases, the court held that even though the U.S. shareholder had
structured transactions that, in form, allowed the U.S. shareholder to avoid a section
951 inclusion, the transaction lacked the substance required by the statute.
Accordingly, the courts held that the U.S. shareholders were subject to tax under
subpart F consistent with the substance of the transactions, which resulted in the U.S.
shareholders including section 951 inclusions in income.
166
79 A.F.T.R. 2d 97-1673 (C.D. Cal. 1997), aff’d by unpublished decision, 168 F.3d 499 (9th Cir. 1999).
167
Id. Under section 956, investments in United States property, including loans to U.S. shareholders,
held by a CFC on particular dates generally are includible in the U.S. shareholder’s section 951 inclusion.
168
Id.
169
Id.
170
651 F .Supp. 2d 219 (D. N.J. 2007), aff’d sub. nom. Merck & Co., Inc. v. United States, 652 F.3d 475
(3d Cir. 2011).
171
Merck, 652 F.3d at 481.
172
Id.
POSTU-131660-15 62
In the instant case, Sub 3 would have had a section 951 inclusion calculated
based on 100 percent of Sub 4’s subpart F income if it owned Sub 4 directly for the
entire Year Y taxable year, irrespective of any distributions from Sub 4. Likewise, any
member of US Group, including Sub 2 and Sub C, would have included in income
section 951 inclusions calculated based on 100 percent of Sub 4’s subpart F income as
a section 951 inclusion if such member directly owned Sub 4 for the entire Year Y
taxable year, irrespective of any distributions from Sub 4. If any member of US Group
held the stock of Sub 4 throughout the year, the member would not have been eligible
for the section 245 DRD with respect to any part of the section 951 inclusion attributable
to the entire Year. Instead, members of US Group shuffled the stock of Sub 4 from one
member to another, all of whom were U.S. shareholders of Sub 4 potentially subject to
an income inclusion under section 951, in furtherance of its tax avoidance plan.
Accordingly, under the substance over form principles announced in Gregory and
followed in Garlock Inc. v. Commissioner,173 Jacobs Engineering, and Schering-Plough,
a member of US Group that was a U.S. shareholder of Sub 4 during Sub 4’s Year Y
taxable year should be required to include in income 100 percent of Sub 4’s subpart F
income pursuant to section 951(a).
CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS
173
58 T.C. 423 (1972).
POSTU-131660-15 63
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this writing may undermine our ability to protect the privileged information. If disclosure
is determined to be necessary, please contact this office for our views.
Please call ---------------------if you have any further questions with regard to this
memorandum generally or ---------------------with regard to the argument in Part III.C.2 of
the LAW AND ANALYSIS section of this memorandum.
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