REGULATIONS WILL SUSPEND PROVISION WHICH RECHARACTERIZES GAINS AS DIVIDENDS; NONRECOGNITION PROVISION WILL ALSO BE MODIFIED.

Notice 87-64

The Internal Revenue Service today announced that, pursuant to the regulatory authority granted by section 631(d)(2) of the Tax Reform Act of 1986 (the Act), regulations under section 1248(e) and (f) of the Internal Revenue Code will be published to suspend the application of section 1248(e) for periods during which there is no capital gains rate differential in the Code and to limit the application of section 1248(f).

Section 1248 generally recharacterizes gain recognized by a United States shareholder on the disposition of stock in a controlled foreign corporation (CFC) as a dividend to the extent of earnings attributable to the United States shareholder's ownership interest in the CFC.

Prior to the Act, there were several important consequences of section 1248. Primarily, section 1248 prevented repatriation of income at capital gains rather than ordinary income rates. In addition, because section 1248 recharacterized gain as a dividend, a corporate United States shareholder received an indirect credit for an appropriate portion of foreign taxes paid or accrued by the CFC. After the effective date of the repeal of the capital gains rate differential by sections 301(a) and 311(a) of the Act, the primary consequence of characterizing gain on CFC stock as a dividend will be the receipt of the indirect foreign tax credit that accompanies the deemed dividend.

Section 1248(e), which treats certain dispositions of the stock of a domestic corporation as a disposition of the stock of a foreign corporation, is an anti-abuse provision designed to prevent a United States shareholder from converting what would be ordinary income under section 1248 to capital gain. The repeal of the capital gains rate differential eliminates the need for section 1248(e). Section 631(d)(2) of the Act amended section 1248(e) and (f) of the Code to provide that those provisions would be applicable "Except as provided in regulations prescribed by the Secretary." Pursuant to the grant of regulatory authority in section 631(d)(2) of the Act, regulations under section 1248(e) will be published to suspend the application of section 1248(e) for periods during which capital gains are taxed at the same rates as ordinary income.

Regulations will also be published to restrict the application of section 1248(f). Section 1248(f) prevents a taxpayer from avoiding section 1248 by engaging in certain nonrecognition transactions. The Act, by amending certain sections, including sections 311, 336, 337 and 361(c), expands the number of situations in which gain is recognized on distributions, sales or exchanges of stock in CFCs. In situations in which gain on CFC stock is recognized under the rules of subchapter C as if the CFC stock were sold on the date of the distribution, section 1248(a) shall apply so that the gain recognized under the rules of subchapter C will be characterized as a dividend accompanied by an indirect foreign tax credit. Accordingly, regulations will be published under section 1248(a) and (f) to provide that section 1248(f) will not apply to those distributions in which gain on CFC stock is recognized pursuant to certain sections, including sections 311, 336, and 361(c), as if the CFC stock had been sold at its fair market value at the time of the distribution. In situations in which gain on the CFC's stock is recognized under the rules of subchapter C but the gain is deferred under the consolidated return rules, section 1248(a) will apply at such time as the deferral of gain ends.

Pursuant to the exception contained in section 1248(f)(2), section 1248(f)(1) will not apply to certain distributions of CFC stock to a domestic corporation in which no gain is recognized under new section 337. In addition, regulations under section 1248(f) may limit the application of section 1248(f)(1) in section 355 distributions of CFC stock to situations in which the CFC is no longer a CFC after the distribution or in which one or more of the distributees of the CFC stock are not "United States shareholders" within the meaning of section 951(b) after the distribution. These regulations would also contain provisions to ensure that subsequent to a section 355 distribution that would not be subject to section 1248(f)(1) as stated above, the amount of section 1248 dividend resulting from a subsequent disposition of the CFC stock would include the section 1248 earnings attributable to the CFC stock as of the date of the section 355 distribution. The regulations may require appropriate adjustments to the basis and holding period of the stock of the CFC in the hands of the distributee. The changes to the section 1248(f) regulations would remain in effect regardless of whether a capital gains rate differential exists.

The regulations described in this notice will be effective as of September 21, 1987, the date of publication of this notice, even though the regulations are published after such date.