Rev. Rul. 78-83

Advice has been requested whether income of X corporation diverted to Y corporation will be treated as a distribution taxable as a dividend to P corporation to the extent of the earnings and profits of X and a capital contribution by P to Y, under the circumstances described below.

The taxpayer, P, a domestic corporation, owned all of the stock of X, a foreign corporation incorporated in country M. X produces and exports fiber for sale on the world market, but due to monetary restrictions, X has had difficulty in securing dollars needed to pay refunds to foreign customers and to pay travel expenses of its employees outside country M. P, therefore, formed Y, a wholly owned foreign corporation incorporated in country T to act on behalf of X to receive part of the sales price charged by X. Thereafter, some of these dollars accumulated by Y were used to pay the above-mentioned refunds and expenses, as well as certain promotion expenses in connection with the fiber sales. P provided incidental services for X in connection with these disbursements, but performed no services in connection with the fiber sales. The funds diverted from X to Y were in excess of the amounts necessary to provide Y with reasonable compensation for its services to X and to reimburse Y for the expenses it incurred on behalf of X.

Section 301(a) of the Internal Revenue Code of 1954 provides that except as otherwise provided in subchapter C of the Code, a distribution of property (as defined in section 317(a)) made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in subsection (c).

Section 301(c) of the Code provides, in part, that in the case of a distribution to which subsection (a) applies, that portion of the distribution which is a dividend (as defined in section 316) shall be included in gross income.

Section 1.301-1(c) of the Income Tax Regulations provides that section 301 is not applicable to an amount paid by a corporation to a shareholder unless the amount is paid to the shareholder in his capacity as such. A distribution to a shareholder in his capacity as such, need not be formally declared and paid but may take the form of a constructive dividend.

Section 482 of the Code provides authority to distribute, apportion or allocate gross income, deductions, and credits among related organizations, trades, or businesses if it is necessary in order to clearly reflect the income of such entities or to prevent the evasion of taxes.

Section 482 of the Code applies to transactions between brother-sister corporations involving the performance of services by one for the benefit of the other that result in significant shifting of income.

Where an allocation is made under section 482 as a result of an excessive charge for services rendered between brother-sister corporations, the amount of the allocation will be treated as a distribution to the controlling shareholder with respect to the stock of the entity whose income is increased and as a capital contribution by the controlling shareholder to the other entity involved in the transaction. See Rev. Rul. 69-630, 1969-2 C.B. 112, relating to a bargain sale between brother-sister controlled corporations.

A constructive dividend is paid when a corporation diverts property, directly or indirectly, to the use of a shareholder without expectation of repayment, even though no formal dividend has been declared.

Generally, in those cases involving corporations controlled by the same persons, the courts have found a constructive dividend to have been distributed to the common shareholders where one of the corporations was used as a device for siphoning off the earnings and profits. See Helvering v. Gordon, 87 F.2d 663 (8th Cir. 1937); Commissioner v. Greenspun, 156 F.2d 917 (5th Cir. 1946); Biltmore Homes, Inc. v. Commissioner, 288 F.2d 336 (4th Cir. 1961).

However, a constructive dividend is a diversion of the property, not of the income. Income is a characterization which tax law attributes to certain receipts of property, whereas a constructive distribution is that of property itself. Thus, where property is transferred from one affiliate to a sister corporation without adequate consideration therefor, there is a constructive distribution to the common parent whether or not the motive for the transfer was an attempt improperly to allocate income or deductions between the corporations.

However, any amount diverted to Y for disbursements on behalf of X, or as reasonable compensation for services rendered to X, would not be considered as constructive dividend income to P.

Accordingly, the income of X diverted to Y in excess of the disbursements on behalf of X and reasonable compensation for services of Y will be treated as a distribution taxable as a dividend to P to the extent of the earnings and profits of X, and a capital contribution by P to Y.