SHAREHOLDER CORPORATION RECEIVING PROPERTY FROM CONTROLLED FOREIGN CORPORATION MUST INCLUDE SUCH PROPERTY IN GROSS INCOME ONLY ONCE

Rev. Rul. 86-131

ISSUE

How are the earnings and profits of a controlled foreign corporation to be adjusted to reflect a distribution to its domestic shareholder of property that has an adjusted basis that exceeds its fair market value?

FACTS

P, a domestic corporation, owns all of the outstanding stock of FX1, a controlled foreign corporation (CFC) within the meaning of section 957(a) of the Internal Revenue Code. On December 31, 1983, FX1 purchased from an unrelated third party, in a transaction in which gain or loss was recognized, all of the outstanding shares of FX2, a CFC engaged in manufacturing.

On July 1, 1985, the fair market value of the FX2 stock held by FX1 was 50x dollars, and FX1's adjusted basis in the FX2 stock was 100x dollars. On that day, FX1 distributed all of its FX stock to P.

On December 31, 1985, FX1 had accumulated earnings and profits that had been previously included in P's income as subpart F income.

LAW AND ANALYSIS

Since FX1 acquired the stock of FX2 within five years of the distribution of such stock in a transaction in which gain or loss was recognized, the distribution described above will not qualify as a tax-free distribution of stock under section 355 of the Code and will be treated as a dividend to the extent provided in sections 301 and 316. Section 355(a)(3)(B).

Section 301(b)(1)(C) of the Code provides that, in the case of a distribution to a corporate shareholder from a foreign corporation, the amount taken into account by the shareholder with respect to the property distributed (other than money) is the fair market value of such property. Under section 301(d)(4), such amount becomes the basis of the distributed property in the hands of the distributee. Under section 301(c)(1), the portion of the distribution that is a dividend, as defined in section 316, is included in gross income.

Section 316(a) of the Code provides that a dividend is any distribution of property made by a corporation to its shareholders out of its earnings and profits. Section 959 of the Code provides specific rules for the application of section 316 to the earnings and profits of a CFC. To the extent that an actual distribution is attributable to earnings and profits described in sections 959(c)(1) and 959(c)(2), which previously have been included in the gross income of a United States shareholder of a CFC, section 959(a) provides that such amount is not be again included in the gross income of the United States shareholder when actually distributed. Section 959(d) provides that such amounts are generally to be treated as distributions that are not "dividends". Only those distributions, if any, attributable to section 959(c)(3) amounts constitute section 316 dividends. In determining the extent to which distributions are attributable to previously taxed earnings and profits, a distribution made by a foreign corporation is to be considered a distribution first out of earnings and profits attributable to amounts previously included in a United States shareholder's gross income under section 951(a)(1)(B) as an increase in earnings invested in United States property under section 956 (section 959(c)(1)), second as a distribution out of earnings and profits attributable to amounts previously included in gross income of a United States shareholder under section 951(a)(1)(A) as subpart F income (section 959(c)(2)), and finally as a distribution out of other earnings and profits (not yet included in a United States shareholder's income) (section 959(c)(3)).

Section 311(a) of the Code provides that, except as provided in section 311(d), no gain or loss is recognized to a corporation on the distribution of property with respect to its stock. Section 311(d)(1) provides that, if a corporation distributes property (other than an obligation of such corporation) to a corporate shareholder in a distribution to which section 301 applies and the fair market value of such property exceeds its adjusted basis in the hands of the distributing corporation, gain shall be recognized to the distributing corporation in an amount equal to such excess as if the property had been sold at the time of distribution. Section 311(d) does not result in the recognition of a loss on the distribution of property.

Section 312(a) of the Code provides that a corporation that distributes property with respect to its stock must decrease its earnings and profits (to the extent thereof) by the sum of:

(1) the amount of money.

(2) the principal amount of the obligations of such corporation (or, in the case of obligations having original issue discount, the aggregate issue price of such obligations), and

(3) the adjusted basis of the other property so distributed.

Under section 1.312-1(b) of the Income Tax Regulations, the reduction of earnings and profits for the adjusted basis of the "other property," as provided in section 312(a)(3), is to be made regardless of whether the property has appreciated or depreciated in value.

The rules of section 312(a) of the Code apply to distributions by a foreign corporation as well as a domestic corporation. See H.H. Robertson Co. v. Commissioner, 59 T.C. 53 (1972), aff'd, unpublished opinion (3d Cir. 1974). The distribution of FX2 stock to P by FX1 constitutes a distribution of "other property" within the meaning of section 312(a)(3) of the Code. The total earnings and profits of FX1 will be reduced (but not below zero) by the adjusted basis of FX2 stock distributed to P pursuant to section 1.312-1(b) of the regulations.

Because the section 959(c) components are intended to reflect the composition of the CFC's total earnings and profits, the section 959(c) components must be reduced by the same amount as the reduction under section 312(a)(3). However, pursuant to section 959(a), the section 959(c)(1) and 959(c)(2) components are reduced, to the extent thereof, by the amount of the dividend before application of section 959, which, under section 301(b)(1)(C), is generally the fair market value of the property distributed. In order to insure that the sum of the components described in section 959(c) will equal the CFC's total earnings and profits after the application of section 312(a)(3), the section 959(c)(3) component must be increased or decreased so that the total of the adjustments to the section 959(c) components equals the section 312(a)(3) reduction.

In the present situation, since the basis of the FX2 stock (100x dollars) in the hands of FX1 is in excess of the stock's fair market value (50x dollars), FX1 will reduce its section 959(c)(1) and 959(c)(2) components of earnings and profits, to the extent thereof, by the fair market value of the FX2 stock distributed to P and will reduce its section 959(c)(3) component by an amount equal to the difference between adjusted basis of the FX2 stock and the amount used to reduce the section 959(c)(1) and 959(c)(2) components of earnings and profits. See the following example:

       Earnings and Profits of FX1 for purposes of section 959

In a situation in which the fair market value of the property distributed to P by FX1 exceeds FX1's adjusted basis in such property, section 311(d), as amended by the Tax Reform Act of 1984, would require FX1 to recognize gain in the amount of the appreciation in the property distributed, thereby increasing FX1's earnings and profits by that amount. FX1's earnings and profits would be reduced (to the extent of FX1's section 312 earnings and profits) by the amount of the basis of the property distributed, as adjusted to reflect the gain recognized on the distribution. This amount would be applied first against the previously taxed section 959(c)(1) and (c)(2) components, to the extent thereof, and the remainder, if any, would be applied against the section 959(c)(3) account.

HOLDING

Following a distribution out of earnings and profits by FX1 to P of FX2 stock, which had depreciated in value, FX1's total earnings and profits will be adjusted: first, by reducing the section 959(c)(1) component, to the extent thereof, by the fair market value of the property distributed; second, by reducing the section 959(c)(2) component, to the extent thereof, by any excess of the fair market value of the distributed property over the total section 959(c)(1) component; and third, by reducing the section 959(c)(3) component by the difference, if any, between the section 312(a)(3) adjustment and the reductions in the second 959(c)(1) and 959(c)(2) components to reflect the application of section 312(a)(3).