|Selling Stock to a Corporation
When is a sale gain actually a dividend to the full amount of the sale price?
January 13, 2011
A taxpayer must consider the application of Section 304 whenever a taxpayer sells stock of one corporation (the target) to another corporation (the buyer). Generally speaking, Section 304 can apply if the seller and the buyer are both at least 50 percent owned by the taxpayer (with attribution), either as brother-sister or the buyer is a subsidiary of the target. The sale is treated as a redemption if Section 304 applies, and the redemption can then be treated as a Section 301 distribution, which can be a dividend. The difference between taxation as a dividend under Section 304 and as capital gain will depend on the basis of the stock sold, as to individual sellers and other factors such as the dividends received deduction to a selling shareholder that is a corporation. In any event, it can be an unhappy surprise to find that a sale gain was actually a dividend to the full amount of the sale price.
Earnings and Profits
Section 304(b)(2) states that the "amount and source" of dividends under Section 304 shall be determined as if the purchase price were distributed first by the buyer to the extent of its earnings and profit (E&P) and then by the target to the extent of its E&P. Section 304(a) states that stock sales it treats as redemptions will be treated as redemptions by the buyer of its own stock or by the target of its own stock. These two provisions seem to be in conflict: Does the "sourcing" rule in Section 304(b)(2) change the identity of the purchaser established in Section 304(a) or not? It does.
The answer to the question matters in several cases, such as when a foreign corporation sells stock of a domestic corporation to a related foreign corporation, Section 304(a)(1) applies, the sale is treated as a Section 301 distribution and both the buyer and target's E&P are applied to the distribution. To the extent the domestic target's E&P is used, has the foreign buyer paid a dividend from its deemed U.S. source E&P or is the deemed source of the E&P also the deemed payor of the dividend from its own E&P? The Internal Revenue Service (IRS) seems to have adopted the latter interpretation, but the matter is confused because of the uncertain meaning of sourcing.
Sourcing. In the Code, sourcing of income and deductions as foreign or domestic is an important concept addressed in Section 861 and 862. However, these rules generally do not purport to dictate actual cash flows; rather they provide information that is used in other code sections that depend on counting foreign and domestic income and deductions. With that concept in mind, a natural reading of the reference to sourcing in Section 304(b)(2) would be that it does not purport to recast who actually paid what to whom, but rather to characterize the nature of what was paid. On the facts of the example above, that would mean the foreign buyer paid, in part, U.S. source earnings in its own dividend to the seller.
The congressional history on the issue is not clear, but lends itself to the other interpretation, which the IRS has adopted: the source of the E&P is also the deemed payor of the dividend for all purposes, particularly including determining which tax treaty applies. Rev. Rul. 92-85, 1992-2 C.B. 68, clearly states that the treaty between the U.S. and the country of residence of the stock seller controls withholding on the portion of the dividend that is deemed to come from the U.S. E&P of the target, even though the target is not the buyer and did not pay the purchase price.
Withholding. Sections 1441 and 1442 require 30-percent withholding on dividends paid by a U.S. corporation to a foreign shareholder; tax treaties may reduce the withholding rate. The revenue ruling does fairly clearly limit the withholding duty, however, to the corporation that controlled the cash, which is the actual buyer. Later IRS rulings confirm this view, for example from FSA 199926018:
Similarly, Rev. Rul. 92-85, 1992-2 C.B. 69, holds that deemed dividend distributions under Section 304(b)(2) by domestic acquiring or domestic acquired/issuing corporations to foreign controlling corporations give rise to tax under section 881(a)(1) and that the acquiring corporation (whether foreign or domestic) is responsible for withholding under section 1442 with respect of such deemed dividends.
Of course a foreign buyer usually will not be subject to levy by the IRS, so the effect of making it the withholding agent is unclear.
Other Amendments to Section 304
First in 1997 and now in 2010, Congress has further amended Section 304 to reduce the possibility that E&P of a foreign buyer will be used to create the deemed dividend, meaning that more of the dividend is likely to come from the target, which will be taxable and withholdable dividend if target is domestic.
In 1997, Section 304(b)(5) was added to limit the E&P attributable to the foreign buyer in certain cases and in 2010 Section 304 was amended again by section 215 of P.L. 111-226 to further limit it. The Joint Committee explanation once again confirmed that sourcing of the dividend to the E&P of one of the corporations meant that the transferor received the dividend directly from that corporation. JCT Technical Explanation, JCX-46-10 (August 10, 2010), p. 27.
The E&P issues of Section 304 are only one group of multiple groups of confusing issues in Section 304. Any time a shareholder sells stock of one corporation to another corporation and both are closely held, the possible application of Section 304 should be examined; and if applicable, the other issues such as E&P must be resolved.
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Jack Cummings, Alston & Bird LLP, Raleigh, NC 919-862-2302. He was an IRS Associate Chief Counsel (Corporate) in 2000 and 2001.