Service Applies Substance Over Form Doctrine To DisallowDividends-Received Deduction

IRS employed a detailed analysis and several judicial doctrines to disallow a taxpayer's attempt to deduct 100% of the dividends it received from a regulated investment company after purposefully routing investments abroad via a controlled foreign corporation.

In CCA 201320014, the IRS concluded that, under the substance over form doctrine, a U.S. taxpayer was not eligible for the Section 245dividends-received deduction with respect to funds distributed to it from a regulated investment company (RIC) (i.e., a mutual fund) through a newly formed controlled foreign corporation (CFC). In reaching this conclusion, the Service looked to the congressional intent of the applicable statutes and determined that the substance of the transaction was inconsistent with such intent.

The CCA also concluded that the transaction should be recast in one of two alternative ways. Under the first alternative, the Service would apply the step transaction doctrine to disregard the intermediate transfers through the CFC and treat the common parent as receiving the distributions directly from the RIC. Under the second alternative, the IRS would treat the distributions as Section 951(i.e., Subpart F) inclusions. In either scenario, the common parent would not be eligible for the Section 245dividends-received deduction.

The result in the CCA was not all that surprising, given that the U.S. parent (1) interposed the CFC for the sole purpose of converting income that would have been fully taxable into income that purportedly was eligible for an 80% dividends-received deduction, and (2) sold the shares in the CFC to a related partnership before the end of the tax year to avoid having a Subpart F inclusion. Nevertheless, CCA 201320014is noteworthy in that it demonstrates the Service's position regarding highly structured transactions undertaken with a principal purpose of generating a dividends-received deduction.

Background

Under Section 245(a), a U.S. corporation is allowed a deduction on dividends received from a qualified 10%-owned foreign corporation. The amount of the deduction is equal to the percentage (specified under Section 243for the tax year) of the U.S. source portion of such dividends. The deductible amount will be either 70%, 80%, or 100%, depending on the percentage ownership. The U.S. source portion of the dividend is essentially the ratio of (1) the foreign corporation's post-1986 E&P that has been subject to U.S. federal income tax on a net basis and that has not been distributed, to (2) the corporation's total accumulated E&P. 1

A dividend received from a RIC, however, generally is not eligible for the dividends-received deduction, except to the extent that the RIC identifies the distribution as a dividend eligible for the deduction. 2The amount of dividends a RIC can identify as eligible in a tax year generally is limited to the amount of dividends that it receives from domestic corporations in that year that would give rise to a dividends-received deduction in the hands of the RIC if it were permitted to claim such deduction.3 In addition, while a RIC may not take a dividends-received deduction under Section 243or 245, it generally is able to take a deduction on dividends paid. 4

In general, a CFC is a foreign corporation that is more than 50% owned (directly, indirectly, or constructively) by 10% U.S. shareholders. 5 Section 951(a)generally provides that if a foreign corporation is a CFC for an uninterrupted period of 30 days or more during a tax year, each "U.S. shareholder" that owns stock of the CFC on the last day of the CFC's tax year must include in income the shareholder's pro rata share of the CFC's Subpart F income.

As discussed above, the amount of a U.S. shareholder's Section 951inclusion is based in part on the shareholder's "pro rata share" of the CFC's Subpart F income. If the foreign corporation is a CFC for its entire tax year, a U.S. shareholder's pro rata share generally is the amount that would have been distributed to the shareholder with respect to its ownership interest if the CFC had distributed its Subpart F income for the tax year. Thus, "pro rata share" generally is based on the U.S. shareholder's percentage of CFC stock ownership.

Special rules for determining pro rata share apply when there is a change in ownership during a CFC's tax year, and the CFC's status as a CFC is not changed. Under Section 951(a)(1), the selling U.S. shareholder does not include a Section 951inclusion in income. 6Instead, only the acquiring U.S. shareholder includes a Section 951inclusion (provided the acquiring U.S. shareholder holds the CFC shares on the last day of the CFC's tax year). In addition, under Section 951(a)(2), the amount of the acquiring shareholder's Section 951inclusion is reduced by all or a portion of any dividends paid to the selling shareholder with respect to the transferred shares during the tax year.

In general, foreign persons are subject to U.S. federal income tax on two categories of income:

Income that is effectively connected with the conduct of a trade or business within the U.S. is taxed at graduated rates on a net basis. U.S. source income that is not effectively connected with a U.S. trade or business (otherwise known as FDAP income) is subject to a 30% withholding tax. 7Under Sections 871(h)and 881(c), "portfolio interest" paid to foreign persons generally will be exempt from the 30% U.S. withholding tax. Sections 871(k)and 881(e)generally exempt interest-related dividends paid to a foreign person by a RIC from the 30% withholding tax. In effect, these provisions give the foreign investor in a RIC that holds U.S. source interest-paying investments the same tax result as if the investor had directly invested in the underlying interest-paying investment. The CCA Transaction

The taxpayer (Common Parent) was a domestic corporation that was the parent of an affiliated group of U.S. corporations that filed a U.S. consolidated return ("US Group"). Common Parent directly owned all of the stock of Member, a member of US Group. Member received a significant amount of cash from its customers as collateral ("customer funds"). Due to regulatory requirements, Member was generally required to invest the customer funds only in high-grade liquid assets. Common Parent and subsidiary members of US Group concluded that a better after-tax return on the investment of Member's cash could be earned if instead of continuing to have Member make direct investments, it routed the cash through a series of entities, including a foreign entity.

To achieve this result, Common Parent formed a CFC and caused the CFC to invest in a RIC. The CFC did not have its own employees. Rather, the CFC paid the employees of Common Parent and other members of US Group to oversee RIC's investment activities. During the tax year, the RIC invested in domestic high-grade securities and primarily earned interest income on these investments. The RIC paid dividends to the CFC, and, in turn, claimed a dividends-paid deduction with respect to those dividends. The RIC did not withhold any U.S. federal income...