Rev. Rul. 86-33

1986-1 C.B. 287, 1986-9 I.R.B. 17.

CONTROLLED FOREIGN CORPORATIONS; SUBPART F INCOME; DIVIDEND DISTRIBUTION

WITHIN SAME CHAIN OF FOREIGN CORPORATIONS

Published: March 3, 1986

Section 952.-Subpart F Income Defined 26 CFR 1.952-1: Subpart F income defined.

(Also Sections 312, 951, 954, 958, 964; 1.312-1, 1.951-1, 1.954-1, 1.958-1,

1.964-1.)

  Controlled foreign corporations; Subpart F income; dividend distribution within same chain of foreign corporations. For purposes of calculating the limitation on subpart F income under section 952(c) of th ecode, a controlled foreign corporation (CFC) that recieves a dividend distribution from another CFC within the same chain of ownership is required to increase its earnings and profits for the tax year by the amount of the distribution.

ISSUE

  If a controlled foreign corporation (CFC) receives a dividend distribution from another CFC within the same chain of foreign corporations, is the recipient CFC required to increase its earnings and profits for the tax year by the amount of the distribution for purposes of calculating the limitation on subpart F income under section 952(c) of the Internal Revenue Code?

FACTS

  Z, a domestic corporation, wholly owns P, a foreign corporation. P is principally a holding company and wholly owns two foreign corporation, S-1 and S-2. S-1 and S-2 are engaged in foreign commerce through shipping operations. P, S-1, and S-2 are CFCs within the meaning of section 957(a) of the Code for the entire 1984 calendar year. For purposes of section 952(d), P, S-1, and S-2 form a 'chain of foreign corporations,' as described in section 1.952-

1(d)(2)(ii) of the Income Tax Regulations, because P is owned directly by Z and S-1 and S-2 are considered as being owned by Z under section 958(a). Such a chain is also called a 'chain of ownership'.

  For the year 1984, P has foreign personnel holding company income (FPHCI), as defined in section 954(c) of the Code, consisting of interest and dividends of

5x dollars and has foreign base company shipping income (FBCSI), as defined in section 945(f), of 2x dollars . During 1985 S-1 has FBCSI of 8x dollars, and S-

2 has an operating loss of 40x dollars. S-1's pre-1984 accumulated earnings and profits (all of which are attributable to FBCSI) are 100x dollars, and because of the application of section 954(b)(2), this amount has not been previously taxed. Similarly, by application of section 954(b)(2), S-1's FBCSI of 8x dollars and P's FBCSI of 2x dollars will be excluded from foreign base company income.

  Prior to the end of 1984, S-1 distributed all of its current and accumulated earnings and profits (108x dollars) to P. For 1984, Z elected to include P and S-1 in a 'related group' pursuant to section 955(b)(2) of the Code and section

1.955A-3 of the regulations. Pursuant to section 1.955A-3(c)(1), because the dividend that P received from S-1 is attributable entirely to FBCSI, P excluded that dividend from P's gross income for purposes of determining P's foreign base company income within the meaning of section 954.

LAW AND ANALYSIS

  Section 951(a)(1)(A)(i) of the Code provides that if a foreign corporation is a CFC for an uninterrupted period of 30 days or more during any tax year of the corporation, a United States shareholder that owns stock in the corporation on the last day which is in the year and on which the corporation is a CFC shall include in gross income, for the United States shareholder's tax year in which or with which the tax year of the corporation ends, the shareholder's pro rata share of the corporation's subpart F income. The types of income that comprise subpart F income are described in section 952 through 954. Subpart F income includes foreign base company income, which in turn includes FPHCI and FBCSI.

  Section 952(c) of the Code provides generally that the subpart F income of any CFC for any tax year shall not exceed the earnings and profits of such corporation for such year reduced by an amount that reflects the deficits in earnings and profits for prior years.

  With respect to section 952(c) of the Code, section 1.952-1(c) of the regulations provides as follows:

  (1) In general. A United States shareholder's pro rata share of a controlled foreign corporation's subpart F income for any tax year shall not exceed such shareholder's pro rata share of the earnings and profits (as defined in section

964 (a) and section 1.964-1) of such corporation for such tax year, computed as of the close of such tax year without diminution by reason of any distributions made during such tax year, minus the sum of-

  (i) The amount, if any, by which such shareholder's pro rata share of-

  (a) The sum of such corporation's deficits in earnings and profits for prior tax years beginning after December 31, 1962, plus

  (b) The sum of such corporation's deficits in earnings and profits for tax years beginning after December 31, 1959, and before January 1, 1963 (reduced by the sum of the earnings and profits (as so defined) of such corporation for any of such tax years) exceeds

  (c) The sum of such corporation's earnings and profits for prior tax years beginning after December 31, 1962, which, with respect to such shareholder, are allocated to other earnings and profits under section 959(c)(3) and section

1.959-3; and

  (ii) Such shareholder's pro rata share of any deficits in earnings and profits of other foreign corporations for a tax year beginning after December

31, 1962, which are attributable to stock of such other foreign corporations owned by such shareholder within the meaning of section 958(a) and which, in accordance with section 952(d) of section 1.952-1(d), are taken into account as a reduction in the controlled foreign corporation's earnings and profits for such tax year.

  For purposes of applying section 1.952-1(c)(1), the reduction (if any) provided by section 1.952-1(c)(1)(i) in a United States shareholder's pro rata share of the earnings and profits of a controlled foreign corporation shall be taken into account before the reduction provided by section 1.952-1(c)(1)(ii). See section 952(c).

  Section 952(d) of the Code provides a special rule for the reduction of earnings and profits in the case of indirect ownership.

  With respect to section 952(d) of the Code, section 1.952-1(d) of the regulations provides as follows:

  (1) In general. For purposes of section 1.952.1(c)(1)(ii), if-

  (i) A United States shareholder owns (within the meaning of section 958(a)) stock in two or more foreign corporations in a chain of foreign corporations

(as defined in section 1.952-1(d)(2)(ii), and

  (ii) Any of the corporations in such chain has a deficit in earnings and profits for a tax year beginning after December 31, 1962, then, with respect to such shareholder and only for purposes of determining the limitation on subpart F income under section 1.952- 1(c), the earnings and profits for the tax year of each such foreign corporation which is a controlled foreign corporation shall, in accordance with the rules of section 1.952-1(d)(2), be reduced to take into account any deficit in earnings and profits referred to in section

1.952-1(d)(2)(ii). See section 952(d).

  (2) Special rules. For purposes of this paragraph-

  (ii) 'Chain' defined. A chain of foreign corporations shall, with respect to the United States shareholder, include-

  (a) Any foreign corporation in which such shareholder owns (within the meaning of section 958(a)(1)(A)) stock, but only to the extent of the stock so owned, and

  (b) All foreign corporations in which such shareholder owns (within the meaning of section 958(a)(2)) stock, but only to the extent of the stock so owned by reason of such shareholder's ownership of the stock referred to in section 1.952-1(d)(2)(ii)(a).

  (iii) Allocation of deficit. If one or more foreign corporations (whether or not a controlled foreign corporation) includible in a chain of foreign corporations has a deficit in earnings and profits (determined under section

964(a) and section 1.964-1) for the tax year, the amount of deficit taken into account under section 952(d) with respect to a United States shareholder in such chain as a reduction in earnings and profits for the tax year of a controlled foreign corporation includible in such chain shall be an amount which bears the same ratio to such shareholder's pro rata share of the total deficit in earnings and profits for the tax year of all includible foreign corporations as such shareholder's pro rata share of the earnings and profits

(determined under section 1.952-1(c) but without regard to the provisions of section 1.952-1(c)(ii) for the tax year of such includible controlled foreign corporation bears to such shareholder's pro rata share of the total earnings and profits (as so determined under section 1.952-1(c) for the tax year of all includible controlled foreign corporations. The amount of deficit taken into account under section 1.952-1(d)(2)(iii) with respect to any controlled foreign corporation includible in a chain of foreign corporations shall not exceed the United States shareholder's pro rata share of the controlled foreign corporation's earnings and profits for the tax year.

  The rule in the paragraph quoted immediately above is sometimes called the

'chain deficit rule.'

  Section 958(a)(1) of the Code provides that, as a general rule, 'stock owned' means stock owned directly and stock owned by applying section 958(a)(2). Section 958(a)(2) provides that stock owned, directly or indirectly, by or for a foreign corporation is considered as being owned proportionately by its shareholders. Stock considered to be owned by a person by reason of the application of section 958(a)(2) is, for purposes of applying that section, treated as actually owned by such person.

  Section 964(a) of the Code provides that, except as provided in section

312(k)(4), for purposes of subpart F the earnings and profits of any foreign corporation, and the deficit in earnings and profits of any foreign corp ration, for any taxable year, shall be determined according to rules substantially similar to those applicable to domestic corporations, under regulations prescribed by the Secretary.

  Section 1.964-1(a) of the regulations provides that for purposes of section

951 through 964, the earnings and profits (or deficit in earnings and profits) of a foreign corporation for its tax year shall be computed substantially as if such corporation were a domestic corporation.

  Section 312(f)(2) of the Code provides that where a corporation receives a distribution for a second corporation which (under the law applicable to the year in which the distribution was made) was not a taxable dividend to the shareholders of the second corporation, the amount of such distribution shall not increase the earnings and profits of the first corporation in the following two circumstances. First, there is no increase in respect of the part of such distribution which (under the law) is directly applied in reduction of the basis of the stock in respect of which the distribution was made. Second, there is no increase if (under such law) the distribution causes the basis of the stock in respect of which the distribution was made to be allocated between such stock and the property received.

  As noted above, section 1.952-1(c)(1) of the regulations provides that a United States shareholder's pro rata share of a CFC's subpart F income for any tax year shall not exceed the shareholder's pro rata share of the earnings and profits, as defined in section 964(a) of the Code and section 1.964-1, of such corporation for such tax year, computed as of the close of such tax year without diminution by reason of any distributions made during such tax year. Section 964(a) and section 1.964-1(a) provide the general rule that the earnings and profits of a foreign corporation shall be computed substantially as if such corporation were a domestic corporation. A domestic corporation's earnings and profits for any tax year include the amount of any distributions received from its subsidiaries. The fact that the dividend distribution is not taxed to the recipient corporation does not preclude the distribution from increasing the recipient's earnings and profits except in situations that are described in section 312(f)(2) and that require an adjustment or allocation of basis. There is no indication in the instant case that the distribution from S-

1 to P will be directly applied to reduce P's basis in the S-1 stock, and thus section 312(f)(2) is not applicable.

  Examples 2 and 3 under section 1.952-1(d)(3) of the regulations illustrate how the earnings and profits of a CFC for the tax year are computed under the chain deficit rule. These examples state that the earnings and profits are determined 'without regard to distributions' for the tax year.

  In these examples, the phrase 'without regard to distributions' refers to distributions of a dividend in the tax year by the CFC whose earnings and profits are at issue and not to distributions received by that CFC. The phrase

'without regard to distributions' in these examples simply reflects the fact that dividend distributions made by a CFC for the tax year do not affect the CFC's earnings and profits for that tax year for purposes of the limitation in section 952(c) on subpart F income. Section 1.952-1(c)(1) of the regulations. Also, section 316(a)(2) 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 for the tax year (computed as of the close of the tax year without diminution by reason of any distributions made during the tax year), without regard to the amount of the earnings and profits at the time the distribution was made. See also section 1.952-1(c)(3), example (1)(d), which illustrates that in determining the subpart F income limitation under section

952(c), the earnings and profits of a CFC for the tax include dividend distributions received by the CFC during the tax year from another CFC within the same chain of ownership. Example 1(d) indicates that although the earnings and profits of a CFC for the tax year are determined 'without diminution for any distributions made during such year,' the earnings and profits of the CFC, nevertheless, are increased by dividends received form another CFC within the same chain of ownership during the year.

  Accordingly, the dividend distributions received by P from S-1 in 1984 increases P's earnings and profits for 1984 by the amount of the dividend (108x dollars), and the chain deficit rule of section 952(d) of the Code applies only after P's earnings and profits for 1984 are increased to reflect the dividend P received from S-1 in that year. Pursuant to the chain deficit rule, P's earnings and profits are reduced by the amount of S-2's deficit in earnings and profits for the year (40x dollars). After the reduction, P has sufficient earnings and profits so that the 5x dollars of FPHCI are subpart F income includible in the 1984 gross income of Z.

HOLDING

  For purposes of calculating the limitation on subpart F income under section

952(c) of the Code, a CFC that receives a dividend distribution from another CFC within the same chain of ownership is required to increase its earnings and profits. The earnings and profits are to be increased for the tax year in which the dividend is recieved and are to be increased by the amounts of the dividend distribution.

Rev. Rul. 86-33, 1986-1 C.B. 287, 1986-9 I.R.B. 17.