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Participation Exemption System Changes Paradigm for CFC Spinoffs

POSTED ON Mar. 13, 2018

The transition to a territorial international tax system under the Tax Cuts and Jobs Act raises questions concerning the device and business purpose requirements for tax-free spinoffs involving controlled foreign corporations.

The new participation exemption system under the TCJA (P.L. 115-97) with a dividends received deduction creates a paradigm shift that’s contrary to the underlying premise of section 355 if dividend treatment is now “not such a bad thing,” Robert Wellen, IRS associate chief counsel (corporate), said March 9 during the Federal Bar Association Section on Taxation conference in Washington. The appropriateness of that section’s principal focus — whether a distribution would be taxed as a dividend — and the traditional device test in the international context are now being questioned, he said.

A corporation may generally distribute the stock of a controlled corporation to its shareholders without recognizing gain or loss if the requirements of section 355 are met. The device requirement for those tax-free spinoffs prevents corporations from structuring transactions primarily for the purpose of distributing the company's earnings to shareholders at favorable tax rates rather than having the distributions treated as section 301 dividends that would be taxed at higher rates.

The participation exemption under section 245A provides a 100 percent dividends received deduction for the foreign-source portion of dividends paid to U.S. corporate shareholders owning 10 percent or more of the foreign payer corporation for longer than a year.

Jay M. Singer of McDermott Will & Emery said the traditional thinking that companies may structure spinoff transactions to convert dividend income to capital gains may no longer apply in the context of CFC spinoffs because dividends paid to U.S. corporate shareholders would not be subject to tax while the capital gains on the disposition of CFC stock would still be taxed.

Section 1248 rules also operate differently under a participation exemption system because those rules generally prevent companies with significant earnings and profits from “escaping taxation on the disposition of CFCs” by recasting capital gains as dividends, Singer said. That regime “has gone from something [designed] to protect the fisc to something that is a friend of the taxpayer” because the deemed dividend qualifies for the section 245A deduction, he said.

Now that deemed dividends paid from CFCs to U.S. corporate shareholders are “generally good for U.S. taxpayers rather than bad,” practitioners are wondering how the IRS will apply the device requirement in the context of CFCs, Singer said.

The IRS has given this some thought, but “it’s far too early for us to have reached any conclusions [on] how we might adapt these rules,” Wellen said. Under final regulations that have been in place for a long time, “if a dividend is subject to a 100 percent or 80 percent dividends received deduction, then ordinarily the transaction is a device. That kind of points the way to looking at this,” he said, noting that there aren’t any rules for dealing with the new international regime.

Wellen suggested that whether “old-fashioned device thinking would be appropriate is going to be fact-intensive,” which will put more pressure on the IRS’s letter ruling process to determine whether consequences of a taxable section 301 dividend are in fact benign or whether in some cases “other consequences might be less friendly.”

Wellen said he doesn’t envision the IRS “reaching a systematic global view . . . of the consequences of these changes for quite some time,” but the agency is “open for business” on letter rulings that could involve device issues. The IRS will need to understand how all the moving parts in the international tax provisions work in a taxpayer’s deal before it “could make an intelligent assessment of what an alternative [section] 301 distribution might look like,” he added.

In May 2017 Wellen said the IRS will only rule on significant legal issues pertaining to the device requirement and that generally questions involving the ambiguity of the good and bad device factors would be legal issues the IRS would be interested in.

Sandwich Spinout: Good Business Purpose?

Multinationals have used transactions to unwind so-called sandwich structures in which either a foreign entity is sandwiched between two U.S. entities or the other way around, and the entity at the bottom of the structure is spun off to the parent.

Singer explained that the sandwich structure generally arises when a U.S.-parented corporation acquires a foreign-parented company that has a U.S. subsidiary, which can result in “an inconvenient and inefficient structure.” Thus, corporations then look for a way to combine all the U.S. subsidiaries into a single consolidated group.

According to Singer, it has been difficult for practitioners to write opinions for taxpayers that their transaction — spinning out of a sandwich — meets section 355 business purpose requirements because the U.S. tax benefits were so significant. But under the TCJA, the stakes — the tax inefficiencies of the sandwich structure — are dramatically reduced by the participation exemption system, which raises the question whether the IRS would view the section 355 business purpose hurdle differently for those transactions in which the corporation is trying to consolidate all its U.S. subsidiaries into a single group.

Wellen agreed that the stakes involved in spinning out of a sandwich qualifying under section 355 are likely to be reduced compared with pre-TCJA scenarios, but said that may not necessarily affect the narrow question of business purpose. He noted that whether “joining a consolidated group is the kind of business purpose that [section] 355 is intended to cover” is something the IRS is going to have to think about.

If a taxpayer has an important tax and nontax business purpose for a section 355 spinoff but each is insufficient by itself to do the transaction, Wellen said that could be a legal issue that the IRS might consider ruling on. He emphasized that generally the IRS resists evaluating a taxpayer’s business purpose and that these “novel questions” would have to go through an internal challenge process.

In August 2016 the IRS announced in Rev. Proc. 2016-45, 2016-37 IRB 344, that it would rule on significant legal issues not inherently factual in nature pertaining to whether a tax-free section 355 spinoff is motivated by a nonfederal tax corporate business purpose.