Rev. Rul. 76-539

Advice has been requested regarding the computation of the basis of the stock of a controlled foreign corporation in the hands of its domestic parent and the computation of the controlled foreign corporation's earnings and profits under the circumstances described below.

P is a domestic corporation engaged in a trade or business and S is a wholly owned controlled foreign corporation of P organized in country M.

In April 1974, S loaned 10,000x dollars to P in exchange for P's debt obligation, which qualifies as an obligation of a United States person under section 956(b)(1)(C) of the Internal Revenue Code of 1954, which is generally the type of investment in United States property that would be includible in P's gross income as an increase in earnings invested in United States property for such year under section 951(a)(1)(B). In May 1975, P repaid the loan with interest to S. In June 1975, P realized a gain on the sale of its S stock to an unrelated third party.

All of S's income for its taxable years 1974 and 1975 was subpart F income included in P's gross income pursuant to section 951(a)(1)(A)(i) of the Code. The 10,000x dollar loan to P was an investment in United States property within the meaning of section 956(b), but was excluded from P's gross income pursuant to section 959(a)(2) because all of S's earnings for taxable year 1974 had already been included in P's gross income as subpart F income under section 951(a)(1)(A)(i). See Rev. Rul. 76-538, page 230, this Bulletin.

The specific issues presented are the following:

(1) Whether the basis of P's stock in S is reduced under section 961(b) of the Code by any amount excluded from P's gross income with respect to S pursuant to section 959(a)(2); and

(2) Whether, under section 1248, S's earnings and profits, with respect to P, include the amount of such earnings and profits excluded from P's gross income pursuant to section 959(a)(2).

Section 957(a) of the Code provides, in part, that the term "controlled foreign corporation" means any foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned by United States shareholders on any day during the taxable year of such foreign corporation.

Section 951(a)(1) of the Code, effective for taxable years beginning before December 31, 1975, provides, in part, that if a foreign corporation is a controlled foreign corporation for an uninterrupted period of 30 days or more during any taxable year beginning after December 31, 1962, every person who is a United States shareholder of such corporation and who owns stock in such corporation on the last day, in such year, on which such corporation is a controlled foreign corporation shall include in gross income, for such person's taxable year in which or with which such taxable year of the corporation ends--

(A) the sum of--

(i) such person's pro rata share of the corporation's subpart F income for such year and

(ii) * * *; and

(B) such person's pro rata share of the corporation's increase in earnings invested in United States property for such year (but only to the extent not excluded from gross income under section 959(a)(2)).

Section 956(b)(1)(C) of the Code provides that an obligation of a United States person is United States property.

Section 959(a) of the Code provides, in part, that the earnings and profits for a taxable year of a foreign corporation attributable to amounts that are, or have been, included in the gross income of a United States shareholder under section 951(a) shall not, when--

(1) such amounts are distributed to, or

(2) such amounts would, but for section 959(a), be included under section 951(a)(1)(B) in the gross income of,

such shareholder directly, or indirectly, be again included in the gross income of such United States shareholder.

Section 961(a) of the Code provides, in part, that the basis of a United States shareholder's stock in a controlled foreign corporation shall be increased by the amount required to be included in such shareholder's gross income under section 951(a) with respect to such stock, but only to the extent to which such amount was included in such shareholder's gross income.

Section 961(b)(1) of the Code provides, in part, that the adjusted basis of stock with respect to which a United States shareholder receives an amount that is excluded from gross income under section 959(a) shall be reduced by the amount so excluded.

S. Rep. No. 1881, 87th Cong., 2d Sess. 94 (1962), 1962-3 C.B. 707, 800, in discussing section 961 of the Code, provides in part:

It is necessary where amounts not actually distributed to the taxpayer are nevertheless taxed to him, to increase his basis for the stock in the controlled corporation by the amount so taxed to him. However, if subsequently actual distributions are made which do not result in any tax to the shareholder because of the prior tax payment by him, then the basis of the stock needs to again be reduced.

S. Rep. No. 1881 indicates that Congress intended to require a reduction in basis under section 961(b)(1) of the Code only when amounts excluded from gross income under section 959(a) are actually distributed to the United States shareholder. Therefore, section 961(b)(1) applies to amounts excluded from gross income under section 959(a)(1) (actual distributions) and not to amounts excluded from gross income under section 959(a)(2) (constructive distributions attributable to increases in earnings invested in United States property). Such a result is logical since under section 961(a) there is an increase in the basis of a shareholder's stock in a controlled foreign corporation in the amount included in the shareholder's gross income under section 951(a) but not distributed to the shareholder. Upon distribution of such amount, section 961(b) provides for a corresponding reduction in basis. In the instant case, however, there is no distribution, but rather a subsequent investment in United States property of previously taxed subpart F income. To reduce the shareholder's basis in such a situation would result in the shareholder's not only having been previously taxed on its subpart F income under section 951 but also being placed in the same position with respect to basis as a shareholder who has actually received the amount included in income under section 951.

Accordingly, with respect to issue (1), pursuant to section 961(a) of the Code, the basis of P's stock in S shall include all amounts required to be included in P's gross income under section 951(a) with respect to such stock, to the extent such amounts were included in P's gross income, without reduction under section 961(b) for any amount excluded from P's gross income with respect to S pursuant to section 959(a)(2).

Section 1248(a) of the Code provides, in part, that if a United States person sells or exchanges stock in a foreign corporation and such person owns, within the meaning of section 958(a), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation at any time during the 5-year period ending on the date of the sale when such foreign corporation was a controlled foreign corporation, then the gain recognized on the sale of such stock shall be included in the gross income of such person as a dividend, to the extent of the earnings and profits of the foreign corporation attributable to such stock that were accumulated in the period specified therein.

Section 1248(d)(1) of the Code provides, in part, that there shall be excluded, with respect to any United States person, from the earnings and profits of a foreign corporation, earnings and profits attributable to any amount previously included in the gross income of such person under section 951, with respect to the stock sold or exchanged, but only to the extent the inclusion of such amount did not result in an exclusion of an amount from gross income under section 959. Sections 1.1248-2(e)(3)(ii) and 1.1248-3(e)(2)(i) of the Income Tax Regulations provide that such exclusion from earnings and profits of the foreign corporation is applicable to the extent amounts previously included in the gross income of United States shareholders under section 951 of the Code exceed amounts excluded from such income under section 959(a)(1). That is, the earnings and profits of the foreign corporation are reduced by the amounts previously included in the United States shareholder's gross income under section 951 and then increased to the extent that any portion of that income is excluded from such shareholder's gross income under section 959(a)(1) by way of an actual distribution.

In limiting the increase in earnings and profits to actual distribution situations under section 959(a)(1) of the Code, the regulations under section 1248 necessarily imply that the section 1248(d)(1) exclusion from earnings and profits is not reduced by amounts excluded from the United States shareholder's gross income under section 959(a)(2).

Accordingly, with respect to issue (2), because there was no actual distribution to which section 959(a)(1) of the Code applies but rather an increase in investment in United States property to which section 959(a)(2) applies, the amount of S's earnings and profits does not include the amount of such earnings and profits excluded from P's gross income pursuant to section 959(a)(2).