Rev. Rul. 77-343

Advice has been requested whether, under the circumstances described below, the gain realized by a controlled foreign corporation from the sale of all of the outstanding capital stock of its wholly owned foreign subsidiary to its parent corporation is excluded from treatment as foreign base company income by section 954(b)(4) of the Internal Revenue Code of 1954.

P, a domestic corporation, is the parent corporation of a wholly owned foreign subsidiary, S, a corporation organized in 1955 and incorporated under the laws of country X. S was organized by P for the purpose of manufacturing and selling products solely within country X, and has been so actively engaged since its date of incorporation. P is a United States shareholder of S within the meaning of section 951(b) of the Code. Inasmuch as all of the stock of S is owned by P, S is a controlled foreign corporation within the meaning of section 957(a).

During July, 1971, S purchased all of the capital stock of S-1 in a taxable transaction from an unrelated party. S-1 is incorporated under the laws of country Y. In 1975, P purchased from S all of the capital stock of S-1. The sale took place in country X. The sales price was 11,500x dollars, which was based on an appraisal made by an independent third party. S had a basis of 200x dollars in the shares of S-1. S paid no foreign or United States taxes on its realized gain from the sale. The effective tax rate in country X to S in respect to the accumulated profits attributable to a dividend of the property sold was less than 43 percent. P does not have any present intention of disposing of the S-1 stock. Neither country X nor country Y is a less developed country.

The sale was consummated in accordance with a corporate policy that P retain effective and direct control of significant facilities throughout the world in order to supervise and harmonize the implementation of P's decisions, policies, and objectives.

Section 954(a)(1) of the Code provides, in part, that the term "foreign base company income" for any taxable year includes the foreign personal holding company income for the taxable year as determined under section 954(c).

Section 954(c)(1) of the Code provides, in part, that the term "foreign personal holding company" income means the foreign personal holding company income as defined in section 553, with certain modifications and adjustments not relevant herein.

Section 553(a)(2) of the Code provides, in part, that the term "foreign personal holding company income" means that portion of the gross income that consists of, except in cases of regular dealers in stock and securities, gains from the sale or exchange of stock or securities.

Section 954(b)(4) of the Code provides, in part, that foreign base company income does not include any item of income received by a controlled foreign corporation if it is established to the satisfaction of the Secretary that neither the creation nor organization of such controlled foreign corporation under the laws of the foreign country in which it is incorporated nor the effecting of the transaction giving rise to such income through the controlled foreign corporation has as one of its significant purposes a substantial reduction of income taxes.

Section 1.954-1(b)(4)(i) of the Income Tax Regulations provides, in part, that the foreign base company income of a controlled foreign corporation for any taxable year ending after October 9, 1969, does not include any item of gross income received or accrued by such corporation during such year if it is established that both (a) the creation or organization of such corporation under the laws of the foreign country in which it is incorporated, and (b) the effecting through such corporation of the transaction that gives rise to such income did not have as a significant purpose a substantial reduction of income taxes. If the controlled foreign corporation receives or accrues an item of income in respect of which there has been no substantial reduction for the taxable year of income, war profits, excess profits, or similar taxes, it may without reference to section 1.954-1(b)(4)(i)(a) or (b) be excluded from foreign base company income under section 954(b)(4) of the Code.

Section 1.954-1(b)(4)(ii)(a) of the regulations provides, in part, that for purposes of section 1.954-1(b)(4), a determination as to whether there has been a substantial reduction of income, war profits, excess profits, or similar taxes with respect to an item of foreign personal holding company income described in section 1.954-2 shall be made by applying the principles of section 1.954-1(b)(3)(ii).

Section 1.954-1(b)(3)(ii) of the regulations provides, in part, that the creation or organization of a controlled foreign corporation will be considered not to have the effect of substantially reducing income taxes with respect to an item of foreign personal holding company income, if it can be established that, if such item were the only income of such corporation for the taxable year and the United States shareholder of such corporation were a corporate United States shareholder making a first-tier election (as defined in section 1.963-1(b)(5)) to receive a minimum distribution for such year with respect to stock that it directly owns in such controlled foreign corporation, no minimum distribution would be required to be received by such shareholder from such controlled foreign corporation.

Section 1.954-1(b)(4)(iii) of the regulations provides that for purposes of section 1.954-1(b)(4), to be significant a purpose must be important, but it is not necessary that it be the principal purpose or the purpose of first importance.

Section 963(b)(3) of the Code, which was repealed by section 602(a)(1) of the Tax Reduction Act of 1975, 1975-1 C.B. 545, effective for taxable years of foreign corporations beginning after December 31, 1975, and for taxable years of United States shareholders (within the meaning of section 951(b)) within which or with which such taxable years of such foreign corporations end, provided, in part, that a minimum distribution of zero with respect to the earnings and profits for a taxable year after 1964 of any foreign corporation shall be required if the effective foreign tax rate is 43 percent or greater.

Section 1.954-1(b)(4)(iv) of the regulations provides, in part, that for purposes of determining whether the creation or organization of a controlled foreign corporation in a particular foreign country, or whether the effecting of the income-producing transaction through that corporation has as one of its significant purposes a substantial reduction of income taxes, all the facts and circumstances involved will be taken into account. Among the factors to be considered are the various purposes for the action; the type of business carried on by the controlled foreign corporation; the classes of income derived by such corporation; the frequency with which the particular item of income is derived; the effective rate of tax imposed on such income; the place in which the income-producing transaction occurs or the source of such income; and the location of the persons purchasing the corporation's goods or services. That section further provides that generally, if the income-producing activity carried on by a controlled foreign corporation takes place within the foreign country in which the corporation is created or organized, the creation or organization of the corporation in that country will not be considered to have as a significant purpose a substantial reduction of income taxes.

Section 1.954-1(b)(4)(vii) of the regulations sets forth an example in which the requirements of section 954(b)(4) of the Code and the regulations thereunder are satisfied. In that example, a controlled foreign corporation organized in its country of incorporation a number of other corporations to operate radio and television stations. Because of a change in the regulatory laws of the foreign country, the controlled foreign corporation was required by foreign law to dispose of its stock in the other corporations. Consequently, the controlled foreign corporation disposed of the stock realizing a gain that was not taxed by the foreign country. Those gains were excluded from foreign base company income because the controlled foreign corporation was organized in the foreign country to actively engage in business in that country and because the acquisition and sale of the stock of the radio and television corporations by the controlled foreign corporation (rather than by its parent or an affiliated corporation) did not have as one of its significant purposes a substantial reduction of income taxes.

In this case, the gain realized by S on the sale of its S-1 capital stock to P is foreign personal holding company income within the meaning of section 553(a)(2) of the Code; and, therefore, is foreign base company income within the meaning of section 954(a) unless excluded from such treatment by section 954(b).

Section 1.954-1(b)(4) of the regulations will exclude S's gain from being treated as foreign base company income if it is established that either there has been no substantial reduction of income or similar taxes with respect to such item of income or that both the creation and organization of S in country X and the effecting of the sale of S-1 capital stock through S to P did not have as a significant purpose a substantial reduction of income taxes. That determination is based on all the facts and circumstances existing at the time of such sale.

S paid no taxes to country X with respect to the gain S realized on the sale of the stock. The effective rate of foreign tax on such gain would be zero percent, a rate that is less than 43 percent needed for a zero minimum distribution under section 963 of the Code. Consequently, pursuant to section 1.954-1(b)(3)(ii) of the regulations, there was a substantial reduction of income taxes.

Inasmuch as S was created and organized and has been actively engaged in a trade or business within country X since 1955, and all of its income-producing activities for 1975, in addition to the sale of S-1 stock, took place in country X, its creation and organization in country X is not considered to have as a significant purpose a substantial reduction of income taxes.

Although one purpose of S's sale of the S-1 stock to P was to effect the corporate policy that P obtain direct control of S-1, the resulting tax effects of the transaction are factors to be considered pursuant to section 1.954-1(b)(4)(iv) of the regulations in determining whether the effecting of the transaction through S had as a significant purpose a substantial reduction of income taxes. In the instant case, S paid no taxes to country X on the gain derived from the sale of the S-1 stock to P.

Moreover, unlike the example illustrated in section 1.954-1(b)(4)(vii) of the regulations, the stock transaction in the instant case was not mandated by foreign law, but was purely voluntary between P and S.

Accordingly, in this case the effecting of the sale of S-1 stock by S to P had as one of its significant purposes a substantial reduction of income taxes. Thus, the gain realized by S on such sale is not excluded from treatment as foreign base company income by section 954(b)(4) of the Code.