Rev. Rul. 77-284

Advice has been requested concerning the effect on earnings and profits of a corporation when certain funds are deposited into statutory reserve funds pursuant to section 607 of the Merchant Marine Act of 1936, as amended, 46 U.S.C. 1177, but prior to its amendment by the Merchant Marine Act of 1970, section 21, 1970-2 C.B. 372 (Act), under the circumstances described below.

S corporation was a wholly owned subsidiary of P corporation until P sold all of S's stock as of the close of December 31, 1969, to an unrelated third party. For 20 years prior to the sale, S entered into several operating-differential subsidy (ODS) contracts with the United States Maritime Administration. Pursuant to such contracts S was required to establish and make deposits into a capital reserve fund and a special reserve fund (reserve funds) maintained by depositories approved by the Secretary of Commerce. The deposits into the reserve funds included, in part, insurance proceeds from losses incurred on subsidized ships, gross proceeds from sales of subsidized ships, and a percentage of net profits earned by S from shipping operations. The proceeds from these reserve funds were generally to be used for the replacement, reconstruction, or acquisition of additional vessels to be used in foreign trade, for the payment of indebtedness secured by mortgages on subsidized vessels, and for the maintenance of the subsidized vessels.

P and S have always filed consolidated Federal income tax returns on a calendar year basis. On December 31, 1969, pursuant to section 1.1502-32(f)(2) of the Income Tax Regulations, P properly elected to increase its basis in the stock of S by the amount of S's accumulated earnings and profits computed as of December 31, 1968. Even though the deposits and their earnings either remained in the reserve funds or were used solely for qualified purposes under the Act, P included in the computation of S's accumulated earnings and profits the entire amount deposited in these reserve funds and the earnings on such deposits.

The specific question is whether the deposits to the reserve funds and earnings thereon are includible in the computation of S's earnings and profits when deposited in the reserve funds.

Section 1.312-6(a) of the regulations provides that the amount of earnings and profits will be dependent upon the method of accounting properly employed in computing taxable income.

Section 1.312-6(b) of the regulations provides that among the items entering into the computation of corporate earnings and profits is all income exempted by statute. Gains and losses within the purview of section 1002 of the Internal Revenue Code of 1954 are brought into the earnings and profits at the time and to the extent such gains and losses are recognized under that section.

Section 1.1502-32(f)(2) of the regulations provides that the parent of a wholly owned subsidiary may elect, by submitting a statement on or before the due date of the consolidated return, to treat the subsidiary as having made a distribution (deemed dividend), on the first day of such taxable year, in an amount equal to, and out of, the subsidiary's accumulated earnings and profits on the last day of the preceding year. In addition, the parent is considered to have immediately contributed such distribution to the capital of the subsidiary, thereby increasing the parent's basis in the stock of its subsidiary.

Section 607(h) of the Act provides that earnings deposited in the reserve funds are exempt from all Federal income taxes. However, other language in that Act suggests that this is instead only a tax deferral. Section 607(h) of the Act, for example, further provides that earnings withdrawn from the special reserve funds and paid into the contractor's general funds or distributed as dividends or bonuses are taxable as if earned during the year of withdrawal from such funds. Amounts of income that are merely deferred are not included in earnings and profits until actually taxed. Section 1.312-6(a) of the regulations.

When earnings are withdrawn from the special reserve funds and are so taxed the amount of such income will be reflected in the earnings and profits of the year of withdrawal. Section 1.312-6(b) of the regulations. If the earnings and profits were also to reflect the same earnings for the year in which deposit is made in the reserve funds, the same earnings would be reflected twice in the earnings and profits computation thus distorting the earnings and profits computation.

Accordingly, in the present case, the amounts deposited by S and the earnings on such funds do not increase the earnings and profits of S when deposited into the reserve funds. Section 607(d)(1)(D) as added by the Merchant Marine Act of 1970 provides, in essence, that earnings and profits within the meaning of section 316 of the Code will not be reduced by amounts deposited into the funds. However, section 607(d)(1)(D) does not apply to reserve funds existing on or before the effective date, generally taxable years beginning after December 1, 1969, of the Merchant Marine Act of 1970.