In Chief Counsel Advice (CCA) 201640018, the IRS has concluded that a subsidiary of a US corporation is not eligible for a dividends received deduction (DRD) under Section 245 with respect to funds distributed from a regulated investment company (RIC) to the subsidiary through its own subsidiary.

Facts

A publicly traded company is the common parent (Common Parent) of an affiliated group of corporations (US Group or Taxpayer) in State T that file a consolidated US federal income tax return. US Group engages in Business N; some members of the group engage in Business O, subject to certain regulatory requirements. Business O entities must invest customer funds "in high-grade, domestic liquid assets … and cannot invest the funds in dividend-paying stock of unrelated corporations." Therefore, Business O eligible investments "generally produce interest income, and, to a lesser extent, capital gain or loss."

Taxpayer began planning the transaction at issue before Year X. In Year X, Common Parent directly held all of the stock of Sub B, which directly held all of the stock of Sub C. Sub C directly held all of the stock of Subs D and E. Sub E directly held all of the stock of Sub 1, which held all of the stock of Sub 2, which held all of the stock of Sub 3, which held all of the stock of Sub 4, which directly held the stock of Subs 5 and 6. Subs 1, 2, 3 and 4 were all State T corporations; Subs 5 and 6 were State T limited liability companies treated as corporations for US federal income tax purposes.

To carry out the transaction, Common Parent caused Subs 4 and 5 to re-domicile into Country U and Sub 6 to become a RIC. The stated purpose of the transaction was to increase US Group's after-tax return on its Business O eligible investments by claiming an 80% DRD for interest and capital gain income flowing from the investments. If the DRD were allowed, the investments would yield 130% of their value after the transaction. The costs associated with carrying out the transaction were substantial enough that, if the DRD were disallowed, Taxpayer would lose money on the transaction.

Before carrying out the transaction, Taxpayer expected these results from a US federal income tax perspective:

1. Sub 6 (referred to as Sub 6 RIC after the transaction) would invest in Business O eligible investments and make distributions to Sub 4 (Sub 6's sole shareholder) in Year Y, setting off any interest or capital gain income by taking a dividends paid deduction (DPD). (Sections 852(b)(2)(D) and 852(b)(3)(A))

2. Sub 4 would not be liable for US federal income tax on distributions it received from Sub 6 RIC, and Sub 6 RIC would not be required to withhold tax on the distributions to Sub 4. (Section 871(k) and 881(e))

3. Sub 3 would not be required to include in income distributions that Sub 6 RIC made to Sub 4 (Section 951(a)(1)). Although the Sub 6 RIC distributions that Sub 4 received would be foreign personal holding company income under Section 954(c), and therefore subpart F income, Sub 3 would not have a "Section 951 inclusion" with respect to Sub 4 in Year Y "because Sub 3 would dispose of its Sub 4 stock before the close of Sub 4's taxable year ending in [Y]ear Y and Sub 4 would remain a CFC after the disposition."

4. Sub 2 would pay a small amount of US federal tax on a Section 951 inclusion with respect to Sub 4 in Year Y because Sub 2 would hold all of the stock of Sub 4 on the last day of Sub 4's tax year, but Sub 2's pro rata share of Sub 4's subpart F income would be reduced by the amount that Sub 4 distributed to Sub 3 in Year Y. (Section 951(a)(2)(B))

5. Sub 3 would claim an 80% DRD, including the distribution from Sub 6 RIC via Sub 4 in income as a dividend and treating it as a US-source dividend under Section 245. (Sections 245(a) and 861(a)(2)(B))

6. Sub 4 would change its tax year at the beginning of the transaction so it would differ from the US Group's tax year.

7. Sub 6 RIC would distribute its Year X and Year Y income to Sub 4, which would distribute the funds to Sub 3, but because Sub 4's tax year was not the same as US Group's tax year, US Group could defer including Sub 6 RIC's Year X income until Year Y.

The transaction at issue involved these steps:

1. Sub 6 changed its name and, in anticipation of becoming a RIC, sold all of its assets, retaining only cash.

2. Subs 4 and 5 converted from State T corporations to Country U corporations.

3. Sub 4 formed a wholly owned Country U subsidiary (F-DE), which elected to be a disregarded entity for US federal income tax purposes; Sub 4 contributed all of its Sub 6 shares to F-DE.

4. Sub 6 registered as a RIC and elected to be taxed as a RIC for Year X.

5. Subs 4 and 5 changed their tax year ends from Date 5 to Date 4.

6. Sub 1 directly wired funds to Sub 6 RIC, which Common Parent treated as a contribution by Sub 3 to Sub 4 and then by Sub 4, through F-DE, to Sub 6 RIC.

7. Sub 6 RIC authorized a bank to act as placement agent for a private sale of Sub 6 RIC notes due in Year Y, one year after issuance. Sub 6 RIC subsequently issued notes and US Group directed the bank to issue the notes to more than 100 investors, at least one of which was not a "qualified purchaser." (The IRS explains that US Group "caused the notes to be issued in this manner in order to treat Sub 6 RIC as an Investment Company, which requires Sub 6 RIC to register with the U.S. Securities and Exchange Commission.")

8. In Year Y, one or more members of US Group transferred additional funds to Sub 6 RIC in a transaction that Common Parent treated as a contribution by Sub 3 to Sub 4 and then to Sub 6 RIC, through F-DE.

9. In Year X, Sub 6 RIC purchased Business O eligible investments.

10. In Year Y, Sub 6 RIC distributed certain amounts to Sub 4.

11. In Year Y, Sub 4 distributed certain amounts to Sub 3.

12. Later in Year Y, Sub 3 distributed all of its shares in Sub 4 to Sub 2.

On its Year X federal income tax return, Sub 6 RIC reported ordinary income as well as long-term and short-term capital gain and deducted the total as DPD, but did not distribute the funds until Year Y. On its Year Y federal income tax return, Sub 6 RIC again reported ordinary income, long-term and short-term capital gain and deducted the total as DPD in Year Y.

Filing an Amended Form 1120X for Year Y, Common Parent reported that Sub 3 had US-source dividend income reduced by an 80% DRD, resulting in tax savings.

Common Parent contends that its predominant purpose in creating and implementing the transaction was "to invest in, and earn a return on, investment securities," in addition to reducing expenses attributable to the investment, "including tax expenses."

Common Parent also contends that Sub 6 RIC should be treated as a RIC under the Internal Revenue Code (IRC). Sub 6 RIC did not have any employees, and contracted with Sub D (a registered investment advisor) to serve as its investment advisor. Common Parent indirectly maintained control over Sub 6 RIC and could, through Sub 4, remove Sub 6 RIC's "independent" directors.

The IRS points out that "US Group did not derive the customary benefits of using a RIC, such as pooling of funds and obtaining the Investment Company's professional investment management services." Although generally accepted accounting principles (GAAP) generally require a RIC to file audited financial statements with the SEC, Common Parent apparently determined that this was not necessary and instead consolidated Sub 6 RIC's financials with the financials for US Group. Common Parent relied on the definition of an investment company for GAAP purposes — "an 'entity that pools shareholders' funds to provide the shareholders with professional management'" — and decided that Sub 6 RIC did not meet this definition.

Sub 6 RIC eventually deregistered its RIC status by filing a form with the SEC.

The planning documents for the transaction state that Sub 4, Sub 5, and F-DE would do business solely in the United States and have contacts in Country U merely to satisfy certain statutory requirements. Common Parent asserted that Sub 4 would become a Country U corporation because:

— It is easier and less expensive to attract investment capital from non-US investors by using an entity organized in Country U.

— Some non-US investors might view an investment in Country U more favorably for various reasons (ranging from the absence of withholding tax to political and reputational reasons).

— Country U had promised that it would not tax any entities that US Group formed in Country U for at least 20 years, but State T did not offer similar tax relief.

The planning documents also noted disadvantages of the transaction, including:

— Sub 6 RIC's assets could not be pledged.

— If Sub 6 RIC's assets were sold at a loss, the loss would not pass through to its shareholders.

— If the IRS successfully challenged the transaction, US Group's investment return would be lower than if it had not engaged in the transaction because of the substantial costs associated with the transaction.

— The transaction would create a risk to Common Parent's reputation if it received adverse publicity for participating in tax arbitrage.

US Group contends that its federal income tax reporting position is consistent with the form of the transaction and the literal language of the IRC, asserting that its business purpose was to maximize return on investment and to use Sub 4 as a Country U entity to attract non-US investors and to take advantage of Country U's tax waiver.

Law and analysis

US Group asserted that Sub 4's distributions to Sub 3 constituted dividends under Section 316(a) because the distributions were made from earnings and profits (E&P) and that the dividends qualify for the Section 245 DRD. The amount of a DRD is limited (under Section 245(a)(1)) based on the percentage of the US-source portion of the dividends, which is any amount that bears the same ratio to the dividends as the post-1986 undistributed US earnings bears to the total post-1986 undistributed earnings (Section 245(a)(3)).

However, the CCA explains, during "the years that the Taxpayer engaged in the Transaction, [S]ection 245 did not contain an explicit limitation that would have prevented distributions from a RIC from being taken into account in determining the 'U.S.-source portion' of a dividend paid by a 'qualified 10% owned foreign corporation.'" Although "distributions from Sub 4 attributable to distributions from Sub 6 RIC explicitly would not be eligible for the [S]ection 245 DRD under the revised statute," statutory history indicates that "'[n]o inference is intended with respect to the proper treatment under [S]ection 245 of dividends received from RICs or REITs before such date.'"

Post-1986 undistributed US earnings are limited (Section 245(a)(5)) to:

A. Income of the foreign corporation that is effectively connected with the conduct of a trade or business in the United States and is subject to tax under Chapter 1, or

B. Any dividend received, either directly or through a wholly owned foreign corporation, from a domestic corporation that has at least 80% of its stock (by vote or value) held by a qualified 10% owned foreign corporation.

The CCA concludes that the funds Sub 4 received from Sub 6 RIC do not constitute post-1986 undistributed US earnings under Section 245(a)(5)(A) because Sub 4 did not have income from the conduct of a trade or business within the United States and subject to US federal income tax.

RIC shareholders are only eligible for a Section 243 DRD for distributions that the RIC has designated as dividends eligible for the deduction. The CCA points out that Sub 6 RIC did not issue a statement to Sub 4 that qualified any distributions as dividends and that "Sub 6 RIC generally only held debt instruments and its income therefore consisted of interest and capital gain rather than dividends."

US Group argued that, even though one of its members "would not have been able to claim a DRD with respect to the interest income and capital gain derived on the Business O Eligible Investments if it had received it directly … distributions attributable to such income are dividends eligible for the 80% [S]ection 245 DRD if funneled through Sub 4."

Anti-avoidance rule

Generally, a transaction may not be engaged in or structured with the principal purpose to avoid tax (Reg. Section 1.1502-13(h)). A similar rationale is at work in common law principles, such as the step-transaction and economic substance doctrines.

Under the instant facts, Common Parent constructed and carried out a complex, multi-step plan to alter the group's consolidated income tax liability by using an intercompany transaction, and the result does not clearly reflect income, the IRS concluded.

Common Law

US Group asserted that Sub 3 was eligible to claim an 80% DRD because the transaction had complied with the literal requirements of the IRC. However, the IRS went beyond the statutory language (i.e., the letter of the law) to apply common law doctrines that reflect the spirit of the law, and concluded that Taxpayer failed to satisfy both the economic substance doctrine and the substance-over-form doctrine.

Economic substance doctrine. The economic substance doctrine requires courts to disregard a transaction if the taxpayer entered into it without a business purpose and merely for tax reasons.

The IRS concluded that, even if US Group "satisfied the literal requirements of [S]ection 245 as in effect for the relevant taxable years, Sub 3 is not entitled to the [S]ection 245 DRD with respect to the dividends it received from Sub 4 attributable to Sub 6 RIC's distributions because moving funds through a Country U corporation lacked economic substance."

Countering Taxpayer's contention that the entire transaction served the business purpose of investing in Business O eligible investments and that it is entitled to structure the transaction in the most advantageous way possible from a tax perspective, the IRS pointed out that the transaction at issue focuses on the portion of the larger transaction that generated the claimed DRDs. "Elements of the larger series of steps in the Transaction did not generate any incremental profit other than tax benefits and, being strictly among controlled entities, entailed no risk other than tax risk," the IRS noted.

The portion of the transaction that must be examined under the economic substance doctrine involved: (1) re-domiciling Sub 4 to Country U; (2) funneling investment funds and return on investment through a Country U entity; and (3) transferring the Sub 4 stock from Sub 3 to Sub 2 before the end of Sub 4's Year Y tax year. The IRS concluded that Taxpayer failed to satisfy the objective prong of the economic substance test, finding that these three steps "did not give Taxpayer any reasonable expectation of economic profit over and above the profit it could expect if a member of US Group directly invested in Business O Eligible Investments or invested in a RIC that invested in Business O Eligible Investments." Further, the IRS concluded that Taxpayer failed to satisfy the objective prong by funneling investment funds and investment returns through a Country U corporation.

Turning to the business purpose prong of the economic substance test, the IRS rejected Taxpayer's claim that it had a valid business reason for moving Sub 4 to Country U, finding "no support for Taxpayer's claim that it was necessary to use a Country U corporation as an investment vehicle for potential foreign investors in order to reduce U.S. federal withholding taxes." Specifically, the IRS found Taxpayer's reasoning "unpersuasive because Taxpayer relied on [S]ections 871(k) and 881(e) to exempt distributions from Sub 6 RIC to Sub 4 from U.S. federal withholding taxes" and because non-US investors "would likewise have been exempt from U.S. federal withholding tax under Sections 871(k) and 881(e) if they had invested directly in Sub 6 RIC … there is no support for Taxpayer's claim that it was necessary to use a Country U corporation as an investment vehicle for potential foreign investors." Further, the IRS found "no evidence that Taxpayer actually sought, or planned to seek, non-U.S. investors for Sub 4" and that "Taxpayer's claimed business purpose of using a Country U corporation in order to save State T tax is unpersuasive." Finally, the IRS found there "is evidence to support the inference that Taxpayer's only purpose for moving funds from Sub 6 RIC to Sub 4 before returning the funds to a member of US Group was tax avoidance."

Although the economic substance test may be disregarded if a taxpayer's treatment of an item is consistent with congressional intent, the IRS concluded that "there is clear evidence that Congress did not intend taxpayers to be able to convert interest income and capital gains into dividends eligible for the DRD" and therefore the economic substance doctrine applies to disallow Taxpayer's DRD.

Substance-over-form doctrine. The substance-over-form doctrine provides that the substance of a transaction, and not its mere form, determines the tax consequences of the transaction. The step-transaction doctrine allows a court to collapse steps of a transaction if they are not substantive to determine how the transaction should be taxed.

Applying the step-transaction doctrine to the instant facts, the IRS concluded the steps that "served only to route funds through Sub 4, served no independent business purpose" and therefore should be disregarded. These steps are: Sub 3's transfers to Sub 4; Sub 4's transfers to Sub 6 RIC; Sub 6 RIC's transfers to Sub 4; and Sub 4's transfers to Sub 3. Collapsing these steps, "Sub 3 is treated as directly acquiring stock in Sub 6 RIC and receiving distributions from Sub 6 RIC with respect to [the] stock. Accordingly, Sub 3 does not qualify for the DRD under Section 245 or 243," the IRS concludes.

Alternative substance-over-form analysis. Taxpayer asserted that Sub 3 is not required to include in income its pro rata share of Sub 4's subpart F income under Section 951(a) because Sub 3 distributed all of its interest in Sub 4 to Sub 2 immediately before the end of Sub 4's Year Y tax year.

The CCA explains that subpart F helps avoid double counting of income inclusions in a chain of corporations by limiting income inclusion to the corporations in the chain that hold interests in the CFC, directly or through foreign entities, on the last day of the CFC's tax year. "But," the IRS admonished, "when a chain of 100% U.S. shareholders holds the CFC on every day of the taxable year, these statutory provisions were not intended to result in the exclusion of subpart F income merely by manipulating which U.S. shareholder in the chain owned a direct interest in the CFC on the last day of the year."

"Moving the stock of a CFC between related U.S. shareholders at the end of the CFC's taxable year to avoid a [S]ection 951 inclusion is contrary to the purposes of subpart F," the IRS concluded.

Implications

CCAs are advice provided by the Office of Chief Counsel to IRS personnel in their National Office or in field offices on either a general topic or a particular fact pattern. They are written by docket attorneys and subject to limited review. As such, CCAs are not precedential and have limited authority. They can, however, be extremely instructive. In CCA 201640018, the Service disallowed the DRD under the economic substance doctrine, regardless of whether the literal requirements of Section 245 were satisfied. This CCA provides useful insight into the IRS interpretation and use of common law doctrines and other anti-avoidance measures at its disposal to combat perceived tax arbitrage. Prudent taxpayers and tax advisors should take note.