In ILM 201320014 (released by the IRS to the public during the week of May 13, 2013), the IRS applied both the substance over form and step transaction doctrines to deny a U.S. corporate taxpayer the use of the dividends received deduction. This internal legal memorandum is significant, not only for its conclusions but for the mode of its analysis. In applying what I (and others) like to call the common law anti-abuse doctrines, the IRS went through a thorough analysis of the purposes of the statutes at issue and the purposes of the substance versus form and step transaction doctrines to arrive at its conclusion that a dividends received deduction under section 245 for the corporate taxpayer was not allowable.
The facts of this legal memorandum can be summarized as follows. A U.S. taxpayer in the business of investing money for its clients developed a plan whereby it believed that it could derive a better after-tax rate of return by taking advantage of the rules in the Internal Revenue Code allowing a dividends received deduction for certain dividends from a foreign corporation. The U.S. taxpayer formed a foreign corporation (with no employees of its own), and the foreign corporation invested its capital in the shares of a regulated investment company (RIC). Ordinarily, as the legal memorandum explains, a dividends received deduction is not allowed to an investor in a RIC because the RIC itself pays no federal income tax if it distributes the required amounts of its income to its investors, and so the dividends received deduction, designed to avoid the double taxation of the investor, is not needed. The U.S. taxpayer then, before the close of the foreign corporation’s taxable year, transferred the ownership of the foreign corporation to a U.S. partnership controlled directly and indirectly by the U.S. corporate taxpayer. The RIC then made distributions to the foreign corporation which, in turn, made distributions to the U.S. partnership which, in turn, made distributions, directly and indirectly, to the U.S. corporate taxpayer.
Because the U.S. partnership was presumably the owner of the foreign corporation at the close of the foreign corporation’s taxable year, the income of the foreign corporation, which constituted subpart F income in the hands of its U.S. shareholder (see sections 951 et. seq.), was taxed to the U.S. partnership (see Treas. Reg. sec. 1.701-2(f), example 3, which treats a U.S. partnership as the U.S. shareholder of a controlled foreign corporation (CFC) even though the U.S. partnership is predominantly foreign owned), or so the taxpayer claimed. At that point, the U.S. partnership allocated its income, consisting of dividend income, or at least that is what the taxpayer claimed, to its partners, the U.S. taxpayer and its affiliates (once the income of the foreign corporation was characterized as subpart F income in the hands of the U.S. partnership, that income became taxable to its partners but the character of the partnership’s income was presumably dividend income because subpart F income is not a character of income type that can be allocated to the partners under section 702). The U.S. taxpayer then claimed an 80 percent dividends received deduction to net against the dividend income.
The IRS started off its legal analysis with a broad general statement about its view of the substance versus form doctrine and its application to this set of facts.
“The starting point for our analysis is the fundamental principle of income taxation: a transaction’s tax consequences depend on its substance, not its form. Under this doctrine, courts have disallowed the tax benefits of a transaction even if the transaction formally complies with a literal reading of the Code and its implementing regulations. Although in numerous situations the form by which a transaction is effected does influence, and may decisively control, the taxation of a transaction, the substance over form doctrine allows the courts and the Internal Revenue Service … to look beyond the superficial formalities of a transaction to determine its proper tax treatment….Although investing the Customer Funds served a business purpose, routing the investment and investment returns through FSub-1 [the foreign corporation] and RIC did not serve a meaningful business purpose. Rather, the indirect investment strategy was a contrivance to avoid U.S. federal income tax.” (footnotes omitted).
The IRS next turned to the purposes of the statutes at issue. First, with respect to the dividends received deduction, the IRS stated that the purposes of this statute were not met in this case because there was no double taxation of the RIC earnings and the avoidance of double taxation was the purpose of the dividends received deduction statute. Then the IRS turned to the purposes of subpart F, stating that the subpart F provisions (sections 951 through 964) were added to prevent U.S. shareholders from inappropriately deferring income on certain income earned by CFCs. The IRS then stated that the rule in subpart F that provides that a U.S. shareholder does not have a section 951 inclusion when it transfers its CFC interest to another U.S. person during the CFC’s taxable year is a rule for administering the subpart F regime in a year in which two U.S. persons hold the same CFC shares in order to avoid double taxation and is not meant to be used by taxpayers to manipulate the character of income in order to avoid U.S. income tax. There is no evidence, the IRS stated, that Congress intended a former U.S. shareholder [the U.S. corporate taxpayer] to rely on the subpart F rules to achieve a better result by transferring its interests in a CFC [as the U.S. taxpayer did here by transferring the foreign corporation shares to its controlled U.S. partnership] prior to the end of the CFC’s year.
The IRS then concluded that the substance versus form and step transaction doctrines applied to tax the U.S. corporate taxpayer on the income from the offshore investments on several alternative recasting theories.
“We conclude that Common Parent’s purported tax result is inconsistent with Congressional intent. In substance, the Customer Funds were by-in-large put into domestic interest paying investments and Taxpayer should pay tax on this interest income. Interest income is not eligible for a DRD. To a lesser extent, the Customer Funds were put into investments that gave rise to capital gains. Capital gains are not eligible for a DRD either. One can reach a result consistent with Congressional intent through different iterations of the substance over form doctrine. One approach is the application of the step transaction doctrine in which Common Parent is treated as directly investing in RIC and RIC is treated as directly making distributions to Common Parent. As such, the transaction does not implicate sections 951 and 881. The distribution of dividends from RIC to Common Parent is not eligible for the DRD. This result is consistent with the intent of sections 243 and subchapter M….One can also reach essentially the same result by treating Common Parent’s income (attributable to funds paid by RIC to FSub-1) as income subject to a section 951 inclusion. A section 951 inclusion is not eligible for a DRD. This approach is consistent with the intent of sections 881, 245 and 951.”
The taxpayer argued in this case that the transfer of the shares in the foreign corporation to the U.S. partnership controlled by the taxpayer prevented the application of the subpart F rules to the U.S. corporate taxpayer because the U.S. partnership was the owner of the shares on the last day of the taxable year of the CFC. The IRS rejected giving independent tax effect to this transfer, stating that “Common Parent continued to indirectly own FSub-1 after moving it to Partnership-C [the U.S. partnership]. Common Parent transferred its interest in FSub-1 to Partnership-C in order to change the character of the income that it derived with respect to FSub-1 during Year T from a section 951 inclusion that was not eligible for a section 245 DRD to a dividend, which it claims is eligible for a section 245 DRD.”
Similar to the analysis of both the district court and the court of appeals in Schering-Plough v. U.S., the IRS looked to the purpose of the subpart F rules and concluded, based on the U.S. corporate taxpayer’s continued direct and indirect ownership of the foreign corporation through the U.S. partnership, and not explicitly or expressly based on the aggregate view of partnerships, that the U.S. corporate taxpayer remained the owner of the shares, stating that “Common Parent transferred FSub-1 to Partnership-C in order to change the character of its Year T income from a section 951 inclusion to a dividend. In substance, however, Common Parent owned and controlled FSub-1 throughout the entire taxable year. Common Parent should be required to include in income 100 percent of FSub-1’s subpart F income, either as a result of its direct ownership or its ownership through Partnership-C. Therefore, under the substance over form principle announced in Gregory and followed in Garlock, Jacobs Engineering, and Schering-Plough, the income derived by Common Parent with respect to FSub-1 should be treated as a section 951 inclusion rather than a dividend for purposes of section 245, and Common Parent should not qualify for a section 245 DRD in respect thereof.”
This is a significant IRS legal memorandum. First and foremost, the IRS went through a detailed purposive analysis of the statutes at issue in order to determine whether the common law ant-abuse doctrines applied to the transaction at issue. The IRS concluded that that common law doctrines of substance versus form and step transaction applied to defeat the plans of the taxpayer. Second, the IRS disregarded the existence of a partnership as a holder of the shares because the partnership continued to be controlled by the taxpayer and its affiliates. No one disputed that the partnership was in form the owner of the foreign corporation shares and no one asserted that the partnership should be treated as an aggregate for the purpose of testing CFC status. The thrust of the IRS here appears to be that a partnership that remains controlled by the taxpayer after the transfer of property to that partnership will not be treated as the owner of the property transferred to it in order to implement the policies of other Code provisions. This is a unique and aggressive application of the substance versus form doctrine and time will tell whether this approach will have continuing viability in the future.