Distributions by CFCs with wholly-owned foreign subsidiaries

Treas. Reg. §1.1248-1T(b) provides that distributions from a foreign corporation that are treated as gains to a Section 1248 shareholder under Section 301(c)(3) of the Internal Revenue Code (the Code) will be treated as dividends to the extent of the earnings and profits (E&P) of the distributing corporation’s controlled foreign corporation subsidiaries under Section 1248(c)(2).

Gain on sale of CFC stock

A US person who holds at least 10 percent of the stock of a controlled foreign corporation (CFC), will be considered to be a Section 1248 shareholder for US tax purposes. A CFC is defined as a foreign corporation that is owned more than 50 percent by one or more US shareholders. The definition of a US shareholder is exactly the same as that of a Section 1248 shareholder. Section 1248 requires that any gain recognized on the sale or exchange of the stock of a CFC be treated as a dividend to the Section 1248 shareholders to the extent of the E&P of the CFC. The E&P of the CFC includes any foreign subsidiaries of the CFC that would independently qualify as a CFC through indirect ownership.

For example, a US corporation (US corp.) owns all of the stock of a foreign corporation (CFC 1). Assume the US corp. has a basis of $100 in the CFC 1 stock; and CFC 1 has E&P of $500. The US corp. is treated as both a US shareholder of CFC 1 and as a Section 1248 shareholder of CFC 1, because it owns at least 10 percent of the stock of CFC 1. If the US corp. sells the stock of CFC 1 to a third party purchaser for $1,000, $500 of the $900 gain on the sale will be treated as a deemed dividend to the US corp. because the US corp. is a Section 1248 shareholder of CFC 1. The remaining $400 would be treated as a capital gain from the sale or exchange of CFC 1 stock. Section 1248(c)(2) further provides that on the sale of CFC 1 described above, any E&P of subsidiary CFCs owned by CFC 1 would also be included in the amount of the deemed dividend to the US corp.

For example, if CFC 1 also owns all of the stock of a second foreign corporation (CFC 2), and CFC 2 has E&P of $100 on the date of the sale of the stock of CFC 1, that $100 would also be included in the income of US corp. as a deemed dividend. Thus, of the $1,000 of gain realized on the sale of CFC 1 stock by the US corp., $600 ($500 of E&P attributed to CFC 1 stock and $100 of E&P attributed to CFC 2 stock) would be treated as a deemed dividend to the US corp., and $300 would be treated as a capital gain from the sale or exchange of the CFC 1 stock.