Revisions of the Section 338 Consistency Rules With Respect to Target Affiliates That Are Controlled Foreign Corporations

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8710]

RIN 1545-A073

Revisions of the Section 338 Consistency Rules With Respect to

Target Affiliates That Are Controlled Foreign Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

consistency rules under section 338 of the Internal Revenue Code of

1986 that are applicable to certain cases involving controlled foreign

corporations. The final regulations substantially revise and simplify

the stock and asset consistency rules. The final regulations include

the provisions of the consistency rules applicable to controlled

foreign corporations contained in recent proposed and temporary

regulations. The final regulations would affect taxpayers that own

controlled foreign corporations.

EFFECTIVE DATE: These regulations are effective January 20, 1997.

FOR FURTHER INFORMATION CONTACT: Kenneth D. Allison at (202) 622-3860

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains final Income Tax Regulations (26 CFR part 1)

under section 338 of the Internal Revenue Code.

[[Page 3459]]

On January 20, 1994, temporary regulations (TD 8516) were published

in the Federal Register (59 FR 2956) under section 338 of the Internal

Revenue Code. See 1994-1 C.B. 119. A notice of proposed rulemaking

(INTL-0177-90) cross-referencing the temporary regulations was

published in the Federal Register for the same day (59 FR 3045). See

1994-1 C.B. 818. The temporary regulations provided rules to replace

the asset and stock consistency rules of Secs. 1.338-4T and 1.338-5T.

The temporary regulations included consistency rules applicable to

certain cases involving controlled foreign corporations (CFCs).

No written comments responding to the notice were received. No

public hearing was requested or held. The proposed regulations under

section 338 are adopted as revised by this Treasury decision, and the

corresponding temporary regulations are removed.

Explanation of Provisions

The preamble to the temporary and proposed regulations (1994-1 C.B.

119) contains a discussion of the provisions. Changes to the temporary

and proposed regulations are noted below.

Section 1.338-4T(h)(3) of the temporary regulations is clarified by

stating that the basis of the stock of a controlled foreign corporate

target affiliate is not increased by section 1248 earnings attributable

to the disposition of an asset in which a carryover basis is taken

under this section.

Section 1.338-4T(h)(4) of the temporary regulations addresses a

situation in which the income or gain from the disposition of a

controlled foreign corporation target affiliate (CFC T affiliate) asset

is not subject to the consistency rules of paragraph (h)(2). The

regulation states that if a CFC T affiliate pays a dividend to a target

(T) or a domestic T affiliate wholly or partially out of the earnings

generated by the disposition of that asset, and the dividend increases

the basis of the T stock under Sec. 1.1502-32, then the basis of the

stock of the CFC T affiliate is reduced by the amount of the dividend

that was paid from the earnings and profits resulting from the asset

disposition. This rule applies to any actual dividend, amount treated

as a dividend under section 1248 (or that would have been so treated

but for section 1291) or amount included in income under section

951(a)(1)(B).

The final regulations retain this rule. The final regulations also

add a special ordering rule, in Sec. 1.338-4(h)(4)(ii), clarifying that

any such dividend is first considered attributable to earnings and

profits resulting from the disposition of the asset.

Section 1.338-4(h)(4)(ii) is clarified to state that the basis of

the stock of a controlled foreign corporation may not be reduced below

zero under the carryover basis rules of Sec. 1.338-4.

Section 1.338-4(h)(2)(iv)(A) and Sec. 1.338-4(h)(4)(iii)(A) are

added to allow the purchasing group in certain instances to increase

the basis of the CFC T stock by the amount of either the basis increase

denied under Sec. 1.338-4(h)(2)(ii) or the basis reduction required

under Sec. 1.338-4(h)(4)(ii). The rule applies when the purchasing

group disposes of an asset acquired from CFC T that is subject to the

consistency rules to an unrelated party in a taxable transaction and

includes in U.S. gross income the greater of (i) the income or gain

equal to the basis amount denied to the asset under either Sec. 1.338-

4(h)(2)(i) or Sec. 1.338-4(g) and Sec. 1.338-4(h)(4)(i), respectively,

or (ii) the gain recognized on the asset.

Similarly, Sec. 1.338-4(h)(2)(iv)(B) and Sec. 1.338-4(h)(4)(iii)(B)

are added to allow the purchasing group to increase the basis of an

asset acquired from CFC T that is subject to the consistency rules by

the basis amount denied to the asset under either Sec. 1.338-4(h)(2)(i)

or Sec. 1.338-4(g) and Sec. 1.338-4(h)(4)(i). The rule applies when the

purchasing group disposes of the stock of CFC T to an unrelated party

in a taxable transaction and includes in U.S. gross income the greater

of (i) the gain equal to the basis increase denied under Sec. 1.338-

4(h)(2)(ii) or the basis reduction required under Sec. 1.338-

4(h)(4)(ii), respectively, or (ii) the gain recognized in the stock.

Special Analyses

It has been determined that this final regulation is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to these regulations, and because the notice of proposed

rulemaking preceding the regulations was issued prior to March 29, 1996

the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply.

Therefore, a regulatory flexibility analysis is not required. Pursuant

to section 7805(f) of the Internal Revenue Code, the notice of proposed

rulemaking preceding these regulations was submitted to the Small

Business Administration for comment on its impact on small businesses.

Drafting Information: The principal author of these regulations

is Kenneth D. Allison of the Office of Associate Chief Counsel

(International), IRS. However, other personnel from the IRS and

Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

removing the entry for Section 1.338-4T(h) to read as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. In Sec. 1.338-0, the outline of topics is amended by

revising the entry for Sec. 1.338-4(h) and removing the entry for

Sec. 1.338-4T to read as follows:

Sec. 1.338-0 Outline of topics.

* * * * *

Sec. 1.338-4 Asset and stock consistency.

* * * * *

(h) Consistency for target affiliates that are controlled

foreign corporations.

(1) In general.

(2) Income or gain resulting from asset dispositions.

(i) General rule.

(ii) Basis of controlled foreign corporation stock.

(iii) Operating rule.

(iv) Increase in asset or stock basis.

(3) Stock issued by target affiliate that is a controlled

foreign corporation.

(4) Certain distributions.

(i) General rule.

(ii) Basis of controlled foreign corporation stock.

(iii) Increase in asset or stock basis.

(5) Examples.

* * * * *

Par. 3. Section 1.338-4 is amended as follows:

1. Paragraph (a)(5) is amended by removing the language ``Section

1.338-4T(h)'' and adding ``Paragraph (h) of this section'' in its

place.

2. Paragraph (c)(4) is amended by removing the language

``Sec. 1.338-4T(h)(2)'' and adding ``paragraph (h)(2) of this section''

in its place.

3. Paragraph (d)(2)(iii) is amended by removing the language

``Sec. 1.338-4T(h)(3)'' and adding ``paragraph (h)(3) of this section''

in its place.

4. Paragraph (g)(2) is amended by removing the language

``Sec. 1.338-4T(h)(4)'' and adding ``paragraph (h)(4) of this section''

in its place.

5. Paragraph (h) is revised.

6. Paragraph (j)(3)(i)(A)(2) is amended by removing the language

``Sec. 1.338-4T(h)'' and adding ``paragraph (h) of this section'' in

its place.

[[Page 3460]]

The revision reads as follows:

Sec. 1.338-4 Asset and stock consistency.

* * * * *

(h) Consistency for target affiliates that are controlled foreign

corporations--(1) In general. This paragraph (h) applies only if target

is a domestic corporation. For additional rules that may apply with

respect to controlled foreign corporations, see paragraph (g) of this

section. The definitions and nomenclature of Sec. 1.338-1 (b) and (c)

and paragraph (e) of this section apply for purposes of this section.

(2) Income or gain resulting from asset dispositions--(i) General

rule. Income or gain of a target affiliate that is a controlled foreign

corporation from the disposition of an asset is not reflected in the

basis of target stock under paragraph (c) of this section unless the

income or gain results in an inclusion under section 951(a)(1)(A),

951(a)(1)(C), 1291 or 1293.

(ii) Basis of controlled foreign corporation stock. If, by reason

of paragraph (h)(2)(i) of this section, the carryover basis rules of

this section apply to an asset, no increase in basis in the stock of a

controlled foreign corporation under section 961(a) or 1293(d)(1), or

under regulations issued pursuant to section 1297(b)(5), is allowed to

target or a target affiliate to the extent the increase is attributable

to income or gain described in paragraph (h)(2)(i) of this section. A

similar rule applies to the basis of any property by reason of which

the stock of the controlled foreign corporation is considered owned

under section 958(a)(2) or 1297(a).

(iii) Operating rule. For purposes of this paragraph (h)(2)--

(A) If there is an income inclusion under section 951 (a)(1) (A) or

(C), the shareholder's income inclusion is first attributed to the

income or gain of the controlled foreign corporation from the

disposition of the asset to the extent of the shareholder's pro rata

share of such income or gain; and

(B) Any income or gain under section 1293 is first attributed to

the income or gain from the disposition of the asset to the extent of

the shareholder's pro rata share of the income or gain.

(iv) Increase in asset or stock basis--(A) If the carryover basis

rules under paragraph (h)(2)(i) of this section apply to an asset, and

the purchasing corporation disposes of the asset to an unrelated party

in a taxable transaction and recognizes and includes in its U.S. gross

income or the U.S. gross income of its shareholders the greater of the

income or gain from the disposition of the asset by the selling

controlled foreign corporation that was reflected in the basis of the

target stock under paragraph (c) of this section, or the gain

recognized on the asset by the purchasing corporation on the

disposition of the asset, then the purchasing corporation or the target

or a target affiliate, as appropriate, shall increase the basis of the

selling controlled foreign corporation stock subject to paragraph

(h)(2)(ii) of this section, as of the date of the disposition of the

asset by the purchasing corporation, by the amount of the basis

increase that was denied under paragraph (h)(2)(ii) of this section.

The preceding sentence shall apply only to the extent that the

controlled foreign corporation stock is owned (within the meaning of

section 958(a)) by a member of the purchasing corporation's affiliated

group.

(B) If the carryover basis rules under paragraph (h)(2)(i) of this

section apply to an asset, and the purchasing corporation or the target

or a target affiliate, as appropriate, disposes of the stock of the

selling controlled foreign corporation to an unrelated party in a

taxable transaction and recognizes and includes in its U.S. gross

income or the U.S. gross income of its shareholders the greater of the

gain equal to the basis increase that was denied under paragraph

(h)(2)(ii) of this section, or the gain recognized in the stock by the

purchasing corporation or by the target or a target affiliate, as

appropriate, on the disposition of the stock, then the purchasing

corporation shall increase the basis of the asset, as of the date of

the disposition of the stock of the selling controlled foreign

corporation by the purchasing corporation or by the target or a target

affiliate, as appropriate, by the amount of the basis increase that was

denied pursuant to paragraph (h)(2)(i) of this section. The preceding

sentence shall apply only to the extent that the asset is owned (within

the meaning of section 958(a)) by a member of the purchasing

corporation's affiliated group.

(3) Stock issued by target affiliate that is a controlled foreign

corporation. The exception to the carryover basis rules of this section

provided in paragraph (d)(2)(iii) of this section does not apply to

stock issued by a target affiliate that is a controlled foreign

corporation. After applying the carryover basis rules of this section

to the stock, the basis in the stock is increased by the amount treated

as a dividend under section 1248 on the disposition of the stock (or

that would have been so treated but for section 1291), except to the

extent the basis increase is attributable to the disposition of an

asset in which a carryover basis is taken under this section.

(4) Certain distributions--(i) General rule. In the case of a

target affiliate that is a controlled foreign corporation, paragraph

(g) of this section applies with respect to the target affiliate by

treating any reference to a dividend to which section 243(a)(3) applies

as a reference to any amount taken into account under Sec. 1.1502-32 in

determining the basis of target stock that is--

(A) A dividend;

(B) An amount treated as a dividend under section 1248 (or that

would have been so treated but for section 1291); or

(C) An amount included in income under section 951(a)(1)(B).

(ii) Basis of controlled foreign corporation stock. If the

carryover basis rules of this section apply to an asset, the basis in

the stock of the controlled foreign corporation (or any property by

reason of which the stock is considered owned under section 958(a)(2))

is reduced (but not below zero) by the sum of any amounts that are

treated, solely by reason of the disposition of the asset, as a

dividend, amount treated as a dividend under section 1248 (or that

would have been so treated but for section 1291), or amount included in

income under section 951(a)(1)(B). For this purpose, any dividend,

amount treated as a dividend under section 1248 (or that would have

been so treated but for section 1291), or amount included in income

under section 951(a)(1)(B) is considered attributable first to earnings

and profits resulting from the disposition of the asset.

(iii) Increase in asset or stock basis--(A) If the carryover basis

rules under paragraphs (g) and (h)(4)(i) of this section apply to an

asset, and the purchasing corporation disposes of the asset to an

unrelated party in a taxable transaction and recognizes and includes in

its U.S. gross income or the U.S. gross income of its shareholders the

greater of the gain equal to the basis increase denied in the asset

pursuant to paragraphs (g) and (h)(4)(i) of this section, or the gain

recognized on the asset by the purchasing corporation on the

disposition of the asset, then the purchasing corporation or the target

or a target affiliate, as appropriate, shall increase the basis of the

selling controlled foreign corporation stock subject to paragraph

(h)(4)(ii) of this section, as of the date of the disposition of the

asset by the purchasing corporation, by the amount of the basis

reduction under paragraph (h)(4)(ii) of this section. The preceding

sentence shall apply only to the extent that the

[[Page 3461]]

controlled foreign corporation stock is owned (within the meaning of

section 958(a)) by a member of the purchasing corporation's affiliated

group.

(B) If the carryover basis rules under paragraphs (g) and (h)(4)(i)

of this section apply to an asset, and the purchasing corporation or

the target or a target affiliate, as appropriate, disposes of the stock

of the selling controlled foreign corporation to an unrelated party in

a taxable transaction and recognizes and includes in its U.S. gross

income or the U.S. gross income of its shareholders the greater of the

amount of the basis reduction under paragraph (h)(4)(ii) of this

section, or the gain recognized in the stock by the purchasing

corporation or by the target or a target affiliate, as appropriate, on

the disposition of the stock, then the purchasing corporation shall

increase the basis of the asset, as of the date of the disposition of

the stock of the selling controlled foreign corporation by the

purchasing corporation or by the target or a target affiliate, as

appropriate, by the amount of the basis increase that was denied

pursuant to paragraphs (g) and (h)(4)(i) of this section. The preceding

sentence shall apply only to the extent that the asset is owned (within

the meaning of section 958(a)) by a member of the purchasing

corporation's affiliated group.

(5) Examples. This paragraph (h) may be illustrated by the

following examples:

Example 1. Stock of target affiliate that is a CFC. (a) The S

group files a consolidated return; however, T2 is a controlled

foreign corporation. On December 1 of Year 1, T1 sells the T2 stock

to P and recognizes gain. On January 2 of Year 2, P makes a

qualified stock purchase of T from S. No section 338 election is

made for T.

(b) Under paragraph (b)(1) of this section, paragraph (d) of

this section applies to the T2 stock. Under paragraph (h)(3) of this

section, paragraph (d)(2)(iii) of this section does not apply to the

T2 stock. Consequently, paragraph (d)(1) of this section applies to

the T2 stock. However, after applying paragraph (d)(1) of this

section, P's basis in the T2 stock is increased by the amount of

T1's gain on the sale of the T2 stock that is treated as a dividend

under section 1248. Because P has a carryover basis in the T2 stock,

the T2 stock is not considered purchased within the meaning of

section 338(h)(3) and no section 338 election may be made for T2.

Example 2. Stock of target affiliate CFC; inclusion under

subpart F. (a) The S group files a consolidated return; however, T2

is a controlled foreign corporation. On December 1 of Year 1, T2

sells an asset to P and recognizes subpart F income that results in

an inclusion in T1's gross income under section 951(a)(1)(A). On

January 2 of Year 2, P makes a qualified stock purchase of T from S.

No section 338 election is made for T.

(b) Because gain from the disposition of the asset results in an

inclusion under section 951(a)(1)(A), the gain is reflected in the

basis of the T stock as of T's acquisition date. See paragraph

(h)(2)(i) of this section. Consequently, under paragraph (b)(1) of

this section, paragraph (d)(1) of this section applies to the asset.

In addition, under paragraph (h)(2)(ii) of this section, T1's basis

in the T2 stock is not increased under section 961(a) by the amount

of the inclusion that is attributable to the sale of the asset.

(c) If, in addition to making a qualified stock purchase of T, P

acquires the T2 stock from T1 on January 1 of Year 2, the results

are the same for the asset sold by T2. In addition, under paragraph

(h)(2)(ii) of this section, T1's basis in the T2 stock is not

increased by the amount of the inclusion that is attributable to the

gain on the sale of the asset. Further, under paragraph (h)(3) of

this section, paragraph (d)(1) of this section applies to the T2

stock. However, after applying paragraph (d)(1) of this section, P's

basis in the T2 stock is increased by the amount of T1's gain on the

sale of the T2 stock that is treated as a dividend under section

1248. Finally, because P has a carryover basis in the T2 stock, the

T2 stock is not considered purchased within the meaning of section

338(h)(3) and no section 338 election may be made for T2.

(d) If P makes a qualified stock purchase of T2 from T1, rather

than of T from S, and T1's gain on the sale of T2 is treated as a

dividend under section 1248, under paragraph (h)(1) of this section,

paragraphs (h)(2) and (3) of this section do not apply because there

is no target that is a domestic corporation. Consequently, the

carryover basis rules of paragraph do not apply to the asset sold by

T2 or the T2 stock.

Example 3. Gain reflected by reason of section 1248 dividend;

gain from non-subpart F asset. (a) The S group files a consolidated

return; however, T2 is a controlled foreign corporation. In Years 1

through 4, T2 does not pay any dividends to T1 and no amount is

included in T1's income under section 951(a)(1)(B). On December 1 of

Year 4, T2 sells an asset with a basis of $400,000 to P for

$900,000. T2's gain of $500,000 is not subpart F income. On December

15 of Year 4, T1 sells T2, in which it has a basis of $600,000, to P

for $1,600,000. Under section 1248, $800,000 of T1's gain of

$1,000,000 is treated as a dividend. However, in the absence of the

sale of the asset by T2 to P, only $300,000 would have been treated

as a dividend under section 1248. On December 30 of Year 4, P makes

a qualified stock purchase of T1 from T. No section 338 election is

made for T1.

(b) Under paragraph (h)(4) of this section, paragraph (g)(2) of

this section applies by reference to the amount treated as a

dividend under section 1248 on the disposition of the T2 stock.

Because the amount treated as a dividend is taken into account in

determining T's basis in the T1 stock under Sec. 1.1502-32, the sale

of the T2 stock and the deemed dividend have the effect of a

transaction described in paragraph (g)(1) of this section.

Consequently, paragraph (d)(1) of this section applies to the asset

sold by T2 to P and P's basis in the asset is $400,000 as of

December 1 of Year 4.

(c) Under paragraph (h)(3) of this section, paragraph (d)(1) of

this section applies to the T2 stock and P's basis in the T2 stock

is $600,000 as of December 15 of Year 4. Under paragraphs (h)(3) and

(4)(ii) of this section, however, P's basis in the T2 stock is

increased by $300,000 (the amount of T1's gain treated as a dividend

under section 1248 ($800,000), other than the amount treated as a

dividend solely as a result of the sale of the asset by T2 to P

($500,000)) to $900,000.

* * * * *

Sec. 1.338-4T [Removed]

Par. 4. Section 1.338-4T is removed.

Par. 5. In Sec. 1.338(i)-1, paragraphs (a) and (b) are revised to

read as follows:

Sec. 1.338(i)-1 Effective dates.

(a) In general. Sections 1.338-1 through 1.338-5 (except

Sec. 1.338-4(h)), 1.338(b)-1, and 1.338(h)(10)-1 generally are

applicable for targets with acquisition dates on or after January

20, 1994. Section 1.338-4(h) is applicable for targets with

acquisition dates on or after January 20, 1997. Section 1.338-4T(h)

(as contained in 26 CFR part 1 as revised April 1, 1996) is

generally applicable for targets with acquisition dates on or after

January 20, 1994, and before January 20, 1997.

(b) Elective retroactive application. A target with an

acquisition date on or after January 14, 1992 and before January 20,

1994 may apply Secs. 1.338-1 through 1.338-5, 1.338-4T(h) (as

contained in 26 CFR part 1 as revised April 1, 1996), 1.338(b)-1,

and 1.338(h)(10)-1 by including a statement with its return

(including a timely filed amended return) for the period that

includes the acquisition date to the effect that it is applying all

of these sections pursuant to this paragraph (b). A target with an

acquisition date on or after January 14, 1992, and before January

20, 1997, may choose to apply Sec. 1.338-4(h) for the period that

includes the acquisition date pursuant to paragraph (b) of this

section.

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: January 13, 1997.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 97-1521 Filed 1-22-97; 8:45 am]

BILLING CODE 4830-01-U