office_of_chief_counsel internal_revenue_service memorandum number release date cc corp b05 postu-131660-15 third party communication none date of communication not applicable uilc date date to senior counsel large business international from senior counsel corporate subject application of sec_245 to the transaction this chief_counsel_advice responds to your request for assistance this document should not be used or cited as precedent legend common parent sub b sub c sub d sub e sub sub sub sub sub -------------------------------- ----------------------------------- ---------------------------- ------------------------------------------ -------------------------------------- ------------------------------------ ---------------------------------------- --------------------------------------------- --------------------------------------------- ------------------------------- postu-131660-15 sub sub sub ric f-de bank bank ----------------------------------------------- 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-------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------- -------- state s state t country u country v year w year x year y year z year aa year bb date w date date date w date w date w date w date x date x date x ---------- ------------ --------------------------- ---------------- ------ ------ ------ ------ ------ ------ --------------------------- ------------------ ------------------ -------------------------- -------------------------- -------------------------- -------------------------- --------------------- -------------------------- --------------------- postu-131660-15 date x date x date x date y date y date y date y date y date y date y date y date y date z date z date aa date bb date bb date bb date bb b d e ------------------------ ---------------- ----------------- --------------------- ----------------------- --------------------- 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--------------------------------------------------------------- --------------------------------------------------------------- --------------------------------------------------------------- --------------------------------------------------------------- --------------------------------------------------------------- --------------------------------------------------------------- --------------------------------------------------------------- -------------------------------------------------------------- issue whether sub is eligible for a dividends received deduction drd under sec_245 of the code1 the sec_245 drd with respect to the funds distributed from a regulated_investment_company within the meaning of sec_851 ric to sub via sub during year y conclusion no sub is not eligible for the sec_245 drd with respect to the funds distributed from the ric to sub via sub during year y facts i ownership structure and business operations common parent is a state t corporation and the common parent of an affiliated_group_of_corporations that file a consolidated u s federal_income_tax return us group or taxpayer common parent is a publicly-traded company its taxable_year ends date common parent owns numerous entities some of which are described in this memorandum us group generally engages in business n certain members of us group including sub c engage in business o collectively the business o entities in connection with this business the business o entities --------------------------------------------------------------------------- customer funds --------------------------------------------------------------------------------------------------------------------- unless otherwise indicated all section references are to the internal_revenue_code_of_1986 title_26 of the united_states_code as amended and as in effect during the years at issue postu-131660-15 --------------------------------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------- business o is subject_to regulatory requirements administered by agency and agency pursuant to agency regulations the business o entities must invest the customer funds in high-grade domestic liquid_assets business o eligible investments and cannot invest the funds in dividend-paying stock of unrelated corporations accordingly the business o eligible investments generally produce interest_income and to a lesser extent capital_gain or loss taxpayer began planning the transaction that is the subject of this memorandum the transaction prior to year x during year x common parent directly held all of the stock of sub b which directly held all of the stock of sub c which directly held all of the stock of sub d and sub e sub e directly held all of the stock of sub sub held all of the stock of sub which in turn held all of the stock of sub which held all of the stock of sub sub sub sub and sub were all state t corporations sub directly held all of the membership interests in sub and sub sub and sub were state t limited_liability companies that were treated as corporations for u s federal_income_tax purposes sub c sub d sub e sub sub sub sub sub and sub were all members of us group see diagram one for the pre-transaction ownership structure at the beginning of year w postu-131660-15 diagram one diagram two common parent sub b sub c common parent sub b sub c sub d sub e sub d sub e sub sub sub sub sub sub ric sub country u sub sub sub sub country u f-de country u sub ric in furtherance of the transaction common parent caused certain us group members to deconsolidate from us group specifically sub and sub re-domiciled into country u and sub became a ric see diagram two ii taxpayer’s planning of the transaction a intent of the transaction postu-131660-15 common parent planned the transaction with the stated principal goal of increasing us group’s after-tax return on the business o eligible investments by claiming an percent drd with respect to income attributable to the interest and capital_gain derived from the investments as reflected in its planning documents taxpayer calculated that the post-transaction yield on the investments would be percent of the pre-transaction yield with the increased yield due to a decrease in taxpayer’s u s federal_income_tax liability the transaction would result in a better after-tax return only if the drd were allowed if the drd were not allowed taxpayer’s after-tax return would decrease because of the costs associated with the transaction b taxpayer’s expected u s federal_income_tax treatment of transaction prior to commencing the transaction taxpayer anticipated the treatment of the transaction for u s federal_income_tax purposes as follows sub hereinafter referred to as sub ric during the period after its conversion to a ric would not pay u s federal_income_tax sub ric would invest in business o eligible investments similar to investments purchased by us group in years prior to year x and make distributions to its sole shareholder sub during year y thus sub ric would not pay u s federal_income_tax on its interest or capital_gain income because its income would be offset by a dividends_paid deduction dpd sec_852 d and b a sub would not pay u s federal_income_tax sub would not be subject_to u s federal_income_tax on the distributions that it received from sub ric and sub ric would not be required to withhold tax on its distributions to sub during year y sec_871 and sec_881 document id pursuant to the transaction the taxpayer interposed f-de a foreign_entity that was disregarded as an entity separate from its owner for u s federal_income_tax purposes between sub and sub ric when a ric meets certain requirements sec_852 allows the ric a deduction in computing its investment_company_taxable_income for dividends_paid as defined in sec_561 but the amount of dividends with respect to which the deduction applies is computed without regard to capital_gain dividends and exempt-interest dividends net capital_gains are separately excluded from the definition of investment_company_taxable_income sec_852 sec_852 imposes on a ric a tax determined as provided in sec_1201 on the excess if any of the net_capital_gain over the deduction for dividends_paid as defined in sec_561 determined with reference to capital_gain dividends only sec_881 generally imposes a percent tax on certain income received from sources within the united_states by a foreign_corporation unless otherwise excepted except as otherwise provided section postu-131660-15 sub would not pay u s federal_income_tax sub would not have an inclusion under sec_951 a sec_951 inclusion with respect to sub as a result of the distributions from sub ric the sub ric distributions received by sub would constitute foreign_personal_holding_company_income within the meaning of sec_954 and thus would be subpart_f_income within the meaning of sec_952 however sub would not have a sec_951 inclusion with respect to sub in year y because sub would dispose_of its sub stock before the close of sub 4’s taxable_year ending in year y and sub would remain a cfc after the disposition sec_951 sub would pay at most a small amount of u s federal_income_tax sub would have a sec_951 inclusion with respect to sub in year y because sub would hold all of the stock of sub on the last day of sub 4’s taxable_year however sub 2’s pro_rata share of sub 4’s subpart_f_income would be reduced by the amount of sub 4’s distribution to sub during year y sec_951 sub would claim an percent drd sub would distribute the amounts that it received from sub ric to sub during year y before sub disposed of its sub stock sub would include the distribution in income as a dividend and treat the entire amount as a u s -source dividend for purposes of sec_245 thus sub would offset the dividend income with an percent drd sec_245 and sec_861 sub would change its taxable_year at the outset of the transaction so that its taxable_year would differ from us group’s taxable_year in date x and year y sub ric would distribute its year x and year y income to sub and in turn sub would distribute the funds to sub thus by changing sub 4’s taxable_year to a year different from us group’s taxable_year us group would be able to defer including the income attributable to sub ric’s year x earnings in us group’s income until year y e provides an exception to the tax imposed by sec_881 for any interest-related_dividend as defined in sec_871 from a ric if a foreign_corporation is a controlled_foreign_corporation cfc for an uninterrupted period of days or more during any taxable_year sec_951 generally imposes a tax on every person who is a u s shareholder as defined in sec_951 of such corporation and who owns within the meaning of sec_958 stock in such corporation on the last day in such year on which such corporation is a cfc the propriety of us group’s deferral of tax on income attributable to business o eligible investments by investing through a captive ric rather than making these investments directly is beyond the scope of this memorandum and no inference should be drawn as to the u s federal_income_tax treatment of that postu-131660-15 iii transaction steps after preliminary restructuring steps us group undertook the following steps in connection with the transaction on date w sub changed its name in anticipation of becoming a ric sub sold all of its assets prior to date w so that it only held cash on date w dollar_figure effective date w sub and sub converted from state t corporations to country u corporations thereby deconsolidating from us group on date w sub had approximately dollar_figureb of investments on date w sub formed f-de a wholly-owned country u subsidiary which made an election to be disregarded as an entity separate from sub for u s federal_income_tax purposes effective as of the date of its formation sub contributed all of its sub shares to f-de on date w sub registered as an investment_company under the investment_company act of investment_company effective date x sub elected to be taxed as a ric for its year x taxable_year effective date x sub and sub each changed its taxable_year end to date from date on date x sub directly wired dollar_figured to sub ric common parent treated this transfer in relevant part as a contribution of dollar_figured by sub to sub and then by sub through f-de to sub ric common parent stated that due to internal control restrictions sub directly wired the cash to sub ric’s deposit account at bank common parent reflected its treatment of the contributions through accounting entries on date x sub ric entered into an agreement with bank authorizing bank to act as placement agent for the private sale of sub ric notes due in year y one year from issuance on date x sub ric issued notes with a aspect of the transaction or any other aspect of the transaction not addressed in this memorandum as part of the preliminary restructuring on date w sub while still a member of us group distributed its entire_interest in sub to sub effective on date w sub elected to be disregarded as an entity separate from its owner for u s federal_income_tax purposes sub held dollar_figuree on date w postu-131660-15 principal_amount of approximately dollar_figuree taxpayer directed bank to issue sub ric’s notes to more than investors at least one of which was not a qualified purchaser sub ric paid bank dollar_figuref for the placement of the notes during year y one or more members of us group transferred an additional dollar_figureq to sub ric in a transaction that common parent treated in relevant part as a contribution of dollar_figureq by sub to sub and then by sub through f-de to sub ric during year x sub ric purchased business o eligible investments during year x sub ric derived interest_income and capital_gains from the investments in the amount of dollar_figurep during year y sub ric derived interest_income and capital_gains from the investments in the amount of dollar_figurey during year y sub ric distributed dollar_figurek to sub as follows date date y date y date y date y amount dollar_figureh13 dollar_figurel14 dollar_figurem dollar_figureo during year y sub distributed dollar_figureaa an amount in excess of dollar_figurek to sub as follows date y date y date y dollar_figurebb dollar_figurecc dollar_figuredd on date y sub distributed all of its shares in sub to sub taxpayer caused the notes to be issued in this manner in order to treat sub ric as an investment_company which requires sub ric to register with the u s securities_and_exchange_commission sec as an investment_company taxpayer takes the position that the dividend of dollar_figureh paid on date y was a time certain dividend deemed to have been paid on december of year x for purposes of sub ric’s dpd sub ric declared the dividend on date x taxpayer treated the dividend of dollar_figurel paid on date y as having been paid in year x for purposes of sub ric’s dpd sec_855 for tax years beginning before date a dividend to which a ric elects to apply sec_855 must be declared by the due_date of the ric’s return with extensions and paid within_12_months postu-131660-15 iv taxpayer’s treatment of the transaction a sub ric sub ric reported income and deductions related to the transaction for year x and year y as follows year x on its u s federal_income_tax return for its year x taxable_year i sub ric reported income as follows ordinary_income net of expenses long and short-term_capital_gains total taxable_income before dpd dollar_figurer15 dollar_figures16 dollar_figurep _____________ sub ric deducted dollar_figurep as a dpd for its year x taxable_year but did not distribute any of the amount until year ydollar_figure sub ric made two distributions during year y totaling dollar_figurep which ric treated as having been paid during year x for purposes of sub ric’s dpd year y on its u s federal_income_tax return for its year y taxable_year ii sub ric reported income as follows ordinary_income net of expenses long and short-term_capital_gains total taxable_income before dpd dollar_figurew18 dollar_figurex19 dollar_figurey ______________ sub ric reported dollar_figureu of interest_income and dollar_figuret of dividends on its year x form 1120-ric sub ric reported dollar_figurev in short term capital_gain on its year x form 1120-ric sub ric distributed only a separate amount dollar_figureg to sub in year x in one document it characterized this distribution as a return_of_capital in another it stated that this amount constituted a dividend of sub 6’s undistributed_income for the period date w through date w a period prior to sub becoming a ric common parent reported that the distribution qualified for an percent drd the amounts used in this memorandum are taken from several different documents any discrepancies between the amounts of the distributions as stated in this memorandum and taxpayer’s tax filings do not impact the legal analysis in this memorandum sub ric reported dollar_figuress of interest_income and dollar_figurett in dividends on its year y form 1120-ric sub ric reported dollar_figureuu of gain offset by capital_loss of dollar_figurevv on its year y form 1120-ric postu-131660-15 sub ric deducted dollar_figurey as a dpd for its year y taxable_year b us group on the us group’s amended form 1120x for taxable_year year y common parent reported that sub had u s -source dividend income of dollar_figureee which was reduced by an percent drd of dollar_figureii this deduction gave rise to a tax savings of dollar_figurejj the form_1120 also reported a sec_951 inclusion for sub but did not report a sec_951 inclusion for sub common parent asserts that sub did not have a sec_951 inclusion with respect to sub because it did not hold any sub stock on the last day of sub 4’s year y taxable_year in addition common parent takes the position that sub was able to reduce the amount of its sec_951 inclusion with respect to sub by the amount of sub 4’s distributions to sub during year y v additional facts a taxpayer’s asserted business_purpose for the transaction common parent maintains that the predominant purpose for creating and implementing the transaction was to invest in and earn a return on investment securities in addition common parent states that one of its objectives was to reduce expenses relating to the investment including tax expenses thus common parent states that it used tax planning to reduce its expenses b sub ric common parent asserts that sub ric is properly treated as a ric under the code common parent notes that a ric offers advantages over non-ric investment entities i a ric receives preferable tax treatment under the code relative to a non-ric corporation provided it distributes nearly all of its earnings annually and ii certain investors that are concerned about misinformation and fraud are more likely to invest in a ric than a non-ric because a ric is subject_to sec oversight sub ric did not have any employees sub d a member of us group and a registered investment_advisor acted under an asset management agreement as the investment_advisor to sub ric sub d directed sub ric’s investment portfolio in accordance with the guidelines for certain of us group’s investments as it did for other members of us group bank provided accounting custody and transfer agent services to sub ric common parent indirectly maintained beneficial_ownership and complete control of sub ric although at least two of sub ric’s directors were required to be independent common parent through sub had the right to remove the directors postu-131660-15 the information memorandum provided to prospective sub ric note holders stated that quote dollar_figure as evidenced by its accounting practices 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 under generally_accepted_accounting_principles gaap a ric generally is required to file audited financial statements on a stand-alone basis with the sec however common parent determined that it was not required to use the specialized accounting required for an investment_company and instead consolidated sub ric’s financials with those of us group on common parent’s financial statementsdollar_figure common parent based this decision on the definition of an investment_company for gaap purposes as an entity that pools shareholders’ funds to provide the shareholders with professional management common parent concluded that sub ric did not meet the definition of an investment_company under gaap because quote dollar_figure sub ric elected to be disregarded as an entity separate from its owner for u s federal_income_tax purposes effective date bb and filed a final u s federal_income_tax return for its year ended date bb in addition sub ric filed form n- 8f with the sec to deregister its status as a ric on date bb c sub taxpayer’s planning document states that sub sub and f-de would conduct all of their operations in the united_states and that their only contacts with country u would be to satisfy certain statutory requirements eg maintaining a registered office agent for all other purposes these entities would do business only in the united_states and would maintain their books_and_records in the united statesdollar_figure common parent provided the following reasons for causing sub to become a country u corporation for a variety of political regulatory and tax reasons it is easier and cheaper to attract investment capital from non-u s investors for certain types of investments by using an entity organized in country u rather than in the united_states when entities act as a group as defined in section d of the securities and exchange act they are required to separately file a schedule 13d pursuant to rule 13d-1 the following entities filed as group members and each was designated as a beneficial_owner of all of the ric shares sub sub sub common parent sub b and sub c see document id at p document at p postu-131660-15 an investment in country u may be viewed more favorably by some non-u s investors because the investors would not be subject_to_withholding tax on interest payments made by an entity formed in country u but would be subject_to u s federal withholding_tax if they invested in debt of u s entities non-u s investors who often invest funds obtained from international sources may prefer to invest relatively less in the united_states and relatively more in other jurisdictions for political and reputational reasons common parent states that in previous transactions non-u s investors have specifically requested that common parent use a foreign_subsidiary for these reasons non-u s investors prefer to invest in an entity formed in country u rather than the united_states because they would be treated more favorably if common parent declared bankruptcy for example if common parent declared bankruptcy in the united_states common parent’s creditors in the united_states would have more difficulty reaching the assets of a subsidiary in country u than reaching the assets of a domestic subsidiary another significant benefit of having a subsidiary in country u instead of state t is that the government of country u provided a binding undertaking that any entities formed by the us group in country u would not be taxed by country u for at least years state t did not offer similar tax relief d taxpayer noted disadvantages of the transaction common parent’s planning documents for the transaction noted that the transaction structure had several disadvantages the assets of sub ric could not be pledged in the event that sub ric’s assets were sold at a loss the losses would not pass through to the sub ric shareholders if the transaction was successfully challenged by the internal_revenue_service irs the taxpayer’s investment return would be lower than if it had not engaged in the transaction due to the costs of the transaction and the transaction would create a risk to common parent’s reputation due to adverse publicity for engaging in tax arbitrage e taxpayer’s correspondence with agency as noted above sub c is engaged in business o is subject_to agency 1’s rules and must invest only in business o eligible investments under agency 1’s guidelines sub and sub ric only could make investments that sub c could make directly postu-131660-15 taxpayer maintained that it did not need formal approval from agency to implement the transaction because sub ric would hold only business o eligible investments and common parent had received prior approval from agency to establish operating subsidiaries to hold the assets nonetheless in year w prior to engaging in the transaction common parent informed agency that sub ric would not be quote and asked for a determination that quote dollar_figure in seeking assurances from agency taxpayer told agency that sub c planned to make an indirect investment in a closed-end diversified fund that would principally hold quote at the time of the communication sub c planned to make the ric investment through an entity organized in country v that was treated as a pass- through entity for u s federal_income_tax purposesdollar_figure taxpayer assured agency that the country v entity would limit its activities to holding the ric shares which sub c was permitted to hold directlydollar_figure in a follow-up communication common parent informed agency that it changed the transaction structure stating that quote taxpayer told agency that sub 4’s principal office would be located at addre sec_1 in state s and that all of its activities would be in the united_states further taxpayer stated that all of sub 4’s officers and directors would be united_states residents and employees of common parent a u s -based affiliate of common parent or another domestic entity sub 4’s only contact with country u other than its incorporation and appointment of a resident agent would be annual meetings held in country u which could be carried out by proxy granted to the resident agent common parent further noted that sub 4’s annual meetings could be limited to the authorization of a one page filing required by country u law moreover common parent would indirectly provide funds to sub ric on behalf of sub although sub did not receive funds because they were wired directly from a member of us group to sub ric taxpayer advised agency that sub 4’s use of the funds was limited to purchasing interests in f-de which would in turn purchase interests in sub ric sub ric’s use of the funds was limited to acquiring business o eligible investments f taxpayer’s transaction costs common parent incurred significant costs in connection with the transaction including planning costs and costs for setting up the transaction structure and maintaining sub ric common parent estimated that an initial investment in sub ric of dollar_figureff with a minimum investment by sub ric in business o eligible assets of date w e-mail from person of common parent to person of agency id id this e-mail states that sub c would quote postu-131660-15 dollar_figuregg was necessary in order for the u s federal_income_tax savings to be greater than the costs of implementing and maintaining the transaction structure in year x the cost to register and maintain sub ric was dollar_figuremm and the amount of a payment to bank in connection with sub ric’s note issuance was dollar_figurekk in year x sub ric claimed expenses of dollar_figurehh including dollar_figureoo in interest to noteholders in year y sub ric claimed expenses of dollar_figurepp including dollar_figureqq in interest to noteholders g taxpayer’s potential claims for the drd in subsequent tax years on date y and date z sub ric made distributions to sub the total of which was dollar_figureww taxpayer reported this amount in income under sec_951 on date z and date aa sub ric made distributions to sub the total of which was dollar_figureyy prior to the end of sub 4’s year aa tax_year sub distributed the stock of sub to sub taxpayer reported that sub received dividends from sub in year aa and reported the u s source portion was dollar_figurezz it is our understanding that taxpayer intends to have sub claim an percent drd of dollar_figureaaa at a future date this deduction would result in a tax savings of dollar_figurebbb on date bb and date bb sub ric made distributions to sub the total of which was dollar_figureccc prior to the end of sub 4’s year bb tax_year sub distributed the stock of sub to sub e taxpayer reported that sub received dividends from sub in year bb and reported the u s source portion was dollar_figureddd it is our understanding that taxpayer intends to have sub claim an percent drd of dollar_figureeee at a future date this deduction would result in a tax savings of dollar_figurefff adding the amounts for years aa and bb to the amounts for year y discussed above taxpayer’s claim and potential future claims from this transaction give rise to an aggregate drd of dollar_figureggg and an aggregate tax savings of dollar_figurehhh taxpayer’s position taxpayer asserts that its u s federal_income_tax reporting position is consistent with the form of the transaction and the literal language of the code taxpayer states that its business_purpose for the transaction was to maximize the return on its investments as discussed in greater detail in the facts section of this memorandum taxpayer maintains that it used sub an entity formed under the laws of country u in the transaction in order to attract non-u s investors and because country u agreed not to tax any entities formed in country u for a twenty-year period law and analysis postu-131660-15 i statute sec_245 allows a corporation a drd on dividends received from a qualified_foreign_corporation sec_316 generally defines the term dividend as any distribution_of_property as defined in sec_317 made by a corporation to its shareholders out of earnings_and_profits e_p sec_1_312-6 provides that income exempted from taxation by statute is included in e_p sub increased its e_p by the amount of the distributions it received from sub ric taxpayer argues that sub 4’s distributions to sub were dividends within the meaning of sec_316 because the distributions were made out of e_p accumulated after date or out of the current taxable_year and asserts that the dividends qualify for the sec_245 drd sec_245 limits the amount of the sec_245 deduction to an amount equal to the percent specified in sec_243 for the taxable_year of the u s source portion of such dividends the u s source portion of any dividend is any amount which bears the same ratio to such dividends as the post-1986_undistributed_u_s_earnings bears to the total post-1986 undistributed earningsdollar_figure sec_245 during the years that taxpayer engaged in the transaction sec_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-percent_owned_foreign_corporation section of the protecting americans from tax hikes act of public law stat the path act added sec_245 to provide that with respect to dividends received on or after date for purposes of the definition of post-1986_undistributed_u_s_earnings in sec_245 a domestic_corporation does not include a ric or a real_estate_investment_trust accordingly distributions from sub attributable to distributions from sub ric explicitly would not be eligible for the sec_245 drd under the revised statute consistent with the indication in section c of the path act the joint_committee on taxation states that n o inference is intended with respect to the proper treatment under sec_245 of dividends received from rics or reits before such date sec_245 defines the term post-1986_undistributed_earnings as having the same meaning given to such term by sec_902 sec_902 defines the term as the amount of earnings_and_profits of the foreign_corporation computed in accordance with sec_964 and sec_986 accumulated in taxable years beginning after date - a as of the close of the taxable_year of the foreign_corporation in which the dividend is distributed and b without diminution by reason of dividends distributed during such taxable_year sec_964 provides that the earnings_and_profits of a foreign_corporation are calculated according to rules substantially_similar to those applying to domestic corporations except as otherwise provided technical explanation of the protecting americans from tax hikes act of house amendment postu-131660-15 sec_245 limits the definition of post-1986_undistributed_u_s_earnings to a income of the foreign_corporation which is effectively connected with the conduct_of_a_trade_or_business within the united_states and is subject_to tax under this chapter or b any dividend received directly or through a wholly-owned foreign_corporation from a domestic_corporation at least percent of the stock of which by vote and value is owned directly or through such wholly owned foreign_corporation by the qualified_10-percent_owned_foreign_corporation the funds that sub received from sub ric are not post-1986_undistributed_u_s_earnings within the meaning of sec_245 because sub did not have income that was effectively connected with the conduct_of_a_trade_or_business within the united_states and subject_to u s federal income taxdollar_figure pursuant to sec_245 post-1986_undistributed_u_s_earnings includes a dividend received from a domestic_corporation sec_854 states that a capital_gain dividend received from a ric shall not be considered a dividend for purposes of determining whether a shareholder is entitled to the drd under section dollar_figure sec_854 applies to distributions from a ric other than those to which sec_854 applies it states that in computing any deduction under sec_243 there shall be taken into account only the portion of such dividend reported by the ric as eligible for such deduction in written statements furnished to its shareholders the shareholder of a ric is only eligible for the sec_243 drd with respect to moreover sub did not have fixed or determinable annual or periodic_income that was subject_to tax sec_881 generally imposes a percent flat_tax on among other things interest and dividends under taxpayer’s analysis neither sub ric nor sub was subject_to u s federal_income_tax on the interest generated by the business o eligible investments or income attributable thereto because sub ric distributed amounts attributable to the interest to sub and sub treated the distribution as exempt from tax under sec_881 and sec_871 similarly under taxpayer’s analysis neither sub ric nor sub were subject_to u s federal_income_tax on any short-term_capital_gain generated by the business o eligible investments or income attributable thereto because sub ric distributed amounts attributable to the gain and sub treated the distribution as exempt from tax under sec_881 and sec_871 however any capital_gain dividend other than a short-term_capital_gain_dividend although not effectively connected with a u s trade_or_business would be subject_to tax under sec_881 under sec_243 certain taxpayers are allowed a deduction for certain dividends received from a domestic_corporation postu-131660-15 those distributions that are designated by the ric as dividends eligible for such a deduction the amount that a ric designates for a taxable_year generally cannot exceed the amount of dividends the ric receives from domestic corporations that would be eligible for the drd if rics were permitted to claim the drd sub ric generally held only debt instruments and its income therefore consisted of interest and capital_gain rather than dividends sub ric did not issue a statement to sub that qualified any of the sub ric distributions as dividends eligible for a drd accordingly sub could not claim a sec_243 drd with respect to sub ric’s distributions due to the application of sec_854 and b if sub had directly held the sub ric shares it could not have claimed the sec_243 drd either because sub would have been precluded from claiming a drd under sec_243 on direct distributions from sub ric taxpayer inserted a foreign_corporation between sub and sub ric in order to claim a drd under sec_245 with respect to dividends attributable to the sub ric distributions sec_854 does not discuss whether or not ric distributions are to be taken into account in calculating the amount of dividends eligible for the drd under sec_245 although the sub ric distributions to sub are not dividends eligible for the drd under sec_243 sub treats them as dividends received from a domestic_corporation in calculating sub 4’s post-1986_undistributed_u_s_earnings for the purpose of sec_245 under taxpayer’s position even though a member of us group 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 and likewise would not have been able to claim a drd if it had received distributions from sub ric attributable to such income distributions attributable to such income are dividends eligible for the percent sec_245 drd if funneled through sub ii sec_1502 and sec_1_1502-13 a statute and regulation congress enacted the consolidated_return regime to levy tax according to the true net_income and invested capital of a single business_enterprise even though the business is operated through more than one corporationdollar_figure article of sec_31 see 288_us_152 citing art of treas reg no see also s rep no pincite which states t he permission to file consolidated_returns by affiliated corporations merely recognizes the business_entity as distinguished from the legal corporate entity of the business_enterprise the mere fact that by legal fiction several corporations owned by the same stockholders are separate entities should not obscure the fact that they are in reality one and the same postu-131660-15 no states in pertinent part w here one corporation owns the capital stock of another corporation or corporations or where the stock of two or more corporations is owned by the same interests a situation results which is closely analogous to that of a business maintaining one or more branch establishments in the latter case because of the direct ownership of the property the invested capital and net_income of the branch form a part of the invested capital and net_income of the entire organization when such branches are owned and controlled through the medium of separate corporations it is necessary to require a consolidated_return in order that the invested capital and net_income of the entire group may be accurately determined otherwise opportunity would be afforded for the evasion of taxation by the shifting_of_income through price fixing charges for services and other means by which income could be arbitrarily assigned to one or another unit of the group in other cases without a consolidated_return excessive taxation might be imposed as a result of purely artificial conditions existing between corporations within a controlled_group congress’ concern about corporate taxpayers avoiding tax also is evidenced in sec_1502 in which congress grants authority to the secretary to prescribe such regulations as he may deem necessary in order that the tax_liability of any affiliated_group_of_corporations making a consolidated_return and of each corporation in the group both during and after the period of affiliation may be returned determined computed assessed collected and adjusted in such manner as clearly to reflect the income_tax_liability and the various factors necessary for the determination of such liability and in order to prevent avoidance of such tax_liability in carrying out the preceding sentence the secretary may prescribe rules that are different from the provisions of chapter that would apply if such corporations filed separate returns a legislative_regulation is issued under a specific grant of authority to prescribe a method of executing a statutory provision the supreme court explained that the power of an administrative agency to administer a congressionally created program business owned by the same individuals and operated as a unit much of the misapprehension about consolidated_returns will be removed when it is realized that it is only when the corporations are really but one corporation that the permission to file consolidated_returns is given and that no ultimate advantage in the tax laws really results regulations relating to the income_tax and war profits and excess_profits_tax under the revenue act of 911_f2d_1128 5th cir internal quotations and citations omitted postu-131660-15 ‘necessarily requires the formulation of policy and the making of rules to fill any gap left implicitly or explicitly by congress ’ when congress explicitly leaves a gap for the agency to fill there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation these legislative regulations are given controlling weight unless they are arbitrary capricious or manifestly contrary to the statute the supreme court stated that it has long recognized that considerable weight should be accorded to an executive department’s construction of a statutory scheme it is entrusted to administer and the principle of deference to administrative interpretations has been consistently followed by this court congress explicitly left a large gap for the irs and the department of the treasury to fill by regulation in order to administer the consolidated_return regime and granted explicit authority in sec_1502 for the secretary to issue regulations to prevent tax_avoidance b intercompany_transactions sec_1_1502-13 provides rules for taking into account items of income gain deduction and loss of members derived from intercompany_transactions the purpose of these rules is to clearly reflect the taxable_income and tax_liability of the group as a whole by preventing intercompany_transactions from creating accelerating avoiding or deferring consolidated_taxable_income or consolidated_tax_liability an intercompany_transaction is a transaction between corporations that are members of the same consolidated_group immediately after the transaction sec_1_1502-13 s is the member transferring property or providing services and b is the member receiving the property or services intercompany_transactions include distributions by s to its shareholder b in the transaction sub 3’s distribution of its sub stock to sub is an intercompany_transaction sub is the member transferring property and sub is the member receiving property sec_1_1502-13 defines intercompany items to include generally s’s income gain deduction and loss from an intercompany_transaction thus sub 3’s gain if any from the distribution of its sub stock to sub would be its intercompany gain sec_1_1502-13 further provides that a n item is an intercompany_item whether it is directly or indirectly from an intercompany_transaction taxpayer maintains that sub changed the character of the income derived from sub from an 467_us_837 quoting 415_us_199 id pincite citations omitted postu-131660-15 amount required to be included in income pursuant to sec_951 to a dividend that qualifies for the sec_245 drd because sub transferred its sub stock to sub before the end of sub 4’s taxable_year accordingly although it is not a change with respect to sub 3’s gain_or_loss on the transfer of the sub stock this purported change in the character of sub 3’s income is the result of the intercompany_transaction sec_1_1502-13 explains that the participants in an intercompany_transaction s and b are treated as separate entities for some purposes but as divisions of a single corporation for other purposes the amount and location of s’s intercompany items and b’s corresponding items are determined on a separate_entity basis separate_entity treatment however the timing and the character source and other attributes of the intercompany items and corresponding items although initially determined on a separate_entity basis are redetermined under this section to produce the effect of transactions between divisions of a single corporation single entity treatment accordingly although the character of sub 3’s income from sub is initially determined on a separate_entity basis under the general principles of sec_1_1502-13 it must be redetermined to produce the same effect as though sub merely transferred the sub stock from one division to another division of a single corporation thus all of sub 3’s and sub 2’s income from sub that is attributable to distributions from sub ric is includible in income under section dollar_figure c the anti-avoidance rule in addition to the general principles set forth in sec_1_1502-13 sec_1_1502-13 a legislative_regulation that addresses congress’ concerns about tax_avoidance sets forth an anti-avoidance rule which states if a transaction is engaged in or structured with a principal purpose to avoid the purposes of this section including for example by avoiding treatment as an intercompany_transaction adjustments must be made to carry out the purposes of this section sec_1_1502-13 provides several examples of the application of the anti-avoidance rule in example member s of a consolidated_group owns land with a dollar_figure basis and dollar_figure value instead of selling the land directly to x an unrelated party in year f s contributes the land to a partnership in exchange for a percent partnership_interest sec_721 applies to the transfer and the partnership does not have a sec_754 election in effect s then sells its partnership_interest to another member of its consolidated_group b for dollar_figure as a result b’s basis in the partnership_interest is dollar_figure s’s dollar_figure gain or income is deferred under the the distributions from sub would be treated as distributions of e_p described in sec_959 pti distributions to the extent they are included in income pursuant to sec_951 the pti distributions would be excluded from income under sec_959 and would not be treated as dividends for purposes of chapter of the code pursuant to sec_959 postu-131660-15 consolidated_return rules b has net operating losses from separate_return years that are subject_to limitation under sec_1_1502-21 the partnership then sells the land to x in year g under sec_704 the partnership’s dollar_figure gain is allocated to b and b’s basis in its partnership_interest increases to dollar_figure under sec_705 the dollar_figure partnership gain would ordinarily increase b’s separate_return_limitation_year srly limitation in a later year b sells its partnership_interest to a nonmember for dollar_figure thereby realizing a dollar_figure loss which is not subject_to limitation under the srly rules the example disallows the dollar_figure increase in b’s unlimited srly loss accordingly b is not able to offset its dollar_figure gain upon its sale of the partnership_interest example states that s’s contribution of property and its sale of its partnership_interest were part of a plan a principal purpose of which was to achieve a reduction in consolidated_tax_liability if s had directly sold its land to x in year f immediately after the sale s would have held dollar_figure x would have owned the land and s would have had dollar_figure of gain or income which would have been includable in the group’s consolidated tax computationdollar_figure s’s dollar_figure profit would not have been offset by b’s losses the rationale underlying the sec_1_1502-13 adjustment in example is consistent with the rationale underlying such common_law doctrines as the step_transaction_doctrine and the economic_substance_doctrine s likely had a business_purpose for the overall transaction selling its land however rather than sell the land directly to x in year f s engaged in a number of steps so that it indirectly transferred the land to x in year g the extra steps did not increase the group’s profit other than the purported tax savings because x paid only dollar_figure for the land in year g aside from the tax benefits of the transaction taking the time_value_of_money into account and the costs of planning and engaging in the transaction s would have been better off selling the land directly to x for dollar_figure in year f and investing the proceeds example of sec_1_1502-13 shows that the tax_avoidance aspect of a transaction is not cured by stretching steps of a transaction out over an extended period of time a legitimate business operation or a third-party participant in example two members of a consolidated_group m-1 and m-2 engage in a partnership mixing_bowl_transaction in order to shift dollar_figure of basis from m-2’s nondepreciable asset land to m-1’s asset which could be amortized but had a dollar_figure basis m-1 contributed an intangible asset to the partnership and m-2 contributed land an unrelated third party contributed cash the partnership engaged in a legitimate business for over years before liquidating in connection with the liquidation m-1 received the land which then had a dollar_figure basis in m-1’s hands and m-2 received the intangible asset which then had a the example does not state whether s held the land as inventory or as an investment postu-131660-15 dollar_figure basis in m-2’s hands the basis exchange does not escape the application of sec_1_1502-13 d application of sec_1_1502-13 to the transaction in the transaction as in example of sec_1_1502-13 instead of carrying out a direct transaction a consolidated_group carried out a multi-step plan that included an intercompany_transaction in order to alter the group’s consolidated income_tax cit in each case the taxpayer used the combination of steps to get a tax result that distorted the intended results of the consolidated_return_regulations taxpayer takes the position that sub did not own any stock of sub on the last day of sub 4’s year y taxable_year and that sub 3’s only inclusions in income with respect to sub for year y were dividends eligible for the sec_245 drd rather than inclusions under sec_951 had sub held the sub stock on the last day of sub 4’s year y sub would have been required under sec_951 to include in income its pro_rata share of sub 4’s subpart_f_income which would have included the distributions received by sub from sub ric had sub merely moved the sub stock from one branch of sub to another it would not have changed the character of sub 3’s income with respect to sub from a sec_951 inclusion to a dividend eligible for an percent sec_245 drd although the consolidated_return rules respect sub 3’s transfer of the sub stock to sub they treat the transfer as between divisions of a single corporation sec_1_1502-13 and -13 c determined accordingly the character of sub 3’s income with respect to sub is an inclusion under sec_951 taxpayer attempted to change the character of sub 3’s income through the use of an intercompany_transaction sub 3’s distribution of its sub stock to sub taxpayer’s characterization of sub 3’s income with respect to sub as taxable dividends eligible for the sec_245 drd distorts the tax_liability of sub in addition as the income of sub is used to calculate the cit liability of us group taxpayer’s characterization distorts us group’s cit liability as each member of a consolidated_group is severally liable for the cit taxpayer’s characterization of sub 4’s distributions to sub distorts the tax_liability of every member of us groupdollar_figure taxpayer’s position does not clearly reflect the taxable_income of the group as a whole accordingly as discussed in part ii b of the law and analysis section of this memorandum although sub 3’s income from sub is initially determined on a separate_entity basis it then must be redetermined to produce the same effect as though sub transferred the stock of sub from one division to another division of a single corporation sec_1_1502-11 sec_1_1502-6 postu-131660-15 iii common_law doctrines a overview taxpayer asserts that sub is eligible for an percent sec_245 drd because the transaction complied with the literal requirements of the code although u s federal tax law is based on statute the tax treatment of a transaction is also subject_to common_law doctrines including the economic_substance_doctrine and the substance over form doctrinedollar_figure when determining whether a taxpayer is entitled to a deduction or loss courts generally review the text and purpose of the applicable statute and analyze whether mere compliance with the statute is sufficient courts generally conclude that a taxpayer’s formal compliance with a statute is not sufficient if the transaction’s form is inconsistent with its substance or if the transaction is a sham one commentator suggests that common_law doctrines may be considered to be a method of statutory interpretation or that the legislature assumes that such doctrines will be used to interpret the statutes it enacts this view is consistent with judge learned hand’s analysis in commissioner v transport trading terminal corpdollar_figure judge hand stated that in construing words of a tax statute which describe commercial or industrial transactions we are to understand them to refer to transactions entered upon for commercial or industrial purposes and not to include transactions entered upon for no other motive but to escape taxation the proposition that statutory law is applied only to the extent that it is consistent with the economic_substance of an underlying transaction is also supported by the analysis of the court_of_appeals_for_the_federal_circuit in coltec industries inc v united_states which treated economic_substance as a prerequisite to the application of any code provision that provides favorable tax treatment for a taxpayerdollar_figure 641_f3d_1319 fed cir judicial anti-abuse doctrines ‘prevent taxpayers from subverting the legislative purpose of the tax code’ quoting 454_f3d_1340 fed cir although income_tax determination is generally rule based there are a set of standards that overlay the rules some are built into the rules such as anti-abuse provisions other standards are judicially created joseph bankman the economic_substance_doctrine s cal l rev suggesting that under this latter theory the common_law doctrines have been implicitly adopted as part of the statute 176_f2d_570 2d cir id pincite 454_f3d_1340 id pincite postu-131660-15 even if taxpayer satisfied the literal requirements of sec_245 as in effect for the relevant taxable years sub is not entitled to the sec_245 drd with respect to the dividends that it received from sub attributable to sub ric’s distributions because moving funds through a country u corporation lacked economic substancedollar_figure alternatively sub is not entitled to the sec_245 drd under the substance_over_form_doctrine b economic_substance_doctrine although one of the fundamental principles of taxation is that taxpayers can structure their transactions to minimize their tax_liabilities the economic_substance_doctrine requires a court to disregard a transaction that a taxpayer enters into without a business_purpose in order to claim tax benefits not consistent with the purpose of the code or regulations thereunder ------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- --------------------------- case law the economic_substance_doctrine is founded in several supreme court cases including gregory v helveringdollar_figure in gregory mrs gregory owned all of the shares of the united mortgage corporation mortgage which owned some of the shares of monitor securities corporation monitor if mortgage sold its monitor shares it would incur a corporate level tax on its significant capital_gain and mrs gregory would incur a shareholder level tax when mortgage distributed the cash proceeds to her as a dividend to reduce her tax_liability she caused mortgage to transfer the stock of monitor to averill corporation a newly formed corporation wholly owned by mrs gregory under an agreement pursuant to which averill issued all of its stock to mrs gregory in exchange for the monitor shares the transaction satisfied the literal terms of the reorganization provisions then in effect a few days after receiving the averill stock mrs gregory caused averill to dissolve in connection with its dissolution averill distributed all of its monitor stock to mrs gregory and she then sold the monitor stock the court opined that the issue to be determined was whether what was done apart from the tax motive was the thing which the statute intended in interpreting the reorganization statute the court concluded that the transfer of assets by one corporation to another required a transfer in pursuance of a reorganization of corporate taxpayer entered into the transaction before the effective date of sec_7701 which codified the economic_substance_doctrine accordingly this memorandum does not address the application of sec_7701 to the transaction 293_us_465 id pincite postu-131660-15 business the court concluded mrs gregory’s transaction was an operation having no business_purpose but was instead a mere device to transfer shares to mrs gregory in the guise of a corporate_reorganization although the court acknowledged that averill was a valid corporation it found that averill was nothing more than a contrivance to accomplish mrs gregory’s plan the court denied the transaction reorganization treatment stating that to hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose --------------------------- in the eighth circuit under the common_law ‘sham transaction’ or ‘economic substance’ doctrine ‘even if a transaction is in ‘formal compliance with code provisions’ a deduction will be disallowed if the transaction is an economic sham ’ under this analysis sub 3’s sec_245 drd is disallowed if the steps in the transaction that result in the deduction constitute an economic sham even if the transaction otherwise satisfies the literal terms of the relevant code provisions although the eighth circuit also traces the origin of the economic_substance_doctrine to the supreme court’s holding in gregory it attributes the current application of the doctrine to frank lyon co v united statesdollar_figure in frank lyon a bank wanted to build a new_building for its headquarters after determining that federal and state laws and regulations prohibited it from constructing and financing a new_building through more conventional means it entered into a sale-and-leaseback arrangement with frank lyon company lyon an unrelated entity lyon was owned by a member of the bank’s board_of directors the bank selected lyon to enter the arrangement following a competitive proposal process that involved independent potential investorsdollar_figure lyon obtained construction financing and a mortgage loan from two independent lendersdollar_figure the lease agreement between lyon and the bank provided the bank with id id id pincite 728_f3d_736 8th cir quoting 435_f3d_594 6th cir quoting am elec power co inc v united_states 326_f3d_737 6th cir 435_us_561 id pincite id pincite id postu-131660-15 both a purchase option and a lease renewal option for the buildingdollar_figure although lyon bore the risk that the bank would default or fail to exercise either of its options the agreement terms were such that lyon would receive payments sufficient to cover its mortgage payments as well as a return of its initial investment plus interest compounded on the amount of the investmentdollar_figure the irs disallowed lyon’s rental income and expenses for interest and depreciation with respect to the bank building after determining that lyon was not the owner for tax purposes of any portion of the buildingdollar_figure the irs took the position that the transaction should be disregarded because it was a sham designed to produce tax deductions the supreme court disagreed and indicated that a transaction should be respected for tax purposes where there is a genuine multiple-party transaction with economic_substance which is compelled or encouraged by business or regulatory realities is imbued with tax-independent considerations and is not shaped solely by tax-avoidance features that have meaningless labels attached the government should honor the allocation of rights and duties effectuated by the partiesdollar_figure in its decision in shriver v commissioner the eighth circuit applied the two-part test set forth in rice’s toyota world inc v commissioner but did not adopt it under rice’s toyota world a transaction is a sham if it lacks a business_purpose apart from obtaining tax benefits and has no economic_substance because no reasonable possibility of a profit exists even though the eighth circuit analyzed the shriver transaction under both parts of the test it said in dictum w e do not read frank lyon to say anything that mandates a two-part analysis the eighth circuit also considered the economic_substance_doctrine in ies industries inc v united state sec_65 in in ies the court concluded that the transactions at issue had both economic_substance and a business_purpose but did not decide whether the doctrine required a two-part analysis it noted however that shriver suggests that the failure of id pincite id pincite id pincite id pincite 899_f2d_724 8th cir 752_f2d_89 4th cir id pincite id pincite 253_f3d_350 8th cir postu-131660-15 one test would result in the conclusion that the transaction in question is a sham for u s federal_income_tax purposesdollar_figure in wfc holdings corp v united_states a more recent decision the eighth circuit noted that that the courts of appeals do not have a consistent approach on the application of the economic_substance sham_transaction doctrinedollar_figure it outlined the following approaches taken by various courts of appeal a disjunctive analysis under which a transaction is valid if it has a business_purpose or has economic_substance a conjunctive analysis under which a transaction is valid only if the transaction has both a business_purpose and economic_substance beyond tax objectives an analysis under which a lack of economic_substance is sufficient to sham a transaction even if the taxpayer has motives other than tax_avoidance and an analysis under which the objective and subjective prongs of the two-part test are factors to consider in determining whether a transaction has any practical economic effects other than with respect to taxes after setting forth the possible ways to apply the doctrine the court held that the transaction at issue had neither economic_substance nor a business_purpose and accordingly noted that it did not need to reach a conclusion about which test to apply -------------------------- the ninth circuit has explained in case law that the commissioner’s determination that a transaction is a sham is presumptively correct and taxpayers have the burden of producing evidence to rebut the deficiency determination and the burden of persuasion to substantiate the deductiondollar_figure the ninth circuit’s application of the economic_substance_doctrine focuses on both the subjective aspect of whether the taxpayer intended to do anything other than acquire tax deductions and the objective aspect of whether the transaction had any id pincite 728_f3d_736 8th cir see id pincite n 755_f3d_1051 9th cir quoting 843_f2d_351 n 9th cir postu-131660-15 economic_substance other than the creation of tax benefits however ninth circuit case law emphasizes that the economic_substance_doctrine is not a rigid two-step analysis rather the court focuses holistically on whether the transaction had any practical economic effects other than the creation of income_tax lossesdollar_figure ---------------------------------------------------------------------------------------------------- in its most recent pronouncement on the economic_substance_doctrine the federal_circuit reiterated that it follows the disjunctive test for determining whether a transaction should be disregarded as an economic shamdollar_figure that is a transaction should be disregarded if it lacks objective economic_substance or if it is subjectively shaped solely by tax_avoidance motives with regard to the objective prong the court stated that a transaction lacks economic reality if it does not alter the taxpayer’s economic position in any meaningful way apart from their tax consequences typically entailing no risk and no significant possibility of profit other than as a result of tax consequences importantly the fact that a transaction lacks the potential for economic profit is not dispositive of the lack of economic reality in salem financial inc v united_states the court cited the following characteristics of the transaction to support its finding that it lacked economic reality circular cash flows that had no real economic_effect other than tax benefits the transfer of income producing assets to controlled entities that had no incremental effect on the taxpayer’s activities a lack of genuine economic risk and an unlimited capacity to generate gains without any additional exposure or commitment of resources in considering the lack of a business_purpose for the transaction the salem court relied on evidence establishing that the transaction had been designed to save taxes and had been promoted as a prepackaged tax strategydollar_figure without incremental profit potential other than tax benefits and risk other than tax risk the court found that the 843_f2d_351 9th cir 786_f3d_932 fed cir 82_fedclaims_636 786_f3d_932 fed cir id pincite taxpayer maintains that it did not purchase the transaction that is the subject of this memorandum as a prepackaged tax strategy however this tax strategy has not been limited to taxpayer’s use a very similar transaction is discussed in a chief_counsel advisory memorandum dated date cca postu-131660-15 transaction was created solely to generate tax savings and therefore lacked a business purposedollar_figure as stated by the court in stobie creek investments v united_states the disjunctive approach reflects the more flexible and considered approach to the supreme court’s economic_substance_doctrine as set forth in frank lyon in its overview of the economic_substance_doctrine in coltec the court_of_appeals_for_the_federal_circuit explained that over many years the doctrine has required disregarding for tax purposes transactions that comply with the literal terms of the tax code but lack economic reality and noted that the economic_substance_doctrine is a judicial effort to enforce the statutory purpose of the tax code it is a tool to prevent taxpayers from subverting the legislative purpose of the tax code by engaging in transactions that lack economic reality simply to reap a tax_benefit the court stated that the economic_substance_doctrine incorporates the following principles although a taxpayer has a right to decrease taxes by means which the law permits a taxpayer may not reap tax benefits from a transaction that lacks economic reality the gregory case gives support to disregarding transactions that do not serve a business_purpose do not vary control or do not change the flow of economic benefits the economic_substance_doctrine may apply if the taxpayer’s sole subjective motivation is tax_avoidance even if a transaction has economic_substance but if a transaction has no economic_substance it may also be disregarded even if tax_avoidance is not the taxpayer’s sole motivedollar_figure when a taxpayer claims a tax_benefit the taxpayer must prove that the transaction has economic_substance it is a heavy burden for the taxpayer to demonstrate that congress intended to give favorable tax treatment to a transaction that would not have occurred but for the motive of tax avoidancedollar_figure salem f 3d pincite 82_fedclaims_636 id pincite 454_f3d_1340 fed cir id pincite id pincite id pincite id pincite postu-131660-15 t he economic_substance of a transaction must be viewed objectively rather than subjectively black decker corp v united state sec_86 explains that the economic_substance inquiry requires an ‘objective determination of whether a reasonable possibility of profit from the transaction existed ’ t he transaction to be analyzed is the one that gave rise to the alleged tax_benefit a rrangements with subsidiaries that do not affect the economic_interest of independent third parties deserve particularly close scrutiny application of the economic_substance_doctrine to taxpayer’s transaction a the transaction to be analyzed a preliminary step of the economic_substance inquiry is to identify the transaction to be analyzed as discussed in coltec the economic_substance_doctrine should be applied to the transaction steps that gave rise to the alleged tax_benefit if a member of us group had invested directly in business o eligible investments it would have had to include the resulting interest and capital_gain in its income without any offsetting drddollar_figure similarly if a member of us group had invested id pincite 436_f3d_431 4th cir explaining that shamming a corporation under 319_us_436 is a different analysis than shamming a transaction with a controlled_corporation under the objective prong of the economic_substance_doctrine id pincite quoting 752_f2d_89 4th cir coltec f 3d pincite the court describes as an example the transaction in 549_f2d_740 ct_cl in basic in anticipation of the sale of its carbon business to a third party a parent_corporation caused its first-tier subsidiary to distribute the stock of a second-tier_subsidiary to the parent the parent_corporation then sold both subsidiaries to the buyer as a result of the distribution the parent corporation’s tax_liability with respect to the sale was lower than it would have been if the first-tier subsidiary had sold the stock of the second-tier_subsidiary to the buyer the basic court did not allow the business_purpose for the ultimate sale to justify the intermediate transfer coltec f 3d pincite 801_f3d_104 2d cir clearly a member of us group could not offset interest and capital_gain income through the use of the sec_243 drd because such income would comprise dividends postu-131660-15 directly in a ric such as sub ric it would have had to include its interest-related_dividend distributions and capital_gain distributions in income without an offsetting sec_243 drddollar_figure taxpayer treated sub as contributing funds to sub and receiving dividend distributions from sub in order to avoid the application of sec_854 and instead claim the sec_245 drd taxpayer moved funds through sub in order to convert interest and capital_gain income into sec_316 dividends of u s - source earnings from a foreign_corporation that would qualify for an percent drd under sec_245 in furtherance of its plan to eliminate almost all u s federal_income_tax on the income from the business o eligible investments taxpayer also caused sub to distribute the stock of sub to sub in order to avoid the application of sec_951 with respect to most of sub 4’s subpart_f_income taxpayer will likely maintain that the transaction viewed in its entirety served the business_purpose of investing in business o eligible investments having identified a business activity taxpayer may assert that it should be able to structure this activity in a manner that is advantageous from a tax savings perspective although taxpayer’s investments in business o eligible investments produced a profit and served a valid business_purpose the transaction at issue in this economic_substance inquiry is not the investment activity itself but rather the part of a larger series of steps ‘that generated the claimed deductions ’ 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 in order to avoid the application of sec_854 invoke the sec_245 drd and avoid sec_951 taxpayer i re-domiciled sub to country u ii funneled investment funds and the return on investment through a country u corporation and iii transferred the sub stock from sub to sub before the end of sub 4’s year y taxable_year accordingly this part of the larger transaction is analyzed under the economic_substance_doctrine if these elements of the transaction lack economic_substance they are not given effect and sub does not get the benefit of the sec_245 drd in the alternative taxpayer will fail to sustain its position that sub qualifies for the sec_245 drd if taxpayer’s use of the country u corporation to funnel funds between us group and sub ric in and of itself lacks economic_substance if just this part of the transaction lacks economic_substance the country u corporation’s participation in the transaction is not given effect and accordingly sub does not get the benefit of the sec_245 drd as discussed in part iii b d i of the law and analysis section of this memorandum the sec_243 drd would have been precluded under sec_854 bank of n y mellon f 3d pincite quoting 320_f3d_282 2d cir postu-131660-15 b the economic_substance test the objective economic_substance prong focuses on whether a transaction has an effect on a taxpayer’s economic position apart from u s federal_income_tax effects under this prong a transaction does not have economic_substance if there is not a reasonable possibility of deriving a profit from the transaction as discussed in part i of the facts section of this memorandum one or more members of us group historically invested the customer funds in business o eligible investments and sought to make a profit on such investments during certain periods of time business o eligible investments produced a very low return therefore taxpayer planned to increase its net investment profit by paying less u s federal_income_tax taxpayer’s investment of the customer funds in business o eligible investments had economic_substance however the transaction in which taxpayer moved sub to country u routed funds through sub and moved the location of the sub stock within us group did not provide a potential for increasing us group’s investment return other than by the amount of the tax savings attributable to the sec_245 drd a taxpayer cannot avoid the requirements of economic_substance simply by coupling a routine economic transaction generating substantial profits with no inherent tax benefits to a unique transaction that otherwise has no hope of turning a profit courts have opined that transfers of income-producing assets to controlled entities do not imbue an arrangement with substance if the transfer has no incremental effect on the taxpayer’s activities engaging in the transaction in order to ultimately invest in business o eligible investments did not increase taxpayer’s profit potential on such investments independent of tax savings to the contrary it reduced profitability by adding substantial transaction costs taxpayer candidly acknowledged that it expected its profits to be reduced as a result of the multi-step transaction if the irs disallowed the deduction because of the costs of creating and implementing the transaction taxpayer’s contemporaneous documents reflect that it did not have a reasonable expectation of increasing its pre-tax profit on its business o eligible investments 330_fsupp2d_122 d conn 112_fedclaims_543 aff’d in part rev’d in part and remanded by 786_f3d_932 fed cir see also 659_f3d_466 5th cir disregarding partnership used to acquire loan receivables 157_f3d_231 3d cir disregarding returns on citicorp notes where economic returns on capital were unaffected by the transaction 731_f2d_1417 9th cir disregarding contribution of income producing assets to foreign trusts postu-131660-15 because of its indirect investment strategy taxpayer’s documents show that the increase in profit from the transaction was to result solely from the drd taxpayer’s indirect investment of customer funds in business o eligible investments through sub did not provide a reasonable opportunity for economic profit other than the profit that would have been earned had taxpayer invested directly in sub ric or directly in the business o eligible investments sub did not provide investment advice with respect to the business o eligible investments rather sub d a member of us group and a registered investment_advisor operated as sub ric’s investment_advisor sub d managed sub ric’s investments in accordance with us group’s investment guidelines moreover the business o eligible investments continued to be subject_to agency 1’s oversight and restrictions even though us group held them indirectly through sub a country u entity taxpayer sought assurances from agency that the transaction would not cause safety and soundness issues because sub c a member of us group needed to take the business o eligible investments into account in determining whether it satisfied certain of agency 1’s requirements to this end taxpayer informed agency that quote in addition taxpayer informed prospective note holders of sub ric that quote the funds used to invest in the business o eligible investments came from one or more members of us group employees of a member of us group determined what investments were to be made taxpayer did not increase its profit on the business o eligible investments by accounting for the funds as if they were routed from us group members through sub on their way to sub ric or by having sub hold distributions from sub ric for a transitory period before transferring the funds to sub we conclude that taxpayer fails to satisfy the objective prong of the economic_substance test moving sub to country u funneling funds through sub as a country u corporation and moving the sub stock from sub to sub 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 taxpayer took these steps to avoid the application of sec_854 which prevents sub from offsetting its income attributable to sub ric’s distributions with the sec_243 drd and to avoid an inclusion under sec_951 with respect to sub in the alternative we conclude that taxpayer fails to satisfy the objective prong of the economic_substance test with respect to its funneling of investment funds and its investment returns through a country u corporation taxpayer routed its customer funds and its return on investment through sub to circumvent the application of sec_854 routing funds through sub did not give taxpayer any reasonable expectation of economic profit over and above the profit it could expect if a member of postu-131660-15 us group directly invested in business o eligible investments or invested in a ric that invested in business o eligible investments c the business_purpose test the subjective business_purpose prong of the economic_substance test focuses on whether the taxpayer acted with a business_purpose other than tax_avoidance a sophisticated and well-advised taxpayer is aware of the business_purpose prong of the economic_substance_doctrine analysis likely anticipating a challenge by the irs taxpayer included a list of purported business purposes for_the_use_of a country u corporation in its planning documents taxpayer claims that it used a corporation organized in country u in the transaction for the business_purpose of attracting foreign investors taxpayer maintains that foreign investors would be subject_to u s federal withholding taxes on distributions from a domestic entity but would not be subject_to similar withholding taxes on payments made by an entity organized in country u this justification is unpersuasive because taxpayer relied on sec_871 and sec_881 to exempt distributions from sub ric to sub from u s federal withholding taxes non-u s investors would have likewise been exempt from u s federal withholding taxes under sec_871 and sec_881 if they had invested directly in sub ric thus 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 in order to reduce u s federal withholding taxes taxpayer presents additional justifications to support its purported business_purpose for using a country u corporation taxpayer suggests that non-u s investors may prefer to invest in u_s_assets indirectly through non-u s entities so that they appear to be investing in a country other than the united_states for non-tax personal reasons however there is no evidence that taxpayer actually sought or planned to seek non-u s investors for sub to the contrary taxpayer assured agency that quote taxpayer would not have made this representation to agency if it intended to issue sub stock to non-u s investors in addition taxpayer claims that non-u s investors would prefer to invest in a corporation organized in country u because they would be afforded better protection in the event that common parent declared bankruptcy as the creditors would have more difficulty reaching assets of a country u subsidiary taxpayer assured agency that the assets would be held in the united_states taxpayer’s continued reliance on the business o eligible investments for purposes of satisfying the safety and soundness requirements of sub c is inconsistent with taxpayer’s alleged business_purpose of moving the assets out of the reach of u s creditors accordingly taxpayer’s argument that it used an entity organized in country u in order to attract non-u s investors has no merit postu-131660-15 another claimed business_purpose for having sub hold sub ric stock indirectly through sub rather than holding the stock directly or through another subsidiary organized in state t was to avoid tax that state t would have imposed on distributions received by a state t subsidiary from sub ric country u had agreed to not subject sub to income_tax under the laws of country u for at least twenty years but no such agreement had been reached with state t as planned by the end of year y taxpayer caused sub to distribute its earnings to sub a state t corporation thus income attributable to the business o eligible investments was apparently subject_to state t tax taxpayer has not substantiated the difference between the state tax that sub would have had to pay had it directly invested in the business o eligible investments invested in the stock of sub ric through another state t subsidiary or directly invested in the stock of sub ric and the amount of state t tax it paid because it received a distribution from sub even assuming that there were state t tax savings any savings must be offset by the transaction costs and as taxpayer noted the potential loss of valuable public goodwill taxpayer’s claimed business_purpose of using a country u corporation in order to save state t tax is unpersuasive it is notable that taxpayer’s asserted business purposes for using an entity formed in country u in the transaction do not include operating a business in country u in connection with obtaining agency 1’s approval for the transaction structure taxpayer in effect asked agency to disregard sub and look through to sub ric and sub ric’s underlying investments taxpayer assured agency that sub would conduct only de_minimis activities in country u in fact in its correspondence with agency taxpayer referred to sub as a domestic operating subsidiarydollar_figure the funds used to invest in the business o eligible investments came from one or more members of us group employees of a member of us group determined what investments were to be made taxpayer’s transaction planning documents make it clear that taxpayer did not intend that sub itself would benefit from the investment funds or the investment return on the business o eligible investments members of us group directly wired the investment funds to sub ric sub did not have any opportunity to control the funds before sub ric used them to purchase business o eligible investments in accordance with taxpayer’s transaction plan before commencing the transaction taxpayer determined that sub would distribute the funds it received from sub ric to sub before the end of sub 4’s year ydollar_figure taxpayer taxpayer has not explained its treatment of the corporation organized in country u as a domestic operating subsidiary in its dealings with agency taxpayer claims that sub received funds from sub ric in year z and did not distribute them to sub before the end of sub 4’s year z taxable_year we understand that sub did not claim a sec_245 drd in year z however in year aa and year bb taxpayer carried out the transaction again it is our understanding that in years aa and bb taxpayer intends to have a member of us group claim the benefit of the sec_245 drd the dollar amount of the funds held by sub in year z and included by sub as a sec_951 inclusion was small compared to the amounts taxpayer treated and may treat as dividends qualifying for the percent sec_245 drd in years y aa and bb sub 4’s retention of postu-131660-15 carried out the transaction consistent with its plan there is evidence to support the inference that taxpayer’s only purpose for moving funds from sub ric to sub before returning the funds to a member of us group was tax_avoidance taxpayer’s contemporaneous documents discuss the deduction that the transaction was to provide rather than any increased business profit or other valid business_purpose the documents evaluate the success of the transaction solely in terms of its tax consequences taxpayer moved funds through a foreign_corporation in order to create a dividend eligible for a drd taxpayer did not have a legitimate business_purpose for funneling the income derived from the business o eligible investments through a cfc we conclude that taxpayer fails to satisfy the business_purpose prong of the economic_substance test taxpayer’s business_purpose for the transaction was to invest in business o eligible investments so as to maintain the safety and soundness of sub c taxpayer has not provided a plausible business_purpose for moving sub to country u funneling funds through sub as a country u corporation and moving the sub stock from sub to sub taxpayer also fails to satisfy the business_purpose prong of the economic_substance test specifically with respect to its funneling investment funds and its investment returns through a country u corporation funneling the customer funds and the return on investment through a country u corporation did not enhance taxpayer’s profit potential on the business o eligible investments other than the tax savings and did not serve any other non-tax business_purpose d congressional intent the economic_substance_doctrine does not apply when a taxpayer’s treatment of an item is consistent with the congressional intent underlying the relevant code sections thus in addition to the two-pronged test discussed earlier in this memorandum the economic_substance_doctrine requires an analysis of the congressional intent underlying the code sections at issue this section of the memorandum analyzes the congressional purpose for enacting the drd provisions as well as other code sections relied on by taxpayer with respect to its treatment of the transaction for u s federal_income_tax purposes prior to the enactment of sec_881 and sec_871 which exempt foreign shareholders from withholding_tax on interest-related dividends received from a ric such dividends were subject_to_withholding tax as explained below congress provided tax relief to foreign investors in sec_881 and sec_871 to encourage them to invest funds in year z and interest earned on the funds during this time does not change our economic_substance analysis any interest earned by sub on the funds it received from sub ric is dwarfed by the magnitude of the tax deduction that taxpayer’s use of sub was designed to generate postu-131660-15 in the united_states sec_245 gives tax relief to domestic shareholders of foreign_corporations congress did not amend sec_245 upon enacting sec_881 and sec_871 to expressly forbid domestic corporations from using foreign conduits to convert ric interest-related and capital_gain dividends into dividends eligible for a sec_245 drd taxpayer took the lack of such a specific statutory prohibition as permission to do so taxpayer’s drd should be disallowed under the economic_substance_doctrine because as set forth below 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 i sec_243 and subchapter_m rics are generally subject_to taxation under special rules in subchapter_m sec_851 through 860g a ric that satisfies the requirements under sec_852 is generally able to take a dpd in computing its taxable incomedollar_figure thus a ric can eliminate tax at the entity level by properly distributing its income rics generally make timely distributions to their shareholders in order to take advantage of the dpd corporate earnings are generally subject_to two levels of tax the corporation is taxed on its earnings and the corporation’s shareholders are taxed on the corporation’s distributions of its earnings the taxation of rics under subchapter_m provides an exception from the corporate level tax on corporate earnings the drd provides another exception from the multiple layers of tax on corporate earnings when originally enacted in the drd was intended to eliminate or minimize further multiples of taxation of corporate earnings as the earnings pass from one corporation to another accordingly as noted upon amendment of the drd provisions in w here the distributing_corporation is exempt from tax there is no reason why the dividends should be deducted from the gross_income of the stockholder corporation sec_243 generally allows a corporation to take as a deduction an amount equal to a specified percentage of the amount received as dividends from a domestic_corporation that is itself subject_to u s federal_income_tax however sec_243 states that for purposes of sec_243 a dividend received from a ric is subject_to the limitations prescribed in sec_854 the internal_revenue_code of added sec_854 which governs which dividends received from a ric give rise to a drd in sec_852 and sec_852 cong rec h6319-03 h_rep_no 72d cong 1st sess pincite noting also d ividends received by a corporation are allowed as a deduction in computing the net_income of a corporation upon the theory that a corporate tax has already been paid upon the earnings out of which the dividends are distributed pub_l_no postu-131660-15 enacting this provision congress noted that the purpose of the drd is to limit the multiple taxation of intercorporate dividends congress was concerned that under prior_law a corporate shareholder of a ric might claim a drd with respect to a dividend paid_by a ric attributable to interest that the ric received on bond investments congress believed that this resulted in tax_avoidance because the corporation that issued the bond received an interest_deduction and neither the ric nor the corporate shareholder of the ric paid the full tax on the interest_income sec_854 was congress’ attempt to prevent this abuse by limiting the use of the drd with respect to ric distributions in congress amended sec_854 to further narrow the eligibility of ric distributions for the drd under sec_854 as originally enacted if at least percent of a ric’s gross_income consisted of dividends from domestic corporations then all of the ric’s distributions were treated as dividends eligible for the drd thus up to percent of the ric’s gross_income could consist of interest_income congress was concerned that the original rules permit a taxpayer to convert interest_income into dividend income taxpayers have organized rics to take advantage of this conversion opportunity congress explained that a change in the law was necessary because this opportunity was unwarranted to prevent such inappropriate use of the sec_243 drd congress amended sec_854 so that a shareholder of a ric cannot treat any dividend received from the ric as a dividend for purposes of the drd except to the extent that the ric can identify the distribution as eligible for the drd the amount of dividends a ric can identify as eligible for the drd in a taxable_year generally is limited to the amount of dividends that the ric receives from domestic corporations in that year that would give rise to a drd in the hands of the ric if rics were permitted to claim the drd in the instant case sub ric did not receive any dividends that would qualify for s rep no 83rd cong 2d sess pincite emphasis added id pincite sec_854 of the code h_r rep no ii 98th cong 2d sess pincite id sec_854 the rule for identifying dividends eligible for a drd was changed by the regulated_investment_company modernization act of pub_l_no 124_stat_3537 from a designation requirement to a written notice requirement the limit on the amount of a ric dividend that may be treated as a drd-eligible dividend remains unchanged see sec_854 and under sec_852 a ric is not allowed a drd postu-131660-15 a drd if sub ric were allowed a drd and therefore none of sub ric’s distributions were eligible for the drd thus sub ric did not provide notice to its shareholder that the distributions were dividends eligible for the sec_243 drd ii portfolio_interest exception in the instant case taxpayer claims that the distributions from sub ric to sub are exempt from withholding_tax under sec_881 taxpayer needs to rely on sec_881 and e in order to avoid withholding_tax on the distribution to sub which is necessary to achieve its tax savings on the transaction congress enacted sec_871 and sec_881 in the tax_reform_act_of_1984 the tax reform act to encourage foreign investors to invest in the united_states to enhance the u s government’s and u s business’ access to international capital markets and to eliminate the need for u s borrowers to use intermediary financing affiliates prior to a foreign_person that received u s -source interest_income was generally subject_to u s federal_income_tax on the interest if the interest was not connected with the foreign person’s trade_or_business_within_the_united_states the tax generally was collected by withholding the amount of tax from the interest when it was paid to the foreign_person the legislative_history of the tax reform act indicates that congress wanted to allow u s businesses and the u s government to raise money through the eurobond market congress determined that the u s federal withholding_tax on certain interest_paid to foreign lenders impeded access to the eurobond market the portfolio_interest provisions in the tax reform act eliminated the percent withholding_tax on interest received by nonresident_aliens and foreign_corporations with respect to certain debt obligations issued by u s_corporations or the u s government after date through the addition of sec_871 and sec_881 to the code in congress expanded the portfolio_interest exemption with the addition of sec_871 and sec_881 which generally exempt interest-related dividends_paid to a foreign_person by a ric from the percent withholding_tax in effect these pub_l_no 98_stat_494 see s rep no i 98th cong 2d sess pincite sec_1441 and sec_1442 see s rep no i 98th cong 2d sess pincite american_jobs_creation_act_of_2004 pub_l_no 118_stat_1418 sec_881 provides that except as otherwise provided no tax shall be imposed on any interest-related_dividend as defined in sec_871 received from a regulated_investment_company an interest related dividend is generally a dividend that the ric pays out of certain interest_income that would not be subject_to tax in the hands of a shareholder that is a foreign_corporation or a nonresident postu-131660-15 provisions give a foreign investor in a ric that holds investments that generate u s - source interest the same u s federal_income_tax result as if the investor had directly invested in the underlying investments when the foreign investor is a cfc any interest-related dividends eligible for the sec_881 exclusion must be included in the cfc’s subpart_f_income without regard to certain exceptions including the de_minimis exception under sec_954 and the related_party exception under sec_954 accordingly the u s shareholders of a cfc generally would have sec_951 inclusions based in part on the full amount of the interest-related dividends received by the cfc congress did not intend to allow u s taxpayers to be able to avoid u s federal_income_tax under sec_881 by investing through a cfc when congress eliminated tax on portfolio_interest paid to foreign persons in congress recognized that u s persons could attempt to evade u s federal_income_tax on interest_income by buying u s bearer obligations on the eurobond market and claiming to be a foreign_person or by buying the bonds through the assistance of a foreign_person if the u_s_person failed to include the interest in its u s return and there was no withholding the income would not be taxed and the tax_avoidance would likely go unnoticed by the irs because the obligations were in bearer rather than registered_form in order to prevent this tax_avoidance congress enacted certain measures including an expansion of the department of the treasury’s authority to require registration of securities designed to be sold to foreign persons furthermore congress required that the withholding_agent receive a statement that the beneficial_owner of the obligation is not a u_s_person and empowered the department of the treasury to make certain determinations that could prevent taxpayers from engaging in back-to-back transactions alien if the shareholder received it directly more specifically sec_871 exempts any interest- related dividends that foreign_corporations and nonresident_aliens receive from rics from the percent withholding_tax a ric must designate an interest-related_dividend by written notice provided to its shareholders sec_871 the amount that a regulated_investment_company may so designate is based on the ric’s qualified_net_interest_income which is the ric’s qualified_interest_income reduced by certain deductions sec_871 qualified_interest_income is the amount of the ric’s u s source interest_income that would be exempt from the percent withholding_tax if the shareholder received the interest directly sec_871 sec_881 which applies the rules of sec_881 to interest-related dividends see s rep no i 98th cong 2d sess pincite see staff of joint comm on taxation 98th cong 2d sess general explanation of the revenue provisions of the deficit_reduction_act_of_1984 pincite see sec_871 see sec_871 and h postu-131660-15 the exemption from taxation of interest-related dividends received from a ric does not apply unless the withholding_agent receives a statement similar to that required under sec_871 stating that the beneficial_owner of the stock is not a u_s_person it is our understanding that sub provided a statement to sub ric that it was the beneficial_owner of the sub ric stock and accordingly that ostensibly conforming to the literal requirements of the withholding rules sub ric did not withhold tax on its distributions to sub iii subpart_f taxpayer contends that under sec_245 sub is entitled to an percent drd to offset the distributions that sub received from sub which are u s -source dividends within the meaning of sec_245 because they are attributable to distributions sub received from sub ric subpart_f was added to the code in to prevent u s persons from inappropriately deferring u s federal_income_tax on certain income earned by cfcs the subpart_f rules provide in part that u s shareholders of a cfc are taxed currently on certain types of income subpart_f_income earned by the cfc under sec_951 specifically a u s shareholder that owns stock of a cfc on the last day of the cfc’s taxable_year has a sec_951 inclusion with respect to the cfc which includes the shareholder’s pro_rata share of the cfc’s subpart_f_income to the extent that the cfc’s subpart_f_income is included in the u s shareholder’s income as a sec_951 inclusion the cfc’s actual distributions to the u s shareholder are excluded from the u s shareholder’s income under sec_959 so that the amounts are not included in the u s shareholder’s income twice neither the sec_951 inclusion nor the tax-free distribution of earnings_and_profits attributable to the sec_951 inclusion is treated as a dividend for the purposes of the sec_245 drd or is otherwise eligible for the sec_245 drd if the foreign_corporation is a cfc owned by a u s shareholder for its entire taxable_year the u s shareholder’s pro_rata share of the cfc’s subpart_f_income is generally the amount that would have been distributed to the shareholder with respect see sec_871 see also sec_871 and h the exemption also does not apply if the interest-related_dividend is paid to a person in a foreign_country with respect to which the secretary has determined that the information exchange between the united_states and the foreign_country is inadequate to prevent evasion of u s federal_income_tax by u s persons sec_871 and h a as originally enacted subpart_f consisted of sec_951 through sec_965 was added to subpart_f in american_jobs_creation_act_of_2004 pub_l_no 118_stat_1418 see 137_tc_174 aff’d 722_f3d_306 5th cir sec_959 and d postu-131660-15 to the stock that it owns within the meaning of sec_958 if the cfc had distributed its subpart_f_income for the taxable_year thus its pro_rata share generally is based on the u s shareholder’s percentage of cfc stock ownership including certain stock owned indirectly by the u s shareholder special rules for determining a u s shareholder’s pro_rata share apply when there is a change in ownership during a cfc’s taxable_year and the cfc’s status as a cfc is not changed under sec_951 the u s shareholder that disposes of its stock prior to the end of a cfc’s taxable_year does not have a sec_951 inclusion with respect to the cfc’s undistributed_income instead only the acquiring u s shareholder has a sec_951 inclusion assuming the acquiring u s shareholder holds the cfc stock on the last day of the cfc’s taxable_year in addition under sec_951 the amount of the acquiring shareholder’s sec_951 inclusion is reduced by all or a portion of any dividends_paid to the disposing shareholder with respect to the transferred shares during the taxable_year the rule requiring a reduction of the sec_951 inclusion for the current u s shareholders of a cfc for the same year distributions to the previous owner s was intended to prevent both the current and former shareholders from being subject_to tax with respect to the same amount of the cfc’s subpart_f_income similarly the rule that provides that a u s shareholder does not have a sec_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 held the same cfc shares in order to avoid double_taxation neither rule was intended to allow taxpayers to structure transactions that avoid subjecting any u s shareholder to u s federal income_taxation with respect to subpart_f_income of a cfc iv sec_245 sec_245 provides rules for the deduction of dividends received from certain foreign_corporations in connection with the promulgation of the technical and miscellaneous review act of the act congress explained that dividends eligible for the sec_245 drd are based on the ratio of a the foreign corporation’s post-1986_earnings_and_profits that have been subject_to net-basis u s corporate_income_tax and that have not been distributed to b the corporation’s total accumulated_earnings_and_profits the statutory rules include tests for determining when dividends are attributable to previously-taxed corporate income and provide rules on deductibility based in part on the recipient’s level of stock ownership in the payor in addition congress specifically disallowed the drd for amounts treated as dividend sec_123 see sec_951 the amount of the acquiror’s sec_951 inclusion is reduced by the lesser_of the amount of the distributions made to the disposing shareholder and the subpart_f_income allocable to the portion of the taxable_year for which the cfc’s stock was owned by the previous owner h_r rep no 100th cong 2d sess pincite emphasis added postu-131660-15 under section because the deemed sec_1248 dividends are generally derived from earnings not subject_to u s corporate_income_tax common parent likely is familiar with congress’ clearly articulated intent to allow the drd only for earnings that have been subject_to net-basis u s federal corporate_income_tax nonetheless sub treated its year y distributions from sub attributable to distributions from sub ric as sec_301 dividends that qualified for the percent drd under sec_245 sec_245 allows a drd as specified in sec_243 for that portion of a dividend paid_by a qualified_10-percent_owned_foreign_corporation that is equal to the u_s_-source_portion of the dividend common parent’s position is that sub is a qualified_10-percent_owned_foreign_corporation and that the u_s_-source_portion of the distribution was percent it is anticipated that common parent will argue that sec_245 does not specifically state that the drd is only available with respect to earnings that have been subject_to u s federal corporate_income_tax however sub should not be able to treat distributions from sub attributable to distributions from sub ric as dividends eligible for the sec_245 drd when under sec_243 and sec_854 sub could not have claimed a drd if it had directly received the distributions from sub ric the general policy of sec_245 is consistent with that of sec_243 to ensure that only a single level of corporate tax is imposed on u s source income distributed to a corporate shareholder it is inconsistent with that policy to allow sec_245 deductions for distributions attributable to interest_income and capital_gains distributed by a ric through a foreign intermediary that have not borne any u s federal corporate-level income_tax that has been made even clearer by the addition of sec_245 to the code in sec_245 s rep no 100th cong 2d sess pincite see s rep no 99th cong 2d sess pincite the committee recognizes that in a two- tiered tax system such as in the united_states double_taxation will occur one tax at the corporate level and a second tax at the individual level at the time of distributions the dividends received deduction is intended to prevent more than one full corporate level tax on the same earnings sec_245 is discussed in part i of the law and analysis section of this memorandum a senate report explanation of an earlier bill that contained a similar provision to that ultimately enacted explained that a n irs chief_counsel advisory memorandum concluded that dividends attributable to interest_income of an 80-percent owned ric are not entitled to be counted in determining the dividends received deduction under sec_245 the committee wishes to preclude any remaining potential that taxpayers might take the position that any ric or reit dividends are eligible for the dividends received deduction under sec_245 no inference is intended with respect to the proper treatment under sec_245 of dividends received from rics or reits before the date of enactment s rep 114th cong 1st sess pincite date postu-131660-15 e conclusion of economic_substance analysis taxpayer fails to satisfy the economic_substance test with respect to moving sub to country u funneling funds through sub as a country u corporation and moving the sub stock from sub to sub in the alternative we conclude that taxpayer fails to satisfy the economic_substance test with respect to its funneling investment funds and its investment returns through a country u corporation in both cases these steps did not provide taxpayer with a realistic possibility of profit over and above its return on the business o eligible investments other than the planned tax savings from the sec_245 drd other than tax savings taxpayer did not have a business_purpose that withstands scrutiny taxpayer’s use of the drd is not consistent with congressional intent thus sub 3’s sec_245 drd is disallowed under the economic_substance_doctrine regardless of whether the literal requirements of sec_245 and the other code sections at issue have been technically satisfied c substance_over_form_doctrine a transaction’s tax consequences depend on its substance not its form under this fundamental principle of income_taxation courts have disallowed the tax benefits of a transaction despite its formal compliance with the code and its implementing regulations although the form by which a transaction is effected does influence and in certain situations may decisively control the taxation of a transaction the substance_over_form_doctrine allows the courts and the irs to look beyond the superficial formalities of a transaction to determine its proper tax treatment the supreme court described the substance_over_form_doctrine in commissioner v court holding co in which the court agreed with the commissioner’ sec_129 see eg 324_us_331 435_us_561 see 361_f2d_93 5th cir 324_us_331 postu-131660-15 determination that the substance of a purported corporate dividend of real_property to shareholders and subsequent sale by the shareholders of that property to a third party was actually a sale by the corporation to the third party directly the court stated the incidence of taxation depends upon the substance of the transaction the tax consequences which arise from gains from the sale of property are not finally to be determined solely by the means employed to transfer legal_title rather the transaction must be viewed as a whole and each step from the commencement of negotiations to the consummation of the sale is relevant a sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as conduit through which to pass title to permit the true nature of a transaction to be disguised by mere formalisms which exist solely to alter tax_liabilities would seriously impair the effective administration of the tax policies of congress the substance_over_form_doctrine allows the government to characterize a transaction based on its actual substance regardless of its form and to tax it accordingly courts recast transactions where the taxpayer’s form does not comport with the reality of the transaction the court has never regarded the simple expedient of drawing up papers as controlling for tax purposes when the objective economic realities are to the contrary the substance_over_form_doctrine is used to effect the underlying purpose of a statute the purpose of the substance_over_form_doctrine is to deny legal effect to transactions that comply with the literal terms of a statute but contravene the purpose of the statute the substance of a transaction is assessed in id pincite id pincite see also eg 651_fsupp2d_219 d n j aff’d sub nom 652_f3d_475 3d cir substance of purported sales in interest rate swaps were loans 523_f3d_461 5th cir substance of purported lease agreement was financing_arrangement and purported loan was circular flow of funds 281_f3d_1108 10th cir substance of purported loan agreement was sale shepherd v comm’r 283_f3d_1108 10th cir substance of purported gift of partnership_interest was a gift of real_estate 251_f3d_1168 8th cir describing the reciprocal_trust doctrine a version of substance over form where reciprocal_gifts of stock left transferors in same position as prior to gifts and 248_f3d_572 7th cir substance of purported lending agreement was a guaranty see court holding u s pincite merck f 3d pincite quoting 435_us_561 703_f3d_1367 fed cir see 714_f2d_977 9th cir postu-131660-15 light of all the facts and circumstances the substance_over_form_doctrine requires viewing the transaction as a whole step_transaction_doctrine a overview of the step_transaction_doctrine one variation of the substance_over_form_doctrine is the step_transaction_doctrine the step_transaction_doctrine was developed by the courts to ensure that a transaction is taxed in accordance with its substance ‘by ignoring for tax purposes steps of an integrated transaction that separately are without substance ’ the well- established doctrine has been expressly sanctioned by the supreme court which has noted that interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction courts have outlined three basic tests to establish the circumstances under which the application of the step_transaction_doctrine applies under the narrowest approach the binding_commitment_test the steps are collapsed if at the first step there was a ‘binding commitment to undertake the later step’ in a series of transactions the interdependence test focuses on whether ‘the steps are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series ’ it requires a determination of whether the steps had independent significance or had meaning only as part of a larger transaction - that is a transaction with the end result that the taxpayer hoped to achieve accordingly the interdependence test is sometimes viewed as a variation of the third test the end result test under the end result test the doctrine is applied if it appears that separate transactions were ‘really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result ’ 77_tc_1221 141_tc_1 the 422_f3d_1339 fed cir quoting dietzch v united_states 498_f2d_1344 ct_cl 489_us_726 falconwood corp f 3d pincite quoting 88_tc_1415 id quoting king enter inc v united_states f 2d ct_cl id quoting king enter inc v united_states f 2d ct_cl postu-131660-15 b step_transaction_doctrine analysis the transaction consisted of a carefully planned and orchestrated series of steps as set forth in part iii of the facts section of this memorandum which included in part the following step and step one or more members of us group transferred funds that were to be invested in business o eligible investments directly to sub ric which taxpayer treated as transfers going directly or indirectly to sub from sub to sub and from sub to sub ric step sub ric purchased business o eligible investments in accordance with the advice of a member of us group step sub ric made distributions of its earnings with respect to the business o eligible investments to sub and step sub made distributions of the funds it received from sub ric to sub sub 3’s deemed transfers to sub sub 4’s deemed transfers to sub ric sub ric’s transfers to sub and sub 4’s transfers to sub as enumerated above should be disregarded as this memorandum sets forth in the discussion of the economic_substance_doctrine these steps which served only to route funds through sub served no independent business_purpose taxpayer planned the entire transaction before moving funds from one or more members of us group to sub ric the transaction plan required sub to transfer the funds to sub ric and required sub ric to use the funds to invest in business o eligible investments moreover the plan required sub ric to distribute its earnings on the business o eligible investments back to one or more members of us group routing the funds through sub taxpayer carried out the steps in the transaction in accordance with the plan application of the interdependence test the interdependence test analyzes the relationship between the intermediate steps of a complex transaction this test focuses on whether the intervening steps in a series of steps would have been fruitless or meaningless if the other steps in the series had not taken place the steps in which taxpayer moved funds through sub as enumerated above are interdependent and should be disregarded under the interdependence test because 927_f2d_1517 10th cir 88_tc_1415 postu-131660-15 each of the steps would have been fruitless in the larger transaction if the other steps had not taken place sub 3’s contribution of funds to sub would have been fruitless unless sub contributed the funds to sub ric so that sub ric could invest in the business o eligible investments sub 4’s receipt of distributions from sub ric would have similarly been fruitless unless sub in turn distributed the return on investment back to sub so that sub could claim the drd in its application of the interdependence test the tax_court in barnes group v commissioner focused its inquiry on whether there was a non-tax business_purpose for each of the separate steps in the transaction as set forth in the discussion of the economic_substance_doctrine in part iii b of the law and analysis section of this memorandum the steps of the transaction that taxpayer took to move funds through sub did not have an independent business_purpose as in barnes group the lack of a non-tax business_purpose for these steps supports disregarding the routing of funds through sub accordingly sub should be treated as directly contributing funds to sub ric and sub ric should be treated as making direct distributions to sub to which sec_243 would not apply as a result of sec_854 application of the end result test the end result test analyzes whether a series of steps are prearranged parts of a single transaction that from the outset is designed to achieve a specific end result the test focuses on the parties’ subjective intent when they structure the transaction taxpayer’s planning documents reflect that taxpayer took steps to move funds through sub in order to generate a drd that it could not obtain if one or more members of us group directly invested in business o eligible investments or invested in them through sub ric taxpayer planned and carried out these steps to achieve the end result of providing taxpayer with a return on the business o eligible investments avoiding the application of sec_854 and ostensibly qualifying for a sec_245 drd under the application of the end result test these steps should be disregarded and sub should be treated as directly contributing funds to sub ric and directly receiving distributions from sub ric in year y which were not eligible for a drd application of the binding_commitment_test as previously discussed sub did not have an independent business_purpose other than tax_avoidance for participating tcmemo_2013_109 aff’d by ruling by summary order 593_fedappx_7 no date id 190_f3d_1165 10th cir 137_tc_70 postu-131660-15 in the acquisition of the business o eligible investments common parent’s control_over sub resulted in a transaction whose steps were as controlled as any contractual arrangement the binding_commitment_test of the step_transaction_doctrine is generally applied when the parties have entered into a binding contract to carry out the transaction steps in the instant case there was no need for the parties to enter into binding contracts to ensure that each step of the transaction would take place as planned there was no risk that sub would deviate from taxpayer’s plan as noted in the facts section of this memorandum sub was not an independent actor it was at all times controlled by taxpayer sub did not have its own employees all of its activities were carried out by employees of members of the us group importantly members of us group directly transferred funds to sub ric to invest in the business o eligible investments thus there was not even the opportunity for sub to control the funds on their journey from members of us group to sub ric and divert the funds for its own use the outcome of the sub ric transaction was even more pre-ordained than would be the outcome of a transaction pursuant to a contractual arrangement between unrelated parties accordingly under the binding_commitment_test sub 4’s participation in the transaction should be disregarded in determining how the transaction is taxed moreover the transaction deserves particular scrutiny because it was carried out among related parties even if sub did not have a binding commitment to move funds to sub ric or make distributions to a member of us group there is ample authority for linking prearranged steps under the interdependence test and end result test in the absence of a contractual obligation or financial compulsion to follow through with the steps no statutory or regulatory provisions have been implemented to prevent application of the step_transaction_doctrine in the context of the transaction a transaction’s steps may be integrated under the step_transaction_doctrine unless the application of the doctrine has been turned off by legislative or regulatory mandate for example congress enacted statutes in response to the supreme court’s application of the step_transaction_doctrine in helvering v bashford in re uneco inc 532_f2d_1204 8th cir advances between a parent_corporation and a subsidiary or other affiliate are subject_to particular scrutiny ‘because the control element suggests the opportunity to contrive a fictional debt ’ quoting 382_f2d_298 ct_cl see eg 137_f3d_1231 10th cir 688_f2d_520 7th cir 302_us_454 postu-131660-15 a discussion of the bashford decision necessitates a preliminary discussion of groman v commissioner in the groman case glidden corporation formed a new corporation ohio to acquire all of the shares of an unrelated corporation indiana the shareholders of indiana including mr groman received in exchange for their shares stock in glidden stock in ohio and cash under the reorganization provision then in effect mr groman would not recognize gain to the extent he exchanged his indiana shares for shares of a corporation that was a party to the reorganization the commissioner determined glidden was not a party to the reorganization and the court agreed accordingly mr groman was taxed on the cash he received and on the glidden shares the bashford transaction had facts similar to those in the groman case in bashford the atlas corporation wanted to acquire the stock of three of its corporate competitors in pursuance of the transaction atlas caused the formation of a new company the shareholders of the three target corporations received in exchange for their shares stock in the new company stock in atlas and cash the commissioner determined that under the law then in effect atlas was not a party to the reorganization and the shareholders of the target corporations were to be taxed on their receipt of the atlas shares mr bashford a shareholder of one of the target corporations attempted to distinguish his transaction from the groman transaction he explained that atlas directly acquired the shares of target corporations and atlas provided all of the consideration which included both atlas shares and shares of the new company accordingly mr bashford argued atlas was a party to the reorganization only after acquiring the target stock did atlas transfer the shares to the new corporation the court applied the step_transaction_doctrine disregarding atlas’ acquisition of the target corporations because a ny direct ownership by atlas of the target corporations was transitory and without real substance it was part of a plan which contemplated the immediate transfer of the stock or the assets or both of the three reorganized companies to the new atlas subsidiary accordingly the court found the distinction in form between the groman transaction and the bashford transaction was not of legal significance to override the effect of the bashford decision congress enacted sec_368 which allows transactions otherwise qualifying as reorganizations not to be disqualified by reason of the fact that part or all of the assets or stock which were acquired in the transaction are transferred to a corporation controlled by the corporation acquiring the assets or stock in effect sec_368 prevents the application of the step_transaction_doctrine to the facts of a transaction such as the one described in bashford 302_us_82 bashford u s pincite the court did not specifically state that it was applying the step_transaction_doctrine postu-131660-15 there are no statutes or regulations that prevent the application of the step_transaction_doctrine to the transaction therefore under the application of the step_transaction_doctrine sub is treated as directly acquiring stock in sub ric and receiving distributions from sub ric with respect to such stock accordingly sub does not qualify for a drd under sec_245 or sec_243 c conduit analysis in the context of the step_transaction_doctrine the ninth circuit has identified a class of cases in which the form of the transaction is particularly suspect where a party acts as a ‘mere conduit’ of funds - a fleeting stop in a predetermined voyage toward a particular result - the court has readily ignored the role of the intermediary in order appropriately to characterize the transaction taxpayer’s moving funds through sub had no purpose or effect other than as steps to facilitate taxpayer’s reduction of tax through the use of the sec_245 drd in robino v commissioner the ninth circuit integrated a series of steps to find that two individuals sold a parcel of land to a developer and that they used their tax- exempt trusts as conduits to accomplish this result the individuals mr filler and mr schlosberg purchased the land in as tenants in common during that same year mr schlosberg was approached by a builder who wanted to build on the land mr schlosberg was the sole trustee and beneficiary of a tax-exempt_pension_trust that purchased an option to buy mr filler’s interest in the land mr and mrs filler set up a similar trust to buy an identical option to purchase mr schlosberg’s interest in the land the fillers and mr schlosberg signed the cross-options in under which each would sell for dollar_figure an option to buy a half share in the land within two years for dollar_figure notwithstanding that the fillers and mr schlosberg granted options to the trusts they also offered options to buy the property to a real_estate agent working on behalf of the builder they agreed to an option_price of about dollar_figure million later that same year the trusts exercised their options to buy the parcel of land and a few weeks later sold the land to the builder filler and schlosberg each reported gain of approximately dollar_figure the difference between each individual’s basis in the land of dollar_figure and the dollar_figure paid_by the trust to exercise its option the irs determined that the trusts were merely conduits and thus treated mr filler and mr schlosberg as selling their respective rights in the land to the builder the ninth circuit agreed with the commissioner finding that mr filler and mr schlosberg i sold options to the trusts at below market prices ii negotiated the terms of the builder’s option to purchase the land iii structured the transaction through the trusts to avoid taxes and had little justification for using the trusts other than tax 329_f3d_664 9th cir 894_f2d_342 postu-131660-15 avoidance and iv as the transaction was carried out at each moment retained complete control_over the property the court focusing on the realities of the transaction rather than the refinements of legal_title the verbiage of written instruments or the chronological order of formal events found that in substance mr filler and mr schlosberg directly sold their property interests to the builder under the conduit theory of the substance_over_form_doctrine the use of an entity may be disregarded if it is a mere conduit in a transaction as set forth in the discussion of the economic_substance and step transaction doctrines taxpayer planned and oversaw the entire transaction in which sub was a mere intermediary in routing funds between taxpayer and sub ric taxpayer structured the transaction to move funds through a country u corporation to avoid taxes by circumventing the application of sec_854 and instead claiming the sec_245 drd taxpayer had little if any justification for moving funds through a country u corporation other than tax_avoidance sub 4’s role in the transaction which was predetermined by taxpayer and under taxpayer’s control had no substantive effect on us group’s investment in the business o eligible investments moreover throughout the transaction taxpayer retained complete control of the funds it held in sub thus sub 4’s role should be disregarded as that of a conduit sub should be treated as directly contributing funds to sub ric and as directly receiving distributions from sub ric in year y alternative_substance over form analysis sub is a cfc and sub is a u s shareholder of sub within the meaning of sec_951 the dividends received by sub from sub ric during year y are foreign_personal_holding_company_income fphci which is a type of subpart_f_income however taxpayer takes the position that sub is not required to include in income its pro_rata share of sub 4’s subpart_f_income under sec_951 because sub distributed its entire_interest in sub to sub just prior to the end of sub 4’s year y taxable_year as noted in part i of the facts section of this memorandum sub c directly owned all of the stock of sub and indirectly owned the stock of sub sub sub and sub ric throughout sub 4’s year y taxable_year sub c used the business o eligible investments and the income they produced to satisfy its safety and soundness requirements without regard to whether the business o eligible investments were held directly or through one or more of its subsidiaries that were members of us group or sub ric sub c indirectly wholly owned sub prior to sub 3’s distribution of sub shares to sub and sub c continued to own indirectly sub after the distribution of the shares to sub for purposes of subpart_f a u s shareholder of a cfc includes a united_states_person who is considered as owning percent or more of the total sec_954 provides that dividends are a type of fphci none of the exceptions to fphci apply to the dividends received by sub from sub ric during year y postu-131660-15 combined voting power of all classes of stock entitled to vote by applying the rules of ownership of sec_958 which incorporates the constructive_ownership rules of sec_318 subject_to certain exceptions not relevant here accordingly as members of a percent-owned chain of domestic corporations common parent and each intervening domestic subsidiary in the us group including each of sub c sub and sub was a u s shareholder of sub throughout year y and during year z and year bb for subpart_f purposes because each was considered under sec_951 and sec_958 as owning percent of the total combined voting power of sub unlike cases in the subpart_f area in which parties varied voting rights in order to avoid u s shareholder status in this case it is undisputed that all corporations of us group in the chain of ownership of sub were u s shareholders under subpart_f and potentially subject_to sec_951 inclusions in order to avoid the double counting of income inclusions in a chain of corporations subpart_f limits the income inclusion to only those corporations in the chain that own interests in the cfc on the last day of the cfc’s taxable_year directly or through foreign entities but when a chain of percent 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 all 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 as taxpayer did in the transaction if sub had owned the stock of sub on the last day of sub 4’s year y taxable_year it would have had an income inclusion under sec_951 because sub owned percent of sub 4’s stock within the meaning of sec_958 that income inclusion would have been based on the full amount of sub 4’s subpart_f_income because sub would have owned the stock on every day of sub 4’s year y taxable_year instead sub transferred its interest in sub to sub days before the end of sub 4’s year y taxable_year and claimed that it did not have a subpart_f inclusion because it did not hold the stock on the last day of the taxable_year sub did so in order to change the character of the income that it derived with respect to sub during year y from a sec_951 inclusion that was not eligible for a sec_245 drd to a dividend which taxpayer claims is eligible for a sec_245 drd if sub c or any other u s shareholder in us group had directly owned the stock of sub every day of sub 4’s year y taxable_year it would have been required to include in income amounts under sec_951 with respect to all of sub 4’s income that see 651_fsupp2d_219 aff’d sub nom 652_f3d_475 3d cir schering-plough through its domestic subsidiaries was a united_states_shareholder within the meaning of sec_951 and sec_958 sec_951 and sec_958 see the discussion of the subpart_f rules described in part iii b d iii of the law and analysis section of this memorandum postu-131660-15 was attributable to the business o eligible investments sub c and these other members were u s shareholders of sub for subpart_f purposes throughout the year yet other than a small sec_951 inclusion reported by sub none of these u s shareholders included amounts in income under sec_951 with respect to the subpart_f_income earned by sub taxpayer’s structuring ensured that no single member of us group that was a u s shareholder of sub owned within the meaning of sec_958 all of the stock of sub on every day of sub 4’s year y taxable_year however each member of us group that was a u s shareholder of sub including sub retained ownership within the meaning of sec_958 of voting power with respect to sub at all times during sub 4’s year y taxable_year moving the stock of a cfc between related u s shareholders at the end of the cfc’s taxable_year to avoid a sec_951 inclusion is contrary to the purposes of subpart_f which require amounts to be included in income under sec_951 when u s shareholders control a foreign_corporation although there are no cases that address the avoidance of sec_951 with the same facts as those in the transaction courts have rejected schemes devised to avoid sec_951 inclusions since the enactment of subpart_f as early as taxpayers contrived to avoid sec_951 inclusions by transferring nominal voting power to friendly foreign persons and then arguing that the foreign_corporation did not meet the definition of a cfc under sec_957 because more than half the voting control of the corporation was held by foreign persons the courts ignored these transfers for purposes of determining whether the foreign_corporation was a cfc because it was clear that the u s shareholders in substance continued to control the voting power of the stock nominally held by foreign persons further the courts rejected the taxpayers’ arguments that the statute provided a mechanical test instead the courts concluded that mere technical compliance with the statute was not sufficient and that the rules in the statute would be applied to the substance of the transaction rather than the form of the transaction similarly u s shareholders have tried to avoid sec_951 inclusions attributable to loans from their wholly-owned cfcs by engaging in transactions that in form were outside the scope of sec_956 in jacobs engineering v sub 4’s subpart_f_income subject_to inclusion by such u s shareholder would not have been reduced by a drd because sub 4’s income is calculated as if it were a domestic_corporation see sec_1_952-2 therefore sub would not have been able to claim a drd under sec_243 due to the application of sec_854 58_tc_423 aff’d 489_f2d_197 2d cir see also 59_tc_681 aff’d 490_f2d_898 2d cir weiskopf 64_tc_78 aff’d per curiam 538_f2d_317 2d cir 583_f2d_313 7th cir see supra note postu-131660-15 commissioner a u s shareholder frequently borrowed and repaid funds from its wholly-owned cfc with only short periods of time between repayments and new borrowings the taxpayer carefully ensured that the loans were never outstanding on a sec_956 measuring date which would have resulted in a sec_951 inclusion the court observed that under the substance_over_form_doctrine the commissioner may deny legal effect to a transaction if the sole purpose of the transaction was to avoid tax and the court must simply decide whether the facts of the case fall within the intended scope of the internal_revenue_code provision at issue the court concluded that the series of loans was in substance a single loan outstanding for the entire year notwithstanding that the loans were not in form outstanding on a sec_956 measurement date furthermore in schering-plough v united_states the taxpayer tried to avoid a sec_951 inclusion attributable to a loan from its wholly-owned cfc by arranging a series of circular interest rate swaps with the cfc and a third party the court noted that when applying the substance_over_form_doctrine transactions between related parties merit extra scrutiny the court held that the interest rate swaps were in substance a loan from the cfc that resulted in a sec_951 inclusion to the u s shareholder and found that the third party a large unrelated bank was a mere conduit between the u s parent and the cfc in the tax_avoidance scheme in all of these cases the courts recognized that the statutory rules in the subpart_f regime are not purely mechanical instead the courts applied the gregory principle to determine whether the subject transaction met both the terms and intent of the statute in each of the cases the court held that even though the u s shareholder had structured transactions that in form allowed the u s shareholder to avoid a sec_951 inclusion the transaction lacked the substance required by the statute accordingly the courts held that the u s shareholders were subject_to tax under subpart_f consistent with the substance of the transactions which resulted in the u s shareholders including sec_951 inclusions in income a f t r 2d c d cal aff’d by unpublished decision 168_f3d_499 9th cir id under sec_956 investments in united_states_property including loans to u s shareholders held by a cfc on particular dates generally are includible in the u s shareholder’s sec_951 inclusion id id f_supp 2d d n j aff’d sub nom 652_f3d_475 3d cir merck f 3d pincite id postu-131660-15 in the instant case sub would have had a sec_951 inclusion calculated based on percent of sub 4’s subpart_f_income if it owned sub directly for the entire year y taxable_year irrespective of any distributions from sub likewise any member of us group including sub and sub c would have included in income sec_951 inclusions calculated based on percent of sub 4’s subpart_f_income as a sec_951 inclusion if such member directly owned sub for the entire year y taxable_year irrespective of any distributions from sub if any member of us group held the stock of sub throughout the year the member would not have been eligible for the sec_245 drd with respect to any part of the sec_951 inclusion attributable to the entire year instead members of us group shuffled the stock of sub from one member to another all of whom were u s shareholders of sub potentially subject_to an income inclusion under sec_951 in furtherance of its tax_avoidance plan accordingly under the substance over form principles announced in gregory and followed in garlock inc v commissioner jacobs engineering and schering-plough a member of us group that was a u s shareholder of sub during sub 4’s year y taxable_year should be required to include in income percent of sub 4’s subpart_f_income pursuant to sec_951 case development hazards and other consideration sec_173 58_tc_423 postu-131660-15 this writing may contain privileged information any unauthorized disclosure of this writing may undermine our ability to protect the privileged information if disclosure is determined to be necessary please contact this office for our views please call ---------------------if you have any further questions with regard to this memorandum generally or ---------------------with regard to the argument in part iii c of the law and analysis section of this memorandum