Tax

On January 3, 2025, the Internal Revenue Service (“IRS”) issued a legal advice memorandum (from the Office of Chief Counsel) – CCA 202501008 (the “CCA”) dealing with a tax planning transaction aggressively applying an anti-avoidance rule. Specifically, the CCA concerned the application of the anti-abuse provision of Section 269 of the Internal Revenue Code (the “Code”) to the deemed incorporation of a foreign entity (“Company Z”) owned directly by a foreign corporation (“Company Y”) treated as a controlled foreign corporation for U.S. federal income tax purposes (a “CFC”).¹

Specifically, the CCA considers whether Section 269 permits the IRS to disallow an election made under Section 898(c)(2) with respect to Company Z that otherwise would achieve the effect of excluding Company Z’s income for the first eleven months of 2018 from its relevant U.S. shareholder’s (“U.S. Sub’s”) global intangible low taxed income (“GILTI”). The CCA also addresses, in the alternative, whether temporary Treasury regulations Section 1.245A-5T would apply to increase Company Y’s subpart F income to the extent that Section 269 was inapplicable. While the CCA deals with a specific fact pattern, the application of the CCA has broad application to all tax planning. 

1. Background

U.S. Sub, a member of a U.S. consolidated group for Federal income tax purposes (the “U.S. Group”), owns, within the meaning of Section 958(a), 100% of the shares of Company Y, a foreign corporation treated as a CFC of the U.S. Group. Company Z, which Company Y wholly owns, was a foreign entity that was disregarded as an entity separate from its owner for U.S. federal income tax purposes before December 30, 2017.

In March 2018, an election under Treas. Reg. § 301.7701-3(c)(1)(i) was made for Company Z to be treated as an association taxed as a corporation for U.S. federal income tax purposes, effective as of December 30, 2017 (the “CTB Election”). Company Z purported to elect to adopt, for its first taxable year as an association taxed as a corporation, a taxable year ending November 30 pursuant to Section 898(c)(2). Under that purported election, Company Z’s first taxable year as an association taxed as a corporation ended on November 30, 2018.

The U.S. Group took the position that the CTB Election and Section 898(c)(2) election permitted U.S. Sub to change which CFC (as between Company Z and Company Y) was treated as earning the income generated from January 1, 2018 through November 30, 2018 (the “Gap Income”). And further, the U.S. Group took the position that the CTB Election followed by Company Z’s purported adoption of a November 30 taxable year pursuant to Section 898(c)(2) caused the Gap Income to be excluded from US Sub’s GILTI calculation under Section 951A because Section 951A did not apply to Company Z’s first taxable year (as discussed further below).

At the end of its taxable year reported as ending November 30, 2018, Company Z paid a dividend to Company Y in the amount of $Z (the “2018 Dividend”). $Z equaled the amount of all of Company Z’s E&P reported for its 2018 taxable year, including a small amount of previously taxed E&P associated with the 2018 Sub F Income (the “Sub F PTEP”). $Z minus the amount of the Sub F PTEP equaled $W. The U.S. Group took the position that the portion of the 2018 Dividend in excess of the Sub F PTEP (i.e., $W of the 2018 Dividend) was excluded from Company Y’s foreign personal holding company income within the meaning of Section 954(c) (“FPHCI”) pursuant to Section 954(c)(6) and, therefore, excluded from Company Y’s subpart F income.

2. Law

1. Section 269 and CTB Election.

Section 269(a) applies where: (1) “any person or persons acquire, directly or indirectly, control of a corporation” (the “Acquisition Requirement”); and (2) “the principal purpose for which such acquisition was made is evasion or avoidance of Federal income tax by securing the benefit of a deduction, credit, or other allowance which such person or corporation would not otherwise enjoy” (the “Principal Purpose Requirement”). Where it applies, Section 269 permits the Secretary to disallow such deduction, credit, or other allowance.

Treas. Reg. § 301.7701-3(g)(1)(iv) provides that, if an entity that is disregarded as an entity separate from its owner elects to be classified as an association taxed as a corporation, the owner of the disregarded entity is deemed to contribute all of the assets and liabilities of the entity to the association in exchange for stock of the association.

2. Section 898

Section 898(c)(1)(A) generally provides that a CFC must have the same taxable year as its majority U.S. shareholder. As provided in the legislative history, Section 898 was necessary to address circumstances leading to an improper deferral of a U.S. shareholders’² subpart F income inclusion. For example, the prototypical fact pattern that Section 898 was intended to address was when a CFC had a taxable year ending on January 31, while its U.S. shareholder used the calendar year as its taxable year. Any subpart F income earned by the CFC in such case would be deemed distributed to the U.S. shareholder on January 31, thus allowing the U.S. shareholder to defer tax on eleven months’ worth of current subpart F income.

Notwithstanding this general anti-deferral policy, Section 898(c)(2) provides a limited deferral exception. Specifically, Section 898(c)(2) allows a CFC to elect a taxable year beginning one month before the majority U.S. shareholder’s taxable year; thereby, allowing one month of deferral to the majority U.S. shareholder.

3. Section 951A and Revenue Procedure

On December 22, 2017, Congress passed the tax legislation known as the Tax Cuts and Jobs Act (the “TCJA”). The TCJA included the GILTI anti-deferral regime in new Section 951A. Section 951A generally requires that each U.S. shareholder of a CFC include in gross income the U.S. shareholder’s GILTI for the taxable year determined by taking into account the tested income or tested loss of each of the U.S. shareholder’s CFCs, among other attributes. Section 951A is effective for “taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of United States shareholders in which or with which such taxable years of foreign corporations end” (emphasis added).

Revenue Procedure 2018-17, 2018-9 I.R.B. 384, which was issued to prevent taxpayers from changing taxable years to avoid Section 965, generally prohibits certain foreign corporations owned, directly or indirectly, by one or more U.S. shareholders from changing their taxable year ending December 31, 2017. Specifically, the Revenue Procedure provides that a request to change the annual accounting period of a CFC will not be approved if: (1) the CFC’s taxable year (determined without regard to the requested change) ends on December 31; (2) were the change granted, the first effective year of the CFC would begin on January 1, 2017, and would end before December 31, 2017; and (3) the CFC has one or more U.S. shareholders that are required to include an amount in income under section 951(a)(1) by reason of section 965 (emphasis added).

4. Limitation of Section 245A deduction and Section 954(c)(6) Exception

As relevant here, Temp. Treas. Reg. § 1.245A-5T provides rules that limit the applicability of Section 954(c)(6) when a portion of a dividend is paid out of an extraordinary disposition account. Section 954(c)(6) provides that certain types of income that would otherwise constitute FPHCI are, when received or accrued from a related person, not FPHCI to the extent attributable or properly allocable to income of the related person which is neither subpart F income nor income treated as effectively connected with the conduct of a trade or business in the United States.

3. Analysis.

1. Application of Section 269

The CCA concludes that the transaction satisfies both the Acquisition and Principal Purpose Requirement such that Section 269 applies to the transaction which would provide the Secretary the ability to deny the “allowance” obtained as a result of the Section 898(c)(2) election (i.e., exclusion of certain of the offshore income of the U.S. Group from tax).

1. Acquisition Requirement.

The CTB Election results in the deemed contribution of assets and liabilities to the newly regarded Company Z, which constitutes the organization of a corporation (which is squarely addressed in Treas. Reg. § 1.269-1(c) as constituting the acquisition of (indirect) control of a corporation), and, thus, the CCA concludes that U.S. Sub meets the Acquisition Requirement with respect to the CTB Election.

2. Principal Purpose Requirement.

The Principal Purpose Requirement, as defined above, has four elements: (1) whether U.S. Group secured the benefit of a “deduction, credit, or other allowance”; (2) whether the benefit is one which the taxpayer “would not otherwise enjoy” absent the acquisition; (3) whether the acquisition of control resulted in “evasion or avoidance of Federal income tax”; and (4) whether the principal purpose for the acquisition of control was evasion or avoidance of U.S. federal income tax.

(1) Secured the benefit of an allowance. The CCA’s analysis with respect to prong (1) hinges on the fact that the election under Section 898(c)(2) gave rise to an exclusion of income for the initial taxable year as a CFC for Company Z, which the CCA concludes is an “allowance.” In coming to that conclusion, the CCA relies on legislative history and an analogy to the former surtax exemption and the application of the predecessor version to Section 269. The CCA also relies on Treas. Reg. § 1.269-1(a), which defines an allowance as “anything in the internal revenue laws that has the effect of diminishing tax liability.” The regulation goes on to provide that an allowance “includes, among other things, a deduction, a credit, an adjustment, an exemption, or an exclusion.”

Weil Tax Observation: The CCA’s conclusion regarding the treatment of such excluded income as an “allowance”, combined with the CCA’s citing of Briarcliff Candy Corp. v. Commissioner, T.C. Memo 1987-487 (which noted that Section 269 “was broadly drafted to include any type of acquisition which constitutes a device by which one corporation secures a tax benefit to which it is otherwise not entitled”), lays bare concerns that Section 269 is an expansive and broad provision that may be implicated any time an acquisition of control yields a reduction in taxable income and is just “the relatively most important purpose” (see, CAA 20251008, pg. 6).  

(2) Benefit that the taxpayer would not otherwise enjoy. By making the Section 898(c)(2) election for Company Z, the CCA concludes that U.S. Sub obtained the benefit of excluding the Gap Income from its calculation of its GILTI inclusion because Section 951A did not apply to income earned by Company Z during the period from January 1, 2018 to November 30, 2018, as Section 951A did not apply with respect to Company Z until its taxable year beginning on December 1, 2018, which is eleven months later than the beginning of the first taxable year of Company Y to which Section 951A applied. In short, as a result of the CTB Election (i.e., the acquisition of control of Company Z within the meaning of Section 269(a)(1)), the CCA concludes that U.S. Sub obtained the benefit of the Section 898(c)(2) election for Company Z (with the resulting exclusion of Gap Income from the GILTI tax base of U.S. Sub and the U.S. Group), which it would not have otherwise enjoyed absent the CTB Election.

(3) Evasion or Avoidance of Federal Income Tax. The CCA concludes that the Section 898(c)(2) election was used as a device to reduce U.S. Sub’s taxable income by excluding the Gap Income from U.S. Sub’s GILTI calculation. In support of that conclusion, the CCA cites the statutory structure of Section 898, the provision’s legislative history, and related IRS guidance to demonstrate that the provision was intended to curb tax abuse and level the playing field across similarly situated taxpayers by generally preventing deferral of Subpart F income. The CCA points to Section 898(c)(2)’s limited nature and Company Z’s use of the election combats the specific deferral which Section 898 was intended to combat because as much as eleven months of deferral of tax on CFC income (and, in fact, full exclusion of such income) occurred by reason of Company Z’s Section 898(c)(2) election (as opposed to just one month of deferral).

Weil Tax Observation: The IRS’ position in the CCA regarding the evasion or avoidance of U.S. federal income tax, in some respects, is at odds with existing IRS and judicial guidance. Such prior guidance, in each case, concluded that, even where a taxpayer forms or acquires a corporation with an eye toward obtaining a tax benefit, Section 269 will not apply to prevent “tak[ing] advantage of provisions that represent a deliberate granting of tax benefits.” Rocco, Inc. v. Commissioner, 72 T.C. 140, 152 (1979) (holding that Section 269 did not apply to disallow deferral of tax resulting from adoption of the cash method of accounting, in part because the tax benefits of the cash method were “consciously granted” by Congress). In this vein, Section 269 has been historically interpreted not to permit the Commissioner to disallow the benefits of incorporation for purposes of obtaining tax benefits specifically granted to certain corporations. See Rev. Rul. 70-238, 1970-1 C.B. 61 (concluding that the special deduction allowed in computing the taxable income of a Western Hemisphere trade corporation “was intended primarily to grant relief . . . to American corporations trading in foreign countries within the Western Hemisphere,” and that therefore, “the creation of a new domestic corporation to carry on the business in the Western Hemisphere (other than in the United States) of an existing domestic corporation is not tax avoidance” within the meaning of Section 269). Similarly, Section 269 has been interpreted not to permit the Commissioner to disallow an election of status as a subchapter S corporation. See Modern Home Fire & Casualty Insurance Co. v. Commissioner, 54 T.C. 839, 853 (1970) (reasoning that, had taxpayer’s sole motivation for electing to be taxed under subchapter S been to offset the taxpayer’s income against its owner’s losses, “the enjoyment of this benefit would be consistent with the intent of Congress . . . and thus cannot be regarded as tax avoidance”); Rev. Rul. 76-363, 1976-2 C.B. 90 (concluding that, even though the taxpayer’s principal purpose for the acquisition was to secure the exemption from corporate tax provided by subchapter S, that benefit “cannot be regarded as tax avoidance,” and therefore Section 269 did not apply). In each such circumstance, even though the formation or acquisition of a corporation resulted in a tax benefit, because that benefit was directly aligned with Congress’s intent in enacting the underlying provisions, Section 269 was not applicable.

In contrast, the CCA notes that where a deliberate granting of tax benefits by Congress is not manifest, Section 269 may be invoked. See, e.g., Coastal Oil Storage Co. v. Commissioner, 242 F.2d 396, 400 (4th Cir. 1957), affirming in part and reversing in part, 25 T.C. 1304 (1956) (holding that the predecessor of section 269 applied where multiple corporations were formed to exploit a prior-law surtax exemption). Despite the CCA’s reference to legislative intent and the result of Company Z’s use of the Section 898(c)(2) election to distinguish it from the prior IRS and judicial guidance described above, one could argue that Congress did deliberately grant tax benefits in spite of the general rule of Section 898, which may appear to more closely resemble the facts set forth under such prior guidance. In fact, as the CCA notes, the one month deferral rule of Section 898(c)(2) was specifically crafted for the purpose of providing a carve out from the general rule of Section 898 – just because the benefits that the U.S. Group was entitled to exceeded those set forth in Section 898(c)(2) (because the Section 898(c)(2) election gave rise to a larger benefit than one month deferral), that should not itself implicate Section 269. See, Rocco, Inc. v. Commissioner, 72 T.C. 140, 152 (1979).

 (4) Principal Purpose. The CCA concludes that the sole purpose for acquiring Company Z was the evasion or avoidance of U.S. federal income tax, citing several facts, including that the U.S. Group failed to provide a business purpose for making the CTB Election and making that election effective December 30, 2017, rather than January 1, 2018. The CCA further notes that the CTB Election and subsequent Section 898(c)(2) election “served no purpose other than to exclude permanently eleven months of tested income from U.S. Sub’s GILTI calculation. As such, tax avoidance or evasion was the principal purpose of the transaction.”

Weil Observation: While the facts set forth in the CCA are presented in a light favorable to the government, the fact that the U.S. Group failed to substantiate a business purpose for the CTB Election and the timing thereof are red herrings. No business purpose is per se required when making a CTB Election, and importantly, CTB Elections are almost exclusively tax motivated. Thus, the fact that the U.S. Group failed to provide such information should not be dispositive with respect to the CCA’s conclusion that the principal purpose of the acquisition of Company Z was tax avoidance, despite the Section 269 rules, as the Information Document Request was only respect to the CTB Election (and not the Section 898(c)(2) election). See, Dover Corp. v. Commissioner, 122 T.C. 324, 348 (2004). One could assume, however, that the IRS was not trying to assert that a business purpose requirement exists for a CTB Election, but rather understanding the business purpose for the CTB Election would help make the IRS’ case to directly connect the CTB Election to the tax avoidance planning intended by Section 898(c)(2) (i.e., acquisition of control of a corporation with a tax avoidance principal purpose). 

2. 1.245A-5T application.

The CCA also concludes that if Section 269 were not applied, Temp. Treas. Reg. §1.245A-5T applies to the transactions described above to increase Company Y’s subpart F income.

Under Temp. Treas. Reg. §1.245A-5T(d)(1), although US Sub claimed that Section 954(c)(6) applied to $W of the 2018 Dividend, only (50% * $W) of that portion of the 2018 Dividend qualified for Section 954(c)(6). The remainder of that portion of the 2018 Dividend — also equal to (50% * $W) — was subpart F income to Company Y for its 2018 taxable year. The CCA notes that because Temp. Treas. Reg. §1.245A-5T(d)(1) provides that if an upper-tier CFC receives a dividend from a lower-tier CFC, the dividend is eligible for the exception to FPHCI under Section 954(c)(6) only to the extent that the amount that would be eligible for the Section 954(c)(6) exception (determined without regard to Temp. Treas. Reg. §1.245A-5T(d)(1)) exceeds the “disqualified amount,” and a portion of the 2018 Dividend so qualifies, there was an understatement of Company Y’s subpart F income.  

The CCA also points to the anti-abuse rule under Temp. Treas. Reg. §1.245A-5T(h) to the 2018 Dividend to reach the same result.