[Federal Register Volume 62, Number 15 (Thursday, January 23, 1997)]
[Rules and Regulations]
[Pages 3458-3461]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-1521]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8710]
RIN 1545-A073


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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
consistency rules under section 338 of the Internal Revenue Code of 
1986 that are applicable to certain cases involving controlled foreign 
corporations. The final regulations substantially revise and simplify 
the stock and asset consistency rules. The final regulations include 
the provisions of the consistency rules applicable to controlled 
foreign corporations contained in recent proposed and temporary 
regulations. The final regulations would affect taxpayers that own 
controlled foreign corporations.

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

FOR FURTHER INFORMATION CONTACT: Kenneth D. Allison at (202) 622-3860 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains final Income Tax Regulations (26 CFR part 1) 
under section 338 of the Internal Revenue Code.

[[Page 3459]]

    On January 20, 1994, temporary regulations (TD 8516) were published 
in the Federal Register (59 FR 2956) under section 338 of the Internal 
Revenue Code. See 1994-1 C.B. 119. A notice of proposed rulemaking 
(INTL-0177-90) cross-referencing the temporary regulations was 
published in the Federal Register for the same day (59 FR 3045). See 
1994-1 C.B. 818. The temporary regulations provided rules to replace 
the asset and stock consistency rules of Secs. 1.338-4T and 1.338-5T. 
The temporary regulations included consistency rules applicable to 
certain cases involving controlled foreign corporations (CFCs).
    No written comments responding to the notice were received. No 
public hearing was requested or held. The proposed regulations under 
section 338 are adopted as revised by this Treasury decision, and the 
corresponding temporary regulations are removed.

Explanation of Provisions

    The preamble to the temporary and proposed regulations (1994-1 C.B. 
119) contains a discussion of the provisions. Changes to the temporary 
and proposed regulations are noted below.
    Section 1.338-4T(h)(3) of the temporary regulations is clarified by 
stating that the basis of the stock of a controlled foreign corporate 
target affiliate is not increased by section 1248 earnings attributable 
to the disposition of an asset in which a carryover basis is taken 
under this section.
    Section 1.338-4T(h)(4) of the temporary regulations addresses a 
situation in which the income or gain from the disposition of a 
controlled foreign corporation target affiliate (CFC T affiliate) asset 
is not subject to the consistency rules of paragraph (h)(2). The 
regulation states that if a CFC T affiliate pays a dividend to a target 
(T) or a domestic T affiliate wholly or partially out of the earnings 
generated by the disposition of that asset, and the dividend increases 
the basis of the T stock under Sec. 1.1502-32, then the basis of the 
stock of the CFC T affiliate is reduced by the amount of the dividend 
that was paid from the earnings and profits resulting from the asset 
disposition. This rule applies to any actual dividend, amount treated 
as a dividend under section 1248 (or that would have been so treated 
but for section 1291) or amount included in income under section 
951(a)(1)(B).
    The final regulations retain this rule. The final regulations also 
add a special ordering rule, in Sec. 1.338-4(h)(4)(ii), clarifying that 
any such dividend is first considered attributable to earnings and 
profits resulting from the disposition of the asset.
    Section 1.338-4(h)(4)(ii) is clarified to state that the basis of 
the stock of a controlled foreign corporation may not be reduced below 
zero under the carryover basis rules of Sec. 1.338-4.
    Section 1.338-4(h)(2)(iv)(A) and Sec. 1.338-4(h)(4)(iii)(A) are 
added to allow the purchasing group in certain instances to increase 
the basis of the CFC T stock by the amount of either the basis increase 
denied under Sec. 1.338-4(h)(2)(ii) or the basis reduction required 
under Sec. 1.338-4(h)(4)(ii). The rule applies when the purchasing 
group disposes of an asset acquired from CFC T that is subject to the 
consistency rules to an unrelated party in a taxable transaction and 
includes in U.S. gross income the greater of (i) the income or gain 
equal to the basis amount denied to the asset under either Sec. 1.338-
4(h)(2)(i) or Sec. 1.338-4(g) and Sec. 1.338-4(h)(4)(i), respectively, 
or (ii) the gain recognized on the asset.
    Similarly, Sec. 1.338-4(h)(2)(iv)(B) and Sec. 1.338-4(h)(4)(iii)(B) 
are added to allow the purchasing group to increase the basis of an 
asset acquired from CFC T that is subject to the consistency rules by 
the basis amount denied to the asset under either Sec. 1.338-4(h)(2)(i) 
or Sec. 1.338-4(g) and Sec. 1.338-4(h)(4)(i). The rule applies when the 
purchasing group disposes of the stock of CFC T to an unrelated party 
in a taxable transaction and includes in U.S. gross income the greater 
of (i) the gain equal to the basis increase denied under Sec. 1.338-
4(h)(2)(ii) or the basis reduction required under Sec. 1.338-
4(h)(4)(ii), respectively, or (ii) the gain recognized in the stock.

Special Analyses

    It has been determined that this final regulation is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
does not apply to these regulations, and because the notice of proposed 
rulemaking preceding the regulations was issued prior to March 29, 1996 
the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. 
Therefore, a regulatory flexibility analysis is not required. Pursuant 
to section 7805(f) of the Internal Revenue Code, the notice of proposed 
rulemaking preceding these regulations was submitted to the Small 
Business Administration for comment on its impact on small businesses.

    Drafting Information: The principal author of these regulations 
is Kenneth D. Allison of the Office of Associate Chief Counsel 
(International), IRS. However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entry for Section 1.338-4T(h) to read as follows:

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

    Par. 2. In Sec. 1.338-0, the outline of topics is amended by 
revising the entry for Sec. 1.338-4(h) and removing the entry for 
Sec. 1.338-4T to read as follows:


Sec. 1.338-0  Outline of topics.

* * * * *


Sec. 1.338-4  Asset and stock consistency.

* * * * *
    (h) Consistency for target affiliates that are controlled 
foreign corporations.
    (1) In general.
    (2) Income or gain resulting from asset dispositions.
    (i) General rule.
    (ii) Basis of controlled foreign corporation stock.
    (iii) Operating rule.
    (iv) Increase in asset or stock basis.
    (3) Stock issued by target affiliate that is a controlled 
foreign corporation.
    (4) Certain distributions.
    (i) General rule.
    (ii) Basis of controlled foreign corporation stock.
    (iii) Increase in asset or stock basis.
    (5) Examples.
* * * * *
    Par. 3. Section 1.338-4 is amended as follows:
    1. Paragraph (a)(5) is amended by removing the language ``Section 
1.338-4T(h)'' and adding ``Paragraph (h) of this section'' in its 
place.
    2. Paragraph (c)(4) is amended by removing the language 
``Sec. 1.338-4T(h)(2)'' and adding ``paragraph (h)(2) of this section'' 
in its place.
    3. Paragraph (d)(2)(iii) is amended by removing the language 
``Sec. 1.338-4T(h)(3)'' and adding ``paragraph (h)(3) of this section'' 
in its place.
    4. Paragraph (g)(2) is amended by removing the language 
``Sec. 1.338-4T(h)(4)'' and adding ``paragraph (h)(4) of this section'' 
in its place.
    5. Paragraph (h) is revised.
    6. Paragraph (j)(3)(i)(A)(2) is amended by removing the language 
``Sec. 1.338-4T(h)'' and adding ``paragraph (h) of this section'' in 
its place.

[[Page 3460]]

    The revision reads as follows:


Sec. 1.338-4  Asset and stock consistency.

* * * * *
    (h) Consistency for target affiliates that are controlled foreign 
corporations--(1) In general. This paragraph (h) applies only if target 
is a domestic corporation. For additional rules that may apply with 
respect to controlled foreign corporations, see paragraph (g) of this 
section. The definitions and nomenclature of Sec. 1.338-1 (b) and (c) 
and paragraph (e) of this section apply for purposes of this section.
    (2) Income or gain resulting from asset dispositions--(i) General 
rule. Income or gain of a target affiliate that is a controlled foreign 
corporation from the disposition of an asset is not reflected in the 
basis of target stock under paragraph (c) of this section unless the 
income or gain results in an inclusion under section 951(a)(1)(A), 
951(a)(1)(C), 1291 or 1293.
    (ii) Basis of controlled foreign corporation stock. If, by reason 
of paragraph (h)(2)(i) of this section, the carryover basis rules of 
this section apply to an asset, no increase in basis in the stock of a 
controlled foreign corporation under section 961(a) or 1293(d)(1), or 
under regulations issued pursuant to section 1297(b)(5), is allowed to 
target or a target affiliate to the extent the increase is attributable 
to income or gain described in paragraph (h)(2)(i) of this section. A 
similar rule applies to the basis of any property by reason of which 
the stock of the controlled foreign corporation is considered owned 
under section 958(a)(2) or 1297(a).
    (iii) Operating rule. For purposes of this paragraph (h)(2)--
    (A) If there is an income inclusion under section 951 (a)(1) (A) or 
(C), the shareholder's income inclusion is first attributed to the 
income or gain of the controlled foreign corporation from the 
disposition of the asset to the extent of the shareholder's pro rata 
share of such income or gain; and
    (B) Any income or gain under section 1293 is first attributed to 
the income or gain from the disposition of the asset to the extent of 
the shareholder's pro rata share of the income or gain.
    (iv) Increase in asset or stock basis--(A) If the carryover basis 
rules under paragraph (h)(2)(i) of this section apply to an asset, and 
the purchasing corporation disposes of the asset to an unrelated party 
in a taxable transaction and recognizes and includes in its U.S. gross 
income or the U.S. gross income of its shareholders the greater of the 
income or gain from the disposition of the asset by the selling 
controlled foreign corporation that was reflected in the basis of the 
target stock under paragraph (c) of this section, or the gain 
recognized on the asset by the purchasing corporation on the 
disposition of the asset, then the purchasing corporation or the target 
or a target affiliate, as appropriate, shall increase the basis of the 
selling controlled foreign corporation stock subject to paragraph 
(h)(2)(ii) of this section, as of the date of the disposition of the 
asset by the purchasing corporation, by the amount of the basis 
increase that was denied under paragraph (h)(2)(ii) of this section. 
The preceding sentence shall apply only to the extent that the 
controlled foreign corporation stock is owned (within the meaning of 
section 958(a)) by a member of the purchasing corporation's affiliated 
group.
    (B) If the carryover basis rules under paragraph (h)(2)(i) of this 
section apply to an asset, and the purchasing corporation or the target 
or a target affiliate, as appropriate, disposes of the stock of the 
selling controlled foreign corporation to an unrelated party in a 
taxable transaction and recognizes and includes in its U.S. gross 
income or the U.S. gross income of its shareholders the greater of the 
gain equal to the basis increase that was denied under paragraph 
(h)(2)(ii) of this section, or the gain recognized in the stock by the 
purchasing corporation or by the target or a target affiliate, as 
appropriate, on the disposition of the stock, then the purchasing 
corporation shall increase the basis of the asset, as of the date of 
the disposition of the stock of the selling controlled foreign 
corporation by the purchasing corporation or by the target or a target 
affiliate, as appropriate, by the amount of the basis increase that was 
denied pursuant to paragraph (h)(2)(i) of this section. The preceding 
sentence shall apply only to the extent that the asset is owned (within 
the meaning of section 958(a)) by a member of the purchasing 
corporation's affiliated group.
    (3) Stock issued by target affiliate that is a controlled foreign 
corporation. The exception to the carryover basis rules of this section 
provided in paragraph (d)(2)(iii) of this section does not apply to 
stock issued by a target affiliate that is a controlled foreign 
corporation. After applying the carryover basis rules of this section 
to the stock, the basis in the stock is increased by the amount treated 
as a dividend under section 1248 on the disposition of the stock (or 
that would have been so treated but for section 1291), except to the 
extent the basis increase is attributable to the disposition of an 
asset in which a carryover basis is taken under this section.
    (4) Certain distributions--(i) General rule. In the case of a 
target affiliate that is a controlled foreign corporation, paragraph 
(g) of this section applies with respect to the target affiliate by 
treating any reference to a dividend to which section 243(a)(3) applies 
as a reference to any amount taken into account under Sec. 1.1502-32 in 
determining the basis of target stock that is--
    (A) A dividend;
    (B) An amount treated as a dividend under section 1248 (or that 
would have been so treated but for section 1291); or
    (C) An amount included in income under section 951(a)(1)(B).
    (ii) Basis of controlled foreign corporation stock. If the 
carryover basis rules of this section apply to an asset, the basis in 
the stock of the controlled foreign corporation (or any property by 
reason of which the stock is considered owned under section 958(a)(2)) 
is reduced (but not below zero) by the sum of any amounts that are 
treated, solely by reason of the disposition of the asset, as a 
dividend, amount treated as a dividend under section 1248 (or that 
would have been so treated but for section 1291), or amount included in 
income under section 951(a)(1)(B). For this purpose, any dividend, 
amount treated as a dividend under section 1248 (or that would have 
been so treated but for section 1291), or amount included in income 
under section 951(a)(1)(B) is considered attributable first to earnings 
and profits resulting from the disposition of the asset.
    (iii) Increase in asset or stock basis--(A) If the carryover basis 
rules under paragraphs (g) and (h)(4)(i) of this section apply to an 
asset, and the purchasing corporation disposes of the asset to an 
unrelated party in a taxable transaction and recognizes and includes in 
its U.S. gross income or the U.S. gross income of its shareholders the 
greater of the gain equal to the basis increase denied in the asset 
pursuant to paragraphs (g) and (h)(4)(i) of this section, or the gain 
recognized on the asset by the purchasing corporation on the 
disposition of the asset, then the purchasing corporation or the target 
or a target affiliate, as appropriate, shall increase the basis of the 
selling controlled foreign corporation stock subject to paragraph 
(h)(4)(ii) of this section, as of the date of the disposition of the 
asset by the purchasing corporation, by the amount of the basis 
reduction under paragraph (h)(4)(ii) of this section. The preceding 
sentence shall apply only to the extent that the

[[Page 3461]]

controlled foreign corporation stock is owned (within the meaning of 
section 958(a)) by a member of the purchasing corporation's affiliated 
group.
    (B) If the carryover basis rules under paragraphs (g) and (h)(4)(i) 
of this section apply to an asset, and the purchasing corporation or 
the target or a target affiliate, as appropriate, disposes of the stock 
of the selling controlled foreign corporation to an unrelated party in 
a taxable transaction and recognizes and includes in its U.S. gross 
income or the U.S. gross income of its shareholders the greater of the 
amount of the basis reduction under paragraph (h)(4)(ii) of this 
section, or the gain recognized in the stock by the purchasing 
corporation or by the target or a target affiliate, as appropriate, on 
the disposition of the stock, then the purchasing corporation shall 
increase the basis of the asset, as of the date of the disposition of 
the stock of the selling controlled foreign corporation by the 
purchasing corporation or by the target or a target affiliate, as 
appropriate, by the amount of the basis increase that was denied 
pursuant to paragraphs (g) and (h)(4)(i) of this section. The preceding 
sentence shall apply only to the extent that the asset is owned (within 
the meaning of section 958(a)) by a member of the purchasing 
corporation's affiliated group.
    (5) Examples. This paragraph (h) may be illustrated by the 
following examples:

    Example 1. Stock of target affiliate that is a CFC. (a) The S 
group files a consolidated return; however, T2 is a controlled 
foreign corporation. On December 1 of Year 1, T1 sells the T2 stock 
to P and recognizes gain. On January 2 of Year 2, P makes a 
qualified stock purchase of T from S. No section 338 election is 
made for T.
    (b) Under paragraph (b)(1) of this section, paragraph (d) of 
this section applies to the T2 stock. Under paragraph (h)(3) of this 
section, paragraph (d)(2)(iii) of this section does not apply to the 
T2 stock. Consequently, paragraph (d)(1) of this section applies to 
the T2 stock. However, after applying paragraph (d)(1) of this 
section, P's basis in the T2 stock is increased by the amount of 
T1's gain on the sale of the T2 stock that is treated as a dividend 
under section 1248. Because P has a carryover basis in the T2 stock, 
the T2 stock is not considered purchased within the meaning of 
section 338(h)(3) and no section 338 election may be made for T2.
    Example 2. Stock of target affiliate CFC; inclusion under 
subpart F. (a) The S group files a consolidated return; however, T2 
is a controlled foreign corporation. On December 1 of Year 1, T2 
sells an asset to P and recognizes subpart F income that results in 
an inclusion in T1's gross income under section 951(a)(1)(A). On 
January 2 of Year 2, P makes a qualified stock purchase of T from S. 
No section 338 election is made for T.
    (b) Because gain from the disposition of the asset results in an 
inclusion under section 951(a)(1)(A), the gain is reflected in the 
basis of the T stock as of T's acquisition date. See paragraph 
(h)(2)(i) of this section. Consequently, under paragraph (b)(1) of 
this section, paragraph (d)(1) of this section applies to the asset. 
In addition, under paragraph (h)(2)(ii) of this section, T1's basis 
in the T2 stock is not increased under section 961(a) by the amount 
of the inclusion that is attributable to the sale of the asset.
    (c) If, in addition to making a qualified stock purchase of T, P 
acquires the T2 stock from T1 on January 1 of Year 2, the results 
are the same for the asset sold by T2. In addition, under paragraph 
(h)(2)(ii) of this section, T1's basis in the T2 stock is not 
increased by the amount of the inclusion that is attributable to the 
gain on the sale of the asset. Further, under paragraph (h)(3) of 
this section, paragraph (d)(1) of this section applies to the T2 
stock. However, after applying paragraph (d)(1) of this section, P's 
basis in the T2 stock is increased by the amount of T1's gain on the 
sale of the T2 stock that is treated as a dividend under section 
1248. Finally, because P has a carryover basis in the T2 stock, the 
T2 stock is not considered purchased within the meaning of section 
338(h)(3) and no section 338 election may be made for T2.
    (d) If P makes a qualified stock purchase of T2 from T1, rather 
than of T from S, and T1's gain on the sale of T2 is treated as a 
dividend under section 1248, under paragraph (h)(1) of this section, 
paragraphs (h)(2) and (3) of this section do not apply because there 
is no target that is a domestic corporation. Consequently, the 
carryover basis rules of paragraph do not apply to the asset sold by 
T2 or the T2 stock.
    Example 3. Gain reflected by reason of section 1248 dividend; 
gain from non-subpart F asset. (a) The S group files a consolidated 
return; however, T2 is a controlled foreign corporation. In Years 1 
through 4, T2 does not pay any dividends to T1 and no amount is 
included in T1's income under section 951(a)(1)(B). On December 1 of 
Year 4, T2 sells an asset with a basis of $400,000 to P for 
$900,000. T2's gain of $500,000 is not subpart F income. On December 
15 of Year 4, T1 sells T2, in which it has a basis of $600,000, to P 
for $1,600,000. Under section 1248, $800,000 of T1's gain of 
$1,000,000 is treated as a dividend. However, in the absence of the 
sale of the asset by T2 to P, only $300,000 would have been treated 
as a dividend under section 1248. On December 30 of Year 4, P makes 
a qualified stock purchase of T1 from T. No section 338 election is 
made for T1.
    (b) Under paragraph (h)(4) of this section, paragraph (g)(2) of 
this section applies by reference to the amount treated as a 
dividend under section 1248 on the disposition of the T2 stock. 
Because the amount treated as a dividend is taken into account in 
determining T's basis in the T1 stock under Sec. 1.1502-32, the sale 
of the T2 stock and the deemed dividend have the effect of a 
transaction described in paragraph (g)(1) of this section. 
Consequently, paragraph (d)(1) of this section applies to the asset 
sold by T2 to P and P's basis in the asset is $400,000 as of 
December 1 of Year 4.
    (c) Under paragraph (h)(3) of this section, paragraph (d)(1) of 
this section applies to the T2 stock and P's basis in the T2 stock 
is $600,000 as of December 15 of Year 4. Under paragraphs (h)(3) and 
(4)(ii) of this section, however, P's basis in the T2 stock is 
increased by $300,000 (the amount of T1's gain treated as a dividend 
under section 1248 ($800,000), other than the amount treated as a 
dividend solely as a result of the sale of the asset by T2 to P 
($500,000)) to $900,000.
* * * * *


Sec. 1.338-4T  [Removed]

    Par. 4. Section 1.338-4T is removed.
    Par. 5. In Sec. 1.338(i)-1, paragraphs (a) and (b) are revised to 
read as follows:


Sec. 1.338(i)-1  Effective dates.

    (a) In general. Sections 1.338-1 through 1.338-5 (except 
Sec. 1.338-4(h)), 1.338(b)-1, and 1.338(h)(10)-1 generally are 
applicable for targets with acquisition dates on or after January 
20, 1994. Section 1.338-4(h) is applicable for targets with 
acquisition dates on or after January 20, 1997. Section 1.338-4T(h) 
(as contained in 26 CFR part 1 as revised April 1, 1996) is 
generally applicable for targets with acquisition dates on or after 
January 20, 1994, and before January 20, 1997.
    (b) Elective retroactive application. A target with an 
acquisition date on or after January 14, 1992 and before January 20, 
1994 may apply Secs. 1.338-1 through 1.338-5, 1.338-4T(h) (as 
contained in 26 CFR part 1 as revised April 1, 1996), 1.338(b)-1, 
and 1.338(h)(10)-1 by including a statement with its return 
(including a timely filed amended return) for the period that 
includes the acquisition date to the effect that it is applying all 
of these sections pursuant to this paragraph (b). A target with an 
acquisition date on or after January 14, 1992, and before January 
20, 1997, may choose to apply Sec. 1.338-4(h) for the period that 
includes the acquisition date pursuant to paragraph (b) of this 
section.
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: January 13, 1997.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 97-1521 Filed 1-22-97; 8:45 am]
BILLING CODE 4830-01-U