[Federal Register Volume 70, Number 164 (Thursday, August 25, 2005)]
[Proposed Rules]
[Pages 49897-49900]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-16715]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-133578-05]
RIN 1545-BE74


Dividends Paid Deduction for Stock Held in Employee Stock 
Ownership Plan

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under sections 
162(k) and 404(k) of the Internal Revenue Code (Code) relating to 
employee stock ownership plans (ESOPs). The regulations provide 
guidance concerning which corporation is entitled to the deduction for 
applicable dividends under section 404(k). These regulations also 
clarify that a payment in redemption of employer securities held by an 
ESOP is not deductible. These regulations will affect administrators 
of, employers maintaining, participants in, and beneficiaries of ESOPs. 
In addition, they will affect corporations that make distributions in 
redemption of stock held in an ESOP.

DATES: Written or electronic comments and requests for a public hearing 
must be received by November 23, 2005.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-133578-05), room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
133578-05), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
comments electronically directly to the IRS Internet site at http://www.irs.gov/regs, or via the Federal eRulemaking Portal at http://www.regulations.gov (IRS-REG-133578-05).

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, John T. 
Ricotta at (202) 622-6060 with respect to section 404(k) or Martin Huck 
at (202) 622-7750 with respect to section 162(k); concerning submission 
of comments or to request a public hearing, Robin Jones at (202) 622-
7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

    This document contains proposed regulations under sections 162(k) 
and 404(k) of the Internal Revenue Code (Code). These regulations 
address two issues that have arisen in the application of these 
sections. The first issue arises in a case in which the applicable 
employer securities held in an employee stock ownership plan (ESOP) are 
not securities of the corporation or corporations that maintain the 
plan. The issue is which corporation is entitled to the deduction under 
section 404(k) for certain dividends paid with respect to the stock 
held in the ESOP. The second issue is whether payments in redemption of 
stock held by an ESOP are deductible.

Code and Regulations

    Section 404(a) provides that contributions paid by an employer to 
or under a stock bonus, pension, profit sharing, or annuity plan are 
deductible under section 404(a), if they would be otherwise deductible, 
within the limitations of that section. Section 404(k)(1) provides 
that, in the case of a C corporation, there is allowed as a deduction 
for a taxable year the amount of any applicable dividend paid in cash 
by such corporation during the taxable year with respect to applicable 
employer securities held by an ESOP. The deduction under section 404(k) 
is in addition to the deductions allowed under section 404(a).
    Section 4975(e)(7) provides, in relevant part, that an ESOP is a 
defined contribution plan that is a stock bonus plan qualified under 
section 401(a) and designed to invest primarily in qualifying employer 
securities. Section 4975(e)(8) states that the term qualifying employer 
security means any employer security within the meaning of section 
409(l). Section 409(l) generally provides that the term employer 
security means common stock issued by the employer (or a corporation 
that is a member of the same controlled group) that is readily tradable 
on an established securities market, if the corporation (or a member of 
the controlled group) has common stock that is readily tradable on an 
established securities market. Section 409(l)(4)(A) provides that, for 
purposes of section 409(l), the term controlled group of corporations 
has the meaning given to that term by section 1563(a) (determined 
without regard to subsections (a)(4) and (e)(3)(C) of section 1563). 
Section 409(l)(4)(B) provides that, for purposes of section 
409(l)(4)(A), if a common parent owns directly stock possessing at 
least 50 percent of the voting power of all classes of stock and at 
least 50 percent of each class of nonvoting stock in a first tier 
subsidiary, such subsidiary (and all corporations below it in the chain 
which would meet the 80 percent test of section 1563(a) if the first 
tier subsidiary were the common parent) are treated as includible 
corporations.
    Section 404(k)(2), for taxable years beginning on or after January 
1, 2002, generally provides that the term applicable dividend means any 
dividend which, in accordance with the plan provisions--(i) is paid in 
cash to the participants in the plan or their beneficiaries, (ii) is 
paid to the plan and is distributed in cash to participants in the plan 
or their beneficiaries not later than 90 days after the close of the 
plan year in which paid, (iii) is, at the election of such participants 
or their beneficiaries--(I) payable as provided in clause (i) or (ii), 
or (II) paid to the plan and reinvested in qualifying employer 
securities, or (iv) is used to make payments on a loan described in 
section 404(a)(9), the proceeds of which were used to acquire the 
employer securities (whether or not allocated to participants) with 
respect to which the dividend is paid. Under section 404(k)(4), the 
deduction is allowable in the taxable year of the corporation in which 
the dividend is paid or distributed to a participant or beneficiary.
    Prior to 2002, section 404(k)(5)(A) provided that the Secretary may 
disallow the deduction under section 404(k) for any dividend if the 
Secretary determines that such dividend constitutes, in substance, an 
evasion of

[[Page 49898]]

taxation. Section 662(b) of the Economic Growth and Tax Relief 
Reconciliation Act of 2001 (115 Stat. 38, 2001) amended section 
404(k)(5)(A) to provide that the Secretary may disallow a deduction 
under section 404(k) for any dividend the Secretary determines 
constitutes, in substance, an avoidance or evasion of taxation. The 
amendment is effective for tax years after December 31, 2001.
    Section 162(k)(1) generally provides that no deduction otherwise 
allowable under chapter 1 of the Code is allowed for any amount paid or 
incurred by a corporation in connection with the reacquisition of its 
stock or the stock of any related person (as defined in section 
465(b)(3)(C)). The legislative history of section 162(k) states that 
the phrase ``in connection with'' is ``intended to be construed 
broadly.'' H.R. Conf. Rep. No. 99-841, at 168 (1986).

Corporation Entitled to Section 404(k) Deduction

    An ESOP may benefit employees of more than one corporation. In 
addition, an ESOP may be maintained by a corporation other than the 
payor of a dividend. In these cases, the issue arises as to which 
entity is entitled to the deduction provided under section 404(k). 
Assume, for example, that a publicly traded corporation owns all of the 
stock of a subsidiary. The subsidiary operates a trade or business with 
employees in the U.S. and maintains an ESOP that holds stock of its 
parent for its employees. If the parent distributes a dividend with 
respect to its stock held in the ESOP maintained by the subsidiary, 
questions have arisen as to whether the parent or subsidiary is 
entitled to the deduction under section 404(k). This question arises in 
cases in which the parent and subsidiary file a consolidated return as 
well as in cases in which the parent and subsidiary do not file a 
consolidated return.
    The IRS and Treasury Department believe that the statutory language 
of section 404(k) clearly provides that only the payor of the 
applicable dividend is entitled to the deduction under section 404(k), 
regardless of whether the employees of multiple corporations benefit 
under the ESOP and regardless of whether another member of the 
controlled group maintains the ESOP. Therefore, in the example above, 
the parent, not the subsidiary, is entitled to the deduction under 
section 404(k).

Treatment of Payments Made To Reacquire Stock

    Some corporations have claimed deductions under section 404(k) for 
payments in redemption of stock held by an ESOP that are used to make 
benefit distributions to participants or beneficiaries, including 
distributions of a participant's account balance upon severance from 
employment. These taxpayers have argued that the payments in redemption 
qualify as dividends under sections 301 and 316 and, therefore, are 
deductible under section 404(k).
    In Rev. Rul. 2001-6 (2001-1 C.B. 491), the IRS concluded that 
section 162(k) bars a deduction for payments made in redemption of 
stock from an ESOP. This conclusion was based on the fact that section 
162(k)(1) disallows a deduction for payments paid in connection with 
the reacquisition of an issuer's stock and that the redemption payments 
are such payments. The IRS also concluded that such payments were not 
applicable dividends under section 404(k)(1). The IRS reasoned that 
allowing a deduction for redemption amounts would vitiate important 
rights and protections for recipients of ESOP distributions, including 
the right to reduce taxes by utilizing the return of basis provisions 
under section 72, the right to make rollovers of ESOP distributions 
received upon separation from service, and the protection against 
involuntary cash-outs. Finally, the IRS stated that a deduction under 
section 404(k)(1) for such amounts would constitute, in substance, an 
evasion of tax.
    In Boise Cascade Corporation v. United States, 329 F.3d 751 (9th 
Cir. 2003), the Court of Appeals for the Ninth Circuit held that 
payments made by a corporation to redeem its stock held by its ESOP 
were deductible as dividends paid under section 404(k), and that the 
deduction was not precluded by section 162(k). The court reasoned that 
the distribution by the ESOP of the redemption proceeds to the 
participants was a transaction separate from the redemption 
transaction. Therefore, the court concluded that the distribution did 
not constitute a payment in connection with the corporation's 
reacquisition of its stock, and section 162(k) did not bar the 
deduction of such payments.
    For the reasons stated in Rev. Rul. 2001-6, the IRS and Treasury 
Department continue to believe that allowing a deduction for amounts 
paid to reacquire stock is inconsistent with the intent of, and 
policies underlying, section 404. In addition, the IRS and Treasury 
Department believe that allowing such a deduction would constitute, in 
substance, an avoidance or evasion of taxation within the meaning of 
section 404(k)(5)(A) because it would allow a corporation to claim two 
deductions for the same economic cost: once for the value of the stock 
originally contributed to the ESOP and again for the amount paid to 
redeem the same stock. See Charles Ilfeld Co. v. Hernandez, 292 U.S. 62 
(1934). Moreover, despite the Ninth Circuit's conclusion in Boise 
Cascade, the IRS and Treasury Department continue to believe that, even 
if a payment in redemption of stock held by an ESOP were to qualify as 
an applicable dividend, section 162(k) would disallow a deduction for 
that amount because such payment would be in connection with the 
reacquisition of the corporation's stock.
    This notice of proposed rulemaking, therefore, includes proposed 
regulations under section 404(k) that confirm that payments made to 
reacquire stock held by an ESOP are not deductible under section 404(k) 
because such payments do not constitute applicable dividends under 
section 404(k)(2) and a deduction for such payments would constitute, 
in substance, an avoidance or evasion of taxation within the meaning of 
section 404(k)(5). It also includes proposed regulations under section 
162(k) that provide that section 162(k), subject to certain exceptions, 
disallows any deduction for amounts paid or incurred by a corporation 
in connection with the reacquisition of its stock or the stock of any 
related person (as defined in section 465(b)(3)(C)). The proposed 
regulations also provide that amounts paid or incurred in connection 
with the reacquisition of stock include amounts paid by a corporation 
to reacquire its stock from an ESOP that are then distributed by the 
ESOP to its participants (or their beneficiaries) or otherwise used in 
a manner described in section 404(k)(2)(A).

Proposed Effective Date

    These regulations are proposed to be effective on the date of 
issuance of final regulations. However, before these regulations become 
effective, the IRS will continue to assert in any matter in controversy 
outside of the Ninth Circuit that sections 162(k) and 404(k) disallow a 
deduction for payments to reacquire employer securities held by an 
ESOP. See Chief Counsel Notice 2004-038 (October 1, 2004) available at 
http://www.irs.gov/foia through the electronic reading room.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure

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Act (5 U.S.C. chapter 5) does not apply to these regulations, and, 
because the regulations do not impose a collection of information on 
small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
does not apply. Pursuant to section 7805(f) of the Code, this notice of 
proposed rulemaking will be submitted to the Chief Counsel for Advocacy 
of the Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department specifically request comments on 
the clarity of the proposed regulations and how they may be made easier 
to understand. All comments will be available for public inspection and 
copying. A public hearing will be scheduled if requested in writing by 
any person that timely submits written comments. If a public hearing is 
scheduled, notice of the date, time, and place for the public hearing 
will be published in the Federal Register.

Drafting Information

    The principal authors of these regulations are John T. Ricotta, 
Office of Division Counsel/Associate Chief Counsel (Tax Exempt and 
Government Entities) and Martin Huck of Office of Associate Chief 
Counsel (Corporate). However, other personnel from the IRS and Treasury 
participated in the development of these regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended to read, 
in part, as follows:

    Authority: 26 U.S.C. 7805 * * *.
    Section 1.162(k)-1 is also issued under 26 U.S.C. 162(k) * * *.
    Section 1.404(k)-3 is also issued under 26 U.S.C. 162(k) and 
404(k)(5)(A) * * *.

    Par. 2. Section 1.162(k)-1 is added to read as follows:


Sec.  1.162(k)-1  Disallowance of deduction for reacquisition payments.

    (a) In general. Except as provided in paragraph (b) of this 
section, no deduction otherwise allowable is allowed under Chapter 1 of 
the Internal Revenue Code for any amount paid or incurred by a 
corporation in connection with the reacquisition of its stock or the 
stock of any related person (as defined in section 465(b)(3)(C)). 
Amounts paid or incurred in connection with the reacquisition of stock 
include amounts paid by a corporation to reacquire its stock from an 
ESOP that are used in a manner described in section 404(k)(2)(A). See 
Sec.  1.404(k)-3.
    (b) Exceptions. Paragraph (a) of this section does not apply to 
any--
    (i) Deduction allowable under section 163 (relating to interest);
    (ii) Deduction for amounts that are properly allocable to 
indebtedness and amortized over the term of such indebtedness;
    (iii) Deduction for dividends paid (within the meaning of section 
561); or
    (iv) Amount paid or incurred in connection with the redemption of 
any stock in a regulated investment company that issues only stock 
which is redeemable upon the demand of the shareholder.
    (c) Effective date. This section applies with respect to amounts 
paid or incurred on or after the date these regulations are published 
as final regulations in the Federal Register.
    Par. 3. Section 1.404(k)-2 is added to read as follows:


Sec.  1.404(k)-2  Dividends paid by corporation not maintaining ESOP.

    Q-1: What corporation is entitled to the deduction provided under 
section 404(k) for applicable dividends paid on applicable employer 
securities of a C corporation held by an ESOP if the ESOP benefits 
employees of more than one corporation or if the corporation paying the 
dividend is not the corporation maintaining the plan?
    A-1: (a) In general. Under section 404(k), only the corporation 
paying the dividend is entitled to the deduction with respect to 
applicable employer securities held by an ESOP. Thus, no deduction is 
permitted to a corporation maintaining the ESOP if that corporation 
does not pay the dividend.
    (b) Example. (i) Facts. S is a U.S. corporation that is wholly 
owned by P, an entity organized under the laws of Country A that is 
classified as a corporation for Federal income tax purposes. P is not 
engaged in a U.S. trade or business. P has a single class of common 
stock that is listed on a stock exchange in a foreign country. In 
addition, these shares are listed on the New York Stock Exchange, in 
the form of American Depositary Shares, and are actively traded through 
American Depositary Receipts (ADRs) meeting the requirements of section 
409(l). S maintains an ESOP for its employees. The ESOP holds ADRs of P 
on Date X and receives a dividend with respect to those employer 
securities. The dividends received by the ESOP constitute applicable 
dividends as described in section 404(k)(2).
    (ii) Conclusion. P, as the payor of the dividend, is entitled to a 
deduction under section 404(k) with respect to the dividends, although 
as a foreign corporation P does not obtain a U.S. tax benefit from the 
deduction. No corporation other than the corporation paying the 
dividend is entitled to the deduction under section 404(k). Thus, 
because S did not pay the dividends, S is not entitled to a deduction 
under section 404(k). The answer would be the same if P is a U.S. C 
corporation.
    Q-2: What is the effective date of this section?
    A-2: This section applies with respect to dividends paid on or 
after the date these regulations are published as final regulations in 
the Federal Register.
    Par. 4. Section 1.404(k)-3 is added to read as follows:


Sec.  1.404(k)-3  Disallowance of deduction for reacquisition payments.

    Q-1: Are payments to reacquire stock held by an ESOP applicable 
dividends that are deductible under section 404(k)(1)?
    A-1: (a) Payments to reacquire stock held by an ESOP, including 
reacquisition payments that are used to make benefit distributions to 
participants or beneficiaries, are not deductible under section 404(k) 
because--
    (1) Those payments do not constitute applicable dividends under 
section 404(k)(2); and
    (2) The treatment of those payments as applicable dividends would 
constitute, in substance, an avoidance or evasion on taxation within 
the meaning of section 404(k)(5).
    (b) See Sec.  1.162(k)-1 concerning the disallowance of deductions 
for amounts paid or incurred by a corporation in connection with the 
reacquisition of its stock from an ESOP.
    Q-2: What is the effective date of this section?
    A-2: This section applies with respect to payments to reacquire 
stock that are made on or after the date these

[[Page 49900]]

regulations are published as final regulations in the Federal Register.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 05-16715 Filed 8-24-05; 8:45 am]
BILLING CODE 4830-01-P