Check and Sell – Alive and Well?

Steve Bortnick, a counsel in the New York office of global law firm Dechert LLP examines the implications of recent US Tax Court decisions on the use of “check and sell” strategies.

A popular technique for avoiding Subpart F income on a partial exit is alive, having survived the passage of 2004 legislation that might have killed it.  In mid 2004, the United States Tax Court in Dover Corp. v. Commissioner upheld the taxpayer’s position that a retroactive election to treat a controlled foreign corporation (“CFC”) (hereafter “H&C”) as a disregarded entity had the effect of a deemed liquidation of the CFC into its parent CFC, and that the sale of H&C did not give rise to Subpart F income, which would be immediately taxable to H&C’s US parent.  Dover represented a significant victory to taxpayers.

Under Subpart F of the Internal Revenue Code, certain types of income earned by a CFC, including passive income and capital gains from the sale of assets that give rise to passive income or no income, is deemed to have been distributed (whether or not it actually is distributed) to US shareholders who directly, indirectly or constructively own 10 percent or more of the CFC’s voting stock.  Even gain on the sale of a 100 percent owned subsidiary by a CFC would be considered to generate Subpart F income. On the contrary, capital gains from the sale of most assets that are used, or held for use, in the CFC’s trade or business do not give rise to Subpart F income and, thus, would not be taxable to the US shareholders until distributed to them.  When a CFC holding company disposes of one or more of its portfolio companies, it can cause the portfolio companies to sell their assets directly.  This generally allows US shareholders of the CFC to avoid recognizing Subpart F income.  However, this route could raise issues, such as the need to obtain consents to transfer intangibles or leases, and can result in additional corporate-level taxation in the CFC’s home country.  The sale of stock generally would be preferable to the seller, but this raises the Subpart F issue.  The check and sell technique eliminates these issues.

The United States Tax Court in the Dover case examined the propriety of the check and sell strategy.  The decision is the first court decision addressing the effect of tax regulations, known widely as the check the box regulations, that generally authorize taxpayers to elect to be treated as corporations, partnerships or, in the case of entities owned by a single member, disregarded entities.  H&C was a CFC that was wholly owned by Dover UK, a United Kingdom holding company.  Dover UK was wholly owned by a Delaware corporation and, thus, was itself a CFC.  In 1997, Dover UK entered into an agreement to sell the stock of H&C.  The stock and the consideration therefore exchanged hands approximately 11 days later.  Approximately 27 months after the sale, H&C made an election to be treated as a disregarded entity effective immediately before the sale.  Although a check the box election may be effective up to 75 days prior to the date of filing, he taxpayer had missed the normal deadline and requested (and ultimately received) permission from the IRS to file the election late.

The check the box regulations provide that when an entity previously treated as a corporation elects to be treated as a disregarded entity, the entity is deemed to distribute all of its assets and liabilities to its single owner in liquidation.  These events are treated as occurring immediately before the close of the day before the election is effective, and the election will be effective at the start of the day for which it is elective.  A liquidation of one corporation into another corporation that owns at least 80 percent of the stock of the liquidated corporation is tax-free, and the tax attributes of the liquidated corporation carry over to the parent corporation.  The IRS previously had ruled publicly that the parent corporation should be viewed as if it has always operated the business of the liquidated subsidiary, and reaffirmed this position in various published and private rulings, although none of them specifically related to the provisions in question in Dover.  Additionally, the check the box regulations themselves provide that the activities of a disregarded entity are treated in the same manner as a branch or division of the owner.

Nevertheless, the government argued that because Dover UK never used the assets in its trade or business, gain on the sale of H&C constituted Subpart F income.  The court  found that the IRS itself had rejected the only authority that supported its position in issuing its rulings.  Accordingly, the court held for the taxpayer.  Ironically, the court indicated that the IRS could have issued regulations to prevent the transaction.  In fact, the IRS had proposed regulations that would have prevented the result in Dover, but repealed them in the face of significant criticism from tax practitioners as to their breadth and the need for certainty in tax planning.

Proposed legislation in 2004 contained a provision that would have retroactively authorized the IRS to set aside the favorable tax treatment resulting from a liquidation  (actual or deemed) of the target CFC.  The provision was not aimed specifically at check and sell transactions, but, rather, more generally at some of the transactions effected by Enron and others.  It would have allowed the IRS to ignore the tax benefits afforded to a tax-free liquidation of one corporation into its parent corporation where a principal reason for the liquidation was tax avoidance.

The 2004 legislation was enacted without the offending provision, and the IRS never appealed Dover.  Given the IRS’s distaste for the strategy, it is reasonable to assume that there will be a regulatory response.  Until there is, the strategy can still be used.  Moreover, there seems to be no question that the issues in Dover never would have been raised had H&C elected to be treated as a disregarded entity before Dover UK anticipated selling it.  For this and other reasons, it often is beneficial for subsidiary CFCs to elect to be treated as disregarded entities from inception, or from the time that a private equity fund acquires the CFC.

Unfortunately, in its Options for Compliance Improvement, Tax Expenditure Reform proposal, the Joint Committee on Taxation suggested legislation that would shut down the check and sell strategy by treating a foreign entity as a corporation if the entity is a separate business entity under foreign law and has only one member.  It presently is unclear if or when this proposed legislation will be enacted.

Steve Bortnick is a counsel in the New York office of global law firm Dechert LLP