A SECOND SCHEME TO RELEASE FOREIGN TAX CREDITS also was shot down
A US parent company owned an offshore subsidiary that had paid foreign taxes on its earnings. The subsidiary plowed the earnings back into its business so that it had no cash to pay a dividend to the US parent. A dividend would have released the foreign tax credits for use in the United States.
Therefore, the US parent made a capital contribution of cash to the subsidiary and received back more shares for its capital contribution. The subsidiary then used the cash a few days later to pay a dividend to the parent, thereby releasing the foreign tax credits. However, the parent described the capital contribution and quick dividend back in a footnote to its financial statements as “in substance . . . a transfer of retained earnings to paid-in capital.”
The IRS refused to recognize the cash dividend on audit. It said that what the US parent company really received was a dividend of more stock in the subsidiary. Stock dividends do not release foreign tax credits. The IRS explained its position in a “field service advice” that the agency made public in late September. The number is FSA 200135020.
The case serves as a warning not to assume favorable tax consequences from circling cash.