While much of the focus on tax reform has been the interpretation and implementation of the newly adopted rules, it is also worth considering how the changes adopted in tax reform have given new life to some preexisting provisions. One such provision regarding “extraordinary dividends” is section 1059.
Section 1059 requires a taxpayer that receives an extraordinary dividend to reduce its basis in the stock of the distributing corporation by the nontaxed portion of the dividend; to the extent that the nontaxed portion exceeds basis, the taxpayer is required to recognize gain. Extraordinary dividend is defined as any dividend the amount of which equals or exceeds 5 percent of the basis in the preferred stock or 10 percent of the basis in any non-preferred stock. The nontaxed portion is defined as the amount excluded from gross income by virtue of a dividend received deduction under sections 243, 245 and 245A.
Taxpayers are generally not subject to section 1059 if they have held the stock of the distributing corporation for more than two years at the time of the dividend announcement date. This two-year rule, however, does not apply to an extraordinary dividend distributed in a redemption that falls within one of three categories: (1) a redemption that is part of a partial liquidation of the redeeming corporation; (2) a redemption that is not pro rata as to all shareholders; and (3) a redemption that would not be treated, in whole or in part, as a dividend, had section 304 not applied (or had certain options not been taken into account). A section 356 reorganization “boot” dividend is treated as a redemption for purposes of this rule, meaning that a “boot” extraordinary dividend would be subject to section 1059 regardless of the holding period if the target corporation’s distribution is not pro rata to all of its shareholders. A deemed dividend as a result of a section 304 transaction would be subject to section 1059 regardless of the holding period, provided that the deemed dividend constitutes an extraordinary dividend.
Pre-tax reform, section 1059 was not a frequently confronted provision. While it potentially applied to corporate shareholders of companies making significant one-off dividend distributions, it rarely applied in the section 304 context because section 304 tended not to involve sales by domestic corporations of, or to, domestic corporations (e.g., such that section 243 could have applied).
Even post-tax reform, in many instances section 1059 will continue to be irrelevant because of the prevalence of previously taxed income (PTI) as a result of the transition tax and Global Intangible Low Taxed Income tax (GILTI) provisions. While section 1059 potentially applies to any dividend that constitutes an extraordinary dividend, a distribution of PTI to the US shareholder is not treated as a dividend for US federal income tax purposes. Under section 959, a distribution from a foreign subsidiary is first attributed to PTI and then to untaxed earnings and profits.
On the other hand, because of newly enacted section 245A, taxpayers are more likely to see section 1059 apply when distributing untaxed earnings and profits. Section 245A allows a 100 percent deduction for dividends received from 10 percent owned foreign corporations. To the extent eligible for a section 245A deduction, an extraordinary dividend would be treated as nontaxed for section 1059 purposes, potentially causing a basis reduction and potentially gain recognition. Moreover, section 245A applies to both actual dividends and certain deemed dividends, including deemed dividends under sections 304 and 1248. A sale by a domestic corporation of stock of a foreign corporation to a foreign corporation under section 304 therefore could give rise to section 1059 extraordinary dividend treatment, and section 245A may apply to certain dividends received by a controlled foreign corporation from another controlled foreign corporation.
Taxpayers may structure transactions to manage their risk under section 1059. For example, a section 304 transaction in many instances can be converted to an “all-cash D” reorganization simply by checking the box on the corporation that is sold after the sale. Such an all-cash D reorganization, if structured properly and treated as giving rise to a pro rata redemption, would not cause section 1059 to apply.