Imagine a lush green garden on a bright sunny day. A glistening teapot sits on a table in the garden. As you approach the table, you see that the teapot is made of chocolate. It doesn't make sense, does it? What is the use of a teapot that would melt in on itself by the time the hot, steaming tea is poured into a cup?

A similar question may be raised as to the relevance of the 100% dividend received deduction ("D.R.D.") under Code §245A in the context of the gain arising from the sale of the stock of a controlled foreign corporation ("C.F.C.") that is treated as a dividend for certain shareholders.1 This article will discuss exactly that – the usefulness of Code §245A D.R.D. and the interplay between the Code §245A and Code §1248, especially in light of the enactment of the Transition Tax and Global Intangible Low-Taxed Income ("G.I.L.T.I.") regime.


Let's start with the general rule. Assuming no depreciation recapture under Code § 1245 or Code §1250, the amount realized from the sale or other disposition of a capital asset in excess of its adjusted basis is taxed as a capital gain.2 If the asset has been held for more than one year at the time of the sale, the gain is treated as long-term capital gain taxed at the rate of 20%3 if the taxpayer is an individual or 21% for an entity taxed as a corporation. If the property were held for a year or less before the sale, the gain is treated as a short-term capital gain, which is taxed at ordinary rates, up to 37%, in the case of an individual or the same tax rate of 21% for an entity taxed as a corporation.


Generally, a U.S. Shareholder, as defined, recognizes gain or loss on the sale or exchange of stock in a C.F.C. equal to the difference between the sales price and the shareholder's adjusted basis in the stock sold or exchanged. If applicable, Code §1248 recharacterizes the gain from the sale of the stock of a C.F.C. as dividend income (instead of the default capital gain tax treatment).

Code §1248 provides that if a U.S. Person, as defined, sells or exchanges stock in a C.F.C. and that person owns4 10% or more of the total combined voting power of all classes stock entitled to vote, then the gain recognized on the sale or exchange of the stock must be included in the person's gross income as a dividend. The original purpose of the provision was to prevent accumulated earnings in a C.F.C. from being converted to capital gains under prior U.S. tax law, which imposed high tax on dividend income and low tax on capital gains.

Code §1248 includes a five-year look back rule that treats the gain from the sale of the stock of a foreign corporation as a divined even if it is not a C.F.C. at the time of the sale, provided the corporation was a C.F.C. at any time during the five-year period ending on the date of the sale or exchange.

Also, Code §1248 does not apply to any amount of gain that is a short-term capital gain or gain from the sale of an asset that is not a capital asset.5 Again, under prior law, such short-term gain was taxed in the hands of an individual at ordinary income rates, which often exceeded 50%.

Limitations to Dividend Treatment

The gain is treated as a dividend only to the extent of the foreign corporation's earnings and profits ("E&P") attributable to the shares of stock that are sold or exchanged.

The E&P attributable to those shares of stock consist of a pro rata share of the earnings that were accumulated (i) after 1962, (ii) while the taxpayer held the stock, and (iii) while the corporation was a C.F.C.6 In other words, the §1248 dividend is the lesser of two amounts:

- The actual gain recognized on the sale or exchange (which includes redemption or liquidation)

- The E&P attributable to the stock sold or exchanged

The limitation of treating the gain as dividends only to the extent of the foreign corporation's E&P attributable to the disposed stock applies only if the taxpayer establishes the amount of its E&P.7 A taxpayer is said to have established this amount if a schedule is attached to the income tax return for the relevant taxable year clearly demonstrating the computation.8 If the amount of E&P is not established, then the entire amount of gain is treated as dividends.9 At a time when dividends and long-term capital gains are taxed at the same rate, the provision is somewhat of an anachronism in the context of an individual shareholder effecting the sale.

The allocation of the C.F.C.'s E&P to the shares of stock being sold can be explained with the help of the following example.

Download >> Is The 100% Dividend Received Deduction Under Code §245a About As Useful As A Chocolate Teapot?

1 Governed by Code §1248.

2 Code §1001.

3 U.S. individuals are also subject to the Net Investment Income Tax of 3.8%.

4 Either directly or indirectly under Code §958(a) or constructively under Code §958(b).

5 Code §1248(g)(2)(C); Treas. Reg. §1.1248-1(e).

6 Code §1248(a).

7 Code §1248(h).

8 Treas. Reg. §1.1248-7(a)(1)(i).

9 Treas. Reg. §1.1248-7(a)(1).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.