ble manipulation of the timing of dividend payments that these rules might foster.48 The deduction might also be allocated first to U.S. or first to foreign income. Allocating all dividends first to foreign source income might be considered harsh, while allocation first to U.S. income may be inappropriately lenient.

Treatment of foreign tax credit

As discussed above, the Administration proposal generally would not permit a dividends paid deduction at the corporate level to the extent dividends are paid out of earnings that bore no corporate tax. The proposal treats corporate income that did bear foreign tax, but that did not bear U.S. tax due to the foreign tax credit, in the same manner as income that did not bear U.S. tax for other reasons such as accelerated depreciation or other tax preference items. Thus, income that does not bear from U.S. tax due to the foreign tax credit is not added to the QDA.

There is controversy about whether the foreign tax credit should properly be treated in the same manner as a "preference" item. The credit is widely used by countries to reduce international double taxation. It is generally available only where foreign taxes are paid or accrued, thus reducing the amounts a corporation will have available for distribution. On the other hand, foreign countries that have adopted some form of relief from corporate double taxation generally do not treat foreign taxes paid by their domestic corporations as taxes paid, for purposes of a shareholder credit or comparable provision.

Some may contend that the Administration proposal does not provide equal treatment for U.S. and foreign investment by U.S. corporations, because the dividends paid deduction is allowed for distributions of income that has borne only U.S. tax, but not for income that has borne a comparable foreign tax. Others may contend that a U.S. tax benefit has been derived from the foreign tax credit, even though foreign taxes have also been paid. They may also contend that the U.S. should not unilaterally grant relief where other countries do not.

Tax-exempt shareholders

The Administration proposal contains no special rules for situations where a corporation has tax-exempt shareholders such as charitable organizations or tax-qualified pension plans.

Where relief from the two-tier tax is granted, the treatment of shareholders who are tax-exempt raises difficult issues. Denying the relief could be viewed as inappropriately diminishing the relative advantage of tax exemption over ordinary taxable status. On the other hand, granting the relief where a shareholder is a taxexempt entity could permit business income earned by a taxable corporation and distributed to its tax-exempt shareholders to escape tax entirely, simply because the shareholders are taxexempt.

As one example, if a taxable corporation owned entirely by a taxexempt entity distributed all its income, and if there were a 100

48 Compare problems arising in connection with the deemed-paid foreign tax credit, discussed in a separate Joint Committee pamphlet, n. 46, supra, pp. 63-70.

percent dividends paid deduction, the corporation would pay no tax. This result would be inconsistent with the rules that tax unrelated business income of tax-exempt entities and generally do not permit tax-exempt entities to engage in regular business activities free of tax on the business income. Although the Administration proposes only a 10 percent (rather than 100 percent) dividends paid deduction, the issue is inherent in the proposal.

If it were considered desirable to deny the relief in the case of distributions to tax-exempt shareholders, and a dividends paid deduction were chosen as the basic method of relief, the relief could be denied by treating the deductible portion of dividends paid to tax-exempt entities as unrelated business income. This would require reporting of the same type already required by the Administration for dividends paid to corporations.

Such an approach would be similar to the compensatory withholding tax the Administration proposes for certain foreign shareholders; however, the tax would not be collected by the paying corporation as a withholding agent. A withholding tax approach could be used if desired.

Another possibility would be to deny the dividends paid deduction to a corporation that is owned entirely, or to a specified extent, by tax exempt entities. Where a corporation is owned both by taxable persons as well as tax-exempt entities, however, denial of the dividends paid deduction for dividends paid to tax-exempt shareholders would impose an additional tax burden on the taxable shareholders. If an imputation credit system were used, the credit could simply be denied (i.e., be made nonrefundable) in the case of a tax-exempt shareholder.

Transition issues

Certain issues exist relating to the one-time effects of implementing some measure of relief from the two-tier tax. One such issue is whether the relief may give a windfall to present owners of corporate equity, whose shares may become more valuable because of the lower corporate tax burden. The extent of this windfall is somewhat speculative because of uncertainty about the incidence of the corporate tax. To the extent the corporate tax is passed on to consumers or employees, for example, its elimination would not necessarily provide a windfall to shareholders, at least in the long run. Nevertheless, if the possibility of a windfall were perceived to be a problem, one solution would be a phase in of the relief. Another solution would be to extend the relief only to equity issued after the the relief provisions generally become effective, as suggested by the ALI Reporter's study.

Considerations relating to the revenue impact of any major relief also might favor distinguishing new equity from equity existing at the time such relief is granted.

Nevertheless, any approach that requires distinguishing new from old equity may raise substantial administrative difficulties, particularly with respect to situations where a corporation has undertaken various capital transactions-for example, a redemption of old stock and issuance of new stock, possibly to some of the "old" shareholders.

III. DISTRIBUTIONS AND LIQUIDATING SALES OF APPRECIATED ASSETS-THE GENERAL UTILITIES RULE

Overview

Present Law and Background

As a general rule, corporate earnings from sales of appreciated property are taxed twice, first to the corporation when the sale occurs, and again to the shareholders when the net proceeds are distributed as dividends. At the corporate level, the income is taxed at ordinary rates if it results from the sale of inventory or other ordinary income assets, or at capital gains rates if it results from the sale of a capital asset held for more than six months. With certain exceptions, shareholders are taxed at ordinary income rates to the extent of their pro rata share of the distributing corporation's current and accumulated earnings and profits (see Part II, above). An important exception to this two-level taxation is the so-called General Utilities rule. 49 The General Utilities rule permits nonrecognition of gain by corporations on certain distributions of appreciated property 50 to their shareholders and on certain liquidating sales of property. Thus, its effect is to allow appreciation in property accruing during the period it was held by a corporation to escape tax at the corporate level. At the same time, the transferee (the shareholder or third-party purchaser) obtains a stepped-up, fair market value basis under other provisions of the Code. The "price" of a step up in the basis of property subject to the General Utilities rule is typically a single, capital gains tax paid by the shareholder on receipt of a liquidating distribution from the corporation.

Although the case involved a dividend distribution of appreciated property by an ongoing business, the term "General Utilities rule" is often used (and will be used herein) in a broader sense to refer to the nonrecognition treatment accorded in certain situations to liquidating as well as nonliquidating distributions to shareholders and to liquidating sales. The rule is codified in several elaborate and often complex provisions of the Internal Revenue Code. Section 311 governs the treatment of nonliquidating distributions of property (dividends and redemptions), while section 336 governs the treatment of liquidating distributions in kind. Section 337 provides nonrecognition treatment for certain sales of property pursuant to a plan of complete liquidation.

49 General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935).

so Taxable gain may result on disposition of property even if the property's economic value remains constant (or decreases) over the taxpayer's holding period, due to tax depreciation and other downward adjustments to basis. The term "appreciated property" as used herein refers to property whose fair market value exceeds its adjusted (and not necessarily its original) basis in the hands of the transferor corporation.

As described in the historical discussion below, numerous limitations on the General Utilities rule, both statutory and judicial, have developed over the years. Some directly limit the statutory provisions embodying the rule, while others, including the collapsible corporation provisions, the recapture provisions, and the tax benefit doctrine, do so indirectly.

Case law and statutory background

Genesis of the General Utilities rule

The precise meaning of General Utilities has been a matter of considerable debate since the decision was rendered in 1935. The essential facts were as follows. General Utilities had purchased 50 percent of the stock of Islands Edison Co. in 1927 for $2,000. In 1928, a prospective buyer offered to buy all of General Utilities' shares in Islands Edison, which apparently had a fair market value at that time of more than $1 million. Seeking to avoid the large corporate-level tax that would be imposed if it sold the stock itself, General Utilities offered to distribute the Islands Edison stock to its shareholders with the understanding that they would then sell the stock to the buyer. The company's officers and the buyer negotiated the terms of the sale but did not sign a contract. The shareholders of General Utilities had no binding commitment upon receipt of the Islands Edison shares to sell them to the buyer on these terms.

General Utilities declared a dividend in an amount equal to the value of the Islands Edison stock, payable in shares of that stock. The corporation distributed the Islands Edison shares and, four days later, the shareholders sold the shares to the buyer on the terms previously negotiated by the company's officers.

The Internal Revenue Service took the position that the distribution of the Islands Edison shares was a taxable transaction to General Utilities. Before the Board of Tax Appeals, 51 the Commissioner's rationale was that the company had created an indebtedness to its shareholders in declaring a dividend, and that the discharge of this indebtedness using appreciated property produced taxable income to the company under the holding in Kirby Lumber Co. v. United States.52 The Board rejected this argument, holding that where a dividend resolution imposes only the obligation to distribute in kind and it is discharged in that manner, the corporation realizes no gain or loss. It found that General Utilities had declared and paid a dividend in Islands Edison stock.

Before the Fourth Circuit,53 the Commissioner renewed his discharge of indebtedness argument and raised a new argument. He argued that the sale of the Islands Edison stock was in reality made by General Utilities rather than by its shareholders following distribution of the stock. The court, while agreeing with the court below in rejecting the discharge of indebtedness argument, found that the shareholders were merely the agents or conduits of the true seller, General Utilities. It held that since the transaction was

51 29 B.T.A. 934 (1934)

52 284 U.S. 1 (1931).

53 74 F.2d 972 (4th Cir. 1935).

in substance a sale by General Utilities, gain was realized and must be recognized by the corporation.

Before the Supreme Court, the Commissioner made both of the arguments advanced in the courts below and raised a third argument. He argued that a distribution of appreciated property by a corporation in and of itself constitutes a realization event. All dividends are distributed in satisfaction of the corporation's general obligation to pay out earnings to shareholders, he contended, and the satisfaction of that obligation with appreciated property causes a realization of the gain.

The Supreme Court affirmed the holdings of both of the lower courts that the distribution did not give rise to taxable income under a discharge of indebtedness rationale. It reversed the Court of Appeals' decision on the imputed sale theory on procedural grounds, however, holding that the court should not have considered an argument not presented to the trial court. The Court did not directly address the Commissioner's third argument, that the company realized income simply by distributing appreciated property as a dividend. There is disagreement over whether the Court rejected this argument on substantive grounds or merely on the ground it was not timely made. Despite the ambiguity of the Supreme Court's decision, however, subsequent cases interpreted the decision as rejecting the Commissioner's third argument and as holding that no gain is realized on corporate distributions of appreciated property to its shareholders.

Five years after the decision in General Utilities, in a case in which the corporation played a substantial role in the sale of distributed property by its shareholders, the Commissioner successfully advanced the imputed sale argument the Court had rejected earlier on procedural grounds. In Commissioner v. Court Holding Co.,5 54 the Court upheld the Commissioner's determination that in substance the corporation rather than the shareholders had executed the sale and, accordingly, must recognize gain.

In United States v. Cumberland Public Service Co.,55 the Supreme Court reached a contrary result where the facts showed the shareholders had in fact negotiated a sale on their own behalf. The Court stated that Congress had imposed no tax on liquidating distributions in kind or on dissolution, and that a corporation could liquidate without subjecting itself to corporate gains tax notwithstanding a primary motive to avoid the corporate tax. 56

In its 1954 revision of the Internal Revenue Code, Congress reviewed General Utilities and its progeny and decided to deal with the corporate-level consequences distributions statutorily. It essentially codified the result in General Utilities by enacting section 311(a), providing that no gain or loss is recognized to a corporation. on a distribution of property with respect to its stock. Congress also enacted section 336, which in its original form provided for nonrecognition of gain or loss to a corporation on distributions of property in partial or complete liquidation. As discussed below, section 336 no longer applies to distributions in partial liquidation, though in

54 324 U.S. 331 (1945). 55 338 U.S. 451 (1950). 56 Id. at 454-455.