Appeal from the United States District Court for the Eastern District of Pennsylvania (D.C. Civil No. 72-2283).
Seitz, Chief Judge, and Van Dusen and Weis, Circuit Judges.
VAN DUSEN, Circuit Judge.
The Government appeals from a May 13, 1975, district court judgment denying its claim for an offset against a tax refund awarded to plaintiffs-taxpayers, Richard T. and Margaret H. Brigham, on their 1966 individual tax return.*fn1 The question presented concerns the taxation of the gain taxpayers recognized on the liquidation of a "controlled foreign corporation" in which they held stock. The principal issue is whether 26 U.S.C. § 1248(d)(2)*fn2 permitted taxpayers to exclude from the corporation's "earnings and profits" account a $210,586 gain the corporation would have had to recognize as a taxable gain on the sale of its excessively depreciated property if it had been a domestic corporation. 26 U.S.C. § 1245(a) and (d).*fn3 Resolution of this issue will determine whether a certain portion of the gain taxpayers recognized on the final liquidation of the corporation was taxable as a capital gain, 26 U.S.C. § 331, or as a dividend includible in their gross income to the extent of their pro rata share of the $210,586 gain on which the corporation would have paid ordinary corporate income tax had it been a domestic corporation. 26 U.S.C. § 1248(a)-(b).*fn4 The district court concluded that § 1248(d)(2)permitted taxpayers to exclude the $210,586 from the corporation's earnings and profits and that, as a consequence, capital gain rates were applicable to taxpayers' pro rata share of this gain. See Brigham v. United States, 396 F. Supp. 823 (E.D. Pa. 1975). We reverse and remand.
The facts and much of the applicable law have been stipulated. In 1966 taxpayers owned more than 10% of the voting stock of Numar, S.A., a corporation that was organized under the laws of Costa Rica and qualified as a "controlled foreign corporation." 26 U.S.C. § 957. In 1965 Numar adopted a plan of complete liquidation and sold its assets to United Fruit Company ("United"). Numar realized a net gain on this sale of $4,371,720. Within 12 months of the adoption of the plan, Numar distributed the proceeds of this sale, less assets retained to meet claims, to its United States shareholders, including taxpayers.
The parties agree that the gain taxpayers recognized on the final liquidating distribution was taxable as a dividend under the principles of § 1248(a)-(b), rather than as a capital gain, 26 U.S.C. § 331, to the extent of Numar's post-1962 accumulated earnings and profits attributable to taxpayers' Numar stock. See 26 U.S.C. § 1248(a)-(b). In determining the amount of the liquidating distribution that was taxable as a dividend under § 1248(a)-(b), taxpayers excluded from Numar's earnings and profits the entire amount of the $4,371,720 gain realized on the sale of assets to United. As authority for this exclusion, taxpayers relied on § 1248(d)(2), which authorizes the exclusion from earnings and profits of "any net gain" on the sale of assets by a "controlled foreign corporation" if § 337(a) "would apply if such foreign corporation were a domestic corporation." 26 U.S.C. § 1248(d)(2).
Under § 337(a) a domestic corporation normally pays no tax on any gain realized on the sale or exchange of its assets pursuant to a qualifying plan of complete liquidation. The Government concedes that § 337(a) would have applied to Numar if it had been a domestic corporation.
The difficulty in this case arises because § 337(a) would not have insulated from corporate taxation the entire amount of the $4,371,720 gain due to § 1245(a) and (d) (see note 3 above). Numar had taken excess depreciation on some of the assets it sold to United. Section 337(a) "notwithstanding," the depreciation recapture provision of the Code, 26 U.S.C. § 1245(a) and (d), would, therefore, have required a domestic corporation to pay ordinary corporate income tax on $210,586, the gain attributable to the excess depreciation. It is the Government's position that this $210,586 was improperly excluded from Numar's earnings and profits under § 1248(d)(2).
Before beginning our analysis of § 1248(d)(2), it is important to clarify what is not at issue on this appeal. First, we are not dealing with the question of whether Numar itself is liable for any tax under § 1245. As a foreign corporation Numar is not directly subject to United States taxation on foreign source income.*fn5 Nor are we concerned with whether § 337(a) or § 1245 in any sense "create [s] earnings and profits." Appellees' brief at 19-21 and 26-31. Section 1248(c)(1) establishes the general rule that "the earnings and profits of any foreign corporation for any taxable year shall be determined according to rules substantially similar to those applicable to domestic corporations under regulations prescribed by the Secretary or his delegate." The parties have stipulated that under this general rule the entire amount of the $4,371,720 gain, including the $210,586, was initially includible in Numar's earnings and profits.*fn6 The sole question presented here is whether § 1248(d)(2), an exception to the general rule, permitted the exclusion from Numar's earnings and profits of the $210,586 gain that would have been taxable to a domestic corporation "notwithstanding" the non-recognition provision of § 337(a). We turn to § 1248(d)(2).
Section 1248(d)(2) provides in pertinent part as follows:
"For the purposes of this section , the following amounts shall be excluded, with respect to any United States person, from the earnings and profits of a foreign corporation:
"(2) Gain realized from the sale or exchange of property in pursuance of a plan of complete liquidation. - If a foreign corporation adopts a plan of complete liquidation . . . and if section 337(a) would apply if such foreign corporation were a domestic corporation, earnings and profits of the foreign corporation attributable (under regulations prescribed by the Secretary or his delegate) to any net gain from the sale or exchange of property."
The taxpayers' position is that the phrase "any net gain" refers to the entire amount of any gain "realized" in a sale of assets under a plan of complete liquidation, regardless of the fact that a portion of the gain, "notwithstanding" § 337(a), would have been taxable to a domestic corporation under § 1245. The Government, on the other hand, asserts that the § 1248(d)(2) exclusion applies only to gains that would have been "tax free" to the corporation under § 337(a). See Treas. Reg. § 1.1248-2(d)(ii).*fn7 Thus, they argue, § 1248(d)(2) does not ...