Section 1.951-1(e) defines pro rata share for purposes of section 951(a) of the Code. Proposed §1.951-1(e)(3)(v) adds a special rule that would modify the general rule of §1.951-1(e)(3)(i) regarding the allocation of a CFC’s current earnings and profits to more than one class of stock. The general rule provides for the allocation of current earnings and profits to different classes of stock on the basis of the respective amounts of such earnings and profits that would be distributed with respect to each class if such earnings and profits were distributed on the last day of the CFC’s taxable year on which it is a CFC.

The special rule applies where a CFC has earnings and profits and subpart F income for its taxable year attributable to a transaction described in section 304 of the Code and that transaction is part of a plan a principal purpose of which is to avoid Federal income taxation by allocating the subpart F income resulting from the section 304 transaction disproportionately to a tax-indifferent party. Pursuant to the rule, such earnings and profits will be allocated to each class of stock of the CFC in accordance with the value of such class relative to all other classes.

In the absence of the special rule, the current earnings and profits of a CFC having a class of preferred stock with a fixed return and a class of common stock would be allocated under the general rule on the basis of a hypothetical distribution. Thus, the preferred stock would receive an allocation equal to the amount of the fixed return on the total investment in such stock, and the common stock would receive an allocation of the remainder of the earnings and profits. This result would not reflect the actual economic interest in the CFC of the respective classes of stock in a case where the earnings and profits were artificially inflated as a result of the dividend arising from the section 304 transaction. The amount allocated to the preferred stock in such a case under the general rule would be a significantly smaller percentage of the total than the percentage of the corporation’s value represented by the preferred stock.

This is illustrated by the example that would be added to §1.951-1(e)(6) by these proposed regulations. By modifying the allocation of earnings and profits to classes of stock in this limited category of cases, the proposed regulations ensure that the allocation will be consistent with the economic interest in the CFC represented by the respective classes of stock.

Proposed §1.951-1(e)(4)(ii) would add a special rule that would determine the hypothetical distribution of earnings and profits with respect to cumulative preferred stock with a mandatory redemption date by reflecting the present value of accrued but unpaid dividends with respect to such stock, determined generally on the basis of the implied annual rate of return on such stock and the length of time between the current year’s hypothetical distribution date and the mandatory redemption date. This special rule would apply only if the rate of compounding on the accrued but unpaid cumulative dividends would be less than the appropriate applicable Federal rate and if a distribution on the stock would not be included in the gross income of a United States taxpayer.

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(e) * * *

(3) * * *

(v) Earnings and profits attributable to certain section 304 transactions. For taxable years of a controlled foreign corporation beginning on or after January 1, 2006, if a controlled foreign corporation has more than one class of stock outstanding and the corporation has earnings and profits and subpart F income for a taxable year attributable to a transaction described in section 304, and such transaction is part of a plan a principal purpose of which is the avoidance of Federal income taxation, the amount of such earnings and profits allocated to any one class of stock shall be that amount which bears the same ratio to the remainder of such earnings and profits as the value of all shares of such class of stock, determined on the hypothetical distribution date, bears to the total value of all shares of all classes of stock of the corporation, determined on the hypothetical distribution date.

(4) * * * (i) * * *

(ii) Certain cumulative preferred stock. For taxable years of a controlled foreign corporation beginning on or after January 1, 2006, if a controlled foreign corporation has one or more classes of preferred stock with a mandatory redemption date and cumulative dividend rights, arrearages on which compound at a rate less than an annual compounding at the applicable Federal rate (as defined in section 1274(d)(1)) (AFR) that applies on the date the stock is issued for the term from such issue date to the mandatory redemption date, then, to the extent that—

(A) A distribution with respect to such stock on the hypothetical distribution date would not be includible in the gross income of a citizen or individual resident of the United States, a domestic corporation, or a foreign person as income effectively connected with such foreign person’s conduct of a trade or business in the United States; and

(B) Any dividends accruing with respect to such stock during the taxable year of the controlled foreign corporation have not been paid during such taxable year (accrued but unpaid dividends), the amount of earnings and profits that shall be considered to be distributed as part of the hypothetical distribution for purposes of paragraph (e)(3)(i) of this section with respect to such stock shall be equal to the present value of such accrued but unpaid dividends for the taxable year. The present value of such accrued but unpaid dividends for the taxable year is determined for the purposes of this paragraph by discounting such accrued but unpaid dividends for that taxable year from the mandatory redemption date to the hypothetical distribution date using the implied annual rate of return on an investment at par in a share of such stock that is held from the date of issue until the mandatory redemption date, on the assumption that no dividends with respect to the stock are paid prior to redemption.

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(6) * * *

Example 9. (i) Facts. In 2006, FC10, a controlled foreign corporation within the meaning of section 957(a), has outstanding 100 shares of common stock and 100 shares of 6-percent, voting, preferred stock with a par value of $10x per share. All of the common stock is held by Corp H, a foreign corporation which invested $1000x in FC10 in exchange for the common stock. All of FC10’s preferred stock is held by Corp J, a domestic corporation which invested $1000x in FC10 in exchange for the FC10 preferred stock. The value of the common stock of FC10 at all relevant times is $1000x and the value of the preferred stock of FC10 at all relevant times is also $1000x. In 2006, FC10 borrows $3000x from a bank and invests $5000x in preferred stock issued by FC11, a foreign corporation owned by Corp J. FC11, which has no current or accumulated earnings and profits, uses the proceeds to lend $5000x to Corp J. In 2008, FC10 sells the FC11 preferred stock to FC12, a wholly owned foreign subsidiary of FC11 that has $5000x of accumulated earnings and profits, for $5000x in a transaction described in section 304. FC10 repays the bank loan in full. The acquisition and sale of the FC11 preferred stock by FC10 was part of a plan a principal purpose of which was the avoidance of Federal income tax. For 2008, FC10 has $5000x of earnings and profits, all of which is subpart F income attributable to a deemed dividend arising from FC10’s sale of the FC11 preferred stock to FC12.

(ii) Analysis. FC10 has $5000x of earnings and profits for 2008 attributable to a dividend from a section 304 transaction which was part of a plan a principal purpose of which was the avoidance of Federal income taxation. Under paragraph (e)(3)(v) of this section, these earnings and profits are allocated to the common and preferred stock of FC10 in accordance with the relative value of each class of stock. Thus, for taxable year 2008, $2500x is allocated to FC10’s common stock and $2500x is allocated to its preferred stock.

(7) Effective dates. Except as provided in paragraphs (e)(3)(v) and (e)(4)(ii) of this section, this paragraph (e) applies for taxable years of a controlled foreign corporation beginning on or after January 1, 2005. * * *

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