Rev. Rul. 82-63: Contribution to Capital vs. Deduction

Internal Revenue Service (IRS) Revenue Ruling 82-63 provides guidance on the tax treatment of payments from a U.S. parent corporation to its foreign subsidiary. The ruling addresses whether payments meant to cover the subsidiary’s costs for training its own personnel can be claimed as a business expense by the parent. The ruling establishes that such payments are not currently deductible expenses for the parent corporation. Instead, they are treated as contributions to the subsidiary’s capital, which has different and delayed tax implications.

The Ruling’s Factual Scenario and Holding

Revenue Ruling 82-63 is based on a scenario involving a domestic parent corporation, P, and its wholly-owned foreign subsidiary, S. The parent company was engaged in a trade or business in the United States, while its subsidiary operated its own distinct business in a foreign country. The issue arose from payments P made to S.

These payments were not for services rendered to the parent but were explicitly designated to cover costs that S incurred for training its own personnel. The skills the employees acquired were for the benefit of S’s business operations. The funds transferred from P to S were equivalent to the expenses S shouldered for this training program.

The IRS held that P could not deduct the payments as an ordinary and necessary business expense under Section 162 of the Internal Revenue Code (IRC). The IRS concluded that the payments were not an expense of P’s own trade or business, disallowing an immediate tax benefit for the parent.

Rationale for Denying the Business Expense Deduction

The IRS’s decision to deny the business expense deduction is based on its interpretation of IRC Section 162. This section permits a deduction for “ordinary and necessary” expenses incurred in carrying on a trade or business. A requirement is that the expense must be directly connected to the taxpayer’s own business, not the business of another entity.

The analysis focused on whose business the training expenses served. While the parent, P, might benefit indirectly from a more efficient subsidiary, this benefit relates to its role as an investor. The direct beneficiary of the trained workforce was the subsidiary, S, making the costs an ordinary and necessary expense for S, not P.

This reflects a core concept in corporate tax law: a corporation is a separate legal and taxable entity from its shareholders. The expenses of one entity cannot be deducted by another. Because the training costs were S’s obligation, P’s payment of them was not a deductible expense for P.

Treatment as a Contribution to Capital

Since the payment was not a deductible business expense, the IRS recharacterized the transaction as a contribution to the capital of the subsidiary, S. A contribution to capital is an investment made by a shareholder that increases their equity in the corporation. This treatment has distinct tax consequences for both the parent and the subsidiary.

For the parent corporation, P, the payment’s recognition is deferred. The amount paid to S is added to P’s tax basis in the stock of S. A taxpayer’s basis in an asset is their investment cost for tax purposes. By increasing its basis, P reduces the amount of taxable gain or increases the capital loss it would recognize if it were to sell the subsidiary’s stock in the future.

For the foreign subsidiary, S, the receipt of the payment is not considered taxable income. Under IRC Section 118, a corporation does not include contributions to its capital in its gross income. This provision ensures that when a corporation receives assets from a shareholder acting as an investor, it is not taxed on that investment. The payment from P is viewed as a transfer to enhance the subsidiary’s working capital, not as revenue from its business activities.

Interaction with Broader Tax Principles

Revenue Ruling 82-63 operates within the broader framework of U.S. international tax law governing transactions between related entities. A key part of this framework is IRC Section 482, which grants the IRS authority to reallocate income and deductions among organizations under common control. The purpose of Section 482 is to ensure that transactions between related parties are conducted at “arm’s length,” meaning on terms that would be expected between unrelated parties.

The principles of the ruling and Section 482 both address the proper characterization of intercompany transactions. While the ruling provides a specific answer for payments covering a subsidiary’s own operating costs, Section 482 is a more flexible tool. For instance, if the subsidiary’s employees were providing direct services to the parent, the IRS could use Section 482 to determine an arm’s-length price for those services, which the parent would then pay as a deductible service fee.

In the scenario of Rev. Rul. 82-63, a Section 482 adjustment was not necessary because the payment was clearly for the subsidiary’s own expenses. However, in more ambiguous situations, the IRS might invoke Section 482 to recharacterize a payment. For example, if a parent made a purported capital contribution that was, in substance, a payment for services rendered by the subsidiary, the IRS could reclassify it as taxable service income to the subsidiary.