Introduction: Why Section 304 Matters to American Owners of UK Companies
Section 304 of the Internal Revenue Code treats a sale of shares in one company to another company that you control as a redemption, so the cash or loan note you receive is usually taxed in America as a dividend rather than as a capital gain. If you are a US citizen or green card holder who owns a UK trading company, that single rule can turn an ordinary British reorganisation into a large and immediate US tax bill.
The danger is that nothing about the transaction looks like a dividend from London. Your solicitors call it a share exchange, HMRC grants clearance, and the loan note sits quietly on the balance sheet. Meanwhile, the IRS reads the same paperwork through Section 304 and sees a distribution of the company's retained profits straight into your hands. Consequently, you can owe American tax in the year of the reorganisation while Britain defers its own charge for years.
At TaxYork, we prepare US and UK returns for company owners, investment bankers and entrepreneurs whose wealth sits inside British companies. This guide explains how Section 304 works in 2026, where it collides with UK share-exchange relief, and how you can plan a holding company insertion, an intra-group sale or a family transfer without paying tax twice.
Section 304 in One Paragraph
Section 304 applies when one or more persons control two corporations and one of those corporations buys shares in the other from the controlling persons for property. The statute then pretends the buyer redeemed its own shares. Furthermore, it tests whether that deemed redemption counts as a sale or a dividend under the ordinary redemption rules in section 302 of the Code. Because most owner-managers still control everything afterwards, the answer is almost always a dividend.
Who This Guide Is Written For
We wrote this guide for Americans and dual nationals in Britain who own at least half of a UK company, either directly or through family members. It also matters if you are planning a pre-sale holding company, moving a property company under a trading group, or selling shares to a company your spouse owns. In addition, it is relevant if you already completed such a reorganisation and never reported it on your US return, because missed reporting here leaves several information returns open.
How Section 304 Works Under the Internal Revenue Code
The full text of 26 USC 304 runs to several pages, yet the core mechanism is simple. Congress designed it to stop shareholders extracting company profits at capital gains rates by selling shares between companies they already own. Therefore, the rule looks through the form of a sale and taxes the economic reality of cash leaving the corporate group.
Brother-Sister Acquisitions Under Section 304(a)(1)
The first pattern covers two sister companies with common control. Suppose you own 100% of a trading company and 100% of a property company, and the property company buys your trading company shares for cash. Section 304 treats you as if you contributed the trading company shares to the property company in exchange for imaginary new shares, and the property company then redeemed those imaginary shares for the cash. As a result, the cash is tested as a redemption payment, not as sale proceeds.
Parent-Subsidiary Acquisitions Under Section 304(a)(2)
The second pattern arises when a subsidiary buys shares of its own parent from the parent's shareholder. In that case, the payment is treated as a redemption by the parent itself. Notably, this pattern is rare in purely British groups, because section 136 of the Companies Act 2006 generally prevents a subsidiary from becoming a member of its holding company. However, it still appears where a US parent sits above a UK subsidiary, so you should not assume it can never apply.
The Control Test and Family Attribution
Control under Section 304 means owning at least 50% of the voting power or at least 50% of the value of a corporation. Importantly, ownership includes shares attributed to you under section 318, which counts shares held by your spouse, children, grandchildren and parents. Moreover, the statute lowers the usual corporate attribution threshold from 50% to 5%, so shares held through other companies count far more readily. For example, a sale of your shares to a company owned entirely by your British wife is caught, even though she is not a US taxpayer and you own nothing in her company directly.
Why Section 304 Produces a Dividend Rather Than a Capital Gain
Once Section 304 recasts the sale as a redemption, the next question is whether that redemption qualifies for exchange treatment. Section 302(b) offers three main escape routes, and each one asks whether your interest in the company genuinely shrank. Accordingly, an owner who still controls the group afterwards rarely qualifies.
The Section 302(b) Tests Applied to the Issuing Company
The redemption tests are applied by reference to your shares in the issuing company, which is the company whose shares were sold. A complete termination of your interest qualifies, as does a substantially disproportionate redemption, which requires your voting percentage to fall below 80% of its former level and below 50% overall. Alternatively, a redemption that is "not essentially equivalent to a dividend" can qualify, but the courts demand a meaningful reduction in your rights. In a holding company insertion, you own 100% before and 100% afterwards through the new parent, so none of these tests can succeed.
Earnings and Profits: Acquiring Company First, Then Issuing Company
When the payment is a dividend, Section 304 decides how much is taxable by looking first at the earnings and profits of the acquiring company and then at those of the issuing company. Earnings and profits is the US measure of accumulated corporate profit, which broadly tracks your UK retained earnings after US adjustments. Furthermore, a newly formed holding company has no earnings and profits, so the dividend is measured almost entirely against the trading company's accumulated profits. Any excess over total earnings and profits reduces your basis and then becomes capital gain under the ordinary distribution rules.
The Special Rule for a Foreign Acquiring Company
Where the acquiring company is foreign, such as a UK holding company, section 304(b)(5) narrows the acquiring company's earnings and profits. Specifically, only profits accumulated while it was a controlled foreign corporation, and attributable to shares owned by a US shareholder who is the seller or a related person, count at the first step. However, this limitation rarely helps a founder, because the second step still reaches the trading company's own profits. Therefore, the practical result for most UK reorganisations is a dividend equal to the lesser of the payment and the trading company's earnings and profits.
Section 304 and the UK Holding Company Insertion
The most common way Americans in Britain trigger Section 304 is the pre-sale or succession holding company. A founder exchanges shares in the trading company for shares in a new holding company, often taking a loan note as part of the consideration. In the UK this is routine planning; in the US it is a high-risk transaction.
Why the Loan Note Is the Problem
Under section 135 of the Taxation of Chargeable Gains Act 1992, an exchange of shares for new shares or debentures in the acquiring company is not treated as a disposal, provided the bona fide commercial purpose test is met. A loan note is a debenture, so the UK defers tax on it as well. In contrast, the US treats a loan note as property, and section 304(c)(2) counts the new holding company shares you receive when testing whether you control the acquirer. Consequently, Section 304 applies to the loan note element while the share element follows the separate rules for transfers to foreign corporations.
Qualifying Corporate Bonds and the Frozen Gain
Most UK loan notes are qualifying corporate bonds, and HMRC explains in CG53711 that section 116(10) freezes the gain at the date of the exchange and charges it only when the loan note is redeemed. As a result, you might pay no UK tax for three or four years. Meanwhile, the US has already taxed the full loan note as a dividend in the year of the exchange. That timing gap, rather than the tax rate, is what makes the structure so expensive.
The Separate Section 367 Question for the Shares
The share element of the exchange does not escape scrutiny either. Transferring shares in a UK company to another foreign corporation engages section 367, and a founder owning more than 5% of the new parent normally needs a five-year gain recognition agreement to avoid immediate US gain. We explain that requirement in detail in our guide to the US tax cost of a UK holding company for an American founder. Therefore, a holding company insertion can generate two separate US problems at once.
The Foreign Tax Credit Mismatch Created by Section 304
A Section 304 dividend from a UK trading company is usually a qualified dividend, because a UK company is eligible for the benefits of the US-UK treaty. That means a top federal rate of 20%, plus the 3.8% net investment income tax. On paper, 23.8% looks similar to the UK capital gains rate of 24% shown on the HMRC capital gains tax rates page. Nevertheless, rates are not the issue; timing and character are.
Why the UK Tax Arrives Too Late to Credit
You claim US relief for UK tax on Form 1116, and the credit generally follows the UK tax into the year it is paid or accrues. If the UK charges nothing until the loan note is redeemed in a later year, there is no UK tax to credit against the dividend year. Furthermore, when the UK tax finally arrives, the IRS sees only the repayment of a debt with a full basis, so there is no matching US income. The UK tax then becomes an excess credit in the passive category, which you can carry back one year or forward ten years but can use only against other foreign passive income.
The 3.8% That No Credit Can Touch
Even when the timing lines up, the net investment income tax remains payable in full. Following the Federal Circuit decisions of August 2026, UK tax cannot be used through the treaty to reduce that 3.8% charge. Consequently, every pound of Section 304 dividend carries an irreducible American cost, even if your UK tax is higher than the US regular tax.
Previously Taxed Earnings Can Rescue the Position
There is one important exception that works in your favour. If the trading company is a controlled foreign corporation and you have already paid US tax on its profits under the subpart F or net CFC tested income rules, those profits are previously taxed earnings. Under section 959, distributions out of previously taxed earnings are not taxed again. Therefore, a Section 304 dividend sourced from those profits can be largely tax-free in the US, which makes your historic CFC elections highly relevant to any reorganisation. Our guide to PTEP distributions from a UK company explains how to trace them.
Other UK Transactions That Trigger Section 304
The holding company insertion is the headline risk, but Section 304 reaches many other British transactions. In our experience preparing returns for owner-managers, the less obvious cases cause the most surprise.
Moving a Property Company Under a Trading Group
Owners frequently tidy up a portfolio by selling shares in a personal property company to their trading company for cash or an intercompany balance. Because you control both companies, the payment is a brother-sister Section 304 dividend measured first against the trading company's profits. Moreover, a credit to your director's loan account counts as property just as much as cash does.
Selling Shares to a Spouse's or Child's Company
Family restructuring often involves a sale to a company owned by a spouse or adult child, with the price left outstanding. Through section 318 attribution, you are treated as owning their shares, so you may still control both companies. As a result, a transfer that HMRC views as a commercial sale between connected persons is a dividend in the eyes of the IRS.
The Acquisition Debt Exception and Management Buyouts
Where a new company borrows from a bank to buy your shares and you retain control, the statute contains a narrow carve-out for liabilities the acquiring company incurred to buy the stock. However, the exception applies only within a transaction that also qualifies as a section 351 exchange, and courts read it strictly. If you sell to a buyout vehicle you do not control, Section 304 generally does not apply at all, which is why our management buyout guide for American sellers focuses on other rules.
Case Study: A London Founder's Pre-Sale Holding Company
The following illustrative example shows how Section 304 interacts with UK loan notes. We have simplified the figures and used an exchange rate of $1.34 to £1 throughout.
The Background
Rachel is a US citizen living in Hampstead. She owns 100% of Fenwick Analytics Ltd, a UK software company worth £10 million, with a base cost of £100,000 and retained profits of £4 million. Because Fenwick pays UK corporation tax at 25%, she has elected the high-tax exception each year, so none of those profits are previously taxed earnings. In November 2026, on her solicitor's advice, she inserts Hale Holdings Ltd, receiving £7.5 million of new shares and a £2.5 million qualifying corporate bond loan note.
The Default Result
In the UK, the exchange qualifies under section 135, and section 116(10) freezes a gain of £2,475,000 on the loan note portion. Rachel therefore pays no UK tax in 2026/27. In the US, however, Section 304 treats the £2.5 million loan note, or $3,350,000, as a dividend sourced from Fenwick's profits. Her federal tax is $670,000 at 20% plus $127,300 of net investment income tax, a total of $797,300, with no UK tax available to credit.
When Hale Holdings redeems the note in 2029, the UK charges capital gains tax on the frozen gain. Business asset disposal relief is not available at that point, so she pays 24% on £2,472,000 after her £3,000 annual exemption, which comes to £593,280. Meanwhile, the IRS sees only a debt repaid at its basis, so that UK tax becomes a stranded passive credit. In total, she pays roughly $1.59 million of combined tax on £2.5 million, an effective rate close to 48%.
The Planned Result
Instead, Rachel makes a business asset disposal relief election under section 169R, which HMRC describes in CG64161, bringing the frozen gain into charge at the date of the exchange. Her UK tax becomes £180,000 on the first £1 million at 18%, plus £353,280 on the remaining £1,472,000 at 24%, a total of £533,280, or $714,595. Because the UK tax year ends on 5 April 2027, the credit accrues in her 2027 US year, and we carry the excess back one year to her 2026 dividend.
The UK tax then wipes out the $670,000 of US regular tax on the dividend, leaving only the $127,300 net investment income tax. Her combined cost falls to roughly $842,000, a saving of about $750,000 compared with the default. Furthermore, if she had simply taken shares only and no loan note, Section 304 would not have applied at all, which is often the cleaner answer.
US Reporting After a Section 304 Transaction
Getting the tax right is only half the work, because a Section 304 reorganisation also creates several information returns. Missing them is one of the most common forms of missed reporting we see when company owners come to us for US tax return preparation.
Form 5471 for Every Company in the Chain
After the reorganisation, you own the holding company directly and the trading company indirectly, so you generally file Form 5471 for both. The holding company's first-year return must also report the acquisition of the subsidiary. Moreover, the penalty for each missed Form 5471 starts at $10,000, and our guide to section 6501(c)(8) explains how a missed form keeps your whole tax year open to assessment.
Form 926 and the Gain Recognition Agreement
Transferring shares to a foreign corporation usually requires Form 926, and a gain recognition agreement must be attached to a timely filed return. If you file late, you lose the agreement and recognise the gain immediately unless you can show reasonable cause. Therefore, the filing deadline for the year of the exchange is critical.
Form 8938 for the Loan Note
A loan note issued by a UK company is a specified foreign financial asset, so it normally belongs on Form 8938 if your foreign assets exceed the reporting thresholds. Many owners report the shares and forget the note. Additionally, a loan note denominated in sterling can produce a currency gain or loss on repayment, which must be reported even though the UK ignores it.
Planning Around Section 304 Before You Sign
The best results come from modelling Section 304 before the share exchange agreement is signed, not after. In our experience, the UK documentation is usually settled weeks before anyone asks about the US position.
Consider a Shares-Only Exchange
If you take only holding company shares, there is no property to trigger Section 304, and you can extract cash later by dividend in years when UK tax lines up. However, you should still check the UK tax on dividends, which from April 2026 is 10.75%, 35.75% or 39.35%, because dividends are taxed more heavily in Britain than capital gains.
Align UK Tax With the US Dividend
Where a loan note is commercially necessary, consider the section 169R election, cash consideration taxed immediately, or timing the exchange between 1 January and 5 April so both tax years align. Additionally, check whether HMRC might counteract the loan note under section 684 of the Income Tax Act 2007, which we cover in our guide to transactions in securities clearance.
Seek Clearance on Both Sides
HMRC offers advance clearance for share exchanges and transactions in securities, but no equivalent ruling covers the US analysis. Accordingly, your clearance application should be drafted with the US consequences already modelled, so that the commercial reasons given to HMRC do not undermine your US filing position.
How TaxYork Can Help
TaxYork prepares US and UK tax returns for American and dual national company owners in Britain. We model Section 304, section 367 and the UK share-exchange rules together before a reorganisation, prepare the Form 5471, Form 926 and Form 8938 filings afterwards, and file the matching UK Self Assessment return. Furthermore, if a holding company was inserted in an earlier year without US reporting, we prepare the catch-up returns and offshore disclosure needed to bring you back into compliance. You can also read about our US tax returns for expats service and our tax treaty optimisation work.
Conclusion
Section 304 is one of the least understood rules affecting American owners of UK companies, yet it decides how the IRS taxes some of the most common British reorganisations. A holding company insertion with a loan note, an intra-group sale or a transfer to a family company can all produce an immediate US dividend while the UK defers its own tax. Consequently, the real cost is the mismatch, not the rate. With the right elections, consideration mix and timing, you can usually align both systems and avoid paying close to half the value in combined tax. Above all, model the US position before you sign anything.
Contact Us
If you are planning a holding company, selling shares between your companies or worried about a past reorganisation, book a consultation with our team. Email hello@taxyork.com or call 020 3488 8606 to speak with a US-UK tax specialist. Alternatively, you can contact us online and we will respond within one working day.
Disclaimer
This article provides general information about US and UK tax rules as at October 2026 and does not constitute tax, legal or financial advice. The case study is illustrative and uses simplified figures and an assumed exchange rate. Tax outcomes depend on your individual circumstances, the documents you sign and the law in force at the relevant time. You should obtain professional advice before acting on any matter discussed here. TaxYork accepts no liability for actions taken in reliance on this article.