Federal Taxation Developments Blog : Federal Taxation Lawyer & Attorney : Fox Rothschild Law Firm : Federal Income Taxation & Tax Litigation

In a decision that has wide-sweeping implications for companies that are doing business in the EU or otherwise become a party to a legal or administrative proceeding governed by the EU, as well as to American persons engaged, directly or indirectly such as through ownership of a controlled subsidiary or company in the EU, the Grand Chamber of the EU Court affirmed the decision of the Court of First Review (trial court) holding that various claims of legal privilege made by Akso Nobel Chemicals and Akcros Chemicals for communications made to the companies' in-house companies were not privileged and thus were discoverable under by the European Commission. Article 14 of Council Regulation 17 (anti-competitive practices; violations) of 6 February 1962, First Regulation implementing Articles [81] and [82] of the Treaty. The case was appealed  by the companies from the adverse decision rendered by the General Court in favor of the EU Commission.  The opinion was issued on September 14, 2010.

This Article 14 permits the EU Commission, through its officials, to investigate undertakings and associations of undertakings including: (1) examine books and other business records; (2) take copies or extracts of such business records; (3) ask for oral explanations “on the spot”; and (4) enter the premises (without prior notice), i.e., so called “dawn raids”

Factual Background

In early 2003, Commission officials assisted by representatives of the Office of Fair Trading of Great Britain, conducted a “dawn raid” at Akso Nobel’s and Akcros Chemical’s facilities in Manchester, England. During the investigation the Commission officials took copies of documents including documents, e.g., e-mails, asserted by the appellants as privileged communications between attorney and client.  The Commission officials explained they had to briefly examine the documents in question and form their own opinion of privilege.  Following a long discussion, and after the Commission officials and the OFT officials had reminded the applicants’ representatives of the consequences of obstructing investigations, it was decided that the leader of the investigating team would briefly examine the documents in question, with a representative of the applicants at her side. This ultimately led to a dispute as to 5 documents, including e-mails from employees of the company to and between its in-house counsel. In general, the legal issue was whether these documents were privileged and not subject to discovery as lawyer-client communications. The lawyer in question for Akso was in house lawyer licenced as an Advocaat of the Netherlands Bar. The Commission officials disagreed and would render a final decision on 8 May 2003 rejecting the privilege claims as to the e-mails and certain documents.

The appellants initiated actions before the General Court in Spring of 2003 to require the Commission to return certain documents seized and to order their return. The General Court dismissed the action on both grounds. (Case T-253/03).

The appellants filed with the Grand Chamber to set aside the judgment of the General Court which rejected the claim of legal professional privilege with Akzo’s in-house lawyer; set aside the judgment and cause the relevant privileged documents to be returned. Various groups intervened and filed claims in support of Akzo including the European Company Lawyers Association and the Association of Corporate Council Association (ACCA)-European Chapter, the International Bar Association, as well as the United Kingdom of Great Britain and Northern Ireland and the Kingdom of Netherlands.

The EU Commission contended that the relevant e-mails do not comply with the first condition for legal professional privilege in accordance with AM& S Europe v. Commission [1982] ECR 1575, whereby the legal advice (to be protected from discovery) must be requested and given for the purpose of the defence of the client’s rights. Neither e-mail, in the view of the Commission, met this foundational critierion. Moreover, the second condition of the AM&S Europe case would not be met since the in house lawyer is employed by the company and in-house counsel communications are not privileged under the decision of the EU Courts.

Recognizing that Akzo and Akcros both had a sufficient interest to appeal the case, they set forth various grounds for appeal and reversal of the holding of the Court below and of the Commission. The main attack made was the second requirement that in-house lawyers are excluded from legal professional privilege in the EU, even if such counsel is a member of the Bar of a EU country. The protection is only afforded under the AM&S Europe case to independent lawyers of member states of the EU.

.

In opposition, the EU Commission contended that in AM & S Europe v Commission the Court placed lawyers in one of the following two categories: (i) employed salaried lawyers and (ii) lawyers who are not bound by a contract of employment. Only documents drafted by lawyers in the second category were regarded as being covered by legal professional privilege.

The Grand Chamber, in its analysis confirmed that the second condition of “indepence” is based on a conception of the lawyer’s role as collaborating in the administration of justice and as being required to provide, in full independence and in the overriding interests of that cause, such legal assistance as the client needs. The counterpart to that protection lies in the rules of professional ethics and discipline which are laid down and enforced in the general interest. Consequently, an in-house lawyer is less able to deal effectively with any conflicts between his professional obligations and the aims of his client.

.

The Grand Chamber then stated that “It follows, both from the in-house lawyer’s economic dependence and the close ties with his employer, that he does not enjoy a level of professional independence comparable to that of an external lawyer.” Thus, the first ground of appeal asserted by the appellants failed.

The second argument pertained to the violation of “equal treatment” and that the position of in-house lawyers who are members of a Bar association is no different from that of external lawyers. The principal of equal treatment is a general principle of the EU law, contained in Articles 20 and 21 of the Charter of Fundamental Rights of the European Union. This argument was also rejected. The appellate court stated that in-house lawyers are in a fundamentally different position from external lawyers and therefore the General Court properly held there was no breach of the principle of equal treatment.

Regulation No 1/2003, contrary to the appellants’ assertions, does not aim to require in-house and external lawyers to be treated in the same way as far as concerns legal professional privilege, but aims to reinforce the extent of the Commission’s powers of inspection, in particular as regards documents which may be the subject of such measures. The principle of legal certainty of EU law is further not violated by the decision of the court below. Therefore, the principle of legal certainty does not require that identical criteria be applied as regards legal professional privilege in those two types of procedure. Accordingly, the fact that, in the course of an investigation by the Commission, legal professional privilege is limited to exchanges with external lawyers in no way undermines the principle relied on by Akzo and Akcros. A final argument claimed by the appellants is that the findings of the General court as a whole, violate the principle of national procedural autonomy and the principle of the conferred powers.

This principle of national procedural autonomy governs situations in which the courts and administrations of the Member States are required to implement European Union law, but does not apply where the legal limits of the actions of the institutions themselves are at issue. The Court responded that the regulation in question here was to be applied at the EU level and not at the level of the home jurisdiction under its national law. Here, the rules of procedure with respect to competition law, as set out in Article 14 of Regulation No 17 and Article 20 of Regulation No 1/2003, are part of the provisions necessary for the functioning of the internal market whose adoption is part of the exclusive competence conferred on the Union by virtue of Article 3(1)(b). In essence, neither the principle of national procedural autonomy nor the principle of conferred powers may be invoked against the powers enjoyed by the Commission in the area in question.The third ground set forth in the appeal also  failed.

Implications of Akso Nobel Chemical and Acros Chemicals Decision.

What is clear from the long-awaited decision in Akso Nobel is that the EU Courts will not accept a claim of attorney-client privilege with respect to in-house counsel situated in EU jurisdictions. Only external lawyers from EU countries, not foreign countries will qualify.

This in turn will lead to problems in the U.S. tax proceedings, including trials, where information gathered with respect to a U.S. taxpayer on its international business activities and tax compliance issues can be discovered far more easily. Upon discovery (and production) the waiver of such information and the subject matter is in play even in a U.S. tax proceeding. Moreover, despite the Supreme Court’s decision in Upjohn that in house communications to a ground of employees with in-house counsel as to the subject matter of an internal investigation are privileged, the same case in the EU would yield the opposite result as evidenced in Akso Nobel, supra. Could this lead to even a greater step that when talking to an in house lawyer in Europe such discussions can not be expected to be protected from disclosure in a US tax or other proceeding since there is no expectation of privacy, as the argument would presuambly go?

It is clear that the narrow attorney client privilege in the EU threatens the fabric of the attorney-client privilege in the States. I am sure there is more discussion, commentary from bar groups and acadmics, as well as from the courts, to follow.

This blogger will be the program moderator and speaker on the Attorney-Client, Work Product and Other Privilelges in Federal Tax Controversies and LItigation for ALI-ABA's National (and EU) webcast scheduled for Wednesday, June 29 at 12 noon (EST) from Philadelphia, Pa. Also speaking on the program is Ian Comiskey, of the Blank Rome law firm also of Philadelphia. Mr. Comiskey is a nationally recognized practitioner and legal authorities on tax procedure and tax litigation.

• Print
• Comments
• Trackbacks
• Share Link

The U.S. Department of the Treasury having announced on June 2, 2011 that it planned to begin formal negotiation of amendments to the existing bilateral income tax treaty with Japan, which Treaty was entered into force in 2004, commenced negotiations on June 8-10 in Washington, D.C. The amendments to the Treaty being discussed was the subject of some speculation in a tax publication, i.e., Tax Notes International, June 13, 2011. The topics for discussion should include, dividend exemption, mandatory arbitration procedures under the competent authority provision, and a more expansive exchange of information provision.

Zero Rate Withholding on Dividends

One area for discussion that reasonably should be on the agenda, at least that of Japan's agenda, is that the Japanese authorities want to lower the threshold for having a zero rate of withholding on dividends paid by a resident corporation of the other country. Under Article 10, 3(a), the current treaty provides an exemption from withholding tax where the beneficial owner of the dividend is a company that (i) is a resident of the other contracting state and has owned, directly or indirectly through one or more residents of either contracting state, more than 50% of the voting stock of the company paying the dividend for a period of 12 months, ending on the date in which the dividend is declared and (ii) such resident meets the special limitation on benefits provision under Article 22 of the Treaty.

Japan has recently been able to obtain a lower threshold for zero dividend withholding in other treaties such as the protocol it signed in 2010 with Switzerland and the new treaty it has with Netherlands, signed also in 2010 but both are not entered into forced as of yet. Under both the Swiss protocol and the new treaty with the Netherlands, the threshold is reduced to "more than 50% of the voting power" to "at least 50%" of the voting power, etc. ending on the date the dividend is declared. Thus, Japan wants a 50-50 joint venture company to qualify for zero rate withholding under the U.S. Treaty. The threshold in Japan’s treaty with Australia is "at least 80%" in contrast. Compare that result with the more liberal provision under the Japan-France income tax convention for zero withholding.

Mandatory Arbitration Procedures

The newswire also hinted that the Japanese negotiators want the adopt mandatory arbitration provisions into Article 25 of the Japan-U.S. Treaty. This was recently accomplished in the Netherlands treaty and in a "double tax agreement" recently signed by the Japanese government with Hong Kong in 2010, both of which are pending. This mandatory arbitration provision states that if under the competent authorities process there is no resolution of the case within 2 years of the presentation to the competent authority of the other contracting state, then any unresolved issues will go to arbitration is the petitioner requests but not if a decision on the issue(s) has already been rendered by a court or administrative body of either contracting state. Other special rules are incorporated in the proposals.

The U.S. model tax treaty of 2006 does not set forth a mandatory binding arbitration provision under the competent authority process. Still, the U.S. has MAP provisions with its treaties with Belgium, Canada and Germany. The Mexico and Netherlands treaties have adopted language that could establish a voluntary MAP approach. The Treasury’s approach to MAP can be said overall to be favorable and is viewed as a valuable aid in resolving competent authority disputes under tax treaties. Perhaps the current negotiations with Japan will include such an amendment for MAP.
 

Exhange of Information Amendment

It is further reported that the Japanese may want to update Article 26 of the Treaty, Competent Authorities, with respect to an evolving international standard on exchange of information. The thought it that one competent authority will have the right to request information from the other treaty country which the other may not use for its own tax purposes. The provision that Japan is believed to want in the Treaty by amendment is similar to if not identical with 4 and 5 of Article 26 of the 2006 U.S. Model Treaty.

Now, with respect to our country's "list" of amendments being sought, the Treasury did not, in its June 2 press release, issue such list of items for inclusion in the Treaty with Japan. It would be reasonable to assume, however,  that differences between the Treaty and the 2006 U.S. Model Treaty could be the subject of proposals requested by the U.S. Treasury.

Given the importance of our trading relationships with Japan, it is important that the Treaty can be amended in a manner that conforms with the policies each government feels is important for the sound tax administration of its countries tax laws and in a manner which fosters greater trading and investment in capital among the countries.

• Print
• Comments
• Trackbacks
• Share Link

In General: U.S. Efforts to Thwart Foreign Tax Credit Generator Arrangements

Several years ago a new tax avoidance (or “abusive” as the Service might phrase it) technique was identified by the Large and Mid-Size Business (LMSB) Division of the IRS in a field directive (LMSB-04-0208-003)(3/19/2008) on the subject of foreign tax credit (FTC) generators.

The FTC provisions in the Code  allow a U.S. taxpayer to claim a credit against its U.S. income tax liability for foreign taxes paid or accrued, directly or indirectly, with respect to its foreign source income. FTC generators are complex transactions that are designed to: (i) recover the foreign tax paid claimed as an FTC to avoid any foreign tax cost; or (ii) to eliminate the income that resulted in the FTC; or (iii) transactions which have elements of both (i) and (ii).  LMSB in its 2008 directive  noted that the FTC generator is causing a “significant drain” on the Treasury and also has resulted in the Treasury allocation substantial resources to combating transactions that are abusive. Such transactions are difficult to identify on a tax return including Schedule M-3 or Form 1118 (FTC-Corporations) but may be detected during an actual audit. The market for using FTC generators is strong in the financial services industry since these transactions “appear as a par of their general business operations” and are more difficult to identify. LMSB announced the formation of an issue management team to specifically address such transactions and coordinate their efforts throughout the Service and with the Appeals Division as well. On July 15, 2008, Treasury and the IRS issued final Regulations ( TD 9416 ) that were proposed in 2007  ("new Regulations") to address certain types of foreign tax credit generators. Two weeks earlier, on June 30,  2008, the IRS released CCA 200826036 (dated February 29, 2008), addressing a type of FTC transaction that was not specifically covered by the new Regulations.

The new Regulations to section 901 disallow FTCs (for foreign taxes paid), in connection with certain inappropriate “passive investment arrangements”, which arrangements, if they meet the six specified conditions contained in the regulations, artificially generate FTCs. See Treas. Reg. §1.901-2(e)(5). The final Regulations apply to foreign tax payments paid or accrued for tax years ending on or after the date of finalization (7/15/2008). Treas. Reg. §1.902-2(e)(5) provides that a FTC may only be claimed if it is involuntary within the criteria set in Treas. Reg. §1.901-2(a), which tests whether the payment of foreign taxes was still the produce of a  bona fide effort to minimize the impact of foreign taxes. 

The Regulations categorize three types of passive investment arrangements which involve a U.S. person and a foreign counterparty: (i) U.S. lender transactions; (ii) U.S. borrower transactions; and (iii) asset-holding transactions. In each situation the IRS claims that the U.S. person’s FTC benefit is shared by the parties through the pricing of the arrangement. See also CCA 200826036.

The six features that must be present to disallow the FTCs under the final Regulations are:

(1)  The transaction uses a "special purpose vehicle” (SPV) entity, the income and assets of which are substantially all passive (under an expansive definition) and the income of which is subject to taxation in a foreign country, other than a withholding tax on its owners (regardless of whether the income is taxed to the SPV or its owners).

(2) From a U.S. federal income tax perspective, a U.S. person has an equity interest in the SPV and is thus able to claim a credit for the SPV's foreign tax liability.

(3) The tax cost to the SPV is greater than the foreign tax expense that would have been imposed on the U.S. investor if the U.S. investor owned its interest in the SPV's assets directly.

(4) A foreign person participates in the transaction by (under foreign law) owning at least 10% of the SPV's equity or acquiring (directly or indirectly) 20% of the SPV's assets.

(5) The structure results in a foreign tax benefit to the foreign person through a credit, deduction, exemption of income, or disregarded payment.

(6) The foreign tax credit claim of the U.S. person results directly from tax arbitrage between the United States and another country involving (a) hybrid entities, (b) hybrid instruments, (c) inconsistent identity of tax ownership, or (d) inconsistent measurement of an entity's taxable income

Recent Attempts to Thwart Application of Foreign Tax Credit Generators in Canada.

A good example or illustration in this area is a transaction that starts with a loan by a Canadian resident corporation to a resident of the U.S..Had the Canadian taxpayer loaned the amount directly to the nonresident, the interest income would have been subject to Canadian tax without any foreign tax being paid by application of treaty reduction. 

The FTC generator inserts a third party, a special purpose entity or SPV, which is generally a flow thru entity for U.S. tax purposes. A  Canadian nonresident, i.e., U.S domiciled corporation, will also invest in the partnership. The partnership then loans an amount (including the amount invested by the Canadian resident) to another member of the nonresident's corporate group. The loan results in  interest income in the partnership and an offsetting interest deduction for the borrower, so there is no net tax to the U.S. nonresident's corporate group. Instead of receiving interest income with no offsetting credit, the Canadian resident receives an allocation of income from the partnership and claims an FTC for its share of the foreign (U.S.) tax paid by the partnership. The Canadian tax savings are divided between the Canadian lender and the nonresident borrower through a reduced yield being given to the Canadian resident taxpayer on what is in substance a loan with a tax receivable adjustment.

Adverse Impact of FTC Generators on Canadian Treasury; Apparantly Not to the Tax Court of Canada in Canada Liimited

In addition to the concerns expressed by the U.S. Treasury, the Canadian Department of Finance has stated that Canada risks losing billions of dollars in tax revenue from the use of FTC generators.  It therefore has proposed amendments to the ITA (Income Tax Act) to stop the FTC generators for tax years ending after March 4, 2010. Canada also has decided to challenge the FTC generator by taking the issue to the courts. The first judicial review of the subject was recently decided by the Tax Court of Canada in Canada Limited v. The Queen(Case 4145356). 2011 TCC 220, Apr. 21, 2011.

A summary of the facts involve a subsidiary (S) of the Royal Bank of Canada. In 2003, S invested in a Delaware limited partnership, Crown Point Investments LP, for $400 million.  The general partner of Crown Point, Gaskell Management LLC (GM) , and the other limited partner of Crown Point (CP), were subsidiaries of Bank of America.  The U.S. limited partner subsidiary, CP, invested $1.2 billion while the U.S. subsidiary general partner, GM, contributed $15 million to Crown Point Investments LP’s capital. While organized as a limited partnership, Crown Point elected to be taxed as a corporation for U.S. tax purposes.

The Royal Bank’s subsidiary S, and the limited partner (CP), entered into a “repo agreement under which S had the right to require CP to purchase its limited partnership units in Crown Point for $400 million (comprising approximately 25% of the capital in the limited partnership) and GM had the right as well to acquire S’s.  Because of the repo arrangement, S’s investment in Crown Point was treated for U.S. tax purposes as a loan by S (again a Canadian subsidiary to the Royal Bank of Canada) to CP (again a U.S. subsidiary of the Bank of America) . The limited partnership,  Crown Point, made a loan of approximately $1.6 billion to Mecklenberg Park Inc.(MP), another subsidiary of Bank of America.

Under the Crown Point partnership agreement, S was entitled to a cash distribution from Crown Point equal to 4.73%  of the $400 million advanced to Crown Point. In 2003 Crown Point distributed approximately $6.1 millionin  cash to S. Under the limited partnership agreement, the appellant's share of the partnership’s net profit was the lesser of: (i) its pro rata share of net profit of the partnership (that is, total net profit x 25%); and (ii) the total cash distributed to S divided by (1 - the applicable tax rate).

In computing its Canadian tax liability for 2003, S included in its income approximately $9.4 million as its distributive share of partnership income and claimed foreign tax credits of approximately $3.2 which was its share of the foreign tax paid by Crown Point to the U.S. total interest income earned on the MP loan. In 2003 Crown Point earned interest income of $28.7M (U.S.) from theMP loan and paid U.S. tax of approx. $10M (U.S.). The Canadian Revenue Department disallowed the FTC of S and did not reduce the amount of S’s distributive share of the limited partnership’s income.

The first issue was to determine whether the entire limited partnership structure would be respected for Canadian ITA purposes; it was a hybrid entity for Canadian tax purposes since it was a corporation for U.S. income tax purposes. While the partnership rules in Canada resemble the treatment of a flow thru entity for U.S. income tax purposes, even for foreign based partnerships such as Crown Point, While there is no specific rule on partnerships and FTCs under the ITA, in Interpretation Bulletin IT-183 and its replacement, IT-270R3, the Canada Revenue Agency allows a partner to include its distributive share of the foreign taxes paid by a partnership of which it was a member in the computation of its FTC.

Stating that Canadian tax law and not U.S. tax law, would be determinative and that as such, the limited partnership was a partnership for Canadian income tax purposes and that S would have potential liability for Canadian taxes. Therefore, S’s income for 2003 was its distributive share of partnership income or approximately $9.4M. The Canadian Revenue Agency’s argument that its income should be the amount of cash distributed to S or $6.1M, i.e., the fixed return that S was entitled to receive.

Under ITA section 126, a Canadian taxpayer is entitled to claim a foreign tax credit for taxes “paid” to a foreign country on foreign source income. The government argued that because the taxpayer was not personally liable for the U.S. tax, i.e., the U.S. corporation (limited partnership) was, it could not claim FTCs in Canada. The Court rejected the idea that ITA section 126 required actual liability. The Court instead viewed, in accordance with the Supreme Court of Canada’s direction that the courts not interpret the ITA in a restrictive manner but to also consider the context or purpose for which the provision was adopted, that no actual liability requirement is implied on the use of the word “paid”  in section 126.

Since S was subject to U.S. tax as an economic matter on its U.S. source income, and even though CP was taxed as a separate entity for U.S. tax purposes, S should be treated as having the foreign taxes charged against the amount that was distributed to it. The Court viewed this outcome as consistent with a strong policy in avoiding double taxation.

The decision may be fair it does not directly address the FTC generator issue and would have been addressed presumably by a U.S. court were the facts of the case inverted. It is noteworthy that Canada’s GAAR provision was not addressed by the Court.

Stay tuned as to whether the Canadian Revenue Agency appeals Canada Limited to the Federal Court of Appeal. 

• Print
• Comments
• Trackbacks
• Share Link

• Print
• Comments
• Trackbacks
• Share Link

France for years has imposed an annual tax of 3% of the value of immovable property situated in France when that property was owned, directly or indirectly, by a legal person. France law provided an exemption from this excise  for those legal persons whose seat of management was situated in a country or territory that had a TIEA or income tax treaty containing a nondiscrimination clause, provided, however, that the identities and addresses of the legal persons’ shareholders were disclosed annually as of a certain date. The exemption also was extended to legal persons that had their effective center of management in France or another EU member state, again provided the identity and addresses of the ultimate shareholders were provided.

Prunus, a company organized under the laws of France, was a wholly owned subsidiary of a Luxembourg holding company, Polonium. Polonium was owned 50% each by two companies organized and established in the British Virgin Islands. Prunus owned, directly or indirectly, a number of properties situated in France, but under the French tax rules, Prunus and Polonium were exempt from the 3% immovable property tax. Nevertheless, the two BVI companies were subject to the 3% tax as the BVI and had not entered into a qualifying tax treaty or TIEA designed to combat tax evasion.  The French taxing authority assessed the 3% tax against the French company, Prunus,  who was, under the provision, jointly and severally liable for the tax owed by the two BVI companies. Prunus and Polonium argued that the French rules at issue were contrary to article 63 (free movement of capital) of the Treaty on the Functioning of the European Union (TFEU).

The European Court of Justice, on May 5, 2011, in its landmark decision, Prunus SARL v. France (C-384/09) held against Prunus and upheld the assessment. Noting that the companies in the BVI are not entitled to EU membership benefits derived from EU law, the French anti-avoidance rules were upheld, i.e., the tax may be imposed if the legal person is established in a country that there is no tax information exchange agreement or an income tax treaty containing a nondiscrimination provision between the BVI and France.

An English  commentator on the case noted that the decision has “major implications for similar companies established in so-called overseas countries and territories such as Bermuda and the Cayman Islands.

• Print
• Comments
• Trackbacks
• Share Link

In May, 2008, temporary and proposed regulations were issued under §367(b) to address the Service’s concern about the tax impacts arising from certain triangular reorganizations involving foreign corporations, a/k/a “Killer B” transactions, in which a subsidiary purchases, in connection with the reorganization, stock of its parent corporation in exchange for property, and exchanges the parent corporation’s stock for the stock or property of a target corporation. This problem area had been on the Service’s radar screen for some time. See Notices 2006-85 and 2007-48. The reason for the concern was that the Service felt that such transactions involved the repatriation of earnings in the form of a tax-free reorganization that in many cases would escape U.S. income taxation on dividend repatriations.

The 2008 regulations contained in Temp. Reg.§ 1.367(b)-14, are now issued in final form in Treas. Reg. § 1.367(b)-10 and apply to transactions occurring after May 16, 2011. The final regulations require that adjustments be made as part of such a reorganization, i.e., subsidiary exchanges property for stock of its parent to acquire target stock (and/or securities) in a reorganization. The adjustments are deemed to be a dividend from the subsidiary  to the parent of the property transferred to the parent in exchange for its stock (and securities). Where the subsidiary purchases parent stock from another party, however, the parent is also treated as having contributed to the subsidiary the property deemed distributed to the parent.

Background.

Section 367(a)(1) provides in connection with a generally non-taxable liquidation of a controlled subsidiary, tax-free incorporation under §351 or non-taxable reorganization, involving a U.S. person’s transfer of appreciated property to a foreign corporation, such foreign corporation shall not be treated as a domestic corporation. This means that gain on the transfer of appreciated property will be recognized unless an exception to §367(a)(1) applies to the transfer. In addition, §367(b)(1) provides that in the case of any exchange that is entitled to non-recognition treatment, e.g., liquidation of a controlled subsidiary, non-taxable reorganization, etc., where there is no transfer of property described in §367(a)(1), such as in a  exhange of stock solely for voting stock in a Type B reorganization, a foreign corporation will be treated as a corporation except to the extent provided in regulations.  

Section 367(a)(1) (and the regulations under that section) and the 2008 regulations could each potentially apply to certain triangular reorganizations. For example, §367(a)(1) and the 2008 regulations could each potentially apply to a triangular reorganization described in  §368(a)(1)(B) if the subsidiary acquires parent corporation stock for property and each corporation involved in a triangular B reorganization, including the target corporation, are foreign corporations and the target corporation stock is held by a U.S. person who realizes gain on the exchange.  See Treas. Reg. § 1.367(a)-3(d)(1)(iii)(A) (providing that there is an indirect transfer by the U.S. person of the target stock to the subsidiary). Under a priority rule, §367(b)(1) will not apply to an exchange if gain is required to be recognized under §367(a)(1) unless an exception is provided by regulation.

Priority Rules

The 2008 regulations included a “priority rule” that provided, in general,  that if the amount of gain in the U.S. person’s disposition of target  stock that would otherwise be recognized under §367(a)(1) (absent an exception) is less than the adjustment treated as a dividend under the 2008 regulations, then the 2008 regulations, and not §367(a)(1), would apply to certain triangular reorganizations. See Treas. Reg. §1.367(a)-3(c). A comment received in response to the 2008 regulations was that the “priority rule” may not always yield the correct result at least from a tax policy standpoint, i.e., the “greater” dividend amount (over the gain amount) may be insulated from U.S. income taxation by a favorable tax treaty.  

While rejecting a full U.S. tax liability impact analysis as had been suggested by a commentator, the final regulations to Treas. Reg. §1.367(b)-10 will not apply (and therefore §367(a)(1) will apply) where the parent and subsidiary corporations in the triangular B reorganization are foreign corporations and neither corporation is a controlled foreign corporation (per Treas. Reg. §1.367(b)-2(a)) immediately before or immediately after the triangular reorganization. As a second exception to application of the  “priority rule”, the final regulations under Treas. Reg. §1.367(b)-10 do not apply if: (1) the parent is a foreign corporation; (2) the subsidiary is a domestic corporation; (3) the  parent’s receipt of a dividend from subsidiary  would not be subject to U.S. income tax under either §881 (for example, by reason of an applicable treaty) or  §882; and (4) the parent’s stock in the subsidiary is not a United States real property interest. See §897(c) .

The final regulations add a protective rule which includes the acquisition by the subsidiary, in exchange for property, of the parent corporation’s securities that are used to acquire the stock, securities, or property of the target corporation in the triangular reorganization, but only to the extent the parent’s securities are treated by the target’s shareholders or security holders as "other property" under §356(d).  Finally, the final regulations modify the “priority rule” by: (1) including exchanges of target securities as well as target corporation stock; (2) comparing the amount of gain that would be recognized under §367(a)(1) with not only the amount of the deemed dividend but also the amount of any gain (per §§301(c)(1) and (3), respectively); and (3) by providing  separate priority rules in  Treas. Regs. § 1.367(a)-3(a) and  Treas. Reg. § 1.367(b)-10.

Under Treas. Reg. § 1.367(a)-3(a)’s  priority rule, as modified, if the amount of gain in the target’s stock or securities that would otherwise be recognized by the target’s shareholders or security holders under §367(a)(1) (without regard to any exceptions to §367(a)(1)) is less than the sum of the amount of deemed dividend and the amount of gain (applying §§301(c)(1) and (3), respectively) under the final regulations, §367(a)(1) does not apply to the §§354 or 356 exchange by the target shareholders or security holders.  Stated in the opposite manner, under Treas. Reg. §1.367(b)-10’s priority rule, if the amount of gain recognized by the target shareholders or security holders under §367(a)(1) (taking into account any exception to §367(a)(1) that is applied) on the §354 or §356 exchange of target stock or securities exceeds the sum of the amount of deemed dividend and the amount of gain (applying §§ 301(c)(1) and (3), respectively) if the final regulations otherwise applied to the triangular reorganization, then the final regulations will not apply.

Priority Rules Apply Where Target is Unrelated to the Parent or Subsidiary Corporations

While commentators to the 2008 regulations posited that the 2008 regulations should not apply where the target is not related to either the parent or subsidiary, the final regulations did not adopt such proposal. The Treasury and IRS felt that even in such situation the potential for inequitable tax avoidance was still present.

Adjustments Having the Effect of a Distribution or Contribution

The final regulations clarify that adjustments are made based on a distribution or contribution of a notional amount, and therefore without the recognition of any built-in gain or loss on the distribution of such notional amount. The notional amount is equal to the amount of money transferred and liabilities assumed plus the fair market value of other property transferred, in connection with the triangular reorganization, by the subsidiary in exchange for the parent corporation’s stock or securities used to acquire the stock, securities or property of the target corporation.  The final regulations clarify that the adjustments that have the effect of a deemed distribution or deemed contribution do not affect the characterization of the actual transaction. For example, where the subsidiary corporation uses  property with a built-in gain to acquire parent corporation stock, its exchange of the property for parent stock is not affected by the regulations. Instead, the regulations require adjustments based on a deemed distribution and deemed contribution of the notional amount that occur apart from, and in addition to, the subsidiary corporation’s exchanging the built-in gain property for the  parent corporation stock. Under this example, the subsidiary would not recognize gain under §311(b) as to the notional amount and the subsidiary’s exchange of property would continue to be treated as an exchange subject to §1001 in which the subsidiary recognizes the built-in gain.

The final regulations apply to transactions occurring on or after May 17, 2011. For transactions that occur prior to May 17, 2011, see  Treas. Reg. § 1.367(b)-14T as contained in 26 CFR part 1 revised as of April 1, 2011.

• Print
• Comments
• Trackbacks
• Share Link