While Christmas and the holiday gift giving may have passed, the Treasury and the Internal Revenue Service bundled up several “gifts” in the form of regulations under Section 367 that were issued on March 18, 2013 that have been long-awaited since proposed regulations were issued in this area in August 2008. The government generally maintained the framework set out in the August 2008 proposed regulations, though it did make some targeted changes to the proposed regulations' new elective exception under Section 367(a)(5), which allows a U.S. transferor to not recognize gain on a transfer of appreciated property in a Section 361 exchange if some conditions are met. Qualifying conditions include: (i) the requirement that the U.S. transferor be controlled per Section 368(c) by at least one but by no more than five domestic corporations (control group); (ii) gain recognition by the U.S. transferor; (iii) adjustments to basis of stock received by control group members are made; (iv) an agreement is made to amend or file a U.S. tax return to recognize gain; and (v) compliance with certain election and reporting requirements. Initial responses from members of the professional community overhaul have been favorable with the various rule-makings issued.
In T.D. 9614, the Treasury and the Internal Revenue Service finalized portions of the proposed regulations under Sections 367, 1248 and 6038B pertaining to the transfer of assets from domestic corporations to foreign corporations.
In T.D. 9615, the Treasury and the Internal Revenue Service issued guidance in the form of temporary regulations part of the 2008 proposed regulations pertaining to the Section 367(a) coordination rule exceptions and makes further revisions in temporary regulations of the February 2009 final gain recognition agreement regulations (see T.D. 9446) pertaining to outbound transfers of stock or securities.
The third “gift” delivered was REG-132702-10, which contains the text of the temporary regulations issued under T.D. 9615.
This post will cover the first of the three releases, T.D. 9614, 78 F.R. 17024-17052. The content summarizes the explanation provided in the Preamble to the rule-making.
Final Section 367(a)(5) Regulations: T.D. 9614
The 2008 proposed regulations (REG-209006-89; 73 FR 49278, 2008-41 IRB 867) issued on August 20, 2008, addressed Sections 367 and 1248 as well as the related reporting requirement rule in Section 6038B pertinent transfers of property by a domestic corporation to a foreign corporation in an exchange described in either Section 361(a) or (b), and certain nonrecognition distributions of stock of a foreign corporation by a domestic. See also 73 FR 56535; 2008-41 IRB 867). While no public hearing was held on the 2008 proposed regulations, the government did receive comments. Much of the 2008 proposed regulations, with certain modifications, are retained in the final regulations just issued. A portion of the same 2008 proposed regulations is also adopted, as modified, as temporary regulations in a second rule-making also issued on March 18, 2013. The temporary regulations also modify final regulations under Section 367(a) concerning transfers of stock or securities by a domestic corporation to a foreign corporation in a Section 361 exchange.
General Framework of Section 367(a)
Section 367(a)(1) provides, in general, that a taxable realization event occurs with respect to transfers of appreciated property by a U.S. person to a foreign corporation in connection with any exchange described in Sections 332, 351, 354, 355, or 361. Moreover, Section 367(e) applies similar principles to outbound liquidation distributions under Section 337 and distributions under Section 355(c). There are certain exceptions from this rule of broad application. Section 367(a)(3)(A) allows nonrecognition treatment for assets used in the active conduct of a trade or business transferred outside of the United States (subject to expansion or contraction by regulations). See Treas. Regs. § 1.367(a)-2T (1986). Med Chem (P.R.) v. Comm’r, 116 TC 308 (2001), aff'd 295 F.3d 118 (1st Cir. 2002) . Assets that are ineligible for the active foreign business exception (i.e., tainted assets) are listed in Section 367(a)(3)(B) and include: (i) inventory and copyrights not otherwise taxed under Section 367(d); (ii) installment obligations and receivables; (iii) foreign currency or property denominated in foreign currency; (iv) other intangibles not subject to Section 367(d); and (v) property that is presently leased (other than to the transferee).
Section 367(a)(2) sets forth a second exception to the general realization of income rule providing non-recognition treatment with respect to a transfer of stock and securities of a foreign corporation, which is a party to a reorganization, to a foreign corporation. Under the regulations where a U.S. transferor transfers foreign stock or securities to a foreign corporation as part of a tax-free reorganization, gain is not required to be recognized under the general rule of Section 367(a)(1) where the transferor either owns (or is treated as owning) less than 5% of both the voting power and total value of the transferee's stock or (where the 5% test is not satisfied) enters into a five-year gain recognition agreement. Where the domestic corporation’s stock or securities are transferred to a foreign corporation, the regulations require that four conditions must be satisfied to avoid gain recognition: (i) the domestic transferors must not receive more than 50% of the transferee's stock (by vote or value) in the transaction; (ii) there must not be a “control group;” (iii) a U.S. person who is a 5% shareholder of the transferee must enter into a five-year gain recognition agreement (“GRA”); and (iv) an active business test must be met.
Certain transactions are treated as indirect stock transfers. For instance, where a triangular reorganization or asset merger is followed by a transfer of part or all of the transferred assets to a corporation controlled by the transferee corporation, the acquiring corporation (or the corporation to which the assets are transferred) is treated as the transferred corporation. In instances where assets are transferred, e.g., a triangular Type C reorganization, Section 367(a) is implicated with respect to the asset transfer while both Sections 367(a) and 367(b) can apply to the indirect stock transfer at the shareholder level. If the drop-down of assets is made by the foreign acquiring corporation back to a controlled domestic corporation, the regulations provide that in certain instances gain will not be recognized. See Treas. Reg § 1.367(a)-3(d)(2)(vi)(B)(1).
There will be instances in which Sections 367(a) and 367(b) overlap. Section 367(a) rules generally apply before the Section 367(b) rules, because a transfer is generally fully taxable or not under the Section 367(a) rules. If the transfer is fully taxable under the Section 367(a) provisions, then the Section 367(b) provisions generally remain dormant. The 2008 proposed regulations under Section 367(a) reverse the priority rule to provide that where a transaction that is concurrently subject to both Sections 367(a) and 367(b), Section 367(b) would take precedence if the all earnings and profits amount is greater than the Section 367(a) gain.
Section 367(a)(5) and Coverage Under the 2008 Proposed Regulations and Recently Issued Final Regulations
Section 367(a)(5) provides that the exceptions to Section 367(a)(1) in Section 367(a)(2)(foreign stocks and securities) and (a)(3)(transfer of all assets of a trade or business outside of the United States) will not be applicable in the case of a Section 361 exchange in which a domestic corporation transfers assets to a foreign corporation, unless the U.S. transferor is controlled (within the meaning of Section 368(c)) by five or fewer (but at least one) domestic corporations (each a control group member, and together the control group) and basis adjustments and other conditions as provided in regulations are satisfied. See H.R. Rep. No 795, 100th Cong., 2d Sess. 60 (1988). See also Section 337(d)(regulations to protect the integrity of the repeal of the General Utilities doctrine as part of the Tax Reform Act of 1986).
The 2008 proposed regulations set forth rules and conditions for implementing Section 367(a)(5). The 2008 proposed regulations provided an exception that at the election of the U.S. transferor and members of the control group (elective exception), subject to conditions intended, in part, to ensure that the net gain (if any) realized by the U.S. transferor in connection with the transfer of property subject to Section 367(a) (defined as “inside gain”) is, in the aggregate, recognized currently by the U.S. transferor or, to the extent permitted, preserved in the basis of the stock received in the reorganization by certain domestic corporate shareholders of the U.S. transferor.
Calculation of Inside Basis
In addition to the adjusted basis of certain transferred property, in computing “inside gain”, the 2008 proposed regulations account for certain liabilities of the U.S. transferor that would give rise to a deduction when paid. See §361(c)(3). Section 361(c)(3) provides that the U.S. transferor recognizes no gain or loss on the satisfaction of a liability with stock received in connection with the reorganization, but does not prevent the U.S. transferor from obtaining a deduction on payment of the liability with the stock received. The policy rationale for allowing a deductible liability to reduce “inside gain” is that the U.S. transferor has not received a tax benefit for such liability but the liability reduces the value of the stock received. This concept is retained in the final regulations which provide that a so-called “deductible liability” is limited to a liability that is assumed in the Section 361 exchange if payment of the liability would give rise to a deduction.
While several comments had suggested that besides “built-in deductions” other tax attributes be taken into account in computing inside gain, e.g., net operating losses and foreign tax credits, because those other tax attributes are similar to the adjusted basis of the transferred property and deductible liabilities or, alternatively permit the U.S. transferor to elect to recognize an amount of gain sufficient to utilize all or a portion of any additional tax attributes. The final regulations did not adopt either suggestion on the basis of undue complexity as well as recognizing that a a U.S. transferor can utilize any other available tax attributes by not electing to apply the elective exception.
Built-in Loss in Stock of the U.S. Transferor Corporation
Under the 2008 proposed regulations, to qualify for the Section 367(a)(5) exception, each control group member must make a downward adjustment in the basis of the stock received in the foreign corporation as part of the reorganization by the amount that its portion of the “inside gain” in the transferred assets exceeds the gain (or loss) unrealized in such stock or “outside gain” but for the application of Section 367(a)(5). The Preamble notes that in some cases the required basis adjustment will actually convert built-in loss stock into built-in gain stock. As an illustration of the elective exception under Section 367(a)(5), a control group member has a $500x adjusted basis, per Section 358, in stock received that has a fair market value of only $300x. This yields a $200x built-in loss in the stock. If the control group member's share of transferred assets inside gain is $350x, its adjusted basis in the stock received must be reduced to $150x, resulting in $150x of built-in gain in the stock and eliminating the $200x pre-existing stock basis “outside” built-in loss.
While comments were received by the Treasury to take a different approach, the Preamble states that “the Treasury Department and the IRS believe that the amount of outside built-in gain or loss should not affect the required reduction to the adjusted basis of the stock received in the transaction. That is, the basis must be reduced to an amount such that the gain in the stock corresponds to the proportionate amount of inside gain.” See S. Rep. No. 445, 100th Cong., 2d Sess. 62-3 (1988).
The final regulations clarify that if a U.S. transferor does not have inside gain, i.e., there is no net built-in gain in the U.S. transferor's assets, stock basis adjustments are not required to be made by control group members, even if the outside stock loss of a control group member is greater than the net built-in loss attributable to the control group member.
Taxable Disposition of Section 367(a) Assets
The 2008 proposed regulations deny application of the elective exception under Section 367(a)(5) where, and provided the taxpayer has a principal purpose of avoiding U.S. tax, the foreign acquiring corporation disposes of a significant amount of the property received from the U.S. transferor. The regulations referred to this problem as the “disposition rule”. The comments received by the Treasury and IRS recommended that the disposition rule be modeled after Treas. Reg. §1.367(a)-8 on GRAs. In general, GRAs generally require gain recognition only where a triggering event takes place during the GRA term, which is the period ending with the close of the fifth full taxable year (not less than 60 months) following the year in which the transfer requiring the gain recognition agreement occurred.
Another comment asked that the final regulations include rules under the GRA provisions in Treas. Reg. §1.367(a)-8(k)(14) for certain non-recognition transfers. Such rules generally provide that a transfer of assets subject to a GRA that are disposed of in a non-recognition transfer will not be a GRA triggering event provide certain conditions are met. But see Treas. Reg. § 1.367(a)-2T(c)(1) which denies the exception under Section 367(a)(3) in certain cases when the transferred property is retransferred to another person as part of the same transaction.
The Treasury Department and the IRS stated in the Preamble that safeguards, in addition to the rule set forth in Treas. Reg. § 1.367(a)-2T(c)(1), are needed in the case of outbound reorganizations that qualify for the elective exception, but agree that adopting certain aspects of the GRAs rules are worthwhile. The final regulations deny the elective exception only if, with a principal purpose of avoiding U.S. tax, the foreign acquiring corporation disposes of a significant amount of the property received from the U.S. transferor during the 60-month period that begins on the date of distribution or transfer (per Treas. Reg. § 1.381(b)-1(b)), which generally is the date on which the transfer of property by the U.S. transferor to the foreign acquiring corporation is completed.
The final regulations also provide that property that is subsequently transferred pursuant to a non-recognition provision will not be treated as “disposed of” under the disposition rule under principles set forth under Treas. Reg. § 1.367(a)-8(k) as well as the broader rules under Treas. Reg. § 1.367(a)-8 as to GRAs.
Another comment, also adopted in the final regulations, allows dispositions of property in the ordinary course of business will not result in denial of the elective exception even in instances where the disposition occurs within the two-year "presumption of tax avoidance" period following the reorganization.
Definitions of Section 367(a) Property and Section 367(d) Property
The 2008 proposed regulations, in general, define Section 367(a) property as any property other than Section 367(d) property. The final regulations clarify that Section 367(d) property is property described in Section 936(h)(3)(B). In accordance with Section 936’s definition, “intangible property” means a: (i) patent, invention, formula, process, design, pattern, or know-how; (ii) copyright, literary, musical, or artistic composition; (iii) trademark, trade name, or brand name; (iv) franchise, license, or contract; (v) method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or (vi) any similar item, which has substantial value independent of the services of any individual.
Section 367(d)(1) provides that, except as provided in regulations, if a United States person transfers any intangible property, per Section 936(h)(3)(B), to a foreign corporation in an exchange described in Section 351 or 361, Section 367(d) (and not section 367(a)) applies to such transfer. Therefore, income or gain attributable to the transfer of property by a U.S. person to a foreign corporation in a Section 351 exchange or Section 361 exchange is taken into account either in accordance with Sections 367(d)(2)(A)(ii)(I) or (d)(2)(A)(ii)(II), or in accordance with Section 367(a) and the regulations thereunder in the case of a Section 361 exchange subject to Section 367(a)(5). See Notice 2012-39, IRB 2012-31 (application of Section 367(d) in outbound asset reorganizations).
Section 367(a)(5)’s Application to a RIC, REIT, or S Corporation
Comments were received to the 2008 proposed regulations that based on the policy rationale inherent in Section 367(a)(5) of preserving U.S. taxation of corporate level gain. Section 367(a)(5) should not apply to a real estate investment trust (REIT), regulated investment company (RIC) or S corporation since such entities are generally not subject to corporate income tax. Perhaps this relief would take into account such instances where such entities are subject to corporate income tax. This led to a suggestion that the final regulations should incorporate a targeted gain recognition rule in such instances. On the other hand, another comment noted that exempting special corporate entities from the application of Section 367(a)(5) may circumvent the imposition of U.S. tax through the use or insertion of special corporate entities. It was also suggested that such special corporate entities should still be permitted to be members of the control group since the amount of inside gain preserved in stock received by special corporate entities could, when recognized, be wholly or partly subject to U.S. tax and includible in the shareholders’ taxable income.
Section 367(a)(1) contains rules for transfers of certain appreciated property by a U.S. person to a foreign corporation in certain non-recognition exchanges under the corporate tax provisions. These rules apply to regular corporations as well as the special corporate entities. The owners of special corporate entities participating in such exchanges generally receive a basis determined under Section 358 in the shares of the foreign acquiring corporation. This means that preservation of corporate-level tax on the “inside gain” is not assured. In addition, the Treasury and IRS was concerned that if a special corporate entity was treated as a member of a control group under Section 367(a)(5), whether the inside gain is ever subject to U.S. corporate tax depends on the extent of the domestic corporate ownership of the special corporate entity at the time the gain is recognized. Based on these concerns the final regulations did not adopt the position asserted in the comments relief be provided from the application of Section 367(a)(5) to special corporate entities, or allow special corporate entities to be control group members.
Indirect Stock Ownership
There are no attribution or constructive stock ownership rules under Section 368(c). Still, comments were received that the final regulations permit indirect ownership of the U.S. transferor through partnerships or foreign corporations to be taken into account for purposes of satisfying the control requirement of Section 367(a)(5). Section 367(a)(5) uses the direct ownership rule under Section 368(c) in testing for control. The final regulations do not contain a stock attribution rule.
Treatment of Affiliated Group Members as a Single Corporation
The 2008 proposed regulations provided that members of an affiliated group of corporations for purposes of Section 1504 are treated as a single corporation under the control requirement of Section 367(a)(5). The question surfaced as to whether affiliated group members should also be treated as one corporation for other purposes such as to determine the amount of any required stock basis adjustments. The final regulations clarify the proposed regulation’s aggregation rule that members of an affiliated group are treated as a single corporation only for applying the control requirement.
Transfers Described in Other Nonrecognition Provisions
The 2008 proposed regulations attempted to clarify that Section 367(a)(5) applies to a transfer of property described in Section 351 if the transfer is also described in Section 361(a) or Section 361 (b). This clarification ensures that the policies underlying Section 367(a)(5) are not undermined by transfers described in Section 361(a) or Section 361 (b) that also qualify for nonrecognition under Section 351. A comment was received that transfers falling with Sections 361(a) or 361(b) could also be described in non-recognition provisions other than Section 351, including Section 354. The final regulations modify the 2008 proposed regulations to provide that, unless a specific exception applies, the U.S. transferor recognizes any gain realized with respect to Section 367(a) property. Where a transfer of items of property that is described in Section 361(a) or (b) is also described in a non-recognition provision that is not excepted from Section 367(a)(1), e.g., Section 1036 exchanges, the U.S. transferor is required to recognize gain or loss realized on the transfer of such items of property, but the amount of loss recognized on the property may not exceed the amount of gain recognized on the property. But see for example, Section 267(f).
Other Clarifications and Modifications to the 2008 Proposed Regulations
The 2008 proposed regulations provide for that for purposes of the control group membership test, that such determination be made "at the time of the Section 361 exchange.” Interpreted literally this rule would not take into account the possibility that the property of the U.S. transferor may be transferred on more than one day to the foreign acquiring corporation. The final regulations revise the 2008 proposed regulations by striking the phrase "at the time of the Section 361 exchange" as the time for making certain determinations required under the regulations. Thus, for example, the final regulations provide that determinations on whether the control requirement is met for Section 367(a)(5) purposes is made immediately before the reorganization. The final regulations further revise the computation of the ownership interest percentage to take into account certain distributions by the U.S. transferor of a portion of its property. More particularly, the final regulations require the ownership interest percentage be determined after taking into account any distribution by the U.S. transferor of money or other property not received from the foreign acquiring corporation in exchange for property of the U.S. transferor acquired in the Section 361 exchange. Other semantic changes were made in the final regulations that were not considered by the Treasury or IRS to be substantive changes. There were also further coordinating modifications made to Treas. Reg. §1.367(a)-7 when the property transferred in the Section 361 exchange is stock or securities. See Treas. Regs. §§1.367(a)-3T(e), 1.367(b)-4, 1.1248(f)-1, and 1.1248(f)-2.
The 2008 proposed regulations set forth a “reasonable cause” relief rule in Treas. Reg. § 1.367(a)-7(e)(2), whereby a control group member's failure to timely comply with any requirement of Treas. Reg. § 1.367(a)-7 will be deemed not to have occurred if the failure was due to reasonable cause and not willful neglect. Included in the reasonable cause relief rule is a “deemed” cure provision whereby the control group member will be deemed to have established that the failure to comply was due to reasonable cause and not willful neglect where the control group member requesting relief is not notified by the IRS within 120 days of IRS acknowledgement of receipt of the request. The final regulations eliminated the 120 day deemed cure provision. The rest of the reasonable cause relief provision is retained in the temporary regulations.
Other Regulations Issued under Section 367(a)
The 2008 proposed regulations would have modified Treas. Reg. § 1.367(a)-1T(b)(4)(i)(B) to provide that an increase in basis under Section 362 for gain recognized by the U.S. transferor under Section 367(a) is allocated among the transferred property with respect to which gain is recognized in proportion to the gain realized by the U.S. transferor. The final regulations clarify that where gain is recognized under Section 367 with respect to a particular item of property, the foreign transferee corporation increases its basis in that item of property for such gain. The final regulations also clarify gain recognized that is not with respect to a particular item of property (for example, gain recognized under the branch loss recapture rules) is to be allocated in proportion to the gain realized by the U.S. transferor with respect to all items of property transferred, but for this purpose the gain realized is determined after taking into account gain recognized under other provisions of Section 367 that apply with respect to particular items of property.
Regulations Issued under Section 367(b)
Modified Example 4 of Treas. Reg. § 1.367(b)-4(b)(1)
Final regulations issued under Section 367(b) on January 24, 2000, provide where a U.S. transferor who is a Section 1248 shareholder of a foreign acquired corporation transfers the stock of such corporation to a foreign acquiring corporation in a Section 361 exchange, the U.S. transferor must include in income the Section 1248 amount attributable to the stock of the foreign acquired corporation. Immediately after the exchange, 2000 final regulations provide that the U.S. transferor is no longer a Section 1248 shareholder because the stock of the U.S. transferor is cancelled even if the foreign acquiring corporation and the foreign acquired corporation are controlled foreign corporations per Treas. Reg. § 1.367(b)-2(a). See Treas. Reg. § 1.367(b)-4(b)(1)(iii), Example 4.
The 2008 proposed regulations attempted to modify Treas. Reg. § 1.367(b)-4(b)(1)(iii), Example 4, to provide that the requirements in Treas. Reg. § 1.367(b)-4(b)(1)(i)(B) are applied immediately after the Section 361 exchange and prior to the distribution of the foreign stock under Section 361(c)(1).
In responding to comments concerning application of step-transaction analysis and disregarding transitory stock ownership for purposes of apply Section 367(b) regulations, see Rev. Rul. 83-23, 1983-1 C.B. 82, the Preamble to the final regulations provides that subject to a specific exception, the judicial doctrines and fundamental tax law principles, such as substance-over-form and the step-transaction doctrine, are to be applied in determining whether the conditions for an income inclusion under Treas. Reg. § 1.367(b)-4(b)(1) are satisfied. As an illustration, the issuance of stock by the foreign acquiring corporation in connection with the exchange being tested under Treas. Reg. § 1.367(b)-4 would be taken into account in determining whether an income inclusion under Treas. Reg. § 1.367(b)-4(b)(1) is required.
Still, the Treasury and IRS consider it necessary to respect the ownership of stock by the U.S. transferor in examining an outbound Section 361 exchange such as that described in Example 4. This is because the Section 1248 amount in the stock of the foreign acquired corporation will, in the aggregate, either be preserved in the hands of certain domestic corporate shareholders of the U.S. transferor pursuant to Treas. Reg. § 1.1248(f)-2(c), or be included in the gross income of the U.S. transferor as a result of the distribution of such stock under Section 361(c) and in accordance with Treas. Reg. § 1.1248(f)-1(b)(3).
The final regulations require that in an outbound transfer of stock of a foreign corporation in a Section 361 exchange, the requirements of Treas. Reg. § 1.367(b)-4(b)(1)(ii)(B) apply after the Section 361 exchange, but prior to and without taking into account the U.S. transferor's distribution under Section 361(c)(1).
The final regul
ations further modify Treas. Reg. § 1.367(b)-4(b)(1) by expanding the type of exchanges for which an income inclusion is not required to include a Section 361 exchange of foreign stock by a foreign target that is itself acquired in a triangular asset reorganization involving stock of a domestic controlling (parent) corporation.
Revisions to Section 1248(f) Regulations and Treas. Reg. §1.1248-8
Section 1248(a) provides that gain from a U.S. person's disposition of controlled foreign corporation’s stock is treated as dividend income to the extent of the earnings and profits attributable to the stock that were accumulated during the term of the U.S. person’s stock ownership. A U.S. person is a person who owns, as provided in Section 958(a), or is considered as owning by applying the constructive ownership rules of Section 958(b), 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation at any time during the 5 year period ending on the date of the sale or exchange when such foreign corporation was a controlled foreign corporation defined under Section 957.
As a protective rule to avoid the circumvention of Section 1248(a), Section 1248(f) provides that even though a U.S. person exchanges stock in a CFC in an otherwise non-recognition transaction, gain is recognized and characterized as dividend income in an amount that is equal to the Section 1248(a) dividend that the distributing corporation would have recognized if it sold the CFC stock for its full fair market value. For example, despite the fact that Section 337 generally allows for a tax-free liquidation of a controlled subsidiary into its parent corporation, where the subsidiary is a CFC and the parent is a domestic corporation, gain is required to be recognized. Section 1248(f) also requires a domestic corporation to recognize gain on distributing CFC stock to its shareholders pursuant to a plan of reorganization which would normally be non-taxable to the shareholders under Section 354. Exceptions from the gain recognition rule are also contained in Section 1248(f)(2) where the distributee of the CFC stock: (i) is also a domestic corporation; (ii) the transaction is an exchanged basis transaction allowing for tacking of holding period with respect to the transferred CFC stock; and (iii) the distribute would be subject to Section 1248(a) on a sale of the stock immediately after the distribution.
On August 20, 2008, some thirty-two years after the enactment of Section 1248(f), which provided that certain otherwise non-taxable exchanges of stock involving a U.S. person’s disposition of CFC stock would still result in ordinary income treatment to the extent that the gain realized could be absorbed by the accumulated earnings and profits of the CFC, proposed regulations were issued under Section 1248(f). See Notice 1987-67.
The principal for preserving Section 1248 taint is contained in Treas. Reg. § 1.1248(f)-2. It provides that Section 1248 gain will not be implicated triggered by the distribution of stock by a Section 1248 stockholder so long as the Section 1248 taint on the distributed stock can be preserved through basis and holding period adjustments. Thus, Treas. Reg. § 1.1248(f)-2(a) deals with “§ 337 distributions” (in a Section 332 liquidation) of Section 1248 tainted stock and gain will not be triggered provided that the the distributee is an 80-percent parent and continues to be a Section 1248 shareholder, holding period for the stock carries over, and basis in the distributed stock is not stepped up.
Treas. Reg. § 1.1248-2(b), which pertains to “§ 355 distributions” of Section 1248 tainted stock, similarly provides that Section 1248 gain will not be recognized on the distribution of Section 1248 tainted stock by a domestic corporation if all the parties to the distribution so elect, and also agree to make appropriate adjustments to their basis and holding period for that stock so as to preserve the Section 1248 taint in the hands of the distribution of stock. In like fashion, Treas. Reg. §1.1248-2(c) deals with distributions pursuant to a plan of reorganization, and provides an election not to trigger Section 1248 taint on the distributed stock by agreeing to make appropriate bases and holding period adjustments so as to preserve the Section 1248 taint on the stock in the hands of the distributees. Examples are provided in the final regulations in Treas. Reg. §1.1248-2(d).
Section 337 Distributions
The 2008 proposed regulations under Section 1248(f) provided exceptions to the operative rule of section 1248(f)(1) that requires a domestic corporation (distributing corporation) that distributes stock of certain foreign corporations under Sections 337, 355(c)(1), or 361(c)(1) to include in income the Section 1248 amount (if any) in the foreign stock distributed. Except in the case of a Section 337 distribution, the exceptions apply only if an affirmative election is made (assuming the requirements for making the election are satisfied). The requirements for the election include making adjustments to the basis and holding period of the stock in the hands of the distributee to the extent necessary to preserve the Section 1248 amount in the foreign stock in the hands of the distributee. In the case of a Section 337 distribution, the exception applies if certain conditions are satisfied without the need to make adjustments to the basis or holding period of the distributed stock, which should generally be the case. The final regulations allow taxpayers to elect to make necessary basis adjustments and holding period adjustments in an effort to avoid a Section 1248 realization even for Section 337 distributions.
Section 361(c)(1) Distributions of Stock With Respect to Section 361 Exchanges
The Preamble states in this area that the application of the 2008 proposed regulations under Section 1248(f), in combination with the 2008 proposed regulations under Treas. Reg. § 1.367(a)-7, could in certain cases result in aggregate basis adjustments and gain recognition (or deemed dividend inclusions) that exceed the built-in gain in the property transferred by the U.S. transferor in the section 361 exchange. The final regulations are modified to address this result.
As to allocations of stock basis, where in a Section 361 exchange the U.S. transferor transfers property, other than a single block of stock of a foreign corporation with respect to which the U.S. transferor is a Section 1248 shareholder, each share of stock of the foreign distributed corporation is required to be divided into portions. The 2008 proposed regulations provided that for purposes of computing basis in a portion of a share of stock of the foreign distributed corporation, the distributee Section 1248 shareholder's Section 358 basis in that share is allocated to a portion of a share pro rata based on the fair market value of the property to which the portion relates relative to the aggregate fair market value of all property received by the foreign distributed corporation.
The final regulations provide that the distributee's Section 358 basis in a share of the distributed foreign corporation is allocated to a portion of a share pro rata based on the basis of the property to which the portion relates relative to the aggregate basis of all property received by the foreign distributed corporation. As a result of this modification, the aggregate built-in gain in the respective portion of all shares to which a block of foreign stock transferred with a Section 1248 amount relates will more closely match the built-in gain in such foreign stock transferred. Since Section 1248 gain is limited to the built-in gain in the stock, the modification will minimize basis reductions to portions of shares that may otherwise be required to preserve the Section 1248 amount in foreign stock transferred.
The 2008 proposed regulations also provided that where the Section 1248(f) amount attributable to a portion of a share of stock (including a whole share, if appropriate) of the foreign distributed corporation received by a distributee Section 1248 shareholder in the distribution exceeds the distributee Section 1248 shareholder's postdistribution amount in the portion (excess amount), then the distributee Section 1248 shareholder's Section 358 basis in the portion is reduced by the excess amount. The final regulations modify this approach and provide that the Section 358 basis in the portion is not reduced below zero, and therefore to the extent the excess amount exceeds the Section 358 basis in the portion, the domestic distributing corporation must include that portion of the Section 1248(f) amount attributable to the portion of the share in gross income as a dividend. The excess amount may be greater than the Section 358 basis in the portion, for example, where the Section 1248(f) amount attributable to the control group member exceeds the inside gain attributable to the control group member. The final regulations also provide that the Section 358 basis in a share of stock is allocated among portions of such share of stock based on the basis (rather than the fair market value) of the property transferred to the foreign distributed corporation in the Section 361 exchange will, in many cases, minimize the amount of basis decreases.
Multiple Classes Of Stock For Section 1248 Purposes
The 2008 proposed regulations did not contain rules for addressing the distribution of multiple classes of stock of the foreign corporation. This issue was covered in the final regulations. The final regulations provide that if multiple classes of stock are received by a control group member, the Section 1248(f) amount "traced" to such control group member is attributed to a share (or portion of a share) of stock received by the control group member based on the ratio of the fair market value of such share to the fair market value of all shares received by the control group member. The final regulations also make consistent modifications to the regulations under Treas. Reg. § 1.1248-8 (attribution of Section 1248 earnings and profits of stock of a foreign corporation transferred in a Section 361 exchange to a share or portion of a share of stock of the foreign distributed corporation received by a Section 1248 shareholder).
Other Modifications to the Regulations Under Section 1248(f)
The final regulations provide that where the domestic distributing corporation distributes stock of the foreign distributed corporation that it did not receive in a Section 361 exchange (existing stock) in addition to stock of the foreign distributed corporation that it did receive in the Section 361 exchange (new stock), then certain rules apply to the existing stock and another set of rules apply to the new stock. For example, this situation could arise where a domestic distributing corporation owns an existing foreign subsidiary and as part of the plan that includes a distribution of that stock that qualifies under Section 355, the domestic distributing corporation contributes additional property to the foreign subsidiary in exchange for additional stock of the foreign subsidiary. The final regulations refer to a distribution of stock that is not received in a section 361 exchange as an "existing stock distribution," and a distribution of stock received in a section 361 exchange as a "new stock distribution."
The 2008 proposed regulations, set forth a reasonable cause relief provision in Prop. Reg. § 1.1248(f)-3, pursuant to which a reporting person's failure to timely comply with any requirement of Prop. Reg. § 1.1248(f)-2 will be deemed not to have occurred if the failure was due to reasonable cause and not willful neglect. The reasonable cause relief provision includes a provision that the reporting person will be deemed to have established that the failure to comply was due to reasonable cause and not willful neglect if the control group member requesting relief is not notified by the IRS within 120 days of IRS acknowledgement of receipt of the request. The Treasury Department and the IRS believe it is appropriate to eliminate the 120-day provision from the reasonable cause relief provision of Prop. Reg. § 1.1248(f)-3. Other than the elimination of the 120-day provision, the reasonable cause relief provision is retained in the temporary regulations.
Definition of "Sale or Exchange" for Purposes of Section 1248
The 2008 proposed regulations amended § 1.1248-1(b) to clarify the definition of the term "sale or exchange" to include gain recognized under section 301(c)(3). No changes to § 1.1248-1(b) are included as part of these final regulations because after issuance of the 2008 proposed regulations a temporary regulation was issued that included this amendment. See Treas. Reg. § 1.1248-1T(b), issued in TD 9444 (February 10, 2009), and changes finalized by TD 9585 (April 24, 2012).
Regulations under Section 6038B
The 2008 proposed regulations contain various reporting requirements. The 2008 regulations to Section 6038B explain the manner in which a U.S. transferor makes the election under Treas. Reg. § 1.367(a)-7(c), including requiring the U.S. transferor to file a statement containing specified information. The final regulations identify certain additional items of information that must be included with the statement making the election. The 2008 regulations also require the U.S. transferor to file a statement agreeing to file an amended return in certain cases if the foreign acquiring corporation subsequently disposes of a significant amount of Section 367(a) property acquired in the Section 361 exchange. The final regulations modify the disposition rules to provide that certain dispositions of Section 367(a) property are not dispositions for this purpose.
Elimination of Coordination Rule Exception in Treas. Reg. § 1.367(a)-3(d)(2)(vi)(B)(1)(i)
Treas. Reg. §1.367(a)-3(d)(2)(vi)(A) (coordination rule) provides that if in connection with an indirect stock transfer, i.e., Treas. Reg. § 1.367(a)-3(d)(1), a U.S. person transfers assets to a foreign corporation (direct asset transfer) in an exchange described in Sections 351 or 361, the rules of Section 367 and regulations apply first to the direct asset transfer and then to the indirect stock transfer. There are two exceptions to this priority rule provision. The exceptions apply to asset reorganizations to the extent the foreign acquiring corporation re-transfers the transferred assets to a controlled domestic corporation, but only if such domestic corporation's basis in the re-transferred assets is not greater than the U.S. transferor corporation's basis in the assets and the conditions in either paragraph Treas. Regs. §§ 1.367(a)-3(d)(2)(vi)(B)(1)(i) or (d)(2)(vi)(b)(1)(ii) are satisfied. The 2008 proposed regulations would modify the exceptions to the coordination rule exceptions, including clarifications described in Notice 2008-10 (2008-1 CB 277). Under the temporary regulations just issued, the coordination rule contained in Treas. Reg. §1.367(a)-3(d)(2)(vi)(B)(1)(i) has been eliminated but the coordination rule exception in § Treas.Reg. §1.367(a)-3(d)(2)(vi)(B)(1)(ii) has been retained in the temporary regulations.
Effective Dates
The Preamble states that the final regulations under Sections 367(a) and 6038B, per Treas. Reg. § 1.367(a)-7 and the revisions to §§ 1.367(a)-1 and 1.6038B-1 apply to transfers occurring on or after April 17, 2013. The 2008 proposed regulations provide that the rules under Sections 367(b) and 1248(f), including the modification to Example 4 of § 1.367(b)-4(b)(1)(iii), apply to distributions or exchanges, respectively, occurring on or after the date that is 30 days after the date the regulations are published as final regulations in the Federal Register.
The Treasury Department and the IRS announced in the Preamble that taxpayers may not rely on the modifications to Example 4 of Treas. Regs. § 1.367(b)-4(b)(1)(iii) and § 1.1248-8, and the regulations under Section 1248(f) prior to the effective date. Taxpayers must apply section 1248(f), which does not include the exceptions provided in Treas. Reg. § 1.1248(f)-2 for such prior periods. Accordingly, distributions described in section 1248(f)(1) during such period result in an inclusion unless the exception described in Section 1248(f)(2) applies. Similarly, taxpayers must take into account Example 4 of Treas. Reg. § 1.367(b)-4(b)(1)(iii) (before amendment by these final regulations) for such prior periods. Since the regulations under Sections 367(b) and 1248(f) operate together with the rules of Treas. Reg. § 1.367(a)-7, the provisions should be subject to consistent effective dates. Therefore, the final regulations retain the 30-day delay in the effective date for these rules. Modifications to § 1.1248-6 apply to a sale, exchange, or other disposition of the stock of a domestic corporation on or after September 21, 1987.
Subject to rules implementing the effective dates announced in Notice 87-64 (1987-2 CB 375), the final regulations under Section 1248(f) are applicable as of the date that is 30 days following the issuance of the final regulations.
As mentioned, more commentary on the regulations package to follow. This posting is a start...perphaps a substantial one, but a start.
