On 18 March 2013, the IRS and Treasury published final, temporary and proposed regulations under Sections 367 and 12481 that address the treatment of outbound transfers of property by US corporations and other matters (“2013 Regulations”). The 2013 Regulations adopt parts of the proposed regulations issued in 2008, with substantial modification, as either final or temporary and proposed regulations.
The 2013 Regulations have broad impact and taxpayers contemplating a cross-border reorganization or asset transfer should carefully consider the impact of these regulations. This is especially true for taxpayers contemplating transactions designed to facilitate post-acquisition business integration and asset repatriations. With certain exceptions described below, the regulations are generally effective on 18 April 2013.
The following briefly summarizes certain significant aspects of the regulations.
Final Regulations under Section 367(a)(5).
Under Section 367(a)(1), a US person must recognize gain (but not loss) on the transfer of property to a foreign corporation in an exchange described in Sections 332 (liquidations), 351 (contributions of assets for stock), 354, 356 or 361 (corporation reorganizations). However, an exception to this gain recognition rule exists for assets transferred to a foreign corporation that uses the assets in an active trade or business. Under Section 367(a)(5), a domestic corporation that transfers property to a foreign corporation in an outbound asset reorganization generally may not use the active trade or business exception, unless it and certain of its controlling shareholders make an election under the Final 367(a)(5) Regulations to preserve built-in gain on its assets attributable to such shareholders, as described below.
To make this election, a domestic corporation that transfers assets to a foreign corporation must satisfy the five requirements detailed below.
- The domestic corporation must be “controlled” (within the meaning of Section 368(c)) by five or fewer, but at least one, domestic corporations (each a member of a control group). Only domestic corporations that directly own stock of the domestic transferor corporation may be members of the control group but RICs, REITs and S Corporations (“special corporate entities”) may not.
- The US transferor corporation must recognize gain on the portion of its “inside gain” attributable to persons not members of the control group (e.g. individuals, partnerships, special corporate entities and foreign corporations) or to any member that cannot make a basis adjustment sufficient to preserve their portion of the domestic corporation’s built-in gains. The Final 367(a)(5) Regulations also provide rules on how to adjust the tax basis of the property for gains recognized. The regulations also provide an anti-stuffing rule that disregards a contribution of built-in loss property to a domestic corporation if the contribution was made with a principal purpose of reducing the domestic corporation’s net inside gain.
- Each qualified group member must make basis adjustments in the stock of the foreign acquiring corporation received in the reorganization necessary to preserve that member’s attributable portion of the domestic corporation’s inside gains.
- The domestic corporation must agree to amend its return and recognize gain if the foreign transferee corporation disposes of a significant amount of the property received from the domestic transferor.
- The domestic corporation and each control group member must file a timely election statement to make the election. A reasonable cause relief provision provides taxpayers with a remedy for failure to make the timely election. However, that relief provision was modified in the Final 367(a)(5) Regulations and no longer includes the automatic 120-day acceptance provision.
While these rules provide taxpayers with a reliable mechanism to avoid gain recognition upon a transfer of assets to a foreign corporation, a domestic transferor must agree to amend its return and recognize gain if the foreign transferee corporation disposes of the assets under certain conditions. For example, if the foreign corporation disposes of 40% of the fair market value of the property received during the 60-month period that begins on the date of the outbound transfer, the election to apply the active trade or business exception is not valid unless an exception applies. One exception is a disposition by the foreign corporation of assets in the ordinary course of business. Of course taxpayers will need to support any claim of exemption through appropriate documentation.
Stock with Built-in losses
The final regulations make clear that basis adjustments made under the election provided in the Final Section 367(a)(5) Regulations can convert built-in loss stock into built-in gain stock. For example, if a control group member has $20 built-in loss ($100 basis and $80 FMV) and the member’s share of inside gain is $40, then the member’s basis in the stock of the foreign corporation received in the reorganization must be reduced to $40, converting the member’s built-in loss on the stock to built-in gain. Of course, the member could forego the election and recognize the $40 of inside gain instead of losing $60 of basis, depending on what is more beneficial under a given set of facts.
Treatment of Intangibles
For many years, it has been unclear whether the transfer of goodwill or certain other intangibles are subject to gain recognition under Section 367(a) or Section 367(d) and the 2013 Regulations unfortunately fail to resolve this issue. While taxpayers may be required to recognize gain on the transfer of property subject to Section 367(a), gain is not recognized on a transfer subject to Section 367(d); rather taxpayers may be required to take into income a deemed royalty upon a transfer of property covered by Section 367(d). While the regulations clarify that certain intangibles (e.g. patents, formulas, copyrights, etc.) are subject to the special rules governing transfers of intangibles contained in Section 367(d), goodwill or certain other intangibles (e.g. workforce in place and know-how) are arguably not covered by Section 367(d) possibly leaving them to be taxed under 367 (a). As a result, the treatment of such intangibles remains unclear although government officials have publicly stated that they plan to address the treatment of these intangibles in a future regulations project under Section 367(d).
Final Regulations under Section 367(b)
Section 367 generally acts as a “backup” to Section 1248, which requires US domestic corporations to recognize ordinary gain (Section 1248 gain) on stock in a controlled foreign corporation upon the sale, exchange or other disposition (including certain distributions that would otherwise be non-taxable). The amount of ordinary gain is generally limited to the shareholder’s pro rata share of the controlled foreign corporation’s earnings and profits.
However, the final regulations potentially limit the triggering of Section 1248 gain when a US domestic corporation transfers its stock in a controlled foreign corporation in exchange for stock in a foreign corporation as part of a reorganization where the domestic corporation liquidates. Under prior rules, a domestic corporation had to recognize gain in such an exchange because it no longer maintained its “Section 1248” status with respect to the foreign corporation immediately after the exchange. The final regulations potentially change this result by requiring a domestic corporation to test its Section 1248 status immediately after the exchange without regard to whether it will liquidate thereafter. As a result, a domestic corporation may not be forced to recognize 1248 gain solely because it liquidates and “loses” its status as a Section 1248 shareholder. Even though this rule provides relief from automatic recognition of Section 1248 gain solely because the domestic corporation liquidates, the final regulations make clear that the domestic corporation must recognize Section 1248 gain if it distributes stock of a foreign corporation received in exchange for its stock in a CFC unless it qualifies for an exception as described below.
Final Section 1248 Regulations
A domestic corporation that transfers stock of a controlled foreign corporation as a liquidating distribution must generally recognize Section 1248 gain unless it qualifies for an exception even though such a distribution would otherwise be non-taxable (e.g. a distribution by a domestic corporation in liquidation to an 80% owner). However, such a distribution is eligible for non-recognition treatment if the distributee is (a) a US corporation that inherits the holding period of the distributing US corporation and (b) a Section 1248 shareholder (i.e. a 10% owner by vote) of the controlled foreign corporation immediately after the distribution. Under the 2013 Regulations, this exception is available if the distributee (i) is an 80% owner of the distributing domestic corporation and a Section 1248 shareholder of the foreign corporation (ii) has a holding period in the stock received that is the same as the US distributing corporation’s holding period and (iii) has a basis in the stock received that is not greater than the US distributing corporation’s basis. Taxpayers that cannot satisfy requirements (ii) and/or (iii) may elect to adjust their basis and holding period in order to take advantage of the non-recognition election.
Temporary Regulations Curtail Cash Repatriation Strategies
The 2013 Regulations include certain temporary regulations designed to address certain outbound transfers known as “Deadly D” transactions that the IRS considered to be abusive repatriation transactions.
There are several variations of Deadly D transactions but they generally take the following form. A US parent corporation “sells” stock in a US corporation (US Sub) to a controlled foreign corporation (CFC) in exchange for cash and little or no stock in the CFC. The CFC liquidates the US Sub and then contributes the assets of the US Sub to a newly formed US corporation (US Newco). Under previously issued regulations (and IRS Notice 2008-10), the transfer of the US Sub to the CFC could be accomplished tax free if certain requirements were met. In particular, the US parent was required to make adjustments to its cost basis in the CFC to reflect any unrecognized gain in the assets of the US Sub, along with certain other requirements. Taxpayers that entered into this transaction could effectively repatriate cash from a CFC without incurring US tax if the requisite basis adjustments were made.
This type of tax-free repatriation was viewed as particularly offensive because it allowed taxpayers to defer taxation on appreciated assets in addition to obtaining previously untaxed cash earned from offshore operations. To curtail this practice, the 2013 Regulations eliminate the rules that allow taxpayers to defer recognition of gain on the outbound transfer of appreciated assets. The IRS also plans to continue to study transactions that achieve similar results and presumably may issue further guidance to address other repatriation transactions that it finds abusive.
Overall, the 2013 Regulations are a “mixed bag” for taxpayers. In some cases, the regulations relieve taxpayers from having to recognize gain on certain outbound transfers, and in other situations the regulations will require taxpayers to recognize gain. In all events, taxpayers must tread carefully because the US tax rules governing outbound transfers and cross-border reorganizations are extremely detailed and complex.