News Briefings - Federal Tax

The following article is from the 8/21/08 issue of Federal Taxes Weekly Alert.

 8/21/08 -- New comprehensive proposed regs on outbound transfers include elective exception to gain recognition

Preamble to Prop Reg, 08/19/2008; Prop Reg § 1.367(a)-3, Prop Reg § 1.367(a)-7, Prop Reg § 1.1248-6, Prop Reg § 1.1248-8, Prop Reg § 1.1248(f)-1, Prop Reg § 1.1248(f)-2, Prop Reg § 1.1248(f)-3

IRS has issued proposed regs under Code Sec. 367(a)(5) that would provide an elective exception under which various exceptions could apply to Code Sec. 367(a), which generally requires gain to be recognized on outbound transfers by domestic corporations to foreign corporations. IRS also has issued proposed regs under Code Sec. 1248(f) that would apply to a domestic corporation that distributes stock of certain foreign corporations in a distribution to which Code Sec. 337, Code Sec. 355, or Code Sec. 361 applies. In addition, the application of Code Sec. 1248(e) would be suspended when capital gains are taxed at a rate equal to or greater than the rate at which ordinary income is taxed. The proposed regs would also set out reporting requirements under Code Sec. 6038B for certain transfers of property by a domestic corporation to a foreign corporation in certain exchanges described in Code Sec. 361(a) or Code Sec. 361(b). Other than regs described in previously issued notices and incorporated in the proposed regs, the proposed regs would generally be effective 30 days after they are finalized. However, taxpayers may make reasonable adjustments based on the Code Sec. 367(a)(5) elective exception in the proposed regs until 30 days after the regs are published as final.

Background. Under Code Sec. 367(a)(1), if a U.S. person transfers property to foreign corporation in connection with an exchange described in Code Sec. 332, Code Sec. 351, Code Sec. 354, Code Sec. 356, or Code Sec. 361, then the foreign corporation generally isn't considered a corporation for purposes of determining gain on the transfer. As a result of the Code Sec. 367(a)(1) rule, transfers of property to a foreign corporation that would otherwise be tax-free are treated as taxable exchanges. An exception to this general rule is provided under Code Sec. 367(a)(2) for transfers of stock or securities of a foreign corporation that's a party to the exchange or reorganization and under Code Sec. 367(a)(3) for certain property used in an active foreign trade or business. However, Code Sec. 367(a)(5) provides that, except to the extent provided in regs, these exceptions do not apply to a transfer of property by a domestic corporation to a foreign corporation in a Code Sec. 361(a) or Code Sec. 361(b) exchange (which generally provides nontaxable treatment for stock or securities and distributed boot that is received in a reorganization).

Under Code Sec. 367(b)(1), where there is no transfer of property in an exchange under the general rule, a foreign corporation is considered to be a corporation, except to the extent provided in regs that are necessary to prevent the avoidance of federal income taxes. A fundamental policy of Code Sec. 367(b) is to preserve the potential application of Code Sec. 1248 following the acquisition of the stock or assets of a foreign corporation by another foreign corporation. Under Code Sec. 367(c)(1), any distribution under Code Sec. 355 (or so much of Code Sec. 356 as relates to Code Sec. 355) is treated as an exchange for purposes of Code Sec. 367 whether or not it's an exchange. Under Code Sec. 1248(a), a U.S. person includes in gross income as a dividend any gain recognized on the sale or exchange of a foreign corporation's stock that was a controlled foreign corporation (CFC) at any time during the 5-year period ending on the date of the sale or exchange but only if the U.S. person owned (or is considered to have owned) 10% or more of the total combined voting power of the foreign corporation at any time during that 5-year period (a section 1248 shareholder). Under Code Sec. 1248(e), except as provided in regs, if a U.S. person sells or exchanges stock of a domestic corporation that was formed or availed of principally for the holding, directly or indirectly, of stock of one or more foreign corporations, the sale or exchange is treated for purposes of Code Sec. 1248 as a sale or exchange of the foreign corporation's stock held by the domestic corporation.

Under Code Sec. 1248(f)(1), except as provided in regs, if a domestic corporation (domestic distributing corporation) that is a section 1248 shareholder with respect to a foreign corporation distributes the stock of the foreign corporation in a distribution described in Code Sec. 311(a), Code Sec. 337, Code Sec. 355(c)(1), or Code Sec. 361(c)(1), then notwithstanding any other provisions of the Code, the domestic distributing corporation must include in income as a dividend the Code Sec. 1248 amount attributable to the stock to the extent the domestic distributing corporation doesn't otherwise recognize gain on the distribution. Under Code Sec. 1248(f)(2), however, Code Sec. 1248(f)(1) doesn't apply to a domestic distributing corporation's distribution of stock of a foreign corporation to a domestic corporation that is treated as holding the stock for the period during which the stock was held by the domestic distributing corporation and that, immediately after the distribution, is a section 1248 shareholder with respect to the foreign corporation.

Elective exception under proposed regs. The proposed regs would confirm the general rule of Code Sec. 367(a)(5) (denying the exceptions under Code Sec. 367(a)), but would provide an elective exception to the general rule under which the exceptions under Code Sec. 367(a) and its regs may be available. They would also clarify that the general rule of Code Sec. 367(a)(5) applies to a transfer of property under a Code Sec. 351 exchange that qualifies as both a Code Sec. 351 exchange and a Code Sec. 361 exchange.

Under the proposed regs' elective exception to Code Sec. 367(a)(5), if certain conditions and requirements are satisfied, then the exceptions provided in Code Sec. 367(a) and its regs would be available to the transfer of property by the U.S. transferor to the foreign acquiring corporation in a Code Sec. 361 exchange. Even if the exception applies, the U.S. transferor might still recognize gain on the Code Sec. 361 exchange in certain circumstances, including any gain otherwise required to be recognized under Code Sec. 367(a) (for example, under Code Sec. 367(a)(3)(B) and Code Sec. 367(a)(3)(C)). The proposed regs would apply to all property transferred by the U.S. transferor in the Code Sec. 361 exchange, other than property to which Code Sec. 367(d) applies (Code Sec. 367(d) property). The proposed regs would preserve (or require the recognition of) the net built-in gain in the Code Sec. 367(a) property transferred in the Code Sec. 361 exchange (generally defined as "inside gain"). Under the proposed regs, a transfer of Code Sec. 367(a) property under a Code Sec. 361 exchange to which the elective exception applies would be treated differently than a transfer of built-in gain property and built-in loss property by a U.S. person to a foreign corporation in a Code Sec. 351 exchange that is not also a Code Sec. 361 exchange. In the latter case, only the built-in gain property would be subject to Code Sec. 367(a)(1), and the U.S. transferor would be required to recognize gain for the property without offsetting the gain with losses related to the built-in loss property.

The proposed regs would also contain an anti-stuffing rule under which property wouldn't be considered Code Sec. 367(a) property if the U.S. transferor acquires the property in connection with the Code Sec. 361 exchange with a principle purpose of affecting the determination under the proposed regs (for example, inside gain and inside basis).

Coordination rule exception. The proposed regs under Code Sec. 367(a) would incorporate the regs described in Notice 2008-10, 2008-3 IRB 277, to thwart transactions intended to use the coordination rule exception inappropriately to repatriate earnings and profits of foreign corporations without the recognition of gain or a dividend inclusion. Certain outbound reorganizations followed by transfers to controlled corporations and certain successive transfers of property to which Code Sec. 351 apply constitute indirect stock transfers; in an indirect stock transfer in which a domestic corporation transfers property to a foreign corporation, the general coordination rule provides that Code Sec. 367(a) and Code Sec. 367(d) apply to the transfer of assets before application of the indirect stock transfer rules of Reg § 1.367(a)-3(d). The proposed regs incorporate, with modifications, the clarifications to the conditions for the application of Notice 2008-10's coordination rule exception.

CFC proposed regs. The proposed regs under Code Sec. 1248(f) would include regs described in Notice 87-64, 1987-2 CB 375, in which IRS said that, in the case of Code Sec. 355 distributions of CFC stock, regs may limit the application of Code Sec. 1248(f)(1) to distributions in which the CFC is no longer a CFC after the distribution or in which one or more of the distributees are not U.S. shareholders of the CFC after the distribution. Notice 87-64 further stated that the regs would ensure that, subsequent to a Code Sec. 355 distribution of CFC stock that would not be subject to Code Sec. 1248(f)(1) under the regs, the amount of gain recognized from a disposition of the CFC stock that would be recharacterized as a dividend under Code Sec. 1248(a) would include the earnings and profits attributable to the CFC stock under Code Sec. 1248 as of the date of the Code Sec. 355 distribution. To achieve this result, the notice provided that the regs may require appropriate adjustments to the basis and holding period of the CFC stock received by one or more of the distributees.

The proposed regs under Code Sec. 1248(f) would provide that a domestic distributing corporation that is a section 1248 shareholder of a foreign corporation and that distributes stock of such foreign corporation in (1) a distribution to which Code Sec. 337 applies, or (2) a Code Sec. 355 distribution, other than stock received by the domestic distributing corporation in a Code Sec. 361 exchange, would generally include in income as a dividend the section 1248 amount attributable to the stock distributed. The rule in (2) would apply only to the extent the domestic distributing corporation doesn't otherwise recognize gain on the Code Sec. 355 distribution, in which case the gain recognized would be recharacterized as a dividend under Code Sec. 1248(a). The proposed regs would also provide that a domestic distributing corporation that is a section 1248 shareholder of a foreign distributed corporation and that distributes stock of the corporation received in a Code Sec. 361 exchange, in a Code Sec. 355 distribution or a distribution to which Code Sec. 361 applies would, notwithstanding any other provision of the Code, include in income as a dividend the Code Sec. 1248(f) amount attributable to the stock distributed. The Code Sec. 1248(f) amount would equal the aggregate amount that would be included in income as a dividend by the foreign distributed corporation under Code Sec. 964(e) if, immediately after the Code Sec. 361 exchange that preceded the Code Sec. 355 distribution or Code Sec. 361 distribution, the foreign distributed corporation sold the stock of each foreign corporation received in the Code Sec. 361 exchange. This rule would supplement the proposed regs under Code Sec. 367(b) which provide an exception to the general rule of Reg § 1.367(b)-4(b)(1)(i) in certain cases where stock of a foreign acquired corporation is transferred by a U.S. transferor in a Code Sec. 361 exchange. The proposed regs would also incorporate the statutory exception provided by Code Sec. 1248(f)(2) and provide elective exceptions for Code Sec. 355 and Code Sec. 361 distributions.

Effective dates. Prop Reg § 1.367(a)-7 and Prop Reg § 1.6038B-1 would apply to transfers occurring on or after the date that is 30 days after the regs are published as final regs. However, until 30 days after the regs are published as final, taxpayers may make reasonable adjustments, as described in the legislative history, that are consistent with the policy of Code Sec. 367(a)(5) so that the exceptions provided by Code Sec. 367(a)(2) and Code Sec. 367(a)(3) apply to the transfer of property by a U.S. transferor to a foreign corporation in a Code Sec. 361 exchange. Reasonable adjustments would have to include adjusting the basis of the stock received by the control group members in the transaction that is attributable to Code Sec. 367(a) property as described in Preamble to Prop Reg, 08/19/2008; adjusting the basis of stock of the foreign acquiring corporation held by a control group member before the Code Sec. 361 exchange wouldn't be a reasonable adjustment. In addition, the U.S. transferor would have to recognize gain to the extent it has shareholders that aren't control group members and to the extent any built-in gain in the Code Sec. 367(a) property transferred in the Code Sec. 361 exchange cannot be preserved in the hands of the control group members through their ownership of stock received in the transaction in exchange for the stock or securities of the U.S. transferor.

In accordance with Notice 87-64, Prop Reg § 1.1248-6(d) (suspending application of Code Sec. 1248(e)) would apply to sales, exchanges, or other dispositions of stock of a domestic corporation occurring on or after Sept. 21, '87. Prop Reg § 1.367(a)-3(d)(2)(vi)(B)(1) and (2) described in Notice 2008-10 generally would apply to transactions occurring on or after Dec. 28, 2007; the requirement to treat Code Sec. 367(d) property as Code Sec. 367(a) property for purposes of the coordination rule exception would apply to transactions occurring on or after Aug. 19, 2008. Prop Reg § 1.1248-8(b)(2)(iv), Prop Reg § 1.1248(f)-1 through Prop Reg § 1.1248(f)-3, and the modifications to Prop Reg § 1.367(b)-4 would apply to transfers or distributions occurring on or after the date that is 30 days after the regs are published as final.

References: For transfers to foreign corporations, see FTC 2d/FIN ¶ F-6000; United States Tax Reporter Income ¶ 3674; Tax Guide ¶ 4925. For sales of stock of a foreign corporation, see FTC 2d/FIN ¶ O-2800; United States Tax Reporter Income ¶ 12,484; Tax Guide ¶ 30475.

References: For corporate reorganizations, see FTC 2d/FIN ¶ F-2000; United States Tax Reporter Income ¶ 3684; Tax Desk ¶ 234,000; Tax Guide ¶ 5150.

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