2013-Issue 17 – On March 19, 2013, the Department of Treasury and IRS issued final regulations under Section 367(a)(5) concerning transfers of property by a domestic corporation to a foreign corporation in an exchange described in Section 361. The regulations replace proposed regulations issued in 2008 and, in large part, adopt the proposed regulations. In response to taxpayer comments, certain modifications were made to clarify the application of Section 367(a)(5). However, other proposed amendments intended to clarify and streamline the regulations were not adopted, leaving a few traps for the unwary. A few of the taxpayer friendly and not-so-friendly updates are discussed here.
In general, Section 367(a)(5) provides that the exceptions to Section 367(a)(1) in Section 367(a)(2) and (a)(3) do not apply in the case of a Section 361 exchange in which a domestic corporation transfers assets outbound 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 (the Control Group), certain stock basis adjustments are made and other conditions are satisfied (the Elective Exception). The policy underlying Section 367(a)(5) is the preservation of corporate-level gain (and in turn corporate-level tax) on appreciated property following the repeal of the General Utilities doctrine.
Not Subject to Corporate-Level Tax? Keep Reading: the Section 367(a)(5) Regulations Could Still Apply to You
Despite the stated policy that Section 367(a)(5) is intended to preserve corporate-level gains, the Treasury Department and IRS declined to adopt recommendations from commentators to exempt special corporate entities, such as regulated investment companies (RICs), real estate investment trusts (REITs) and S corporations, from the application of Section 367(a)(5). The government expressed concern that exempting special entities from Section 367(a)(5) may undermine the preservation of corporate-level tax.
How, you may ask. Section 367(a)(1) applies to the outbound transfer of appreciated property by U.S. persons, which include S corporations, RICs and REITs. Although these entities are generally not subject to corporate-level tax, gains from the transfer of appreciated property flow through to their shareholders.
So what, you may ask. The government's view is that because owners of special corporate entities generally receive a basis in the foreign acquiring corporation stock determined under Section 358, corporate-level tax on the inside gain is not assured. Because of this, the government declined to exempt special entities from the application of Section 367(a)(5). Accordingly, special corporate entities should be mindful of Section 367(a)(5) when considering any outbound reorganization planning.
Preservation of Inside Gain Requires Obliteration of Outside Stock Loss — How Can That Be?
To qualify for the Elective Exception, the proposed regulations required each Control Group member to reduce its adjusted basis (as determined under Section 358) in the foreign corporation stock received in the outbound reorganization by the amount (if any) the shareholder's allocable portion of the inside gain exceeded the gain in the foreign corporation stock (outside gain). In certain cases, the basis adjustments had the effect of converting built-in loss stock to built-in gain stock.
For example, assume that a Control Group member held foreign corporation stock with a fair market value of $100 and an adjusted basis of $150 before Section 367(a)(5) adjustments (i.e., built-in loss of $50), and its share of inside gain was $30. The proposed regulations required the basis of the foreign corporation stock be reduced to $70 to preserve the inside gain that caused built-in loss stock to become built-in gain stock. Commentators suggested that this reduction to basis was inappropriate and instead recommended the basis adjustment be limited to a shareholder's allocable inside gain. In the example above, the adjusted basis in the foreign corporation stock would be reduced to $120. This would preserve the inside gain by reducing but not eliminating the outside loss. This is a reasonable result, as the taxpayer's resulting adjusted stock basis takes into account the inside built-in gain without having the punitive effect of eliminating the amount of economic stock loss in excess of the inside gain.
However, the Treasury Department and IRS believe that the amount of outside built-in gain or loss should not affect the required basis adjustments of the foreign corporation stock received in the transaction. Thus, the final regulations require basis adjustments to both built-in gain shares and built-in loss shares. Without proper planning, taxpayers may find themselves in the unpleasant situation of realizing (but not recognizing) an outside stock loss in the reorganization but ending up with built-in gain stock.
Final Regulations Implement a Bright-Line Date for the Disposition Rule
The proposed regulations denied the application of the Elective Exception if, with a principal purpose of avoiding U.S. tax, the foreign acquiring corporation disposed of a significant amount of the property received from the U.S. transferor (the Disposition Rule). The proposed regulations did not provide clear guidance as to the time period or reach of the Disposition Rule.
Several commentators recommended that a defined period of time be set for the Disposition Rule similar to the gain recognition agreement provisions in Treas. Reg. Section 1.368(a)-8. The gain recognition agreement provisions generally require gain recognition only if there is a triggering event during the term of the agreement, which is the period ending with the close of the fifth full taxable year following the year of the transfer.
The government agreed with taxpayer suggestions. Accordingly, 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 property received from the U.S. transferor during the 60-month period that begins on the date of distribution or transfer (within the meaning of Treas. Reg. Section 1.381(b)-1(b)), which is generally the date upon which the reorganization is completed. The final regulations also clarify that subsequent transfers of property in non-recognition transactions and transfers of property in the ordinary course of business are generally not considered dispositions for purposes of the Disposition Rule. These clarifications provide helpful guidance to taxpayers.
Alvarez & Marsal Taxand Says:
Under the new regulations, tax-free asset reorganization treatment may still be available, but such treatment may carry the price of losing a surprising amount of stock basis, and the required computations are complex and burdensome going forward.
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