Stock Basis Recovery in Outbound Sec. 304 Transfers

By Arthur W. Sewall, J.D., LL.M., Washington, DC

Editor: Annette B. Smith, CPA

The IRS recently issued final and temporary regulations addressing recovery of basis in a stock sale subject to both Secs. 304(a)(1) and 367 (T.D. 9444 — the 2009 regulations). In 2006, the IRS finalized regulations that exempted Sec. 304 transactions from the application of Secs. 367(a) and (b) (T.D. 9250 — the 2006 regulations). However, the 2009 regulations in effect revoke the exemption provided in the 2006 regulations where the transferor in a Sec. 304 transaction claims to recover basis other than basis in the stock deemed issued under Sec. 304(a)(1) and thereby to avoid recognizing the entire gain built into the stock transferred.


Sec. 304 is designed to prevent corporations from bailing out earnings and profits (E&P) through related-party stock purchases. Specifically, Sec. 304(a) (1) treats a brother-sister stock sale as a deemed exchange under Sec. 351 followed by a redemption of the stock of the acquiring corporation deemed issued.

This fictional Sec. 351 exchange may raise issues in the international context. For instance, Sec. 367(a) provides that an outbound transfer that otherwise qualifies under Sec. 351 does not qualify for nonrecognition treatment. Further, Sec. 367(b) generally provides that certain 351 exchanges can cause the transferor to receive a deemed dividend (Regs. Sec. 1.367(b)-4). Prior to the 2006 regulations, taxpayers were concerned that a relatedparty stock sale would result in the application of both Sec. 304(a)(1) and, as a result of the deemed Sec. 351 contribution, Sec. 367.

The IRS mitigated the concern of Sec. 304/367 overlap transactions by providing in the 2006 regulations that Sec. 367 would not apply to Sec. 304 transactions because the income recognized in a Sec. 304 transaction should equal or exceed the transferor’s inherent gain in the issuing corporation’s stock transferred to the foreign acquiring corporation.

The IRS’s view that all the inherent gain would be taxed under Sec. 304 was premised on the notion that the transferor could recover basis only in the shares deemed issued (an amount equal to the transferor’s basis in the shares sold). However, the IRS’s position that basis recovery in a Sec. 304 transaction is limited to the shares deemed issued in the Sec. 351 exchange is not free from doubt. Prior to a 1997 amendment to Sec. 304, courts looked to the transferor’s basis in the shares deemed issued and the shares of the acquiring corporation (see Cox, 78 T.C. 1021 (1982)).

Basis Recovery Prior to the 2009 Regs.

The following example illustrates how the reasoning underpinning the 2006 regulations falls short when the transferor looks to its basis in the shares of both the acquired and the acquiring companies.

Example: USP, a domestic corporation, is the sole shareholder of two foreign corporations, FC1 and FC2. The FC1 stock has a $40 basis and $100 fair market value. The FC2 stock has a $100 basis and $100 fair market value. As of December 31, year 1, FC1 has zero E&P and FC2 has $20x E&P. On December 31, year 1, in a transaction described in Sec. 304(a)(1), USP sells the FC1 stock to FC2 for $100x cash (the FC1 sale) (Temp. Regs. Sec. 1.367(a)-9T(e)).

Under the 2006 regulations, Sec. 367 would not apply to the FC1 sale. Applying the principles of Sec. 304, the FC1 sale is treated as a distribution under Sec. 301 because USP constructively owns 100% of the FC1 shares (Regs. Sec. 1.304-2). The distribution is treated as a dividend to the extent of first FC2’s and then FC1’s E&P, resulting in a $20 dividend in the example (Secs. 304(b)(2)(A) and 301(c)(1)).

Next, the transferor recovers its basis (Sec. 301(c)(2)). If the transferor looks only to the basis in the shares deemed issued and redeemed, USP recovers $40 in basis (i.e., the amount equal to USP’s basis in FC1’s shares immediately before the deemed contribution). The remaining $40 would be treated as gain from the sale or exchange of property (Sec. 301(c) (3)).

In the above example, the mechanics worked as the IRS had envisioned: USP recognized the $60 of gain built into the shares of FC1. However, if USP took the position that it was entitled to recover basis in both the deemed issued FC2 shares and its actual FC2 shares, USP would receive a $20 dividend, recover $40 in basis in the deemed issued shares, and reduce its basis in the actual FC2 shares by $40. As a result, USP’s basis in the FC2 shares would be reduced to $60. Conceptually, the built-in gain would be preserved by the reduction of USP’s basis in FC2’s shares, but the transaction would no longer result in USP’s recognizing the built-in gain in FC1’s shares at the time of the outbound transfer of the FC1 shares.

Application of the 2009 Regs. to Outbound Transfers

Rather than wade into the debate over the proper method for recovering basis in a Sec. 304 transaction, the 2009 regulations provide that Sec. 367 will apply to a Sec. 304 transaction if a U.S. person claims to recover basis other than the basis in the shares deemed issued (Temp. Regs. Sec. 1.367(a)-9T(b)). The gain realized as a result of Sec. 367 equals the amount by which the gain realized exceeds the amount of the distribution received by a U.S. person that is treated as a dividend under Sec. 301(c)(1) and included in gross income. Furthermore, the 2009 regulations provide that the taxpayer may not enter into a gain recognition agreement (id.).

In the example above, if USP looked to its basis in the actual FC2 shares to avoid recognizing the built-in gain in FC1’s shares, the 2009 regulations would apply. Under those regulations, the $40 difference between USP’s $60 amount realized and the $20 dividend would be treated as gain from a sale or exchange. The gain recognized by USP would increase FC2’s basis in the FC1 shares by $40 (Temp. Regs. Sec. 1.367(a)-1T(b)(4)). In addition, USP’s basis in the actual shares of FC2’s shares would increase by $40 immediately before the transaction. Thus, after the application of the 2009 regulations to the example, USP would be in the same position as if it had not attempted to recover basis in the FC2 shares.


The 2009 regulations approach the issue of basis recovery in outbound Sec. 304 transactions from the Sec. 367 perspective rather than attempting to impose a questionable view of basis recovery under Sec. 304. Interestingly, the IRS has reasserted its view of basis recovery in a Sec. 304 transaction as part of proposed regulations that impose a share-by-share method of recovering basis generally (see REG-143686-07). While the IRS has contended that the transferor in a Sec. 304 transaction may recover basis only in the deemed issued shares, the 2009 regulations illustrate that such an approach may not be as universal as the IRS initially believed.


Annette Smith is with Price-waterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.

Unless otherwise noted, contributors are members of or associated with Pricewater-houseCoopers LLP.

For additional information about these items, contact Ms. Smith at (202) 414-1048 or

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