Temporary regulations were issued regarding the application of Secs. 367(a) and (b) to certain transactions described in Sec. 304.
The IRS and Treasury published new final regulations governing gain recognition agreements filed in connection with certain outbound stock transfers under Sec. 367(a).
A comprehensive package of proposed regulations outlines a uniform proposal for the allocation and recovery of basis in various transactions involving corporate stock or securities.
Temporary regulations and a notice were published regarding the anti-inversion provisions of Sec. 7874.
In May 2009, the White House and Treasury published a detailed explanation of the proposed budget, including a number of legislative proposals that would affect U.S.-based multinational corporations
This article discusses selected developments in U.S. federal income taxation of corporations and consolidated groups during 2009. Not surprisingly, the arrival of a new administration was accompanied by the introduction of a variety of proposals for reform of the U.S. income tax system, with a principal focus for corporate taxpayers on the taxation of international activities. In addition to these legislative proposals, the IRS and Treasury issued several packages of final, temporary, and proposed regulations providing guidance on a variety of issues.
Final and Temporary Regs.
Application of Sec. 367 to Outbound Sec. 304 Transactions
Sec. 304(a)(1) generally provides that if one or more persons are in control of each of two corporations and, in return for property, one corporation acquires stock in the other from the person(s) in control, the property is treated as a distribution in redemption of the acquiring corporation’s stock. To the extent the distribution is treated as a dividend-equivalent redemption, the transferor and the acquiring corporation are treated as if:
- The transferor contributed the target corporation’s stock to the acquiring corporation in exchange for its stock in a transaction to which Sec. 351(a) applies (the deemed 351 exchange); and
- The acquiring corporation then redeemed the stock it is treated as having issued (the deemed redemption).
Secs. 367(a) and (b) generally apply to certain outbound nonrecognition transactions, including Sec. 351 exchanges. However, final regulations adopted in 2006 provided that Secs. 367(a) and (b) would not apply to a deemed 351 exchange arising from a Sec. 304(a)(1) transaction. Treasury and the IRS initially adopted this position based on their views of permitted basis recovery in Sec. 304 transactions, which would generally require the current recognition of any gains that would be subject to Secs. 367(a) or (b). However, the law in the area of basis recovery in Sec. 304 transactions is unsettled, and the 2006 regulations have been revised accordingly.
On February 10, 2009, Treasury and the IRS issued temporary and final regulations 1 under Secs. 367, 304, and 1248. The new temporary regulations modify the general rule to provide for limited circumstances under which either Sec. 367(a) or (b) may apply to the deemed 351 exchange.
Sec. 367(a): Temp. Regs. Sec. 1.367(a)- 9T(a) retains the general rule of the prior regulations that an outbound deemed 351 exchange is not subject to Sec. 367(a)(1). However, Temp. Regs. Sec. 1.367(a)- 9T(b) provides a special rule under which Sec. 367(a) will apply to the deemed 351 exchange. Under this special rule, where the deemed redemption received by a U.S. transferor is a dividend-equivalent distribution, if such distribution is applied against and reduces (in whole or in part) the basis of the stock of the foreign acquiring corporation held by the U.S. transferor, other than the stock issued in the deemed 351 exchange, 2 the U.S. transferor recognizes gain. The amount of gain recognized is equal to the excess of the gain realized with respect to the transferred stock over the amount of the distribution that is treated as a dividend under Sec. 301(c)(1). It is important to note that this gain recognition rule operates independently of the other provisions of Sec. 367(a), such that a U.S. transferor may not avoid the gain by simply entering into a gain recognition agreement.
Effectively, this provision will cause the U.S. transferor to recognize the same amount of gain it would have recognized under Sec. 301(c)(3) had it not applied the distribution against its "old and cold" stock of the acquiring corporation. However, there is still an added benefit to taxpayers of taking such a position and falling into the special rule of Temp. Regs. Sec. 1.367(a)-9T(b). Because the special rule treats the gain as having been recognized in the deemed 351 exchange, the basis of the target corporation stock in the hands of the acquiring corporation will be increased by the amount of gain recognized under the special rule. A similar basis increase would not result if the gain were recognized under Sec. 301(c)(3).
Sec. 367(b): Temp. Regs. Secs. 1.367(b)-4T(e)(1) and (2) make similar changes to the 2006 regulations with respect to the potential application of Sec. 367(b) to the deemed 351 exchange. The special rule of Temp. Regs. Sec. 1.367(b)- 4T(e)(2) provides that to the extent a deemed redemption distribution is applied against and reduces the U.S. transferor’s basis in the stock of the acquiring corporation, other than the stock deemed issued in the deemed 351 exchange, the rules of Regs. Sec. 1.367(b)-4(b) shall apply to the deemed 351 exchange. Unlike the changes to the Sec. 367(a) regulations, this special rule does not automatically result in an income or gain inclusion to the transferor. Instead, it only defines a specific situation in which the current rules of Regs. Sec. 1.367(b)-4(b) must be applied to the deemed 351 exchange. Consequently, the transfer must still fall within one of the three designated transactions described in Regs. Sec. 1.367(b)-4(b) in order for the U.S. transferor to have a current income inclusion as a result of the transaction.
Sec. 1248: These final and temporary regulations also include a provision clarifying that any gain recognized under Sec. 301(c)(3) is treated as gain from the sale of stock for purposes of Sec. 1248(a).
Gain Recognition Agreements
The regulations under Sec. 367(a) provide that certain outbound stock transfers are not subject to the provisions of Sec. 367(a), but only if the U.S. transferor satisfies certain enumerated requirements, including the filing of a gain recognition agreement (GRA) under applicable regulations. In February 2007, the IRS and Treasury issued temporary regulations concerning the terms and conditions required for a GRA and addressed the impact of certain events on an existing GRA. These temporary regulations described a number of events that would cause the U.S. transferor to recognize gain under an existing GRA (each a triggering event), as well as certain events that would terminate the GRA, and also established exceptions to the triggering event rules for a number of specified transactions. However, these specific triggering event exceptions did not cover every situation in which the recognition of gain under an existing GRA seemed inappropriate from a policy perspective.
In response, on February 11, 2009, the IRS and Treasury issued final GRA regulations (T.D. 9446). These final regulations retain the general framework of the temporary regulations but include a number of significant changes, including the addition of new specific triggering event exceptions and a general triggering event exception that applies to certain nonrecognition transactions not otherwise covered by one of the specific exceptions.
Regs. Sec. 1.367(a)-8(k) outlines the various exceptions to the triggering event rules. These exceptions generally include only nonrecognition transactions. Notably, the exceptions apply only if:
- Immediately after the disposition or other triggering event, a U.S. transferor retains a direct or indirect interest in the transferred stock or securities (or in the assets of the transferred corporation); and
- A new GRA is entered into with respect to the initial transfer.
In addition to retaining the basic exceptions of the temporary regulations, these final regulations add exceptions for certain intercompany transactions 3 (as defined in Regs. Sec. 1.1502-13(b)(1)), certain divisive reorganizations under Sec. 355, 4 and the aforementioned general exception.
Regs. Sec. 1.367(a)-8(k)(14) provides the new general exception, which may be applied to triggering events that are not otherwise covered by one of the specific exceptions provided in Regs. Secs. 1.367(a)-8(k)(1) through (13). Under this general exception, a disposition or other event will not constitute a triggering event if:
- The disposition qualifies as a nonrecognition transaction (as defined in Sec. 7701(a)(45));
- 2. Immediately after the disposition, a U.S. transferor retains a direct or indirect interest in the transferred stock or securities (or in substantially all the assets of the transferred corporation); and
- 3. A new GRA is filed (1) explaining why the general exception applies to the disposition or other event and (2) describing each subsequent disposition or other event that would constitute a triggering event, other than those described in Regs. Sec. 1.367(a)-8(j), with respect to the new GRA, based on the principles of Regs. Secs. 1.367(a)- 8(j) and (k).
In addition, if the transferee in the subsequent disposition or other event is a foreign corporation, the U.S. transferor must also own at least 5% (by vote and value) of the stock of such foreign corporation immediately after the disposition. Clearly, this general exception provides taxpayers with far more flexibility in modifying their ownership of any entity that is subject to the parameters of an existing GRA.
In addition to the triggering event rules, the final regulations also retain the same general rules regarding GRA terminations. Under the temporary regulations, certain dispositions, transfers, or distributions were not triggering events. Instead, the temporary regulations provided that the following events terminated the GRA or reduced the amount of gain required to be recognized pursuant to a GRA under:
- A taxable disposition of the transferee foreign corporation’s stock by the U.S. transferor;
- Certain dispositions by a domestic transferred corporation of substantially all of its assets; and
- A distribution or transfer by a transferee foreign corporation of stock or securities of a transferred corporation under Secs. 337, 355, or 361. 5
One condition for the application of this termination rule was that the basis of (1) the transferred stock or securities in the hands of the U.S. transferor immediately following the acquisition or (2) the stock of the transferee foreign corporation disposed of by the U.S. transferor, as relevant, must not be greater than the basis of the transferred stock or securities at the time of the initial transfer. To satisfy this basis condition, the 2007 regulations permitted the U.S. transferor to reduce the basis of the transferred stock or securities (or the stock of the transferee foreign corporation, as applicable). The 2007 regulations also permitted an increase to the basis of other stock or securities in the transferred corporation in an amount equal to the reduction, but not in excess of fair market value (FMV).
The final regulations generally retain the GRA termination provisions of the 2007 temporary regulations. Regs. Sec. 1.367(a)-8(o)(1)(iii) also retains the stock basis reduction provision to enable the U.S. transferor to satisfy the basis limitation. However, the final regulations do not permit a corresponding basis increase to other stock or securities of the transferred foreign corporation. In addition, the termination provisions do not apply to dispositions that are subject to the intercompany transaction exception of Regs. Sec. 1.367(a)-8(k)(12).
The final regulations also delivered some much-needed clarity regarding the impact of certain Sec. 301(c) distributions from a transferred or transferee corporation. Under the final regulations, a disposition is broadly defined as any transfer that constitutes a disposition for any purpose of the Internal Revenue Code. 6 However, the regulations clarify that, as a general rule, a disposition does not include the receipt of a distribution of property to which Sec. 301 applies. This includes a stock redemption that is treated as a Sec. 301 distribution by reason of Sec. 302(d), provided that the U.S. transferor enters into a new GRA that includes appropriate provisions to account for the redemption. 7 This exclusion is a significant modification of the temporary regulations, which specifically excluded Sec. 302(d) transactions only to the extent that Sec. 301(c) (1) applied to the distribution (i.e., under the temporary regulations, the treatment of Sec. 301(c)(2) and (3) distributions was unclear).
Finally, although not treated as dispositions, distributions subject to the application of Sec. 301(c)(3) are subject to two special rules in the final regulations. First, Regs. Sec. 1.367(a)-8(n)(2) provides that if gain is recognized under Sec. 301(c) (3) with respect to the transferred corporation’s stock, the U.S. transferor must recognize a corresponding amount of gain under the GRA (but not in excess of the amount of gain subject to the GRA). Second, Regs. Sec. 1.367(a)-8(o)(3) states that if the U.S. transferor recognizes gain under Sec. 301(c)(3) with respect to the transferee foreign corporation’s stock received in the initial transfer, the amount of gain subject to the GRA is reduced by the amount of the Sec. 301(c)(3) gain.
Consideration and Basis Recovery in Certain Distributions, Sales, and Exchanges
The most ambitious guidance issued in 2009 came in the form of proposed regulations 8 that are intended to provide a uniform set of rules for stock basis recovery and stock basis identification in transactions to which Sec. 301 or 302(a) applies. The primary objective of the proposed regulations is to harmonize the tax treatment of economically similar transactions by providing a single model for basis recovery for dividend-equivalent transactions on the one hand and for sale and exchange transactions on the other, regardless of the form of the transaction. The theoretical underpinning of the proposed regulations is that a share of stock is the basic unit of property that can be disposed of, so the tax treatment of a transaction should derive from the consideration received for that share. This view is based on Sec. 1012 and the principles espoused in Johnson. 9
Distributions subject to Sec. 301: Following the model of Johnson, Prop. Regs. Sec. 1.301-2(a) provides that the portion of a Sec. 301 distribution that is not a dividend shall be treated as received on a pro-rata, share-by-share basis to reduce the adjusted basis of each share of stock within the class upon which the distribution is made. As result, it is possible that a shareholder may have Sec. 301(c)(2) basis recovery with respect to some shares and may have Sec. 301(c)(3) gain on other shares.
The proposed regulations extend this same basic approach to other dividend-equivalent transactions, such as Sec. 302(d) redemptions and certain Sec. 304 transactions. A dividend equivalent redemption under Sec. 302(d) (including those occurring with respect to a Sec. 304 transaction) results in a pro-rata, shareby- share distribution to all shares of the redeemed class held by the shareholder immediately prior to the redemption. 10 Thus, as with actual Sec. 301 distributions, it is possible for a shareholder to recognize Sec. 301(c)(3) gain for some of the redeemed shares but not others.
For purposes of identifying the shares subject to the redemption, Prop. Regs. Sec. 1.302-5(b)(2) provides that "redeemed class" means all the shares of that class held by the redeemed shareholder. For this purpose, a class of stock is defined with respect to economic distribution rights, rather than the legal classification or label assigned to such shares or rights with respect to corporate governance. This definition prevents taxpayers from bypassing the application of the uniform rules through the creation of multiple classes of stock with similar economic rights.
If less than all of a holder’s shares are redeemed, following the redemption the holder is deemed to exchange all its shares in the class, including the redeemed shares, for the actual number of shares held after the redemption transaction in a hypothetical Sec. 368(a)(1)(E) recapitalization. The basis of the remaining shares is then determined under the rules of Sec. 358 and Regs. Sec. 1.358-2.
On the other hand, if all a holder’s shares are redeemed, any unrecovered basis in the redeemed shares is essentially treated as a deferred taxpayer loss that the taxpayer can use on its "inclusion date." 11 The inclusion date is generally defined as the first date on which the redeemed shareholder satisfies the criteria of Sec. 302(b)(1), (2), or (3) or the first date on which all classes of stock of the redeeming corporation become worthless within the meaning of Sec. 165(g). 12 For corporate taxpayers, the inclusion date also contains the date on which the corporation disposes of all its assets in a taxable transaction and ceases to exist for tax purposes. Special rules may also apply to foreign corporations.
This deferred loss concept is a departure from current law, which generally provides that the unrecovered basis in the redeemed shares may be shifted to other shares in certain circumstances (see Regs. Sec. 1.302-2(c)). 13 The preamble to the proposed regulations states that the IRS and Treasury believe such shifting is inconsistent with the fundamental principle of treating each share as a separate unit of property and can lead to inappropriate results.
Redemptions treated as a sale or exchange under Sec. 302(a): For redemptions that are characterized as a sale or exchange under Sec. 302(a), the preamble to the proposed regulations states that under current law, a shareholder that owns shares of stock with different bases can elect which shares to surrender for redemption, citing Regs. Sec. 1.1012- 1(c). Because this approach is consistent with treating a share as a separate unit of property, the proposed regulations do not limit this election. For example, Prop. Regs. Sec. 1.304-2(a)(5) provides that if Sec. 301 does not apply to the property received in the deemed redemption, the basis and holding period of the acquiring corporation’s common stock that is treated as redeemed will be the same as the basis and holding period of the issuing (target) corporation’s stock that is actually surrendered.
Reorganization exchanges for boot: The proposed regulations apply similar concepts to the receipt of boot in a reorganization transaction. Prop. Regs. Sec. 1.354-1(d)(1) provides that as a general rule, a pro-rata portion of any boot shall be treated as received in exchange for each share of stock and security surrendered, based on their respective FMVs. Notwithstanding this general rule, for exchanges that are not dividend equivalent, to the extent the terms of the exchange specify which property is received in exchange for each share or security surrendered, the terms of the exchange shall control, provided the terms are economically reasonable. On the other hand, if the exchange does have the effect of a dividend distribution, the boot is treated as received pro rata in exchange for each share of stock within that class that is held by the exchanging shareholder, even if the terms of the exchange provide a specification that would otherwise be economically reasonable. However, economically reasonable designations between different classes of stock or securities will generally control.
More significantly, where shares of stock are surrendered solely in exchange for boot, the proposed regulations provide that neither Sec. 354 nor Sec. 356 will apply to the exchange. Instead, Sec. 302 and the regulations thereunder shall govern the treatment of such exchanges. 14 Therefore, it is possible under the proposed regulations for a shareholder that exchanges a class of stock solely for boot to recognize a loss on such shares, notwithstanding the statutory limitation of Sec. 356(c).
Extension of tracing principles to Sec. 351 exchanges and capital contributions: The most controversial aspect of the proposed regulations involves the extension of basis tracing principles to certain Sec. 351 exchanges and other capital contributions to which Sec. 118 applies. Under current law, Sec. 358 regulations apply tracing principles to determine the basis of stock received in a Sec. 351 transaction only to the extent that such transaction overlaps with the reorganization provisions of Sec. 368 (i.e., a Sec. 351 contribution of stock that also qualifies as a B reorganization) and no liabilities are assumed in the exchange. The preamble to the proposed regulations states that the reason for this limitation is the interaction of the basis tracing rules with the application of Sec. 357(c), which adopts an aggregate approach to basis for purposes of gain determination thereunder. However, the IRS and Treasury have concluded that resolution of this issue was not required prior to extending the tracing regime to nonoverlapping Sec. 351 exchanges in which no liabilities are assumed.
Prop. Regs. Sec. 1.358-2(g)(2) applies the general basis allocation rules of Prop. Regs. Secs. 1.358-2(b)(1) through (b)(3) to any Sec. 351 exchange in which stock or stock and property are transferred to a corporation and no liability is assumed by the corporate transferee. In addition, if insufficient shares, or no shares, are issued in the exchange, the proposed regulations require taxpayers to apply a deemed issuance and recapitalization model for purposes of applying the basis tracing rules. 15
The extension of these tracing rules to such transactions should prove to be administratively burdensome for taxpayers. For example, in a routine transaction in which a parent contributes property to a wholly owned subsidiary in exchange for no stock, these regulations will require taxpayers to determine the FMV of the contributed property, deem the issuance of an amount of stock equal to the value of the contributed property, and trace the basis of the deemed issued stock through a hypothetical recapitalization of such shares into the actual number of shares of subsidiary stock held by the parent entity.
Final and Temporary Regs. Under Sec. 7874
Sec. 7874 was enacted in 2004 to combat the movement of U.S.-based multinational corporations to foreign jurisdictions in which the taxpayer had a minimal presence (typically a tax haven jurisdiction). Congress felt that such transactions permitted these corporations to continue conducting business in the same manner as prior to the inversion, but with the added benefit of avoiding U.S. taxation of domestic operations through certain earnings- stripping techniques. To stop that, Congress added Sec. 7874 to effectively disregard inversion transactions that are not motivated by nontax purposes. 16
In general, the anti-expatriation provisions of Sec. 7874 apply to corporate transactions whereby:
- A foreign corporation acquires substantially all the properties of the domestic corporation (the acquisition test); 17
- The former shareholders of the domestic corporation own at least 80% (a domestic corporation) or 60% (an expatriated entity) of the stock of the foreign corporation by reason of holding stock in the domestic corporation (the ownership test); 18 and
- The expanded affiliated group (EAG) that includes the foreign corporation does not have substantial business activities in the foreign incorporation country when compared with the total business activities of the EAG (the foreign business test). 19
If the former shareholders of the domestic corporation own at least 80% of the foreign corporation’s stock under the ownership test, the foreign corporation is treated as a U.S. domestic corporation for all U.S. federal income tax purposes. 20 If the former shareholders own at least 60% (but less than 80%) of the foreign corporation, the inversion is respected but the inverted U.S. corporation cannot use certain tax attributes to offset inversion gain. 21 Inversion gain generally includes any gain recognized in the inversion as well as certain gain or income recognized from the transfer or licensing of assets to a related foreign party for the 10-year period following the inversion date. 22
2006 regulations: In June 2006, the IRS and Treasury published temporary regulations 23 providing guidance on the treatment of a foreign corporation (FC) as a surrogate foreign corporation (the 2006 regulations), including a safe harbor under which the FC would be treated as having substantial business activities in its country of incorporation. This safe harbor generally provided that a taxpayer had substantial business activities in the foreign incorporation country (and thus fell outside the scope of Sec. 7874) if:
- At least 10% of EAG employees were located in the country;
- At least 10% of the value of all EAG assets was located in the foreign incorporation country; and
- EAG sales made in the foreign incorporation country accounted for at least 10% of the total EAG sales during the testing period (12-month period as defined in former Temp. Regs. Sec. 1.7874-2T(d)(3)(v)).
2009 regulations: As temporary regulations, the 2006 regulations were set to expire in 2009, prompting the IRS and Treasury to issue a new package of temporary regulations effective June 12, 2009. 24 However, the new temporary regulations introduce some changes to the 2006 regulations that create significant obstacles for taxpayers considering a potential inversion transaction. Most significantly, the new regulations eliminated the substantial business activities safe harbor of the 2006 regulations, replacing it with a purely facts-and-circumstances test. Under this test, the taxpayer must compare the amount of its business activities in the FC with the total business activities of the EAG, taking into account certain "relevant items" identified in the regulations. 25
Relevant items include:
- Historical conduct of continued business activities in the FC by the EAG;
- The conduct of
continuous business activities in the FC by the EAG occurring in
the ordinary course of the active conduct of one or more trades or
- Property located in the FC that is owned by the EAG members;
- Services performed in the FC by employees of the EAG members; and
- Sales of goods to customers.
- The performance of substantial managerial activities by EAG members, officers, and employees based in the FC;
- A substantial degree of ownership of the EAG by investors resident in the FC; and
- The existence of business activities in the FC that are material to the achievement of the EAG’s overall business objectives. 26
The regulations provide that the presence or absence of relevant items is not determinative and that weight should be given based on all the facts and circumstances. The regulations also specify certain items that shall not be considered, including:
- Business activities or income attributable to properties or liabilities the transfer of which is disregarded under Sec. 7874(c)(4);
- Any assets, business activities, or employees located in a foreign country at any time as part of a plan with a principal purpose of avoiding the purposes of Sec. 7874; and
- Any assets, business activities, or employees located in the foreign country in which, or under the law of which, the foreign corporation is created or organized if such assets, business activities, or employees are transferred to another country under a plan that existed at the time of the acquisition described in Sec. 7874(a)(2)(B)(i). 27
Clearly this change in the regulations makes it far more difficult for taxpayers and their advisers to be certain that Sec. 7874 will not apply to a potential inversion transaction.
In addition to the removal of the former safe harbor, the new temporary regulations include rules designed to prevent the avoidance of Sec. 7874 through the use of various structural mechanisms, including transactions involving partnerships, multiple foreign acquisition companies, and multiple domestic target corporations. The new regulations also provide guidance regarding the treatment of options and similar interests, certain "exchangeable" shares or economically equivalent interests, and creditors as shareholders of insolvent entities for purposes of applying the ownership test. These regulations are applicable to acquisitions completed on or after June 9, 2009, though taxpayers may apply the regulations to prior acquisitions if applied consistently to all acquisitions completed before that date.
In the wake of the new temporary regulations, taxpayers face limited options for structuring an inversion transaction to avoid the application of Sec. 7874. For those taxpayers uncomfortable relying solely on a facts-and-circumstances approach under the foreign business test, perhaps the only certain way to avoid the rules is by ensuring that the ownership test is not satisfied at either the 80% or the 60% threshold, depending on the taxpayer’s particular situation.
In applying the ownership test, Sec. 7874(c)(2)(B) provides that taxpayers shall not take into account any stock held by members of the EAG, or any stock of a foreign corporation that is sold in a public offering related to the acquisition. Thus, taxpayers cannot fail the ownership test by selling more than 20% (or 40%) of the foreign acquiring corporation’s stock in a public offering. Nevertheless, the language of Sec. 7874(c)(2)(B) left open the possibility that any stock sold in a private placement, as opposed to a public offering, could be taken into account in applying the ownership test.
Realizing that taxpayers might attempt to avail themselves of this potential loophole, on September 17, 2009, the IRS published Notice 2009-78, 28 in which it announced that it would exercise its authority under Secs. 7874(c)(6) and (g) to issue regulations identifying certain stock of a foreign acquiring corporation that is disregarded for purposes of applying the ownership test. In general, the regulations issued under the notice will provide that stock of the foreign acquiring corporation issued in exchange for nonqualified property in a transaction related to the acquisition of the domestic corporation will be disregarded for purposes of the ownership test, without regard to whether such stock is publicly traded. For this purpose, "nonqualified property" shall generally mean (1) cash or cash equivalents, (2) marketable securities (as defined in Sec. 453(f)(2)), and (3) any other property acquired in a transaction with a principal purpose of avoiding Sec. 7874. Thus, the notice effectively expands the scope of Sec. 7874(c)(2)(B) to include the "private placement" alternative, leaving taxpayers with even fewer options for structuring inversion transactions.
In May 2009, the White House and Treasury published a detailed explanation of the administration’s budget proposals for the 2010 fiscal year. 29 This Green Book detailed several new proposals, including a number of "loophole closers" that would significantly affect U.S. multinational corporations. Although most of these proposed loophole closers address a broader reform of the U.S. international tax system, three of the proposals merit attention due to their potential interplay with current corporate tax law:
- Repeal of the "boot-within-gain" limitation of Sec. 356(a)(1) in certain crossborder reorganizations;
- Reformation of the entity classification (or check-the-box) regulations; and
- Codification of the economic substance doctrine.
The first proposal is aimed at what the administration believes is a loophole enabling foreign subsidiaries of a U.S. corporation to repatriate their untaxed earnings to the U.S. parent without any adverse U.S. tax consequences. A typical transaction involves a U.S. parent corporation that owns a subsidiary corporation (typically foreign) with a high outside stock basis (the target corporation) and a foreign subsidiary corporation with excess cash (the acquiring corporation). Pursuant to an all-cash D reorganization, the U.S. parent exchanges the target corporation’s stock solely for cash or a note paid by the foreign acquiring corporation in a transaction subject to Sec. 356(a). Under Sec. 356(a)(1), even though the U.S. parent receives only boot in the exchange, it is only required to recognize gain equal to the lesser of the gain realized or the amount of the boot received. Thus, if the U.S. parent has little or no built-in gain in the target stock, it can receive cash from the foreign acquiring corporation with minimal U.S. tax consequences, without regard to the amount of the acquiring corporation’s accumulated earnings and profits.
The proposal detailed in the Green Book merely states that it will repeal the boot-within-gain limitation of current law in the case of any reorganization in which the acquiring corporation is foreign and the exchange has the effect of the distribution of a dividend as determined under Sec. 356(a)(2). The proposal provides no detail on how this repeal would be implemented, though it is possible that the IRS would exercise its broad regulatory authority under Sec. 367(b) to address the issue. At any rate, the proposal leaves open the possibility for inbound investors to utilize similar transactions in which the jurisdictions are reversed—i.e., repatriation of earnings of a U.S. subsidiary to a foreign parent. This proposal would be effective for tax years beginning after December 31, 2010.
The second proposal would amend the current entity classification regulations 30 to limit the circumstances under which a foreign eligible entity may be disregarded as separate from its sole owner. In general, the proposal would allow a foreign eligible entity to be disregarded for U.S. tax purposes only where such entity is owned by (1) an entity created or organized in the same country in which the foreign eligible entity is organized or (2) except in cases of U.S. tax avoidance, a U.S. person. The proposal does not provide any detail as to what might constitute tax avoidance in this context.
Should this proposal be adopted, any currently disregarded entity that does not satisfy either of the exceptions set forth above will be effectively treated as a per se corporation. Consequently, for these entities, taxpayers will have to navigate the usual rules associated with a conversion from disregarded to association status— e.g., qualification under Secs. 351(a) and (b), potential gain recognition under Sec. 357(c), and springing liabilities. This proposal would be effective for tax years beginning after December 31, 2010.
Economic Substance Doctrine
Finally, the Green Book contains a proposal for the codification of the economic substance doctrine. The proposal provides that a transaction would satisfy the economic substance doctrine only if (1) it changes in a meaningful way (apart from federal tax effects) the taxpayer’s economic position and (2) the taxpayer has a substantial purpose (other than a federal tax purpose) for entering into the transaction. In addition, the proposal states that it would clarify that a transaction will not be treated as having economic substance solely by reason of a profit potential unless the present value of the reasonably expected pretax profit is substantial in relation to the present value of the net federal tax benefits arising from the transaction.
This broadly crafted proposal leaves plenty of open issues for consideration, but it does indicate that Treasury would be given regulatory authority to carry out the purposes of the proposal. The proposal also contains two specific punitive measures. First, it includes a 30% penalty on an understatement of tax attributable to a transaction that lacks economic substance (reduced to 20% in the case of a transaction for which there is adequate disclosure in the taxpayer’s return). Second, the proposal would deny any deduction for interest attributable to an understatement of tax arising from the application of the economic substance doctrine. This proposal would generally be effective for tax years ending after the date of enactment.
Brandon Hayes is a senior manager, National Tax M&A/ Transaction Advisory Services, at Ernst & Young LLP in Washington, DC. For more information about this article, contact Mr. Hayes at firstname.lastname@example.org.
1 T.D. 9444.
2 For example, if the taxpayer in control of the target corporation is also the historic sole shareholder of the acquiring corporation, that taxpayer might take the position that its basis in its "old and cold" stock of the acquiring corporation may also be applied against the distribution.
3 Regs. Sec. 1.367(a)-8(k)(12).
4 Regs. Sec. 1.367(a)-8(k)(1)(iii).
5 Temp. Regs. Sec. 1.367(a)-8T(g).
6 Regs. Sec. 1.367(a)-8(b)(1)(iii).
7 See Regs. Secs. 1.367(a)-8(n)(1) and (q)(2), Example (14).
8 REG-143686-07, released on January 21, 2009.
9 Johnson, 435 F.2d 1257(4th Cir. 1971).
10 Prop. Regs. Sec. 1.302-5(a)(1).
11 Prop. Regs. Sec. 1.302-5(a)(3)(i).
12 Prop. Regs. Sec. 1.302-5(a)(4).
13 But see Notice 2001-45, 2001-2 C.B. 129, which describes certain transactions for which the IRS believes basis shifting is not permitted.
14 See Prop. Regs. Sec. 1.354-1(d)(2).
15 Prop. Regs. Sec. 1.358-2(g)(3).
16 See H.R. Rep’t No. 108-548, 108th Cong., 2d Sess., Part 1, 244 (2004).
17 Sec. 7874(a)(2)(B)(i).
18 Sec. 7874(a)(2)(B)(ii).
19 Sec. 7874(a)(2)(B)(iii).
20 Sec. 7874(b).
21 Sec. 7874(a)(2)(B).
22 Sec. 7874(d)(2)(B).
23 T.D. 9265.
24 T.D. 9453.
25 Temp. Regs. Sec. 1.7874-2T(g).
26 Temp. Regs. Sec. 1.7874-2T(g)(3).
27 Temp. Regs. Sec. 1.7874-2T(g)(5).
28 Notice 2009-78, 2009-40 I.R.B. 452.
29 Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals (May 11, 2009) (the Green Book).
30 See Regs. Secs. 301.7701-1 through -3.