While many details of the new provision are beyond the scope of this discussion, an important tax planning issue involves its potential interaction with Sec. 382. That is, can a U.S. corporation with net operating losses (NOLs) subject to an annual Sec. 382 limit treat the new deemed repatriation Subpart F income as built-in income or gain and thus increase its annual Sec. 382 limit on its NOLs?
To explore this issue of whether all or a portion of the toll charge might be treated as a recognized built-in gain (RBIG) under Sec. 382(h), a refresher on the built-in gain rules of Sec. 382 is helpful. (This discussion does not consider parallel rules for recognized built-in losses since they are irrelevant to this issue.)
Built-in gain rules
If a loss corporation has a net unrealized built-in gain (NUBIG) — defined in Sec. 382(h)(3)(A) as the excess of the fair market value (FMV) of the loss corporation's assets over the adjusted basis of such assets immediately prior to an ownership change — Sec. 382(h)(1)(A) allows the Sec. 382 limitation to be increased by RBIGs. RBIG is defined in Sec. 382(h)(2)(A) as gain recognized during the recognition period (the five-year period beginning on the ownership change date) on the disposition of any asset to the extent the loss corporation establishes that: (1) the asset was held by the loss corporation prior to the change date; and (2) the gain does not exceed the built-in gain of the asset on that date. Furthermore, Sec. 382(h)(6)(A) treats as RBIG any items of income that are properly taken into account during the recognition period but that are attributable to periods before the change date. The amount of increase to the Sec. 382 limitation is limited to the amount of the NUBIG computed under Sec. 382(h)(1)(A), reduced by any RBIG items that are recognized in prior years during the recognition period.
Additional permissible methodologies
In addition to the statutory computation rule described above, the IRS offered two permissible methodologies for determining built-in income items in Notice 2003-65: the Sec. 1374 approach and the Sec. 338 approach.
Under the Sec. 1374 approach, NUBIG is the net amount of gain that would be recognized by the loss corporation in a hypothetical sale of the assets to a third party immediately prior to the ownership change. With respect to the calculation of RBIG under the Sec. 1374 approach, the amount of gain recognized during the recognition period on the sale or exchange of an asset is RBIG (as calculated under Sec. 382(h)(2)(A)), and the sum of all of the RBIGs recognized by the loss corporation during the recognition period cannot exceed the loss corporation's NUBIG. Furthermore, the Sec. 1374 approach treats an item of income as RBIG only if (1) it is "attributable to periods before the change date" under Sec. 382(h)(6)(A); and (2) an accrual-method taxpayer would have included the item in income before the change date.
Under the Sec. 338 approach of the notice, NUBIG generally is calculated in the same manner as under the Sec. 1374 approach. However, the two approaches diverge in the calculation of RBIG. The Sec. 338 approach identifies RBIG by comparing the loss corporation's actual items of income and gain with those that would have resulted if a Sec. 338 election had been made with respect to a hypothetical purchase of all the outstanding stock of the loss corporation on the ownership change date.
Unlike the Sec. 1374 approach, built-in gain assets may be treated as generating RBIG, even if not disposed of at a gain during the recognition period. This is accomplished through the wasting or consumption of certain built-in gain assets, which assumes that an asset with a built-in gain on the change date generates income equal to the cost-recovery deduction that would have been allowed if an election under Sec. 338 had been made on the ownership change date. The amount of the RBIG is equal to the amount of the hypothetical cost recovery resulting from the deemed Sec. 338 election and the loss corporation's actual allowable cost recovery.
Although there is no clear guidance in support of, or contrary to, the treatment of Subpart F income as RBIG, before the TCJA, some practitioners questioned whether actual or deemed dividends paid by a controlled foreign corporation attributable to E&P earned before an ownership change date should be economically attributable to the prechange period and therefore considered RBIG under Sec. 382(h)(6). Similarly, if a deferred foreign income corporation owned by the loss corporation has post-1986 undistributed E&P that was generated prior to a Sec. 382 ownership change, such prechange undistributed E&P included in the Sec. 965 earnings amount could be treated as a built-in income item under Sec. 382(h)(6)(A) and treated as RBIG to the extent the loss corporation has a NUBIG in the stock of the deferred foreign income corporation and recognizes additional Subpart F income during the recognition period as a result of Sec. 965. This position may be illustrated by the following example:
Example: USP, a loss corporation, owns 100% of the stock of FSub 1, a non-U.S. corporation. At all times in this example, FSub 1 has accumulated post-1986 undistributed E&P of $50. The value of USP's stock in FSub 1 is $100, and its tax basis in the stock is $50. Additionally, FSub 1 holds Asset 1 with an FMV of $100 and tax basis of $30.
Alternative 1: Assume the loss corporation undergoes a Sec. 382 ownership change on date 1, and during the five-year recognition period following the ownership change, USP sells the stock of FSub 1 to a third-party buyer for $100. Under Sec. 1248, the $50 gain on the sale would be recharacterized as a Sec. 1248 dividend to the extent of the E&P of FSub 1. Furthermore, and following the logic of Letter Ruling 201051020, the $50 gain recognized by USP on the sale of the FSub 1 stock should be treated as RBIG even though recharacterized as a dividend by Sec. 1248.
Alternative 2: Assume that instead of the sale of the stock in FSub 1, FSub 1 sells Asset 1 and distributes the proceeds to USP. In this situation, USP would recognize $50 of dividend income. The second alternative differs from the first because the income recognized by USP does not result from the disposition of a built-in gain asset but rather from the receipt of the dividend from FSub 1. However, in both scenarios, the characterization of the income depends solely upon the E&P of FSub 1 accrued during the prechange period. Not allowing the loss corporation the benefit of an increase to the Sec. 382 limitation in two situations with analogous tax consequences would yield a harsh result.
The Sec. 338 approach is consistent with the conclusion in the preceding sentence. Items of RBIG are identified by comparing the loss corporation's actual items of income and gain with those that would have resulted if a Sec. 338 election had been made with respect to a hypothetical purchase of all the outstanding stock of the loss corporation on the ownership change. Under this approach, the "actual" toll charge inclusion would be compared with the "hypothetical" toll charge inclusion — which would be zero because in the Sec. 338 fiction the attributes of the target (i.e., E&P) would be cleansed — and the difference would be treated as RBIG (not to exceed the built-in gain in the deferred foreign income corporation stock and the overall NUBIG for the loss corporation).
However, while treating amended Sec. 965 deemed Subpart F income as RBIG may appear reasonable, there are several contrary arguments against classifying income resulting from Sec. 965 as RBIG.
The first, and likely most obvious, is that the receipt of an actual or deemed dividend distribution in situations where the loss corporation does not dispose of a built-in gain asset does not meet the literal definition of RBIG under Sec. 382(h)(2)(A). Furthermore, it could be argued that dividend income should not be a built-in income item because a dividend is recognized into income only when it is actually paid or deemed included under Subpart F or similar mechanisms. Support for this position can be found in the Sec. 1374 approach, which relies on the accrual method of accounting to identify income items as RBIG. An accrual-method loss corporation that made an actual or deemed-paid dividend following an ownership change would not have recognized income prior to the date on which the dividend was actually, or deemed to have been, paid.
Additionally, one also might argue that comparing a corporation's actual items of income and gain with its hypothetical items of income and gain under the Sec. 338 approach applies solely to assets for which the wasting asset approach is applicable (i.e., assets eligible for cost-recovery deductions). The legislative history to Sec. 382(h)(6)(A) also does not contemplate dividend income as a built-in income item but does contain a list of such items including: (1) accounts receivable of a cash-basis taxpayer arising before an ownership change date but collected after it; (2) the recognition of income under Sec. 481 resulting from an accounting method change; and (3) the gain on completion of a long-term contract performed by a taxpayer using the completed-contract method (H.R. Rep't No. 795, 100th Cong., 2d Sess. 46 (1988)).
Finally, and from a policy perspective, allowing a loss corporation that elects under Sec. 965(n) to forgo the use of its NOLs to offset its Subpart F inclusion under Sec. 965 would seem to be at odds with the "neutrality" principle reflected in Sec. 382(h), which ensures that a purchaser would be in the same position as a seller with respect to the use of the loss corporation's NOLs to offset certain built-in items. By forgoing the use of its NOLs under Sec. 965(n), the loss corporation would gain the benefit of recognizing taxable income at a reduced rate (either 8% or 15.5% under Sec. 965(c)(2)) while obtaining the full benefit of the RBIG, which may be used in a later year to offset taxable income at the higher 21% corporate tax rate. Said another way, the loss corporation would get the benefit of the RBIG without having to utilize its NOLs to offset taxable income in the same year.
RBIG benefit: Handle with care
There are valid arguments in support of treating taxable income resulting from amended Sec. 965 as RBIG, which can be a significant benefit for a corporation that undergoes an ownership change, permitting the increased utilization of otherwise limited NOLs. However, given the lack of guidance from the IRS on the general topic of Subpart F income and Sec. 382 and certain arguments against such a position, practitioners should proceed with caution.
Annette B. Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.