Gain recognition agreements: US corporation’s transfer of a foreign corporation followed by the foreign corporation’s disposition of its assets

Editor: Christine M. Turgeon, CPA

U.S. corporations regularly transfer property to subsidiaries in transactions that qualify for tax-deferred treatment for U.S. federal income tax purposes (see, e.g., Secs. 351 and 354). If a subsidiary to which property is transferred is a foreign corporation, however, there is a risk that untaxed appreciation in the assets could permanently escape the tax jurisdiction of the United States.

To address this concern, Sec. 367(a)(1) provides that a transfer of property from a U.S. person to a foreign corporation (an outbound transfer) in an exchange described in Sec. 332, 351, 354, 356, or 361 is treated as not made to a corporation for purposes of determining whether the U.S. person recognizes gain on the transfer. Any realized gain, therefore, is not afforded tax-deferred treatment.

Certain exceptions may suspend the applicability of Sec. 367(a)(1) and make it possible to defer tax on a transfer of property from a U.S. person to a foreign corporation. For example, Sec. 367(a)(2) allows tax deferral for outbound transfers of stock in a foreign corporation that is a party to a reorganization. In addition, under Regs. Sec. 1.367(a)-3(b)(1), a U.S. person’s outbound transfer of stock in a foreign corporation to a foreign transferee corporation will not be subject to Sec. 367(a)(1)’s rule against tax deferral if (1) the U.S. person owns less than 5% of the total voting power and value of the stock of the foreign transferee corporation immediately after the transfer (applying certain attribution rules) or (2) the U.S. person enters into a “gain recognition agreement” (GRA). The discussion below examines the use of GRAs to defer tax on the outbound transfer of stock to a foreign corporation.

A GRA must disclose, among other items, the manner in which the outbound transfer occurred, the parties involved, a calculation of the built-in gain in the transferred stock, and other prescribed information (see generally Regs. Sec. 1.367(a)-8 (the GRA regulations)). Taxpayers must monitor future transactions involving the parties listed in the GRA throughout its term, which is a period of 60 months following the close of the tax year in which the outbound transfer of stock occurs (the GRA term) (Regs. Sec. 1.367(a)-8(c)). A GRA may terminate before the end of the GRA term if the entire amount of gain subject to the GRA is recognized, certain transactions occur that are described in Regs. Sec. 1.367(a)-8(o), or a new GRA is entered into following a triggering event.

Triggering events and triggering event exceptions

Within the GRA term, certain transactions may require that the gain deferred under a GRA be recognized (each, a triggering event) (see Regs. Secs. 1.367(a)-8(j)(1) through (10)). Exceptions may be available for triggering events if certain conditions are satisfied (each, a triggering event exception) (see Regs. Secs. 1.367(a)-8(k)(1) through (14)).

The present discussion focuses on the rule that a disposition of “substantially all” of the assets of a transferred corporation is considered a triggering event and thus may require the gain deferred under the GRA to be recognized (Regs. Sec. 1.367(a)-8(j)(2)). A triggering event exception may apply, however, if the relevant assets are transferred to a corporation or partnership pursuant to an exchange to which Sec. 351, 354 (but only in a Sec. 368(a)(1)(B) reorganization), or 721 applies, provided that a “new” GRA is entered into. Specifically, the new GRA must provide that any future complete or partial dispositions of the stock (or partnership interest) received in the asset exchange shall constitute a triggering event for purposes of the new GRA (see Regs. Sec. 1.367(a)-8(k)(4)).

Uncertainty regarding application of ‘substantially all’

Treasury and the IRS have significantly revised the rules relating to triggering events and triggering event exceptions over the years in light of taxpayer comments. However, uncertainty remains regarding how “substantially all of the assets of the transferred corporation” should be determined in the context of the triggering event described in Regs. Sec. 1.367(a)-8(j)(2). According to Regs. Sec. 1.367(a)-8(b)(1)(xii), “[t]he determination of whether substantially all of the assets of the transferred corporation have been disposed of is based on all the facts and circumstances.” No further guidance is provided, however, to understand precisely which assets should be considered when applying this “facts and circumstances” standard for purposes of analyzing whether this triggering event has occurred.

Example: In year 1, a U.S. corporation (USCorp) contributes all the stock of a country X corporation (FC1) to a country Y corporation (FC2) in a transaction that is described in Sec. 351 (the initial outbound transfer). The initial outbound transfer is subject to gain recognition under Sec. 367(a)(1), but USCorp timely enters into a GRA (the initial FC1 GRA).

In year 2, FC1 contributes all of the assets that it held on the date of the initial outbound transfer (the FC1 year 1 assets) to a country X corporation that is a wholly owned subsidiary of FC2 (Fsub1) in exchange for newly issued shares of Fsub1 in a transaction that is described in Sec. 351. Immediately after this contribution, FC2 and FC1 (by reason of the newly issued shares of FSub1) own all of the issued and outstanding shares of Fsub1.

The FC1 contribution of the FC1 year 1 assets to Fsub1 is a triggering event with respect to the initial FC1 GRA under Regs. Sec. 1.367(a)-8(j)(2). USCorp timely enters into a new GRA (the new FC1 GRA) in accordance with the triggering event exception in Regs. Sec. 1.367(a)-8(k)(4). The transaction is depicted in the diagram below.

Question 1: Which assets should be considered in determining whether a triggering event under Regs. Sec. 1.367(a)-8(j)(2) has occurred?

In the example, if FC1 did not obtain any additional assets after the initial outbound transfer, then its contribution of the FC1 year 1 assets would be considered a disposition of “substantially all” of its assets for purposes of Regs. Sec. 1.367(a)-8(j)(2). On the other hand, if FC1 had acquired additional assets after the initial outbound transfer (the after-acquired assets) it is less clear which assets should be considered in determining whether FC1 disposed of “substantially all” of its assets. For example, should all of the assets, including the after-acquired assets, be taken into account? Additionally — and irrespective of whether only the FC1 year 1 assets should be considered — if less than all of FC1′s assets are disposed of, it will be necessary to calculate the assets disposed of relative to those that FC1 continues to hold.

It is unclear how assets that are disposed of should be measured relative to assets that FC1 continues to hold. For example, should taxpayers make this “substantially all” determination based on either the assets’ fair market values (FMVs) or adjusted tax bases? Moreover, if the assets’ FMVs are used, it is unclear which valuation dates should be used. Specifically, if only the FC1 year 1 assets are considered in determining whether a disposition of “substantially all” of the assets has occurred, should the values on the date of the initial outbound transfer be used, or should the values on the date in year 2 when the assets are contributed to Fsub1 be used?

Question 2: How should the FC1 year 1 assets be tracked and treated after they have been contributed toFsub1?

If, after FC1′s contribution of the FC1 year 1 assets to Fsub1, Fsub1 disposed of the FC1 year 1 assets, it is unclear whether this disposition would be considered relevant in determining whether a triggering event under Regs. Sec. 1.367(a)-8(j)(2) has occurred with respect to the new FC1 GRA. Because FC1 no longer directly holds the FC1 year 1 assets, perhaps it could be argued that it would not be appropriate to consider those assets in determining whether “substantially all” of the assets of FC1 have been disposed of. Under this line of reasoning, only the assets that FC1 directly holds, including the Fsub1 stock, would be considered.

On the other hand, perhaps it could be argued that because the FC1 year 1 assets were those that FC1 held when USCorp initially transferred FC1 to FC2 — and the GRA regulations do not indicate that the FC1 year 1 assets should cease to be considered assets of FC1 — only the FC1 year 1 assets should be considered relevant for determining whether “substantially all” of FC1′s assets have been disposed of. Moreover, examining the assets that FC1 directly holds would seem superfluous because, under Regs. Sec. 1.367(a)-8(k)(4), a disposition of the stock that FC1 received (or is deemed to have received) in exchange for the FC1 year 1 assets (i.e., the Fsub1 stock) must be designated as a triggering event in the new FC1 GRA.

Additional guidance needed

Considering the different answers that could be provided for the questions posed in the example, taxpayers would benefit from guidance pertaining to the asset composition (including after-acquired assets) that should be considered in determining whether “substantially all” of the assets of the transferred corporation (i.e., FC1 in the example discussed previously) have been disposed of. Taxpayers also would benefit from guidance clarifying whether, after the occurrence of a triggering event described in Regs. Sec. 1.367(a)-8(j)(2) and application of the triggering event exception in Regs. Sec. 1.367(a)-8(k)(4), the assets formerly held directly by the transferred corporation continue to be relevant for determining whether subsequent dispositions could result in a disposition of “substantially all” of the assets of the transferred corporation.

EditorNotes

Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Ms. Turgeon at 973-202-6615 or christine.turgeon@pwc.com.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.