TAX MANAGEMENT INTERNATIONAL JOURNAL

Transcription

1 TAX MANAGEMENT INTERNATIONAL JOURNAL a monthly professional review of current international tax issues Reproduced with permission from Tax Management International Journal, Vol. 34, No. 4, 04/08/2005. Copyright 2005 by The Bureau of National Affairs, Inc. ( ) New Proposed 367 Regulations Address a Potpourri of Issues by Philip A. McCarty, Esq. McDermott Will & Emery LLP Washington, D.C. and Michael A. DiFronzo, Esq. McDermott Will & Emery LLP Chicago, Illinois TABLE OF CONTENTS I. INTRODUCTION II. CONCURRENT APPLICATION OF 367(A) AND 367(B) TO AN INBOUND REORGANIZATION A. Inbound Asset Reorganization Subject to 367(b) B. Triangular Asset Reorganizations Subject to 367(a) C. The Treatment of Transactions Subject to Both 367(a) and 367(b) 1. Treatment of Overlap Transactions Under the Existing Regulations 2. Proposed Change to the Overlap Rule III. TRIANGULAR REORGANIZATIONS WHERE U.S. STOCK FOR CFC STOCK OR ASSETS A. Foreign-to-Foreign Triangular Reorganizations Under the Existing Regulations B. Proposed Change to Regs (b)-4 IV. TRANSFERS OF ASSETS FOLLOW- ING CERTAIN ASSET REORGANIZA- TIONS V. TRANSFERS TO A DOMESTIC SUB- SIDIARY FOLLOWING AN OUTBOUND ASSET TRANSFER A. Consideration of the Current Indirect Stock Transfer Regulations B. Consideration of Proposed Changes to Indirect Stock Transfer Regulations TAX MANAGEMENT INC. WASHINGTON, D.C.

2 VI. BASIS AND HOLDING PERIOD RULES A. Section 354 Exchanges B. Triangular Reorganizations C. Section 351 Exchanges VII. CONCLUSION I. INTRODUCTION Recently, the Internal Revenue Service ( IRS ) and the Treasury Department ( Treasury ) issued proposed regulations that would reverse almost 70 years of established law relating to tax-free merger transactions under 368(a)(1)(A). 1 Section 368(a)(1)(A) defines a reorganization to include a statutory merger or consolidation. Since 1935, the relevant Treasury regulations under this section and its predecessor sections have defined a statutory merger or consolidation to mean a merger or consolidation transaction effected pursuant to the laws of the United States or a State or the District of Columbia. 2 Accordingly, prior to the proposed regulations, a taxfree merger or consolidation could only be between two or more domestic corporations. The proposed regulations would redefine the term statutory merger or consolidation and eliminate the requirement that the transaction be effected pursuant to the laws of the United States or a State (or D.C.). In general, under the proposed regulations, a statutory merger or consolidation will include a transaction that is effected pursuant to a statute or statutes necessary to effect a merger or consolidation in which, by operation of law, all of the assets and liabilities of one corporation become the assets and liabilities of another corporation and the transferor corporation ceases its separate legal existence. 3 Thus, the proposed regulations will make it possible for the first time to effect a merger of a U.S. corporation into a foreign corporation or to effect a merger of two foreign corporations where the status of the transaction as a tax-free reorganization is tested under 368(a)(1)(A). This is significant because under existing regulations an asset reorganization involving a foreign corporation is tax-free only if it satisfies the narrow requirements for reorganizations under 368(a)(1)(C) or 368(a)(1)(D). For example, an acquisitive asset reorganization will qualify as a tax-free 1 See Prop. Regs (b)(1), REG , 70 Fed. Reg. 746 (1/5/05). 2 See Regs T(b)(1)(ii), which provides, in part, that a statutory merger or consolidation is a transaction effected pursuant to the laws of the United States or a State or the District of Columbia... 3 Prop. Regs (b)(1)(ii). C reorganization only if substantially all the properties of the transferor corporation are acquired in exchange solely for all or a part of the transferee s voting stock (or the voting stock of a corporation that is in control of the transferee corporation). In contrast, the consideration for assets acquired in an A reorganization can include a combination of stock (whether or not voting) and other assets. 4 The new rules would also permit foreign corporations to engage in tax-free triangular reorganizations that qualify as a forward merger under 368(a)(2)(D) or as a reverse subsidiary merger under 368(a)(2)(E). Under the existing rules, a tax-free triangular reorganization involving a foreign corporation can be effected only pursuant to 368(a)(1)(C), where the transaction involves an asset acquisition, or pursuant to 368(a)(1)(B), where the transaction involves an acquisition of stock. Along with the proposed regulations under 368, the IRS and Treasury separately issued proposed regulations under 367, relating to the treatment of reorganizations involving foreign corporations. Many of the changes are proposed merely to conform the existing 367 regulations to mergers or consolidations of foreign corporations that qualify as A reorganizations. However, other proposed changes to the 367 regulations go beyond the tax-free treatment of a statutory merger or consolidation involving one or more foreign corporations. Many of these additional proposed changes address issues involving triangular reorganizations or reorganizations where, pursuant to an overall plan, all or part of the stock or assets of an acquired company are transferred to one or more subsidiaries of the acquiring company. It is these additional proposed changes that are the subject of this article. II. CONCURRENT APPLICATION OF 367(A) AND 367(B) TO AN INBOUND REORGANIZATION The first proposed change to the existing 367 regulations addresses an unusually narrow class of transactions involving an inbound triangular asset reorganization that is simultaneously subject to both the inbound asset rules of 367(b) and to the outbound stock transfer rules of 367(a). A. Inbound Asset Reorganization Subject to 367(b) By way of background, pursuant to the inbound asset rules of Regs (b)-3, when the assets of a 4 However, a 368(a)(1)(A) reorganization must still satisfy the continuity of interest doctrine, so the use of other property is not without its boundaries. See Roebling v. Comr., 143 F.2d 810 (3d Cir. 1944), cert. denied, 323 U.S. 773 (1944) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

3 foreign corporation are moved to a U.S. corporation in a tax-free reorganization transaction, the U.S. shareholders 5 of the transferor foreign corporation are required to include in income as a deemed dividend the all earnings and profits amount 6 of the foreign corporation attributable to their shares without regard to the amount of gain, if any, inherent in the shares. 7 Thus, for example, assume DC1, a domestic corporation, owns all of the outstanding stock of DC2, a domestic corporation, and also of FC, a foreign corporation, and that FC s all earnings and profits amount is $20. In a reorganization described in 368(a)(1)(D), DC2 acquires all the assets of FC solely in exchange for DC2 stock, and FC distributes the DC2 stock to DC1 in liquidation. B. Triangular Asset Reorganizations Subject to 367(a) In contrast, Regs (a)-3 provides rules for the treatment of an outbound transfer of stock or securities to a foreign corporation in a nonrecognition transaction. Pursuant to these rules, if a U.S. person transfers the stock of a foreign corporation to a foreign corporation in a transaction that would otherwise be subject to tax under 367(a), 367(a) will not apply to tax the transfer if the U.S. transferor owns at least 5% of the stock of the transferee foreign corporation and enters into a 5-year gain recognition agreement ( GRA ) with respect to the transferred stock. 8 For example, assume DC1, a domestic corporation, wholly owns FC1, a foreign corporation. In an exchange that would be subject to 367(a), DC1 transfers the shares of FC1 to FC2, a foreign corporation, solely in exchange for 20% of FC2 s outstanding voting stock. Under the inbound asset reorganization rules of 367(b), DC1 in the above example is required to include $20 in income as a deemed dividend from FC without regard to the gain, if any, that DC1 may have in its FC shares. 5 A U.S. shareholder for this purpose is defined to mean any shareholder described in 951(b) without regard to whether the foreign corporation is a controlled foreign corporation. See Regs (b)-3(b)(2). 6 The term all earnings and profits amount is defined in Regs (b)-2(d) generally to mean the earnings and profits attributable to the stock while it was held, directly or indirectly, by a U.S. person. 7 The earnings and profits amount attributable to the stock of a foreign corporation is determined according to the principles of 1248 without regard to the requirements of 1248 that are not relevant to the determination of a shareholder s pro rata portion of earnings and profits. See Regs (b)-2(d)(3). DC1 s outbound transfer of the FC1 shares to FC2 will be fully taxable to DC1 under 367(a) unless DC1 enters into a GRA with respect to the transfer. If DC1 fails to file a GRA, its recognized gain will equal the gain inherent in the FC1 shares (without regard to the amount of FC1 s earnings and profits). 9 For purposes of the stock transfer rules, the regulations treat certain triangular asset reorganizations as the equivalent of a transfer of stock (i.e., as an indirect transfer of stock). Thus, assume that in the above example instead of DC1 transferring the stock of FC1 to FC2, FC1, in a triangular C reorganization, transfers its assets to FC3, a foreign corporation wholly owned by FC2, in exchange for FC2 shares. 8 See Regs (a)-3(b)(1). A GRA is not required to avoid the application of 367(a) if the U.S. person owns less than 5% of the stock of the transferee foreign corporation immediately after the transfer. Regs (a)-3(b)(1)(i). The rules governing the content and other requirements of a GRA are contained in Regs (a)-8. 9 The transfer by DC1 of its FC1 shares to FC2 might also result in income recognition under 367(b) depending on whether FC2 is a controlled foreign corporation. See Regs (b) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

4 Although the transaction described in the above example is, in form, an asset reorganization, the indirect stock transfer rules treat DC1 as having made, in substance, an outbound transfer of the FC1 stock. Under the fiction of the regulations, DC1 is treated as transferring the FC1 shares to FC2. FC3 represents FC1 for this purpose. 10 C. The Treatment of Transactions Subject to Both 367(a) and 367(b) Because the 367(a) regulations recast certain asset transfers as stock transfers, such transfers may be subject to both 367(a) and 367(b). 11 For example, assume that in the above example FC3 is a U.S. corporation. Consequently, FC1, a foreign corporation, is transferring its assets to a U.S. corporation in what amounts to an inbound asset reorganization subject to 367(b). DC1 therefore is required to include in income as a dividend FC1 s all earnings and profits amount. However, at the same time, the triangular reorganization is also treated as an indirect stock transfer subject to 367(a). As such, DC1 is also treated as making an outbound transfer of the FC1 stock to FC2. 12 Thus, DC1 will recognize 367(a) gain on the transfer unless it files a GRA. 1. Treatment of Overlap Transactions Under the Existing Regulations The existing regulations contain an overlap rule for transactions that are subject to both 367(a) and 367(b). 13 Such transactions are subject to both sets of rules except to the extent that the transaction is fully taxable under 367(a)(1) because, for example, the U.S. transferor of the foreign stock does not enter into a GRA. 14 To illustrate, assume that in the above example, where FC3 (the transferee) is a U.S. corporation, FC1 s all earnings and profits amount is $30 and the gain inherent in the FC1 stock held by DC1 is $50. If DC1 enters into a GRA with respect to the deemed transfer of the FC1 shares, DC1 can avoid recognizing the $50 gain inherent in the FC1 shares under 367(a). However, DC1 cannot avoid having to include in income FC1 s all earnings and profits amount of $30 under Regs (b)(3). By contrast, if FC1 s all earnings and profits amount is $60, to avoid having to include the full $60 in income under Regs (b)-3, DC1 presumably would simply forego the filing of a GRA and thereby include only $50 in income under 367(a). Because the transfer would be fully taxable under 367(a), DC1 would not be required to include any amount as a deemed dividend under 367(b). Put another way, if an asset reorganization is subject to 367(a) as an indirect stock transfer and to 367(b) as an inbound asset reorganization, and the all earnings and profits amount of the foreign transferor exceeds the gain that the U.S. person would otherwise recognize under 367(a), the U.S. person can avoid including the larger all earnings and profits amount in income by choosing not to file a GRA. 2. Proposed Change to the Overlap Rule The IRS and Treasury have determined that the existing overlap rule is inconsistent with the principles of 367(b) in the above case where the assets of a foreign corporation may be brought on-shore without the full recognition of the previously deferred earnings. In a carryover basis transaction, such as an asset reorganization, the basis of the assets should reflect an after-tax amount. 15 Accordingly, the proposed regulations would reverse the existing rule that applies to 10 In applying Regs (a)-3(b), relating to the transfer of the stock of a foreign corporation, and the gain recognition provisions of Regs (a)-8, FC2 is treated as the transferee corporation and FC3 is treated as the transferred corporation. See Regs (a)-3(d)(2). Again, the transaction may also result in income recognition under 367(b) and Regs (b)-4 depending on whether FC2 is a controlled foreign corporation. 11 The indirect stock transfer rules of Regs (a)-3(d) apply only for purposes of 367(a) and not for purposes of 367(b). See Regs (a)-3(d)(3), Ex Even though the assets were transferred by FC1 to a domestic corporation, the indirect stock transfer rules treat the transaction as an outbound transfer of the stock of a foreign corporation because FC1 and FC2 are foreign corporations. See Regs (a)-3(d)(1). Further, as explained in the preamble to the proposed regulations, the IRS and Treasury considered and rejected treating an outbound transfer of stock as an outbound transfer of foreign or domestic stock by looking to the corporation that ultimately received the assets. This principle is illustrated in Ex. 9, Regs (a)-3(d)(3). 13 See Regs (a)-3(b)(2). 14 Id. 15 As explained in the preamble to the proposed regulations, Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

5 transactions that are subject to both 367(a) as an indirect stock transfer and to 367(b) as an inbound asset reorganization. 16 To ensure that the previously deferred earnings are fully subject to U.S. tax, the proposed regulations would apply the 367(b) rules prior to the 367(a) rules. 17 Thus, in the above example, DC1 would be required to include in income as a dividend FC1 s all earnings and profits amount of $60. Because this amount exceeds the gain inherent in the FC1 shares, DC1 would not be required to file a GRA on the transfer, and no additional amount would be included in income under 367(a). While it may be difficult to disagree with the stated policy justification for the proposed regulation, in reality the regulation will rarely apply, if ever, because the transaction to which it would apply (i.e., a transfer of assets from a foreign corporation to a U.S. subsidiary of a foreign corporation in a triangular reorganization) is not likely to occur. The more likely scenario is that the assets in the above hypothetical would remain in foreign corporate solution and not be transferred to a U.S. subsidiary. However, even if we assume such a transfer would be made, faced with a regulation that would require DC1 to include $60 in income as a deemed dividend, DC1 would likely just sell the shares of FC1 to FC2 in a fully taxable transaction and recognize the $50 of gain, thereby avoiding an asset reorganization that would result in a higher tax. It is hoped that the IRS and Treasury will reconsider and delete this proposed regulation from the final regulations as an unnecessary complexity. III. TRIANGULAR REORGANIZATIONS WHERE U.S. STOCK FOR CFC STOCK OR ASSETS The most noteworthy proposed change to the existing regulations involves the treatment of a triangular reorganization where the stock or assets of a controlled foreign corporation are transferred to another foreign corporation in exchange for the stock of a domestic corporation. A. Foreign-to-Foreign Triangular Reorganizations Under the Existing Regulations Under the current regulations, if the stock or assets of a controlled foreign corporation are transferred to another foreign corporation in exchange for the stock of its parent corporation in a triangular reorganization, the U.S. shareholder of the acquired corporation is required to include in income, as a deemed dividend, the 1248 amount attributable to the stock of the acquired corporation if, immediately after the exchange, the stock received is not stock in a corporation that is itself a controlled foreign corporation. 18 This result occurs even though the acquired corporation (or its successor in the case of an asset reorganization) maintains its status as a controlled foreign corporation and there is a new 1248 shareholder that inherits the U.S. shareholder s holding period with respect to the stock. Thus, in all events, on a foreign-to-foreign transfer, the existing regulations require a U.S. shareholder that receives stock in a domestic corporation in exchange for its stock in a controlled foreign corporation to include the 1248 amount as a deemed dividend. Assume, for example, that DC1, a domestic corporation, wholly owns FC1, a foreign corporation, and that the 1248 amount attributable to the FC1 shares is $30. DC2, an unrelated domestic corporation, owns all the outstanding stock of FC2, a foreign corporation. In a triangular reorganization described in 368(a)(1)(B), FC2 uses voting shares of DC2 to acquire 368(c) control of FC1. The ability to elect to recognize the lesser gain inherent in the stock exchanged in such cases is inconsistent with the policies of 367(b) that apply to inbound transactions, including preventing conversion of tax deferral into tax forgiveness and ensuring that the domestic acquiring corporation s 381 carryover basis reflects an after-tax amount. 16 See Prop. Regs (a)-3(b)(2)(i)(A) and Prop. Regs (a)-3(d)(3), Ex. 15, REG , 70 Fed. Reg. 749 (1/5/05). 17 Prop. Regs (a)-3(b)(2)(i)(A) provides, If a foreign corporation transfers assets to a domestic corporation in a transaction to which 1.367(b)-3(a) and (b) and the indirect stock transfer rules of paragraph (d) of this section apply, then the 367(b) rules shall apply prior to the 367(a) rules. 70 Fed. Reg. at Regs (b)-4(b)(1) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

6 Under Regs (b)-4, because DC1 did not receive shares in a controlled foreign corporation, DC1 is required to include in income, as a deemed dividend, the 1248 amount with respect to the shares of FC1. As a further example, assume the same facts as above, except that instead of transferring the shares of FC1 to FC2, FC1 transfers all of its assets to FC2 in exchange for voting shares of DC2 in a triangular reorganization described in 368(a)(1)(C), and that FC1 distributes the DC2 shares to DC1 in liquidation. surviving corporation is a controlled foreign corporation. 19 Thus, in the above example, when FC1 transfers its assets to FC2 in exchange for DC2 stock, DC1 will not be required to include in income the 1248 amount with respect to the exchanged shares because DC1 receives the stock of a U.S. corporation, DC2, in the exchange, and, immediately after the exchange, DC2 is a 1248 shareholder of FC2 (the surviving corporation) and FC2 is a controlled foreign corporation. 20 Again, because DC1 received shares in a domestic corporation, i.e., the shares of DC2, pursuant to Regs (b)-4, DC1 is required to include in income, as a deemed dividend, the 1248 amount with respect to the FC1 shares. B. Proposed Change to Regs (b)-4 Under the proposed rules, in the case of a triangular asset reorganization described in 368(a)(1)(C) or 368(a)(2)(D) involving the transfer of the assets of a controlled foreign corporation, or a triangular stock reorganization described in 368(a)(1)(B) or 368(a)(2)(E) involving the transfer of the stock of a controlled foreign corporation, Regs (b)-4 will not apply to require an inclusion of the 1248 amount attributable to the shares of the target corporation if the stock received in the exchange is stock of a U.S. corporation and, immediately after the exchange, the U.S. corporation is a 1248 shareholder of the acquired corporation (in the case of a triangular 368(a)(1)(B) reorganization) or of the surviving corporation (in the case of a reorganization described in 368(a)(1)(C), (a)(2)(d) or (E)) and such acquired or While the proposed change to Regs (b)-4 is a positive development, the existing (and proposed) 367(a) regulations raise an issue whether the transaction could result in 367(a) gain because DC1 in the above example would not receive stock of a foreign corporation. 21 Hopefully, the IRS and Treasury will address this issue by also including stock of a domestic corporation in the final 367(a) regulations. Otherwise, the proposed fix tothe 367(b) regulations may be made meaningless in the case of a triangular asset reorganization. With respect to the treatment of a triangular stock reorganization, if DC1 in the above example transfers the shares of FC1 to FC2 in exchange for shares of DC2, under the proposed rules, DC1 will not be required to include in income the 1248 amount attributable to the FC1 shares because, again, on the exchange DC1 receives stock of a U.S. corporation, DC2, and, immediately after the exchange, DC2 is a 1248 shareholder of FC2 (the acquiring corporation), 19 Prop. Regs (b)-4(b)(1)(ii). 20 See Prop. Regs (b)-4(b)(1)(iii), Ex. 3B. 21 See Regs (a)-3(a) and Prop. Regs (a)-3(a) ( However, if in an exchange described in a U.S. person exchanges stock of a domestic or foreign corporation for stock of a foreign corporation pursuant to an asset reorganization that is not treated as an indirect stock transfer... (emphasis added)) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

7 and FC2 and FC1 are both controlled foreign corporations. The proposed regulations would also treat this triangular stock reorganization as an indirect stock transfer subject to 367(a). 22 Under the proposed rules, if a U.S. person (DC1 in the above example) exchanges stock of an acquired corporation (FC1) for voting stock of a U.S. corporation (DC2) that is in control of a foreign acquiring corporation (FC2) in a reorganization described in 368(a)(1)(B), then for purposes of 367(a) the foreign acquiring corporation (FC2) is considered to be the transferee foreign corporation even though the U.S. transferor (DC1) receives stock of the U.S. controlling corporation (DC2) in the exchange. 23 Thus, in this hypothetical, to avoid taxation under 367(a), DC1 will be required to file a GRA if DC1 owns at least 5% of FC2 within the meaning of Regs (a)-3(b)(1)(i). 24 The proposed 367(b) rules represent a welcome change to the rule of the existing regulations that is difficult to justify from an overall policy perspective. 25 The 1248 amount of the foreign target is properly preserved in the stock of the foreign corporation owned by the U.S. corporation whose stock is used in the exchange. Other proposed changes, discussed below, would add certain detailed basis and holding period rules that are intended to preserve further the 1248 amount following a triangular reorganization that is not otherwise subject to Regs (a)-3 or 1.367(b) IV. TRANSFERS OF ASSETS FOLLOWING CERTAIN ASSET REORGANIZATIONS The proposed regulations amend the indirect stock transfer rules to reflect certain changes to proposed rules under 368 that would permit a transfer of assets or stock following a transaction that would otherwise qualify as a reorganization under 368(a)(1). 27 Section 368(a)(2)(C) provides generally that any transaction that would otherwise qualify as a reorganization under 368(a)(1)(A), (a)(1)(b), or (a)(1)(c) will not be disqualified if all or part of the assets or stock that were acquired in the transaction are transferred to a corporation that is controlled by the corporation acquiring the assets or stock in the reorganization. Proposed rules under 368 would extend this general rule to all transactions otherwise qualifying as reorganizations under 368(a)(1), including, for example, transactions that would otherwise qualify as a reorganization under 368(a)(1)(D). 28 For example, assume DC1, a domestic corporation, wholly owns FC1, a foreign corporation, and FC2, a foreign corporation. In a transaction that meets the requirements of a D reorganization, FC1 transfers its assets to FC2 and liquidates. As part of the same plan, FC2 transfers all of the former assets of FC1 to its wholly owned subsidiary, FC3, a foreign corporation. 22 See Prop. Regs (a)-3(d)(1)(iii)(B). This indirect stock transfer treatment avoids the Prop. Regs (a)-3(a) concern that exists with an asset reorganization. 23 Id. 24 For purposes of applying the GRA, the U.S. controlling corporation (DC2) will be treated as the transferee foreign corporation. Thus, a disposition of foreign acquiring corporation stock (FC2) by DC2, or a disposition of the acquired corporation stock (FC1) by FC2 will trigger the GRA. 25 See letter dated Aug. 9, 2002, from Wessel, et al. ofkpmg to Eric Solomon of the Treasury Department. 26 See Prop. Regs (b) See Prop. Regs (k); see also Rev. Rul , C.B Id Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

8 29 See Rev. Rul Prop. Regs (a)-3(d)(1)(v) C.B See Prop. Regs (m). 33 Prop. Regs (a)-3(d)(1)(v). See Regs (b)- 2(f)(2), which deems an exchange of shares and an asset transfer to occur in a 368(a)(1)(F) transaction even if such did not occur in fact. 34 Prop. Regs (a)-3(e)(1). The exceptions included in this rule do not seem to include the contemplated transaction. See Prop. Regs (a)-3(d)(1)(v). This transaction should qualify as a D reorganization notwithstanding that all of FC1 s assets are transferred by FC2 to FC3 as part of a plan. 29 The proposed regulations would amend the indirect stock transfer rules to treat a controlled asset transfer that follows a reorganization as an indirect stock transfer to the extent of the assets transferred in the controlled asset transfer. 30 Thus, in the above example, the transfer of FC1 s assets to FC2 that are then transferred to FC3 would be treated as an indirect transfer of the FC1 stock. As such, to avoid gain recognition under 367(a)(1), DC1 will be required to enter into a GRA. The proposed regulations also include as an indirect stock transfer a 368(a)(1)(F) reorganization that is followed by a contribution of assets to a subsidiary. This is particularly troubling because treatment as an indirect stock transfer requires the combination of the F reorganization with the subsequent drop-down of assets. This combination of transactions runs counter to the IRS s own guidance in Rev. Rul and the new proposed F reorganization regulations. 32 Very often, an F reorganization with a drop-down of assets is more similar in substance to a simple 351 transaction by a foreign corporation, which would not require a GRA, than it is to an asset reorganization with a drop-down of assets, which would require a GRA. Nonetheless, the IRS and Treasury have included this in the proposed regulations as an indirect stock transfer. 33 Although not addressed in the preamble to the proposed regulations, the change in the proposed regulations to the rule applicable to F reorganizations (and D reorganizations) with asset contributions seems to be retroactive to July 20, Possibly, the IRS and Treasury believe they have the authority for such a rule and that a seven-year retroactive application of the rule is not burdensome because taxpayers were on notice that such a transaction could be subject to a GRA through a very liberal reading of Regs (a)-1T(c). However, this argument, although plausible for 368(a)(1)(D) reorganizations, is not persuasive, considering the authority applicable to F reorganizations and their treatment as separate transactions. Moreover, unlike D reorganizations, the IRS and Treasury did not clearly put taxpayers on notice of this pending rule change as they did with D reorganizations. 35 Hopefully, the IRS and Treasury will reconsider and reject the inclusion of F reorganizations before the proposed regulations are finalized, or at least modify the effective date rule contained in Prop. Regs (a)-3(e)(1) to make the change prospective. For an example of how the proposed rule would apply to F reorganizations, assume DC1, a domestic corporation, wholly owns FC1, a foreign corporation. As part of a foreign restructuring, FC1 changes its name, its entity type, or its place of organization. Following FC1 s change, it contributes some or all of its assets to FC2, a foreign corporation that FC1 wholly owns. Here, FC1 s change of name, entity type, or place of organization prior to the drop-down of assets to FC2 should be characterized as a 368(a)(1)(F) reorganization. FC1 s drop-down of assets to FC2 should be characterized as a 351 transaction. Although in substance this transaction is little different from a simple 351 contribution by FC1 to FC2, it has the effect, under the proposed regulations, of transforming the contribution into an indirect stock transfer which would require a GRA. Failure to file a GRA could result in 367(a) gain to DC1 on the asset drop-down to FC2. V. TRANSFERS TO A DOMESTIC SUBSIDIARY FOLLOWING AN OUTBOUND ASSET TRANSFER The proposed regulations also alter the treatment of certain indirect stock transfers that involve a transfer of assets by a domestic corporation to a foreign cor- 35 See Rev. Rul , C.B. 986, and Notice , C.B Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

9 poration, when some or all of those acquired assets are then transferred by the foreign acquiring corporation to a domestic subsidiary in a transfer described in 368(a)(2)(C) or in a transfer described in 351. The proposed changes were drafted with a taxable inversion transaction in mind. However, the enactment of 7874 in the American Jobs Creation Act of 2004 (P.L ) on October 22, 2004, would seem to make the rule inapplicable to that type of transaction because the acquiring foreign corporation would be treated as a U.S. corporation. Nonetheless, the retention of this proposed change to the indirect stock transfer rules may still have practical application to prevent certain types of planning in transactions not subject to A. Consideration of the Current Indirect Stock Transfer Regulations Prior to addressing the narrow circumstances in which these proposed changes to the indirect stock transfer rules may have relevance, it is useful to understand the current rules and how they operate in the inversion context (ignoring the application of new 7874). It is clear from the preamble to the proposed regulations that inversion transactions were a noteworthy concern in drafting changes to the indirect stock transfer rules. 36 Under the current regulations, an asset reorganization of a U.S. corporation with and into a foreign corporation, followed by a drop-down of some or all of those acquired assets has the effect of turning off 367(a) for the U.S. target corporation to the extent that the acquired assets are contributed to a controlled U.S. subsidiary of the foreign acquirer. 37 What is not discussed in the preamble is that gain is often recognized under an application of the current regulations by the shareholders of the merging U.S. corporation. In other words, the 367(a) gain that resulted from the inversion transaction is in essence split between the merging U.S. corporation and its U.S. shareholders. In the right facts, this splittreatment (referred to as the coordination rule in the proposed regulations) of an inversion transaction allowed an inverting U.S. corporation some flexibility to move certain assets (presumably, high basis assets) out of U.S. corporate solution as part of the inversion transaction, while reducing the amount of U.S. shareholder gain that resulted from the inversion. 36 The preamble states that [t]he IRS and Treasury are concerned that the asset reorganizations subject to this coordination rule may be used to facilitate inversion transactions. 37 Likewise, a 351 contribution of assets by a U.S. corporation to a foreign corporation, followed by a second 351 contribution by the foreign corporation of some or all of those contributed assets to a U.S. subsidiary also has the effect of treating the asset transfer as an indirect stock transfer to the extent of the second contribution. Regs (a)-3(d)(1)(vi). For example, assume DC1, a domestic corporation, has a market capitalization of $1000 and no outstanding debt. DC1 has $400 of earnings and profits. DC1 holds $100 of cash, Asset X with an adjusted basis of $325 and a fair market value of $300, Asset Y with an adjusted basis of $80 and a fair market value of $100, and Asset Z with an adjusted basis of $100 and a fair market value of $500. DC1 has a net operating loss carryforward of $20. DC1 is publicly traded and widely held. Some of DC1 s shareholders have unrecognized gain in the shares that they hold, while others do not. Pursuant to a plan of reorganization, DC1 merges with and into FC, a foreign corporation, and FC contributes Asset Z to DC2, a wholly owned U.S. subsidiary of FC, solely in exchange for DC2 stock. The shareholders of DC1 will hold more than 80% of the stock of FC as a result of the merger. DC1 should be treated as merging with and into FC in an asset reorganization described in 368(a)(1). FC s contribution of Asset Z to DC2 should be treated as a contribution under 368(a)(2)(C) (presumably, a 351 contribution, and not a 361 transfer 38 ). Under the current regulations, ignoring the application of new 7874, the merger of DC1 with and into FC should be subject to the general outbound asset transfer rules of 367(a), including 367(a)(5) pursuant to which DC1 would be required to recognize gain on such assets. 39 The transaction should also be subject to 367(a) as an indirect outbound transfer of DC1 38 See, e.g., GCM (Apr. 10, 1978) and GCM (Apr. 10, 1978). 39 To the extent that the retained assets are intangible property (within the meaning of 936(h)(3)(B)), the outbound asset transfer rules of 367(d), and not 367(a), would apply. The merger would also be potentially subject to 367(b), although the substantive rules under the current 367(b) regulations should not impact the described transaction. DC1 s shareholders, as the exchanging shareholders, should not be subject to 367(a) on this portion of the transaction. See, e.g., Regs (a)-3(d) Ex. 12 (demonstrating that the gain on an outbound asset reorganization is recognized at the corporate rather than the shareholder level) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

10 stock to the extent that assets are contributed to DC2. 40 Thus, DC1 s transfer of the cash, Asset X, and Asset Y to FC should result in 367(a) gain to DC1 of $20 (i.e., the $20 of built-in gain on Asset Y). DC1 s gain on the assets transferred to FC should be recognized because 367(a)(5) overrides any exceptions otherwise applicable under the regulations. 41 Presumably, DC1 could use its U.S. tax attributes to reduce or eliminate the tax on the gain on the transfer of Asset Y to FC. DC1 should not recognize gain on the transfer of Asset Z because that asset was contributed back into U.S. corporate solution. 42 DC1 s U.S. shareholders should only recognize a proportionate amount of unrecognized gain in their DC1 stock related to the indirect stock transfer that results from FC s contribution of Asset Z to DC2. 43 If the above-described transaction occurred after March 4, 2003, new 7874 would act to treat FC as a U.S. corporation and 367 would not apply. Thus, the above transaction would not have the effect of an inversion and should not evoke the concern noted in the preamble to the proposed regulations. However, if the above transaction were effected in a transaction where the shareholders of DC1 received less than 80% of the stock of FC, FC would not be treated as a U.S. corporation. Therefore, the transaction described above may still have application to: (1) remove assets from U.S. corporate ownership without incurring a withholding tax; and (2) provide for a tax-efficient post-acquisition disposition of unwanted assets. 44 For example, assume the same facts as in the previous example except that DC1 is acquired by FC and 40 Regs (a)-3(d)(1)(v). 41 See Regs (a)-2T. 42 Regs (a)-3(d)(1)(v); Regs (a)-3(d)(2)(vi). 43 Regs (a)-3(d)(1)(v); Regs (a)-3(d)(2)(iii). The current 367(a) regulations do not state how gain is determined when a transaction is treated, only in part, as an indirect stock transfer. If all of the assets acquired in the merger were included in the 368(a)(2)(C) contribution, then the transaction, in its entirety, would be an indirect stock transfer and the shareholder gain would be measured as the excess of: (1) the fair market value of the FC shares received in the transaction, over (2) the DC1 shareholder s adjusted basis in its DC1 shares. While other alternatives may be identified, it seems that the appropriate conceptual approach should be to treat the percentage of shares deemed to be transferred in the indirect stock transfer to be equal to the value of DC2 shares (based on DC2 s net asset value) as a percentage of the value of DC1 shares. The 367 regulations effectively treat DC1 as if it split up into two corporations FC (without DC2 stock or the net assets transferred to DC2) and DC2. This result is consistent with the result of a split up because basis (and therefore gain) would be allocated under 358 in the case of a split-up based on the fair market value (net asset value) of each of the two surviving corporations. 44 The preamble to the proposed regulations states that [t]he IRS and Treasury also are concerned that the coordination rule might be used to facilitate divisive transactions. the shareholders of DC1 receive less than a 50% interest in FC with the other requirements of Regs (a)-3(c) satisfied. Assume further that FC will contribute Asset Y to DC3, another wholly owned U.S. subsidiary of FC. DC1 should not recognize 367(a) gain from the transfer of the cash and Asset X to FC because there is no gain on those assets. DC1 should also not be subject to 367(a) gain recognition on the assets contributed to DC2 and DC3. The DC1 U.S. shareholders should also not be subject to 367(a) gain recognition because the transaction qualifies under Regs (a)-3(c). 45 Despite the enactment of new 7874, the abovedescribed transaction demonstrates what may be the IRS s and Treasury s lingering concern with the current regulations. Here, FC has effectively moved the cash and Asset X out of U.S. corporate solution without incurring a potential U.S. withholding tax cost. Moreover, FC has positioned itself for a later disposition of unwanted assets through the sale of DC2 or DC3, without incurring U.S. income taxation. In essence, the above-described transaction would circumvent the repeal of General Utilities. B. Consideration of Proposed Changes to Indirect Stock Transfer Regulations The proposed regulations address the above transaction by altering a long-standing rule of the 367(a) indirect stock transfer regulations. Under the proposed regulations, 367(a) and (d) would generally apply to DC1 on the transfer of its assets regardless of whether 45 Because the DC1 shareholder exchange would be pursuant to 354, and not 361, 367(a)(5) should not operate to cause gain to the DC1 U.S. shareholders that otherwise qualify for the exception to 367(a) gain under Regs (a)-3(c) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

11 the acquired assets are subsequently contributed back into U.S. corporate solution. 46 This new general rule, however, would not apply if: (1) DC1 is controlled, within the meaning of 368(c), by five or fewer domestic corporations, FC stock is adjusted pursuant to 367(a)(5), and any future 367(a)(5) regulations are satisfied; 47 or (2) the indirect stock transfer satisfies the requirements of Regs (a)-3(c)(1)(i), (ii) and (iv) and (c)(6), and DC1 attaches a statement to its tax return for the year of the transfer (presumably, its final tax return in the case of a 368(a)(2)(C) transfer following an asset reorganization) certifying that it will amend its tax return for the year of the transfer to include 367(a) gain on the contributed assets if FC disposes of DC2 stock within two years of the transfer. 48 In essence, the proposed regulations turn off the new general rule of 367(a) and (d) gain recognition on the outbound transfer, regardless of a subsequent contribution of the acquired assets back into U.S. corporate solution, when: (1) the transaction occurs as part of related corporate group restructuring; 49 or (2) the transferring U.S. corporation files a two-year certification (i.e., a gain recognition agreement) in the case of a transaction subject to the exception of Regs (a)-3(c). Of the two above-described exceptions to the new general rule, the second is the most interesting. If a transaction is effected and subject to nonrecognition at the shareholder level because of Regs (a)-3(c) and the acquiring foreign corporation disposes of the stock of a domestic corporation (including in a nonrecognition transaction) within two years of the contribution of acquired assets, then the transferring U.S. corporation, assuming it filed the two-year certification, would be required to recognize gain, but not loss, as though it had contributed the assets to the domestic controlled corporation in a potential 351 exchange and then sold the stock in that new U.S. subsidiary to an unrelated party at fair market value immediately before it transferred those assets to the foreign acquiring corporation. 50 For example, assume the same facts as in the previous example except that FC sells the stock of DC3 46 Prop. Regs (a)-3(d)(2)(vi)(A). 47 Prop. Regs (a)-3(d)(2)(vi)(B)(1)(i). 48 Prop. Regs (a)-3(d)(2)(vi)(B)(1)(ii). 49 The exception provided in the proposed regulations is a bit more expansive than a related group restructuring because it includes facts in which five or fewer corporate shareholders hold 80% or more of the stock of the transferring U.S. corporation, but as a practical matter this exception will most commonly be applied in a related group restructuring. 50 Prop. Regs (a)-3(d)(2)(vi)(E). The domestic acquired corporation may avoid this construct if it can demonstrate to the satisfaction of the Commissioner that the disposition was not one with a principal purpose of U.S. tax avoidance. within two years of DC1 s merger with and into FC. In that case, DC1 would be treated as having contributed Asset Y to DC3 in a potential 351 exchange and then sold the stock of DC3 to an unrelated party immediately before the merger of DC1 with and into FC. The above construct could be characterized as punitive because it should not result in a fair market value basis of Asset Y in the hands of DC3. Rather, that basis should continue to be the transferred basis as provided in 362(a), i.e., $80. If instead DC1 had transferred Asset Y to FC and FC had retained that asset, DC1 would have recognized gain similar to the failure to satisfy the two-year certification, but the basis in Asset Y would have been stepped up to its fair market value i.e., if FC later contributed Asset Y to DC3, not as part of the merger with DC1, and then sold DC3, DC3 would have a 362(a) transferred basis in Asset Y of $100. VI. BASIS AND HOLDING PERIOD RULES Generally, gain recognized by a 1248 shareholder on the disposition of foreign stock is recognized as a dividend by the shareholder to the extent of the 1248 amount. The proposed regulations alter the basis and holding period rules under 367(b) to better preserve 1248 amounts following certain nonrecognition transactions. In order to preserve the application of 964(e), which like 367(b) serves to preserve recognition of the 1248 amount, the proposed regulations also apply to foreign corporate shareholders where at least one U.S. person is a 1248 shareholder in that foreign corporate shareholder. To preserve the 1248 amount, the proposed 367(b) regulations apply the principles of the recently proposed 358 regulations, which provide that the basis of each share or security received in a 354 (or 356 exchange) should be the same as the basis of each share or security exchanged. 51 The proposed regulations are limited to certain 354 (or 356) exchanges and certain triangular reorganizations. The proposed regulations do not address 351 transfers (including transactions that may also qualify as reorganizations) if other property is received or liabilities are assumed. 52 The proposed regulations also do not apply to 355 distributions. The IRS and Treasury state that they are also considering specific rules for transactions that do not result in the issuance of stock by the acquiring corporation (e.g., when the exchanging shareholder also wholly 51 Prop. Regs (a)(2). 52 Prop. Regs (b)-13(b)(4) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

12 owns the acquiring corporation and the issuance of additional shares would be a meaningless gesture 53 ). A. Section 354 Exchanges The proposed regulations apply to 354 (or 356) exchanges involving foreign corporation stock. 54 The proposed regulations generally require the exchanging shareholders to identify the shares of stock or securities received in the exchange in accordance with the terms of the exchange. 55 In essence, the exchanging shareholder must trace the shares of foreign corporation stock that it exchanges for the identified stock that it receives. If the exchanging shareholder fails to identify and trace the stock exchanged (either pursuant to the transfer agreement or by specific designation), and the acquiring corporation stock is later sold, then the exchanging shareholder is treated as selling the received shares with a basis equal to the earliest share purchased or acquired. 56 For example, assume that DC1, a domestic corporation, wholly owns FC1, a foreign corporation. DC1 has a block of stock representing 50% of FC1 in which it has a basis of $300. DC1 has a basis of $200 in the remaining 50% block of stock that it owns. FC1 merges with and into FC2, a foreign corporation, and DC1 receives FC2 stock in exchange for its FC1 stock. Under the proposed regulations, DC1 would be required to trace its FC1 stock blocks that were exchanged for the FC2 stock that it received and identify and take a basis and holding period in that FC2 stock equal to the two blocks of stock in FC1 that it exchanged. Thus, DC1 s basis in the FC2 stock received would be split into two blocks, one 50% block with a basis of $300 and the remaining 50% block with a basis of $200. B. Triangular Reorganizations The proposed regulations also address certain triangular reorganizations, such as forward 57 and reverse 58 triangular mergers and parenthetical 368(a)(1)(C) reorganizations, 59 where the merging or surviving corporation is a foreign corporation. The proposed regulations provide that the exchanging shareholders will not apply the basis rules of Regs (c)(1) (referred to as the over-the-top basis rules in the preamble to the proposed regulations), as provided under the current regulations. Rather, the exchanging shareholder must use the outside basis of the target corporation. For example, assume the same facts as in the previous example except FC3, a foreign corporation, is wholly owned by FC2. FC1 has a basis of $700 in its assets. FC1 merges with and into FC3, and DC1 receives FC2 stock in exchange for its FC1 stock. 53 See Lessinger v. Comr., 872 F.2d 519, 526 (2d Cir. 1989). 54 Prop. Regs (b)-13(b)(1). 55 Prop. Regs (b)-13(b)(2)(i). To the extent possible, this rule may be applied to blocks of stock. 56 Prop. Regs (b)-13(b)(2)(ii). Presumably, this language demonstrates a first-in, first-out approach to basis, which is the default rule if the transfer agreement fails to designate the exchanged basis and the exchanging shareholder fails to specifically designate the basis. See Prop. Regs (a)(2)(iii). Under the current regulations, FC2 would adjust its basis in its FC3 stock as if it had acquired FC1 s assets directly from FC1 and then contributed those assets to FC3. Thus, FC2 s basis in FC3 would be ad (a)(1)(A) and (D) (a)(1)(A) and (E). 59 This would include a transfer of the target corporation s shares followed by a liquidation of the target corporation pursuant to the plan of reorganization. Rev. Rul , C.B Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C

13 justed to include the $700 of basis that FC1 had in its assets. Under the proposed regulations, FC2 would have to account for DC1 s basis in the FC1 stock. 60 Thus, FC2 s basis in its FC3 stock would be adjusted to include the $500 basis that DC1 had in its FC1 stock, and not the $700 basis that FC1 had in its assets. To preserve DC1 s 1248 amount, FC2 s FC3 stock would have a divided basis and holding period that would reflect DC1 s basis and holding period in the two blocks of stock deemed acquired by FC2 from DC If the target corporation, FC1 in this example, is widely held, then the acquiring corporation s parent, FC2 in this example, may use statistical sampling as provided in Rev. Proc , C. B. 729, to determine the target shareholders bases in the target corporation. 61 Prop. Regs (b)-13(c)(2)(i)(A). If, in this transaction, DC1 was a foreign corporation and a U.S. shareholder was a 1248 shareholder in that foreign corporation, a later sale could result in the conversion of gain to dividend treatment under 964(e). Section 964(e) does not allow the netting of gains and losses. Therefore, it is possible that a situation could exist whereunder acquiring company stock would have gain and loss built into a single share. The loss could not be used to offset the gain and the U.S. shareholder could only avoid an income pickup under Subpart F if the high-tax exception applied. Thus, these rules have the effect of creating future traps that will need to be considered carefully in disposition planning. C. Section 351 Exchanges The proposed 358 and 367(b) regulations do not address 351 exchanges, including reorganization transactions that also qualify as 351 exchanges, if liabilities are assumed or other property is received. Those exchanges continue to be subject to Rev. Rul , 62 which generally provides for an aggregate basis approach. The IRS and Treasury note that they are considering approaches for the preservation of 1248 amounts in 351 transactions in which liabilities are assumed or other property is received. However, it may be difficult to apply a rule other than an aggregate basis approach because an aggregate approach also operates under 357(c). VII. CONCLUSION As discussed above, the proposed regulations include significant changes to the 367(a) and 367(b) regulations beyond conforming regulations that allow for foreign statutory reorganizations under 368(a)(1)(A). Although most of the proposed changes are welcome or address valid U.S. tax policy concerns, some of the changes should be reconsidered before the proposed regulations are finalized C.B Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C