On May 11, 2009, the Internal Revenue Service

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1 Gain Recognition Agreements and Reasonable Cause Exception By Marcellin Mbwa-Mboma and Awo Archampong-Gray 1 Marcellin Mbwa-Mboma and Awo Archampong-Gray explain TAM , which addresses the issue of whether a U.S. corporation qualifies for the reasonable cause exception and can, therefore, cure its failure to timely file a GRA for an outbound stock transfer in a reorganization. On May 11, 2009, the Internal Revenue Service issued a Technical Advice Memorandum (TAM), 2 that addresses the issue of whether a U.S. corporation qualifies for the reasonable cause exception under the Code Sec. 367 regulations such that it is eligible to cure its failure to timely file a gain recognition agreement (GRA) for an outbound stock transfer in a reorganization. 3 Overall, the IRS appears to have set a high standard for the application atio of the reasonable cause exception in the context t of the GRA rules. The TAM underscores the importance of conducting cting and documenting thorough technical analyses s of issues in cross-border rtransactions and, most importantly, timely filing a GRA. Background Marcellin Mbwa-Mboma is with Ernst and Young LLP in New York. Awo Archampong-Gray is with Ernst and Young LLP in Washington DC. The taxpayer, a publicly traded U.S. corporation and common parent of a consolidated group ( Parent ), owned all of the stock of another U.S. corporation that was a member of the taxpayer s consolidated group ( Sub ), which, in turn, was the single owner of a U.S. limited liability company (LLC), treated as a disregarded entity for U.S. federal income tax purposes. Parent, together with the LLC, owned all the stock of a foreign corporation ( FC ), with the LLC owning at least 80 percent of FC by vote and value. Since LLC was a disregarded entity, the stock it held in FC was essentially considered to be held by Sub, its owner. Parent also separately owned all of the stock of another foreign corporation ( FC1 ). FC1 engaged in a triangular reorganization under Code Sec. 368(a), widely known as the Killer B transaction in which a subsidiary typically acquires its parent stock from either the parent or the parent s shareholders in exchange for property (e.g., cash, a note) and uses that stock to acquire stock or assets of a target corporation where either the subsidiary or the parent (or both) is foreign. 5 Specifically, FC1 purchased Parent stock from its public shareholders on the open market. Then, FC1 acquired FC stock from Sub (through LLC) in exchange for Parent stock. This public triangular reorganization should have been completed before May 31, 2007, the date on which Notice entered into force. Prior to May 31, 2007, only internal triangular reorganizations involving one or more foreign corporations were struck down by the IRS as abusive cross-border repatriations of earnings. The taxpayers did not treat the transfer of property (e.g., cash or note) from the subsidiary to the parent, in exchange for the parent stock, as a Code Sec. 301 distribution. 7 However, on September 22, 2006, the IRS and Treasury Department issued Notice , 8 which 2009 M. Mbwa-Mboma and A. Archampong-Gray CORPORATE BUSINESS TAXATION MONTHLY 23

2 Gain Recognition Agreements and Reasonable Cause Exception provided guidance on the proper U.S. tax treatment of such internal triangular reorganizations. The IRS announced that regulations to be issued under Code Sec. 367(b) would make adjustments that would have the effect of a deemed distribution of property from the subsidiary to its parent under Code Sec. 301(c). Thus, the parent first would be treated as receiving a dividend to the extent of the earnings and profits of the subsidiary (with a corresponding reduction of the subsidiary s earnings and profits as a result of the dividend distribution), and second parent s basis in the distributing corporation s stock would be reduced to the extent the distribution exceeded the subsidiary s earnings and profits. Any amount in excess of the parent s basis would be treated as gain from the sale or exchange of the subsidiary s stock. Notice extended the reach of Notice by targeting public triangular reorganizations involving one or more foreign corporations. Prior to Notice , consistent with case law squarely on point, 9 the taxpayers were taking the position that by purchasing parent stock from the public shareholders, the subsidiary did not make a Code Sec. 301 distribution potentially taxable to the parent. 10 In Notice , the IRS stated that under regulations to be issued under Code Sec. 367(b), the subsidiary would be deemed to make a Code Sec. 301 distribution of property (e.g., cash, a note) to its parent when purchasing the parent stock from a person other than the parent itself such as from the public shareholders ho ers on the open market. On May 27, 2008, the IRS and Treasury ry Department issued temporary regulations implementing the rules described din Notice and Notice In short, under the temporary regulations, the purchase of parent stock would result in a deemed distribution from the subsidiary to the parent if the acquisition of a target corporation stock or assets qualified as a tax-free triangular reorganization. Therefore, the utilization of the subsidiary s earnings to purchase parent stock to use as currency for the acquisition of a target corporation s stock or asset may prove beneficial only if such acquisition is a taxable transaction. Issues Addressed in TAM The TAM addressed the issue of whether Sub s transfer of the stock of FC to FC1 (the Outbound Stock Transfer ) in exchange for Parent s stock in a tax-free 24 triangular reorganization was subject to Code Sec. 367(a)(1). Code Sec. 367(a)(1) provides that if, in connection with any exchange described in Code Sec. 332, 351, 354, 356 or 361, a U.S. person (U.S. transferor) transfers property to a foreign corporation, such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered to be a corporation. Code Sec. 367(a)(2), (3) and (6) provide exceptions to this general rule and grant regulatory authority to provide additional exceptions and to limit the statutory exceptions. Exceptions to the general gain recognition rule of Code Sec. 367(a)(1) are provided for certain transfers by a U.S. transferor of stock or securities of a foreign corporation or a U.S. corporation. 12 In some cases, these exceptions require, among other things, that the U.S. transferor file a GRA as provided in Reg (a) Pursuant to a GRA, the U.S. transferor agrees, among other things, to include in income the gain realized, but not recognized, on the initial transfer of the stock or securities, and pay any applicable interest, upon certain events that occur before the close of the fifth full tax year following the year of the initial transfer. In the TAM, the taxpayer did not argue that the exception in Reg (a)-3(b) for stock or securities of a foreign corporation applied to the Outbound Stock Transfer. Rather, the taxpayer asserted that such transfer was not subject to the general gain recognition rule of Code Sec. 367(a)(1) since, in the reorganization, Sub only received stock of Parent, a U.S. corporation. At that time, the regulations did not treat a triangular B reorganization where the acquiring corporation was foreign and the controlling corporation was a U.S. corporation as an indirect stock transfer subject to Code Sec. 367(a). The taxpayer reasoned that the Code Sec. 354 exchange by Sub of FC stock for stock of Parent, a U.S. corporation, in a triangular B reorganization was not taxable under Code Sec. 367(a) and, thus, no GRA was required to defer taxation of the gain realized on such exchange. The TAM, somehow, concedes that the then-current regulations did not work well but suggests it was incumbent upon the taxpayer to conform these regulations with the policies of Code Sec. 367(a). As the TAM points it out, the indirect stock transfer rules of Treas. Reg (a)-3(d) were revised in January of 2006 to close this loophole in two ways. First, a triangular B reorganization where the acquiring corporation is foreign and the controlling corporation is domestic is treated as an indirect stock transfer subject to the general gain recog-

3 nition rule of Code Sec. 367(a)(1) and the exceptions thereof. Second, in such a triangular B reorganization, the transferee foreign corporation means the foreign acquiring corporation. 14 These regulatory revisions deprive of practical interest any discussion of the arguments and analysis surrounding this issue in the TAM. After concluding that the Outbound Stock Transfer was unequivocally subject to the general gain recognition rule of Code Sec. 367, the IRS also ruled that the taxpayer did not qualify for the exception for foreign corporation s stock in Reg (a)-3(b)(1) as the taxpayer did not enter into a GRA. The taxpayer tried to retreat and argue that the transaction should be subject to Code Sec. 304, which would not have required the filing of a GRA. However, the IRS quickly dismissed this fall back argument because Code Sec. 367(a)(1) only makes the U.S. transferor recognize gain on the exchange; it does not change the character of the reorganization for other purposes. To cure the taxpayer s failure to enter into a GRA, the IRS has to determine that such failure was due to a reasonable cause. The Reasonable Cause Standard Pursuant to the reasonable cause exception of the 1998 final GRA regulations at issue in the TAM, if a U.S. transferor who is permitted under Reg (a)-3(b) or (c) to defer gain realized on the initial transfer of a foreign or domestic corporation s stock or securities fails to file a GRA in a timely manner, the deferred gain will not become taxable and no penalty will be assessed if the U.S. transferor r (x) is able to show that the failure to file a GRA was due to reasonable e cause and not willful neglect and (y) files the GRA or reaches compliance as soon as he becomes es aware of the failure. 15 Since the 1998 final GRA regulations do not tdefine what constitutes reasonable cause, the IRS considered other areas of the law where the reasonable cause standard is employed, excluding the prejudice to the government s interest standard for Code Sec relief (as alleged by the taxpayer) but including the penalty provisions of the Internal Revenue Code and court cases. 16 Specifically, the IRS result hinged on the Supreme Court s definition of reasonable cause as ordinary business care and prudence. 17 Also, based on the express language in the 1998 final GRA regulations, the penalty regulations and case law, 18 the IRS noted that the determination of reasonable cause is to be made on a case-by-case basis, taking into account all the facts and circumstances. In addition, reasonable cause is determined at the time the tax return was filed, or if not filed, when it was due. Finally, taxpayers bear the burden of proving they have met the reasonable cause standard. Notwithstanding the case-by-case, facts and circumstances determination of reasonable cause, the IRS relied on case law to provide a list of five factors that may indicate that a taxpayer exercised ordinary care and prudence and concluded that the taxpayer did not satisfy those standards: (1) taxpayer s sophistication (2) contemporaneous documentation, research and analysis (3) complexity, uncertainty and ambiguity of the law (4) mistaken belief and lack of knowledge (5) reasonable reliance on professionals Taxpayer s Sophistication The first factor is the taxpayer s sophistication, experience, knowledge and education. The IRS reasoned that sophistication may factor into a determination of whether a misunderstanding of law was reasonable. The IRS noted that the taxpayer had experienced tax professionals and hired respected accounting and law firms to assist it with the structuring, implementation and reporting of the Killer B transaction. In addition, the taxpayer had received advice from its outside counsel recommending it to file a GRA. Specifically, the taxpayer s accounting firm prepared a draft letter opinion based on draft representations that included the taxpayer s undertaking to file a GRA. Interestingly, the opinion was never finalized because Taxpayer was comfortable with the advice received, presumably because of the taxpayer s omission (or decision not) to file a GRA. The IRS further noted that no one in the working group, including the taxpayer s in house tax experts er questioned the need for the GRA representation although, in audit, an employee of the accounting firm asserted that the draft letter opinion did not focus on the GRA as a critical aspect of the Killer B transaction, presumably inferring that a different conclusion could have been drawn if a thorough analysis of the Code Sec. 367 regulations was conducted. Based on the breadth of its in-house tax team, the IRS concluded that the taxpayer was sophisticated but did not exercise ordinary business care and prudence in failing to use its significant resources to conduct further research and analysis to verify or disprove [its advisors ] advice [to file a GRA with respect to the Outbound Stock Transfer] before choosing to disregard it. CORPORATE BUSINESS TAXATION MONTHLY 25

4 Gain Recognition Agreements and Reasonable Cause Exception Contemporaneous Documentation, Research and Analysis The second factor is the existence of contemporaneous documentation, research, analysis and supporting legal authority. As the TAM sums it up, [t]he extent to which a taxpayer documents the position taken, conducts related analysis, and has supporting legal authority, must be considered because such efforts reflect a taxpayer s attempt to properly assess its tax liability. In this case, the taxpayer unreasonably relied on undocumented research of complex tax issues conducted by an in-house tax expert to disregard the accounting firm s opinion. Such unreasonable reliance was indicative of a lack of reasonable cause. Complexity, Uncertainty and Ambiguity of the Law The third factor in a reasonable cause determination pertains to the complexity, uncertainty and ambiguity of the law. One would expect the complexity of law to be the usual circumstance justifying relief for reasonable cause. The IRS, however, relying on a technical reading of the all facts and circumstances standard in the GRA regulations goes on to say that complexity of the law is only one of many factors in the reasonable cause determination. In the IRS s view, weight should be given to the extent to which complexity affects a taxpayer s decision not to comply with the tax law, a highly hl subjective test. t. Not surprisingly, singly the TAM does not articulate the IRS s application ion of this factor to the taxpayer s ayer facts. Mistaken Belief and Lack of Knowledge The fourth factor is a taxpayer s mistaken belief and lack of knowledge that is reasonable in light of all the facts and circumstances. Noting that the taxpayer should have known that its accounting firm unequivocally advised that it file the GRA, the IRS concluded that any alleged mistaken belief was not reasonable and, thus, not indicative of reasonable cause. Reasonable Reliance on Professionals The fifth factor consists of a taxpayer s reliance on advice received from qualified tax professionals. If reasonable, reliance on such advice may be indicative of reasonable cause. The IRS found unreasonable the taxpayer s reliance on undocumented advice of its in house tax expert which contradicted the accounting firm s opinion that the Outbound Stock Transfer was subject to Code Sec. 367(a) and a GRA should be filed. Conclusion The IRS is required to make a reasonable cause determination under the GRA regulations on a case-by-case basis, after taking into consideration all the facts and circumstances. This means that none of the five factors discussed in the TAM, including the complexity of the law, establishes per se that a taxpayer exercised ordinary care and prudence in meeting its tax obligations. However, the TAM shed some light on the high standards for reasonable cause that the government could apply in audit or in litigation. These high standards could apply not only in the context of the GRA regulations but also in other areas, such as the dual consolidated loss regulations, 19 where relief for failure to timely file an election, agreement or other information could only be cured if the taxpayer establishes reasonable e cause. Taxpayers are particularly advised that a tax advisor s opinion recommending the filing of a GRA should not be disregarded without a well-reasoned and documented analysis supporting a different reporting position. 26 ENDNOTES 1 The authors wish to thank Marnie Metsch, Ernst & Young LLP, Stamford, for her helpful comments. 2 TAM (Jan. 29, 2009) 3 The reasonable cause exception could be found in the 1998 final GRA regulations (Reg (a)-8(c) and T.D. 8770, CB 3, in the 2007 temporary GRA regulations (Reg (a)-8T(e)(10) and T.D. 9311, CB 635 and in the 2009 final GRA regulations (Reg (a)-8(p) and T.D. 9446, IRB , 607 (Feb. 9, 2009). Those three sets of GRA rules are still applicable depending on the date on which a U.S. person transferred stock or securities to a foreign corporation. 5 The term triangular reorganization, for this purpose, is not limited to a triangular B reorganization under Code Sec. 368(a)(1)(B). It also encompasses triangular C reorganization under Code Sec. 368(a)(1)(C), a forward triangular merger under Code Sec. 368(a)(2) (D), a reverse triangular merger under Code Sec. 368(a)(2)(E) as those terms are defined in Reg (b)(2)(i) through (iv), as well as a triangular reorganization under Code Sec. 368(a)(1)(G). 6 Notice , IRB , Under the ordering rule of Code Sec. 301(c), a distribution generally is treated as a dividend to the extent of the earnings

5 and profits of the distributing corporation, then a return of the shareholder s basis in the distributing corporation s stock, and any amount in excess of the shareholder s basis is treated as gain from the sale or exchange of the distributing corporation s stock. 8 Notice , IRB , 677; CB In Rev. Rul , CB 94, the IRS took the position that, whenever a subsidiary acquires its parent stock in a Code Sec. 304(a)(2) redemption, the subsidiary must be treated as making a Code Sec. 301 distribution of the property used to acquire the parent s stock to the parent which the parent then uses to redeem the shares purchased by the subsidiary, after which the parent contributes the purchased shares to the subsidiary. This view initially received limited judicial acceptance (see Union Bankers Ins. Co., 64 TC 807, Dec. 33,370 (1975), and Broadview Lumber Co., Inc., DC Ind., 75-2 USTC 9832, rev d in part, mod d in part and aff d in part, CA-7, 77-2 USTC 9615, 561 F2d 698. However, it was later rejected by the courts in H.M. Webb, 67 TC 293, Dec. 34,113 (1976), aff d, CA-5, 78-1 USTC 9406, 572 F2d 135, Virginia Materials Corp., 67 TC 372, Dec. 34,129, aff d in an unpublished opinion, CA-4, Jun. 20, 1978, and Broadview Lumber Co., Inc., CA-7, rev g in part, mod g in part and aff g in part, DC Ind., 75-2 USTC In Rev. Rul , CB 106, considered in GCM (Feb. 22, 1980), the IRS modified Rev. Rul to the extent it held that there is a constructive dividend from the subsidiary to the parent. Thus, the IRS accepted the decisions of the Tax Court in Webb, Virginia Materials, and the appellate decision in Broadview Lumber that no dividend resulted to the parent from a Code Sec. 304(a)(2) redemption of parent stock by its controlled subsidiary. 10 Only the public shareholders could potentially incur U.S. tax liability in connection with the sale of the parent stock as such a transaction was correctly characterized as a distribution of cash or other consideration to the public shareholders in redemption of the parent stock under Code Sec. 304(a)(2). This could be treated under the redemption rules of Code Sec. 302 either as a Code Sec. 301 distribution or a payment in exchange for the parent stock. 11 Temporary Reg (b)-14T. 12 Reg (a)-3(b) and Reg (a)- 3(c) (c). 13 Reg (a)-3(b)(1)(ii) and (c)(1)(iii)(b). 14 Reg (a)-3(d)(2)(i)(B). See T.D. 9243, IRB , 475; CB The reasonable cause exception of the 1998 final GRA regulations (Reg (a)-8(c)) is also included in the 2007 temporary regulations (Temporary Reg (a)-8T(e)(10)) and in the 2009 final GRA regulations (Reg (a)- 8(p)). Thus, the standards set forth in the TAM would apply whenever a GRA is required. 16 Reg (b) provides that requests for relief are granted when the taxpayer provides the evidence to establish to the satisfaction of the IRS that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the Government. 17 R.W. Boyle, SCt, 85-1 USTC 13,602, 469 US 241, 246, 105 SCt Reg (b)(1) [ The determination of whether a taxpayer acted with reasonable cause and good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances ]; See also C. Reynolds, CA-7, USTC 50,525, 296 F3d See Reg (d)-1(c)(1). This article is reprinted with the publisher s permission from the CORPORATE BUSINESS TAXA- TION MONTHLY, a monthly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher s permission is prohibited. To subscribe to CORPORATE BUSINESS TAXATION MONTHLY or other CCH Journals please call or visit www. CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH. CORPORATE BUSINESS TAXATION MONTHLY 27