Stock basis recovery in outbound sec. 304 transfers.

• Author: Sewall, Arthur W.

The IRS recently issued final and temporary regulations addressing recovery of basis in a stock sale subject to both Sees. 304(a)(1) and 367 (T.D. 9444-the 2009 regulations). In 2006, the IRS finalized regulations that exempted Sec. 304 transactions from the application of Sees. 367(a) and (b) (T.D. 9250--the 2006 regulations). However, the 2009 regulations in effect revoke the exemption provided in the 2006 regulations where the transferor in a Sec. 304 transaction claims to recover basis other than basis in the stock deemed issued under Sec. 304(a)(1) and thereby to avoid recognizing the entire gain built into the stock transferred.

Background

Sec. 304 is designed to prevent corporations from bailing out earnings and profits (E&P) through related-party stock purchases. Specifically, Sec. 304(a) (1) treats a brother-sister stock sale as a deemed exchange under Sec. 351 followed by a redemption of the stock of the acquiring corporation deemed issued.

This fictional Sec. 351 exchange may raise issues in the international context. For instance, Sec. 367(a) provides that an outbound transfer that otherwise qualifies under Sec. 351 does not qualify for nonrecognition treatment. Further, Sec. 367(b) generally provides that certain 351 exchanges can cause the transferor to receive a deemed dividend (Regs. Sec. 1.367(b)-4). Prior to the 2006 regulations, taxpayers were concerned that a related-party stock sale would result in the application of both Sec. 304(a)(1) and, as a result of the deemed Sec. 351 contribution, Sec. 367.

The IRS mitigated the concern of Sec. 304/367 overlap transactions by providing in the 2006 regulations that Sec. 367 would not apply to Sec. 304 transactions because the income recognized in a Sec. 304 transaction should equal or exceed the transferor's inherent gain in the issuing corporation's stock transferred to the foreign acquiring corporation.

The IRS's view that all the inherent gain would be taxed under Sec. 304 was premised on the notion that the transferor could recover basis only in the shares deemed issued (an amount equal to the transferor's basis in the shares sold). However, the IRS's position that basis recovery in a Sec. 304 transaction is limited to the shares deemed issued in the Sec. 351 exchange is not free from doubt. Prior to a 1997 amendment to Sec. 304, courts looked to the transferor's basis in the shares deemed issued and the shares of the acquiring corporation (see Cox, 78 T.C. 1021 (1982)).

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