Final sec. 367(a) regulations are generally favorable, but contain some surprises.

• Author: Gordon, Richard A.

Earlier this year, the IRS issued final regulations under Sec. 367(a) on transfers of a domestic corporation's stock or securities by a U.S. person to a foreign corporation in a corporate organization, reorganization or liquidation. The regulations are effective for transactions after Jan. 29, 1997; however, taxpayers may elect to apply them retroactively to all transfers occurring after April 17, 1994, provided the tax year is still open. The new rules are generally taxpayer-favorable, and remove some problems of the ownership tests contained in the temporary regulations. However, the active trade or business test" has been modified in ways that may affect transactions now in progress.

The final regulations generally follow the rules set forth in the temporary regulations issued Dec. 26, 1995, with a few modifications. Under Sec. 367(a)(1), a transfer by a U.S. person of stock or other property to a foreign corporation in a corporate formation, reorganization or liquidation is generally taxable. The temporary regulations allowed tax-free treatment of certain transfers of stock in a U.S. company to a foreign corporation, provided the taxpayer satisfied the reporting requirements and the transfer met the enumerated conditions. These conditions included: (1) U.S. transferors could not receive more than 50% of the voting power and value of the stock of the transferee foreign corporation; (2) immediately after the exchange, U.S. persons could not own (in the aggregate) more than 50% of the voting power and value of the transferee foreign corporation; (3) 5% U.S. shareholders must have entered into a five-year gain-recognition agreement (GRA); and (4) the transferee foreign corporation or an affiliate must have carried on a substantial active trade or business during the 36 months preceding the transfer. Final Regs. Sec. 1.367(a)-3 eliminates stock received in exchange for "other property" from the 50%-ownership calculation and modifies the active business requirement.

The tainting of the transfer of other property" was designed to prevent "stuffing" transactions; however, practitioners have noted that the broad language could potentially prevent the tax-free formation of a joint venture in unintended situations. For example, if a U.S. and a foreign company were each contributed to a joint venture and the value of the U.S. company was less than 50% of the total value, the transactions could still be taxable if the foreign corporation was widely...