A guide to the new proposed regulations under Sections 367(a) and (b).

• Author: Klein, Kenneth

OVERVIEW

New proposed regulations under section 367(a) and (b) of the Internal Revenue Code (1) were published in the Federal Register on August 26, 1991. The proposed regulations would apply to a variety of stock and asset transfers involving foreign corporations that, but for the potential application of section 367(a) or 367(b), would qualify for tax-free treatment under certain statutory nonrecognition provisions. More specifically, the new proposed rules would apply to (i) certain direct or indirect transfers of stock or securities (in a domestic or a foreign corporation) by a U.S. person to a foreign corporation ("outbound" transfers described in section 367(a)), (ii) certain transfers of stock or assets of a foreign corporation to a foreign or domestic corporation ("foreign-to-foreign" or "inbound" transfers described in section 367(b)), and (iii) certain distributions otherwise governed by section 355 (relating to tax-free spin-offs, split-offs, and split-ups), also under section 367(b).

Following the general approach of existing rules, under the proposed regulations outbound transfers generally would not be subject to tax under section 367(a) if a 5- or 10-year gain recognition agreement were filed. U.S. transferors owning less than 5 percent of the foreign transferee would not be required to file such an agreement. By contrast, certain liquidations or reorganizations of foreign corporations into U.S. corporations (inbound transfers) generally would constitute taxable events to the shareholders exchanging stock in the transaction (though not to the foreign corporation that liquidated or reorganized). So-called foreign-to-foreign reorganizations generally would be tax-free unless the transferor were a controlled foreign corporation (CFC) and the transferee were not. Finally, certain section 355 distributions would be taxable events to either the distributing corporation or its shareholders.

The proposed regulations under sections 367(a) and (b) are not necessarily exclusive; some transfers would be subject to both sets of rules. In addition, certain transactions subject to the new outbound stock transfer rules might also be subject to a separate set of existing rules under section 367(a) governing non-stock asset transfers to foreign corporations.

With two exceptions, the proposed regulations would apply only prospectively, to transfers occurring on or after the 30th day after final regulations are published in the Federal Register. The first exception is discretionary: at the taxpayer's election, certain of the new rules relating to outbound stock transfers could be applied to transfers occurring after December 16, 1987. The second exception is mandatory but narrow in scope: a revised definition of the "all earnings and profits amount" (the measure of taxable income in certain inbound asset transfers under section 367(b)) would apply to exchanges occurring on or after August 26, 1991.

OUTBOUND STOCK TRANSFERS

Background

Section 367(a) prevents taxpayers from using certain nonrecognition provisions of the Internal Revenue Code -- sections 332, 351, 354, 356, and 361 -- as a device to remove appreciated property from U.S. tax jurisdiction without the payment of tax. Mechanically, section 367(a)(1) achieves this result by deeming the foreign transferee corporation not to be a corporation "for purposes of determining the extent to which gain is recognized on such transfer." Because corporate status is a prerequisite to the application of the nonrecognition provisions, the denial of corporate status under section 367(a) causes the exchanges to be taxable.

The proposed regulations revise existing exceptions to this general rule. The basic rationale for excepting certain transactions from current gain recognition is that a continued deferral of tax on the appreciation in transferred property (pursuant to an otherwise applicable nonrecognition provision) is appropriate in the outbound transfer context where an adequate mechanism exists to ultimately collect that tax.

The current regulations relating to outbound transfers of stock and securities (2) are set forth in Temp. Reg. $S 1.367(a)-3T. They address transfers that are otherwise governed by one of the nonrecognition provisions specified in section 367(a) (other than section 355, for which the rules are reserved). The rather cumbersome regulatory scheme in the temporary regulations, however, was superseded by Notice 87-85, 1987-2 C.B. 395, which announced a simplified set of rules that, when incorporated in final regulations, would apply to transactions occurring after December 16, 1987. Because the new proposed regulations provide that existing Temp. Reg. $S 1.367(a)-3T, as modified by Notice 87-85, will apply until the new regulations become effective, the rules prior to modification by the Notice are not discussed in this article.

Under the current rules, a U.S. person that transfers stock or securities in a domestic or foreign corporation to a foreign corporation generally does not recognize gain under section 367(a) if, immediately after the transfer, such transferor owns (3) less than five percent (by vote or value) of the stock of the transferee foreign corporation. A U.S. transferor that owns a greater percentage of the transferee foreign corporation's stock immediately after the transfer is eligible for this favorable treatment only if such transferor enters into a gain recognition agreement (GRA).

The GRA commits the transferor to report the gain it realized on the outbound transfer in an amended return for the year of the transfer if, subject to a number of special rules and exceptions, the foreign transferee disposes of the transferred stock within the term of the GRA. The GRA has a 10-uear term (and the transferor must execute a waiver of the statute of limitations for, apparently, a 13-year period(4)) if all U.S. transferors own 50 percent or more (by vote or value) of the foreign transferee. Otherwise, the agreement has a 5-year term and the waiver is for an 8-year period.

The amended return requirement is onerous to the taxpayer not only from a procedural standpoint but also because interest must be paid on any tax deficiency resulting from the adjustment to taxable income. If the U.S. transferor had simply retained the stock and sold it in the later year in which, in fact, the foreign transferee disposed of such stock, the gain would be taxable income only in that later year and deficiency interest would not accrue.

Notice 87-85 establishes two exceptions to these rules. First, if the transferred stock is stock in a CFC with respect to which the U.S. transferor is a U.S. shareholder, (5) then section 367(a) applies (requiring the recognition of realized gain on the exchange) unless the stock received by the transferor is stock in a CFC with respect to which the transferor is also a U.S. shareholder. Second, if the transferred stock is stock in a domestic corporation, section 367(a) applies if the U.S. transferor owns more than 50 percent (by vote or value) of the foreign transferee's stock after the transaction.

The foregoing rules also apply to certain "indirect" stock transfers described in Temp. Reg. $S 1.367(a)-1T(c). Specifically, a forward or reverse merger of one domestic corporation into another domestic corporation pursuant to section 368(a)(2)(D) or (E) is treated as an indirect outbound transfer of stock by the U.S. persons exchanging stock of the target corporation if the controlling corporation (the stock of which is received by such exchanging shareholders) is foreign. Similarly, if a domestic corporation acquires assets of another domestic corporation in a reorganization under section 368(a)(1)(C) in exchange for stock in its foreign parent, the exchanging shareholders of the transferor corporation are considered to have made an outbound stock transfer. Finally, a reorganization under section 368(a)(1)(B) is considered an indirect outbound stock transfer if a domestic corporation acquires, in exchange for stock of its foreign parent, the stock of another domestic corporation. The apparent rationale for these rules is that the end result of each transaction is similar to a case in which a U.S. person transfers stock in a domestic corporation directly to a foreign corporation.

The current rules governing outbound stock transfers do not apply to the transfer of stock in a foreign corporation pursuant to a reorganization described in section 368 if that foreign corporation is a party to the reorganization (within the meaning of section 368(b)). Instead, such transfers are subject to the regulations under section 367(b). (6) Furthermore, if stock in a foreign corporation ("F") is transferred to another foreign corporation in a stock-for-stock exchange qualifying under both section 368(a)(1)(B) (to which F is a party) and section 351 (to which F is not a party to a reorganization), the overlap is resolved by generally treating the transaction as governed by section 367(b). (7) This overlap provision has been widely used to avoid application of the section 367(a) provisions.

Section 367(a)(5) is an important additional restriction on outbound transfers. A domestic transferor corporation must recognize gain in a reorganization involving an outbound transfer of assets notwithstanding the application of section 361 unless, subject to basis adjustments and other conditions prescribed in future regulations, such transferor corporation is controlled (within the meaning of section 368(c)) by 5 or fewer domestic corporations.

Outbound Transfers of Stock or Securities

Under the Proposed Regulations

Overview

Subject to extraordinarily broad new rules for indirect transfers, Prop. Reg. $S 1.367(a)-3 would apply to outbound transfers of stock or securities in the context of exchanges described in (i) section 351, (ii) section 354 (provided that the underlying reorganization is governed by section 368(a)(1)(B)), and (iii)...