Closing Yet Another Repatriation Loophole in Related-Party Cross-Border Stock Transfers — §§367 and 304

By Edward Tanenbaum, Esq. Alston & Bird LLP, New York, NY

On February 10, 2009, the Internal Revenue Service (IRS) issued temporary and final regulations (“the Regulations”) on the application of §367 of the Internal Revenue Code in cross-border stock transfers governed by §304. The Regulations are intended to stop a transaction used by some taxpayers to repatriate cash to the United States tax-free and address an aspect of that transaction previously addressed in 2006 regulations. The Regulations apply to transfers or distributions on or after February 11, 2009.

Section 367(a)(1) generally provides that if a U.S. person transfers property to a foreign corporation in a transaction governed by a specified tax-free exchange provision (including §351), the foreign corporation will not be considered a corporation for purposes of determining the extent to which the U.S. person recognizes gain on such transfer. Section 367(b)(1) provides that in the case of certain exchanges (including §351) in connection with which there is no transfer of property described in §367(a)(1), a foreign corporation will be considered to be a corporation except to the extent provided in regulations.

Section 304(a)(1) generally provides that, for purposes of §§302 and 303, if one or more persons are in control of each of two corporations and, in return for property, one of the corporations (the acquiring corporation) acquires stock in the other corporation (the issuing corporation) from the person(s) in control, then such property will be treated as a distribution in redemption of the stock of the acquiring corporation. To the extent §301 applies to the distribution, the transferor and the acquiring corporation are treated as if: (1) the transferor transferred the stock of the issuing corporation to the acquiring corporation in exchange for stock of the acquiring corporation in a transaction to which §351(a) applies; and (2) the acquiring corporation then redeemed the stock it is deemed to have issued. Under §304(b)(2), the determination of the amount of the property distribution that is a dividend is made as if the property is distributed by the acquiring corporation to the extent of its earnings and profits and then by the issuing corporation to the extent of its earnings and profits.

The 2006 regulations discussed a transaction in which a U.S. parent sells a subsidiary (domestic or foreign) to a foreign acquiring subsidiary. For example, a domestic corporation (USP) owns all of the stock of each of two foreign corporations, F1 and F2. The stock of F1 has a basis in USP's hands of $0x and a fair market value of $100x. The stock of F2 has a basis and a fair market value of $100x. Neither F1 nor F2 has earnings and profits. USP sells the stock of F1 to F2 for $100x in cash.

This sale transaction sets in motion §§304 and 367 discussed above. Under §304(a)(1), USP is deemed to have transferred the F1 stock to F2 in exchange for F2 stock in a transaction to which §351 applies, and then F2 is considered to have redeemed the stock deemed issued to USP for the $100x paid.

The 2006 regulations provided that §367(a) and (b) would not apply to certain transfers of stock of a foreign or domestic corporation to a foreign acquiring corporation to which §351 applies by reason of §304(a)(1). These regulations were premised on the supposition that the policies under §367(a) and (b) were preserved, even if a deemed §351 exchange was not subject to §367(a) and (b), because generally the income recognized by the transferor in the transaction (dividend income, capital gain, or both) should equal or exceed the built-in gain, in the transferred stock. Thus, the IRS maintained that the $100 gain is taxable because there was no tax basis to recover in the stock of F1.

However, taxpayers maintained that a transferor would not recognize income equal to or greater than the built-in gain in the transferred stock if, under §301(c)(2), the transferor were permitted to recover the basis of shares of the foreign acquiring corporation held before (and after) the transaction. So, in the example above, taxpayers have argued that USP had no gain from the $100 payment because it could reduce the basis of the F2 stock that USP already owned prior to the transfer of the F1 stock. As such, without more, USP would have repatriated the $100 tax-free.

In response to the position taken by taxpayers, the IRS has turned on §367 in situations in which basis in previously owned shares is used by a taxpayer to shield gain. The Regulations, Regs. §1.367(a)-9T, modify the application of §367(a) and (b) to the deemed §351 exchanges by providing an exception to the general rule. The general rule under the 2006 regulations continues, i.e., in the context of a deemed §351 exchange occurring by reason of a §304 transaction, the transfer will not be deemed to be a transfer to a foreign corporation for §367(a) purposes. However, for situations in which a distribution received by an exchanging shareholder would reduce (in whole or in part) the basis of stock of a foreign acquiring corporation that was held by a U.S. person before the transaction -- other than the stock deemed issued to the U.S. person in the deemed §351 exchange -- the U.S. person recognizes gain under §367(a)(1) equal to the amount by which the gain realized by the U.S. person with respect to the transferred stock in the deemed §351 exchange exceeds the amount of the distribution received by the U.S. person in redemption of the foreign acquiring corporation stock that is treated as a dividend under §301(c)(1) and included in the U.S. person's gross income. Moreover, the exceptions to the application of §367 provided in the regulations will not apply to situations covered by the Regulations. For example, a U.S. person cannot avoid gain recognition under the Regulations by entering into a gain recognition agreement with respect to the deemed §351 exchange.

Accordingly, the repatriation opportunity presented by the scarcity of offshore earnings and profits is rendered much less attractive in light of the fact that USP must report taxable income in connection with the extraction of the $100x from F2.

Nonetheless, it didn't take too long for people to observe some interesting issues coming out of these Regulations. First, it seems like taxpayers are able to pick and choose whether to apply tax basis of stock previously owned in the acquiring corporation (in which case, the Regulations will exact a §367(a) toll charge) or whether to forgo that basis offset (in which case, there's no gain under §367(a) but there would be gain under the normal §301 distribution rules). That, in and of itself, seems odd. What's that about?

But, in any event, if gain is recognized either way, what's the difference, you ask? Well, under the Regulations, it seems like picking and choosing does, in fact, yield a different result. For example, if the taxpayer chooses not to apply the basis of the previously held F2 stock to offset the gain realized, i.e., the tax results follow the §301 distribution rules, then there will be gain under §301(c)(3) and there will be carryover of the tax basis in the stock of F1 (i.e., $0) in the fictional §351 exchange, and the tax basis in the previously held stock of F2 will remain the same as it was before the sale of F1 (i.e., $100).

On the other hand, if the taxpayer chooses to apply the basis in the previously held stock of F2 to offset the gain under §301(c)(3), then, under the Regulations, §367(a) will apply. In that case, gain is still recognized, albeit under §367(a), but because of the gain recognition, the basis in the stock of F2 increases to $100 under §358 and the basis of the F1 stock deemed contributed to F2 in the fictional §351 exchange will also increase by $100 under §362.

Interesting difference in the tax results. Which would you choose?

This commentary also will appear in the June 2009, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Davis, 919 T.M., Outbound Transfers Under Section 367(a), and Koutouras and Tizabgar, 768 T.M., Stock Sales Subject to Section 304and in Tax Practice Series, see ¶7130, U.S. Persons -- Foreign Activities.