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The Tax Basics of Outbound Domestic Liquidations Under §367(e)(2)

Wednesday, November 30, 2011

By Edward Tanenbaum, Esq.

Alston & Bird LLP, New York, NY

Oftentimes, foreign taxpayers are surprised to learn about the multiplicity of tax issues involved in a so-called "simple" winding up and liquidation of their U.S. subsidiaries. As will be shown, a liquidating U.S. subsidiary may be required to recognize gain on the liquidation and, in some cases, the liquidation may result in the imposition of withholding taxes on the distribution.

Liquidations of U.S. subsidiaries into their foreign corporate parents are governed by §367(e)(2), which basically provides that the usual parent/subsidiary non-recognition rule of §337(a) will not apply to a liquidating U.S. subsidiary, except as otherwise provided in regulations. The theme of the exceptions is that if assets distributed in liquidation remain subject to U.S. taxing jurisdiction they are ripe for delayed income recognition.

One exception applies with respect to an asset that was used by the U.S. corporation in a conduct of a U.S. trade or business if: (1) a foreign corporate distributee uses the asset in the conduct of a U.S. trade or business (realizing effectively connected income) for the next 10 years; (2) a U.S. liquidating corporation attaches a statement to its tax return (to the effect that: (a) the parties to the liquidating distribution agree to be bound by the terms of the exception as set forth in the regulations; (b) the foreign corporate distributee irrevocably waives any treaty entitlement that would otherwise exempt income from the asset, or subject it to a reduced tax rate, on a sale or exchange of the asset or in connection with the use of the asset; and (c) the parties agree to extend the statute of limitations on assessment and collection until three years after the asset has ceased to be used in a U.S. trade or business); and (3) certain other filings are made. If the asset is disposed of or ceases to be used in a U.S. trade or business within the 10-year period, then, with some exceptions, the foreign corporate distributee must recognize gain (or, under certain circumstances, must amend the U.S. corporation's return for the year of the liquidating distribution, reflecting gain therein).

One key carve-out to the trade or business exception is that it does not apply to the distribution of rights in intangibles, a rule that is often overlooked by taxpayers (or ignored because they are in denial as to the existence of any intangibles).

With respect to the trade or business exception, however, there would have to be significant cross-border tax efficiencies for a group to be willing to liquidate a U.S. subsidiary and continue to operate the business in the United States in branch form, what with branch profits tax issues, certain limitations on deductions, and other administrative inconveniences.

Moreover, as previously indicated, due to the treaty waiver requirement, it would not be possible for the foreign corporate distributee, which might otherwise benefit from the permanent establishment (PE) article in an income tax treaty, to claim a lack of a PE in order to escape taxes on the business profits realized.  Indeed, the regulations warn the parties to the liquidation that the intentional failure to properly file the required statements in a distribution that would otherwise qualify for non-recognition would not prevent the IRS from treating the liquidating distribution as a non-recognition event if such treatment is necessary in order to prevent either the domestic distributing corporation or the foreign corporate distributee from deriving a tax benefit from such failure.  An example might be if the group determined that it made sense to suffer a little income recognition on the liquidation and continue the operation in branch form but claim a lack of a PE under a treaty going forward by simply failing to comply with the filing requirements for non-recognition under the trade or business exception.

Another exception applies in the case of a liquidating distribution of a "United States real property interest" (USRPI) within the meaning of the Foreign Investment in Real Property Tax Act (FIRPTA) (with the exception of stock in a former "United States real property holding corporation" (USRPHC) that is treated as a USRPI for five years under §897(c)(1)(A)(ii)). Again, the theory is that the foreign corporate distributee will eventually recognize gain on the disposition of the asset. In the case of an overlap between the USRPI and the trade or business exceptions, the USRPI exception governs.

Finally, an exception applies in the case of a liquidating distribution by the U.S. corporation of stock in underlying 80%-owned U.S. subsidiaries. Carved out of this exception is a distribution by a U.S. USRPHC (or one that is still a USRPI), unless the 80%-owned subsidiary is, itself, a USRPHC at the time of the distribution.  There is also an anti-abuse rule in the case of tax-avoidance-motivated distributions; a tax avoidance motive is deemed to exist if the foreign corporate distributee disposes of the U.S. subsidiary within two years of the distribution.

In connection with this third exception for distributions of 80%-owned U.S. subsidiaries, §332(d), enacted by American Jobs Creation Act of 2004, curbs a perceived abusive fact pattern involving otherwise tax-free liquidating distributions of U.S. subsidiaries. Section 332(d) provides that, in the case of a distribution to a foreign corporation in complete liquidation of an "applicable holding company," the normal non-recognition rule of §332(a) to the corporate distributee of a distribution in complete liquidation will not apply. Rather, the distribution will be treated as a distribution under §301 subject to U.S. withholding taxes.

An "applicable holding company" refers to a U.S. corporation that is a common parent of an affiliated group, whose stock is directly owned by the foreign corporate distributee, substantially all the assets of which consist of stock in other members of the affiliated group and which has not been in existence at all times during the five years immediately preceding the date of liquidation.

As described in the Senate Committee Report (S. Rep. No. 108-192), Congress was concerned that foreign corporations were establishing U.S. holding companies to receive tax-free dividends from the underlying U.S. operating companies and then liquidating the U.S. holding companies in order to receive distributions without the imposition of withholding taxes. This is not inconsistent with the general anti-abuse rule of the §367(e) regulations, which provides that the IRS can require the liquidating distributing corporation to recognize gain if the principal purpose of the distribution is tax avoidance, including, but not limited to, a distribution of earnings and profits with the proscribed purpose. However, rather than going after the distributing corporation and requiring it to pick up gain on the liquidating distribution, §332(d) goes after the distributee by treating the distribution as a dividend distribution subject to withholding tax.

It is not clear whether the approach of §332(d) is the sole approach to the problem or whether the various anti-abuse rules still have relevance. To the extent they do, such anti-abuse rules can cause gain recognition at the liquidating corporation level, thus creating additional earnings and profits, and thus possibly increasing the amount of withholding tax on the distribution.

So, at the end of the day, the liquidation of a U.S. corporation into a foreign corporate distributee is not that "simple" after all.

This commentary also will appear in the December 2011 issue of the  Tax Management International Journal. For more information, in the Tax Management Portfolios, see Davis, 920 T.M., Other Transfers Subject to Section 367, and in Tax Practice Series, see ¶7120, Foreign Persons — Gross Basis Taxation, and ¶7130, Foreign Persons — Effectively Connected Income.

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