Traps for the Unwary in Loss Recapture

By Dirk J.J. Suringa, Esq. Covington & Burling LLP, Washington, DC

One item to check off in planning international M&A transactions is overall foreign loss (“OFL”) recapture, which can override what would otherwise be tax-free treatment of a foreign nonrecognition transaction. This commentary discusses how complicated it has become in recent years to check loss recapture off the list.

First, the basic trap for the unwary. Section 904(f)(3) requires recapture of a taxpayer's OFL account even when the transaction in question would not otherwise be taxable. When the foreign manufacturing branch of a U.S. corporation incurs a general category loss, for example, the U.S. corporation can claim the benefit of that loss on its U.S. tax return, which generates an OFL. If the same taxpayer later incorporates the branch, contributing to a new foreign subsidiary property that, if sold, would produce general category income, then the taxpayer must recognize that gain, notwithstanding §§351 and 367(a)(3)(A). The rationale for making tax-free transactions into taxable transactions is that the transferred property was supposed to produce foreign-source income that the OFL recapture rules would have converted into U.S.-source income in order to recapture the benefit of the foreign loss. If the property instead leaves the U.S. tax system in a tax-free transaction, then recapture of the taxpayer's U.S. tax benefit might be delayed or even forgiven.

A somewhat more obscure but no less parlous trap is separate limitation loss (“SLL”) recharacterization under §904(f)(5)(F). This provision also overrides nonrecognition treatment by applying rules “similar to” §904(f)(3), but it does so merely to recharacterize one category of foreign-source income as another. An SLL is a foreign-source loss in one foreign tax credit limitation category that offsets positive foreign-source income in the other category. For example, a foreign manufacturing (general category) loss might offset the taxpayer's foreign investment (passive category) income. Under the general SLL recapture rule, later foreign-source general category income would be converted into foreign-source passive category income, up to the amount of the offset.

The purpose of SLL recharacterization is not to reverse a U.S. tax benefit but rather to preserve the separateness of the separate limitation categories and prevent cross-crediting over time. Whatever the reason, by incorporating rules “similar to” §904(f)(3), §904(f)(5)(F) overrides nonrecognition treatment of a transaction that would otherwise have produced income in the loss category. Checking OFL recapture off the list really also means checking SLL recapture off the list. Nevertheless, clients may have a harder time spotting this trap than the OFL recapture trap: clients usually know whether they are making money abroad or losing money abroad, but if they are making money abroad they may not automatically know that their net foreign-source income includes an SLL.

Before the 2004 Act, OFL and SLL recapture applied to the transfer of active foreign business assets, which generally did not include stock. The 2004 Act extended OFL and SLL recapture to cover gain from the transfer of the stock of majority-owned CFCs. The stated reason for the expansion was that interest expense allocated against the CFC stock could lead to an OFL, and recapture of the OFL might not occur if the taxpayer could transfer the CFC stock to an unrelated party in a tax-free transaction.1 SLL recapture went unmentioned in the legislative history, but it tagged along in the statutory cross-reference of §904(f)(5)(F).

Section 904(f)(3)(D) thus overrides nonrecognition treatment on the transfer of the stock of a majority-owned CFC. There are two exceptions for internal restructurings. First, the nonrecognition-override rule generally does not apply to §351 or §721 contributions, or to other exchange-basis transactions, but only if the transferor owns the same percentage in the CFC before and after the transaction. The requirement of ownership parity before and after the transaction is a pretty significant limitation for joint ventures between unrelated parties. Second, the nonrecognition-override rule does not apply to the acquisition of CFC assets by the taxpayer or an affiliated group member in a §332 liquidation or a §368(a)(1) asset acquisition. For this purpose, however, the affiliated group appears to include only U.S. corporations “filing a consolidated return under section 1501.” Liquidation of one foreign corporation into another thus can implicate SLL recapture and the nonrecognition-override rule, at least according to the legislative history of §904(f)(5)(F).2

The complexity does not end here, unfortunately. Taxpayers only are required to recapture an OFL or recharacterize an SLL if they earn income in the former loss category. For example, if a taxpayer has a general category SLL with respect to the passive category, subsequent passive category income is not recharacterized. Only general category income has to be recharacterized as passive category income. Thus, there would be no override of nonrecognition treatment if the taxpayer transferred an asset with built-in passive category gain.

In the context of §904(f)(3)(D), this principle means that the taxpayer must determine the limitation category of the income that would have been recognized had it sold the CFC stock, in order to know whether OFL recapture or SLL recharacterization will override nonrecognition treatment. The sale of CFC stock typically produces passive category gain, because such gain is foreign personal holding company income, unless the §904 high-tax kick-out applies.3 However, the gain might have been subject to §1248 or §964(e), and thus some or all of the gain might have been treated as a dividend.

The §904(d)(3)(D) look-through rule typically would apply to determine the limitation category of such a dividend. Hence, a taxpayer's entitlement to tax-free treatment of its CFC stock transfer may depend not only on the amount of the realized gain, but also the relative amounts of general and passive category earnings in the CFC's post-1986 earnings pools. When a taxpayer with a passive category SLL contributes its wholly-owned CFC to a foreign joint venture corporation in exchange for an 80% controlling interest, it must determine how much of the realized gain would be covered by a deemed dividend of general category earnings. It may be that in this case an asset transaction would work better than a stock transaction in preserving deferral.

This commentary also will appear in the April 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Suringa, 904 T.M., The Foreign Tax Credit Limitation Under Section 904, and in Tax Practice Series, see ¶7130, U.S. Persons -- Foreign Activities.

1 See S. Rep. No. 108-192, at 172 (2004).

2 See S. Rep. No. 99-313, at 323-24 (1986). In the author's view, this is the type of transaction that should be excluded from nonrecognition override, under the regulatory authority granted by §904(f)(5)(F), because it extends preservation of the separate limitation categories beyond the realm of administrability.

3 See §§904(d)(2)(B), 954(c)(1)(B).