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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
In my first installment of "FIRPTA in the 21st Century,"1 I covered an often-overlooked trap set by Notice 89-85.2 That Notice announced the IRS's position that an inbound transfer of a U.S. real property interest (USRPI) by a foreign corporation to a U.S. corporation, including in an "F" reorganization,3 is treated for purposes of the Foreign Investment in Real Property Tax Act (FIRPTA) as a taxable disposition by the foreign corporation of the USRPI unless it pays a toll charge. The toll charge is the amount of taxes that, had the foreign corporation been a U.S. corporation, would have been due and payable under FIRPTA from all persons that sold stock in the corporation after June 18, 1980 (the effective date of FIRPTA), plus interest.4 Notice 2006-465 revised the 1989 Notice, among other ways, to shorten the look-back period to 10 years.
The IRS recently issued a private letter ruling, PLR 201321007,6 involving a simple domestication that is subject to the rule of the Notice. The ruling involved a publicly traded foreign corporation (Parent) that owned, as its sole asset, 100% of the stock of a U.S. real property holding corporation (USRPHC) within the meaning of §897(c)(2) (Sub). Parent decided to domesticate by reincorporating as a U.S. corporation. This appears to have been accomplished under a state statute similar or identical to Delaware Code §388, which requires simply that a foreign corporation file a certificate of domestication and a new Delaware certificate of incorporation with the Delaware Secretary of State.
Domestications of foreign corporations (though not usually publicly traded ones) were common in 1986. Prior to that time, nonresident aliens, for a variety of reasons, often held U.S. real property through Netherlands Antilles corporations. Two things happened in 1986 to render this a suboptimal structure. First, the United States revoked its income tax treaty with the Netherlands Antilles. Second, the 1986 Code introduced a new branch tax on foreign corporations having income effectively connected with the conduct of a U.S. trade or business.7 To avoid branch tax and for other reasons, many of these foreign corporations were domesticated into Delaware.
At that time, many tax advisors believed -- and this author still does -- that a one-step domestication was an "F" reorganization that did not involve the transfer by the foreign corporation of any assets to anyone, and thus was not subject to FIRPTA. This belief was grounded on the nature of an F reorganization as a "mere change in place of organization" and on §381(b), which by carving F reorganizations out of its operating rules suggests that such a reorganization involves no transfers (the successor corporation in an F reorganization is not even required to obtain a new EIN).
However, the Notice took the position that an F reorganization is not just a mere change in form, but involves actual deemed transfers. This position was eventually reflected in regulations promulgated under §367.8 Under the regulations, an inbound F reorganization is treated as if the foreign corporation transferred its assets to the U.S. corporation in exchange for shares of the latter, and then distributed the U.S. corporation's shares thus deemed received to its shareholders in liquidation.
The shareholders are likewise treated as having actually exchanged their shares in the foreign corporation for shares of the U.S. corporation. Because a domestication is treated as an exchange by any U.S. shareholder of his foreign shares for domestic shares, Regs. §1.367(b)-3(b)(3) generally requires a U.S. shareholder to include in income, as a deemed dividend, the "all earnings and profits amount" allocable to his shares. This rule is explainable in the context of an acquisitive transaction where a foreign corporation is being combined with an existing U.S. corporation, due to the commingling of earnings and profits. It is a harsh rule as applied to the mere change in form of a single corporation, whose earnings and profits are unaffected by the change. In the case involved in PLR 201321007, it is likely that Parent had little or no earnings and profits.
The Notice was aimed at the following transaction, and others like it:Example. Mrs. G, a nonresident alien, created a foreign corporation (Forco) in 1975. Forco acquired a U.S. office building for 100. In 1981, when the building had appreciated in value to 150, Mrs. G sold her Forco shares for 150 to Mr. R, another nonresident alien. Because FIRPTA does not apply to the sale of stock of a foreign corporation, Mrs. G paid no tax on the sale, and Mr. R took a stepped-up basis in the Forco shares of 150. In 1986, Mr. R caused Forco to domesticate. If the domestication were tax-free, the 50 of USRPI appreciation realized by Mrs. G would have escaped U.S. tax.
Some observers asked "Where's the beef?" While it is true that Mrs. G escaped tax and Mr. R has a step-up, this is the normal result as long as the corporation remains foreign. When the corporation was domesticated, the full 50 of unrealized appreciation on the U.S. office building was imported into the U.S. tax net, because the newly-domesticated corporation is subject to tax on its worldwide income without the benefit of a basis step-up. And although FIRPTA is generally designed so as to impose only a single level of tax on foreign persons' FIRPTA gains, nothing in the Notice or the regulations gives the newly-domesticated corporation a basis increase for the toll charge paid in this case.9 What the Notice teaches us is that subjecting built-in gain to U.S. tax at the corporate level does not relieve a foreign shareholder of his FIRPTA obligation on the same gain; the new corporate-level tax is not a proxy for the old shareholder-level tax. So, in the example above, nonrecognition at the corporate level would be conditioned on the corporation paying tax on Mrs. G's 50 of gain, plus interest.
Despite its infirmities, the Notice remains the law (or at least the IRS' position). When the toll charge regime is applied to a widely held or publicly traded corporation, however, things can start to get ugly. If, in the year 2013, a corporation had to go back and reconstruct all sales of its stock by foreign persons since 1980, including small shareholders whom it might have no information on, it would in most cases be impossible to calculate the toll charge. While Notice 2006-46 limited the look-back period to 10 years, in the case of a widely held corporation this is still a challenging if not impossible task.
This is where PLR 201321007 provides some help. First, the ruling recognized that under §897(c)(3) a foreign shareholder of a USRPHC is not subject to tax under FIRPTA if she owns no more than 5% of a class of stock that is publicly traded. The ruling therefore exempted from the toll charge calculation any shares sold by such 5%-or-less shareholders. Since securities law requirements in the United States and many other countries generally require reporting by 5%-or-greater shareholders, their identities are normally known or knowable by the traded corporation. Thus, the exclusion of smaller, non-reporting shareholders from the toll charge calculation left only a few, presumably known, persons to take into account. Second, the ruling waived the condition of Regs. §1.897-9T(d)(3), which requires as a condition to reliance on the §897(c)(3) exception that a foreign corporation register with the SEC or make certain filings with the IRS.
As helpful as this ruling is, it does nothing for a widely held corporation the stock of which is not publicly traded. A better solution to the problem would be to limit the "deemed transfer" rules of the §367 regulations and the Notice to acquisitive transactions, treating a simple "F" reorganization or domestication as a "nothing" for tax purposes. It is hard to imagine why the IRS would wish to discourage foreign corporations from immigrating into the United States - settled policy is to discourage the reverse!10 - but as long as the toll charge regime remains, foreign corporations that own USRPIs will be discouraged from doing just that.
This commentary also will appear in the September 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Kliegman, 774 T.M., Single Entity Reorganizations: Recapitalizations and F Reorganizations, Caballero, Feese, and Plowgian, 912 T.M., U.S. Taxation of Foreign Investment in U.S. Real Estate, and Davis, 920 T.M., Other Transfers Subject to Section 367, and in Tax Practice Series, see ¶7140, Foreign Persons - FIRPTA.
Copyright©2013 by The Bureau of National Affairs, Inc.
4 In effect, the Notice mandates a retroactive §897(i) election as a condition to domestication. Under the election, a foreign corporation may elect to be treated as a U.S. corporation for purposes of FIRPTA only, but only if it is entitled to benefits under an applicable U.S. tax treaty. The purpose of §897(i) was to neuter claims of discrimination under treaties.
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