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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
Section 332(d) is a targeted anti-abuse rule enacted in 2004. It has never been the subject of any guidance, and is largely overlooked by practitioners, especially those not seeking to avoid tax. It is easily avoided by those who know about it, and for those who do not, it is a classic trap for the unwary. As we shall see, its application to a "United States real property holding corporation," as defined in §897(c)(2) (USRPHC), was quite clearly overlooked by Congress.
Section 332(d) provides that in the case of any distribution to a foreign corporation (other than a controlled foreign corporation (CFC)) in complete liquidation of an "applicable holding company" (AHC), §§332(a) and 331 do not apply, and instead §301 applies to the distribution. An AHC is a U.S. corporation, owned directly by the distributee foreign corporation, that is the common parent of a U.S. affiliated group substantially all of the assets of which consists of stock of one or more members of that group. A U.S. corporation will be an AHC only if it has not been in existence for the full five years preceding the complete liquidation, although the IRS has authority to treat a corporation as not in existence during any period it is not engaged in the active conduct of a trade or business and does not own stock of a subsidiary that is so engaged.
Section 332(d) was aimed at a fairly obvious form of abuse. The concern was that a foreign corporation would set up a holding company to own the stock of an operating subsidiary, and cause the subsidiary to pay dividends out of its earnings and profits (E&P) to the holding company parent. The dividends would be excluded from the parent's income under either the consolidated return rules or the 100% dividends-received deduction. The foreign owner would then liquidate the holding company and avoid U.S. withholding tax on the subsidiary's E&P, because a liquidation is treated as a sale or exchange and not as a dividend. Congress's real concern was that the foreign owner would then drop the stock of the subsidiary back into a new holding company and begin the "churning" process all over again, permanently avoiding U.S. dividend withholding taxes.
An earlier version of this legislation proposed in 1999 would have made §332(d) applicable only to the extent of an AHC's E&P. Under that approach, if an AHC lacking E&P completely liquidated, §332(d) would not have applied. This approach made sense, given that the targeted abuse was the failure to withhold tax on U.S.-source dividends paid to a foreign person. However, §332(d) as enacted is not so limited. As a result, it can apply even where the AHC has no E&P. There is no indication that Congress understood that a distribution would then be treated as a nontaxable return of basis and then as a capital gain under §301(c)(3). Even if this were recognized, it may have been deemed harmless, as foreign persons are not generally subject to U.S. tax on capital gains, including §301(c)(3) distributions.
But as applied to complete liquidations of USRPHCs, §332(d) can give rise to tax in a case where the targeted abuse is wholly absent, and in a manner flatly inconsistent with the operation of the Foreign Investment in Real Property Tax Act (FIRPTA) and §367(e). To take a simple example, imagine that foreign corporation F owns 100% of the stock of an AHC, the only asset of which is 100% of the stock of a USRPHC. Assume that F has a basis in the stock of the AHC of 10, the AHC has a basis in the stock of the USRPHC of 10, the value of such stock is 100, and the AHC has no E&P. Further assume that the application of §332(d) does not cause the AHC to recognize gain (i.e., §337 still applies) and therefore does not give rise to any additional E&P. (This topic is addressed below.) If F causes the AHC to liquidate, distributing the stock of the USRPHC to F, treating the distribution as described in §301 would cause F to recognize 90 of FIRPTA gain under §301(c)(3).
This result is completely inconsistent with §897(e) and the regulations thereunder, as well as with the regulations under §367(e)(2). In this simple example, the AHC will itself be a USRPHC. Section 897(e) generally provides that the exchange by a foreign person of one United States real property interest (USRPI) for another in a nonrecognition transaction will qualify for nonrecognition treatment, at least as long as the foreign person takes the same basis in the replacement property that it had in the exchanged property. In the simple example above, since F had a basis of 10 in its AHC stock, under the normal rules for complete liquidations of subsidiaries, F would have received the stock of the lower-tier USRPHC free of U.S. tax with a basis of 10. Section 367(e)(2) would not have applied to require the AHC to recognize gain, because the gain would have been preserved in U.S. corporate solution.1
The results of applying §332(d) become even stranger when one considers the possible effect of that provision on the liquidating corporation. Congress was aware, in enacting §332(d), that the §367(e)(2) regulations already addressed in some detail the fact pattern with which it was concerned. That section generally provides for corporate nonrecognition in a §332/§337 liquidation involving an outbound transfer of stock of controlled U.S. subsidiaries,2 but contains an anti-abuse rule that in most cases would require the liquidating corporation in the fact pattern that concerned Congress to recognize gain. Nevertheless, Congress felt that the anti-abuse rule was not sufficient to preclude the U.S. withholding tax abuse that it targeted. There is no indication that Congress was aware that there is a separate §367(e)(2) nonrecognition rule for distributions of USRPIs, which is consistent with §897(e).3
Wholly apart from whether the various anti-abuse rules in §367(e)(2) might apply to require the liquidating corporation to recognize gain, there is the separate question as to whether §332(d) affects the tax treatment of the AHC. Based on the legislative history, it appears that Congress was focused solely on the treatment of the liquidating distribution at the shareholder level, in which case §337 would apply to the AHC if the liquidation was made to an 80%-or-greater corporate shareholder. Most commentators seem to believe that §332(d) has no effect on the taxation of the liquidating corporation.4 For one thing, §332(d) applies to §331 liquidations as well as to §332 liquidations.5 If an AHC that is owned 80% by a U.S. corporation and 20% by a foreign corporation were to completely liquidate, §332(d) would apply to the distribution made to the foreign shareholder but not to the distribution to the U.S. shareholder. It is difficult to imagine that, in such a case, the AHC would be treated as having undergone a §337 liquidation with respect to the stock owned by the U.S. shareholder, but a §336 liquidation with respect to the stock owned by the foreign shareholder! There is simply no precedent anywhere in the Code for treating a single liquidation or distribution differently at the corporate level, depending upon the characteristics of the corporation's shareholders.
However, a literal reading of the statute as amended by §332(d) suggests that a liquidation covered by that provision is removed from §337 at the corporate level, with the result that the AHC would be treated as having made a taxable §336 distribution of property. This is because §337 expressly applies only to a liquidation described in §332. If the AHC is taxable on the distribution - whether under §336, under one of the §367(e)(2) anti-abuse rules, or even under §311 - the distribution would create E&P to the extent of any gain recognized by the AHC. In that event, the liquidation would be subject to U.S. tax at two levels: first, to the distributing U.S. corporation, and, second, as a dividend to the foreign shareholder.
This double taxation at the corporate and shareholder levels is again completely at odds with the manner in which FIRPTA is designed to operate. FIRPTA was designed to impose a single tax on a foreign person's investment in U.S. real property. The so-called cleansing rule of §897(c)(1)(B) operates to ensure that if a USRPHC disposes of all of its USRPIs in a taxable transaction, the stock of such USRPHC ceases to be a USRPI, allowing the foreign shareholder to dispose of such stock, including by way of a complete liquidation, without further U.S. tax.
One can imagine a case in which the application of §332(d) in the context of FIRPTA actually avoids the imposition of the FIRPTA tax and allows a foreign corporation to step up the basis of a FIRPTA asset without tax. Suppose F is a foreign corporation resident in a country that has a tax treaty with the United States providing for a zero rate of U.S. withholding tax on dividends. F owns an AHC, and the AHC is a USRPHC by reason of owning stock in USRPHCs, but also owns stock in non-USRPHCs constituting less than 50% of its assets by value. Suppose further that the AHC has lots of E&P. If the AHC liquidates and §332(d) applies, the distribution would be taxable as a dividend to the extent of the AHC's E&P, resulting in no tax to F. F will have exchanged an interest in a USRPHC for interests in both USRPHCs and stock in subsidiaries that are not USRPHCs, which it can now sell without the imposition of U.S. tax. If instead §332 had applied to the distribution, as would be the case but for §332(d), the AHC would have recognized the gain allocable to the non-USRPHCs distributed.6 By turning off §332 in this case, §332(d) has effectively turned off all of the FIRPTA and §367(e)(2) rules applicable to USRPHCs! As noted above, it is possible that the IRS would seek to tax the AHC as if the distribution were taxable under §336 or §311, but that argument may be difficult to sustain.
It should be apparent by this time that §332(d) does not mesh with the FIRPTA rules. As has been pointed out,7 §332(d) can be avoided by a taxpayer who is aware of it in one of several ways. In the simple case, assuming a business purpose exists to combine the AHC and its subsidiary, the rule could be avoided by merging the AHC down into the USRPHC, a §368(a)(1)(A) merger. Alternatively, the USRPHC could be liquidated into the AHC. And finally, if the foreign owner is determined to achieve the result sought to be precluded by §332(d), it could liquidate the AHC and immediately drop all or a portion of its assets down into a new U.S. holding company in an upstream "C" reorganization not treated as a complete liquidation.8
One might suppose that the IRS could write regulations turning off §332(d) with respect to USRPHCs, as it has in other areas of the Code, to conform to §897(e) and other rules in FIRPTA. However, Congress deliberately wrote §332(d) in a manner that appears to preclude any authority to ameliorate the rule. It is a mechanical, not a subjective or "principal purpose" rule. No wonder the IRS has issued no guidance under this subsection! Others have argued persuasively that §332(d) should be repealed. At the least, it should be amended to apply only to the extent of an AHC's E&P. The rule is easily avoided by those who seek to achieve the result it targeted, and applies only in those cases where no abuse is present. Section 332(d) is a classic example of why rifle-shot rules enacted without consideration of the Code's elaborate structure distinguishing between exchanges of stock and dividend-type distributions should be avoided.
This commentary also will appear in the January 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Zarlenga, 784 T.M., Corporate Liquidations, and 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 Under Section 367,and in Tax Practice Series, see ¶7120, Foreign Persons - Gross Basis Taxation, and ¶7140, Foreign Persons - FIRPTA.
1 Regs. §1.367(e)-2(b)(2)(ii).
2 Regs. §1.367(e)-2(b)(2)(iii).
3 Note that if an AHC had two or more subsidiaries, the anti-abuse rule of Regs. §1.367(e)-2(d) could apply to override the FIRPTA exception, requiring the AHC to recognize gain on the liquidation. This might be the case, for example, where the principal purpose of the liquidation is to permit the foreign shareholder to sell the distributed subsidiaries separately.
See, e.g., Bakke, "An Incomplete Liquidation Provision: Section 332(d)," 52 Tax Mgmt. Memo. 403 (9/26/11); Dolan et al, U.S. Taxation of International Mergers, Acquisitions and Joint Ventures, ¶ 15.05[e] (2010).
5 Note that while §332(d) requires that the foreign distributee own the stock of the AHC directly, there is no requirement that the foreign corporate distributee own all or even 80% of the AHC - any amount of direct ownership is covered. The reference to §331 makes clear that a complete liquidation need not be a §332 carryover basis transaction, but includes a §331 taxable liquidation. In the case of a complete §331 liquidation where less than all distributees are foreign corporations, §332(d) would apply only to the foreign distributees, raising the question how any E&P of the corporation would be allocated among them. Presumably, the E&P would be allocated on a per share basis even though it has no effect on a shareholder that is not a foreign corporation. However, it seems possible that all of the E&P would be allocated solely to the foreign corporate shareholder(s).
6 Regs. §1.897-5T(b)(3)(iv) and Regs. §1.367(e)-2(b)(1).
7 See Bakke, above, n. 4.
8 Section 332(d) was conceived of before other changes made to the §368 regulations led the IRS to adopt the view that a complete liquidation in form, followed by a drop of some or all of the distributed assets, could in most cases qualify as a §368(a)(1)(C) reorganization. See, e.g., PLR 201127004 (Dec. 17, 2010). In this case, §332(d) would have no application because there is no "complete liquidation."
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