Another Swat at Killer Bs

By James J. Tobin, Esq.* 

Ernst & Young LLP, New York, NY

I read Notice 2014-32 with great interest. It involves various
changes to the final §367(b) regulations that were issued in 2011
(Reg. §1.367(b)-10).  Transactions that could be impacted by
the Notice include controlled foreign corporation (CFC)
repatriation transactions and U.S. acquisitions by foreign groups,
including inversion-type transactions, a topic which has been
getting a lot of press lately and a real trend which says a lot
about our uncompetitive U.S. international tax system.  So
significant, high-profile, high-stakes stuff.

Reg. §1.367(b)-10 was issued after proposed regulations under
that section had been around for quite a while. (The temporary and
proposed regulations were issued in 2008.) So one would have
thought that the IRS was well aware of the effects of these
regulations and likely would be reluctant to make further changes.
The Notice, nonetheless, makes three significant changes - or
perhaps two changes and a clarification - to the existing
regulations.

First, let's recap the basics of the final regulations. They
apply to cross-border triangular reorganizations where a subsidiary
uses parent stock to make an acquisition - in cases where the
subsidiary has used cash or other property to pay for the parent
shares. So in the outbound context, think of CFC1 using cash to
acquire USP shares and then using those USP shares to acquire
shares of CFC2 - which was the so-called "Killer B" transaction in
the pre-regulations world.

As a general rule, the (b)-10 regulations treat the cash in the
above example as a dividend up to the amount of CFC1's earnings and
profits (E&P), which was expected to take away the fun from the
Killer Bs. Likewise, in the opposite direction, where US1 uses cash
to purchase FP shares and then uses the FP stock to acquire shares
of US2, under the regulations the cash element would be deemed to
be a dividend up to the amount of the E&P of US1, which
therefore would be subject to U.S. withholding tax. I don't quibble
here with the policy objectives of the regulations. But I always
find it odd when the tax character of a transaction is different
depending on the profile of the participants - not just their
related-party status but in this case also the fact that the
deemed-dividend characterization applies only to transactions with
cross-border related parties. Recharacterization of a transaction
always carries with it some complexity and also breeds further
complexity with the recharacterization of the collateral effects of
the transaction, such as E&P and basis effects. And the
complexity created is all the greater when, as here, the
recharacterization is limited in its effect to certain
related-party, cross-border transactions. For example, I can
imagine lots of unanswered questions when less-than-100%-owned
companies are parties to the transaction. But whining any further
about this would be beyond the scope of this commentary.

The second aspect of this deemed construct in the regulations is
what is bothering the IRS. Reg. §1.367(b)-10(h)(2) provides that,
in addition to the deemed distribution, there is a deemed
contribution by the parent to the subsidiary in the amount of the
cash or other property used in the above examples. In the final
regulations, this was obviously thought to be equitable because the
cash/property was not actually distributed but rather was used to
acquire P shares at fair value. Thus, the deemed contribution
results in basis remaining in the stock of the subsidiary,
reflecting the fact that its value remains the same after the
transaction due to its acquisitions of the U.S. or foreign target
(although possibly some or all of its E&P has been included in
income by its parent). And because the final regulations actually
expanded the deemed contribution rule that was contained in the
earlier temporary and proposed regulations, it would seem that the
deemed contribution rule had been subject to thorough consideration
over several years and the expansion would seem to indicate a
well-considered decision consistent with the regulations under
§367(b) that tax unremitted E&P.

Nonetheless, after reflection for an additional three years, the
IRS and Treasury now believe that this basis increase gave
taxpayers too much opportunity to achieve low-tax repatriation
through basis recovery. Therefore, the Notice indicates that the
IRS and Treasury will eliminate the deemed contribution provision
of the regulations. The Notice makes clear that the parent's basis
in the subsidiary instead will be adjusted under Reg. §1.358-6 as
if the parent had provided its own stock pursuant to the plan of
reorganization, which means that the parent will increase its basis
in the subsidiary stock by the amount of its basis in the stock of
the target, i.e., CFC2 in my first example above, or possibly the
basis in the assets of the target in the case of certain
reorganizations. This will typically be a lower amount than the
value of the cash or other property that was used to purchase the
parent stock. Thus, the Notice will limit future use of this
technique for repatriation planning.

The second element of the Notice deals with the so-called
"§367(b) priority rule." This rule in the final regulations
primarily affected U.S. transferors of U.S. target stock to a
foreign acquiror.  The priority rule basically turned off gain
recognition under §367(a) in certain outbound transfers (for
example where U.S. transferors acquire more than 50% of a foreign
parent) as long as the income created under the (b)-10 rules
exceeded the total gains realized by the U.S. transferors. Sounds
fair, but the problem recognized by the IRS and Treasury with the
Notice is that deemed gains under (b)-10 would consist of dividends
that are subject to some level of U.S. withholding tax under §1441
and potentially also gains under §301(c)(3) which would be capital
gains not subject to U.S. tax at the foreign parent level unless
either FIRPTA or Subpart F applied. Thus, the priority rule
eliminated U.S. tax for U.S. transferors in cases where there could
be no corresponding U.S. tax on at least a portion of the (b)-10
deemed income. Per the Notice, the IRS and Treasury now believe
that the (b)-10 income that is taken into account for purposes of
the priority rule should include only dividends and gains that are
subject to U.S. tax. The final regulations will be changed
accordingly.

The third element of the Notice is described not as a change to
the final regulations but rather as a clarification as to how the
IRS and Treasury now believe the anti-abuse rule that is contained
in the (b)-10 regulations should apply. The anti-abuse rule is
broadly worded to grant authority to make "appropriate adjustments"
in connection with a triangular reorganization engaged in with a
view to avoid the purpose of the regulations. Section 367(b)
provides the Treasury authority to issue regulations providing for
circumstances in which gain or dividends (or both) shall be
included in income by an exchanging shareholder; interestingly, the
anti-abuse rule in the regulations provides only for unspecified
"appropriate adjustments" that presumably would result in income
inclusions in circumstances the IRS determines to be inconsistent
with the unstated purpose of the regulations.  Query whether
this anti-abuse rule is outside the scope of Treasury's grant of
regulatory authority under §367(b). The illustration given in the
existing regulations is where a subsidiary is created, organized,
or funded to avoid application of the deemed-dividend consequence
of the regulation with respect to E&P of a related
corporation.  So the anti-abuse rule requires two conditions
to be met for it to apply. First, a transaction separate from the
reorganization must be entered into "in connection with" the
reorganization and, second, that transaction must be entered into
with a view to avoiding the purpose of the regulations. Oddly, the
final regulations do not specify the "purpose" of the regulations.
However, the temporary regulations (and the notices preceding such
temporary regulations) stated that the purpose of the regulations
was to prevent what was "in effect a distribution of property …
without the application of provisions otherwise applicable to
property distributions." Given the deemed distribution created by
the (b)-10 rules, the relevant provisions include those in §301 and
therefore obviously focus on potential dividend
characterization.

The IRS and Treasury were kind enough to provide in the Notice
an example of how they now believe the anti-abuse rule should apply
in the inbound context. In the example, FP owns USS (which is
stated to have zero E&P) which acquires UST, an unrelated
party. To effect the acquisition, FP transfers an amount of FP
stock to USS for a note and USS transfers the FP stock to sellers.
The example states that the structure was designed with a view to
avoid the purposes of the section and therefore, in determining the
character of the deemed distribution from USS, the E&P of UST
would be attributed to USS. Because the example indicates that USS
is an existing subsidiary of FP, it has presumably not been created
or organized for the tainted purpose - so the "abuse" must be in
the funding. Presumably, the anticipated later dividend from UST to
USS to service the note is considered by the IRS to be a "funding"
even though it hasn't happened yet and may never happen. The
example does not include a subsequent dividend from UST to USS as
one of its assumptions. So it would seem that an actual dividend by
UST to USS is not required to have a "funding" and merely the
potential for such dividend is sufficient to create the funding.
Seems a big stretch to me and, in a case of a USS with existing
subsidiaries or multiple targets where the future sources of funds
for servicing of the note are not even predictable, such an
interpretation would seem impractical to apply. Maybe this is why
the IRS and Treasury used a simple example and state as a fact that
the transaction had a tainted "principal" purpose. 

For an inbound related-party acquisition, the anti-abuse rule
would typically be unnecessary because, in the case of a newly
formed USS or a USS that is small compared to UST, the acquisition
of UST in the triangular reorganization would be treated as a
reverse acquisition and the E&P of UST would produce a deemed
dividend in any event. But for an inbound unrelated-party
acquisition, this new anti-abuse rule interpretation seems to me to
go too far, even beyond my concern about the remarkably wide
implicit interpretation of funding.

Consider a straight taxable cash acquisition of UST by FP.
Typically FP would form USS to make the acquisition and would
structure the capital of USS with an appropriate amount of debt
versus equity. No deemed dividend would result. The transaction
would not be characterized as a reverse acquisition and thus UST's
E&P would not cascade up to USS. Likewise, if USS used FP's
shares in addition to cash in connection with the UST acquisition
in a taxable transaction and set a reasonable debt/equity
structure, there should be no E&P tiering and no deemed
dividend.  So it's hard for me to see why the normal use of an
acquisition company in a reorganization should be considered an
abusive transaction - one "engaged in with a view to avoid the
purpose of this section."  But, given the Notice, it seems
that prudence would dictate doing U.S. inbound deals as taxable
transactions wherever possible, including deals in which U.S.
exchanging shareholders would otherwise be required to recognize
gain under §367(a).

From an outbound transaction perspective, the "clarification" of
the anti-abuse rule is potentially even more troubling. Assume USP
owns CFC Holdco which owns CFC1 and CFC2. And assume CFC Holdco
acquires USP shares for a note and uses the USP shares to acquire
CFC3 shares from a U.S. subsidiary of USP. The (b)-10 regulations
would treat the note as a deemed dividend from CFC Holdco - fair
enough. And the modification to the regulations described in the
Notice presumably would limit the basis increase in the shares of
CFC Holdco to the existing basis of CFC3 - also fair enough. 
But query whether the IRS and Treasury think that the E&P of
CFC1 and CFC2, and potentially even CFC3, should be deemed to be
E&P of CFC Holdco for purposes of the deemed dividend. The
anti-abuse rule applies if CFC Holdco is created, organized, or
funded to avoid the application of this section. The example could
be read by one prone to any paranoia - and as I have admitted
before I am a paranoid guy - to support the proposition that, when
the purchase of parent stock is done for a note (in this case a
note from CFC Holdco), any E&P down the chain could be
anticipated to be available to repay the note and therefore could
represent a potential funding.  If that interpretation was
intended and were correct, in many cases the "anti-abuse rule"
would arguably become the "general rule" and could arguably require
deemed dividend treatment up to the amount of E&P anywhere in
the relevant ownership chains.  I would not be inclined to
read too much of such a broad intended application of the
anti-abuse rule into the IRS and Treasury's simple example. But,
unfortunately, the Notice doesn't identify the outside boundary of
the anti-abuse rule. Which is worrying to a paranoid guy like
me.

The effective date for the changes in the Notice is generally
prospective, including a binding contract exception. However, the
Notice clearly states that the final regulations are "modified"
with respect to the elimination of the deemed contribution and the
§367(b) Priority rule but are "clarified" with respect to how the
anti-abuse rule applies. That "clarification" is in the form of the
addition of the single, very simplified example discussed above.
But to my mind that example is more worrying than clarifying.

This commentary also will appear in the July 2014 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,
¶7150, U.S. Persons - Worldwide Taxation.

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   The
views expressed herein are those of the author and do not
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