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A guide to the new proposed regulations under Sections 367(a) and (b).

OVERVIEW

New proposed regulations under section 367(a) and (b) of the Internal Revenue Code (1) were published in the Federal Register on August 26, 1991. The proposed regulations would apply to a variety of stock and asset transfers involving foreign corporations that, but for the potential application of section 367(a) or 367(b), would qualify for tax-free treatment under certain statutory nonrecognition provisions. More specifically, the new proposed rules would apply to (i) certain direct or indirect transfers of stock or securities (in a domestic or a foreign corporation) by a U.S. person to a foreign corporation ("outbound" transfers described in section 367(a)), (ii) certain transfers of stock or assets of a foreign corporation to a foreign or domestic corporation ("foreign-to-foreign" or "inbound" transfers described in section 367(b)), and (iii) certain distributions otherwise governed by section 355 (relating to tax-free spin-offs, split-offs, and split-ups), also under section 367(b).

Following the general approach of existing rules, under the proposed regulations outbound transfers generally would not be subject to tax under section 367(a) if a 5- or 10-year gain recognition agreement were filed. U.S. transferors owning less than 5 percent of the foreign transferee would not be required to file such an agreement. By contrast, certain liquidations or reorganizations of foreign corporations into U.S. corporations (inbound transfers) generally would constitute taxable events to the shareholders exchanging stock in the transaction (though not to the foreign corporation that liquidated or reorganized). So-called foreign-to-foreign reorganizations generally would be tax-free unless the transferor were a controlled foreign corporation (CFC) and the transferee were not. Finally, certain section 355 distributions would be taxable events to either the distributing corporation or its shareholders.

The proposed regulations under sections 367(a) and (b) are not necessarily exclusive; some transfers would be subject to both sets of rules. In addition, certain transactions subject to the new outbound stock transfer rules might also be subject to a separate set of existing rules under section 367(a) governing non-stock asset transfers to foreign corporations.

With two exceptions, the proposed regulations would apply only prospectively, to transfers occurring on or after the 30th day after final regulations are published in the Federal Register. The first exception is discretionary: at the taxpayer's election, certain of the new rules relating to outbound stock transfers could be applied to transfers occurring after December 16, 1987. The second exception is mandatory but narrow in scope: a revised definition of the "all earnings and profits amount" (the measure of taxable income in certain inbound asset transfers under section 367(b)) would apply to exchanges occurring on or after August 26, 1991.

OUTBOUND STOCK TRANSFERS

Background

Section 367(a) prevents taxpayers from using certain nonrecognition provisions of the Internal Revenue Code -- sections 332, 351, 354, 356, and 361 -- as a device to remove appreciated property from U.S. tax jurisdiction without the payment of tax. Mechanically, section 367(a)(1) achieves this result by deeming the foreign transferee corporation not to be a corporation "for purposes of determining the extent to which gain is recognized on such transfer." Because corporate status is a prerequisite to the application of the nonrecognition provisions, the denial of corporate status under section 367(a) causes the exchanges to be taxable.

The proposed regulations revise existing exceptions to this general rule. The basic rationale for excepting certain transactions from current gain recognition is that a continued deferral of tax on the appreciation in transferred property (pursuant to an otherwise applicable nonrecognition provision) is appropriate in the outbound transfer context where an adequate mechanism exists to ultimately collect that tax.

The current regulations relating to outbound transfers of stock and securities (2) are set forth in Temp. Reg. $S 1.367(a)-3T. They address transfers that are otherwise governed by one of the nonrecognition provisions specified in section 367(a) (other than section 355, for which the rules are reserved). The rather cumbersome regulatory scheme in the temporary regulations, however, was superseded by Notice 87-85, 1987-2 C.B. 395, which announced a simplified set of rules that, when incorporated in final regulations, would apply to transactions occurring after December 16, 1987. Because the new proposed regulations provide that existing Temp. Reg. $S 1.367(a)-3T, as modified by Notice 87-85, will apply until the new regulations become effective, the rules prior to modification by the Notice are not discussed in this article.

Under the current rules, a U.S. person that transfers stock or securities in a domestic or foreign corporation to a foreign corporation generally does not recognize gain under section 367(a) if, immediately after the transfer, such transferor owns (3) less than five percent (by vote or value) of the stock of the transferee foreign corporation. A U.S. transferor that owns a greater percentage of the transferee foreign corporation's stock immediately after the transfer is eligible for this favorable treatment only if such transferor enters into a gain recognition agreement (GRA).

The GRA commits the transferor to report the gain it realized on the outbound transfer in an amended return for the year of the transfer if, subject to a number of special rules and exceptions, the foreign transferee disposes of the transferred stock within the term of the GRA. The GRA has a 10-uear term (and the transferor must execute a waiver of the statute of limitations for, apparently, a 13-year period(4)) if all U.S. transferors own 50 percent or more (by vote or value) of the foreign transferee. Otherwise, the agreement has a 5-year term and the waiver is for an 8-year period.

The amended return requirement is onerous to the taxpayer not only from a procedural standpoint but also because interest must be paid on any tax deficiency resulting from the adjustment to taxable income. If the U.S. transferor had simply retained the stock and sold it in the later year in which, in fact, the foreign transferee disposed of such stock, the gain would be taxable income only in that later year and deficiency interest would not accrue.

Notice 87-85 establishes two exceptions to these rules. First, if the transferred stock is stock in a CFC with respect to which the U.S. transferor is a U.S. shareholder, (5) then section 367(a) applies (requiring the recognition of realized gain on the exchange) unless the stock received by the transferor is stock in a CFC with respect to which the transferor is also a U.S. shareholder. Second, if the transferred stock is stock in a domestic corporation, section 367(a) applies if the U.S. transferor owns more than 50 percent (by vote or value) of the foreign transferee's stock after the transaction.

The foregoing rules also apply to certain "indirect" stock transfers described in Temp. Reg. $S 1.367(a)-1T(c). Specifically, a forward or reverse merger of one domestic corporation into another domestic corporation pursuant to section 368(a)(2)(D) or (E) is treated as an indirect outbound transfer of stock by the U.S. persons exchanging stock of the target corporation if the controlling corporation (the stock of which is received by such exchanging shareholders) is foreign. Similarly, if a domestic corporation acquires assets of another domestic corporation in a reorganization under section 368(a)(1)(C) in exchange for stock in its foreign parent, the exchanging shareholders of the transferor corporation are considered to have made an outbound stock transfer. Finally, a reorganization under section 368(a)(1)(B) is considered an indirect outbound stock transfer if a domestic corporation acquires, in exchange for stock of its foreign parent, the stock of another domestic corporation. The apparent rationale for these rules is that the end result of each transaction is similar to a case in which a U.S. person transfers stock in a domestic corporation directly to a foreign corporation.

The current rules governing outbound stock transfers do not apply to the transfer of stock in a foreign corporation pursuant to a reorganization described in section 368 if that foreign corporation is a party to the reorganization (within the meaning of section 368(b)). Instead, such transfers are subject to the regulations under section 367(b). (6) Furthermore, if stock in a foreign corporation ("F") is transferred to another foreign corporation in a stock-for-stock exchange qualifying under both section 368(a)(1)(B) (to which F is a party) and section 351 (to which F is not a party to a reorganization), the overlap is resolved by generally treating the transaction as governed by section 367(b). (7) This overlap provision has been widely used to avoid application of the section 367(a) provisions.

Section 367(a)(5) is an important additional restriction on outbound transfers. A domestic transferor corporation must recognize gain in a reorganization involving an outbound transfer of assets notwithstanding the application of section 361 unless, subject to basis adjustments and other conditions prescribed in future regulations, such transferor corporation is controlled (within the meaning of section 368(c)) by 5 or fewer domestic corporations.

Outbound Transfers of Stock or Securities

Under the Proposed Regulations

Overview

Subject to extraordinarily broad new rules for indirect transfers, Prop. Reg. $S 1.367(a)-3 would apply to outbound transfers of stock or securities in the context of exchanges described in (i) section 351, (ii) section 354 (provided that the underlying reorganization is governed by section 368(a)(1)(B)), and (iii) section 361.

The carve-out under the current outbound stock transfer rules for transfers of stock in a foreign corporation that is a party to the reorganization would be eliminated. As a consequence, a U.S. person that exchanged stock in one foreign corporation for stock in another pursuant to a section 368(a)(1)(B) stock-for-stock transaction would be subject to the outbound stock transfer rules of section 367(a). This does not mean, however, that the transfer therefore would be exempt from the new rules under section 367(b). To the contrary, unless the transferor were required to recognize its realized gain under section 367(a) (e.g., due to the transferor's noncompliance with the GRA requirements), such transferor would also be required to run the gauntlet of the new proposed regulations under section 367(b). (8)

The proposed regulations generally follow the approach taken in Notice 87-85. Thus, outbound stock transfers generally would not be subjec to gain recognition under section 367(a) if the GRA requirements were satisfied. As under the current rules, the U.S. transferor would be required to file a GRA in order to avoid gain recognition unless, immediately after the transfer, it owned less than five percent (by vote or value) of the stock of the transferee foreign corporation. The GRA, if required, would have a 5-year term if, immediately after the transaction, all of the U.S. transferors (including those owning less than 5 percent) owned, in the aggregate, less than 50 percent (by vote and value) of the stock of the foreign transferee corporation; otherwise, the GRA would have a 10-year term. (9)

In contrast, if one U.S. transferor (including an affiliated group) of domestic stock owned more than 50 percent (by vote or value) of the foreign transferee after the transaction, gain would be recognized not only to that U.S. transferor but to all other U.S. transferors owning at least 5 percent (by vote or value) of the stock of the transferee foreign corporation. (10) U.S. transferors that owned less than 5 percent of the transferee after the transfer would not be tainted by this exception. (11)

The other major exception under Notice 87-85 -- where the exchanging shareholder loses U.S. shareholder status with respect to a CFC -- is not included in the proposed regulations. Consequently, gain under section 367(a) would be avoided on such a transfer if the appropriate GRA were filed. The exchange, however, could still be a taxable event under the new section 367(b) proposed regulations.

The proposed regulations also warn that transfers by U.S. corporations pursuant to section 361 are or may be subject to additional rules under section 367(a)(5). No substantive guidance on the scope of section 367(a)(5) is provided, though private letter rulings have addressed the issue.

Indirect Transfers

Perhaps the most complicated rules in the proposed regulations involve a significant expansion of the indirect transfer rules. Currently, the indirect transfer rules apply only if each of the parties to the reorganization, other than the controlling foreign corporation whose stock is the consideration in the transaction, is domestic. The proposed regulations would expand the scope of these rules to include transactions in which one or both of those corporations are foreign. (12) Generally, indirect stock transfers would exist where either (1) stock of the parent of the corporation to which the transfer is made is received or (2) the transferee of assets transfers all or a portion of those assets to a subsidiary.

For example, assume that domestic corporation X transfers its assets to domestic corporation Y in exchange for stock of Y's foreign parent corporation, Z, in a reorganization governed by section 368(a)(1)(C). Assume further that U.S. persons are shareholders of X, and that such persons therefore exchange their X stock for Z stock in the transaction. This transaction is an indirect outbound transfer (with respect to the U.S. persons that receive Z stock) under both the existing and the proposed rules. Under the proposed rules, however, the transaction is an indirect stock transfer even if X is a foreign corporation. The rationale appears to be that this transaction is similar to an outbound transfer of X stock in a section 351 or section 368(a)(1)(B) exchange. Thus, both are subject to the outbound stock transfer rules of the proposed regulations.

Suppose, however, that both X and Y are foreign. The proposed regulations also treat this transaction as an outbound stock transfer. The line between sections 367(a) and 367(b), however, becomes very murky here. If foreign X had transferred its assets directly to foreign Z in exchange for foreign Z stock, the transaction would not be subject to the proposed regulations under section 367(a), but rather to those under section 367(b). It is not clear why the transaction should be converted to a section 367(a) transaction where, instead, foreign X transfers assets to foreign Y in exchange for foreign Z stock.

The first of two new indirect transfer rules applies in the following situation: A domestic or foreign corporation ("X") transfers its assets to a foreign corporation ("Y") in exchange for stock in Y pursuant to secton 368(a)(1)(C); then Y contributes some or all of those assets to its foreign or domestic subsidiary ("Z") in a drop-down described in section 368(a)(2)(C). The U.S. shareholder of X that receives stock in Y in exchange for its stock in X is considered to have made an indirect outbound transfer of stock to the extent that Y contributes assets it receives to Z (pursuant to section 368(a)(2)(C)). The portion of the shareholder's realized gain that is subject to the indirect stock transfer rules is based on the ratio of (i) the realized but unrecognized gain on the assets that Y drops to Z, over (ii) the realized but unrecognized gain on all assets transferred to Y. (13)

Example (1). Assume the basic fact pattern described in the preceding paragraph. A U.S. shareholder of X, a foreign corporation, realizes a $100 gain on its exchange of X stock for Y stock; the realized gain on the assets dropped to Z is $400; and the realized gain on all assets transferred to Y is $1,000. Only 40 percnet ($400/$1,000) of the U.S. shareholder's $100 gain is subject to the indirect stock transfer rules.

The second of the two new indirect transfer rules applies where a U.S. person transfers assets (and not, necessarily, any stock) to a foreign corporation ("X") in a section 351 exchange; X then transfers such assets to a foreign or domestic subsidiary ("Z") in a second section 351 exchange. (14) This rule applies, in part, even if only a portion of the assets are dropped down to Z. (15) The initial transfer of property by the U.S. person is deemed to be a section 354 exchange subject to the indirect transfer rules to the extent of the gain attributable to the assets transferred to Z. (16)

As an additional and rather complicated overlay on the foregoing rules, the proposed regulations make clear that if any of the indirect transfers described above also involves a transfer of non-stock assets by a U.S. corporation ("X") to a foreign corporation ("Y"), then the transaction must be separately tested for nonrecognition treatment under the "active conduct of a trade or business outside the United States" exception set forth in section 367(a)(3) of the Code and Temp. Reg. $S 1.367(a)-2T (as well as under section 367(a)(5), where a section 361 exchange is involved). (17)

The asset transfer rules of section 367(a)(3) do not apply, however, to the extent that the foreign transferee (Y) drops the assets down to its domestic subsdiary pursuant to section 368(a)(2)(C) or pursuant to a successive section 351 transfer (under the second of the new indirect transfer rules). An outbound transfer of non-stock assets simply has not occurred (and no gain therefore is potentially recognized under section 367(a)) to extent that the assets ultimately reside in a domestic corporation. (18)

Special rules are provided to coordinate the gain recognized at the X level (on its asset transfer) with the gain recognized at the level of X's shareholder (on its exchange of stock). If X is required to recognize gain on its outbound asset transfer (notwithstanding the "active conduct" exception of section 367(a)(3)), then only a portion of the realized gain of the exchanging shareholder of X may be subject to the indirect stock transfer rules. The portion is generally equal to the ratio of X's realized but unrecognized gain on the outbound asset transfer over all of X's gain on that transfer (whether or not recognized). (19) In the case of the two new indirect transfer rules, however, this ratio is determined by reference to only the assets transferred to the subsidiary of the initial acquiring corporation (Z under the terminology used above.) (20)

This coordination of "inside" asset level gain and "outside" stock level gain is illustrated by the following example:

Example (2). X, a domestic corporation, transfers assets to Y, a foreign corporation, in an exchange governed by section 368(a)(1)(C). Y transfers a portion of the assets it receives to its domestic subsidiary Z pursuant to section 368(a)(2)(C). X has a realized gain of $1,000 on the assets it transfers to Y, $400 of which is attributable to the assets that Y transfers to Z. $200 of X's realized gain of $600 on the assets retained by Y is eligible for relief under the "active conduct" exception of section 367(a)(3), and $100 of the $400 realized gain of X on the assets transferred by Y to Z is eligible for relief under section 367(a)(3). Finally, A, a U.S. person that is a shareholder of X, exchanges its X stock for a minority stock interest in Y, realizing gain of $100.

X is considered to make an outbound asset transfer of the assets transferred to and retained by Y, and accordingly must recognize $400 of its $600 gain on those assets (since only $200 of the gain is eligible for relief under the active conduct exception). Because Z is a domestic corporation, X recognizes none of its realized gain on the assets that Y transfers to Z, even though $300 of X's gain with respect to those assets is not eligible for relief under the active conduct exception. This is because the assets are viewed as having been transferred directly to Z, a domestic corporation, without having gone through Y, a foreign corporation.

Since Y did not transfer all of the assets it received from X to Z, the portion of the realized gain of A that is subject to the indirect outbound stock transfer rules is the ratio of (i) X's realized but unrecognized gain attributable to the assets Y transferred to Z ($400) over (ii) all of X's realized but unrecognized gain on its transfer of assets to Y ($600). Accordingly, only $67 of A's realized gain is subject to the indirect transfer rules ($100 X $400/$600). Thus, if A owns at least 5 percent of the voting stock of Y after the transfer, A will be required to recognize a gain under section 367(a)(1) of $67 unless it complies with the GRA requirement.

Several special ancillary rules apply in the context of indirect stock transfers. These rules are important primarily for purposes of determining whether a disposition triggering a GRA has occurred. They also have an impact on substantive qualification under the indirect stock transfer rules. (21)

Operation of the GRA

Although a detailed analysis of the mechanics of GRAs is beyond the scope of this article, several special rules relating to the triggering of gain under a GRA should be noted. These special rules are set forth in Prop. Reg. [section] 1.367(a)-3; the general rules for GRAs are contained in Prop. Reg. [section] 1.367(a)-8.

If the transferred corporation disposed of "substantially all" of its assets (as that phrase is defined for purposes of section 368(a)(1)(C)) during the term of the GRA, then the transferee corporation would be considered to have disposed of the transferred stock, thereby triggering gain to the exchanging shareholder under the GRA. Such a disposition would not trigger the GRA, however, if (i) the disposition was compulsory within the meaning of Temp. Reg. [section] 1.367(a)-4T(f) and not reasonably foreseeable at the time of the outbound transfer, (ii) the assets were distributed to the transferee foreign corporation (which retained substantially all of them for the remaining term of the GRA), or (iii) the transfer was a nonrecognition event (without regard to section 357(c)) under the U.S. tax principles and stock of a transferee corporation (or of a corporation controlling that transferee) or an interest in a transferee partnership or trust was received in exchange for the transferred property. (22)

A special rule would apply where the transferred corporation was domestic and the exchanging shareholder was a domestic corporation that owned at least 80 percent (by vote and value) of the transferred corporation's stock. The transferor's GRA would terminate and have no further effect if, during its term, the transferred corporation disposed of substantially all of its assets in a transaction in which all of its gain was recognized. (23)

Effective Date

Unless a special election were made to apply the rules of Prop. Reg. [section] 1.367(a)-3 retroactively to transactions occurring after December 16, 1987, the regulations would apply only to transactions occurring on or after the date which is 30 days after publication of final regulations. In the meantime, the rules of Temp. Reg. [section] 1.367(a)-3T (and the existing indirect transfer rules of Temp. Reg. [section] 1.367(a)-1T(c)) would apply, as modified by Notice 87-85. (24)

IF the retroactive election were made, the new operating rules for GRAs in Prop. Reg. [section] 1.367(a)-8 would not apply retroactively; rather, the existing rules relating to GRAs would apply, as modified, by the guidance on GRAs set forth in Prop. Reg. [section] 1.367(a)-3. (25)

The proposed regulations under section 367(b), described below, cannot be applied retroactively. If Prop. Reg. [section] 1.367(a)-3 were applied retroactively, then the provisions of the existing temporary regulations under section 367(b) would still apply if they otherwise would apply to the transaction. For example, certain transactions qualifying as both a section 351 exchange and a reorganization under section 368(a)(1)(B) currently are governed by the section 367(b) regulations but, under Prop. Reg. [section] 1.367(a)-3, will become section 367(a) transactions. If the latter rules are applied retroactively, any existing requirements applicable to the transaction under the current section 367(b) regulations also must be taken into account.

In section 351/section 368(a)(1)(B) overlap situations, taxpayers may very well wish not to apply the regulations retroactively, thereby avoiding being subject to section 367(a). Taxpayers may also wish to accelerate overlap transactions before the proposed regulations are finalized and become effective.

INBOUND AND FOREIGN TO FOREIGN

TRANSFERS GOVERNED BY SECTION 367(B)

Background

A transaction is subject to the existing temporary regulations under section 367(b) if it (i) involves an exchange under section 332, 351, 354, 355, 356, or 361 with respect to which foreign corporate status is relevant to the determination of recognized gain, and (ii) does not involve a property transfer "described in section 367(a)." (26) The existing regulations under section 367(b) imposed both procedural and substantive requirements. If a taxpayer fails to comply with these requirements, the Commissioner had discretion to determine whether a foreign corporation whose corporate status is relevant to nonrecognition treatment shall be treated as a corporation. Even if a substantive rule does not impose a current tax on a particular taxpayer that is subject to the procedural requirements, that taxpayer theoretically could become subject to gain recognition under section 367(b) simply by failing to comply with the procedural requirements. (27) Given the broad scope of the Commissioner's discretion in the event of substantive or procedural noncompliance, the regulations create a great deal of uncertainty.

Under the temporary regulations, a notice must be filed with the Internal Revenue Service by "any person referred to in section 6012" that realizes gain in an exchange subject to section 367(b). (28) Since section 6012 provides guidance concerning persons required to file U.S. income tax returns, the implication is that the notice requirement applies only to persons otherwise required to file U.S. returns. Other language in the regulations suggests, however, that the notice requirement applies even if a return is not required to be filed. (29)

Although a detailed discussion of the complex substantive requirements of the existing section 367(b) regulations is beyond the scope of this article, a brief summary of the key rules is important to understanding the new proposed regulations. Although many policy considerations have been cited as the underlying rationale for the substantive rules, two basic considerations are particularly relevant. First, the rules reflect the view that U.S. shareholders should not be able to avoid section 1248 dividend consequences through the device of what otherwise would be nonrecognition transfers. Second, the rules reflect the view that if a transaction involves a transfer of assets by a foreign to a domestic corporation, then the earnings of that corporation that are attributable to stock held by U.S. persons generally should be taxed at that time.

Section 332 Liquidations of Foreign Corporations

If a domestic corporation is otherwise entitled to non-recognition treatment under section 332 with respect to a liquidating distribution by a foreign corporation ("F"), the domestic corporation nonetheless must recognize its realized gain on such a liquidating distribution unless it agrees to include in gross income, as a dividend, its "all earnings and profits amount" with respect to F. (30) The otherwise applicable rules apply to F in either case (e.g., the liquidation is a nonrecognition event to F and there is a carryover basis in the distributed assets). In general, the domestic corporation must own 80 percent (by vote and value) of F's stock in order to qualify under section 332. All other U.S. persons that own F stock and receive a liquidating distribution therefrom are fully taxed under section 331 (and possibly section 1248), without regard to section 367(b). (31)

The "all earnings and profits amount" for this purpose consists generally of F's positive earnings and profits that are attributable to the F stock held by the domestic shareholder under section 1248 principles, but without regard to the exclusion under section 1248 of pre-1963 earnings. (32) Earnings apparently are taken into account only for periods during which F satisfied the stock ownership requirements for CFC status, since only those earnings count for purposes of section 1248.

IF the recipient of assets in a seciton 332 liquidation of F is another foreign corporation (whether or not a CFC), no special rules apply under the section 367(b) regulations.

Reorganizations of Foreign Corporations

(Except Pursuant to Section 355)

If stock in a foreign corporation is exchange by a U.S. shareholder (i.e., generally, a U.S. person holding at least 10 percent (by vote) of the foreign corporation's stock) pursuant to section 354 or 356 in connection with a reorganization described in section 368(a)(1)(B), (C), (D), or (F), such shareholder must include in gross income (as a dividend) its "section 1248 amount" with respect to the stock exchange unless the stock it receives in the exchange is stock in a CFC with respect to which such shareholder also is a U.S. shareholder. (33) The section 1248 amount is the amount that would be treated as a dividend to the exchanging shareholder under section 1248 had the stock been exchanged in a taxable sale. (34)

If the section 1248 amount is not required to be included in income pursuant to this rule (because the stock received is stock in a CFC with respect to which the exchanging shareholder is a U.S. shareholder), certain earnings and profits amounts are "attributed" to the stock in the CFC received by the exchanging shareholder, certain special adjustments (apart from section 381) are made to the earnings and profits of the corporation the stock of which is received, and certain stock basis adjustments may be required. (35) These rules add considerable complexity to the temporary regulations and create the possibility of double taxation on subsequent sales if consent-dividend elections are not made.

A different rule applies to inbound reorganizations where a foreign corporation transfers assets to a domestic corporation in a reorgnization under section 368(a)(1)(C), (D), or (F) and a domestic corporation receives stock in a domestic corporation in exchange for its stock in the foreign transferor corporation. The exchanging shareholder must recognize the gain it realizes on the exchange unless it includes in income (as a dividend) its all earnings and profits amount. (36) The scope of this rule, which mirrors the rule for section 332 liquidations, is unclear since it applies to an exchanging "U.S. person." Thus, the rule on its face does not require that the exchanging domestic corporation own at least 10 percent (by vote) of the foreign transferor's stock. Nor is there an explicit requirement that the transferor foreign corporation be a CFC. Both U.S. shareholder and CFC status perhaps can be read into the rule, however, since the all earnings and profits amount is determined under section 1248 "principles."

The temporary regulations also apply, with certain modifications, if the exchanging shareholder is a foreign corporation, provided that it has a "United States shareholder" that is also a U.S. shareholder of the foreign corporation whose stock is exchange. The regulations do not require an immediate income inclusion at any level in such a case, even if the stock received in the exchange is not stock in a CFC with respect to which the ultimate U.S. shareholder (of the exchanging foreign corporation) also is a U.S. shareholder. Rather, adjustments to earnings and profits (and possibly to stock basis) are made. (37)

Section 355 Transactions

Special rules apply to section 355 distributions of (i) stock in CFCs by U.S. shareholders thereof, and (ii) stock in domestic or foreign corporations by foreign corporations that have U.S. shareholders. (38) With two exceptions, these rules do not impose a current tax on the transaction but simply require a series of highly complex adjustments to earnings and profits and stock basis.

Under the first exception, U.S. shareholders of a distributing foreign corporation are required to include in gross income as a dividend a portion of their section 1248 amount with respect to the distributing corporation if, in general, the distribution otherwise would have the effect of reducing the section 1248 dividend consequences of a subsequent disposition of foreign stock. Under the second exception (which overrides the first where applicable), domestic corporate shareholders of the distributing corporation may be required to include in income a portion of their all earnings and profits amount if the transaction involves a transfer of assets by a foreign corporation to a domestic corporation followed by a distribution of stock in that domestic corporation pursuant to sections 368(a)(1)(D) and 355. As in the case of a section 332 liquidation, the domestic corporate recipient of stock in that domestic corporation must recognize the gain it realizes in the transaction unless it includes in gross income the specified portion of its all earnings and profits amount.

Section 367(b) Transactions Under

the Proposed Regulations.

Overview

The new proposed regulations under section 367(b) apply to any exchange described in section 332, 351, 354, 355, 356, or 361 in which a foreign corporation's status as a corporation is relevant to the determination of (i) recognized gain, (ii) earnings and profits, or (iii) basis in property. The new rules, however, do not apply "to the extent that the foreign corporation fails to be treated as a corporation by reason of section 367(a)(1)." (39)

This formulation is substantially broader than under the current temporary regulations. Indeed, it arguably is broader than contemplated by section 367(b) itself, which exempts from its scope transactions "described in" section 367(a). Under the proposed rules, as long as an exception to gain recognition under the section 367(a) regulations applies (which presupposes that foreign corporate status is not disregarded under section 367(a)), the transaction will also be subject to the section 367(b) regulations. Thus, transactions that clearly are "described in" secton 367(a) nonetheless are subject to the proposed regulations.

In general, the new substantive rules would represent a simplification of the existing rules. Swept away is the dauntingly complex current regime -- one under which, as the price for avoiding a current tax on the transaction, earnings are attributed to stock, earnings and profits are inherited under rules independent of section 381, and special stock basis adjustments are required. In its place would be a far more comprehensive regime that, in general, would either impose a current tax or permit the otherwise applicable rules to apply without elaborate modifications. The explicit tradeoff ffr this simplications, however, is the imposition of harsher results in certain transactions that under current law.

Although the range of transactions technically subject to the new section 367(b) regulations would be quite broad, the substantive rules would address relatively narrow categories of cases. It is important to keep in mind, however, that many transactions subject to the proposed regulations under section 367(b) would also be subject to the proposed section 367(a) regulations (e.g., the GRA requirement), so much of the simplicity would be lost.

As under the existing section 367(b) regulations, any person realizing income in a transaction subject to section 367(b) is required to file a notice with the IRS. The notice must be filed on or before the due date of the return (including extensions) for that person's taxable year. Contrary to the existing section 367(b) regulations, the notice requirement is not limited to persons "referred to" in section 6012. Unlike under the current regulations, however, failure to file a notice could not result in a taxable transactions, though penalties could apply.

The Commissioner's discretionary authority under the existing regulations to disregard foreign corporate status in the absence of compliance is eliminated. As a result and contrary to the current regulations, taxpayers failing to comply should have no doubts about the substantive rules that apply to the transaction.

The proposed regulations deal with three basic types of transactions: (1) "inbound" section 332 liquidations and reorganizations in which, generally, a U.S. corporation acquires the stock or assets of a foreign corporation of a foreign corporation; (ii) reorganizations and section 351 transactions in which stock or assets of a foreign corporation are transferred to another foreign corporation; and (iii) certain section 355 distributions. Each of these categories is discussed below.

Inbound Liquidations and Reorganizations

In the event of a section 332 liquidation of a foreign corporation into a domestic corporation or a reorganization in which a foreign corporation transfers assets to a U.S. corporation, certain exchanging shareholders otherwise entitled to tax-free treatment are required to either (i) include in taxable income as a dividend their "all earnings and profits amount" plus any exchange gain or loss with respect to their allocable shares of the transferor corporation's capital, or (ii) pursuant to an election, recognize the gain (but not loss) realized on their exchange of stock in the transaction. These rules apply even if the transferor foreign corporation has never been a CFC. In the event that an election is made to recognize realized gain, certain tax attributes of the foreign transferor corporation are reduced by an amount equal to the excess, if any, of the all earnings and profits amount attributable to the exchanging shareholder over that person's recognized gain on the exchange. [40] In the case of inbound reorganizations, the exchanging shareholder's basis in the stock received is increased by the all earnings and profits amount included in its income. This basis adjustment prevents double taxation if the stock of the domestic corporation is sold since the earnings would still be held by the corporation.

The foregoing rules apply to shareholders of the transferor foreign corporation that are either (i) U.S. shareholders or (ii) foreign corporations with, generally, U.S. shareholders. If the distributee shareholder is a CFC, the deemed dividend is foreign personal holding company income without regard to the same country exception of section 954(c)(3)(A)(i). [41] Similarly, if that distributes elects to recognize its realized gain on its exchange of stock, such gain is foreign personal holding company income. [42] In both cases, the income generally would be Subpart F income taxable to the CFC's U.S. shareholders. The proposed regulations do not apply to foreign-to-foreign section 332 liquidations in which no domestic corporation acquires assets. Accordingly, as under the existing temporary regulations, the normal nonrecognition rules would apply to such liquidations.

The rules described above do not apply if the exchanging shareholder is a U.S. person that does not satisfy the stock ownership requirements for U.S. shareholder status. Under the proposed regulations, such shareholders are required to recognize the gain (but not the loss) they realize on the exchange. [43] In the cases of a liquidation under section 332, a minority shareholder is required to recognize its gain under current law section 331. In the case of an inbound reorganization, however, such a minority shareholder would be entitled to nonrecognition treatment under current law (pursuant to section 354) unless Temp. Reg. $S 7.367(b)-7(c)(2) applied. As previously noted, although it is unclear whether the latter current-law rule has application to domestic corporations that are not U.S. shareholders, it clearly does not apply to U.S. persons that are not corporations.

The proposed regulations include a new definition of the "all earnings and profits amount." While generally similar to the existing definition, the new definition makes clear that earnings must be taken into account without regard to whether the transferor corporation ever satisfied ownership requirements for CFC status. [44] The proposed regulations also clarify that a section 332 liquidation will not itself generate additional earnings and profits for this purpose except to the extent that gain is recognized in the distribution under U.S. tax principles (e.g., due to a distribution, in part, to a person other than an 80-percent corporate shareholder). [45]

The requirement that the exchanging shareholder recognize its exchange gain or loss with respect to its share of the foreign corporation's capital is both new and complicated. The amount of exchange loss (but not gain) that may be recognized is limited, however, to the exchanging shareholder's all earnings and profits amount.

The requirement to recognize exchange gain or loss is intended to prevent the repatriation of basis (in the form of appreciated foreign currency capital) on a tax-free basis when the corporation's functional currency asset bases are translated into U.S. dollars. The preamble to the proposed regulations invites comments on how the new rule should operate.

Several special rules apply to the transferor corporation's tax attributes. First, if the exchanging shareholder elects to be taxed on its realized gain rather than include its all earnings and profits amount in income, the transferor corporation's tax attributes are reduced by an amount equal to the excess of the all earnings and profits amount over the gain recognized. Net operating losses, if any, are reduced first, followed by capital loss carryovers and asset basis. With respect to the last category, basis in tangible depreciable or depletable assets is reduced first, followed by basis in (i) other non-inventory tangibles, (ii) amortizable intangibles, and (iii) all remaining assets.(46) This attribute reduction rule is generally intended to prevent taxpayers from using asset basis generated from tax-free earnings in the foreign corporation to offset taxable earnings in a domestic corporation.

Second, the only foreign taxes of the transferor corporation that are inherited by the transferee are unused foreign tax credits allowable to the transferor under section 906 (subject to otherwise applicable limitations).

The following example illustrates the operation of the inbound transfer rules.

Example (3). P, a domestic corporation, owns 10 percent of the only class of stock of F1, a foreign corporation. P also owns all of the stock of F2, which owns 15 percent of the stock of F1. A, a U.S. person (other than a corporation), owns 5 percent of the stock of F1. F1 transfers its assets to an unrelated domestic corporation, X, in a reorganization governed by section 368(a)(1)(C), and P, F2, and A exchange their F1 stock for stock of X. F1 never has been a CFC.

Absent elections to recognize their realized gain, P and F2 must include in income their respective all earnings and profits amounts with respect to their F1 stock. F2's all earnings and profits amount is determined by reference to the period of time that P has held its stock in F2. Assume that the all earnings and profits amounts of P and F2 with respect to their F1 stock are $50 and $75, respectively. These amounts are treated as dividends, and F2's deemed dividend of $75 is subpart F income to P. The bases of P and F2 in the X stock they receive is equal to their bases in F1 stock, increased by $50 and $75, respectively.

P and F2 also must recognize their exchange gain or loss with respect to their shares of F1's capital (assuming that F1 has a non-dollar functional currency). Assume that P originally contributed $1,000 to F1 in exchange for F1 stock at a time when the spot exchange rate was one U.S. dollar to one unit of the foreign currency. Assume that the exchange rate at the time of the reorganization is $.80 to one unit of the foreign currency. Accordingly, P realizes a $200 exchange loss. Because P's all earnings and profits amount was only $50, however, only $50 of the exchange loss may be recognized.

A is required to recognize his or her gain on the exchange notwithstanding section 354. Under the current regulations, A would not be required to recognize gain.

Example (4). Assume the same facts as in Example (3) except that P's all earnings and profits amount is $1,000 and P's realized gain on the exchange of F1 stock for X stock is $200. Absent an election to recognize its realized gain, P must include the $1,000 in income as a dividend and is entitled to claim the full $200 exchange loss. Since the $200 realized gain on the exchange is less than the all earnings and profits amount net of the exchange loss ($800), P elects to recognize its $200 gain in lieu of including in income the $1,000 all earnings and profits amount and taking into account the $200 exchange gain or loss. The regulations do not require that this election also be made for F2, even though the U.S. tax consequences with respect to F2 flow through to P.

Because P's all earnings and profits amount ($1,000) exceeds P's recognized gain ($200) by $800, the attributes of F1 that are inherited by X must be reduced by $800. The tax consequences to F2 and A are the same as in Example (3).

Foreign-to-Foreign Reorganizations and

Section 351 Transactions

The new rules relating to foreign-to-foreign reorganizations and section 351 transactions apply in the context of transactions described in section 351 or section 368(a)(1)(B), (C), (D), (E), (F), or (G), in which a foreign corporation (designated the "foreign acquiring corporation") acquires stock or assets of another foreign corporation (designated the "foreign acquired corporation").

Where applicable, the proposed regulations require certain shareholders that exchange stock in the transaction to include in income, as a deemed dividend, their respective "section 1248 amounts" with respect to the stock they exchange. In the context of an exchanging shareholder that is a U.S. person, the section 1248 amount is defined in essentially the same way as under the existing temporary regulations: it is the amount such shareholder would be required to treat as a dividend under section 1248 if it disposed of the stock exchanged in a taxable transaction. Contrary to the existing rules, however, exchanging foreign corporate shareholders may also be required to include in gross income a section 1248 amount. Such a foreign corporate shareholder is deemed to be a U.S. person for purposes of determining the section 1248 amount, except that the requisite CFC status of the corporation whose stock is exchanged and the holding period of the exchanging foreign corporation therein are determined by reference to ultimate domestic shareholders of such exchanging foreign corporation.(47)

If a foreign exchanging corporation must include in income a section 1248 amount, such amount is presumed to be eligible for the "some country" exception to foreign personal holding company income.(48) Thus, that deemed dividend will not be subpart F income to the U.S. shareholders of an exchanging foreign corporation.

A section 1248 amount may be includible in gross income under either the general rule or an anti-abuse rule. The general rule applies where the exchange results in the loss of status as a section 1248 shareholder.(49) Specifically, the rule applies if, immediately before the exchange, the exchanging shareholder is either (i) a U.S. person that is a section 1248 shareholder of the foreign acquired corporation, or (ii) a foreign corporation with respect to which there exists a U.S. person that is a section 1248 shareholder of both that foreign corporation and the foreign acquired corporation. In such a case, the exchanging shareholder must include the section 1248 amount in income if, immediately after the exchange, either (i) the stock received is not stock in a CFC with respect to which the U.S. person is a section 1248 shareholder, or (ii) the foreign acquiring corporation is not a CFC with respect to which the U.S. person is a section 1248 shareholder. In the case of a reorganization under section 368(a)(1)(B), the U.S. person must be a section 1248 shareholder of the foreign acquired corporation immediately after the transaction in order to avoid a current income inclusion.

These rules reflect the policy that nonrecognition transactions should not be used to eliminate the potential application of section 1248 to a future disposition. If the transaction has that effect, a current income inclusion (in lieu of a section 1248 dividend in the future) is required.

Example (5). P, a domestic corporation that owns all of the stock of F1, a foreign corporation, exchanges all of that stock for stock of F2, another foreign corporation, in connection with F2's acquisition of F1's assets in a reorganization under section 368(a)(1)(C). The F2's only class of outstanding stock and P owns no other F2 stock. P must include in income its section 1248 amount.

Example (6). The facts are the same as in Example (5), except that P's wholly owned foreign subsidiary, F3, owns the stock of F1 and receives the F2 stock in the reorganization. F3 must include the section 1248 amount in income as a dividend, but such amount will not be subpart F income to P (because the "same country" exception to foreign personal holding company income is deemed to apply).

In addition to this general rule, the section 1248 amount may be required to be included in income under an anti-abuse rule. This rule applies if (i) both the foreign acquiring and the foreign acquired corporations were members of the same affiliated group (as specially defined(50)) immediately before the exchange, (ii) a domestic corporation satisfies the ownership requirements for indirect tax credits under section 902 with respect to the foreign acquiring corporation immediately after the transaction, and (iii) common stock is exchanged in the transaction for either preferred stock (other than fully participating preferred) or, at the district director's discretion, common or preferred stock that participates disproportionately in the return on particular assets (so-called "tracking stock").(51) The anti-abuse rule is intended to discourage transactions that could produce an artificial shifting of earnings (and associated foreign tax credits).

If a section 1248 amount is not required to be included in income under either the general rule or the anti-abuse rule (including the corollary to the latter), special rules are provided for purposes of applying section 367(b) or section 1248 to subsequent exchanges. Specifically, the earnings and profits of the foreign acquired corporation that the foreign acquiring corporation succeeds to under section 381 (where applicable) will be treated as earnings accumulated by the acquiring corporation in the years actually accumulated by the acquired corporation, and the exchanging shareholders will be deemed to have held acquiring corporation stock for the period they held stock of the acquired corporation. Again, the essential purpose of these rules is to ensure that section 1248 is not avoided.

Section 355 Transactions

The proposed regulations under section 367(b) relating to section 355 transactions can be divided generally into transactions in which the distributing corporation is domestic and those in which it is a CFC. In the context of the former, the domestic distributing corporation must recognize the gain (but not the loss) it realizes on a distribution of stock in a foreign corporation that otherwise qualifies under section 355 only if the distributee shareholder is an individual.(52) Although this rule makes no distinction between foreign and domestic distributees, the regulations make clear that section 367(e)(1) and the regulations thereunder (relating to section 355 distributions by domestic corporations to foreign persons) constitute additional restrictions on tax-free treatment.(53) In addition, section 1248(f) provides additional rules on distributions of stock in foreign corporations by domestic corporations.

Although the rules relating to distributions by CFCs under section 355 are complicated, the essential policy consideration is simple: U.S. shareholders should not be permitted to reduce their section 1248 exposure through section 355 transactions.

If a CFC makes a pro rata distribution of stock of a controlled corporation (whether or not foreign) to its shareholders, a determination must be made whether, in the event of the distributee's sale of stock in either the distributing or controlled corporation immediately after the distribution, its section 1248 amount ("hypothetical section 1248 amount") would be less than such distributee's "predistribution amount" for that corporation. If it is less, then the distributee's post-distribution basis in the stock of that corporation (as determined under the otherwise applicable rules) must be reduced (but not below zero) by the difference. If the difference exceeds basis, the excess is considered a deemed dividend from that corporation. [54]

In general, the "predistribution amount" is the section 1248 amount that would be attributable to the earnings of the particular corporation on the assumption that the distributee was a U.S. person that sold all of its distributing corporation stock immediately before the actual section 355 distribution. [55]

It seems that, in many cases, pro-rata distributions should not give rise to basis reductions (or a deemed dividend) because the section 1248 amounts in respect of the distributing and controlled corporations often will be the same as the predistribution amounts in respect of such corporations.

Similar rules apply if such a distribution is not pro rata, except that any excess of the hypothetical section 1248 amount over the predistribution amount automatically is included in income as a deemed dividend. If a distributee owns no stock in the distributing or the controlled corporation after the transaction, its section 1248 amount with respect to that corporation (pursuant to the hypothetical post-distribution sale) is deemed to be zero. Thus, any predisposition amount with respect to that corporation automatically is treated as a deemed dividend. Thus, it seems most non-pro-rata distributions will result in deemed dividends.

In addition, and absent a "taxable distribution election," all shareholders of the distributing corporation are deemed to be distributees for this purpose, regardless of whether they actually receive stock in the controlled corporation. Thus, a shareholder that received no stock in the controlled corporation and did not thereafter have an indirect interest in that controlled corporation could be required to include an amount in gross income. [56]

Under a rather unusual rule, a shareholder that does not participate in the section 355 transaction and that, under the rules just described, otherwise would be required to include an amount in gross income, is permitted to make an election whereby the distributing and the controlled corporations would not be considered corporations for purposes of gain (but not loss) recognition "by all persons affected by the taxable status of the transaction." [57] The election is made by delivering a notice to the distributing corporation within 30 days after the transaction. Thus, a shareholder that does not receive stock in the controlled corporation may unilaterally and retroactively cause the distribution to be a recognition event to (i) the distributing corporation, and (ii) all shareholders that receive stock in the controlled corporation. The proposed rule appears to reflect a concern whether there is authority to require a deemed dividend to a shareholder that does not take part in the exchange. The rule seems to potentially give a enormous amount of power to a non-exchanging shareholder, even though that power many be grossly disproportionate to the amount of stock owned (e.g., in the case of a small minority shareholder). The preamble to the regulations solicits comments on whether this proposed rule is appropriate.

Miscellaneous Matters

The proposed regulations incorporated certain ancillary rules that merit brief mention.

F Reorganizations. Prop. Reg. [section] 1.367(b)-2(f) provides guidance on reorganizations under section 368(a)(1)(F). Generally incorporating previously announced IRS positions, the regulations provide that such transactions involve a deemed asset transfer subject to the rules relating to inbound and foreign-to-foreign transactions. If the "acquiring" corporation is domestic or if the "transferor" corporation has effectively connected earnings and profits, the transferor's year closes on the date of the transfer. Prop. Reg. [section] 1.367(b)-2(g) provides that the deemed conversion of a foreign corporation to a domestic corporation under the stapled stock rules of section 269B is considered an F reorganization for purposes of the section 367(b) regulations.

Other Domestication Transactions. Rules generally incorporating previously announced guidance on domestication elections under section 953(d) (relating to certain foreign insurance companies) are provided, as are rules relating to elections to treat certain Canadian and Mexican corporations as domestic corporations pursuant to section 1504(d).

Foreign Currency. Prop. Reg. [section] 1.369(b)-2(k) provides that the adjustments required by Temp. Reg. [section] 1.985-5T (relating to changes in functional currency) must be made in the event of a section 381(a) transaction if the acquiring and acquired corporations have different functional currencies. In addition, if an exchanging shareholder must include an amount in income as a deemed dividend (pursuant to the rules described above), such shareholder is deemed to have received, immediately before the exchange and solely for purposes of the determination of exchange gain or loss under section 986(c), a distribution of the previously taxed earnings attributable to the exchanged stock. Any such exchange gain or loss will increase (or decrease) that shareholder's basis in the foreign corporation's stock.

[1] Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, or to the Treasury regulations promulgated thereunder.

[2] Throughout this article, the term "stock" is generally intended to refer to "securities" as well.

[3] For purposes of the various stock ownership requirements described in Notice 87-85, the constructive stock ownership rules of section 958 apply.

[4] The existing temporary regulations provide only for a 5-year GRA, and an 8-year waiver. Since Notice 87-85 requires a 10-year GRA in certain cases, it is reasonable to conclude that a 13-year waiver is also required in those cases.

[5] In general, a U.S. person is a U.S. shareholder of a foreign corporation for this purpose if it satisfies the stock ownership requirements of section 1248(a)(2). The latter provision applies if the U.S. person owns at least 10 percent (by vote) of the stock of a foreign corporation at any time during a 5-year period ending on the date of such person's sale or exchange of such stock, provided that the foreign corporation was a CFC at any time during that holding period. The basic 10-percent ownership requirement under section 1248(a)(2) tracks the definition of a U.S. shareholder in section 951(b). Under section 957(a), a foreign corporation is a CFC if more than 50 percent of its stock (by vote or value) is owned by U.S. shareholders. Special rules apply with respect to foreign insurance companies; e.g., the CFC threshold is reduced from 50 percent to 25 percent and all U.S. persons that own stock are considered U.S. shareholders.

[6] See I.R.C. [section] 367(a)(2); Temp. Reg. [section] 1.367(a)-3T(b).

[7] Detailed guidance on the tax consequences of such a transaction is set forth in Temp. Reg. [section] 7.367(b)-4(b).

[8] See Prop. Reg. [section] 1.367(a)-3(a).

[9] Prop. Reg. [subsection] 1.367(a)-3(b) and 1.367(a)-3(c)(1). If it cannot be determined whether all U.S. transferors own less than 50 percent, it will be presumed that they do not. Prop. Reg. [section] 1.367(a)-3(c)(2).

[10] Prop. Reg. [section] 1.367(a)-3(b)(3).

[11] Prop. Reg. [section] 1.367(a)-3(b)(1)(i).

[12] Prop. Reg. [section] 1.367(a)-3(d)(1).

[13] Prop. Reg. [subsection] 1.367(a)-3(d)(1)(v), 1.367(a)-3(d)(2)(vii).

[14] Prop. Reg. [section] 1.367(a)-3(d)(1)(vi).

[15] Prop. Reg. [section] 1.367(a)-3(d)(3), Example 10.

[16] See Prop. Reg. [section] 1.367(a)-3(d)(3), Example 10.

[17] Prop. Reg. [section] 1.367(a)-3(d)(2)(vi). See Prop. Reg. [section] 1.367(a)-3(d)(3), Example 7.

[18] See Prop. Reg. [section] 1.367(a)-3(d)(3), Example 8.

[19] Prop. Reg. [section] 1.367(a)-3(d)(2)(vi).

[20] Prop. Reg. [subsection] 1.367(a)-3(d)(2)(vi), 1.367(a)-3(d)(2)(v)(C) & (D).

[21] The foreign corporation whose stock is received by the exchanging shareholder (Y in Example (2)) is the "transferee foreign corporation." Prop. Reg. [section] 1.367(a)-3(d)(2)(i). The "transferred corporation" generally is the corporation that actually acquires assets in the transaction (or, in the context of a reverse merger under section 368(a)(2)(E), the surviving corporations). In the context of a section 368(a)(1)(C) or 368(a)(2)(C) transaction, however, the transferred corporation is the corporation receiving assets pursuant to section 368(a)(2)(C) (Z in Example (2)). In the case of an indirect transfer consisting of successive section 351 drop-downs, the ultimate recipient of the assets is deemed to be the transferred corporation. Prop. Reg. [section] 1.367(a) - 3(d)(2)(ii). Consistent with the foregoing, the transferred property in the indirect stock transfer context is the stock of the deemed "transferred corporation."

[22] Prop. Reg. [subsection] 1.367(a)-3(c)(3), 1.367(a)-3(c)(4). Special procedural requirements under the GRA rules apply in such cases.

[23] Prop. Reg. [section] 1.367(a)-3(c)(5).

[24] Prop. Reg. [section] 1.367(a)-3(f)(1).

[25] Prop. Reg. [section] 1.367(a)-(f)(2).

[26] I.R.C. [section] 367(b); Temp. Reg. [section] 7.367(b)-1(a).

[27] Temp. Reg. [section] 7.367(b)-1(b).

[28] Temp. Reg. [section] 7.367(b)-(c)(1).

[29] See Temp. Reg. [section] 7.367(b)-1(c)(1) (requiring that the notice be filed at the office where the filer "would" be required to file a U.S. return); Temp. Reg. [section] 7.367(b)-1(c)(2)(vi) (requiring the filing of certain information required under other Code sections "whether or not a Federal income tax return is required to be filed"). Of course, a foreign person nominally required to file notice likely would be indifferent to the requirement if a taxable exchange by that person would not be taxed by the United States in any case. Also, such a person's failure to comply would not taint other persons involved in the transaction that did comply.

[30] Temp. Reg. [section] 7.367(b)-5(b). The requirement that gain be recognized absent inclusion of the all earnings and profits amount is automatic rather than subject to the Commissioner's discretion.

[31] F stock ownership by members of a U.S. consolidated return group is aggregated for purposes of the 80-percent ownership requirement of section 332; thus, a group member may qualify under section 332 even if it actually owns only a minority stock interest. Treas. Reg. [section] 1.1502-34.

[32] Temp. Reg. [section] 7.367(b)-2(f).

[33] Temp. Reg. [subsection] 7.367(b)-7(b) and (c). Foreign investment companies are excluded from these rules. Special rules in Temp. Reg. [section] 7.367(b)-5 apply to such corporations.

[34] Temp. Reg. [section] 7.367(b)-2(d). Since the toll charge is based on the section 1248 dividend amount, this rule has tax consequences only if the foreign corporation was a CFC within the preceding 5-year period during which the exchanging shareholder was a U.S. shareholder. See I.R.C. [Section] 1248(a) (flush language).

[35] Temp. Reg. [section] 7.367(b)-9. In general, positive adjustments to the basis of stock in certain lower-tier acquired corporations (reflecting the movement, under the regulations, of those earnings to the acquiring corporation) are permitted only if the U.S. shareholders agree to a consent dividend election with respect to such earnings. See Temp. Reg. [section] 7.367(b)-9(f).

[36] Temp. Reg. [section] 7.367(b)-7(c)(2).

[37] If the stock received in the exchange is stock in a CFC with respect to which the ultimate U.S. shareholder of the exchanging foreign corporation is also a U.S. shareholder, the operative rules are set forth in Temp. Reg. [section] 7.367(b)-9. Otherwise, the operative rules are contained in Temp. Reg. [subsection] 7.367(b)-7(c)(1)(ii) and (iii).

These rules also apply to certain transfers of stock in one foreign corporation by another foreign corporation in a section 351 exchange. Temp. Reg. [section] 7.367(b)-8(c).

[38] Temp. Reg. [section] 7.367(b)-10.

[39] Prop. Reg. [section] 1.367(b)-1(a).

[40] Prop. Reg. [section] 1.367(b)-3.

[41] Prop. Reg. [section] 1.367(b)-3(b)(2)(A). The deemed dividend may qualify for "look-through" treatment under section 904(d)(3), however, assuming the other requirements are satisfied. Id.

[42] See I.R.C. [section] 954(c)(1)(B)(i).

[43] Prop. Reg. [section] 1.367(b)-3(c).

[44] Prop. Reg. [section] 1.367(b)-2(d)(3).

[45] Prop. Reg. [section] 1.367(b)-2(d)(2)(iii). See also I.R.C. [section] 337(a).

[46] Prop. Reg. [section] 1.367(b)-3(b)(2)(iii). If basis in a category exceeds the reduction amount allocable to that category, the taxpayer is permitted to select which assets are adjusted first.

[47] Prop. Reg. [section] 1.367(b)-2(c).

[48] Prop. Reg. [section] 1.367(b)-4(c).

[49] A U.S. person is a "section 1248 shareholder" of a foreign corporation if it would be subject to section 1248 upon a disposition of stock in that foreign corporation, i.e., a U.S. person that owned at least 10 percent (by vote) of the stock of the foreign corporation within the preceding 5-year period during which the foreign corporation was a CFC.

[50] For this purpose, section 1504(a) applies without regard to the exclusions of section 1504(b) (e.g., the exclusion for foreign corporations) and by reducing the stock ownership thresholds to "more than 50 percent" (rather than at least 80 percent).

[51] Prop. Reg. [section] 1.367(b)-4(b)(2). Under a corollary rule, a recapitalization involving a stock exchange described in (iii) will be treated as an exchange subject to the anti-abuse rule if that recapitalization occurs within 24 months before or after a transaction that would be subject to the anti-abuse rule but for the stock exchange requirement described in (iii).

[52] Prop. Reg. [section] 1.367(b)-5(b).

[53] See Temp. reg. [section] 1.367(e)-1T.

[54] Prop. Reg. [section] 1.367(b)-5(c).

[55] Prop. Reg. [section] 1.367(b)-5(e).

[56] Prop. Reg. [section] 1.367(b)-5(d).

[57] Prop. Reg. [section] 1.367(b)-5(d)(3)(ii).

KENNETH KLEIN is a tax partner in the Washington, D.C., office of Cadwalader, Wickersham & Taft. Mr. Klein practices primarily in the international tax area. From 1988 to 1990, he was Associate Chief Counsel (Technical) at the Internal Revenue Service.

DUANE H. PELLERVO also is a tax partner in the Washington, D.C., office of Coadwalader, Wickersham & Taft. Mr. Pellervo practices primarily in the corporate tax and insurance tax areas. From 1981 to 1985, he was an attorney in the corporate tax branch of the former Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service.
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