Final sec. 367(a) regulations are generally favorable, but contain some surprises.

Earlier this year, the IRS issued final regulations under Sec. 367(a) on transfers of a domestic corporation's stock or securities by a U.S. person to a foreign corporation in a corporate organization, reorganization or liquidation. The regulations are effective for transactions after Jan. 29, 1997; however, taxpayers may elect to apply them retroactively to all transfers occurring after April 17, 1994, provided the tax year is still open. The new rules are generally taxpayer-favorable, and remove some problems of the ownership tests contained in the temporary regulations. However, the active trade or business test" has been modified in ways that may affect transactions now in progress.

The final regulations generally follow the rules set forth in the temporary regulations issued Dec. 26, 1995, with a few modifications. Under Sec. 367(a)(1), a transfer by a U.S. person of stock or other property to a foreign corporation in a corporate formation, reorganization or liquidation is generally taxable. The temporary regulations allowed tax-free treatment of certain transfers of stock in a U.S. company to a foreign corporation, provided the taxpayer satisfied the reporting requirements and the transfer met the enumerated conditions. These conditions included: (1) U.S. transferors could not receive more than 50% of the voting power and value of the stock of the transferee foreign corporation; (2) immediately after the exchange, U.S. persons could not own (in the aggregate) more than 50% of the voting power and value of the transferee foreign corporation; (3) 5% U.S. shareholders must have entered into a five-year gain-recognition agreement (GRA); and (4) the transferee foreign corporation or an affiliate must have carried on a substantial active trade or business during the 36 months preceding the transfer. Final Regs. Sec. 1.367(a)-3 eliminates stock received in exchange for "other property" from the 50%-ownership calculation and modifies the active business requirement.

The tainting of the transfer of other property" was designed to prevent "stuffing" transactions; however, practitioners have noted that the broad language could potentially prevent the tax-free formation of a joint venture in unintended situations. For example, if a U.S. and a foreign company were each contributed to a joint venture and the value of the U.S. company was less than 50% of the total value, the transactions could still be taxable if the foreign corporation was widely held and had U.S. shareholders. The transfer of the foreign corporation's stock by a U.S. person would be "other property," requiring the value of the joint venture stock received to be aggregated with the value of the U.S. company being transferred. In response to comments, in the final regulations the IRS removed the reference to "other property" and intended for the active business requirement rules to prevent "stuffing" transactions from qualifying for tax-free treatment.

Regs. Sec. 1.367(a)-3(c)(3)(i)(A) retains a 36-month time period as the requirement for conducting an active trade or business, but adds a requirement that no intention exist at the time of the transfer to discontinue or dispose of the trade or business used to fulfill this requirement. Additionally, the regulations clarify that for this test, certain transfers of business assets may also be considered, as well as the activities of qualified subsidiaries and partnerships. This is a departure from the temporary regulations that allowed the consideration of the activities of affiliates; transactions in progress relying on the affiliate rule should be examined to ensure that the affiliate's activities are still eligible under the new rules.

Another new rule that may require a reevaluation of transactions in progress is the "substantiality" test, which is part of the new definition of an active trade or business. Regs. Sec. 1.367(a)-3(c)(3)(iii) now requires that the fair market value (FMV) of the foreign transferee at least equal the FMV of the U.S. target at the time of the transfer. This can create problems in some typical situations.

Example: Acquirer is worth $90 and Target is worth $100. Target stock is transferred to a joint venture in exchange for a 50% interest and $10 in cash. Although the 50%-ownership threshold is not exceeded, the transaction fails the substantiality test.

Recognizing that the mechanical nature of these new rules may present problems, Regs. Sec. 1.367(a)-3(c)(9) provides that the Service will, in limited circumstances, issue letter rulings allowing tax-free treatment when the active trade or business requirement is technically not met but the overall transaction appears to comport with the policies behind the rules.

Under the final regulations, all GRAs are required to be entered into for a period of five years. Thus, 5% transferees are no longer required to enter into a 10-year GRA (Regs. Sec. 1.367(a)-3(c)(10), Example (2)).

Finally, the IRS noted it intends to issue additional final regulations dealing with other areas of Sec. 367(a) covered in proposed regulations but not addressed in these rules.

From Richard A. Gordon, J.D., and T.Timithy Tuerff, CPA, J.D., Washington, D.C.