New temporary regulations consolidate rules for treatment of stock transfers to foreign corporations under sec. 367(a).

On Dec. 26, 1995, the IRS issued new temporary regulations dealing with the requirement in Sec. 367(a) that gain be recognized on certain transfers of domestic stock or securities by U.S. persons to foreign corporations. The new regulations incorporate many of the modifications set forth in proposed regulations issued in 1991 and in Notices 87-85 and 94-46. The new regulations also significantly increase the disclosure requirements for taxpayers seeking to qualify for an exception to Sec. 367(a) (1). Except for a new active trade or business requirement, the new temporary regulations are applicable retroactively to transactions occurring after Apr. 17, 1994.

Because the regulations add filing requirements, some companies that were largest in post-Apr 17, 1994 transactions may need to file amended returns.

Exception for Transfer of Stock or Securities of Domestic Corporation to Foreign Corporation by U.S. Person

The new regulations include the rule in Notices 87-85 and 94-46 that gain will be recognized without exception when a single U.S. transferor transfers stock or securities of a domestic corporation and owns directly or by attribution more than 50% of the transferee foreign corporation immediately after the transfer.

Notice 87-85 will continue to govern the availability of Sec. 367(a) exceptions for transfers of stock or securities of foreign. corporations until final regulations are released; see also Prop. Regs. Sec. 1.367(a)-3.

New Temp. Regs. Sec. 1.367(a)-3T(c) (1) sets out four conditions that must be satisfied for nonrecognition to apply to a transfer of stock or securities in a U.S. corporation:

1. The U.S. transferors of the acquired U.S. corporation (U.S. target), in the aggregate, must receive 5% or less of the transferee foreign corporation's stock (by vote and value).

2. Immediately following the transfer, officers, directors and 5% shareholders of the U.S. target, in the aggregate, must own 50% or less of the foreign transferee corporation (by vote and value).

3. In the case of a transfer occurring after Jan. 25, 1996, the transferee foreign corporation (or its affiliate) must have been engaged in an active trade or business that is substantial in comparison to the trade or business of the U.S. target for a 36-month period immediately preceding the transfer.

4. Either:

a. The U.S. person transferring U.S. target stock must not be a 5% shareholder of the transferee foreign corporation immediately after the transfer, or

b. If the U.S. person transferring U.S. target stock is a 5% shareholder of the transferee foreign corporation immediately after the transfer, that person must sign a gain recognition agreement to secure tax deferral on the resulting gain.

In determining post-transaction ownership, the attribution rules of Sec. 958 apply. In addition, under the second and fourth conditions, stock owned by U.S. persons after the transfer includes all stock owned, whether or not it was actually received in the exchange. If the U.S. target owns, directly or through attribution, stock of the transferee foreign corporation, that stock is not taken into account in determining whether the 50% threshold in the first two conditions are met (i.e., that stock is not treated as outstanding).

Presumption That Transferors Are U.S. Persons

Notice 94-46 included a presumption that, if a taxpayer cannot determine the ownership of the transferee corporation, U.S. transferors will be presumed to own 50% or more of the transferee foreign corporation immediately following the exchange. (Thus, according to the IRS, a transaction was presumed to be taxable unless the U.S. ownership threshold could be proven otherwise.) The new temporary regulations somewhat relax this presumption.

For purposes of the first condition described in the preceding section, the new regulations presume transferors of stock or securities in the U.S. target to be U.S. persons. To rebut the presumption, the U.S. target must obtain ownership statements from a sufficient number of non-U.S. transferors to show that the 50% threshold is not exceeded. Under Temp. Regs. Sec. 1.367(a)-3T (c) (6) (i), an ownership statement must be signed under penalties of perjury and must include the following information:

[] The identity and taxpayer identification number (TIN), if any, of the person making the statement.

[] The person making the statement is not a U.S. person (as defined in Temp. Regs. Sec. 1.367(a)-1T(d) (1)).

[] The stock or securities owned by the person making the statement are not attributable to any other U.S. person, or, if stock or securities are attributable, the identity and TIN of the other U.S. person (s).

[] The citizenship, permanent residence, home address and U.S. address, if any, of the person making the statement.

[] The amount of stock or securities (by voting and value) in the U.S. target owned by the person making the statement before the exchange and the amount of stock (by vote and value) in the transferee foreign corporation received in the exchange.

Temp. Regs. Sec. 1.367(a)-3T(c)(4)(ii) requires that certain information about these ownership statements, and about other matters, be attached to the U.S. target's income tax return for the tax year that includes the transfer.

The IRS has relaxed this presumption somewhat with respect to the determination of U.S. transferors that own the transferee foreign corporation (the second condition described in the preceding section). The notices and the proposed regulations presumed that U.S. transferors owned enough stock in the transferee foreign corporation independent of the exchange to bring their total ownership up to the 50% threshold. Notice 94-46 also stated that, if all U.S. transferors owned, in the aggregate, 50% or more of the transferee foreign corporation (by vote and value) immediately after the exchange, all U.S. transferors, regardless of their level of ownership, would recognize gain on the transfer.

The new temporary regulations no longer apply this presumption. However, if the second condition is not met (i.e., officers, directors and 5% shareholders of the U.S. target own, in the aggregate, more than 50% of the transferee foreign corporation after the transfer), the presumption will apply and the exchange will be taxable to all U.S. transferors. Taxpayers may generally rely on Schedule 13-D or 13-G filings made under the Securities Exchange Act of 1934 to identify 5% shareholders of public companies for this purpose. These reports are generally required for persons who acquire directly or indirectly ownership of 5% or more of a registered U.S. corporation.

In addition, this presumption of 50% ownership by U.S. transferors under Notices 87-85 and 94-46 will continue to apply (unless rebutted) for purposes of determining whether a five-year or 10-year gain recognition agreement is required.

Transferee's Active Trade or Business Requirement

For transfers after Jan. 25, 1996, the new temporary regulations require the transferee foreign corporation (or its affiliate) to have been engaged in the active conduct of a trade or business for the entire 36-month period prior to the transfer. That business must also be substantial in relation to the U.S. target's business. An affiliate is a corporation that is a member of the same affiliated group, as defined in Sec. 1504(a) without regard to Sec. 1504(b) (3), as the transferee foreign corporation (Temp. Regs. Sec. 1.367(a)-3T(c) (6) (vii)).

A trade or business is generally defined as a specific unified group of activities that constitutes (or could constitute) an independent economic enterprise carried on for profit, and is active if the corporation's officers and employees carry out significant managerial and operational activities (Temp. Regs. Sec. 1.367(a)-2T(b)). However, the term "substantial" is not defined in these temporary regulations. Therefore, there is no standard for determining whether the active trade or business requirement is met.

Term of the Gain Recognition Agreement

The new temporary regulations retain the rules in the old temporary regulations, as modified by the proposed regulations and Notices 87-85 and 94-46, with respect to the applicable term five years or 10 years) of a gain recognition agreement. If the first three conditions previously described are met, U.S. transferors that own (with attribution) less than 5% of the transferee foreign corporation are not taxable under Sec. 367(a) (1) and are not required to enter into a gain recognition agreement.

When all U.S. transferors own, in the aggregate, less than 50% of the stock (by vote and value) of the transferee foreign corporation immediately after the transfer (whether or not the stock was received in the transfer), a gain recognition agreement is required to preserve tax-free treatment; its term is five years for any U.S. transferor owning at least 5% of the foreign transferee corporation. When all U.S. transferors own, in the aggregate, 50% or more of the transferee foreign corporation's stock (by vote or value) (whether or not the stock was received in the transfer), or the 5% shareholder of the transferee foreign corporation cannot determine the total amount of the transferee foreign corporation's stock owned by all U.S. transferors, the term of the required gain recognition agreement is 10 years for any U.S. transferor owning at least 5% of the foreign transferee corporation.

Reporting Requirements of U.S. Target

To satisfy the gain recognition agreement requirements, the U.S. target must provide certain information on its timely filed income tax return for the year that includes the transfer. Under Temp. Regs. Sec. 1.367(a)-3T(c)(4)(i), in addition to the information provided by each U.S. transferor on its income tax return, the U.S. target must now include information on its return with respect to the transfer. (See also Temp. Regs. Secs. 1.367(a)-3T(g) and 1.6038B-1T(c).) Failure to comply with these new additional disclosure requirements could result in the loss of nonrecognition treatment, even if all of the other conditions for nonrecognition are met.

These new rules are likely to be troublesome and represent a trap for the unwary. In addition to requiring significant information, they place the onus for collecting and reporting the information on the U.S. target, which is not directly affected by the tax consequences of the transfer and, therefore, may not be attuned to the filing requirements. Furthermore, the former U.S. shareholders of the U.S. target, who are directly affected, presumably are no longer in control of the corporation and therefore may not be able to ensure that the information is collected and reported properly. Reporting the transfer to the foreign corporation: The U.S. target must include a statement entitled, "Section 367 (a)--Reporting of Cross-Border Transfer Under Reg. [section] 1.367 (a)-3T (c) (4)." The statement must be signed by an officer of the corporation under penalties of perjury and must disclose:

[] A description of the transaction.

[] The percentage of the total voting power and the total value of stock of the transferee foreign corporation received in the transaction, in the aggregate, by persons who transferred stock or securities of the U.S. target or other property.

[] The amount (if any) of transferee foreign corporation stock owned directly or indirectly (applying the attribution rules of Sec. 267(c) (1) and (5)) by the U.S. target immediately after the exchange.

[] A statement that the second condition is met (officers, directors and 5% shareholders of the U.S. target own, in the aggregate, 50% or less of the foreign transferee corporation).

[] A list of U.S. persons who are officers, directors or 5% shareholders of the U.S. target and the percentage of the transferee foreign corporation owned by such persons (by vote and value) immediately before and immediately after the transaction.

[] A statement that the third condition--the active trade or business test--is satisfied by the transferee foreign corporation or an affiliate and a description of such business.

Rebutting the ownership presumption: Under Temp. Regs. Sec. 1.367(a)-3T(c) (4) (ii), if a U.S. target wishes to rebut the ownership presumption, in addition to collecting ownership statements from its non-U.S. shareholders, it must also attach to its timely filed income tax return for the year that includes the transfer a statement entitled, "Section 367(a)--Compilation of Ownership Statements under Reg. [section] 1.367(a)-3T(c)." The statement must be signed by an officer of the corporation under penalties of perjury and must disclose the following information:

[] The percentage of the total voting power and the total value of stock of the transferee foreign corporation received, in the aggregate, by U.S. transferors.

[] The percentage of total voting power and total value of stock of the transferee foreign corporation received, in the aggregate, by foreign persons that filed ownership statements.

[] A summary of the information tabulated from the ownership statements, including:

1. The names of the persons that filed ownership statements, stating that they are not U.S. persons.

2. The countries of residence and citizenship of such persons.

3. The ownership of such persons (by vote and value) in the U.S. target prior to the exchange and the amount of stock of the transferee foreign corporation (by vote and value) received by such persons in the exchange.

Timely Filed Return Requirement

For purposes of these reporting requirements, an income tax return (including an amended return) will be considered timely filed if it is filed before the IRS discovers that the reporting requirements have not been satisfied. This is useful for reporting failures discovered during due diligence, on change of tax advisers, and so forth.

It is important to note that the reporting requirements are retroactive to transfers after Apr 17, 1994. Therefore, if a return has been filed for a year that includes a transfer subject to the new regulations, an amended return containing the information necessary to comply with the requirements should be filed immediately. If an amended return is not filed and the Service discovers an omission, the IRS may require the U.S. transferor to recognize the gain.

Effective Dates

The new temporary regulations are generally effective with respect to transfers to a foreign corporation after Apr. 17, 1994. However, the active trade or business requirement of Temp. Regs, Sec. 1.367(a)-3T(c)(1) (iii) only applies to transfers that take place after Jan. 25, 1996.