Planning for the currency gap in dispositions of foreign subsidiaries.

Since the beginning of 2002, the U.S. dollar has significantly declined in value relative to other foreign currencies, most notably the European Union (EU) euro ([euro]). In addition, this period was preceded by an economic boom in the U.S. marked by considerable corporate capital investment. As companies continued to grow during the boom, many of their capital investments involved other markets, including foreign jurisdictions. Consequently, many multinational companies are currently holding large unrealized built-in-gains (BIGs) in their foreign investments, attributable to the devaluation of the U.S. dollar.

Example 1: U.S. company, U, contributes $100 to a newly formed EU company (NEWCo) on Jan. 1, 2002 when the conversion rate was approximately $1: 1 [euro]. NEWCo converts the U.S. dollars to euros immediately and purchases a piece of equipment for 100 [euro]. At the end of 2005, the exchange rate is approximately $1.20: 1 [euro]. Thus, the same assets of NEWCo would essentially be worth $120 for an unrealized BIG of $20. Historically, the swing could be as much as a 40% devaluation (i.e., a BIG) because the euro was considerably weaker than the dollar in 1999 and 2000.

To the extent a U.S. corporation invests in a foreign branch or noncorporate joint venture, this unrealized BIG on capital will be taxable on termination or remittance under Sec. 987. However, in the case of an investment in a foreign corporation (which also includes entities that elect to be treated as associations under Temp. Regs. Sec. 1.7701-3), several Code sections and affiliated regulations must be considered. The effect of these sections may minimize the taxability of the gain on recognition.

Example 2: The facts are the same as in Example 1. Under Sec. 985, transactions must be conducted in the taxpayer's (U's) functional currency, which include determinations of basis and gain. As a result:

* U's initial contribution of $100 cash to NEWCo would be tax free under Secs. 351 and 367(a).

* Pursuant to Sec. 358, U (with a U.S. dollar functional currency) would have a substituted basis in the NEWCo stock of $100.

* Absent special circumstances or elections, NEWCo's functional currency will be the euro, generating a tax basis in its assets of 100 [euro] under Sec. 362.

* U.S. tax and earnings and profits (E&P) principles will generally depreciate foreign-located assets using the straight-line method.

There is a five-year life asset for both foreign tax and U.S. E&P purposes. Also, another EU party would like to purchase NEWCo or its assets for the fair market value (FMV) of the net assets. At the end of 2005, the following tax attributes are noted:

U.S. tax basis in stock = $100

NEWCo tax basis in assets = 20 [euro] (FMV 100 [euro])

NEWCo E&P = (80 [euro])

Depending on how the sale transaction is structured, the U.S. tax cost may be different, due primarily to the recognition of foreign-currency exchange gain.

If NEWCo is a disregarded entity (i.e., a branch or hybrid), the U.S. income tax results would be similar, regardless of whether the stock or assets are sold. Both would be considered an asset sale by the entity, followed by a termination. Although the basis for computing gain on an asset sale is the functional currency of the qualified business unit, the mechanics of the Sec. 987 regulations require the recognition of the currency gain on capital by the U.S. company when the branch or hybrid terminates or remits cash back to the parent, which is termed a Sec. 987 gain or loss. These mechanical rules would result in a tax on the $25 BIG over the life of the branch or hybrid. Although the mechanics are confusing, based on the mixture of average and spot exchange rates (which are outside the scope of this item) the Sec. 987 gain or loss will trigger any previous unrecognized fluctuation in the rate applied to capital on final termination or remittance.

For a corporation, however, the answer could be different, due primarily to the nonexistence of any exchange gain or loss calculation on capital for liquidating distributions of certain controlled foreign corporations. In contrast to the Sec. 987 gain or loss rules, and although contained in previous notices, Regs. Sec. 1.367(b)-3(b)(3)(iii) has reserved recognition of exchange gain or loss with respect to capital for repatriations of foreign assets in nonrecognition transactions, such as Sec. 332 liquidations and reorganizations. Based on the above examples, the different treatment of a stock sale and an asset sale can be illustrated. To the extent that U sold NEWCo stock, it recognizes capital gain of $25 (with the assumption that there would be no foreign tax because there is no gain or loss, and there is no Sec. 1248 pick-up because E&P is negative) . This is calculated as the amount realized of $125 (100 [euro] x 1.25 exchange rate) less the outside basis in the stock of $100. Note: the calculation must be in dollars, as that is the functional currency of U (the seller in this case).

However, if NEWCo first sold its asset and than liquidated into the U.S. corporation, it would have some amount of euro income for foreign purposes, due to the depredation taken in prior years (which income is offset by the net operating loss generated in the prior years by the deductions, so no tax would be due). NEWCo would also have 80 [euro] of E&P on the sale of the asset. The consequences of this are shown in the exhibit above.

As seen above, NEWCo now holds cash of 100 [euro], which is worth $125. To the extent NEWCo liquidates and distributes the 100 [euro], the U.S. corporation would be able to exchange this immediately into $125 and avoid tax on the $25 exchange gain. In this case, the liquidation of the wholly owned subsidiary would be tax free under Sec. 332. Because there is no E&P, there would be no inclusion under Sec. 367(b), nor does it appear that Sec. 367(b) or any other Code section would require taxable exchange gain on the capital; see Regs. Sec. 1.367(b)-3(b) referenced above. Note: if there was accumulated E&P, exchange gain would be recognized on the E&P because the deemed dividend would be included at the spot rate of the liquidation. However, this would not affect the treatment of the original capital returned.

Conclusion

Due to the drastic change in value of the dollar, the exchange fluctuations that were once considered immaterial could now result in unexpected gain on transactions involving disregarded and corporate entities. The potential ability to minimize this gain can create enhanced cash value in structuring and negotiating foreign corporate transactions. As in any major transaction, proper care and effort in modeling the tax effects of alternative structures should be undertaken by tax advisers to help their clients realize this value.

FROM CHRISTOPHER ARNDT, J.D., MINNEAPOLIS, MN

Exhibit: Effect of foreign subsidiary sale of assets

         U.S. Tax basis         NEWCo tax basis          NEWCo E&P
            in stock               in assets

Change        $100         20 [euro] (FMV 100 [euro])   (80 [euro])
after          --          80 [euro]                     80 [euro]
sale          $100        100 [euro] cash                 0 [euro]