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Proposed section 367 regulations.

On August 23, 1991, the Internal Revenue Service issued proposed regulations under section 367 of the Internal Revenue Code, relating to the transfers of stock or securities by U.S. persons to foreign corporations, and foreign liquidations and reorganizations. The regulations were published in the Federal Register on August 26, 1991 (56 Fed. Reg. 41993), and in the September 23, 1991, issue of the Internal Revenue Bulletin (1991-38 I.R.B. 6). The IRS held a public hearing on the regulations on November 22, 1991.

The proposed regulations would replace the current temporary regulations issued at various times from 1977 through 1990, some of which were reissued as final and temporary regulations. The proposed regulations would also incorporate changes announced in notices issued by the IRS during the last few years, particularly Notice 87-85, 1987-2 C.B. 395. For simplicity's sake, the temporary regulations are referred to collectively as the "temporary regulations"; the proposed regulations are referred to as the "proposed regulations." Specific provisions are cited as "Temp. Reg.[SECTION]" and "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

BACKGROUND

Tax Executive Institute is the principal association of corporate tax executives in North America. Our 4,800 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 367 relating to the transfers of stock or securities by U.S. persons to foreign corporations and foreign liquidations and reorganizations.

INTRODUCTION

Section 367 was enacted to prevent taxpayers from utilizing the nonrecognition provisions of the Internal Revenue Code to effect a tax-free transfer of appreciated property beyond the reach of the U.S. taxing authority and to preserve the taxation of the accumulated profits of controlled foreign corporations. H.R. Rep. No. 94-658, 94th Cong., 1st Sess. 242 (1975). Mechanically, the statute accomplishes these results by establishing separate rules for two types of transactions: (i) transfers of property from the United States (so-called outbound transfers); and (ii) other transfers, including transfers into the United States ("inbound transfers") and exclusively foreign transfers.

Section 367(a) reaches "outbound" transactions: If a U.S. person transfers property to a foreign corporation in an exchange described in section 332, 351, 356, or 361 of the Code, the transferee foreign corporation will not be considered a corporation "for purposes of determining the extent to which gain shall be recognized on such transfer." The denial of corporate status to the transferee effectively precludes the taxpayer from using the nonrecognition previsions of the Code and renders the transfer taxable. An exception is provided under section 367(a)(3) for outbound transfers of property to be used by the transferee in the "active conduct" of its trade or business outside the United States. In addition, section 367(a)(6) gives the Secretary of the Treasury broad authority to provide additional exceptions to recognition treatment.

Section 367(b) reaches "inbound" and foreign-to-foreign transactions: In the case of any exchange not described in section 367(a), the foreign corporation will be treated as a corporation "except to the extent provided in regulations prescribed by the Secretary which are necessary or appropriate to prevent the avoidance of Federal income taxes."

The proposed regulations are a welcome simplification of many of the existing rules. For example, the elimination of the temporary regulations' unwieldy earnings and profits attribution rule and the requirement that the section 367(b) notice simply be attached to the return (rather than filed separately with the IRS District Director) will ease compliance burdens for taxpayers and the government alike. In addition, the Institute is particularly pleased that the penalty for failure to file the required notice will be determined under the general penalty provisions of the Code; this change represents a significant improvement over the facts and circumstances test in the temporary regulations which accord the IRS significant leeway in determining whether the foreign corporation will be treated as a corporation. We also welcome the confirmation that a taxpayer's failure to comply with the terms of a gain recognition agreement will be subject to a "reasonable cause" exception.

These helpful changes notwithstanding, there remain several areas in which the proposed regulations could be improved. In particular, we believe that the retention of the amended return and interest requirement provided in Notice 87-85 not only adds significantly to the administrative burdens placed on taxpayers, but will also exact an excessive monetary penalty. As set out in more detail below, the Institute recommends that the requirement be eliminated.

SPECIFIC COMMENTS

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

Transfers of Stock or Securities

to Foreign Corporations

a. Transfers of Domestic Corporation Stock. Prop. Reg. [SECTION] 1.367(a)-3 generally reflects the outbound stock transfer rules of Notice 87-85, 1987-2 C.B. 395. Under the proposed regulations, a transfer of stock or securities by a U.S. person to a foreign corporation will not be subject to section 367(a)'s gain recognition requirements if, immediately after the transfer, any of the following conditions is met --

i. The U.S. person owns less than 5 percent of the total voting power and value of the foreign corporation's stock;

ii. All U.S. transferors own in the aggregate less than 50 percent of the total voting power and value of the foreign corporation and enter into a 5-year gain recognition agreement (GRA); or

iii. All U.S. transferors own 50 percent or more of the total voting power and value of the foreign corporation and enter into a 10-year GRA.

Under Prop. Reg. [section] 1.367(a)-3(b)(3), however, nonrecognition treatment is not available to 5 percent or more shareholders if a single U.S. person transfers stock or securities of a domestic corporation and, immediately after the transaction, that transferor owns more than 50 percent of either the total voting power or total value of the foreign corporation. A GRA is not permitted in these circumstances. (Under Notice 87-85, recognition of gain is required only by the majority shareholder, not by unrelated, minority shareholders.)

The rationale for the gain recognition requirement for more-than 50 percent shareholders is presumably to deter taxpayers from attempting to obtain tax benefits by deconsolidation through foreign affiliates. We suggest, however, that the regulations are overbroad in scope. (1) Thus, we believe that a GRA should be permitted for domestic stock transfers where the transferor owns more than 50 percent of the foreign transferee stock. In addition, the final regulations should not require gain recognition by unrelated minority shareholders.

b. The Section 368(a)(l)(B)/Section 351 Overlap. Under the current rules, outbound stock transactions subject to both sections 351 and 368(a)(1)(B) are covered by the section 367(b) regulations, not the section 367(a) regulations. Accordingly, no GRA is required under Temp. Reg. [SECTION] 1.367(a)-3T(d)(l). In contrast, under Prop. Reg. [SECTION] 1.367(a)-3, if a U.S. transferor transfers stock of a foreign corporation to another foreign corporation in a transaction that falls within both section 368(a)(l)(B) and section 351, the transferor is required not only to enter into a 5-year GRA under section 367(a), but also to satisfy the conditions of the section 367(b) regulations.

TEI submits that subjecting transactions to both section 367(a) and section 367(b) is contrary to the express language of section 367(b), which unequivocally exempts from its scope transactions "described in" section 367(a). Moreover, the requirement for a gain recognition agreement is duplicative since the subsequent disposition of stock of the transferred foreign corporation by the U.S. transferor would be subject to U.S. tax under section 1001 or as Subpart F income pursuant to section 954(c)(l)(B). The approach taken in Temp. Reg. [SECTION] 1.367(a)-3T should therefore be retained.

c. Indirect Transfers. The proposed regulations significantly expand the rules relating to indirect stock transfers. Under Temp. Reg. [SECTION] 1.367(a)-1T(c)(2), the indirect transfer rules apply only if each of the parties to the reorganization, other than the foreign corporation whose stock is the consideration for the transaction, is domestic. Prop. Reg. [SECTION] 1.367(a)-3(d) provides, however, that transactions in which one or both of these corporations are foreign will be treated as stock transfers within the scope of section 367(a) and therefore subject to the GRA requirements.

Under Prop. Reg. [section] 1.367(a)-3(d)(1)(iv), a transfer of assets in exchange for stock of a foreign corporation pursuant to a triangular reorganization is treated as a transfer of stock to a foreign corporation subject to section 367(a). Moreover, under Prop. Reg. [SECTION] 1.367(a)-3(d)(1)(v), a transfer of assets to a foreign corporation pursuant to section 368(a)(l)(C), followed by a drop-down of assets to a subsidiary of the transferee -- which had previously been treated as an asset transfer under section 367(b) -- is now treated as an indirect stock transfer under section 367(a). Such treatment seems contrary to the policy underlying the nonrecognition principles of sections 351, 354, and 361.

TEI submits that such transactions should not be treated as transfers of stock to which section 367(a) applies. Where assets are ultimately transferred to a foreign corporation controlled by a domestic corporation, section 367(a) treatment is unnecessary because the entire deferred gain remains within the U.S. taxing jurisdiction. The domestic transferee corporation will be subject to U.S. tax on a subsequent disposition of the stock received, and the domestic transferor will be subject to U.S. tax on the subsequent transfer of the foreign corporation stock it receives.

TEI believes that the indirect transfer rules are unnecessarily complex and characterize transactions differently for domestic and international tax purposes. Section 367(a) was intended to tax outbound transactions in which the assets might escape U.S. taxation. To the extent that the transferred assets remain within the U.S. taxing jurisdiction, the transaction is beyond the scope of section 367(a).

d. "Cascading" Section 351 Transactions. Under Prop. Reg. [SECTION] 1.367(a)-3(d)(1)(vi), a "cascading" section 351 transaction (i.e., a transfer of stock or assets to a foreign corporation pursuant to section 351, followed by a second "drop down" pursuant to section 351) is treated as a transfer of stock to the ultimate transferee subject to section 367(a). See Prop. Reg. [SECTION] 1.367(a)-3(d), Example 10.

Section 367(a)(3) of the Code provides an exception to gain recognition for certain property transferred to a foreign corporation for use in the "active conduct" of its trade or business outside the United States. There is no logical basis for subjecting successive asset transfers to gain recognition agreements while requiring single-step asset transfers to satisfy only the active use test. Indeed, treating successive section 351 transactions in this manner is contrary to the IRS's own rulings on this issue. See Rev.Rul. 77-449, 1977-2 C.B. 110, amplified by Rev. Rul. 83-156, 1983-2 C.B. 66. Moreover, in the case of a transfer of stock, the successive transaction would already be covered by the provisions of Prop. Reg. [SECTION] 1.367(a)-3(a). TEI submits that the proposed regulations are unwarranted and add to the taxpayer's administrative burden without serving any sound policy need.

2. Prop. Reg. [section] 1.367(a)-8:

Gain Recognition Agreements

a. Amended Return Requirement. Prop. Reg. [SECTION] 1.367(a)-8 provides the rules for GRAs entered into with respect to transferred stock and securities. Subparagraph (b)(2) of that regulation generally provides that, if the transferee foreign corporation disposes of the transferred property within 10 years of the initial transfer, the transferor must file an amended return for the year of the transfer and recognize the gain realized (but not recognized) upon the initial transfer. An interest charge is imposed on the deferred gain relating back to the year of the initial transfer under Prop. Reg. [section] 1.367(a)-8(a)(3)(vi). The preamble to the proposed regulations requests comments on these requirements.

We submit that the amended return and interest charge requirements in the proposed regulations make no sense on either an administrative or tax policy basis. The filing of an amended return is a costly administrative burden that should not be routinely inflicted on taxpayers. The filing requirement not only imposes additional burdens with respect to the federal return, but also triggers filing requirements with respect to state returns. In addition, we believe the GRA requirement is conceptually flawed. If nonrecognition treatment were proper when the initial transfer occurred, then the taxpayer should not be required to "undo" the transaction based on a subsequent(and often unforeseen) event.

Moreover, TEI objects to regulations that penalize taxpayers for the form of their transaction. If the taxpayer had simply retained the stock and sold it directly, it would recognize gain in the year of the sale and no interest charge would be incurred. An intervening event that resulted in nonrecognition treatment should not change this outcome. There is no sound tax policy reason for imposing a higher cost on a taxpayer that transferred the property to a related entity prior to disposition.

The interest charge imposed under the amended return requirement appears unprecedented. In the domestic tax area, for example, the reorganization rules of section 368 do not impose interest upon subsequent dispositions. Nor do the deferral rules set forth in section 704(c) (relating to the distribution of partnership property) or Treas. Reg. [SECTION] 1.1502-13 (relating to deferred intercompany transactions). Finally, in the international tax area, the other section 367 deferral rules do not retroactively tax the initial transfer of the property. See also I.R.C. [SECTION] 1248(f) (relating to nonrecognition transactions in the foreign context).

For these reasons, we believe that the amended return requirement should be eliminated from the final regulations. The appropriate time to commence the running of interest is from the year in which gain is recognized, i.e., the year in which the subsequent disposition occurs.

b. Term of the Agreement. The theory behind the GRA requirement is that, if the foreign transferee sells the property within a relatively short time, then the U.S. transferor should be presumed to have transferred the property with the intent that the property would be so disposed of. We question, however, whether such a presumption is valid when the sale occurs a significant period of time after the initial transfer. Thus, is it realistic or logical to presume that the sale of a property as much as 10 years later was contemplated when the initial transfer took place? Such an approach unfairly penalizes taxpayers that may be required to dispose of property for non-tax economic reasons.

Ten years is clearly too long a period of time to presume such a motive. We suggest that five years is adequate to vindicate section 367's tax policy; such an approach would be consistent with the proposed rule for stock transfers to non-CFCs under Prop. Reg. [SECTION] 1.367(a)-3(c)(l).

c. Reasonable Cause Exception. Prop. Reg. [SECTION] 1.367(a)-8(h)(1) provides that a failure to comply with the regulations will result in the initial transfer of property being subject to section 367(a)(1) and treated as a taxable exchange in the year of transfer. Under Prop. Reg. [SECTION] 1.367(a)-8(h)(2), the penalty will not apply if the failure was due to reasonable cause and not willful neglect and the taxpayer seeks to comply as soon as it becomes aware of the failure. Whether a failure was due to reasonable cause will be determined by the IRS District Director under all the facts and circumstances.

TEI commends the IRS for including a reasonable cause exception in the proposed regulations. As the proposed regulations recognize, penalties should not be routinely assessed against taxpayers who make a good faith effort to comply with the statute. We suggest, however, that the final regulations provide that the timely correction of an error or omission by the taxpayer creates a presumption that reasonable cause exists.

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

All Earnings and Profits

Amount

In the liquidation of a foreign subsidiary into its domestic parent under section 332 or an asset reorganization of a foreign subsidiary into a domestic parent under section 368(a)(1)(C), (D), or (F), the U.S. parent is generally required to include in gross income as a deemed dividend the subsidiary's "all earnings and profits amount" in order for the transaction to qualify for tax-free treatment. under the existing regulations, this term is computed under section 1248 principles without regard to whether the earnings and profits (E&P) accumulated before or after December 31, 1962, and is generally understood to include only the E&P accumulated after the foreign corporation became a CFC. See Treas. Reg. [SECTION] 7.367(b)-2(h).

Prop. Reg. [SECTION] 1.367(b)-2(d)(3) expands the definition of the "all earnings and profits amount" to mean the E&P of a foreign corporation determined (i) under the attribution principles of section 1248, (ii) without regard to whether the foreign corporation was a CFC at any time during the five years to the prior section 367(b) exchange, and (iii) without regard to whether the EAP of the foreign corporation were accumulated in post-1962 taxable years or while the corporation was a CFC. The preamble to the proposed regulations states that this change is intended to "clarify" the scope of the term.

We question whether it is appropriate for the United States to include in the all earnings and profits amount E&P that may have accumulated when the foreign corporation was owned solely by forein shareholders. Moreover, it may be extremely diffucult for a U.S. shareholder to obtain the records necessary to compute such E&P. It would also be a tremendous burden for the U.S. shareholder to reconstruct the foreign corporation's E&P based on records kept according to foreign accounting principles. In these circumstances, the expansion of the all earnings and profit amount definition to include E&P accumulated before the foreign corporation was a CFC is not only poor tax policy, but places a significant administrative burden on taxpayers. The definition in the existing regulations should be retained.

Prop. Reg. & 1.367(b)-2(d)(4) provides that the definition of the "all earnings and profit amount" shall be effective for all exchanges that occur on or after August 26, 1991 (the date the proposed regulations were published in the Federal Register). Thus, although the proposed regulations are generally not effective until final regulations are issued, the "all earnings and profits amount" definition will be applied retroactively in the final regulations.

In Technical Advice Memorandum 8924052 (Mar. 20, 1989), the IRS held that the "all earnings and profits amount" did not include E&P accumulated during the time the foreign corporation was not a CFC. Consequently, the expanded definition in the proposed regulations is not merely a clarification of existing law. TEI strongly objects to the retroactive application of the definition. The proposed regulations are not now binding on taxpayers and will not be effective for some time. Taxpayers should not be placed in limbo, forced to guess which definition might apply. We recommend that the definition of the "all earnings and profits amount" apply with respect to exchanges occurring after the issuance of final regulations.

4. Prop. Reg. [section] 1.367(b)-3(b)(2):

Recognition of Exchange

Gain or Loss

Prop. Reg. [Section] 1.367(b)-3(b)(2)(ii) requires the exchanging shareholder (as defined the Prop. Reg. [Section] 1.367(b)-(b)(3)(i)) to recognize exchange gain or loss to the extent that its share of the foreign acquired corporation's capital account has appreciated or depreciated by reason of changes in the relative exchange rates. The capital account is an amount reflected on the corporation's books as shareholder capital, contributed capital, paid-in capital, or any substantially similar account.

This new rule essentially requires the U.S. shareholders to track and value the exchange rates for each separate contribution to capital -- a tremendously complex burden for taxpayers and the government. We suggest that the requirement be eliminated. At a minimum, an adjustment to basis should be permitted. In addition, an exception should be included for liquidations or reorganizations in which the functional currency applicable to the acquired assets of the liquidated foreign corporation does not change (e.g., when the liquidated corporation becomes a qualified business unit of the acquiring domestic corporation).

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

Exchange of Stock by U.S.

Persons

The proposed regulations significantly change the income recognition requirements of small shareholders that the U.S. persons (i.e., an exchanging shareholder that owns less than 10 percent of the stock in the foreign acquired corporation). Under the temporary regulations, small shareholders are generally entitled to nonrecognition treatment on an inbound transaction. Under Prop. Reg. [Section] 1.367(b)-3(c), however, these shareholders are not only denied nonrecognition treatment on an inbound reorganization, but are also required to recognize gain (but not loss) based on the appreciation of shock.

TEI submits that, while it may be appropriate to tax U.S. shareholders on the repatriated earnings of a foreign corporation in an inbound transaction, gain recognition on the exchange of the stock of a shareholder is an inappropriate surrogate for the taxation of corporate E&P. The gain recognized on the appreciation in a particular shareholder's stock may bear no relationship to the amount of repatriated E&P allocable to such stock at the time of the reorganization. The inequity of a tax on the U.S. shareholders in connection with an inbound reorganization is particularly evident in the case of a foreign corporation with considerable going concern value that has historically distributed most of its E&P. In such a case, we see no policy justification for treating the U.S. shareholders of a foreign corporation differently from those of a domestic corporation.

The final regulations should permit small shareholders nonrecognition treatment if they would otherwise have qualified for such treatment. At a minimum, the final regulations should permit small shareholders that can obtain the necessary information to elect to include the all earnings and profits amount in income rather than recognize the gain on the exchange of the stock. In addition, the final regulations should permit the small shareholders to recognize losses.

6. Effective Dates

Prop. Reg. [Section] 1.367(a)-3 is generally effective for transfers occurring 30 days after the publication of the final regulations. Taxpayers may elect to apply this proposed regulation to transactions occurring after December 16, 1987, and before the effective date of the final regulations. A corresponding election is not available, however, with respect to the new GRA rules of Prop. Reg. [Section] 1.367(a)-8. Thus, for taxpayers electing the application of Prop. Reg. [Section] 1.367(a)-3, the GRA rules of Temp. Reg. [Section] 1.367-3T(g) will continue to apply.

TEI questions whether taxpayers will elect to apply Prop. Reg. [Section] 1.367(a)-3 retroactively if the requirements of Prop. Reg. [Section] 1.367(a)-8 are not available. In addition, the failure to permit such an election unnecessary complicates an already complex provisions. We therefore recommend that taxpayers be able to elect the application of both regulations on a retroactive basis. We also suggest that a similar election be permitted with respect to the proposed regulations under section 367(b).

CONCLUSION

Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations relating to transfers of stock or securities by U.S. person to foreign corporations and foreign liquidations and reorganizations. If you have any questions, please do not hesitate to call Raymond G. Rossi, chair of TEI's International Tax Committee, at (408) 765-1193, or Mary L. Fahey of the Institute's professional staff at (202) 638-5601.

(1) The rule seems especially improper in light of the enactment in 1989 of section 904(i), relating to the use of deconsolidation to avoid the foreign tax credit limitations.
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