The IRS closes another tax loophole.

Transfers of domestic corporations' stock to foreign corporations no longer are tax-free if the U.S. transferors collectively own more than 50% of the stock.

Tax code section 367(a) covers nonrecognition transactions involving transfers by U.S. individuals to foreign corporations. Even if a transaction appears to be tax-free (for example, under Internal Revenue Code section 351 or its reorganization provisions), the involvement of a foreign corporation makes it taxable.

According to notice 87-85, however, a transfer of stock to a foreign corporation by a U.S. individual is not taxable even if he or she (1) owns less than 5% of the foreign company's stock or (2) owns 5% or more of the foreign corporation's stock but executes a gain-recognition agreement. In the latter case, the tax exemption is predicated on the U.S. transferee's agreement not to sell the U.S. corporation's stock for a specified period of time--typically, 5 to 10 years, depending on the U.S. transferors' level of ownership as a group.

Helen of Troy Corp. was a Texas corporation until it reincorporated as a Bermuda company in February 1994 and changed its name to Helen of Troy Ltd. Since the original Helen of Troy's operations were, for the most part, conducted overseas, its subsidiaries were considered controlled foreign corporations (CFCs). Tax code section 956 requires that a U.S. shareholder of a CFC treat amounts lent to it by the CFC as dividends. As a result, Helen couldn't tap into its subsidiaries' resources without incurring taxes on dividend income and was forced to borrow funds from U.S. banks.

The restructuring, with Helen's becoming the subsidiary of a newly created Bermuda company, enabled it to circumvent this rule by revoking the CFC status of its former subsidiaries. Under notice 87-85, the stock swap was tax-free to Helen's shareholders.

The IRS sought to minimize the potential for tax avoidance in such cases by issuing notice 94-46 on April 19, 1994. After April 18, a domestic corporation's transfers of stock to foreign corporations are taxable if the U.S. transferors collectively own 50% of the transferee's stock. In effect, this notice eliminates exemptions for 5%-and-under stockholders.

Observation: The silver lining to this change in the tax law is that it will have no effect on legitimate acquisitions involving unrelated parties, even when the 50% ownership level is breached. The change reduces the potential for improving an operating company's tax situation by creating a holding company.

--Robert Willens, CPA, managing director at Lehman Brothers, New York City.