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"Check-the-box" prop., regs. - extraordinary transactions could cause extraordinary results.

Recently issued proposed regulation contain amendments to the check-the-box regulations. Regs. Secs. 301.7701-2 and -3 could alter the tax treatment of a common transaction involving the transfer of the stock of a U.S. corporation's foreign subsidiary to another foreign subsidiary controlled by the same U.S. corporation, followed by a liquidation of the transferred foreign subsidiary.

Common Transaction and Existing Tax Treatment

If a U.S. parent transfers all the stock of one of its foreign subsidiaries to another of its foreign subsidiaries in a transaction that qualifies as a B reorganization or a Sec. 351 transfer, the transfer will be treated as an outbound transfer of stock subject to Sec. 367. The U.S. parent will, therefore, be required to file a five-year gain recognition agreement (GRA), generally binding the U.S. parent to recognize gain if the transferee foreign corporation disposes (in full or in part) of the stock of the transferred foreign corporation within the five-year period following the close of the tax year of the initial transfer. If, however, the B reorganization or Sec. 351 transfer is followed, as part of the plan, by a liquidation of the transferred corporation, applicable Federal tax principles convert the stock transfer to an asset reorganization. That is, the integrated transaction is treated as if the transferred foreign corporation transferred all of its assets to the transferree foreign corporation in what typically qualifies as a C, D or F asset reorganization; see, e.g., Rev. Rul. 67-274 (B reorganization followed by a liquidation of the transferred corporation tested as a C reorganization) and Rev. Rul. 76-123 (Sec. 351 transfer of a corporation's stock followed by a liquidation of that corporation tested as a C reorganization). Under this recast, the transfer of the assets from one foreign subsidiary to another in an asset reorganization is generally not considered an outbound stock transfer by the U.S. parent (unless the indirect stock transfer rules of Sec. 367(a) apply), and the U.S. parent is not required to file a GRA.

The existing check-the-box regulations provide that the tax treatment of a change-in-entity classification is to be determined based on all applicable Federal income tax principles, including the step-transaction doctrine (Regs. Sec. 301.7701-3(g)(2)). Relying on that language, taxpayers have taken the position that the recast from an outbound stock transfer to a foreign-to-foreign asset reorganization will also apply if the liquidation is a deemed liquidation resulting from a check-the-box election of the transferred foreign corporation.

Example: A domestic corporation, P, has two wholly owned foreign subsidiaries--A and B. If P transfers the shares of A to B solely in exchange for B shares in a tax-free transaction (i.e., in a B reorganization, a Sec. 351 transaction or both), the transfer would be an outbound transfer of A stock. Thus, P would need to file a GRA. If, however, as part of the same plan, A makes a check-the-box election to be treated as a disregarded entity (resulting in a deemed liquidation of A into B), the transaction would be treated as if A had transferred its assets to B in exchange for additional B shares, which were then distributed to P in the liquidation of A. The integrated transaction should generally qualify as a D reorganization of A into B. P would no longer need to file a GRA.

Prop. Regs.

Prop. Regs. Sec. 301.7701-3(h) seeks to alter this outcome. The proposal would invalidate a check-the-box election if an "extraordinary transaction" occurs within a specified time period. If the check-the-box election is invalidated, in the example, there would be no deemed liquidation of the transferred foreign corporation (A), the transaction would not be converted from an outbound stock transfer to a foreign-to-foreign asset reorganization, and P would be required to recognize gain, absent a GRA.

An "extraordinary transaction" is defined as one in which a 10%-or-greater interest in a foreign corporation wishing to make a check-the-box election (the foreign eligible entity) is sold, exchanged, transferred or otherwise disposed of. Although this language contains some ambiguities, it would certainly capture the transaction described in the example, in which a 100% interest in A was transferred. The extraordinary transaction could nevertheless escape the invalidation of the check-the-box election if it did not occur within a certain time period. Unfortunately, such an escape is uncertain, because that time period is described broadly in the proposed regulation. The requisite time period includes extraordinary transactions that "occur (or are treated as occurring) in the period commencing one day before and ending 12 months after" the check-the-box election. (Emphasis added.)

Focusing on the "one day before" language might lead taxpayers to believe that the problem presented by the proposed regulation could be obviated simply by transferring A's stock and then waiting two or three days before making the check-the-box election. The problem is with the phrase "or are treated as occurring." The IRS has informally indicated that this language is designed to capture transfers days, weeks or even months before the check-the-box election, if those transfers are pursuant to a unified plan. This presents a "catch-22" for taxpayers; the stock transfer cannot be isolated from the check-the-box election unless it is not part of the same plan as the check-the-box election. But if the transfer and subsequent deemed liquidation are not pursuant to the same plan, the recast of an outbound stock transfer into a foreign-to-foreign asset reorganization may not occur. These proposed regulations could also produce negative tax consequences in other international reorganization transactions.

This regulation is proposed to be effective on or after the date the final regulation is published in the Federal Register. Although the effective-date language in the proposed regulation is unclear, the final regulation may apply to transactions in which either the check-the-box liquidation or the extraordinary transaction occurs on or after the date on which the final regulation is issued. Because it is not known when this proposed regulation might be finalized, taxpayers are well advised to complete transactions that rely on the treatment described in the example above as soon as possible (and to be careful to avoid a second extraordinary transaction during the subsequent 12-month period).

(Authors' note: The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.)

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Title Annotation:IRS regulations
Author:Zent, Brenda
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jun 1, 2000
Previous Article:Revenue Ruling allows deduction for asset removal costs.
Next Article:Constructive sales treatment for appreciated financial positions.

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