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Submitted By: John Doe

Subject: Treas. Reg. 1.367(b)-3(c)(3) Election Where Foreign Corporation has E&P Deficit

Date/Time: Wed June 5 15:55:23 EDT 2002

FACTS

Canco is a publicly traded Canadian company whose shares are estimated to be held 30 percent by U.S. persons and 70 percent by Canadian persons. Canco is believed to have a current and accumulated deficit in earnings and profits.

Canco wishes to structure itself with a U.S. corporate parent. Assume that this would be accomplished by means of a migration of the Canadian company treated as section 368(a)(1)(F) reorganization into a U.S. corporation. Thus, from a U.S. tax perspective, there would be a reorganization of a foreign corporation into a U.S. corporation (inbound reorganization under section 1.367(b)-2(f)).

Treas. Reg. 1.367(b)-2(f) treats a section 368(a)(1)(F) reorganization, including a mere change in the place of organization or incorporation, as a deemed asset transfer. As such, the transaction would obtain nonrecognition treatment only by being characterized as a C or D reorganization. Thus, the transaction would be subject to Treas. Reg. 1.367(b)-3, which is applicable to an acquisition by a domestic corporation of the assets of a foreign corporation in a liquidation described in section 332 or an asset acquisition described in section 368(a)(1).

U.S. Persons that ARE U.S. Shareholders

Treas. Reg. 1.367(b)-3(b)(3) requires an exchanging shareholder that is a []United States Shareholder[] of the foreign acquired corporation to include in income as a deemed dividend the all earnings and profits amount with respect to its stock in the foreign acquired corporation, Canco.

The term []United States Shareholder[] means any shareholder described in section 951(b) without regard to whether the foreign corporation is a controlled foreign corporation. Treas. Reg. 1.367(b)-3(b)(2), Section 951(b) defines []United States Shareholder[] as a U.S. person who owns or is considered to own by applying the attribution rules, 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation. Thus, if Canco has U.S. shareholders that hold 10 percent or more of the vote of Canco, then such shareholders would be required to recognize their share of the all earnings and profits amount of Canco. Assuming that Canco has a deficit in E&P, such shareholders would have no income inclusion.

U.S. Persons that ARE NOT U.S. Shareholders

Treas. Reg. 1.367(b)-3(c)(1) requires an exchanging shareholder that is a U.S. person not meeting the definition of []United States shareholder[] shall recognize gain with respect to the stock of the foreign acquired corporation. Such shareholders may have an election available to them to instead recognize their share of the foreign corporation's all E&P amount in lieu of recognizing gain on their shares Treas. Reg. 1.367(b)-3(c)(3). Certain requirements must be met.

(We note that a de minimis exception applies, and no gain is required to be recognized under Treas. Reg. 1.367(b)-3, in the case of shareholders whose stock in the foreign acquired corporation, i.e. Canco, has a fair market value of less than $50,000 on the day of the exchange. Treas. Reg. 1.367(b)-3(c)(4).)

QUESTION

Can the U.S. persons who are not []U.S. Shareholders[] make a valid election under Treas. Reg. 1.367(b)-3(c)(3) where Canco has a deficit in E&P?

CONCLUSION

Small shareholders (U.S. persons who are not U.S. shareholders) can make a valid election under Treas. Reg. Sec. 1.367(b)-3(c)(3) to include the E&P amount (if any) rather than to recognize their realized gain on the section 367(b) exchange.

ANALYSIS

The domestication of Canco is treated for U.S. tax purposes as if Canco transferred all of its assets to a new USCO in exchange for stock, followed by a distribution of that stock to Canco shareholders. This is essentially a D reorganization. Your analysis is correct that the transaction would be subject to section 367(b) and section 1.367(b)-3.

Section 1.367(b)-3(c) provides the rules for applying section 367(b) to less than 10% U.S. shareholders in the foreign corporation. The rule for greater than 10 percent U.S. shareholders is contained in section 1.367(b)-3(b)(3)(i) which requires those shareholders to include into income their all E&P amounts irrespective of the gain realized in the transaction. A different rule was provided to the less than 10% shareholders (small shareholders) by the IRS as an administrative convenience. See preamble to TD 8862. Specifically, the government was concerned that those small shareholders might not have the information available to accurately determine their all E&P amount. Thus, the general rule under section 1.367(b)-3(c)(2) is that the small shareholders must recognize their realized gain (and not the loss) with respect to their stock in the foreign corporation.

However, there are times where the all E&P amount would be less than the gain realized in a reorganization. The IRS acknowledged that the small shareholders would want to include the all E&P amount in those situations, rather than their realized gain. Thus, the IRS promulgated section 1.367(b)-3(c)(3). See preamble to TD 8862. This provision provides the small shareholders with an election to include their all E&P amount into income as a deemed dividend, and not to recognize the realized gain. There are two restrictions placed on a taxpayer's ability to make this election: (1) The foreign corporation must have provided the small shareholder with the information necessary 1to substantiate that shareholder's all E&P amount, and (2) the small shareholder must comply with the section 367(b) notice requirements in section 1.367(b)-1(c) including the specific provision related to this election.

Aside from the normal section 367(b) notice requirements, a small shareholder must also satisfy section 1.367(b)-1(c)(4)(vii) which requires that shareholder to include in their notice statement: (1) a copy of the information the shareholder received from the foreign corporation establishing and substantiating the shareholder's all E&P amount, (2) a representation that the small shareholder has notified the foreign corporation that the shareholder is making the section 1.367(b)-3(c)(3) election, and (3) a statement that the shareholder is making the election described in section 1.367(b)-3(c)(3).

However, there is a special notice provision where the foreign corporation never had E&P that would result in any shareholder having an all E&P amount. Section 1.367(b)-1(c)(5) provides an abbreviated notice provision in that circumstance. The abbreviated notice must include: (1) a statement from the foreign corporation that it never had any E&P that would result in any shareholder having an all E&P amount, and (2) the information described in section 1.367(b)-1(c)(4)(i) through (iii).

COMMENTS

It may be helpful to verify how foreign taxes paid by Canco (CAN) are treated after the migration.

Prepared by: Mark Harris

Mark Harris, who recently joined Ernst & Young from the federal government. His areas of concentration are International M&A, check-the-box, section 367, and international partnership issues, He was with the Office of Associate Chief Counsel (Pass-throughs and Special Industries, and International). While with the Pass-throughs and Special Industries office, Mark was primarily responsible for drafting the final check-the-box regulations under section 7701. He assisted in drafting the proposed conversion regulations under section 7701, and other guidance with respect to single member entities, check-the-box, and S corporations. He also worked with various partnership issues. While with the International office, Mark was primarily responsible for drafting the final section 367(b) regulations (the regulations involved in this question) and the proposed extraordinary transaction regulations. He assisted in drafting the final conversion regulations under section 7701.

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Author:Harris, Mark
Publication:Tax Executive
Date:May 1, 2002
Words:1422
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