Outbound Asset Transfer Guidance Under Section 367 Issued By The Treasury And Internal Revenue Service

While Christmas and the holiday gift giving may have passed, the Treasury and the Internal Revenue Service bundled up several "gifts" in the form of regulations under Section 367 that were issued on March 18, 2013 that have been long-awaited since proposed regulations were issued in this area in August 2008. The government generally maintained the framework set out in the August 2008 proposed regulations, though it did make some targeted changes to the proposed regulations' new elective exception under Section 367(a)(5), which allows a U.S. transferor to not recognize gain on a transfer of appreciated property in a Section 361 exchange if some conditions are met. Qualifying conditions include: (i) the requirement that the U.S. transferor be controlled per Section 368(c) by at least one but by no more than five domestic corporations (control group); (ii) gain recognition by the U.S. transferor; (iii) adjustments to basis of stock received by control group members are made; (iv) an agreement is made to amend or file a U.S. tax return to recognize gain; and (v) compliance with certain election and reporting requirements. Initial responses from members of the professional community overhaul have been favorable with the various rule-makings issued.

In T.D. 9614, the Treasury and the Internal Revenue Service finalized portions of the proposed regulations under Sections 367, 1248 and 6038B pertaining to the transfer of assets from domestic corporations to foreign corporations.

In T.D. 9615, the Treasury and the Internal Revenue Service issued guidance in the form of temporary regulations part of the 2008 proposed regulations pertaining to the Section 367(a) coordination rule exceptions and makes further revisions in temporary regulations of the February 2009 final gain recognition agreement regulations (see T.D. 9446) pertaining to outbound transfers of stock or securities.

The third "gift" delivered was REG-132702-10, which contains the text of the temporary regulations issued under T.D. 9615.

This post will cover the first of the three releases, T.D. 9614, 78 F.R. 17024-17052. The content summarizes the explanation provided in the Preamble to the rule-making.

Final Section 367(a)(5) Regulations: T.D. 9614

The 2008 proposed regulations (REG-209006-89; 73 FR 49278, 2008-41 IRB 867) issued on August 20, 2008, addressed Sections 367 and 1248 as well as the related reporting requirement rule in Section 6038B pertinent transfers of property by a domestic corporation to a foreign corporation in an exchange described in either Section 361(a) or (b), and certain nonrecognition distributions of stock of a foreign corporation by a domestic. See also 73 FR 56535; 2008-41 IRB 867). While no public hearing was held on the 2008 proposed regulations, the government did receive comments. Much of the 2008 proposed regulations, with certain modifications, are retained in the final regulations just issued. A portion of the same 2008 proposed regulations is also adopted, as modified, as temporary regulations in a second rule-making also issued on March 18, 2013. The temporary regulations also modify final regulations under Section 367(a) concerning transfers of stock or securities by a domestic corporation to a foreign corporation in a Section 361 exchange.

General Framework of Section 367(a)

Section 367(a)(1) provides, in general, that a taxable realization event occurs with respect to transfers of appreciated property by a U.S. person to a foreign corporation in connection with any exchange described in Sections 332, 351, 354, 355, or 361. Moreover, Section 367(e) applies similar principles to outbound liquidation distributions under Section 337 and distributions under Section 355(c). There are certain exceptions from this rule of broad application. Section 367(a)(3)(A) allows nonrecognition treatment for assets used in the active conduct of a trade or business transferred outside of the United States (subject to expansion or contraction by regulations). See Treas. Regs. § 1.367(a)-2T (1986). Med Chem (P.R.) v. Comm'r, 116 TC 308 (2001), aff'd 295 F.3d 118 (1st Cir. 2002) . Assets that are ineligible for the active foreign business exception (i.e., tainted assets) are listed in Section 367(a)(3)(B) and include: (i) inventory and copyrights not otherwise taxed under Section 367(d); (ii) installment obligations and receivables; (iii) foreign currency or property denominated in foreign currency; (iv) other intangibles not subject to Section 367(d); and (v) property that is presently leased (other than to the transferee).

Section 367(a)(2) sets forth a second exception to the general realization of income rule providing non-recognition treatment with respect to a transfer of stock and securities of a foreign corporation, which is a party to a reorganization, to a foreign corporation. Under the regulations where a U.S. transferor transfers foreign stock or securities to a foreign corporation as part of a tax-free reorganization, gain is not required to be recognized under the general rule of Section 367(a)(1) where the transferor either owns (or is treated as owning) less than 5% of both the voting power and total value of the transferee's stock or (where the 5% test is not satisfied) enters into a five-year gain recognition agreement. Where the domestic corporation's stock or securities are transferred to a foreign corporation, the regulations require that four conditions must be satisfied to avoid gain recognition: (i) the domestic transferors must not receive more than 50% of the transferee's stock (by vote or value) in the transaction; (ii) there must not be a "control group;" (iii) a U.S. person who is a 5% shareholder of the transferee must enter into a five-year gain recognition agreement ("GRA"); and (iv) an active business test must be met.

Certain transactions are treated as indirect stock transfers. For instance, where a triangular reorganization or asset merger is followed by a transfer of part or all of the transferred assets to a corporation controlled by the transferee corporation, the acquiring corporation (or the corporation to which the assets are transferred) is treated as the transferred corporation. In instances where assets are transferred, e.g., a triangular Type C reorganization, Section 367(a) is implicated with respect to the asset transfer while both Sections 367(a) and 367(b) can apply to the indirect stock transfer at the shareholder level. If the drop-down of assets is made by the foreign acquiring corporation back to a controlled domestic corporation, the regulations provide that in certain instances gain will not be recognized. See Treas. Reg § 1.367(a)-3(d)(2)(vi)(B)(1).

There will be instances in which Sections 367(a) and 367(b) overlap. Section 367(a) rules generally apply before the Section 367(b) rules, because a transfer is generally fully taxable or not under the Section 367(a) rules. If the transfer is fully taxable under the Section 367(a) provisions, then the Section 367(b) provisions generally remain dormant. The 2008 proposed regulations under Section 367(a) reverse the priority rule to provide that where a transaction that is concurrently subject to both Sections 367(a) and 367(b), Section 367(b) would take precedence if the all earnings and profits amount is greater than the Section 367(a) gain.

Section 367(a)(5) and Coverage Under the 2008 Proposed Regulations and Recently Issued Final Regulations

Section 367(a)(5) provides that the exceptions to Section 367(a)(1) in Section 367(a)(2)(foreign stocks and securities) and (a)(3)(transfer of all assets of a trade or business outside of the United States) will not be applicable in the case of a Section 361 exchange in which a domestic corporation transfers assets to a foreign corporation, unless the U.S. transferor is controlled (within the meaning of Section 368(c)) by five or fewer (but at least one) domestic corporations (each a control group member, and together the control group) and basis adjustments and other conditions as provided in regulations are satisfied. See H.R. Rep. No 795, 100th Cong., 2d Sess. 60 (1988). See also Section 337(d)(regulations to protect the integrity of the repeal of the General Utilities doctrine as part of the Tax Reform Act of 1986).

The 2008 proposed regulations set forth rules and conditions for implementing Section 367(a)(5). The 2008 proposed regulations provided an exception that at the election of the U.S. transferor and members of the control group (elective exception), subject to conditions intended, in part, to ensure that the net gain (if any) realized by the U.S. transferor in connection with the transfer of property subject to Section 367(a) (defined as "inside gain") is, in the aggregate, recognized currently by the U.S. transferor or, to the extent permitted, preserved in the basis of the stock received in the reorganization by certain domestic corporate shareholders of the U.S. transferor.

Calculation of Inside Basis

In addition to the adjusted basis of certain transferred property, in computing "inside gain", the 2008 proposed regulations account for certain liabilities of the U.S. transferor that would give rise to a deduction when paid. See §361(c)(3). Section 361(c)(3) provides that the U.S. transferor recognizes no gain or loss on the satisfaction of a liability with stock received in connection with the reorganization, but does not prevent the U.S. transferor from obtaining a deduction on payment of the liability with the stock received. The policy rationale for allowing a deductible liability to reduce "inside gain" is that the U.S. transferor has not received a tax benefit for such liability but the liability reduces the value of the stock received. This concept is retained in the final regulations which provide that a so-called "deductible liability" is limited to a liability that is assumed in the Section 361 exchange if payment of the liability would give rise to a...