Source: http://www.bna.com/closer-look-367-n2147484791/
Timestamp: 2016-10-20 21:29:43
Document Index: 595792457

Matched Legal Cases: ['§367', '§304', '§367', '§304', '§367', '§304', '§304', '§351', '§301', '§1', '§304', '§304', '§301', '§304', '§351', '§301', '§358', '§362', '§301', '§358', '§367', '§301', '§367', '§351', '§304', '§301', '§301', '§367', '§367', '§367', '§362', '§301', '§358', '§301', '§301', '§301', '§367', '§367', '§301', '§301', '§358', '§301', '§358', '§367', '§351', '§358', '§351', '§301', '§304', '§367', '§301', '§367', '§301', '§351', '§304', '§351', '§367', '§304', '§1248', '§367', '§367', '§367']

A Closer Look at the §367 Consequences of a §304 Transfer – Weirder Than You Think | Bloomberg BNA
A Closer Look at the §367 Consequences of a §304 Transfer – Weirder Than You Think
Weil, Gotshal & Manges LLP, New York, NY A fair amount has already been written, including in the Tax Management International Journal,1 concerning temporary regulations issued in February 2009 that rewrote the tax rules that apply under §367 where there is a §304 transfer by a U.S. person to a foreign corporation.2 This commentary will illustrate that the temporary regulations adopted a model for taxing these transactions that is not fully fleshed out, and that may not withstand closer scrutiny. In particular, the regulations appear to yield counterintuitive results where the amount deemed distributed in a §304/§351 exchange exceeds the aggregate basis in the shares of the acquiring corporation, or in any case in which application of a basis recovery approach results in §301(c)(3) gain with respect to shares of the acquiring corporation historically owned by the transferor.
This commentary will focus on Regs. §1.367(a)-9T, which addresses a simple §304 cross-chain sale. That regulation incorporates the following example: USP wholly owns FC1 and FC2. USP sells all of the stock of FC1 to FC2 for $100, the stock's fair market value. USP had a basis in its shares of FC1 stock of $40 and has a basis in its shares of FC2 stock of $100. FC1 has no earnings and profits ("E&P") and FC2 has $20 of E&P. Immediately before and after the sale, the fair market value of FC2 is $100.
Under §304(a)(1), the $100 of cash paid by FC2 is treated as a distribution to USP in redemption of FC2 shares. To the extent that the deemed distribution/redemption is treated as a dividend-equivalent redemption under §301, which it would be in this simple case, §304 recasts the transaction as if the transferor, USP, transferred the shares of the issuing corporation, FC1, to the acquiring corporation, FC2, in a deemed §351 exchange for newly issued shares of FC2, and then FC2 immediately redeemed the shares it was deemed to issue. To the extent that the amount deemed distributed ($100 in the example) exceeds the earnings and profits of the acquiring and issuing corporations, the distribution is applied against USP's basis in the FC2 shares, with any excess over such basis being taxable gain under §301(c)(3). Under §358, USP takes a basis in the FC2 shares deemed received equal to the basis it had in the FC1 shares, increased by any gain it recognized. Under §362, FC2 takes a basis in the FC1 shares equal to USP's basis therein, again increased by any gain recognized.
It has never been clear how §301(c)(2) basis recovery works in the case of a dividend-equivalent redemption such as the one created here. In this simple example, USP owns two blocks of FC2 shares — the "historic" shares in which it had a $100 basis and the "deemed" shares in which it took a §358 basis of $40. The question is how this aggregate $140 of basis is accessed. There are at least three approaches that might be applied in recovering basis in a dividend-equivalent redemption.
The IRS view, at least until recently, appears to have been that only the basis in the deemed shares could be recovered; we'll call this the "new basis only" model. A second approach would be an "aggregate" model in which the basis of the historic shares is added to the basis of the deemed shares, and the aggregate basis is available for recovery. A third approach is reflected in proposed regulations, dealing generally with the issue of stock basis,3 that would generally require proportional basis recovery among blocks of a single class of stock, in this case between the historic block and the deemed block.
The temporary regulations (under §367) were issued because the IRS came to realize that, depending on which approach to basis recovery is adopted, the amount of gain recognized under §301(c)(3) will vary. The predecessor to these regulations generally turned off §367 gain recognition with respect to the deemed §351 transfer that occurs in a §304 transaction, on the ground that the transferor would always pick up any §301(c)(3) gain under a new basis only approach. That is, in the simple example above, the prior regulations assumed that USP would recognize $40 of §301(c)(3) gain — the $100 distribution would be treated as a dividend to the extent of the $20 E&P, and the remaining $80 would be recovered only against the $40 basis of the deemed shares. However, if USP applied an aggregate approach, it would not pick up any such gain, because it had a total basis of $140.
The IRS clearly did not like the idea of full basis recovery. Therefore, where the taxpayer "takes the position" that it can recover any basis in historic shares, the temporary regulations require gain to be recognized under §367. The amount of gain that USP must recognize is the excess of the gain realized on the sale – here, $60 – and the amount treated as a dividend – here, $20. Thus, USP would be required to recognize $40 of gain under §367.
On these facts, USP would always be better off choosing the §367 gain recognition approach rather than the new basis only approach. That is because the temporary regulations give FC2 an inside basis credit for the gain recognized by USP; in this example, FC2's §362 basis in the FC1 shares would be increased from $40 to $80. If, instead, USP did not "take the position" that it was entitled to recover its historic basis in FC2's shares, its resulting §301(c)(3) gain would give rise to no basis credit. The regulations also give USP a basis credit in the shares of FC2 under §358 for the amount of gain recognized, and that increased basis becomes the measure of USP's §301(c)(2) basis recovery.4 However, the stakes are raised where the aggregate basis available to be recovered is less than the amount of the deemed distribution, a fact pattern that the temporary regulations did not explicitly cover. First, consider a relatively innocuous example where USP has a basis of $20 in the FC1 shares and a basis of $50 in the FC2 shares, for an aggregate basis of $70. If USP followed the new basis only approach, it would reduce its basis in the deemed FC2 shares from $20 to zero, and would recognize $60 of §301(c)(3) gain. If instead USP accessed its basis in the historic FC2 shares, it would appear to realize $10 of §301(c)(3) gain. However, under the temporary regulations, USP would be required to recognize $60 of §367 gain.
As noted above, the example in the temporary regulations (but, oddly, not the text of the temporary regulations) allows USP to increase its basis in the deemed FC2 shares by the §367 gain recognized, which increase "is taken into account before determining the consequences of the redemption under section 304(a)(1)." Thus, USP will not pick up any §301(c)(3) gain in this scenario. USP is, however, in a worse position than it would be if it were allowed to recover basis in its historic shares. It has recognized more gain, albeit that gain is offset by the stepped-up basis that FC2 takes in its FC1 shares.
As long as USP adopts an aggregate approach to basis recovery, the result will be no different if the numbers are flipped, with USP having a $50 basis in FC1 and a $20 basis in its historic FC2 shares. Any potential §301(c)(3) gain will be eliminated by the §358 increase in its basis for the FC2 shares. However, if the proportional basis recovery approach of the IRS's own proposed regulations were adopted by USP (and for all we know, this is the "correct" approach today), this case results in $10 of extra gain being recognized currently. The result is a timing mismatch, because the extra gain is matched by FC2's increased basis in the shares of FC1.
This occurs because under the proportional basis recovery approach of the proposed regulations, $40 of the distribution would be allocated to the deemed shares having a $50 basis, leaving $10 of unrecovered basis. The other $40 of distribution would be allocated to the historic block having a basis of $20, resulting in a recognized §301(c)(3) gain of $20. This is the peculiar result of the proposed regulations: They may result in a gain on one block with an offsetting basis in another block.
In this scenario, the penalty imposed by the temporary regulations would appear to be $10 of additional gain being recognized, offset by $10 of increased inside basis. That occurs because there can be no increase to USP's basis in its historic shares; only the deemed shares may benefit from a §358 basis increase. The temporary regulations appear to adopt a model in which §367 applies to override §351(a), resulting in gain recognition without "boot." But because the regulations cannot oust Subchapter C, the basis construct of §358 survives, such that the basis of the shares deemed issued in the §351 exchange take an increased basis. When those shares are deemed to be redeemed by FC2, there is extra basis unrecovered, but that basis does not shift to the historic shares prior to the time at which a §301(c)(3) gain is measured. Instead, the unrecovered basis is recapped into the shares remaining after the transaction. The result is unprecedented, at least in the domestic Subchapter C context: The acquiring corporation (FC2) obtains a basis increase in respect of gain recognized on a deemed redemption of its shares. Many commentators have assumed that because the proposed regulations, with their proportional basis recovery approach, were issued shortly before these temporary regulations, the temporary regulations must have had the proposed regulations in mind. However, the foregoing example illustrates that the temporary regulations do not square well with the approach taken in the proposed regulations; the result appears to have been unintended. The drafter of the temporary regulations may have assumed, given the simple example that was used, that the approach set out in the proposed regulations would always lead to the same result as the aggregate approach.5 However, the foregoing example shows that this will not always be the case.
If the proposed regulations are finalized, a taxpayer would no longer have a choice as to how to recover basis, and would be forced to apply some of the deemed distribution against the basis of its historic shares. Every §304 transaction covered by the temporary regulations would result in the recognition of §367(a) gain, and, where aggregate basis is less than the amount distributed and the basis of the historic shares of the acquiring corporation is low, the potential for §301(c)(3) gain (matched by an increased inside basis).
The temporary regulations should, at the least, be amended to give credit against any §367 gain for any §301(c)(3) gain realized in the transaction. A more fundamental observation is that the temporary regulations are flawed and should be restored to their prior version in which the deemed §351 exchange arising upon a §304 transaction was simply turned off. The deemed §351 exchange does not implicate the policy of §367(a) in any way.6 The temporary regulations are instead about "repatriation" generally, and implicate only an uncodified policy that if a U.S. taxpayer uses funds of a CFC to purchase property owned by the U.S. parent, deferral should be ended. But because the regulations seek to end deferral by imposing tax on a sale, they result in basis consequences that are utterly arbitrary.
This commentary also will appear in the May 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Gross, Doloboff, Koutouras and Tizabgar, 768 T.M., Stock Sales Subject to Section 304, and Davis, 919 T.M., U.S.-to-Foreign Transfers Under Section 367(a), and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation and ¶7160, U.S. Income Tax Treaties..
See, e.g., McCarty, Paul, and Ngo, "New Temporary Regulations Fundamentally Alter Operation of §304 and the Application of §1248," 38 Tax Mgmt. Int'l J. 216 (4/10/09). 2 T.D. 9444, 74 Fed. Reg. 6824 (2/10/09).
3 REG-143686-07, 74 Fed. Reg. 3509 (1/21/09). 4 The IRS appears to have accepted the fact that gain recognized under §367 can be treated as gain recognized for purposes of the basis rules in Subchapter C of the Code. 5 If the proposed regulations were applied to the basic example in the temporary regulations, the $80 aggregate non-dividend distribution would be allocated proportionately among two blocks of FC2's shares, each of which, under these facts, is comprised of the same number of shares (and thus receives a 50/50 allocation). One block is the historic block with a $100 basis and the other is the deemed new block with a basis of $40. Under the proposed regulations, $40 would be allocated to the old FC2 shares, reducing their basis to $60, and $40 would be allocated to the deemed-issued shares, reducing their basis from $40 to zero. 6 It has been noted that the temporary regulations do not permit the §367 gain to be avoided by making a gain recognition election; it appears to this author that the reason no GRE was made available in this situation is precisely because these temporary regulations have nothing to do with the policy of §367. Try Bloomberg BNA Tax and Accounting Center now