T.D. 9526, 05/17/2011, Reg. §1.367(a)-3, Reg. §1.367(b)-10
IRS has issued final regs under Code Sec. 367(b) to curb abusive triangular reorganizations involving one or more foreign corporations, sometimes referred to as "Killer B" transactions, which were designed to repatriate the earnings of a foreign subsidiary without subjecting the domestic parent to tax. The final regs largely adopt proposed regs that were published on May 27, 2008.
Statutory background. A U.S. person's transfer of appreciated property (including stock) to a foreign corporation in connection with Code Sec. 332, Code Sec. 351, Code Sec. 354, Code Sec. 356, or Code Sec. 361 exchanges generally is treated under Code Sec. 367(a)(1) as a taxable transaction, unless an exception applies. Code Sec. 367(b) provides that a foreign corporation is considered to be a corporation for purposes of these exchange provisions, except to the extent provided in regs issued to prevent tax avoidance.
No gain or loss is recognized to a corporation on the receipt of money or other property in exchange for stock of that corporation. (Code Sec. 1032) In the case of a forward triangular merger, a triangular C reorganization, or a triangular B reorganization, a parent's stock provided by it to its subsidiary—or provided directly to a target corporation or its shareholders on the subsidiary's behalf—under a reorganization plan is treated as a disposition by the parent of shares of its own stock. (Reg. §1.1032-2(b)) However, if the subsidiary did not receive the parent's stock from the parent under a reorganization plan, it must recognize gain or loss on the exchange of its parent stock for the target's stock or assets. (Reg. §1.1032-2(c)) The subsidiary does not recognize gain or loss on the parent's stock that it exchanges for the target's stock in a reverse triangular merger. (Code Sec. 361)
A corporation's distribution of property to its shareholder with respect to its stock is included in the shareholder's gross income to the extent the distribution is a dividend under Code Sec. 316 (which defines a dividend as a distribution out of a corporation's current and accumulated earnings and profits). (Code Sec. 301(c)(1)) To the extent the distribution is not a dividend, the shareholder reduces basis in the distributing corporation's stock, and any amount of the distribution in excess of the shareholder's basis is treated as gain from the sale or exchange of the corporation's stock. (Code Sec. 301(c)(2), Code Sec. 301(c)(3))
Background on prior IRS notices. In Notice 2006-85, 2006-41 IRB 677, IRS announced that it would issue regs under Code Sec. 367(b) to curb abuses where triangular reorganizations involving foreign corporations had the effect of repatriating the subsidiary's foreign earnings to the parent without a corresponding dividend to the parent that would be subject to U.S. income tax. The regs would treat the transfer of property from the parent to the subsidiary as a distribution of property under Code Sec. 301(c). IRS later issued Notice 2007-48, 2007-25 IRB 1428, to amplify and broaden the reach of Notice 2006-85.
Temporary and proposed regs. In May of 2008, IRS issued temporary and proposed regs (the 2008 regs) that applied to triangular reorganizations where (i) parent (P) or subsidiary (S), or both, are foreign; and (ii) in connection with the reorganization, S acquires, in exchange for property, all or a portion of the P stock that is used to acquire T's stock or assets. The "in connection with" standard included any transaction related to the reorganization, even if not part of the plan of reorganization.
Final regs. The 2008 regs are now final, with modifications as noted below.
The final regs make adjustments for P and S with the effect of a distribution of property from S to P under Code Sec. 301. The amount of the deemed distribution is equal to the amount of money plus the fair market value (FMV) of other property that S used to acquire P stock. For this purpose, "property" has the meaning in Code Sec. 317(a), but includes any liability assumed by S in exchange for the P stock (notwithstanding Code Sec. 357(a)) and any S stock used by S to acquire the P stock from a person other than P.
The deemed distribution is treated as a transaction separate from, and occurring immediately before, the triangular reorganization. Thus, P is not treated as receiving the property from S in exchange for P stock, and the transfer of P stock in the triangular reorganization is subject to the generally applicable provisions, e.g., Reg. §1.1032-2. (Reg. §1.367(b)-10(b)(2)) The deemed distribution is treated as a distribution for all purposes of the Code. (Reg. §1.367(b)-10(c)(1)) Similarly, a deemed contribution of property is treated as a contribution of property for all purposes of the Code. (Reg. §1.367(b)-10(c)(2))
Ordering rules generally require the deemed distribution and, in cases where S buys P stock from a person other than P, the deemed contribution, to be taken into account before the transfers undertaken in the triangular reorganization. If P controls S (under Code Sec. 368(c)) at the time of the purchase, the deemed distribution and deemed contribution are treated as separate transactions occurring immediately before the purchase. If P doesn't control S (under Code Sec. 368(c)) when S purchases the P stock, the deemed distribution and deemed contribution are treated as separate transactions occurring immediately after P acquires control of S.
Appropriate adjustments are made if, in connection with a triangular reorganization, a transaction is engaged in with a view to avoid the purpose of the regs. (Reg. §1.367(b)-10(d)) For example, if S is a newly formed corporation and, in connection with the reorganization, P contributes to S another corporation with positive earnings and profits (S2) to facilitate S's purchase of the P stock or to facilitate the repayment of an obligation incurred by S to purchase the P stock, then the earnings and profits of S may be deemed to include S2's earnings and profits.
The final regs also make the following modifications to the 2008 regs:
In response to a commentator who noted that it might be more appropriate in certain cases for the priority rule to take into account the amount of resulting U.S. tax, as opposed to simply comparing the amount of gain recognized under Code Sec. 367(a)(1) with the amount of the dividend that would result under the 2008 regs, IRS stated that such a method generally isn't administrable. However, to address the commentator's concern, IRS modified the scope of the final regs such that they don't apply if: (i) P and S are foreign corporations and neither P nor S is a controlled foreign corporation under Reg. §1.367(b)-2(a) immediately before or immediately after the triangular reorganization (Reg. §1.367(b)-10(a)(2)(i)); or (ii) P is a foreign corporation, S is a domestic corporation, P's receipt of a dividend from S would not be subject to U.S. tax under Code Sec. 881 or Code Sec. 882, and P's stock in S is not a U.S. real property interest under Code Sec. 897(c). (Reg. §1.367(b)-10(a)(2)(ii))
The scope of the final regs was also modified to include a number of additional situations, including: (i) the acquisition by S, in exchange for property, of P securities that are used to acquire the stock, securities, or property of T in the triangular reorganization, but only to the extent the P securities are treated by T shareholders or security holders as "other property" under Code Sec. 356(d); and (ii) the acquisition by S, in exchange for property, of P stock to the extent such P stock is received by T shareholders or security holders in an exchange to which Code Sec. 354 or Code Sec. 356 applies. (Reg. §1.367(b)-10(b))
The final regs also modify the 2008 regs' priority rule, which generally provided that if the amount of gain in the T stock that would otherwise be recognized under section Code Sec. 367(a)(1), absent an exception, is less than the adjustment treated as a dividend under the 2008 regs, then the 2008 regs apply to the triangular reorganization. The final regs modify the rule to: (i) include exchanges of T securities as well as T stock; (ii) compare the amount of gain that would be recognized under Code Sec. 367(a)(1) with not only the amount of the deemed dividend but also the amount of any gain (applying Code Sec. 301(c)(1) and Code Sec. 301(c)(3), respectively); and (iii) clarify its application by providing separate priority rules in Reg. §1.367(a)-3(a) and Reg. §1.367(b)-10. (T.D. 9526)
Thus, under the modified Reg. §1.367(a)-3(a) priority rule, if the amount of gain in the T stock or securities that would otherwise be recognized by the T shareholders or security holders under Code Sec. 367(a)(1) (without regard to any exceptions) is less than the sum of the amount of deemed dividend and the amount of gain (applying Code Sec. 301(c)(1) and Code Sec. 301(c)(3)), Code Sec. 367(a)(1) does not apply to the Code Sec. 354 or Code Sec. 356 exchange by the T shareholders or security holders of the T stock or securities for P stock or securities. (Reg. §1.367(b)-10(a)(2)(iii))
However, under the Reg. §1.367(b)-10 priority rule, if the amount of gain recognized by the T shareholders or security holders under Code Sec. 367(a)(1) (taking into account applicable exceptions) on the Code Sec. 354 or Code Sec. 356 exchange of T stock or securities exceeds the sum of the amount of deemed dividend and the amount of gain (applying Code Sec. 301(c)(1) and Code Sec. 301(c)(3)) if the final regs otherwise applied to the triangular reorganization, then the final regs do not apply. (Reg. §1.367(b)-10(a)(2)(iii))
Some commentators raised concerns regarding the extent to which Code Sec. 367(b) adjustments, which have the effect of either a deemed distribution of property from S to P under Code Sec. 301 or a deemed contribution of property from P to S if the 2008 regs apply to a triangular reorganization, should be made. In response, IRS stated that the final regs make clear that they are made based on a distribution or contribution of a notional amount, and are therefore without the recognition of any built-in gain or loss thereon. The notional amount is equal to the amount of money transferred and liabilities assumed plus the FMV of other property transferred, in connection with the triangular reorganization, by S in exchange for the P stock or securities used to acquire the stock, securities or property of T. In addition, the final regs clarify that the adjustments that have the effect of a deemed distribution or deemed contribution do not affect the characterization of the actual transaction as provided under applicable tax provisions. (T.D. 9526)
The final regs also combine the two timing separate rules provided in the 2008 regs, one for transactions involving acquisitions of P stock from P and another for acquisitions of stock from persons other than P, into a single rule that applies regardless of who the P stock and securities are acquired from. They also modify the definition of "property" contained in the 2008 regs to include rights (such as options) to acquire S stock, to the extent such rights are used by S to acquire P stock or securities from a person other than P. (T.D. 9526)
Finally, in addition to including a priority rule in Reg. §1.367(a)-3(a), the final regs modify its format and organization. The final regs also clarify Reg. §1.367(a)-3(a) to provide that exchanges subject to Code Sec. 367(a)(1) (absent an applicable exception) result in the recognition of gain, as opposed to being "treated as a taxable exchange" under the current regs. (T.D. 9526)
The final regs also remove Reg §1.367(b)-14T.
Effective date. The final regs apply to transactions occurring on or after May 19, 2011 (i.e., the publication date in the Federal Register). For transactions occurring before that date, see Reg. §1.367(b)-14T.
References: For transfers to foreign corporations, see FTC 2d/FIN ¶F-6000 et seq.; United States Tax Reporter ¶3674; TG ¶4925.