Final Regs Crack Down On Tax Avoidance Repatriations Of CFC Earnings

T.D. 9530, 06/23/2011, Reg. §1.956-1, Reg. §1.956-1T

IRS has issued final and temporary regs on determining the basis of certain U.S. property acquired by a controlled foreign corporation (CFC) in nonrecognition transactions that are intended to repatriate earnings and profits (E&P) of the CFC without triggering U.S. tax to shareholders under Code Sec. 951(a)(1)(B).

Background. Under Code Sec. 957, a CFC is defined as a foreign corporation with regard to which more than 50% of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned (directly, indirectly, or constructively) by U.S. shareholders. A U.S. shareholder for CFC purposes is a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. (Code Sec. 951(b))

A U.S. shareholder of a CFC is taxed under Code Sec. 951(a) on an amount equal to the lesser of: (1) the U.S. shareholder's pro rata share of the average amount of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter of the tax year, less that portion of the CFC's E&P attributable to amounts included previously in that shareholder's gross income on account of investment in U.S. property (or which would have been so included except that it had already been included under another provision of the CFC rules), or (2) that shareholder's pro rata share of the CFC's applicable earnings.

Code Sec. 956 was enacted to require an income inclusion by U.S. shareholders of a CFC that invests certain E&P in U.S. property on the ground that the investment is substantially the equivalent of a dividend being paid to them. The term “U.S. property” includes, among other things, tangible property located in the U.S. and stock of a domestic corporation.

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. 355, 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. Regs under Code Sec. 367(b) prevent the repatriation of a U.S. person's share of E&P of a foreign corporation through what would otherwise be a nonrecognition transaction. (Reg. §1.367(b)-1)

Under Code Sec. 362(a), for property acquired by a corporation in connection with a Code Sec. 351 transaction (relating to transfer of property to corporation controlled by transferor), the basis is the same as it would be in the hands of the transferor, increased by the amount of any gain recognized to the transferor on the transfer.

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)

Proposed and temporary regs. In June of 2008, IRS issued proposed and temporary regs addressing concerns that taxpayers were engaging in certain nonrecognition transfers in which a CFC acquires certain U.S. property without resulting in an income inclusion to the U.S. shareholders—effectively repatriating the CFC's E&P without a corresponding income inclusion by the U.S. shareholders under Code Sec. 951(a)(1)(B).

No comments were received in response to the proposed regs, and no public hearing was requested or held. The proposed regs were adopted with minor changes, and the corresponding temporary regs were removed. (T.D. 9530)

Final regs. The final regs apply when a CFC acquires “specified U.S. property” (i.e., stock or obligations of a domestic corporation) in an exchange in which its basis in the property is determined under Code Sec. 362(a). (Reg. §1.956-1(e)(6)) Solely for Code Sec. 956 purposes, the CFC's basis in the property acquired in a transaction to which the final regs apply will be no less than the fair market value (FMV) of the property transferred by the CFC in exchange for the specified U.S. property.

For this purpose, “property” has the meaning set forth in Code Sec. 317(a), but includes any liability assumed by the CFC in connection with the exchange, notwithstanding Code Sec. 357(a). (Reg. §1.956-1(e)(6)) The final regs also clarify that, for purposes of Reg. §1.956-2(d)(1)(i)(a), a CFC that acquires specified U.S. property in an exchange to which the regs apply acquires an adjusted basis in such property at the time of the CFC's exchange of property for such specified U.S. property.

The final regs also apply when property whose basis is determined under the regs is transferred to a related person (related person transferee), or by a related person transferee to another related person, pursuant to an exchange in which the related person transferee's basis in the property is determined, in whole or in part, by reference to the transferor's basis in the property. For purposes of applying Code Sec. 956 following such an exchange, the CFC's adjusted basis in any U.S. property received in the exchange (or exchanges) will be no less than the aggregate adjusted basis of the specified U.S. property as determined under Reg. §1.956-1(e)(6)(iii), and the related person transferee's adjusted basis in such specified U.S. property will be no less than the adjusted basis of such specified U.S. property in the hands of the CFC as determined under Reg. §1.956-1(e)(6)(iii). This rule is intended to prevent taxpayers from avoiding the general rule of the final regs by subsequently transferring the property to a related person in another nonrecognition transaction. (T.D. 9402, 06/23/2008)

Language was also added to the final regs to clarify the effect of the assumption of a liability by a CFC in connection with an exchange to which Reg. §1.956-1(e)(6) applies. The final regs also modify Reg. §1.956-1(e)(6)(v) to address situations in which a CFC exchanges specified U.S. property, the adjusted basis in which has been determined under Reg. §1.956-1(e)(6), for other U.S. property. The final regs provide that, for purposes of applying Code Sec. 956, the CFC's adjusted basis in the other U.S. property is no less than its adjusted basis in the specified U.S. property as determined under Reg. §1.956-1(e)(6)(iii). (T.D. 9530, 06/23/2011)

Basis determined under the final regs applies only for purposes of determining the amount of U.S. property acquired or held by a CFC under Code Sec. 956, and accordingly the amount of a U.S. shareholder's income inclusion under Code Sec. 951(a)(1)(B) with respect to the CFC. (Reg. §1.956-1(e)(6))

Illustration: USP, a domestic corporation and the common parent of an affiliated group that files a consolidated tax return, owns 100% of the outstanding stock of US1 and US2, both domestic corporations that join USP in the filing of a consolidated tax return. US1 owns 100% of the stock of CFC, a controlled foreign corporation. US2 issues $100 million of its stock to CFC in exchange for $10 million of CFC stock and $90 million cash. (Reg. §1.956-1(e)(6)(vi), and Preamble to TD 9402, 06/23/2008, Example 1)

Before the issuance of the regs, USP may have taken the position that: (i) US2's transfer of its stock to CFC in exchange for $10 million of CFC stock and $90 million cash is an exchange to which Code Sec. 351 applies; (ii) US2 recognizes no gain on the receipt of $10 million of CFC stock and $90 million cash in exchange for its stock under Code Sec. 1032(a); (iii) CFC recognizes no gain on the issuance of its stock to US2 under Code Sec. 1032(a); (iv) CFC's basis in the US2 stock is zero under Code Sec. 362(a); and (v) US1 and US2 do not and will not have an income inclusion under Code Sec. 951(a)(1)(B) as a result of CFC holding the US2 stock (which constitutes U.S. property under Code Sec. 956(c)). (Preamble to TD 9402,, Example 1)

However, under the final regs, the US2 stock acquired by CFC in the exchange constitutes U.S. property under Reg. §1.956-1(e)(6)(ii) because CFC acquires the US2 stock from US2, the issuing corporation. Therefore, because CFC's basis in the US2 stock is determined under Code Sec. 362(a), then for purposes of Code Sec. 956, CFC's basis in the US2 stock is, under Reg. §1.956-1(e)(6)(iii) not less than $90 million, the FMV of the property exchanged by CFC for the US2 stock (the $10 million of CFC stock issued in the exchange does not constitute property for purposes of Reg. §1.956-1(e)(6)(iii)). Under Reg. §1.956-1(e)(6)(iv), for purposes of Reg. §1.956-2(d)(1)(i)(a), CFC is treated as acquiring its basis of not less than $90 million in the US2 stock at the time of its transfer of property to US2 in exchange for the US2 stock. The result would be the same if, instead of CFC transferring $90 million of cash to US2 in the exchange, CFC assumes a $90 million liability of US2. (Reg. §1.956-1(e)(6)(vi), Example 1)

Effective date. The final regs apply to U.S. property acquired in exchanges occurring on or after the date of publication (June 24, 2011). (T.D. 9530, 06/23/2011)

References: For taxation of U.S. shareholders of CFCs, see FTC 2d/FIN ¶O-2600; United States Tax Reporter ¶9514; TG ¶30425.