Bobbe Hirsh is a partner in the law firm of bell, Boyd and Lloyd LLP. She graduated cum laude from Harvard Law School. She co-authored, with ALAN S. Lederman, the NAFTA Guide.
Bobbe Hirsh is a partner in the law firm of bell, Boyd and Lloyd LLP. She graduated cum laude from Harvard Law School. She co-authored, with ALAN S. Lederman, the NAFTA Guide.
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Bobbe Hirsh is a partner in the law firm of bell, Boyd and Lloyd LLP. She graduated cum laude from Harvard Law School. She co-authored, with ALAN S. Lederman, the NAFTA Guide.
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THE SECTION 367(A) AND 367(B) REGULATIONS, INCLUDING
EXPATRIATIONS Bobbe Hirsh, Alan S. Lederman, and Martin B. Tittle May 15, 2007 2007 Bobbe Hirsh, Alan S. Lederman, and Martin B. Tittle {M2436743;3} PROFESSIONAL BIOGRAPHIES BOBBE HIRSH Bobbe Hirsh (telephone 312-781-6809, e-mail bhirsh@bellboyd.com) is a partner in the law firm of Bell, Boyd & Lloyd LLP, located in its Chicago office. She graduated cum laude from Harvard Law School, where she was articles editor of the Harvard International Law Journal. She holds an M.S.B.A. in accounting from the University if Denver. Bobbe is also a CPA. Bobbe publishes extensively in the field of international taxation and has contributed to a number of PLI publications, including Foreign Investment in the United States after the Tax Reform Act of 1986 (1987), International Tax Planning for the U.S. Multinational Corporation (1988), Foreign Investment in the United States 1988, Foreign Investment in the United States 1989, Foreign Investment in the United States - A Practical Approach for the 1990s (1990), Transfer Pricing and the Foreign Owned Corporation: Sections 482 and 6038A & C (1991), and Tax Planning for Domestic and Foreign Partnerships, LLCs, Joint Ventures and Other Strategic Alliances (1999-2007). She is also a frequent contributor to The Journal of Taxation, The Journal of International Taxation, and various other professional publications. She co-authored, with Mr. Lederman, The NAFTA Guide, published by Harcourt Brace. Bobbe serves on the Board of Advisors of the Journal of International Taxation and the Journal of Taxation of Financial Products and is a member of the Board of Directors of International Tax Forum. In addition to writing, Bobbe is a frequent speaker at professional conferences on a variety of international tax and trade issues. ALAN S. LEDERMAN Alan S. Lederman, P.A., is of counsel in the Miami office of the Florida law firm of Akerman Senterfitt (telephone 305-349-4528, e-mail alan.lederman@akerman.com). He graduated cum laude from Harvard Law School and received an M.B.A. from Harvard Business School. Mr. Lederman also is a CPA. Mr. Lederman has taught in the masters program at the University of Miami law school. Alan often speaks at conferences for professionals. These conferences include those sponsored by the NYU Institute on Federal Taxation, the American Bar Association, the Florida Bar, the American Law Institute, and the American Management Association. His articles have often appeared in The Journal of Taxation, The Journal of International Taxation, TAXES, The AICPA Tax Adviser, The ABA Tax Lawyer, The Proceeding of the NYU Annual Tax Institute, BNA Tax Management International Journal, Airfinance Journal, and other professional periodicals. He has also written two BNA Tax Management Portfolios. In addition to the area of taxation, Alan practices in the field of international law. In this connection, he has lectured on topics such as the euro currency, the Helms Burton law, and the money-laundering statutes to such groups as the ABA International Law Section. He co-authored with Ms. Hirsh The NAFTA Guide, published by Harcourt Brace. MARTIN B. TITTLE Martin B. Tittle (telephone 202-344-7592, e-mail mbt@martintittle.com) is an independent consultant who practices in Washington, D.C. and Ann Arbor, Michigan. He works with foreign and U.S. multinationals on a wide range of tax issues pertaining to their cross-border activities. Martin graduated magna cum laude from the University of Michigan Law School. Martin's articles have been published by Tax Notes International, The IBFD Bulletin of International Taxation, and the Inter-American Development Bank. He is also a contributor to The Canada-U.S. Tax Treaty, a treatise that Thomson Carswell will be publishing in fall 2007. In 2005, Martin worked closely with Nardi Bress as vice- chair of the ABA Tax Section's report on the proposed Sec. 367(a) regulations. In addition to writing, Martin frequently speaks at professional conferences on a variety of tax-related topics. PLANNING FOR OUTBOUND TRANSFERS UNDER THE SECTION 367(A) AND 367(B) REGULATIONS, INCLUDING EXPATRIATIONS I. SECTION 367(A) OUTBOUND TRANSFERS......... 1 A. Transfers .................................................................. 4 B. Tax Consequences Under Sec. 367(a)..................... 9 C. Sec. 367(a)(2) - Foreign Stock or Securities Exception 11 D. Section 367(a)(3) - Active Trade or Business Exception 13 E. Treas. Reg. Sec. 1.367(a)-3 ................................... 30 II. OUTBOUND TRANSFERS UNDER SECTION 367(B) 159 A. Outbound Transactions Covered by both Section 367(a) and (b) 160 B. Effect of Section 367(b) ...................................... 162 C. Section 367(b) Notice.......................................... 166 III. REPORTING REQUIREMENTS .......................... 167 A. Section 6038B ..................................................... 167 B. Time and Manner of Reporting ........................... 169 C. Information Required for Section 6038B(a)(1)(A) Transfers 170 D. Failure to Comply with Reporting Requirements 175 E. General Reporting and Recordkeeping Requirements 177 IV. PROPOSED BASIS AND HOLDING PERIOD RULES 184 B. Shareholder's Exchange of Foreign Target Stock for CFC Stock 184 C. P's Stock of S or T Following A Triangular Asset Reorganization 186 D. Examples ............................................................. 190 {M2436743;3} PLANNING FOR OUTBOUND TRANSFERS UNDER THE SECTION 367(A) AND 367(B) REGULATIONS, INCLUDING EXPATRIATIONS Bobbe Hirsh, Alan S. Lederman, and Martin B. Tittle I. SECTION 367(A) OUTBOUND TRANSFERS Internal Revenue Code Secs. 61 and 368 express sometimes conflicting goals that mesh and are resolved, at least in part, in Sec. 367(a). Sec. 61 expresses a policy of worldwide, as opposed to territorial, income taxation. Sec. 368 expresses a policy of facilitating corporate restructurings as required by business exigencies by exempting certain corporate reorganizations from taxation. Treas. Reg. Sec. 1.368-1(b). As has been noted by some commentators, it is possible to utilize Sec. 368 tax-free exchanges, along with Sec. 351 tax-free organizations and Sec. 332 tax-free liquidations, in the cross-border context in a manner that does not advance any business interest other than an escape from U.S. taxation. See, e.g., Samuel C. Thompson, Jr., "Impact of Code Section 367 and the European Union's 1990 Council Directive on Tax-Free Cross-Border Mergers and Acquisitions, " 66 U. Cin. L. Rev. 1193, 1209-11 (1998). The purpose of Sec 367(a) is generally to prevent the tax-free removal of property from United States taxing jurisdiction when the ability of the U.S. to tax the profits from that property cannot be preserved, even in cases when the transaction advances a business interest. Sec. 367(a)(1) denies corporate status to the foreign transferee in Secs. 332, 351, 354, 356, and 361 exchanges when a U.S. person transfers property to a foreign corporation. Because corporate status is required by those provisions for the transaction 2 to qualify for nonrecognition treatment, Section 367(a)(1) causes the transaction to be taxable by the U.S. There are two primary exceptions to the application of Sec. 367(a)(1), but each of them are subject to certain exceptions, and there are also exceptions to those exceptions that may negate their effect. These nested levels of exceptions will be classified as primary, secondary, and tertiary. The first primary exception, the stock or securities exception, is found in Sec. 367(a)(2), which provides that, except as provided by regulations, Sec. 367(a)(1) does not apply to the transfer of stock or securities of a foreign corporation that is a party to an exchange or reorganization. . The second exception, the active trade or business exception, is found in Sec. 367(a)(3), which provides that, except as provided by regulations, Sec. 367(a)(1) "shall not apply to any property transferred to a foreign corporation for use by such corporation in the active conduct of a trade or business outside of the United States." Sec. 367(a)(4) states that, unless the regulations provide otherwise, a transfer of a partnership interest by a U.S. person to a foreign corporation is treated as a transfer of that person's "pro rata share of the assets of the partnership." Not qualifying for this exception are tainted assets, including Sec. 1221(a) and (c) property (inventory and taxpayer created copyrights, compositions, and similar property), installment obligations, accounts receivable, and similar property, foreign currency and foreign currency denominated property, and property transferred by the lessor of the property. Also not included is intangible property, the transfer of which is generally subject to its own special rules under Sec. 367(d) except for outbound Sec. 332 liquidations. 3 Sec. 367(a)(5) is the source of the secondary exception to the Sec. 367(a)(2) and (3) exceptions. It states that even if the exceptions in Secs. 367(a)(2) or (3) would otherwise apply, the qualifying outbound transfer will nevertheless be subject to tax under Sec. 367(a)(1) if it involves "an exchange described in subsection (a) or (b) of section 361." This secondary exception was initially limited to C, D, F and G asset However, now that the proposed expansion of A reorganizations to include mergers with foreign corporations has been made final, this exception applies to them as well. Sec. 367(a)(5) is subject to its own tertiary exception where the transferor is controlled (within the meaning of Sec. 368(c)) by five or fewer domestic corporations and regulations basis adjustments and other conditions are complied with. In applying the "five or fewer" test, all members of the same Sec. 1504 affiliated group are treated as one corporation. Sec. 367(a)(5). Finally, Sec. 367(a)(6) is a catchall provision that allows the Secretary of the Treasury to exempt additional transactions from the purview of Sec. 367(a)(1) by regulation. Sec. 367(a)(5) does not contain any reference to Sec. 367(a)(6) and, therefore, the limitations in 367(a)(5) would not apply to an exception authorized under Sec. 367(a)(6). For purposes of these provisions, a "U.S. person" includes U.S. citizens or residents and domestic partnerships, corporations, trusts and estates. See Treas. Reg. Secs. 1.367(a)-3(c)(5)(iv) and 1.367(a)-1T(d)(1); I.R.C. Secs. 6013(g)-(h) and 7701(a)(30). A nonresident alien and a foreign corporation are not U.S. persons even if they are engaged in a U.S. trade or business. 4 A "foreign corporation" is any corporation that is not created or organized in or under the laws of the United States or a state. I.R.C. Sec.7701(a)(3) and (5); Treas. Reg. Sec. 301.7701-5. Whether an entity is a corporation is determined under the "check-the- box" regulations. Treas. Reg. Secs. 301.7701-1 and 301.7701-2. A foreign corporation in which more than 50% of the stock, by vote or value, is owned directly, indirectly or constructively by U.S. shareholders, as defined in Sec. 951(b), is a "controlled foreign corporation" (CFC), although the ownership threshold is reduce to more than 25% in the case of a foreign insurance company. Sec. 957 Only transfers described in Secs. 332, 351, 354, 356 or 361 are subject to Sec. 367(a). Outbound Sec. 355 distributions are excluded from the coverage of Sec. 367(a). They are governed by Sec. 367(e)(1). As noted, Sec. 367(a) does not apply to outbound transfers of intangible property (within the meaning of Sec. 936(h)(3)(B)) as they are governed by Sec. 367(d). In addition, Sec. 367(a) does not apply to deemed Sec. 351 exchanges resulting from a Sec. 304(a)(1) transaction. A. Transfers Transfers include not only direct transfers, but also indirect or constructive transfers. Direct transfers include B reorganizations (exchanges of stock for voting stock), A and C reorganizations (exchanges of assets for voting stock), acquisitive D reorganizations (exchanges of assets for stock of a commonly controlled acquirer) and transfers to controlled corporations (Sec. 351). Historically, regulations issued under Sec. 368(a)(1)(A) and its predecessors have (with minor variations) interpreted the phrase "statutory merger or consolidation" to apply only to a merger or consolidation effected pursuant to the laws of the United States 5 or of a State or the District of Columbia. Based on these regulations, Rev. Rul. 57-465, 1957-2 C.B. 250, held that a merger accomplished under foreign law could not qualify as an A reorganization. The requirement that a merger be effected under U.S. law generally was understood (or at least assumed) to mean that a merger of two corporations could qualify as an A reorganization only if both corporations were domestic. Where either or both of the corporations was foreign, it was generally understood (or at least assumed) that the transaction would qualify for tax-free treatment, if at all, only as a C or D reorganization. Pursuant to Treas. Reg. Sec. 1.368-2(b)(1)(ii), a statutory merger or consolidation is now defined as "a transaction effected pursuant to the statute or statutes necessary to effect the merger or consolidation," provided that, pursuant to such statute or statutes, the following occur simultaneously: (1) all of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of the target corporation (and its disregarded entities) become the assets and liabilities of the acquiring corporation (and its disregarded entities), and (2) the target corporation ceases its separate legal existence for all purposes (except for certain litigation purposes relating to assets or obligations arising, or relating to activities engaged in, prior to the transaction). Under the new regulations, mergers involving foreign corporations can qualify as A reorganizations. A merger must still satisfy the requirements of Sec. 367(a), however, to achieve non-recognition treatment. Notably, a shareholder's transfer of stock pursuant to a merger (or other reorganization) may constitute an indirect transfer subject to Sec. 367(a) in certain circumstances. 6 Indirect transfers subject to Sec. 367(a) include certain triangular A, B, or C reorganizations, as well as certain asset reorganizations followed by a contribution of assets to a controlled subsidiary. These are discussed in Section E.3, below. Note: An "asset reorganization," for purposes of Treas. Reg. Sec. 1.367(a)-3, "is defined as a reorganization described in Sec. 368(a)(1) involving a transfer of assets under Sec. 361." Treas. Reg. Sec. 1.367(a)-3(a). Treas. Reg. Sec. 1.367(a)-3(a) directs readers to Treas. Reg. Sec. 1.367(a)-1T(c) for "rules regarding other indirect or constructive transfers of stock or securities subject to Sec. 367(a)." The general rule in Treas. Reg. Sec. 1.367(a)-1T(c) is a broad, "catchall" rule that provides that Sec. 367(a)(1) applies to any "transfer of property by a U.S. person to a foreign corporation pursuant to an exchange described in Sec. 332, 351, 354, 355, 356, or 361 . . . whether it is made directly, indirectly, or constructively." Sec. 1.367(a)- 1T(c)(1). The intent and effect of this Catchall Rule has been synthesized as: "If, at the end of the day, assets of the target corporation reside in a corporation other than the foreign corporation, the stock of which was used to acquire such assets, the stock transfer rules of Sec. 367(a)(1) should apply to that acquisition with respect to those assets that lie outside the corporate solution of such foreign corporation." See Bernard T. ["Nardi"] Bress, "The New Section 367 Regulations: Going Beyond Form Over Substance," 9 J. Int'l Tax'n 10, 21 (October 1998). The Catchall Rule "gives the [I.R.S.] general authority to recast any asset acquisition, not just those [in Sec. 1.367(a)-3(d)(1)], as indirect stock transfers for Sec. 367(a)(1) purposes." Id. 7 The Catchall Rule ends by directing the reader to five nonexclusive examples, in subparagraphs (3) through (7) of Sec. 1.367(a)-1T(c), of "indirect or constructive transfers that are described in Sec. 367(a)(1)." First, a transfer by a domestic or foreign partnership is treated as an indirect transfer by the U.S. partners of their proportionate shares of the partnership's property. The U.S. partners' proportionate shares are determined under Secs. 701 through 761. Thus, where a partnership has five equal partners, two of whom are U.S. persons, and the partnership transfers assets to a foreign corporation in an exchange described in Sec. 351, the exchange is considered an indirect transfer of those assets by each of the partners, with the consequence that each U.S. partner is treated as transferring 20% of each asset to the foreign corporation. If a U.S. partner recognizes gain on the partnership's transfer of property to the foreign corporation, then the U.S. partner's basis in the partnership is increased by the amount of gain recognized, the foreign corporation's basis in the assets received is also increased by the amount of gain recognized, and solely for purposes of determining the partnership's basis in the stock of the foreign corporation, the U.S. partner is treated as having newly acquired an interest in the partnership, thereby permitting the partnership to make an optional adjustment to basis under Secs. 743 and 754. Treas. Reg. Sec. 1.367(a)- 1T(c)(3). A transfer under Sec. 367(a) by a U.S. partner of an interest in a domestic or foreign partnership is treated as an indirect transfer of a proportionate share of the partnership's property in an exchange described in Sec. 367(a). Therefore, the application of the exceptions to Sec. 367(a)(1) are determined with reference to the property of the 8 partnership, rather than the partnership interest itself. A U.S. partner's proportionate share of the partnership's property is determined under Secs. 701 through 761. Thus, for example, when a U.S. person who owns a 20% interest in a partnership transfers a 5% interest in the partnership to a foreign corporation in an exchange described in Sec. 351, the exchange is treated as an indirect transfer of the partnership's assets, and the partner is thereby treated as transferring a 5% interest in each of the assets to the foreign corporation. If a U.S. partner is treated as transferring a proportionate share of the partnership's property, then his basis for the stock of the foreign corporation is increased by the amount of any gain recognized, the foreign corporation's basis in the partnership interest is also increased by the amount of any gain recognized, and solely for purposes of determining the partnership's basis in its property, the U.S. partner is treated as having newly acquired an interest in the partnership for an amount equal to the gain recognized, thereby permitting the partnership to make an optional adjustment to basis under Secs. 743 and 754. Treas. Reg. Sec. 1.367(a)-1T(c)(3). The foregoing rule on the transfer of a partnership interest does not apply if the interest transferred is a limited partnership interest that is regularly traded on an established securities market. Treas. Reg. Sec. 1.367(a)-1T(c)(3). Instead, the transfer is treated as a transfer of stock or securities. The partnership must be organized under the laws of a state or the District of Columbia. An established securities market is a national securities exchange registered under the Securities Act of 1934, a foreign national securities exchange that is officially recognized, sanctioned or supervised by governmental authority, or an over-the-counter market. A class of interests is regularly 9 traded if it is regularly quoted by brokers or dealers making a market in such interests. A class of interests is presumed to be regularly traded if the partnership has 500 or more partners. Second, a transfer by a U.S. trust or estate is treated as a transfer by the entity, not by its beneficiaries. Thus, a transfer by a foreign trust or estate is not subject to Sec. 367(a) even if the beneficiaries of the trust or estate are U.S. persons. However, if the trust is a grantor trust, whether domestic or foreign, the grantor is treated as the transferor. Treas. Reg. Sec. 1.367(a)-1T(c)(4). Third, termination of a Sec. 1504(d) election is treated as a constructive transfer to a foreign corporation. Treas. Reg. Sec. 1.367(a)-1T(c)(5). Fourth, if a foreign entity is classified for U.S. tax purposes as an entity that is not taxable as a corporation, and subsequently a change is made in the entity's governing documents, articles, or agreements so that it thereafter is taxable as a corporation, the change in classification is considered a transfer of property to a foreign corporation in connection with an exchange described in Sec. 351 that may be subject to Sec. 367(a). Treas. Reg. Sec. 1.367(a)-1T(c)(6). Finally, a contribution to the capital of a foreign corporation may be a transfer described in Sec. 367(a)(1) if the foreign corporations is controlled by the contributing entity See Sec. 367(c)(2) and the regulations thereunder. This provision could be important if the contributing entity already owns all the stock of the foreign controlled corporation. B. Tax Consequences Under Sec. 367(a) 10 If a transfer is subject to Sec. 367(a) and an exception does not apply, then the foreign corporation is not treated as a corporation under any of the nonrecognition provisions. Accordingly, gain is recognized as if there had been a taxable sale of the property transferred. No loss, however, may be recognized. Treas. Reg. Sec. 1.367(a)- 1T(b)(3)(ii). The gain required to be recognized, however, cannot exceed the gain that would have been recognized on a taxable sale computed as if each item of property had been sold individually and with no offset of individual losses against individual gains. Treas. Reg. Sec. 1.367(a)-1T(b)(3)(i). The character and source of the gain are determined as if the property were sold in a taxable transaction to the transferee foreign corporation. If the realized gain exceeds the limitation, then the limitation is applied by making proportionate reductions in the amounts of ordinary income and capital gain. Further, appropriate adjustments to earnings and profits, basis, and other affected items are to be made, taking into account the gain recognized. Treas. Reg. Sec. 1.367(a)-1T(b)(4). For example, when a domestic corporation transfers inventory with a fair market value of $1 million and an adjusted basis of $800,000 to a foreign corporation in an exchange described in Sec. 351, with title passing in the United States, the corporation is required under Sec. 367(a)(1) to recognize a gain of $200,000. This gain is treated as ordinary income under Secs. 1201 and 1221 from sources within the United States. The domestic corporation's basis in the foreign corporation's stock is increased by the $200,000 gain recognized, and the foreign corporation's basis in the inventory is also increased by the $200,000 gain recognized. 11 C. Sec. 367(a)(2) - Foreign Stock or Securities Exception The first statutory exception to Sec. 367(a)(1) is for transfers of foreign stock. Except for certain transfers by corporations described above, a transfer by a U.S. person of stock or securities of a foreign corporation to another foreign corporation is not subject to Sec. 367(a)(1) if either of the following conditions is met: 1. The U.S. person owns less than 5% (applying the attribution rules of Sec. 318, as modified by Sec. 958(b)) of both the total voting power and the total value of the stock of the transferee foreign corporation immediately after the transfer; or 2. The U.S. person enters into a five-year gain recognition agreement with respect to the transferred stock or securities. Treas. Reg. Sec. 1.367(a)-3(b). In certain circumstances, a transfer of domestic stock is deemed to be a transfer of foreign stock. See Section E.3.b(7). If a transfer of foreign stock or securities is described in both Sec. 367(a) and Sec. 367(b), the regulations generally provide that the transfer will be subject to both provisions. Treas. Reg. Sec. 1.367(a)-3(b)(2)(i). This general, "overlap" rule, however, is subject to two important exceptions. Under the first exception, Sec. 367(b) will not apply if a foreign corporation is not treated as a corporation under Sec. 367(a)(1). Treas. Reg. Sec. 1.367(a)-3(b)(2)(i)(A). Treas. Reg. Sec. 1.367(a)-3(b)(2)(ii) provides the following example: Assume that a domestic corporation owns all of the stock of a CFC, its basis in the foreign corporation's stock is $50, the value of the foreign corporation's stock is $100, and the Sec. 1248 amount with respect to the foreign corporation's stock is $30. If an unrelated foreign 12 corporation that is not a CFC acquires all of the foreign corporation's stock from the domestic corporation in exchange for 20% of the voting stock of the unrelated foreign corporation in a Sec. 368(a)(1)(B) reorganization, the domestic corporation must enter into a five-year gain recognition agreement, or else it will be required to recognize the $50 gain that it realized on the exchange, $30 of which will be treated as a dividend under Sec. 1248. However, if it enters into a five-year gain recognition agreement, although no gain will be recognized under Sec. 367(a)(1), the exchange will still be subject to Sec. 367(b). Therefore, the domestic corporation will be required to recognize the Sec. 1248 amount of $30 on the exchange. See Section II, below. The deemed dividend of $30 that is recognized by the domestic corporation will increase its basis in the foreign corporation's stock that it receives in the exchange. Treas. Reg. Sec. 1.367(a)-3(b)(2)(ii). Under the second "overlap" exception, only Sec. 367(b) will apply in the case of an inbound triangular asset reorganization to which the indirect stock transfer rules would otherwise apply if the "all earnings and profit amount" triggered under Sec. 367(b) is greater than the gain that would be subject to Sec. 367(a). Treas. Reg. Sec. 1.367(a)- 3(b)(2)(i)(B). Note: Under prior regulations, Sec. 367(b) and the regulations thereunder did not apply if the transferee corporation was not treated as a corporation under Sec. 367(a). Therefore, if the all earnings and profits amount was greater than the Sec. 367(a) gain, an exchanging shareholder was permitted to choose to trigger gain under Sec. 367(a), by opting not to enter into a gain recognition agreement, in order to avoid inclusion of the all earnings and profits amount. The current regulations do not permit taxpayers to avoid 13 Sec. 367(b) in this manner. (For a definition of the term "all earning and profits amount," see Section II below.) D. Section 367(a)(3) - Active Trade or Business Exception The second statutory exception to Sec. 367(a)(1) is for transfers of property that will be used by the transferee foreign corporation in the active conduct of a trade or business outside the United States. Sec. 367(a)(3). Although the meaning of "property" in the context of Sec. 367(a)(3) has been debated in the past, it is now accepted that it includes stock and securities, and that Sec. 367(a)(3) is the basis for preserving nonrecognition in the case of outbound transfers of domestic stock. See Phillip Tretiak, "U.S. Section 367(a) Stock Transfers in 1998: All You Need to Know!" 17 Tax Notes Int'l 39, 40 n.8 (July 6, 1998); Bernard T. Bress, "The New Section 367 Regulations: Going Beyond Form Over Substance," 9 J. Int'l Tax'n 10, 21-22 (October 1998). (Philip Tretiak was the author of the 1998 final Sec. 367 regulations.) To qualify for the Sec. 367(a)(3) exception, the Sec. 6038B reporting requirements must be satisfied. Treas. Reg. Sec. 1.367(a)-2T(a)(2). See Section III.A below for a discussion of these reporting requirements. 1. Active Conduct of a Trade or Business Whether property is transferred for use in the active conduct of a trade or business outside the United States requires four factual determinations: a. What is the trade or business of the transferee? b. Do the activities of the transferee constitute the active conduct of that trade or business? c. Is the trade or business conducted outside the U.S.? 14 d. Is the transferred property used or held for use in the trade or business? Treas. Reg. Sec. 1.367(a)-2T(b)(1). Each of these determinations is made taking into account all facts and circumstances. A trade or business is a specific unified group of activities that constitute, or could constitute, an independent economic enterprise carried on for profit. For example, the activities of a foreign selling subsidiary could constitute a trade or business if they could be independently carried on for profit, even though the subsidiary acts exclusively on behalf of, and has operations fully integrated with, its parent corporation. The group of activities must ordinarily include every operation that forms a part of, or a step in, a process by which an enterprise may earn income or profit, and must ordinarily include the collection of income and the payment of expenses. The holding for one's own account of investments in stocks, securities, land, or other property, including casual sales thereof, does not constitute by itself a trade or business. Likewise, any activity giving rise to expenses that would be deductible only under Sec. 212, if the activity were conducted by an individual, does not constitute a trade or business. Treas. Reg. Sec. 1.367(a)-2T(b)(2). For a trade or business to be actively conducted, the officers and employees of the corporation must carry out substantial managerial and operational activities. In making this determination, the activities of independent contractors are disregarded, although incidental activities may be carried out on behalf of the corporation by independent contractors. The officers and employees of the corporation include officers and employees of related entities that are available to, supervised by, and are paid or reimbursed by the corporation. Whether a trade or business that produces rents or 15 royalties is an active trade or business is determined under the principles of Treas. Reg. Sec. 1.954-2(d)(1), without regard to whether the rents or royalties are received from an unrelated person. Treas. Reg. Sec. 1.367(a)-2T(b)(3). For a trade or business to be conducted outside the United States, the primary managerial and operational activities must be conducted outside the United States, and the transferred property must be located outside the U.S. immediately after the transfer. Thus, the active trade or business exception will not apply if the domestic business continues to operate in the United States after the transfer. As long as the primary managerial and operational activities of the trade or business are conducted outside the Unites States and substantially all of the transferred property is located outside the United States, incidental items of transferred property may be located in the United States. Treas. Reg. Sec. 1.367(a)-2T(b)(4). Property is used or held for use in a foreign corporation's trade or business if it is: a. Held for the principal purpose of promoting the present conduct of the trade or business; b. Acquired and held in the ordinary course of the trade or business, or c. Otherwise held in a direct relationship to the trade or business. Property is considered held in a direct relationship to a trade or business if it is held to meet the present needs of the trade or business, and not its anticipated future needs. Thus, property held for future diversification into a new trade or business, future expansion of a trade or business, future plant replacement, or future business 16 contingencies is not held in a direct relationship to a trade or business. Treas. Reg. Sec. 1.367(a)-2T(b)(5). If the transferee foreign corporation transfers the property to another person as part of the same transaction in which it received the property, the initial transfer will not qualify for the active trade or business exception. A transfer within six months of the initial transfer will be considered part of the same transaction. Whether a transfer more than six months after the initial transfer is considered part of the same transaction will be determined under the step transaction doctrine. Notwithstanding, the active trade or business exception will apply if the subsequent transfer is to a controlled corporation under Sec. 351 or a partnership under Sec. 721, each subsequent transferee is either a corporation in which the preceding transferor owns common stock, or a partnership in which the preceding transferor is a general partner, and the ultimate transferee uses the property in the active conduct of a trade or business outside the United States. Treas. Reg. Sec. 1.367(a)-2T(c). 2. Exceptions The Code contains a number of exceptions to the active trade or business exception. In addition, the Internal Revenue Service has promulgated regulatory exceptions under the authority granted by Sec. 367(a)(3). a. Tainted Assets The active trade or business exception does not apply to transfers of tainted assets, which are five categories of liquid or passive assets. I.R.C Sec. 367(a)(3)(B). Inventory, Copyrights and Similar Property. 17 Regardless of its use in an active trade or business, Sec. 367(a)(1) applies to the transfer of stock in trade, property of a kind which would properly be included in inventory if on hand at the close of the taxable year, and property held primarily for sale to customers in the ordinary course of business. Inventory includes raw materials and supplies, partially completed goods, and finished products. Also subject to Sec. 367(a)(1) are copyrights; literary, musical, or artistic compositions; letters or memoranda; and similar property held by the person whose personal efforts created such property. In the case of a letter, memorandum, or similar property, the property must be held by the person from whom such property was prepared or produced. This property is also subject to Sec. 367(a)(1) if it is held by a person whose basis for such property is determined, for purposes of determining gain from a sale or exchange, by reference to the basis of such property in the hands of the person who created it or from whom it was prepared or created. Treas. Reg. Sec. 1.367(a)-5T(b). Installment Obligations. Regardless of their use in an active trade or business, Sec. 367(a)(1) applies to the transfer of installment obligations, accounts receivable, or similar property, but only to the extent that the principal amount of such obligation has not previously been included by the transferor in its taxable income. Treas. Reg. Sec. 1.367(a)-5T(c). Foreign Currency.Regardless of its use in an active trade or business, Sec. 367(a)(1) applies to the transfer of foreign currency or other property denominated in foreign currency, including installment obligations, futures contracts, forward contracts, accounts receivable, or any other obligation entitling its payee to receive payment in a currency other than U.S. dollars. However, if the transferred property is denominated in the 18 currency of the country in which the transferee foreign corporation is organized, and was acquired in the ordinary course of the transferor's business that will be carried on by the transferee foreign corporation, then Sec. 367(a)(1) will apply only to the extent that gain is required to be recognized with respect to previously realized income reflected in installment obligations, as described above. The gain required to be recognized is limited to the gain realized upon the transfer of foreign currency and property denominated in foreign currency, minus any loss realized as part of the same transaction upon the transfer of such property. However, if the result is a loss, it will not be recognized. Treas. Reg. Sec. 1.367(a)-5T(d). Intangible Property.Regardless of its use in an active trade or business, a transfer of intangible property pursuant to Sec. 332 is subject to Sec. 367(a)(1) unless it constitutes foreign goodwill or going concern value. Treas. Reg. Sec. 1.367(a)-5T(e). Outbound transfers of intangible property pursuant to Sec. 351 or Sec. 361 are governed by Sec. 367(d). Leased Tangible Property.Regardless of its use in an active trade or business, Sec. 367(a)(1) applies to a transfer of tangible property leased by the transferor to others at the time of the transfer, unless either of the following two conditions is met. (1) If the transferee will not lease the property to third parties, the transferee was the lessee of the property at the time of the transfer, or (2) If the transferee will lease the property to third parties, the transferee satisfies the conditions for an active leasing business described below. Treas. Reg. Sec. 1.367(a)-5T(f). 19 b. Foreign Branches The active trade or business exception may not apply to a gain realized on a transfer of the assets of a foreign branch of a U.S. person if the foreign branch previously deducted losses. Sec. 367(a)(3)(C). A foreign branch is an integral business operation carried on by a U.S. person outside the United States. Whether the activities of a U.S. person outside the United States constitute a foreign branch operation is determined under all the facts and circumstances. Evidence of the existence of a foreign branch includes, but is not limited to, the existence of a separate set of books and records and the existence of an office or other fixed place of business used by employees or officers of the U.S. person to carry out business activities outside the United States. Activities outside the United States constitute a foreign branch if the activities constitute a permanent establishment under the terms of a treaty between the United States and the country in which the activities are conducted. Treas. Reg. Sec. 1.367(a)-6T(g)(1). If a U.S. person has more than one foreign branch, then this exception applies separately to each foreign branch that is transferred to a foreign corporation. Thus, the previously deducted losses of one foreign branch may not be offset, for purposes of determining the gain to be recognized, by the income of another foreign branch that is also transferred to a foreign corporation. Similarly, the losses of one foreign branch are not recaptured on a transfer of the assets of a separate foreign branch. Whether the foreign activities of a U.S. person are conducted through more than one foreign branch is determined under all the facts and circumstances. A separate branch generally exists if a particular group of activities is sufficiently integrated to constitute a single business that could be operated as an independent enterprise. Treas. Reg. Sec. 1.367(a)-6T(g)(2). 20 The activities of two domestic corporations outside the United States will be considered a single foreign branch if the two corporations are members of the same consolidated group of corporations, and the activities of the two corporations in the aggregate would constitute a single foreign branch if conducted by a single corporation. Notwithstanding, gains of a foreign branch of a domestic corporation arising in a year in which that corporation did not file a consolidated return with the second domestic corporation cannot be applied to reduce the previously deducted losses of the foreign branch of the second corporation, but may be applied to reduce such losses of the foreign branch of the first corporation upon the transfer of the two branches to a foreign corporation, even though the two domestic corporations file a consolidated return for the year in which the transfer occurs and the two branches are considered at that time to constitute a single foreign branch. Treas. Reg. Sec. 1.367(a)-6T(g)(3). A U.S. transferor's failure to transfer any property of a foreign branch to the foreign corporation is irrelevant to the determination of the previously deducted losses of the branch that are subject to recapture. Thus, if the activities with respect to property constituted a part of the branch operation, then the losses generated by those activities will be subject to recapture, notwithstanding the lack of a transfer of thee property. Treas. Reg. Sec. 1.367(a)-6T(g)(4). Gain recognition is required in an amount equal to the sum of the "previously deducted branch ordinary losses" and the "previously deducted branch capital losses." Treas. Reg. Sec. 1.367(a)-6T(b). The gains recognized retain their character as ordinary or capital, all capital gains are long-term, and all are treated as from sources outside the U.S. The previously deducted branch losses are computed separately for each taxable 21 year prior to the transfer (a "branch loss year"), and are calculated separately for the previously deducted branch ordinary loss and the previously deducted branch capital loss. Treas. Reg. Sec. 1.367(a)-6T(c). The previously deducted branch ordinary loss for each branch loss year is then reduced by the amount of any expired net ordinary loss with respect to that branch loss year. Expired net ordinary losses arising in years other than the branch loss year reduce the previously deducted branch ordinary loss for the branch loss year only to the extent that the previously deducted branch ordinary loss exceeds the net operating loss, if any, incurred by the transferor in the branch loss year. The previously deducted branch ordinary losses are reduced in order, proceeding from the first branch loss year to the last branch loss year. For each branch loss year, expired net operating losses are applied in the order in which they arose. Treas. Reg. Sec. 1.367(a)-6T(d)(2). An expired net ordinary loss exists with respect to a branch loss year to the extent that: The transferor incurred a net operating loss; The net operating loss arose in the branch loss year or was available for carryover or carryback to the branch loss year; The net operating loss did not result in a net operating loss deduction for any taxable year prior to the year of the transfer, nor reduce any previously deducted branch ordinary loss of any foreign branch previously transferred to a foreign corporation; and The period during which the transferor can claim a net operating loss deduction for that net operating loss has expired. 22 Treas. Reg. Sec. 1.367(a)-6T(d)(2)(ii). The previously deducted branch capital loss for each branch loss year is similarly reduced by the amount of any expired net capital loss with respect to that branch loss year. Expired net capital losses arising in years other than the branch loss year reduce the previously deducted branch capital loss for the branch loss year only to the extent that the previously deducted branch capital loss exceeds the net capital loss, if any, incurred by the transferor in the branch loss year. The previously deducted branch capital losses are reduced in order, proceeding from the first branch loss year to the last branch loss year. For each branch loss year, expired net capital losses are applied in the order in which they arose. Treas. Reg. Sec. 1.367(a)-6T(d)(3). An expired net capital loss exists with respect to a branch loss year to the extent that the transferor incurred a net capital loss, that net capital loss arose in the branch loss year or was available for carryover or carryback to the branch loss year, the net capital loss was neither allowed for any taxable year prior to the year of the transfer, nor reduced any previously deducted branch capital loss of any foreign branch previously transferred to a foreign corporation, and the period during which the transferor can claim a capital loss deduction with respect to that net capital loss has expired. Treas. Reg. Sec. 1.367(a)- 6T(d)(3)(ii). After the reductions for expired net operating and capital losses, the previously deducted branch ordinary loss and the previously deducted branch capital loss for each branch loss year are further reduced proportionately by the amount of any expired foreign tax credit loss equivalent with respect to that branch loss year. The previously deducted branch losses are reduced in order, proceeding from the first branch loss year to the last 23 branch loss year. For each branch loss year, expired foreign tax credit loss equivalents are applied to reduce the previously deducted branch loss for that year in the order in which the expired foreign tax credits arose. Treas. Reg. Sec. 1.367(a)-6T(d)(4). A foreign tax credit loss equivalent exists with respect to a branch loss year if: (A) The transferor paid, accrued, or is deemed to have paid creditable foreign taxes in a taxable year; (B) The creditable foreign taxes were paid, accrued, or deemed paid in the branch loss year or were available for carryover or carryback to the branch loss year; (C) No foreign tax credit with respect to the foreign taxes paid, accrued, or deemed paid was taken, and such taxes did not reduce any previously deducted branch loss of the foreign branch for a prior taxable year or of any previously deducted branch losses of any foreign branch previously transferred to a foreign corporation; and (D) The period during which the transferor can claim a foreign tax credit for the foreign taxes paid, accrued, or deemed paid has expired. Treas. Reg. Sec. 1.367(a)-6T(d)(4)(ii). The amount of the foreign tax credit loss equivalent for a branch loss year is the amount of creditable foreign taxes divided by the highest rate of tax to which the transferor was subject in the branch loss year. Treas. Reg. Sec. 1.367(a)-6T(d)(4)(iii). The previously deducted branch ordinary loss and the previously deducted branch capital loss for each branch loss year are then further reduced proportionately by the amount of any expired investment credit loss equivalent with respect to that branch year. 24 The previously deducted branch losses are reduced in order, proceeding from the first branch loss year to the last branch loss year. For each branch loss year, expired investment credit loss equivalents are applied to reduce the previously deducted branch loss for that year in the order in which the expired investment credits were earned. Treas. Reg. Sec. 1.367(a)-6T(d)(5). An investment credit loss equivalent exists with respect to a branch loss year if: (A) The transferor earned an investment credit; (B) The investment credit was earned in the branch loss year or was available for carryover or carryback to the branch loss year; (C) The investment credit earned by the transferor in the credit year did not reduce any previously deducted branch loss of the foreign branch for a preceding taxable year or of the previously deducted losses of any foreign branch previously transferred to a foreign corporation; and (D) The period during which the transferor can claim the investment credit has expired. Treas. Reg. Sec. 1.367(a)-6T(d)(5)(ii). The amount of the investment credit loss equivalent for the branch loss year is 85% of the amount of the investment credit divided by the highest rate of tax to which the transferor was subject in the branch loss year. Treas. Reg. Sec. 1.367(a)-6T(d)(5)(iii). Five additional amounts further reduce the sum of the previously deducted branch ordinary losses and the sum of the previously deducted branch capital losses as determined above. Treas. Reg. Sec. 1.367(a)-6T(e). Amounts representing ordinary income first reduce the sum of the previously deducted branch ordinary losses and then 25 the sum of the previously deducted branch capital losses. Similarly, amounts representing capital gains first reduce the sum of the previously deducted branch capital losses and then the sum of the previously deducted branch ordinary losses. These five amounts are as follows: (A) Any taxable income of the foreign branch recognized through the close of the taxable year of the transfer, whether before or after any taxable year in which losses were incurred. (B) Any amount recognized under Sec. 904(f)(3) due to the transfer. (C) Any gain recognized under Sec. 367(a)(1) (other than under this foreign branch rule) on the transfer of the assets of the foreign branch to the foreign corporation. (D) Any portion of any amount recognized under Sec. 904(f)(3) upon a previous transfer of property that was attributable to the losses of the foreign branch, provided that the amount did not reduce any gain otherwise required to be recognized under Sec. 367(a)(3)(C). (E) Any amounts previously recognized upon a previous transfer of assets of the foreign branch. d. Section 361 Transfers The active trade or business exception also does not apply to a Sec. 361 exchange (exchanges by corporations of property for stock). Sec. 367(a)(5). However, the active trade or business exception will apply if five or fewer domestic corporations control (within the meaning of Sec. 368(c)) the transferor. All members of the same affiliated group (within the meaning of Sec. 1504) are treated as one corporation for this purpose. Sec. 367(a)(5). Although this control group exception is subject to basis adjustments and 26 the satisfaction of other conditions to be prescribed in regulations, no regulations have been issued. c. Depreciated Property If depreciated U.S. property is transferred to a foreign corporation in an exchange described in Sec. 367(a)(1), then the transferor must recognize ordinary income even though the property will be used in the active conduct of a trade or business outside the United States. The amount includable in gross income is the amount that would have been includable in the transferor's gross income as ordinary income under Secs. 617(d)(1), 1245(a), 1250(a), 1252(a), or 1254(a), whichever is applicable, had the transferor sold the property for its fair market value in a taxable transaction. The active trade or business exception will apply to any realized gain in excess of the required depreciation recapture. Treas. Reg. Sec. 1.367(a)-4T(b). Depreciated U.S. property is mining property defined in Sec. 617(f)(2), Sec. 1245 property, Sec. 1250 property, farm land defined in Sec. 1252(a)(2), or oil, gas, or geothermal property, any of which was used in the United States or qualified as Sec. 38 property prior to its transfer. Treas. Reg. Sec. 1.367(a)-4T(b)(2). If depreciated U.S. property was used partly within and partly without the United States, then the amount required to be included in ordinary income is the full recapture amount times a fraction, the numerator of which is U.S. use and the denominator of which is total use. The full recapture amount is the amount that would be included in the transferor's income if the property had been used entirely in the United States. U.S. use is the number of months that the property either was used in the United States or qualified 27 as Sec. 38 property, and total use is the total number of months that the property was used (or available for use) by the transferor or a related person. d. Leased Property Tangible property (including non-U.S. real property) transferred to a foreign corporation for lease to others will be used in the active conduct of a trade or business outside the United States only if the following three conditions are met: (1) The foreign corporation's leasing of the property constitutes the active conduct of a leasing business; (2) The lessee is not expected to, and does not use the property in the United States; and (3) The foreign corporation has need for substantial investment in assets of the type transferred. The active conduct of a leasing business requires that the employees of the foreign corporation perform substantial marketing, customer service, repair and maintenance, and other substantial operational activities with respect to the transferred property outside of the United States. Treas. Reg. Sec. 1.367(a)-4T(c)(1). Tangible property that will be used by the foreign corporation in the active conduct of a trade or business, but will be leased during occasional brief periods when the property would otherwise be idle, qualifies for the active trade or business exception. Similarly, real property located outside the United States that is transferred to a foreign corporation for use primarily in the active conduct of a trade or business qualifies for the active trade or business exception if no more than 10% of the square footage of the property will be leased to others. Treas. Reg. Sec. 1.367(a)-4T(c)(2). 28 e. Property to be Sold Property will not qualify for the active trade or business exception if, at the time of the transfer, it is reasonable to believe that in the reasonably foreseeable future the foreign corporation will sell or otherwise dispose of any material portion of the transferred property other than in the ordinary course of business. Treas. Reg. Sec. 1.367(a)-4T(d). f. Working Interest in Oil and Gas Properties A working interest in oil and gas properties will be considered to be transferred for use in the active conduct of a trade or business if: (1) The transfer satisfies the detailed conditions set forth in Treas. Reg. Sec. 1.367(a)-4T(e)(2); (2) At the time of the transfer, the foreign corporation has no intention to farm out or otherwise transfer any part of the transferred working interest; and (3) During the first three years after the transfer there are no farmouts or other transfers of any part of the transferred working interest as a result of which the foreign corporation retains less than a 50% share of the transferred working interest. Treas. Reg. Sec. 1.367(a)-4T(e)(1). g. Compulsory Transfers 29 Property that was previously used in the country in which the transferee foreign corporation is organized will be presumed to be transferred for use in the active conduct of a trade or business outside of the United States, if: (1) The transfer is legally required by the foreign government as a necessary condition of doing business in that country; or (2) The transfer is compelled by a genuine threat of immediate expropriation by the foreign government. Treas. Reg. Sec. 1.367(a)-4T(f). h. Transfers of Certain Property to Foreign Sales Corporations ("FSCs") Sec. 367(a) does not apply to a transfer of property by a U.S. person to a foreign corporation that is an FSC if: (1) The transferee FSC uses the property to generate exempt foreign trade income; (2) The property is not excluded property, as defined in Sec. 927(a)(2); and (3) The property consists of a corporate name or tangible property that is appropriate for use in the operation of an FSC office. The foregoing rule does not apply if, within three years after the original transfer, the original transferee FSC (or a subsequent transferee FSC) disposes of the property other than in the ordinary course of business or through a transfer to another FSC. Treas. Reg. Sec. 1.367(a)-4T(h). 30 As the result of a decision by the World Trade Organization ("WTO") that FSCs constitute an export subsidy violating WTO agreements, the FSC provisions of the Code were repealed effective October 1, 2000, for new FSCs and January 1, 2002 for FSCs in existence on September 30, 2000, except for certain transactions pursuant to a binding contract that was in effect on September 30, 2000. The Tax Increase Prevention and Reconciliation Act of 2005 repealed the grandfathering of binding contracts for tax years beginning after May 17, 2006. See Sec. 513, Pub.L. 109-222 (2006). E. Treas. Reg. Sec. 1.367(a)-3 Although Treas. Reg. Sec. 1.367(a)-3 briefly addresses the Sec. 367(a)(2) foreign stock exception, its main focus lies in implementation of the Sec. 367(a)(3) active business exception with respect to transfers of domestic stock. As noted in Section I.D above, although the authority for excluding transfers of domestic stock from Sec. 367(a) has in the past been attributed to Secs. 367(a)(2) or (6), since 1998 it has been generally conceded to arise from Sec. 367(a)(3), the active trade or business exception. See Phillip Tretiak, "U.S. Section 367(a) Stock Transfers in 1998: All You Need to Know!" 17 Tax Notes Int'l 39, 40 n.8 (July 6, 1998); Bernard T. Bress, "The New Section 367 Regulations: Going Beyond Form Over Substance," 9 J. Int'l Tax'n 10, 21-22 (October 1998). (Philip Tretiak was the author of the 1998 final 367 regulations.) Treas. Reg. Sec. 1.367(a)-3 begins with general statements regarding its purpose and scope. A transfer of stock or securities by a U.S. person to a foreign corporation that is described in Sec. 351, 354 (including a reorganization described in Sec. 368(a)(1)(B) and including an indirect stock transfer described in Sec. 1.367(a)-3(d)), 356 or 361(a) or (b) is subject to Sec. 367(a)(1) unless an exception in 1.367(a)-3(b), (c), or (e) applies. 31 The 1.367(a)-3(b) exception is discussed in Section I.C, above. The exceptions in 1.367(a)-3(c) and (e) are discussed below in paragraphs 1 and 5 of this Section E. The 2006 final version of 1.367(a)-3 made the following three changes to the prior regulation: 1) The prior exception for Sec. 354 exchanges of stock that occur in the course of Code Sec. 368(a)(1)(E) and certain non-indirect-stock-transfer asset reorganizations is expanded to include exchanges of both stock and securities under both Sec. 354 and 356. Treas. Reg. Sec. 1.367(a)-3(a). This change is congruent with the expansion of statutory mergers to include mergers that occur pursuant to foreign law because Sec. 356 addresses exchanges that would comply with Sec. 354 except for the presence of "boot," or consideration in addition to approved stock and securities, and boot is more widely used in statutory mergers than in those reorganizations addressed in the prior version of Sec. 1.367(a)-3. Treas. Reg. Sec. 1.368-2(b)(1)(ii)-(iii); T.D. 9242 (Jan. 26, 2006). 2) The prior exception for Sec. 354 exchanges that occur in the course of those Code Sec. 368(a)(1)(C), (D), and (F) reorganizations
that are not recharacterized by the indirect stock transfer rules of Treas. Reg. Sec. 1.367(a)-3(d) is reframed as an exception for "asset reorganizations." Treas. Reg. Sec. 1.367(a)-3(a). The term "asset reorganization" is defined as a Sec. 368(a)(1) reorganization involving a transfer of assets under Sec. 361. Treas. Reg. Sec. 1.367(a)-3(a). 3) Because a reverse triangular/reverse subsidiary merger frequently involves a contribution of parent stock to the merging subsidiary as part of the merger, the expansion of statutory mergers to include foreign corporations raised the possibility that Sec. 367(a) would apply to the transfer of this stock to a foreign target under Sec. 361. 32 To avoid this result, the 2006 final regulation exempts these transfers. Parent stock not provided as part of the plan of reorganization will continue to be treated as property of the subsidiary, and therefore subject to 367(a). Treas. Reg. Sec. 1.367(a)-3(a). Less than a month following the release of the final Treas. Reg. Sec. 1.367(a)-3 regulations on Jan. 26, 2006, new regulations were issued that amended Treas. Reg. Sec. 1.367(a)-3 to exempt certain Sec. 304(a)(1) transfers by a U.S. person of stock of a domestic or foreign corporation to a foreign corporation in exchange for stock of such foreign corporation. Treas. Reg. Sec. 1.367(a)-3(a); T.D. 9250 (Feb. 21, 2006). Sec. 304(a)(1) generally provides that, for purposes of Secs. 302 and 303, if one or more persons is in control of each of two corporations (i.e., "brother-sister" corporations), and in return for property, one corporation (the acquiring corporation) acquires stock in the corporation (the issuing corporation) from the controlling person or persons, then the property is treated as received as a distribution in redemption of the acquiring corporation's stock. To the extent that such distribution is treated as a Sec. 301 dividend, the transferor is treated as having transferred the stock of the issuing corporation to the acquiring corporation in a Sec. 351 exchange for stock of the acquiring corporation and the acquiring corporation is then treated as redeeming the stock that it is treated as having issued. The distribution is treated as a dividend to the extent of earnings and profits of the acquiring corporation and then of the issuing corporation. Any remaining portion of the distribution reduces the adjusted basis of the stock, to the extent that it exceeds such basis, is treated as gain from the sale or exchange of property. If Sec. 367(a) applied to the transaction, then a U.S. taxpayer could have multiple income inclusions from the 33 same transaction: first, dividend and/or gain under Sec. 304, and second, dividend and/or gain equal to the built-in gain in the stock of the issuing corporation under Sec. 367. Such income inclusions could potentially exceed that value of the transferred stock of the issuing corporation, which is the reason, along with undue complexity, that the IRS gave as the rationale for the new regulation. The IRS reasoning is that the income recognized in a Sec. 304(a)(1) transaction generally equals or exceeds the transferor's inherent gain in the stock of the issuing corporation. The IRS, in its explanation of the new provision, denies that it is possible that the income recognized will not equal or exceed the inherent gain. For example, if the acquiring and issuing corporations (F1 and F2, respectively) have no earnings and profits, the stock of the issuing corporation has a positive fair market value (say $100) and is transferred for consideration equal to such value ($100), and the U.S. shareholder has no basis in F1 but $100 of basis in F2, the IRS maintains that U.S. shareholder would recognize the $100 of built-in gain in the F1 stock and continue to have $100 of basis in the F2 stock that the U.S. shareholder continues to hold. The IRS states that it does not believe that current law allows the U.S. shareholder to recover its basis in the F2 stock that it holds, but only the F2 stock deemed to have been received in the Sec. 351(a) exchange, which would take a basis under Sec. 362 equal to the U.S. shareholder's basis in the F1 stock. The IRS further announced that this issue will be addressed as part of a project dealing with the recovery of basis in redemptions treated as Sec. 301 dividends. The final T.D. 9250, like the earlier proposed regulations (REG-127740-04, 2005- 24 I.R.B. 1254), bifurcates a transfer of issuing stock in return for both property and the stock of acquiring into two transactions: a transfer for property which is treated as a Sec. 34 351 exchange by reason of Sec. 304(a)(1), and a transfer for stock which is treated as a Sec. 351 exchange other than by operation of Sec. 304(a)(1). If the sale of stock is for an amount less than the fair market value of the transferred stock, the acquiring company is deemed to issue stock to the transferor other than as a result of Sec. 304(a)(1). In both cases, Sec. 367 would not apply to only the portion of the transaction in which the stock is treated as transferred for property (i.e., the portion of the transaction treated as a Sec. 351 exchange by operation of Sec. 304), and Sec. 367 would apply to the portion of the transaction in which the consideration for the issuing corporation's stock is, or is deemed to be, stock of the acquiring corporation. The new provisions in T.D. 9250 apply to Sec. 304(a)(1) transactions occurring on or after February 21, 2006. Taxpayers can also apply them to transactions that occurred in all their open tax years, but if they elect to do so, they must apply the new provisions to all of the Sec. 304(a)(1) transactions that took place during all such open tax years. Any gain recognition agreements (discussed in Section I.E.2 below) that had been filed for such transactions will terminate and have no further effect. 1. Transfers of Stock or Securities of Domestic Corporations The paragraphs in this subsection detail the requirements set forth in Treas. Reg. Sec. 1.367(a)-3(c), "Transfers by U.S. persons of stock or securities of domestic corporations to foreign corporations." a. Introduction The 2006 final version of Sec. 1.367(a)-3 in T.D. 9243 made only one change to subparagraph (c): The definition of "transferee foreign corporation" in paragraph (c)(5)(vi) was changed from "the foreign corporation whose stock is received in the 35 exchange by U.S. persons" to "except as provided in [Treas. Reg. Sec. 1.367(a)-3] (d)(2)(i)(B), . . . the foreign corporation whose stock is received in the exchange by U.S. persons." This definition is, unfortunately, at odds with the definition of "transferee foreign corporation" in 1.367(a)-3(d)(2)(i). That definition reads, "Except as provided in paragraph [Treas. Reg. Sec. 1.367(a)-3](d)(2)(i)(B), the transferee foreign corporation shall be the foreign corporation that issues stock or securities to the U.S. person in the exchange." Treas. Reg. Sec. 1.367(a)-3(d)(2)(i). There does not appear to be any reason for the omitting the word "securities" in paragraph (c)(5)(vi) when it is included in paragraph (d)(2)(i), and the version of paragraph (c)(5)(vi) in the 2005 proposed regulation included the word "securities" and was, in fact, identical to the definition in paragraph (d)(2)(i). In light of the implementation of Notice 2005-6, 2005-5 I.R.B. 448, in the 2006 final regulations, it is likely that omission of the word "securities" in paragraph (c)(5)(vi) was an oversight. See T.D. 9243 (Jan. 26, 2006) at Preamble, Summary of Comments and Explanation of Provisions, Sec. B.2. Nevertheless, because the I.R.S. stated in the T.D. 9243 preamble that it intentionally chose to omit "securities" from some provisions (the example given was Treas. Reg. Sec. 1.367(a)-8(e)(1)(i)), taxpayers and their advisors would do well to be cautious until guidance is issued addressing this discrepancy in the definition of "transferee foreign corporation." There is one unchanged portion of Treas. Reg. Sec. 1.367(a)-3(c) that deserves mention because it could be confusing to practitioners who are new to this regulation or who do not deal with it frequently. Paragraph (c) contains two subparagraphs with 36 almost identical title phrases. Paragraph (c)(7), titled "Ownership Statements," sets forth the procedure for rebutting the presumption in paragraph (c)(2) that all target transferors are U.S. persons. Paragraph (c)(5)(i), titled "Ownership Statement," outlines the form and factors to be included in a statement submitted pursuant to paragraph (c)(7). b. The provisions of Treas. Reg. Sec. 1.367(a)-3(c) (1) Except as provided in Sec. 367(a)(5), a transfer by a U.S. person of stock or securities of a domestic corporation to a foreign corporation is not subject to Sec. 367(a)(1) if the following five conditions are met: (A) The domestic corporation whose stock or securities were transferred (the "U.S. target company") complies with the relevant reporting requirements (see Section I.E.1.b(4) below). (B) Fifty percent or less of both the total voting power and the total value of the stock of the transferee foreign corporation is received in the transaction, in the aggregate, by U.S. transferors (the "50% threshold"). (C) No more than 50% of both the total voting power and the total value of the stock of the transferee foreign corporation is owned, in the aggregate, immediately after the transfer by U.S. persons that are either officers or directors of the U.S. target company or that are 5% target shareholders (i.e., there is no "control group"). For purposes of this condition, any stock of the transferee foreign corporation owned by U.S. persons immediately after the transfer is taken into account, whether or not it was received in the exchange. 37 (D) Either the U.S. person is not a 5% transferee shareholder, or the U.S. person enters into a five-year gain recognition agreement to recognize gain with respect to the U.S. target company stock or securities it exchanged. (E) The active trade or business test is satisfied (see Section I.E.1.b(3) below). Treas. Reg. Sec. 1.367(a)-3(c)(1). For purposes of these conditions, any person who transfers stock or securities of the U.S. target company is presumed to be a U.S. person unless this presumption is rebutted, as described below. (2) Definitions The following definitions apply in determining whether the five conditions set forth above are satisfied. Ownership Statement. An ownership statement is used to rebut the presumption of ownership by a U.S. person. It is a statement, signed under the penalties of perjury, stating: The identity and taxpayer identification number, if any, of the person making the statement. That the person making the statement is not a U.S. person. That the person making the statement either owns less than 1% of the total voting power and total value of the U.S. target company's stock, and that he did not acquire the stock with a principal purpose of enabling the U.S. transferors to satisfy the ownership condition to avoid Sec. 367(a)(1); or that the person is not related to any U.S. person to whom the stock or securities owned by him could be 38 attributed under Sec. 958(b), and that he did not acquire the stock with a principal purpose of enabling the U.S. transferors to satisfy the ownership condition to avoid Sec. 367(a)(1). The person's citizenship, permanent residence, home address, and U.S. address, if any. The person's ownership (by voting power and by value) in the U.S. target company prior to the exchange and the amount of stock of the transferee foreign corporation (by voting power and value) received by him in the exchange. Treas. Reg. Sec. 1.367(a)-3(c)(5)(i). 5% Transferee Shareholder. A 5% transferee shareholder is a person that owns at least 5% of either the total voting power or the total value of the stock of the transferee foreign corporation immediately after the transfer. Treas. Reg. Sec. 1.367(a)-3(c)(5)(ii). 5% Target Shareholder. A 5% target shareholder is a person that owns at least 5% of either the total voting power or the total value of the stock of the U.S. target company immediately prior to the transfer. Treas. Reg. Sec. 1.367(a)-3(c)(5)(iii). Qualified Subsidiary. A qualified subsidiary is a foreign corporation at least 80% owned (by total voting power and total value), directly or indirectly, by the transferee foreign corporation. A corporation will not be treated as a qualified subsidiary if it was affiliated with the U.S. target company (within the meaning of Sec. 1504(a)) at any time during the 36-month period prior to the transfer. Nor will a corporation be a qualified subsidiary if it was acquired by the transferee foreign corporation at any time during the 36-month period prior to the transfer for the principal purpose of satisfying the active 39 trade or business test, including the substantiality test. Treas. Reg. Sec. 1.367(a)- 3(c)(5)(vii). Qualified Partnership. A qualified partnership is a partnership in which the transferee foreign corporation has active and substantial management functions as a partner with regard to the partnership's business, or has at least a 25% interest in the partnership's capital and profits. A partnership is not a qualified partnership if the U.S. target company or any affiliate of the U.S. target company (within the meaning of Sec. 1504(a)) held a 5% or greater interest in the partnership's capital and profits at any time during the 36-month period prior to the transfer. Nor will a partnership be a qualified partnership if the transferee foreign corporation's interest was acquired at any time during the 36-month period prior to the transfer for the principal purpose of satisfying the active trade or business test, including the substantiality test. Treas. Reg. Sec. 1.367(a)-3(c)(5)(viii). (3) Active Trade or Business Test The active trade or business test is satisfied if the following conditions are met: The transferee foreign corporation, or any qualified subsidiary or qualified partnership, is engaged in an active trade or business outside the United States, within the meaning of Treas. Reg. Sec. 1.367(a)-2T(b)(2) and (3), for the entire 36-month period immediately before the transfer; At the time of the transfer, neither the transferors nor the transferee foreign corporation (and, if applicable, the qualified subsidiary or qualified partnership engaged in the active trade or business) have an intention to substantially dispose of or discontinue such trade or business; and 40 The substantiality test described below is satisfied. Treas. Reg. Sec. 1.367(a)-3(c)(3)(i). A transferee foreign corporation, qualified subsidiary, or qualified partnership will be considered to be engaged in an active trade or business for the entire 36-month period preceding the exchange if it acquires at the time of, or any time prior to, the exchange a trade or business that has been active throughout the entire 36-month period preceding the exchange. This special rule does not apply, however, if the acquired active trade or business assets were owned by the U.S. target company or any affiliate (within the meaning of Sec. 1504(a)) at any time during the 36-month period prior to the exchange. Nor does this special rule apply if the principal purpose of the acquisition was to satisfy the active trade or business test. Further, an active trade or business does not include managing investments for the account of the transferee foreign corporation or any affiliate. Treas. Reg. Sec. 1.367(a)-3(c)(3)(ii). A transferee foreign corporation satisfies the substantiality test if, at the time of the exchange, the fair market value of the transferee foreign corporation is at least equal to the fair market value of the U.S. target company. For purposes of this condition, the value of the transferee foreign corporation includes assets acquired outside the ordinary course of its business during the 36-month period preceding the exchange only if either of the following conditions is met: At the time of the exchange, such assets or, as applicable, the proceeds thereof, do not produce, and are not held for the production of, passive income as defined in Sec. 1296(b), and such assets were not acquired for the principal purpose of satisfying the substantiality test; or 41 Such assets consist of the stock of a qualified subsidiary or an interest in a qualified partnership. Further, the value of the transferee foreign corporation will not include the value of the stock of any qualified subsidiary or any interest in a qualified partnership to the extent that such value is attributable to assets acquired by the qualified subsidiary or partnership outside the ordinary course of its business and within the 36-month period preceding the exchange unless those assets satisfy either of the two conditions set forth above. The value of the transferee foreign corporation also will not include the value of assets received within the 36-month period prior to the exchange, notwithstanding that either of the two conditions set forth above are met, if such assets were owned by the U.S. target company or an affiliate at any time during the 36-month period prior to the exchange. Treas. Reg. Sec. 1.367(a)-3(c)(3)(iii). If a partnership (whether domestic or foreign) owns stock or securities in the U.S. target company or the transferee foreign corporation, or transfers stock or securities in an exchange described in Sec. 367(a), each partner in the partnership, and not the partnership itself, is treated as owning or having transferred a proportionate share of the stock or securities. An option (or an interest similar to an option) will be treated as exercised and, thus, will be counted as stock for purposes of determining whether the 50% threshold is exceeded or whether a control group exists if a principal purpose for the issuance or acquisition of the option (or other interest) was the avoidance of Sec. 367(a)(1). Treas. Reg. Sec. 1.367(a)-3(c)(4). If immediately after the transfer the U.S. target company owns, directly or indirectly (applying the attribution rules of Secs. 267(c)(1) and (5)), stock of the 42 transferee foreign corporation, that stock will not in any way be taken into account (and, thus, will not be treated as outstanding) in determining whether the 50% threshold is exceeded or whether a control group exists. The stock attribution rules of Sec. 318, as modified by the rules of Sec. 958(b), apply for purposes of determining the ownership or receipt of stock, securities or other property. Treas. Reg. Sec. 1.367(a)-3(c)(4). (4) Reporting Requirements Where 10% or more of the total voting power or the total value of the stock of the U.S. target company is transferred by U.S. persons, a U.S. transferor qualifies for the exception in Treas. Reg. Sec. 1.367(a)-3(c) only if the U.S. target company complies with the following reporting requirements. The U.S. target company must attach to its timely filed U.S. income tax return for the taxable year in which the transfer occurs a statement titled: "Section 367(a) -- Reporting of Cross-Border Transfer Under Reg. Sec. 1.367(a)- 3(c)(6)." The statement must be signed under the penalties of perjury by an officer of the corporation to the best of the officer's knowledge and belief, and must disclose the following information: A description of the transaction in which a U.S. person or persons transferred stock or securities in the U.S. target company to the transferee foreign corporation in a transfer otherwise subject to Sec. 367(a)(1); The amount (specified as to the percentage of the total voting power and the total value) of stock of the transferee foreign corporation received in the transaction, in the aggregate, by persons who transferred stock or securities of the U.S. target company; 43 The amount (if any) of transferee foreign corporation stock owned directly or indirectly (applying the attribution rules of Secs. 267(c)(1) and (5)) immediately after the exchange by the U.S. target company; A statement that there is no control group; A list of U.S. persons who are officers, directors or 5% target shareholders and the percentage of the total voting power and the total value of the stock of the transferee foreign corporation owned by such persons both immediately before and immediately after the transaction; and A statement that includes the following: (A) A statement that the active trade or business test is satisfied by the transferee foreign corporation and a description of such business; (B) A statement that on the day of the transaction, there was no intent on the part of the transferors or the transferee foreign corporation (or any qualified subsidiary or qualified partnership, if relevant) to substantially dispose of or discontinue its active trade or business; and (C) A statement that the substantiality test is satisfied, and documentation that such test is satisfied, including the value of the transferee foreign corporation and the value of the U.S. target company on the day of the transfer, and either one of the following: (D) A statement demonstrating that the value of the transferee foreign corporation 36 months prior to the acquisition, plus the value of any assets acquired by the transferee foreign corporation within the 36-month period, less 44 the amount of any liabilities acquired during that period, exceeds the value of the U.S. target company on the acquisition date; or (E) A statement demonstrating that the value of the transferee foreign corporation on the date of the acquisition, reduced by the value of any assets acquired by the transferee foreign corporation within the 36-month period, exceeds the value of the U.S. target company on the date of the acquisition. Treas. Reg. Sec. 1.367(a)-3(c)(6). An income tax return will be considered timely filed if it is filed, together with the required statement, on or before the last day for filing the federal income tax return (including extensions) for the taxable year in which the transfer occurs. If a return is not timely filed, the District Director may make a determination, based on all facts and circumstances, that the taxpayer had reasonable cause for its failure to timely file a return, and if such a determination is made, the timely-filed requirement will be waived. Treas. Reg. Sec. 1.367(a)-3(c)(6). To rebut the ownership presumption, the U.S. target company must obtain ownership statements from a sufficient number of persons that transfer U.S. target company stock or securities that are not U.S. persons to demonstrate that the 50% threshold is not exceeded. In addition, the U.S. target company must attach to its timely filed U.S. income tax return (as described above) for the taxable year in which the transfer occurs a statement titled: "Section 367(a) - Compilation of Ownership Statements under Reg. Sec. 1.367(a)-3(c)." The statement must be signed under the penalties of perjury by an officer of the corporation, and must disclose the following information: 45 (A) The amount (specified as to the percentage of total voting power and total value) of stock of the transferee foreign corporation received, in the aggregate, by U.S. transferors; (B) The amount (specified as to the percentage of total voting power and total value) of stock of the transferee foreign corporation received, in the aggregate, by foreign persons that filed ownership statements; and (C) A summary of the information tabulated from the ownership statements, including: The names of the persons that filed ownership statements stating that they were not U.S. persons; The countries of residence and citizenship of such persons; and Each of such person's ownership (by voting power and by value) in the U.S. target company prior to the exchange and the amount of stock of the transferee foreign corporation (by voting power and value) received by such persons in the exchange. Treas. Reg. Sec. 1.367(a)-3(c)(7). (5) Private Letter Rulings The Internal Revenue Service may, in limited circumstances, issue a private letter ruling to permit a taxpayer to qualify for the exception in Treas. Reg. Sec. 1.367(a)-3(c) if: The taxpayer is unable to satisfy all of the requirements relating to the active trade or business test in paragraph (c)(1)(iv), but it meets all of the other requirements in paragraphs (c)(1)(i) through (c)(1)(iii) and is substantially in compliance with the active trade or business rules set forth in paragraph (c)(3) (see, e.g. Ltr. Rul. 200536017); or The taxpayer is unable to satisfy any requirement of paragraph (c)((1) due to the application of the stock attribution rules of Sec. 318. 46 Notwithstanding the foregoing, the Internal Revenue Service will not rule on whether the principal purpose of an acquisition was to satisfy the active trade or business test, including the substantiality test. Treas. Reg. Sec. 1.367(a)-3(c)(9). (6) Examples in Treas. Reg. Sec. 1.367(a)-3(c)(10) The exception provided by paragraph (c) is illustrated by the following examples. Example 1. ForCo Corp., a foreign corporation, issues 51% of its stock to the shareholders of USCo Inc., a domestic corporation, in exchange for their USCo stock in a transaction described in Sec. 367(a)(1). All shareholders of USCo who receive stock of ForCo are presumed to be U.S. persons. Unless this ownership presumption is rebutted, the paragraph (c)(1) exception will not be available because more than 50% of ForCo is owned by U.S. persons. As a result, all U.S. persons that transferred USCo stock will recognize gain on the exchange. To rebut the ownership presumption, USCo must comply with the reporting requirements and obtain ownership statements from a sufficient number of non- U.S. persons who received ForCo stock to demonstrate that the amount of ForCo stock received by U.S. persons in the exchange did not exceed 50%. Example 2. Assume the same facts as in Example 1 except that ForCo issues only 40% of its stock to the shareholders of USCo in the exchange, and that ForCo satisfies the active trade or business test. Angela Aline, a U.S. person, owns 10% of USCo's stock immediately before the transfer. All other USCo shareholders own less than 5% of its stock. None of USCo's officers or directors owns any stock in ForCo immediately after the transfer. Angela will own 15% of the stock of ForCo immediately after the transfer, 4% received in the exchange 47 (10% of 40%) and the balance being stock she owned prior to and independent of the transaction. No USCo shareholder besides Angela owns 5% or more of ForCo stock immediately after the transfer. USCo satisfies the reporting requirements. The conditions for the exception in paragraph (c)(1)(i) are satisfied because, even after application of the presumption of U.S. ownership, U.S. transferors did not receive more than 50% of ForCo's stock in the transaction. There is no control group because 5% target shareholders and officers and directors of USCo do not, in the aggregate, own more than 50% of the stock of ForCo immediately after the transfer (Angela, the sole 5% target shareholder, owns only 15% of the ForCo stock immediately after the transfer, and no officers or directors of USCo own any stock of ForCo immediately after the transfer). Thus, U.S. persons that are not 5% transferee shareholders will not recognize any gain on the exchange of USCo shares for ForCo shares. Angela, a 5% transferee shareholder, will not recognize any gain on the exchange if she enters into a five- year gain recognition agreement. Example 3. Assume the same facts as in Example 2 except that Barney Bly, another U.S. person, is a 5% target shareholder, owning 25% of USCo's stock immediately before the transfer. Barney owns 40% of the stock of ForCo immediately after the transfer, 10% received in the exchange (25% of 40%), and the balance being stock in ForCo that he owned prior to and independent of the transaction. A control group exists because Angela and Barney, each a 5% target shareholder, together own more than 50% of ForCo immediately after the transfer (counting both stock received in the exchange and stock owned prior to and 48 independent of the exchange). As a result, the control group condition is not satisfied, and all U.S. persons (not merely Angela and Barney) who transferred USCo stock will recognize gain on the exchange. Example 4. Assume the same as in Example 3 except that Barney is Beta Partnership, a partnership (domestic or foreign) that has five equal partners, only two of whom, Filmore Millard and Mary Squire, are U.S. persons. Filmore and Mary are treated as the owners and transferors of 5% each (20% of 25%) of the USCo stock owned and transferred by Beta, and as owners of 8% each (20% of 40%) of the ForCo stock owned by Beta immediately after the transfer. U.S. persons that are 5% target shareholders thus own a total of 31% of the ForCo stock immediately after the transfer (Angela's 15% plus Filmore's 8% plus Mary's 8%). Because no control group exists and the other conditions are met, the condition in paragraph (c)(1)(ii) is satisfied. Thus, U.S. persons that are not 5% transferee shareholders will not recognize any gain on the exchange of USCo shares for ForCo shares. Angela, Filmore and Mary, each a 5% transferee shareholder, will not recognize gain on the exchange if they enter into five-year gain recognition agreements. 2. Five-Year Gain Recognition Agreements (GRAs) a. In general. Five-year gain recognition agreements (GRAs) are required for nonrecognition under the exceptions provided in Treas. Reg. Sec. 1.367(a)-3(b) and (c) where the U.S. transferor owns 5% or more of the transferee foreign corporation after the transfer. Treas. Reg. Sec. 1.367(a)-8T. The GRA regulations were substantially revised on Feb. 5, 2007 49 with the publication of Treas. Reg. Sec. 1.367(a)-8T in T.D. 9311. Following is a tabular comparison of the provisions in the old and the new regulations. [NEW] Treas. Reg. Sec. 1.367(a)-8T [OLD] Treas. Reg. Sec. 1.367(a)-8 a) In general a) In general 1. Definitions (i) Asset reorganization (ii) Common parent (iii) Consolidated group (iv) Disposition (v) GRA (vi) Initial transfer (vii) Nonrecognition transaction (viii) Transferee foreign corporation (ix) Transferred corporation (x) Triggering event (xi) U.S. transferor 2. Filing requirements 1. Filing requirements 2. GRA forms 3. Who must sign 3. Who must sign b) GRA b) GRA 1. Contents 1. Contents 2. Description of property transferred 2. Description of property transferred 3. Terms of agreement 3. Terms of agreement 4. Waiver of period of limitation 4. Waiver of period of limitation 5. Annual certification 5. Annual certification (See Sec. (d)(8), infra.) c) Failure to comply 1. General rule (re filing GRA) (See Sec. (e)(10), infra.) 2. Reasonable cause exception c) Use of security d) Use of security d) Triggering events (unless relief in e) or g); see also 1.367(a)-3(d)(2)(iv) 1. Disposition of transferred corp stock or securities (SOS) e) Disposition (in whole or in part) of stock of transferred corporation 1. Definition of disposition 2. Partial disposition 3. Deemed disposition 2. Disposition of substantially all (sub all) of transferred corp's assets (i) Sub all asset transfer 3. Disposition of transferee stock (not SOS) 4. Deconsolidation 5. Consolidation 6. Indiv. U.S. transferor becomes non- citizen nonresident (ii) Indiv. U.S. transferor becomes non-citizen nonresident 50 [NEW] Treas. Reg. Sec. 1.367(a)-8T [OLD] Treas. Reg. Sec. 1.367(a)-8 citizen nonresident non-citizen nonresident 7. Indiv. dies; trust/estate goes out of existence 8. Failure to comply (See Sec. (c), supra.) e) Exceptions (to triggering events) 1. Certain nonrecognition transactions (i) Dispositions of transferee stock (ii) Dispositions of transferred corp SOS (iii) Disposition of transferred corp assets 2. Recapitalizations (i) Transferred corp (ii) Transferee corp 3. Certain asset reorganizations (i) Transfers of transferee corp stock (ii) Transfers of transferred corp SOS (iii) Sub all asset transfers by transferred corp 4. Certain triangular reorganizations (i) Triangular transferee corp reorgs (ii) Triangular transferred corp reorgs 5. Compulsory transfers 6. Certain liquidations and upstream reorgs of transferred into transferee 7. Death of indiv. U.S. transferor 8. Deconsolidation 9. Consolidation 10. Reasonable cause for failure to comply (See Sec. (c)(2), supra.) (Parallel provision transferred to Treas. Reg. Sec. 1.367(a)-3T(e)) f) Effect on GRA if U.S. transferor goes out of existence f) Gain recognized in connection with certain nonrecognition transactions g) Effect on GRA of certain nonrecogni- tion transactions 1. Transfers of transferee corp stock or securities (SOS) 1. Dispositions of transferred corp SOS 2. Transfer of transferred corp SOS 2. Sub all dispositions of transferred corp assets 3. Asset transfers by transferred corp g) Transactions that terminate the GRA or reduce the amount of gain required to be recognized pursuant to a GRA h) Transactions that terminate the GRA 1. Taxable disposition of transferee stock (not SOS) by U.S. transferor 1. Taxable dispositions of transferee SOS by U.S. transferor 51 [NEW] Treas. Reg. Sec. 1.367(a)-8T [OLD] Treas. Reg. Sec. 1.367(a)-8 2. Some sub all asset dispositions by a domestic transferred corp 2. Some sub all asset dispositions by a domestic transferred corp 3. Distribution or transfer by transferee of transferred corp's SOS under Secs. 337, 355 or 361 h) Effective date (1) Definitions applicable to GRAs Treas. Reg. Sec. 1.367(a)-8T(a)(1), "Definitions," is entirely new. The only separately stated definition in Treas. Reg. Sec. 1.367(a)-8 was a placeholder definition in Treas. Reg. Sec. 1.367(a)-8(a)(2) for GRA forms that would be developed in the future. That definition was excluded from Treas. Reg. Sec. 1.367(a)-8T. (A) In general, the term asset reorganization means a reorganization described in Sec. 368(a)(1) involving the transfer of assets by one corporation to another pursuant to Sec. 361. Reorganizations described in Sec. 368(a)(1)(D) or (G) are asset reorganizations for GRA purposes only if the requirements of Sec. 354(b)(1)(A) and (B) are met. With respect to the asset reorganization exceptions to triggering events in Treas. Reg. Sec. 1.367(a)-8T(e)(3)(ii) and (iii), the following reorganizations are not asset reorganizations: i) Triangular asset reorganizations described in Secs. 1.358-6(b)(2)(i) through (iii) or in Secs. 368(a)(1)(G) and (a)(2)(D) (i.e., forward triangulars, reverse triangulars, and triangular Cs and Gs). For rules that address exceptions to triggering events regarding triangular reorganizations, see Treas. Reg. Sec. 1.367(a)-8T(e)(4). Treas. Reg. Sec. 1.367(a)-8T(a)(1)(i)(A). 52 ii) Asset reorganizations where, after the reorganization, the same corporation is both the transferee foreign corporation (or successor transferee foreign corporation, as applicable) and the transferred corporation (or the successor transferred corporation, as applicable); for example, the acquisition of the transferee foreign corporation's assets by the transferred corporation in a reorganization described in Sec. 368(a)(1). For rules applicable to certain upstream and downstream reorganizations involving the transferee foreign corporation and transferred corporation, see Treas. Reg. Sec. 1.367(a)-8T(e)(6) and (g)(3). Treas. Reg. Sec. 1.367(a)- 8T(a)(1)(i)(B). (B) The term common parent means a corporation that controls an affiliated group of corporations that files its Federal income tax returns on a consolidated basis. Treas. Reg. Sec. 1.367(a)-8T(a)(1)(ii). (C) The term consolidated group has the meaning set forth in Sec. 1.1502-1(h). Treas. Reg. Sec. 1.367(a)-8T(a)(1)(iii). (D) The term disposition means any transfer that would constitute a disposition for any purpose of the Internal Revenue Code and the regulations thereunder. It also includes an indirect disposition of the stock of the transferred corporation as described in Treas. Reg. Sec. 1.367(a)-3(d). It does not, however, include a redemption of stock under Sec. 302(d) to the extent the redemption is treated as a distribution to which Sec. 301(c)(1) applies. Treas. Reg. Sec. 1.367(a)- 8T(a)(1)(iv). Although not mentioned in this definition of "disposition," taxpayers and their advisors should also consult the Catchall Rule in Treas. Reg. Sec. 1.367(a)-1T(c)(1). As noted in Section I.A above, the Catchall Rule includes within the ambit of Sec. 53 367(a)(1) any "transfer of property by a U.S. person to a foreign corporation pursuant to an exchange described in section 332, 351, 354, 355, 356, or 361 . . . whether it is made directly, indirectly, or constructively." (E) The term gain recognition agreement (usually abbreviated "GRA") means an agreement described in Treas. Reg. Sec. 1.367(a)- 8T(b). Treas. Reg. Sec. 1.367(a)-8T(a)(1)(v). (F) The term initial transfer means a transfer in connection with which a GRA is filed in connection with an exchange described in Secs. 1.367(a)-3(b) through (d) and 1.367(a)-3T(e). Treas. Reg. Sec. 1.367(a)-8T(a)(1)(vi). (G) The term nonrecognition transaction means any disposition of property in a transaction in which gain or loss is not recognized in whole or in part for purposes of I.R.C. Subtitle A. Treas. Reg. Sec. 1.367(a)-8T(a)(1)(vii). (H) The term transferee foreign corporation is defined as the foreign corporation the stock of which is received in an exchange described in Sec. 367(a) by a U.S. transferor. Unfortunately, this definition ignores the situation addressed in Treas. Reg. Secs. 1.367(a)-3(d)(1)(iii)(B) and (d)(2)(i)(B). Those sections discuss triangular/subsidiary B reorganizations involving a foreign acquiring corporation with a domestic parent, and the latter section instructs that in such a reorganization, "the transferee foreign corporation shall be the foreign acquiring corporation," even though it is stock of the domestic parent that is received by the U.S. transferor in the exchange. While it is likely that the definition above and the one in Treas. Reg. Sec. 1.367(a)-3(d)(2)(i)(B) can be harmonized (see, e.g., the definition of "transferred corporation" in Treas. Reg. Sec. 1.367(a)-8T(a)(1)(ix), set forth in Section 54 I.E.2.a(1)(I) below), taxpayers and their advisors would do well to be cautious until guidance resolving this discrepancy is issued. Treas. Reg. Sec. 1.367(a)-8T(a)(1)(viii). (I) Transferred corporation. Other than in the case of an indirect stock transfer, the term transferred corporation means the corporation the stock or securities of which are transferred by a U.S. transferor to a foreign corporation in an exchange described in Sec. 367(a)(1). In the case of an indirect stock transfer, the term transferred corporation has the meaning set forth in Sec. 1.367(a)- 3(d)(2)(ii). Treas. Reg. Sec. 1.367(a)-8T(a)(1)(ix). (J) The term triggering event means an event described in Treas. Reg. Sec. 1.367(a)-8T(d), except as provided in Treas. Reg. Sec. 1.367(a)-8T(e) (exceptions to triggering events) and Treas. Reg. Sec. 1.367(a)-8T(g) (terminations of GRAs). Treas. Reg. Sec. 1.367(a)-8T(a)(1)(x). (K) The term U.S. transferor means a U.S. person (as defined in Sec. 1.367(a)-1T(d)(1)) that transfers stock or securities of the transferred corporation in exchange for stock or securities of the transferee foreign corporation in an exchange described in Sec. 367(a). For the application of the rules of Treas. Reg. Sec. 1.367(a)-8T to indirect transfers involving partnerships and interests therein, see Sec. 1.367(a)-1T(c)(3). Treas. Reg. Sec. 1.367(a)-8T(a)(1)(xi). This definition is problematic because the definition of "transferred corporation," in Treas. Reg. Sec. 1.367(a)-8T(a)(1)(ix) (see Section I.E.2.a(1)(I) above) imports the definition of "transferred corporation" in Treas. Reg. Sec. 1.367(a)-3(d)(2)(ii) for indirect stock transfers, and that definition states that, in general, "the transferred corporation shall be the acquiring corporation." A better formulation would have used the definition 55 of U.S. transferor in Treas. Reg. Sec. 1.367(a)-3(c)(5)(v): "A U.S. transferor is a U.S. person (as defined in [Treas. Reg. Sec. 1.367(a)-3](c)(5)(iv) [which incorporates Sec. 1.367(a)-1T(d)(1) by reference]) that transfers stock or securities of one or more U.S. target companies [defined in the front language of Treas. Reg. Sec. 1.367(a)-3(c)(1) as "domestic corporation's] the stock or securities of which are transferred"] in exchange for stock of the transferee foreign corporation in an exchange described in Sec. 367." Once again, taxpayers and their advisors would do well to be cautious in applying definition of "U.S. transferor" in Treas. Reg. Sec. 1.367(a)-8T(a)(1)(xi) to indirect stock transfers. (2) Filing requirements A U.S. transferor's GRA must be attached to, and filed by the due date (including extensions) of, the U.S. transferor's income tax return for the taxable year that includes the date of the initial transfer, except that if the U.S. transferor is a member of a consolidated group for the taxable year in which the transfer was made, the agreement must be attached to the consolidated group's tax return. If a new GRA is entered into pursuant to a triggering event exception in Treas. Reg. Sec. 1.367(a)-8T(e), the new GRA must be attached to, and filed by the due date (including extensions) of, the applicable income tax return for the taxable year that includes the date of the triggering event. Taxpayers that fail to comply with these timeliness requirements should determine whether the reasonable cause exception in Treas. Reg. Sec. 1.367(a)-8T(e)(10) applies. If it does not, then the failure to comply with constitute a triggering event pursuant to Treas. Reg. Sec. 1.367(a)-8T(d)(8). Treas. Reg. Sec. 1.367(a)-8T(a)(2). (3) Who must sign A GRA must be signed under the penalties of perjury by: 56 In the case of a corporate U.S. transferor, a responsible officer, except that if the U.S. transferor (or successor U.S. transferor designated in a new GRA entered into under Treas. Reg. Sec. 1.367(a)-8T(e)) is a member, but not the common parent of a consolidated group for the taxable year in which the transfer was made (or for the taxable year in which a new GRA is entered into under Treas. Reg. Sec. 1.367(a)-8T(e)) the agreement must be entered into by the common parent and signed by a responsible officer of such common parent. In case of an individual, by the individual U.S. transferor (including a partner who is treated as a transferor pursuant to Treas. Reg. Sec. 1.367(a)-1T(c)(3)). In the case of a trust or estate, by a trustee, executor, or equivalent fiduciary. In a bankruptcy case under Title 11 of the United States Code, by the debtor in possession or trustee. An agreement may also be signed by an agent authorized to do so under a general or specific power of attorney. Additionally, the filing and signing requirements for a GRA, certification, or other information required by Treas. Reg. Sec. 1.367(a)-8T are considered satisfied by the attachment and filing of an unsigned copy with the taxpayer's U.S. federal income tax return as long as the taxpayer retains the original in its records in the manner specified by Treas. Reg. Sec. 1.6001-1(e). Treas. Reg. Sec. 1.367(a)-8T(a)(3). b. Gain recognition agreement (GRA) (1) Contents 57 The GRA must set forth the following information, with the heading "GAIN RECOGNITION AGREEMENT UNDER SEC. 1.367(a)-8T", and with paragraphs labeled to correspond with the numbers set forth in the Regulations: 1. A statement that the document submitted constitutes the U.S. transferor's agreement to recognize gain in accordance with the requirements of Treas. Reg. Sec. 1.367(a)-8T; 2. A description of the property transferred, as described in Treas. Reg. Sec. 1.367(a)-8T(b)(2) and Section E.2.b.(2) below; 3. The U.S. transferor's agreement to recognize gain, as described in Treas. Reg. Sec. 1.367(a)-8T(b)(3) and Section E.2.b.(3)below; 4. A waiver of the period of limitations, as described in Treas. Reg. Sec. 1.367(a)-8T(b)(4) and Section E.2.b.(4)below; 5. An agreement to file a certification, as described in Treas. Reg. Sec. 1.367(a)- 8T(b)(5) and Section E.2.b.(5) below, with the U.S. transferor's tax returns for the five full taxable years following the year of the transfer; 6. A statement that arrangements have been made in connection with the transferred property to ensure that the transferor will be informed of any triggering events; and 7. A statement as to whether, if all or a portion of the GRA is triggered pursuant to Treas. Reg. Sec. 1.367(a)-8T(d), the taxpayer elects to include the required amount in the year of the triggering event rather than in the year of the initial transfer (a "triggering year election"). Treas. Reg. Sec. 1.367(a)-8T(b)(1). As the example in Treas. Reg. Sec. 1.367(a)-8T(e)(1) illustrates, foregoing the election and choosing by default to include 58 gain in the year of the initial transfer freezes the portion of that gain that may be recharacterized as a dividend pursuant to Sec. 1248. Making the election, on the other hand, leaves the Sec. 1248 amount open until the year of the triggering event. Treas. Reg. Sec. 1.367(a)-8T(b)(1). For a definition of a Sec. 1248 amount, see Section II below. (2) Description of property transferred The GRA must include a description of each property transferred by the U.S. transferor, an estimate of the fair market value of the property as of the date of the initial transfer, a statement of the cost or other basis of the property and any adjustments thereto, the date on which the property was acquired by the U.S. transferor, and the following information: (A) The type or class, amount, and characteristics of the stock or securities transferred, as well as the name, address, and place of incorporation of the issuer of the stock or securities, and the percentage (by voting power and value) that the stock represents of the total stock outstanding of the transferred corporation; (B) The name, address and place of incorporation of the transferee foreign corporation, and the percentage of stock (by voting power and value) that the U.S. transferor received or will receive in the transaction; (C) If stock or securities are transferred pursuant to Sec. 1.367(a)-3T(e) (i.e., in a transaction in which the U.S. transferor goes out of existence), a statement that the conditions set forth in the second sentence of Sec. 367(a)(5) and any regulations under that section have been satisfied, and an explanation 59 of any basis or other adjustments made pursuant to Sec. 367(a)(5) and any regulations thereunder; (D) If the transferred corporation is a domestic corporation, the taxpayer identification number of the transferred corporation, together with a statement describing whether, and if so, how, Sec. 7874 applies to the transfer, and a statement that all of the requirements of Sec. 1.367(a)-3(c)(1) are satisfied; (E) If the transferred corporation is a foreign corporation, a statement as to whether the U.S. transferor was a Sec. 1248 shareholder, as defined in Sec. 1.367(b)-2(b), of the transferred corporation immediately before the exchange, and, if so, a statement as to whether the U.S. transferor is a Sec. 1248 shareholder with respect to the transferee foreign corporation stock received, and whether any reporting requirements or other rules contained in regulations under Sec. 367(b) are applicable, and, if so, whether they have been satisfied; and (F) If the transaction involved the transfer of assets other than stock or securities and the transaction was subject to the indirect stock transfer rules of Treas. Reg. Sec. 1.367(a)-3(d) (see Section E.3 below), a statement as to whether the reporting requirements under Sec. 6038B have been satisfied with respect to the transfer of property other than stock or securities, and an explanation of whether gain was recognized under Sec. 367(a)(1) and whether Sec. 367(d) was applicable to the transfer of such assets, or whether any tangible assets qualified for nonrecognition treatment under the active trade or business exception Treas. Reg. Sec. 1.367(a)-8(b)(2). (3) Terms of agreement 60 If before the close of the fifth full taxable year (not less than 60 months) following the close of the taxable year of the initial transfer, there is a triggering event, then, unless a triggering year election was made, by the 90th day thereafter the U.S. transferor must file an amended Federal income tax return for the year of the initial transfer and recognize the gain realized but not recognized upon the initial transfer. The gain recognition period can be from just over 60 months to just under 72 months since it expires at the end of the fifth full taxable year after the year of the transfer. For example, if a calendar year taxpayer transfers assets in January, 2003, the gain recognition periods ends December 31, 2008, or 72 months later. However, if the transfer is in December, 2003, the gain recognition period still ends December 31, 2008, or 60 months later. The U.S. transferor must pay the resulting increase in tax, plus interest. If a triggering year election was made, then the U.S. transferor must include the gain realized but not recognized on the initial transfer in income on its Federal income tax return for the taxable year that includes the date of the triggering event, and interest must be paid on any additional tax due. If a taxpayer makes a triggering year election but fails to include the gain realized in income, the Commissioner may, in his discretion, include the gain in the taxpayer's income in the year of the initial transfer. No special limitations apply with respect to net operating losses, capital losses, credits against tax, or similar items. Treas. Reg. Sec. 1.367(a)-8T(b)(3)(i)-(ii). If additional tax is due, then interest must also be paid on that tax at the rates determined under Sec. 6621 for the period between the due date for the U.S. transferor's Federal income tax return for the year of the initial transfer and the date on which the 61 additional tax is paid. If a triggering year election was made, a taxpayer should include the amount of gain as taxable income on its Federal income tax return (together with other income or loss items) and include the amount of interest in its payment (or reduce the amount of any refund due by the amount of the interest). A taxpayer must also attach to its Federal income tax return a separate schedule with the heading "Calculation of Section 367 Tax and Interest," on which the amount of tax attributable to the gain and the interest required to be paid under Treas. Reg. Sec. 1.367(a)-8T are separately identified and calculated. Treas. Reg. Sec. 1.367(a)-8T(b)(3)(iii). If a U.S. transferor is required to recognize gain under Treas. Reg. Sec. 1.367(a)- 8T as a result of a triggering event, then the transferee foreign corporation's basis in the transferred stock or securities shall be increased (as of the date of the initial transfer) by the amount of gain required to be recognized by the U.S. transferor, and the U.S. transferor's basis in the stock of the transferee foreign corporation received (or deemed received) in the initial transfer shall be increased by the amount of gain required to be recognized (as of the date of the initial transfer). Other appropriate basis adjustments may also be made if they are consistent with the principles of Treas. Reg. Sec. 1.367(a)- 8T(b)(3)(iv), but in no case should an increase in basis include any tax or interest required to be paid on the gain recognized. Additionally, the transferred corporation's net asset basis should not be increased as a result of gain recognized due to the occurrence of a triggering event. Treas. Reg. Sec. 1.367(a)-8T(b)(3)(iv). (4) Waiver of period of limitation The U.S. transferor must file, with the GRA, a waiver of the period of limitation on assessment of tax upon the gain realized on the initial transfer. The waiver shall be 62 executed on Form 8838 "Consent to Extend the Time to Assess Tax Under Section 367-- Gain Recognition Agreement" and shall extend the period for assessment of such tax to a date not earlier than the eighth full taxable year following the taxable year of the initial transfer. The waiver shall also contain such other terms with respect to assessment as may be considered necessary by the Commissioner to ensure the assessment and collection of the correct tax liability for each year for which the waiver is required. The waiver should be signed by a person who would be authorized to sign the GRA pursuant to the provisions of Treas. Reg. Sec. 1.367(a)-8T(a)(3). However, as noted in that section, an unsigned copy attached to and filed with the taxpayer's U.S. Federal income tax return satisfies the filing and signing requirements as long as the taxpayer retains the original in its records in the manner specified by Treas. Reg. Sec. 1.6001-1(e). Treas. Reg. Sec. 1.367(a)-8T(b)(4). (5) Annual certification The U.S. transferor must file with its income tax return for each of the five full taxable years following the taxable year of the initial transfer a certification that there has not been a triggering event, and a description of any exception under Treas. Reg. Sec. 1.367(a)-8T(e) if such an exception is relied upon for the position that there has not been a triggering event. The U.S. transferor must include with its annual certification a statement describing any dispositions of assets by the transferred corporation that are not made in the ordinary course of business. The annual certification pursuant to Treas. Reg. Sec. 1.367(a)-8T(b)(5) must be signed (but not necessarily under the penalties of perjury) by a person who would be authorized to sign the agreement pursuant to the provisions of Treas. Reg. Sec. 1.367(a)-8T(a)(3). However, as noted in that section, an unsigned copy 63 attached to and filed with the taxpayer's U.S. Federal income tax return satisfies the filing and signing requirements as long as the taxpayer retains the original in its records in the manner specified by Treas. Reg. Sec. 1.6001-1(e). Treas. Reg. Sec. 1.367(a)-8T(b)(5). c. Use of Security The U.S. transferor may be required to furnish a bond or other security that satisfies the requirements of Treas. Reg. Sec. 301.7101-1 if the Area Director, Field Examination, Small Business/Self Employed or the Director of Field Operations, Large and Mid-Size Business (Director) determines that such security is necessary to ensure the payment of any tax on the gain realized, but not recognized, upon the initial transfer. Such bond or security generally will be required only if the stock or securities transferred are a principal asset of the U.S. transferor and the Director has reason to believe that a disposition of the stock or securities may be contemplated. Treas. Reg. Sec. 1.367(a)- 8T(c). d. Triggering events. If there is a triggering event described Treas. Reg. Sec. 1.367(a)-8T(d) during the term of the GRA, the U.S. transferor must include in income the gain realized, but not recognized, upon the initial transfer as provided in Treas. Reg. Sec. 1.367(a)-8T(b)(3)(i). In addition, the U.S. transferor must pay any interest required by Treas. Reg. Sec. 1.367(a)-8T(b)(3)(iii). See Treas. Reg. Sec. 1.367(a)-3(d)(2)(iv) for additional triggering events when a GRA has been filed in connection with an indirect stock transfer. Except to the extent provided in Treas. Reg. Secs 1.367(a)-8T(e) and (g), if any of the following events occur during the term of the GRA, it shall constitute a triggering event: 64 (1) Disposition of the Stock or Securities of the Transferred Corporation A disposition, in whole or in part, by the transferee foreign corporation (or any other person) of the transferred stock or securities received by the transferee foreign corporation in the initial transfer. For purposes of Treas. Reg. Sec. 1.367(a)-8T(d)(1), a reference to transferred stock or securities also includes stock or securities of the transferred corporation the basis of which is determined (directly or indirectly) in whole or in part, by reference to the basis of the stock or securities transferred in the initial transfer. A disposition of all or a portion of the stock or securities of the transferred corporation by installment sale is treated as a disposition of the stock or securities in the year of the installment sale. If the transferee foreign corporation or any other person disposes of only a portion of the stock or securities of the transferred corporation, then the U.S. transferor is required to recognize only a proportionate amount of the gain realized, but not recognized, upon the initial transfer. The proportion required to be recognized shall be determined by reference to the fair market value of the transferred stock or securities disposed of and the total fair market value of the transferred stock or securities immediately before the disposition. Treas. Reg. Sec. 1.367(a)-8T(d)(1). (2) Disposition of substantially all of the transferred corporation's assets A disposition of substantially all of the transferred corporation's assets (including stock in a subsidiary corporation or an interest in a partnership) by the transferred corporation or any other person. Solely for purposes of Treas. Reg. Sec. 1.367(a)- 65 8T(d)(2), the term substantially all has the meaning provided under Sec. 368(a)(1)(C). Accordingly, the determination of whether substantially all of the transferred corporation's assets have been disposed of shall be made under all the facts and circumstances. For purposes of Treas. Reg. Sec. 1.367(a)-8T(d)(2), dispositions of stock in connection with an asset reorganization of a corporation all or a portion the stock of which is owned by the transferred corporation, or a liquidation of a corporation the stock of which is owned by the transferred corporation in an amount satisfying the requirements of Sec. 1504(a)(2) and to which Secs. 332 and 337 apply, shall not be taken into account. If the initial transfer was an indirect stock transfer, see Treas. Reg. Sec. 1.367(a)- 3(d)(2)(v). If the transferred corporation is a domestic corporation, see Treas. Reg. Sec. 1.367(a)-8T(g)(2). For an example of when a disposition of substantially all the transferred corporation's assets by a person other than the transferred corporation is a triggering event, see paragraph Treas. Reg. Sec. 1.367(a)-8T(e)(6)(ii). Treas. Reg. Sec. 1.367(a)- 8T(d)(2). (3) Disposition of the stock of the transferee foreign corporation A disposition in whole or in part, by the U.S. transferor of the stock of the transferee foreign corporation that is received (or deemed received) in the initial transfer. For purposes of Treas. Reg. Sec. 1.367(a)-8T(d)(3), a reference to stock described in the preceding sentence shall also include stock of the transferee foreign corporation the basis 66 of which is determined, directly or indirectly, in whole or in part, by reference to the basis of the stock of the transferee foreign corporation that is received (or deemed received) in the initial transfer. If the U.S. transferor disposes of only a portion of the stock of the transferee foreign corporation that is received (or deemed received) in the initial transfer, then the U.S. transferor is required to recognize only a proportionate amount of the gain realized, but not recognized, upon the initial transfer. The proportion required to be recognized shall be determined by reference to the fair market value of the transferee foreign corporation stock disposed of and the total fair market value of the transferee foreign corporation stock immediately before the disposition. Treas. Reg. Sec. 1.367(a)-8T(d)(3). (4) Deconsolidation A U.S. transferor that is a member of a consolidated group ceases to be a member of the consolidated group, other than by reason of an acquisition of the assets of the U.S. transferor in a transaction to which Sec. 381(a) applies, or by reason of joining a new consolidated group as part of the same transaction. However, in the case of a transaction to which Sec. 381(a) applies, see Treas. Reg. Sec. 1.367(a)-8T(d)(3) (providing that a triggering event includes a disposition of the stock of the transferee foreign corporation). Treas. Reg. Sec. 1.367(a)-8T(d)(4). For an exception to this triggering event, see Treas. Reg. Sec. 1.367(a)-8T(e)(8). (5) Consolidation A U.S. transferor becomes a member of a consolidated group. Treas. Reg. Sec. 1.367(a)-8T(d)(5). For an exception to this triggering event, see Treas. Reg. Sec. 1.367(a)-8T(e)(9). 67 (6) Individual U.S. transferor becomes a non-citizen nonresident A U.S. transferor that is an individual loses U.S. citizenship, or a U.S. transferor that is a long-term resident ceases to be taxed as a lawful permanent resident (as defined in Sec. 877(e)(2)). Immediately before the date that the U.S. transferor loses U.S. citizenship or ceases to be taxed as a long-term resident, the GRA will be triggered. No additional inclusion is required under Sec. 877 with respect to the transferred stock or securities, and a GRA under Sec. 877 may not be used to avoid taxation under Sec. 367(a) resulting from the trigger of the Sec. 367(a) GRA. Treas. Reg. Sec. 1.367(a)- 8T(d)(6). (7) Death of an individual; trust or estate goes out of existence An individual U.S. transferor dies, or a U.S. transferor that is a trust or estate goes out of existence. Treas. Reg. Sec. 1.367(a)-8T(d)(7). For an exception to the portion of this triggering event that concerns the death of an individual U.S. transferor, see Treas. Reg. Sec. 1.367(a)-8T(e)(7). Treas. Reg. Sec. 1.367(a)-8T(d)(7). (8) Failure to comply The failure to comply in any material respect with the requirements of Treas. Reg. Sec. 1.367(a)-8T or with the terms of a GRA (for example, a failure to file an annual certification or Form 8838). Such a material failure to comply shall extend the period for assessment of tax until three years after the date on which the Director of Field Operations or Area Director receives actual notice of the failure to comply. For a "reasonable cause" exception to this triggering event, see Treas. Reg. Sec. 1.367(a)- 68 8T(e)(10). Treas. Reg. Sec. 1.367(a)-8T(d)(8). e. Exceptions Notwithstanding Treas. Reg. Sec. 1.367(a)-8T(d), the following events shall not constitute triggering events: (1) Certain nonrecognition transactions (A) Dispositions of stock of the transferee foreign corporation by the U.S. transferor i) Transfers to a corporation or partnership Except to the extent provided in Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv) (which addresses recognition of gain when the U.S. transferor disposes of stock of the transferee foreign corporation in a nonrecognition transaction), a disposition of stock of the transferee foreign corporation by the U.S. transferor in an exchange to which Sec. 351, 354 (but only in a reorganization described in Sec. 368(a)(1)(B)), or 721 applies, will not be a triggering event under Treas. Reg. Sec. 1.367(a)-8T(d)(3), and the original GRA will terminate without further effect, if the U.S. transferor complies with requirements similar to those contained in Treas. Reg. Sec. 1.367(a)-8T(e)(1)(ii), providing for notice and an agreement to recognize gain in the case of a direct or indirect disposition of the stock previously held by the U.S. transferor. See Treas. Reg. Sec. 1.367(a)-8T(e)(3)(i) for dispositions of the transferee foreign corporation stock in certain asset reorganizations. Treas. Reg. Sec. 1.367(a)-8T(e)(1)(i)(A). ii) Liquidations of the U.S. transferor under Secs. 332 and 337 69 The disposition of the transferee foreign corporation stock pursuant to a liquidation of the U.S. transferor under Secs. 332 and 337 will not be a triggering event under Treas. Reg. Sec. 1.367(a)-8T(d)(3), and the original GRA shall terminate without further effect, if the following conditions are satisfied: (1) The distributee is a domestic corporation described in Sec. 332(b)(1). (2) The domestic distributee corporation (successor U.S. transferor) enters into a new GRA pursuant to which it agrees to recognize gain (during the remaining term of the original GRA), with respect to the initial transfer, modified by substituting the successor U.S. transferor in place of the original U.S. transferor, and agreeing to treat the successor U.S. transferor as the original U.S. transferor for purposes of Treas. Reg. Sec. 1.367(a)- 8T. If, however, in connection with a liquidation described in Sec. 332, the U.S. transferor recognizes gain under Sec. 336 with respect to a portion of the stock of the transferee foreign corporation, and the conditions described in Treas. Reg. Sec. 1.367(a)- 8T(g)(1) are satisfied, the new GRA that the successor U.S. transferor enters into shall reflect the gain realized, but not recognized, on the initial transfer (subject to adjustment for prior partial dispositions) less that proportion corresponding to gain recognized under Sec. 336. The proportion is determined by reference to the relative fair market values of the transferee foreign corporation stock received (or deemed received) in the initial transfer on which the U.S. transferor recognized gain under Sec. 336 and the total fair market value of the transferee foreign corporation stock received (or deemed received) by the U.S. transferor in the initial transfer that is distributed by the U.S. transferor in the liquidation. 70 (3) The successor U.S. transferor makes the "triggering year election" described in Treas. Reg. Sec. 1.367(a)-8T(b)(1)(vii). However, if the U.S. transferor was a member of a consolidated group in the year of the initial transfer, and the successor U.S. transferor is also a member of the original consolidated group immediately after the liquidation, no such election must be made. (4) The successor U.S. transferor provides with its next annual certification (described in Treas. Reg. Sec. 1.367(a)-8T(b)(5)) the new GRA, a notice of the liquidation, and Form 8838 to extend the period for assessment of the tax on the initial transfer to a date not earlier than the eighth full taxable year following the taxable year of the initial transfer. Treas. Reg. Sec. 1.367(a)-8T(e)(1)(i)(B). (B) Transfers of stock or securities of the transferred corporation by the transferee foreign corporation to a corporation or partnership Except to the extent provided in Treas. Reg. Sec. 1.367(a)-8T(f)(1)(i) (which addresses gain recognized by the U.S. transferor when the transferee foreign corporation recognizes gain in a nonrecognition transaction) a disposition of stock or securities of the transferred corporation by the transferee foreign corporation in an exchange to which Sec. 351, 354 (but only in a reorganization described in Sec. 368(a)(1)(B)), or 721 applies, will not be a triggering event described in Treas. Reg. Sec. 1.367(a)-8T(d)(1), and the original GRA shall terminate without further effect, if the following conditions are satisfied: (1) The transferee foreign corporation receives (or is deemed to receive) in exchange for the property disposed of, stock in a corporation, or an interest in a 71 partnership, that acquired the transferred stock or securities (or receives stock in a corporation that controls the corporation acquiring the transferred stock or securities in the case of a triangular Sec. 368(a)(1)(B) reorganization). (2) The U.S. transferor provides a notice of the transfer with its next annual certification under Treas. Reg. Sec. 1.367(a)-8T(b)(5), setting forth-- (a) A full description of the transfer; (b) The applicable nonrecognition provision; and (d) The name, address, and taxpayer identification number (if any) of the new transferee of the transferred stock or securities. (3) The U.S. transferor provides with its next annual certification a new GRA pursuant to which it agrees to recognize gain (during the remaining term of the original GRA) with respect to the initial transfer, and in which it agrees that any of the following events also constitutes a triggering event: (a) A disposition of the stock or securities or partnership interest that the transferee foreign corporation received in exchange for the transferred stock or securities (other than in a disposition which itself qualifies under the rules of Treas. Reg. Sec. 1.367(a)-8T(e)). (b) The corporation or partnership that acquired the transferred stock or securities disposes of such property (other than in a disposition which itself qualifies under the rules of Treas. Reg. Sec. 1.367(a)-8T(e)). (c) Any other disposition that has the effect of an indirect disposition of the transferred stock or securities. 72 Paragraph (3)(c) above appears to be an attempt to create a catchall rule. A conservative interpretive approach would treat it as if it were an application by analogy of Treas. Reg. Sec. 1.367(a)-1T(c)(1). That regulation, as noted in Section I.A above, applies Sec. 367(a)(1) to several nonexclusive, enumerated nonrecognition exchanges, including transactions pursuant to Secs. 351 and 354, "whether [they are] made directly, indirectly, or constructively." Treas. Reg. Sec. 1.367(a)-8T(e)(1)(ii). (C) Transfers of the transferred corporation's assets to a corporation or partnership Except to the extent provided in Treas. Reg. Sec. 1.367(a)-8T(f)(1)(ii) (which addresses the portion of gain that must be recognized in a nonrecognition transaction), a disposition of substantially all of the transferred corporation's assets by the transferred corporation in an exchange to which Sec. 351, 354 (but only in a reorganization described in Sec. 368(a)(1)(B)--for example, where stock in a subsidiary corporation comprises substantially all of the transferred corporation's assets), or 721 applies, will not be a triggering event under Treas. Reg. Sec. 1.367(a)-8T(d)(2), and the original GRA shall terminate without further effect, if the transferred corporation receives (or is deemed to receive) in exchange for all or a portion of its assets stock in a corporation or an interest in a partnership that acquired the assets of the transferred corporation (or receives stock in a corporation that controls the corporation acquiring the assets) and the U.S. transferor complies with requirements similar to those contained in Treas. Reg. Sec. 1.367(a)- 8T(e)(1)(ii) (providing for notice and an agreement to recognize gain in the case of a direct or indirect disposition of the assets previously held by the transferred corporation). See Treas. Reg. Sec. 1.367(a)-8T(e)(3)(iii) for dispositions of substantially all of the 73 transferred corporation's assets in certain asset reorganizations. Treas. Reg. Sec. 1.367(a)-8T(e)(1)(iii). (2) Recapitalizations (A) Transferred corporation Except to the extent provided in Treas. Reg. Sec. 1.367(a)-8T(f)(1) (which provides that the U.S. transferor must recognize gain if the transferee foreign corporation recognizes gain in a nonrecognition transaction), a transaction described in Sec. 368(a)(1)(E) of the transferred corporation will not be a triggering event under Treas. Reg. Sec. 1.367(a)-8T(d)(1). The description of this exception that is required to be filed with the annual certification under Treas. Reg. Sec. 1.367(a)-8T(b)(5) must include a description of the type or class, amount, and characteristics of the stock or securities that the transferred corporation issued in the reorganization. Treas. Reg. Sec. 1.367(a)- 8T(e)(2)(i). (B) Transferee foreign corporation A Sec. 368(a)(1)(E) reorganization of the transferee foreign corporation will not be a triggering event under Treas. Reg. Sec. 1.367(a)-8T(d)(3). The description of this exception that is required to be filed with the annual certification under Treas. Reg. Sec. 1.367(a)-8T(b)(5) must include a description of the type or class, amount, and characteristics of the stock or securities that the transferee foreign corporation issued in the reorganization. See Treas. Reg. Sec. 1.367(a)-8T(g)(1) for rules regarding the recognition of gain by the U.S. transferor in connection with nonrecognition exchanges. Treas. Reg. Sec. 1.367(a)-8T(e)(2)(ii). (3) Certain asset reorganizations 74 (A) Transfers of transferee foreign corporation's stock by U.S. transferor Except to the extent provided Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv) (which addresses recognition of gain when the U.S. transferor disposes of stock of the transferee foreign corporation in a nonrecognition transaction), if the U.S. transferor transfers all or a portion of the stock of the transferee foreign corporation to a domestic acquiring corporation (successor U.S. transferor) pursuant to an asset reorganization, the exchanges made pursuant to such asset reorganization will not be triggering events described in Treas. Reg. Sec. 1.367(a)-8T(d)(3), and the original GRA shall terminate without further effect, if the following conditions are satisfied: (1) The common parent of the original consolidated group, successor U.S. transferor, or new common parent, as applicable, enters into a new GRA pursuant to which the successor U.S. transferor agrees to recognize gain (during the remaining term of the original GRA) with respect to the initial transfer, modified by substituting the successor U.S. transferor in place of the original U.S. transferor and agreeing to treat the successor U.S. transferor as the original U.S. transferor for purposes of Treas. Reg. Sec. 1.367(a)-8T. (2) The successor U.S. transferor or new common parent makes the "triggering year election" described in Treas. Reg. Sec. 1.367(a)-8T(b)(1)(vii) (see Section I.E.2.b.(1) above). However, if the U.S. transferor was a member of a consolidated group in the year of the initial transfer, and the successor U.S. transferor is also a member of the original consolidated group immediately after the asset reorganization, no such election must be made. 75 (3) The successor U.S. transferor provides with its next annual certification (described in Treas. Reg. Sec. 1.367(a)-8T(b)(5))-- (a) The new GRA; (b) A notice of the transfer setting forth a full description of the transfer (including the date of such transfer), and the successor U.S. transferor's name, address, and taxpayer identification number; and (c) Form 8838 to extend the period for assessment of the tax on the initial transfer to a date not earlier than the eighth full taxable year following the taxable year of the initial transfer. Treas. Reg. Sec. 1.367(a)-8T(e)(3)(i). Treas. Reg. Sec. 1.367(a)- 8T(e)(3)(i). (B) Transfers of transferred corporation stock or securities by a transferee foreign corporation to a foreign acquiring corporation Except to the extent provided in Treas. Reg. Sec. 1.367(a)-8T(f)(1) (which provides that the U.S. transferor must recognize gain if the transferee foreign corporation recognizes gain in a nonrecognition transaction), if the transferee foreign corporation transfers all or a portion of the stock or securities of the transferred corporation to a foreign acquiring corporation (successor transferee foreign corporation) in an asset reorganization, the exchanges made pursuant to such reorganization will not be triggering events described in Treas. Reg. Sec. 1.367(a)-8T(d)(1) or (d)(3), and the original GRA shall terminate without further effect, if the following conditions are satisfied: (1) The U.S. transferor or common parent, as applicable, enters into a new GRA pursuant to which the U.S. transferor agrees to recognize gain (during the remaining term of the original GRA), with respect to the initial transfer, substituting the successor 76 transferee foreign corporation in place of the original transferee foreign corporation, and agreeing to treat the successor transferee foreign corporation as the original transferee foreign corporation for purposes of Treas. Reg. Sec. 1.367(a)-8T. (2) The U.S. transferor provides with its next annual certification (described in Treas. Reg. Sec. 1.367(a)-8T(b)(5)) the new GRA and a notice of the transfer setting forth a full description of the transfer (including the date of such transfer), and the successor transferee foreign corporation's name, address, and taxpayer identification number (if any). Treas. Reg. Sec. 1.367(a)-8T(e)(3)(ii). (C) Transfers of substantially all of the transferred corporation's assets Except to the extent provided in Treas. Reg. Sec. 1.367(a)-8T(f)(2) (which addresses the method of computing the gain the U.S. transferor must recognize if the transferee foreign corporation recognizes gain in connection with a nonrecognition transaction), if the transferred corporation transfers substantially all of its assets to an acquiring corporation (successor transferred corporation) pursuant to an asset reorganization, the exchanges made pursuant to such asset reorganization will not be triggering events under Treas. Reg. Sec. 1.367(a)-8T(d)(1) or (d)(2), and the original GRA shall terminate without further effect, if the following conditions are satisfied: (1) The U.S. transferor or common parent, as applicable, enters into a new GRA pursuant to which the U.S. transferor agrees to recognize gain (during the remaining term of the original GRA), with respect to the initial transfer, modified by-- 77 (a) Substituting the successor transferred corporation in place of the original transferred corporation and agreeing to treat the successor transferred corporation as the original transferred corporation for purposes of Treas. Reg. Sec. 1.367(a)-8T; and (b) Treating only the assets acquired by the successor transferred corporation from the original transferred corporation pursuant to the asset reorganization as the assets subject to the triggering event rules under Treas. Reg. Sec. 1.367(a)-8T(d)(2). (2) The U.S. transferor provides with its next annual certification (described in Treas. Reg. Sec. 1.367(a)-8T(b)(5)) the new GRA and a notice of the transfer setting forth a full description of the transfer (including the date of such transfer), and the successor transferred corporation's name, address, and taxpayer identification number (if any). Treas. Reg. Sec. 1.367(a)-8T(e)(3)(iii). (4) Certain triangular reorganizations (A) Triangular asset reorganizations of the transferee foreign corporation For purposes of Treas. Reg. Sec. 1.367(a)-8T(e)(4), the term triangular asset reorganization means a triangular reorganization described in Sec. 1.358-6(b)(2)(i) through (iii) (i.e., forward subsidiary mergers, subsidiary C reorganizations, and reverse subsidiary mergers) or in Secs. 368(a)(1)(G) and (a)(2)(D) where the acquiring subsidiary is foreign. Except to the extent provided in Treas. Reg. Sec. 1.367(a)-8T(f)(1) (which addresses gain recognized by the U.S. transferor when the transferee foreign corporation recognizes gain in a nonrecognition transaction) or Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv) (which addresses recognition of gain when the U.S. transferor disposes of stock of the transferee foreign corporation in a nonrecognition transaction), the exchanges made 78 pursuant to a triangular asset reorganization of the transferee foreign corporation will not be triggering events under Treas. Reg. Sec. 1.367(a)-8T(d)(1) or (d)(3), and the original GRA shall terminate without further effect, if the following conditions are satisfied: (1) The U.S. transferor or common parent, as applicable, enters into a new GRA pursuant to which the U.S. transferor agrees to recognize gain (during the remaining term of the original GRA), with respect to the initial transfer, and in which the U.S. transferor agrees to-- (a) If the parent corporation of the foreign acquiring subsidiary is foreign, treat such foreign parent as the original transferee foreign corporation for purposes of Treas. Reg. Sec. 1.367(a)-8T and treat as a triggering event a disposition of the stock of the foreign acquiring subsidiary, or, in the case of a reorganization described in Sec. 368(a)(2)(E), the corporation originally identified as the transferee foreign corporation; and (b) If the parent corporation of the foreign acquiring subsidiary is domestic, treat the foreign acquiring subsidiary as the original transferee foreign corporation for purposes of Treas. Reg. Sec. 1.367(a)-8T, and apply the principles of Treas. Reg. Sec. 1.367(a)-8T(g) to taxable dispositions by the domestic parent corporation of the foreign acquiring subsidiary or, in the case of a reorganization described in Sec. 368(a)(2)(E), the corporation originally identified as the transferee foreign corporation. In the case of a reorganization described in Sec. 368(a)(2)(E) where the transferee foreign corporation is the merged corporation, rather than the surviving corporation, then the surviving corporation shall be treated as the transferee foreign corporation for purposes of Treas. Reg. Sec. 1.367(a)-8T. 79 (2) The U.S. transferor provides with its next annual certification (described in Treas. Reg. Sec. 1.367(a)-8T(b)(5)) the new GRA and a notice of the transfer setting forth a full description of the transfer (including the date of such transfer) and the name, address, and taxpayer identification number (if any) for the parent corporation of the foreign acquiring subsidiary. Treas. Reg. Sec. 1.367(a)-8T(e)(4)(i). (B) Triangular asset reorganizations of the transferred corporation Except to the extent provided in Treas. Reg. Sec. 1.367(a)-8T(f)(1) or (f)(2) (which address recognition of gain by the U.S. transferor due to transfers of stock or securities or sub all dispositions of assets by the transferee foreign corporation in nonrecognition transactions), the exchanges made pursuant to a triangular asset reorganization of the transferred corporation will not be triggering events in Treas. Reg. Sec. 1.367(a)-8T(d)(1) or (d)(2), and the original GRA shall terminate without further effect, if the following conditions are satisfied: (1) The U.S. transferor or common parent, as applicable, enters into a new GRA pursuant to which the U.S. transferor agrees to recognize gain (during the remaining term of the original GRA), in accordance with the rules of Treas. Reg. Sec. 1.367(a)-8T(b), with respect to the initial transfer, and in which the U.S. transferor agrees to-- (a) Treat a disposition of the stock of the acquiring parent as a triggering event; (b) If the reorganization is a triangular C reorganization or a subsidiary reorganization described in Sec. 368(a)(2)(D), treat a disposition of the stock of the foreign acquiring subsidiary as a triggering event; and 80 (c) If the reorganization is a reverse subsidiary merger described in Sec. 368(a)(2)(E) and the merged corporation is the transferred corporation, treat a disposition of the stock of the surviving corporation as a triggering event. (2) The U.S. transferor provides with its next annual certification (described in Treas. Reg. Sec. 1.367(a)-8T(b)(5)) the new GRA and a notice of the transfer setting forth a full description of the transfer (including the date of such transfer) and the name, address, and taxpayer identification number (if any) for the parent corporation of the foreign acquiring subsidiary. Treas. Reg. Sec. 1.367(a)-8T(e)(4)(ii). (5) Compulsory transfers A compulsory transfer under Sec. 1.367(a)-4T(f)(2) that is not reasonably foreseeable by the U.S. transferor is not a triggering event under Treas. Reg. Secs. 1.367(a)-8T(d)(1) through (d)(3). Compulsory transfers under Treas. Reg. Sec. 1.367(a)- 4T(f)(2) are either legally required by a foreign government as a necessary condition of doing business in that country or compelled by a genuine threat of immediate expropriation by a foreign government. Treas. Reg. Sec. 1.367(a)-8T(e)(5). (6) Certain liquidations and upstream reorganizations of the transferred corporation into the transferee foreign corporation A transfer of assets by the transferred corporation to the transferee foreign corporation pursuant to a liquidation described in Sec. 332, where the transferee foreign corporation is described in Sec. 332(b)(1), or pursuant to a reorganization described in Sec. 368(a), and related exchanges of stock or securities of the transferred corporation will not be triggering events under Treas. Reg. Sec. 1.367(a)-8T(d)(1) or (d)(2). The description of this exception that is required to be filed with the annual certification under 81 Treas. Reg. Sec. 1.367(a)-8T(b)(5) must include a description of the transaction. In such a case, the original GRA shall continue to apply during the remainder of its term. If, however, in connection with a liquidation described in Sec. 332, the transferred corporation recognizes gain under Sec. 336 with respect to a portion of its assets, such assets shall be treated as disposed of for purposes of Treas. Reg. Sec. 1.367(a)-8T(d)(2) (which addresses disposition of substantially all of the transferred corporation's assets). Treas. Reg. Sec. 1.367(a)-8T(e)(6). (7) Death of an individual U.S. transferor If the U.S. transferor is an individual and such individual dies, the individual's death will not be a triggering event under Treas. Reg. Sec. 1.367(a)-8T(d)(7), if the person winding up the affairs of the U.S. transferor-- (1) retains, for the duration of the waiver of the statute of limitations relating to the GRA, assets to meet any possible liability of the U.S. transferor under the duration of the GRA; (2) provides security pursuant to Treas. Reg. Sec. 1.367(a)-8T(c) for any possible liability of the U.S. transferor under the GRA; or (3) obtains a ruling from the Internal Revenue Service providing for successors to the U.S. transferor under the GRA. Treas. Reg. Sec. 1.367(a)-8T(e)(7). (8) Deconsolidation A deconsolidation described in Treas. Reg. Sec. 1.367(a)-8T(d)(4) will not be a triggering event, and the original GRA shall terminate without further effect, if the following conditions are satisfied: 82 (1) The U.S. transferor enters into a new GRA pursuant to which the U.S. transferor agrees to recognize gain (during the remaining term of the original GRA) with respect to the initial transfer and makes the "triggering year election" described in Treas. Reg. Sec. 1.367(a)-8T(b)(1)(vii). (2) The U.S. transferor provides with its next annual certification (described in Treas. Reg. Sec. 1.367(a)-8T(b)(5)) notice of the deconsolidation. Treas. Reg. Sec. 1.367(a)-8T(e)(8). (9) Consolidation A consolidation described in Treas. Reg. Sec. 1.367(a)-8T(d)(5) will not be a triggering event, and the original GRA shall terminate without further effect, if the following conditions are satisfied: (1) The common parent of the consolidated group that includes the U.S. transferor immediately after the consolidation enters into a new GRA pursuant to which the U.S. transferor agrees to recognize gain (during the remaining term of the original GRA) with respect to the initial transfer and in which it makes the "triggering year election" described in Treas. Reg. Sec. 1.367(a)-8T(b)(1)(vii). (2) The U.S. transferor provides with its next annual certification (described in Treas. Reg. Sec. 1.367(a)-8T(b)(5)) a notice of the consolidation. Treas. Reg. Sec. 1.367(a)-8T(e)(9). (10) Reasonable cause exception for failure to comply (A) Request for relief A failure to comply described in Treas. Reg. Sec. 1.367(a)-8T(d)(8) will not be a triggering event, and the timeliness requirement with respect to a GRA shall be 83 considered satisfied notwithstanding a failure to file the agreement in a timely manner, if the person required to file the GRA, annual certification, or Form 8838 is able to demonstrate to the Area Director, Field Examination, Small Business/Self Employed or the Director of Field Operations, Large and Mid-Size Business (Director) having jurisdiction of the taxpayer's tax return for the taxable year, that such failure was due to reasonable cause and not willful neglect. In determining whether the person has reasonable cause, the Director shall determine whether, based on all the facts and circumstances, the person acted reasonably and in good faith. The Director shall notify the person in writing within 120 days of the filing if it is determined that the failure to comply was not due to reasonable cause, or if additional time will be needed to make such determination. For this purpose, the 120-day period shall begin to run on the date the Service notifies the person in writing that the request has been received and assigned for review. Once such period commences, if the person is not again notified within 120 days, then the person shall be deemed to have established reasonable cause. The reasonable cause exception of Treas. Reg. Sec. 1.367(a)-8T(e)(10) shall apply only if, once the person becomes aware of the failure to file or comply with the agreement, the person complies with the requirements for granting relief that are set forth in Treas. Reg. Sec. 1.367(a)-8T(e)(10)(ii). Treas. Reg. Sec. 1.367(a)-8T(e)(10)(i). (B) Requirements for granting reasonable cause relief Requests for reasonable cause relief will only be considered if, once the person becomes aware of the failure to file or comply with the agreement, the person attaches all 84 the documents that should have been filed, as well as a complete written statement setting forth the reasons for the failure to timely comply, to an amended return that amends the return to which the documents should have been attached pursuant to the rules of Sec. 367(a) and the regulations under that paragraph In addition to the requirement of Treas. Reg. Sec. 1.367(a)-8T(e)(10)(ii)(A), the person must provide a copy of the amended return and all required attachments to the Director as follows: (1) If the taxpayer is under examination for any taxable year when the person requests relief, the taxpayer must provide a copy of the amended return and attachments to the personnel conducting the examination. (2) If the taxpayer is not under examination for any taxable year when the person requests relief, the taxpayer must provide a copy of the amended return and attachments to the Director having jurisdiction over the taxpayer's return. Treas. Reg. Sec. 1.367(a)- 8T(e)(10)(ii). f. Gain recognized in connection with certain nonrecognition transactions (1) Dispositions of transferred stock or securities If a disposition of the transferred stock or securities occurs in connection with a nonrecognition transaction described in Treas. Reg. Sec. 1.367(a)-8T(e)(1)(ii), (e)(2)(i), (e)(3)(ii), (e)(3)(iii), or (e)(4) and gain is recognized by the transferee foreign corporation in connection with the transaction (for example, under Secs. 351(b) or 356(a)(1)), the U.S. transferor must recognize gain pursuant to the GRA as determined under Treas. Reg. 85 Sec. 1.367(a)-8T(f)(1)(ii). Treas. Reg. Sec. 1.367(a)-8T(f)(1)(i) shall not apply to the extent that the gain recognized is treated as a dividend under Sec. 356(a)(2). The portion of the GRA that must be recognized under Treas. Reg. Sec. 1.367(a)- 8T(f)(1)(i), if any, is the gain that would be recognized by the transferee foreign corporation on such disposition (but not in excess of the amount of the GRA). For purposes of Treas. Reg. Sec. 1.367(a)-8T(f)(1)(ii), the gain that would be recognized in the nonrecognition transactions listed in Treas. Reg. Sec. 1.367(a)-8T(f)(1)(i) by the transferee foreign corporation shall be calculated before taking into account any basis increase that may apply under Treas. Reg. Sec. 1.367(a)-8T(b)(3)(iv) as a result of the gain that the U.S. transferor is required to recognize. If the amount of gain that the transferee foreign corporation would be required to recognize is less than the amount of the gain subject to the GRA, then the new GRA filed pursuant to Treas. Reg. Sec. 1.367(a)-8T(e)(1)(ii), (e)(2)(i), (e)(3)(ii), (e)(3)(iii), or (e)(4) shall provide that the U.S. transferor shall recognize the remaining portion of the gain that was realized, but not recognized, on the initial transfer if a subsequent triggering event occurs. Treas. Reg. Sec. 1.367(a)-8T(f)(1). (2) Dispositions of substantially all of the transferred corporation's assets If a disposition of substantially all of the assets of the transferred corporation occurs in connection with a nonrecognition transaction described in Treas. Reg. Sec. 1.367(a)-8T(e)(1)(iii), (e)(3)(iii), or (e)(4)(ii) and gain is recognized on such disposition (for example, under Sec. 351(b) or 356(a)(1)), the U.S. transferor must recognize gain pursuant to the GRA to the extent of such gain recognized (but not in excess of the gain 86 realized, but not recognized, on the initial transfer). Treas. Reg. Sec. 1.367(a)-8T(f)(2) shall not apply to the extent that recognized gain is treated as a dividend under Sec. 356(a)(2). Treas. Reg. Sec. 1.367(a)-8T(f)(2). g. Transactions that terminate the GRA or reduce the amount of gain required to be recognized pursuant to a GRA Notwithstanding Treas. Reg. Sec. 1.367(a)-8T(d), the following events shall not constitute triggering events and instead shall either terminate the GRA, or reduce the amount of gain required to be recognized pursuant to a GRA: (1) Taxable disposition of stock of the transferee foreign corporation by U.S. transferor If the U.S. transferor disposes of all the stock of the transferee foreign corporation that is received (or deemed received) in the initial transfer, then the GRA shall terminate without further effect if-- (A) Immediately before the disposition, the aggregate basis of the transferee foreign corporation stock disposed of does not exceed the sum of the aggregate basis of the transferred stock or securities immediately before the initial transfer plus any increase in the basis of such stock or securities as a result of the recognition of gain on the initial transfer. For purposes of Treas. Reg. Sec. 1.367(a)-8T(g)(1)(i)(A), an increase in basis of the stock disposed of as a result of an income inclusion with respect to such stock (for example, pursuant to Sec. 961) shall not be taken into account; and (B) All realized gain (if any) in the stock disposed of is recognized currently and included in taxable income as a result of the disposition. Treas. Reg. Sec. 1.367(a)- 8T(g)(1)(i). 87 (A) Partial dispositions If the U.S. transferor disposes of a portion of the stock of the transferee foreign corporation that is received (or deemed received) in the initial transfer in a transaction that satisfies the conditions described in Treas. Reg. Secs. 1.367(a)-8T(g)(1)(i)(A) and (B), such disposition will not be a triggering event and the gain recognition shall remain in effect. For purposes of determining whether the condition described in Treas. Reg. Sec. 1.367(a)-8T(g)(1)(i)(A) is satisfied, however, the aggregate basis of the stock of the transferee foreign corporation disposed of is compared to the aggregate basis of the transferred stock or securities exchanged for such stock at the time of the initial transfer. If a subsequent triggering event occurs -- i.e., if the GRA is triggered after a partial disposition described in Treas. Reg. Sec. 1.367(a)-8T(g)(1)(ii)(A) -- then the U.S. transferor shall be required to recognize only a proportionate amount of the gain subject to the GRA that otherwise would be required to be recognized on a subsequent triggering event. Except as provided in Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv), the proportion required to be recognized shall be determined by reference to the percentage of stock (based on relative fair market value) of the transferee foreign corporation received (or deemed received) in the initial transfer that is retained by the U.S. transferor. Treas. Reg. Sec. 1.367(a)-8T(g)(1)(ii). (B) Certain nonrecognition transactions The rules described in Treas. Reg. Secs. 1.367(a)-8T(g)(1)(iv)(A) through (C) apply if the U.S. transferor disposes of all or a portion of the stock of the transferee foreign corporation received (or deemed received) in the initial transfer pursuant to a nonrecognition transaction described in Treas. Reg. Sec. 1.367(a)-8T(e)(1)(i), (e)(2)(ii), 88 (e)(3)(i), or (e)(3)(ii), the condition described in Treas. Reg. Sec. 1.367(a)-8T(g)(1)(i)(A) is satisfied with respect to such disposition, and gain is recognized in connection with the disposition (for example, under Secs. 351(b), 356(a)(1), or 336). If, however, only a portion of the stock of the transferee corporation stock is disposed of pursuant to Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv), then for purposes of determining whether the condition described in Treas. Reg. Sec. 1.367(a)-8T(g)(1)(i)(A) is satisfied, the aggregate basis of the stock disposed of is compared to the aggregate basis of the transferred stock or securities exchanged for such stock at the time of the initial transfer. Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv). i) U.S. transferor files new GRA Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv)(A) applies if the U.S. transferor (or successor U.S. transferor, as applicable) enters into a new GRA as provided in Treas. Reg. Sec. 1.367(a)-8T(e)(1)(i), (e)(3)(i), or (e)(3)(ii), as applicable. In such a case, the amount of gain subject to the new GRA shall equal the amount of gain realized, but not recognized, on the initial transfer, less any gain recognized by the U.S. transferor in connection with the nonrecognition transaction. If the amount of gain recognized on the transfer is equal to or greater than the amount of gain realized, but not recognized, on the initial transfer, then the original GRA shall terminate without further effect. Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv)(A). ii) U.S. transferor does not file a new GRA Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv)(B) applies if the U.S. transferor (or successor U.S. transferor, as applicable) fails to enter into a new GRA as provided in 89 Treas. Reg. Sec. 1.367(a)-8T(e)(1)(i), (e)(3)(i), or (e)(3)(ii), as applicable. In such a case, the amount required to be recognized by the U.S. transferor pursuant to the GRA shall be the amount of gain realized, but not recognized, on the initial transfer, less any gain recognized by the U.S. transferor in connection with the nonrecognition transaction. Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv)(B). iii) Special rule for recapitalizations Because Treas. Reg. Sec. 1.367(a)-8T(e)(2)(ii) does not require the U.S. transferor to enter into a new GRA, the amount of gain subject to the GRA shall equal the amount of gain realized, but not recognized, on the initial transfer, less any gain recognized by the U.S. transferor in connection with the nonrecognition transaction described in Treas. Reg. Sec. 1.367(a)-8T(e)(2)(ii). Treas. Reg. Sec. 1.367(a)-8T(g)(1)(iv)(C). (C) Election to reduce basis For purposes of Treas. Reg. Secs. 1.367(a)-8T(g)(1)(i), (ii) and (iv), the U.S. transferor may elect to reduce its aggregate basis in the stock disposed of effective immediately before the disposition such that the condition described in paragraph (g)(1)(i)(A) is satisfied (i.e., the aggregate basis of the transferee foreign corporation stock disposed of does not exceed the sum of the aggregate basis of the transferred stock or securities immediately before the initial transfer plus any increase in the basis of such stock or securities as a result of the recognition of gain on the initial transfer). If such an election is made pursuant to Treas. Reg. Sec. 1.367(a)-8T(g)(1)(v), the U.S. transferor may increase its basis in other stock of the transferee foreign corporation it holds, if any, by a corresponding amount but not above the fair market value of such stock. 90 The election allowed by Treas. Reg. Sec. 1.367(a)-8T(g)(1)(v) is made by filing with the U.S. transferor's income tax return for the taxable year in which the disposition of the transferee foreign corporation stock occurs, a statement setting forth the following information, with the heading "Election to Reduce Stock Basis Under Sec. 1.367(a)- 8T(g)(1)(v)": (1) A description of the transferee foreign corporation stock that the U.S. transferor has disposed of. (2) An estimate of the fair market value of the stock as of the date of the disposition. (3) A comparison of the basis of the transferee foreign corporation stock before and after the election that is made pursuant to Treas. Reg. Sec. 1.367(a)-8T(g)(1)(v). (4) The date on which the transferee foreign corporation stock was disposed of by the U.S. transferor. Treas. Reg. Sec. 1.367(a)-8T(g)(1)(v). (2) Certain dispositions by a domestic transferred corporation of substantially all of its assets If, immediately before the initial transfer, the U.S. transferor owned an amount of stock in the transferred corporation described in Sec. 1504(a)(2), and the transferred corporation is domestic, then the GRA shall terminate without further effect if the transferred corporation disposes of substantially all of its assets in a transaction in which all realized gain is recognized currently. If an indirect stock transfer necessitated the filing of the GRA, such agreement shall terminate if, immediately before the indirect transfer, the U.S. transferor owned an amount of stock in the acquired corporation described in Sec. 1504(a)(2) (or, in the case of a Sec. 368(a)(1)(A) and (a)(2)(E) 91 reorganization described in Sec. 1.367(a)-3(d)(1)(ii), the U.S. transferor owned an amount of stock in the acquiring corporation described in Sec. 1504(a)(2)) and the transferred corporation disposes of substantially all of its assets (taking into account Sec. 1.367(a)- 3(d)(2)(v)) in a transaction in which all realized gain is recognized currently. Treas. Reg. Sec. 1.367(a)-8T(g)(2). (3) Distribution or transfer by transferee foreign corporation of stock or securities of transferred corporation under Sec. 337, 355 or 361 (A) Scope Treas. Reg. Sec. 1.367(a)-8T(g)(3) applies if the transferee foreign corporation distributes or transfers the stock or securities that initially necessitated the filing of the GRA (and any additional stock received after the initial transfer) pursuant to any of the following transactions: (A) A liquidating distribution to the U.S. transferor or a domestic corporation that is a member of the same consolidated group of which the U.S. transferor is then a member and that qualifies under Secs. 332 and 337, if such domestic distributee corporation is described in Sec. 332(b)(1). (B) A distribution to the U.S. transferor, a domestic corporation that is a member of the same consolidated group of which the U.S. transferor is a member, or an individual that is a United States person, that qualifies under Sec. 355. (C) A transfer to the U.S. transferor or a domestic corporation that is a member of the same consolidated group of which the U.S. transferor is then a member and to which Sec. 361 applies (but, if in connection with a reorganization described in Sec. 92 368(a)(1)(D) or (G), only if the requirements of Sec. 354(b)(1)(A) and (B) are met).. Treas. Reg. Sec. 1.367(a)-8T(g)(3)(i). (B) General rule If a distribution or transfer is described in Treas. Reg. Sec. 1.367(a)-8T(g)(3)(i), the GRA shall terminate without further effect, provided that immediately after such distribution or transfer the basis in the transferred stock or securities in the hands of the domestic corporation or individual, as applicable, does not exceed the basis that the U.S. transferor had in the transferred stock or securities immediately before the initial transfer. For purposes of Treas. Reg. Sec. 1.367(a)-8T(g)(3)(ii), only the basis in the stock or securities transferred shall be taken into account, and increases to stock basis as a result of income inclusions with respect to stock (for example, pursuant to Sec. 961) shall not be taken into account. In the case of a transaction described in Treas. Reg. Sec. 1.367(a)- 8T(g)(3)(i)(B), any reductions or redistributions of stock basis under Sec. 1.367(b)- 5(c)(2) or (4), respectively, shall be made before applying the rules of Treas. Reg. Sec. 1.367(a)-8T(g)(3)(ii). Treas. Reg. Sec. 1.367(a)-8T(g)(3)(ii). (C) Election to reduce basis in stock or securities of transferred corporation For purposes of Treas. Reg. Sec. 1.367(a)-8T(g)(3)(ii), the domestic corporation or individual, as applicable, may elect to reduce the basis in the stock or securities transferred to equal the basis the U.S. transferor had in the corresponding transferred stock or securities immediately before the initial transfer, such that the GRA shall terminate without further effect. If such an election is made, the domestic corporation or individual may increase its basis in other stock of the transferred corporation it holds, if 93 any, by a corresponding amount but not above the fair market value of such stock. Treas. Reg. Sec. 1.367(a)-8T(g)(3)(iii). The election pursuant to Treas. Reg. Sec. 1.367(a)-8T(g)(3)(iii) is made by filing with the domestic corporation's or individual's income tax return for the taxable year in which the distribution or transfer occurs, a statement setting forth the following information, with the heading "Election to Reduce Stock Basis Under Sec. 1.367(a)- 8T(g)(3)(iii)": (1) A description of the stock or securities received. (2) An estimate of the fair market value of the stock or securities as of the date of their receipt. (3) A statement comparing the basis of the stock or securities before and after the election. (4) The date on which the stock or securities were received. Treas. Reg. Sec. 1.367(a)-8T(g)(3)(iv). h. Effective dates for Treas. Reg. Sec. 1.367(a)-8T In general, the rules of Treas. Reg. Sec. 1.367(a)-8T apply to GRAs filed with respect to transfers of stock or securities under Treas. Reg. Secs. 1.367(a)-3(b) through (d) and 1.367(a)-3T(e) occurring on or after March 7, 2007 and before Feb. 1, 2010, when all of Treas. Reg. Sec. 1.367(a)-8T expires. The rules of Treas. Reg. Sec. 1.367(a)- 8T(f) apply to GRAs filed with respect to transfers of stock or securities under Treas. Reg. Secs. 1.367(a)-3(b) through (d) and 1.367(a)-3T(e) occurring on or after August 6, 2007. In addition, the rules of Treas. Reg. Sec. 1.367(a)-8T do not apply to GRAs filed with respect to such a transfer of stock or securities occurring on or after March 7, 2007, 94 if such transfer was entered into pursuant to a written agreement which was (subject to customary conditions) binding before February 5, 2007, and at all times thereafter. Solely for purposes of Treas. Reg. Sec. 1.367(a)-8T(h), a transfer described in the preceding sentence shall be deemed to be a transfer occurring before March 7, 2007 to which the rules of Sec. 1.367(a)-8 (see 26 CFR part 1, revised April 1, 2006) apply. See Treas. Reg. Sec. 1.367(a)-8T(h)(2)(iii) for the ability to apply the rules of Treas. Reg. Sec. 1.367(a)- 8T with respect to GRAs filed before March 7, 2007. Treas. Reg. Sec. 1.367(a)- 8T(h)(1)(i). For matters that occurred between July 20, 1998 and March 7, 2007, the corresponding rules of Sec. 1.367(a)-8 (see 26 CFR part 1, revised April 1, 2006) apply. For matters covered in Treas. Reg. Sec. 1.367(a)-8T for periods before July 20, 1998, the corresponding rules of Sec. 1.367(a)-3T(g) (see 26 CFR part 1, revised April 1, 1998) and Notice 87- 85 ((1987-2 CB 395); see Sec. 601.601(d)(2)(ii) of this chapter) apply. In addition, if a U.S. transferor entered into a GRA for transfers before July 20, 1998, then the rules of Sec. 1.367(a)-3T(g) (see 26 CFR part 1, revised April 1, 1998) continue to apply in lieu of Treas. Reg. Sec. 1.367(a)-8T in the event of any direct or indirect nonrecognition transfer of the same property. See also, Sec. 1.367(a)-3(h) (addressing former ten-year GRAs). Treas. Reg. Sec. 1.367(a)-8T(h)(1)(ii). To the extent that Treas. Reg. Sec. 1.367(a)-8T contains rules that were not contained in Treas. Reg. Sec. 1.367(a)-8, some or all of new rules may be applied to GRAs filed with respect to transfers of stock or securities, for all open years, on or after July 20, 1998. Treas. Reg. Sec. 1.367(a)-8T(h)(2)(i). If a taxpayer failed to file a GRA with respect to a transfer of stock or securities on or after July 20, 1998 and before March 95 7, 2007, the taxpayer must first obtain reasonable cause relief under Sec. 1.367(a)-8(c)(2) to file the GRA before the taxpayer may apply Treas. Reg. Sec. 1.367(a)-8T(h)(2)(i). Treas. Reg. Sec. 1.367(a)-8T(h)(2). Treas. Reg. Sec. 1.367(a)-8T(h)(2)(ii) provides the time and manner in which taxpayers may apply Treas. Reg. Sec. 1.367(a)-8T(h)(2)(i). Notwithstanding the rules provided in Sec. 1.367(a)-8T(a)(2), all agreements, certifications, or other information related to such GRA that should have been filed on or before March 7, 2007 shall be treated as having been timely filed, provided they are attached to a Federal income tax return amending the taxpayer's Federal income tax return for the taxable year in which they should have been attached. The amended return described in the preceding sentence must be filed before August 6, 2007. A taxpayer that wishes to apply Treas. Reg. Sec. 1.367(a)-8T(h)(2)(i) but that fails to meet the filing requirement described in the preceding sentence must request reasonable cause relief as provided in Treas. Reg. Sec. 1.367(a)-8T(e)(10). Treas. Reg. Sec. 1.367(a)-8T(h)(2)(ii). Finally, a taxpayer that entered into a GRA to which Sec. 1.367(a)-8 (see 26 CFR part 1, revised April 1, 2006) applies may apply the rules of Treas. Reg. Sec. 1.367(a)-8T in a tax year ending on or after March 7, 2007 by attaching the agreement, certification, or other information related to such GRA that the rules of Treas. Reg. Sec. 1.367(a)-8T require in accordance with the rules of this section and with the time and manner rules provided in Sec. 1.367(a)- 8T(a)(2). Treas. Reg. Sec. 1.367(a)-8T(h)(2)(iii). 3. Indirect Stock or Securities Transfers 96 The paragraphs in this subsection detail the requirements set forth in Treas. Reg. Sec. 1.367(a)-3(d), "Indirect stock transfers in certain nonrecognition transfers ." a. Treas. Reg. Sec. 1.367(a)-3(d)(1) -- In general If a U.S. person exchanges stock or securities of a domestic or foreign corporation for stock or securities of a foreign corporation (or a domestic corporation that controls a foreign acquirer in a subsidiary B reorganization) pursuant to Secs. 354 or 356, and that exchange falls into one of six listed categories, then that U.S. person will be treated as having made an indirect transfer of stock or securities to a foreign corporation that is subject to the rules of Treas. Reg. Sec. 1.367(a)-3. Treas. Reg. Sec. 1.367(a)-3(d)(1). The six listed categories are as follows: (1) Forward Subsidiary Merger and Subsidiary G Reorganization In a forward subsidiary merger (i.e., a merger described in Secs. 368(a)(1)(A) and (a)(2)(D)) or a subsidiary G reorganization (i.e., a reorganization described in Secs. 368(a)(1)(G) and (a)(2)(D)) treated as an indirect stock or securities transfer, a U.S. person exchanges stock or securities of the acquired corporation for stock or securities of a foreign corporation that controls the acquiring corporation. The acquiring corporation can be either domestic or foreign. Treas. Reg. Sec. 1.367(a)-3(d)(1)(i). For purposes of applying the GRA requirements, the foreign parent is considered to be the foreign transferee, and the acquiring corporation is considered to be the transferred corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(i) and (ii). (2) Reverse Subsidiary Merger 97 In a reverse subsidiary merger (i.e., a merger described in Secs. 368(a)(1)(A) and (a)(2)(E)) treated as an indirect stock or securities transfer, a U.S. person exchanges stock or securities of the acquiring corporation for stock or securities of a foreign corporation that controls the acquired corporation. Treas. Reg. Sec. 1.367(a)-3(d)(1)(ii). For purposes of applying the GRA requirements, the foreign parent is considered to be the transferee corporation, and the acquiring corporation is considered to be the transferred corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(i) and (ii). (3) Subsidiary B Reorganization In a subsidiary B reorganization treated as an indirect stock transfer, a U.S. person exchanges stock or securities of the acquired corporation for voting stock of a foreign or domestic corporation that controls the acquiring corporation. Treas. Reg. Sec. 1.367(a)- 3(d)(1)(iii)(A) and (B). If the parent is foreign, it is considered to be the transferee corporation for purposes of the GRA requirements, but if the parent is domestic, then the foreign acquiring corporation (i.e., the foreign subsidiary) is deemed to be the transferee corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(i)(A) and (B). In both cases, the acquired corporation is considered to be the transferred corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(ii). (4) Subsidiary C reorganization In a subsidiary C reorganization treated as an indirect stock or securities transfer, the acquired corporation (whether domestic or foreign) transfers substantially all of its properties to the acquiring corporation (whether domestic or foreign) and a U.S. person exchanges stock of the acquired corporation for voting stock or securities of a foreign corporation that controls the acquiring corporation. Treas. Reg. Sec. 1.367(a)-3(d)(1)(iv). 98 For purposes of applying the GRA requirements, the foreign parent is considered to be the transferee corporation, and the acquiring corporation is considered to be the transferred corporation . Treas. Reg. Sec. 1.367(a)-3(d)(2)(i) and (ii). However, if the subsidiary C reorganization is followed by drop-down, or "controlled asset transfer" (see paragraph (e) below), then the transferred corporation is considered to be the controlled corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(i) and (ii). (5) Reorganization Followed by a Drop-down of Assets Drop-downs are given a new name in the 2005 proposed and 2006 final versions of Treas. Reg. Sec. 1.367(a)-3: controlled asset transfers. See Treas. Reg. Sec. 1.367(a)- 3(d)(1), front language; REG 125628-01, 70 Fed. Reg. 749 (Jan. 5, 2005); T.D. 9243, 71 F.R. 4276 (Jan. 26, 2006). Controlled asset transfers, or "CATs," are defined as follows: "For purposes of [Treas. Reg. Sec. 1.367(a)-3](d), if a corporation acquiring assets in an asset reorganization described in Sec. 368(a)(1) transfers all or a portion of such assets to a corporation controlled (within the meaning of Sec. 368(c)) by the acquiring corporation as part of the same transaction, the subsequent transfer of assets to the controlled corporation will be referred to as a controlled asset transfer. See Sec. 368(a)(2)(C)." This language includes reorganizations under Sec. 368(a)(1)(D) and outbound reorganizations under Sec. 368(a)(1)(F). See Treas. Reg. Sec. 1.367(a)-1T(f). Expansion of the indirect stock transfer rules of Sec. 1.367(a)-3 to include D reorganizations followed by CATs had been widely anticipated since 2002. See Rev. Rul 2002-85, 2002- 2 C.B. 986; Notice 2002-77, 2002-2 C.B. 997. To make the change from "drop-down" to "controlled asset transfer" less confusing, we will use the term "drop-down/CAT." 99 An indirect stock or securities transfer includes any exchange of stock or securities for stock or securities of a foreign acquiring corporation pursuant to an asset reorganization (other than a subsidiary C reorganization, a forward or reverse subsidiary merger, or a "same-country" F reorganization) followed by a drop-down/CAT of some or all of the acquired assets to a controlled corporation. The drop-down/CAT is considered an indirect transfer of stock or securities only to the extent that such assets are transferred to the controlled corporation. The remaining assets are treated as having been transferred in an asset transfer (to which the provisions of Sec. 367(a), as well as Sec. 367(d), may apply). Treas. Reg. Sec. 1.367(a)- 3(d)(1)(v). Note: A "same-country" F reorganization is defined as one in which "both the acquired corporation and the acquiring corporation are foreign corporations and are created or organized under the laws of the same foreign country." Id. (6) Successive Section 351 Transfers If a U.S. person transfers property other than stock or securities to a foreign corporation in an exchange described in Sec. 351, and all or a portion of those assets are transferred in connection with the same transaction to a second corporation controlled by the foreign corporation in an exchange described in Sec. 351, the "re-transfer," or second Sec. 351 exchange is considered an indirect transfer of stock . Any assets that are not re- transferred to the transferee corporation's controlled corporation are subject to the general rules of Sec. 367(a). Treas. Reg. Sec. 1.367(a)-3(d)(1)(vi). For purposes of the GRA requirements, the corporation that issues stock or securities to the U.S. person in the exchange is considered to be the foreign transferee, and the controlled corporation is 100 considered to be both the acquiring and the transferred corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(i) and (ii). b. Special Rules for Indirect Transfers -- Treas. Reg. Sec. 1.367(a)-3(d)(2) For purposes of the indirect transfer rules, the following rules and definitions apply: (1) Transferee foreign corporation Except in the case of certain subsidiary B reorganizations, the transferee foreign corporation is the foreign corporation that issues stock or securities to the U.S. person in the exchange. In a subsidiary B reorganization involving a foreign acquiring corporation with a domestic parent, the transferee foreign corporation is the foreign acquiring corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(i). (2) Transferred corporation and transferred property In subsidiary B reorganizations, the transferred corporation is the acquired corporation. In a reorganization followed by a drop-down/CAT, the transferred corporation is the controlled corporation to which the assets are transferred. In cascading, or multiple Sec. 351 transactions, the transferred corporation is last corporation in the chain; the corporation to which the assets are transferred in the final Sec. 351 transfer. In all other cases, the transferred corporation is the acquiring corporation. Transferred property is the stock or securities of the transferred corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(ii). (3) Amount of gain 101 The amount of gain that a U.S. person must include in income as the result of a triggering event is determined using the provisions of Sec. 1.367(a)-8T(b)(3)(i) and (d).. Treas. Reg. Sec. 1.367(a)-3(d)(2)(iii). (4) Gain recognition agreements (GRAs) involving multiple parties The U.S. transferor's agreement to recognize gain must include appropriate provisions requiring the transferor to recognize gain in the event of an indirect disposition of the stock or securities of the transferred corporation. For example, in a subsidiary B reorganization involving a foreign parent, a disposition of the transferred stock must include an indirect disposition of such stock by the transferee foreign corporation, such as a disposition of such stock by the acquiring corporation or a disposition of the stock of the acquiring corporation by the transferee foreign corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(iv). If the subsidiary B parent were domestic, however, its disposition of the stock of the foreign acquiring corporation in a taxable transaction would terminate the gain recognition agreement (GRA) if the principles of Sec. 1.367(a)- 8T(g)(1)(i)(A) and (B) were satisfied. Treas. Reg. Sec. 1.367(a)-3(d)(2)(iv). (5) Asset transfer trigger A GRA may also be triggered by disposition of substantially all of the transferred corporation's assets. Treas. Reg. Sec. 1.367(a)-8T(d)(2). To determine whether the transferred corporation has disposed of substantially all of its assets in the case of a reorganization described in Treas. Reg. Sec. 1.367(a)-3(d)(1), the following assets are taken into account if they are not fully taxable under Sec. 367 in the taxable year that includes the indirect transfer: 102 (A) In the case of a forward subsidiary merger, a subsidiary C reorganization, or a subsidiary G reorganization, the assets of the acquired corporation. (B) In the case of a reverse subsidiary merger, the assets of the acquiring corporation immediately prior to the transaction. (C) In the case of an asset reorganizations described in Treas. Reg. Sec. 1.367(a)-3(d)(1)(v) (i.e., all asset reorganizations other than forward subsidiary mergers, subsidiary C and G reorganizations, reverse subsidiary mergers, and same-foreign-country F reorganizations) followed by a drop-down/CAT of assets, the assets of the acquired corporation that are dropped down. (D) In the case of a forward subsidiary merger, a subsidiary C reorganization, or a subsidiary G reorganization followed by a drop- down/CAT, the assets of the acquired corporation, including the assets that were dropped down. (E) In the case of a forward subsidiary merger, a subsidiary C reorganization, or a subsidiary G reorganization followed by a drop- down/CAT, the assets of the acquired corporation, including the assets that were dropped down. (F) In the case of successive Sec. 351 exchanges, the assets that are both transferred to the foreign corporation initially, and subsequently transferred by the foreign corporation to the controlled corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(v). 103 (6) Coordination between asset transfer rules and indirect stock transfer rules Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi) addresses the rules for coordination between the asset transfer rules and the indirect stock transfer rules," and it is extensively revised by the 2005 proposed and 2006 final versions of Treas. Reg. Sec. 1.367(a)-3. The prior version of the regulation began by stating the general rule: for a transfer (or deemed transfer) of assets from a domestic corporation to a foreign corporation "(other than in an exchange described in Sec. 354), the rules of Sec. 367, including Secs. 367(a)(1), (a)(3) and (a)(5), as well as Sec. 367(d), and the regulations thereunder shall apply prior to the application of the rules of this section." An exception provided that Sec. 367(a) would not apply if 1) the foreign acquiring corporation re-transferred the assets back to a domestic corporation in a paragraph (d)(1)(vi) or Sec. 368(a)(2)(C) transfer and 2) the domestic transferee's basis was no greater than that of the original domestic transferor. The 2006 final regulation does not change the general rule other than to delete its negative description of covered exchanges ("(other than in an exchange described in Sec. 354)") and insert a positive description: "in an exchange described in Sec. 351 or 361." Regarding the exception, however, the final regulation makes sweeping changes. First, it expands the scope of the exception from Sec. 367(a) alone to both Sec. 367(a) and Sec. 367(d). Then, the exchanges to which the exception applies are changed from all those "described in [Treas. Reg. Sec. 1.367(a)-3](d)" to those mentioned in the new general rule: Sec. 351 and 361 exchanges. Next, the final regulation divides the exception into two parts. Re-transfers to a domestic corporation that occur in the course of multiple Sec. 351 exchanges are left 104 virtually unchanged. Re-transfers that involve an exchange described in Sec. 361, however, are subject to new anti-inversion limitations. Either a qualifying transaction must meet the requirements of the second and third sentences of Sec. 367(a)(5) (i.e., the transferor, or domestic acquired corporation, is controlled by five or fewer domestic corporations, makes certain basis adjustments, and meets other conditions prescribed in future Sec. 367(a)(5) regulations), or it must satisfy the requirements of Treas. Reg. Secs. 1.367(a)-3(c)(1)(i), (ii), (iv), and (c)(6) and file a "Required Statement" pursuant to new paragraph (d)(vi)(C). Treas. Reg. Secs. 1.367(a)-3(d)(2)(vi)(B)(i) and (ii). The Required Statement is similar to but broader than a GRA. First, it must be executed, not just by the target, but by the foreign acquiring corporation too. Cf. Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi)(C) with Treas. Reg. Sec. 1.367(a)-8T(a)(3). Second, it lacks finality and certainty because there is no time limit on its requirement that the target recognize gain if the foreign acquirer disposes of any stock of its domestic controlled corporation in a "gain recognition transaction" (GRT). Treas. Reg. Sec. 1.367(a)- 3(d)(2)(vi)(C). A GRT is defined as "a transaction . . . where a principal purpose of the transfer by the domestic acquired corporation is the avoidance of U.S. tax that would have been imposed on the domestic acquired corporation on the disposition of the re-transferred assets. A transfer may have a principal purpose of tax avoidance even though the tax avoidance purpose is outweighed by other purposes when taken together." Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi)(D)(1). There is a rebuttable presumption that a disposition of any stock by the foreign acquiring corporation within two years of the original transfer, whether in a recognition 105 or nonrecognition transaction, has a principal purpose of tax avoidance, but this presumption does not transform the Required Statement into the equivalent of a two-year GRA, as some commentators stated with respect to the 2005 proposed regulations. See Philip A. McCarty and Michael A. DiFronzo, "New Proposed 367 Regulations Address a Potpourri of Issues," 34 Tax Mgmt. Int'l J. 219, 228 (2005). Finally, Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi)(E) prescribes a method involving hypothetical fair market values for calculating the GRT gain and discusses the interest to be paid on the additional tax. As explained in the preamble to the 2005 proposed regulation, these new restrictions in Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi) are motivated by the concern that asset reorganizations otherwise qualifying for tax-free treatment could be used to facilitate corporation inversion transactions or divisive transactions. (7) New rule changing status of domestic acquired corporation to a foreign corporation After the 2005 proposed regulations were promulgated, one commentator suggested that, in asset reorganizations involving a drop-down/CAT, the indirect stock transfer rules should be applied based on the status of the controlled subsidiary, rather than the status of the acquired corporation. The IRS and Treasury agreed in part with this suggestion and adapted it in Treas. Reg. Sec. 1.367(a)-3(d)(2)(vii), which was added by the 2006, final regulation. See T.D. 9243 (Jan. 26, 2006) at Preamble, Summary of Comments and Explanation of Provisions, Sec. E. Under this new rule, a U.S. person that exchanges stock or securities of a domestic corporation for stock or securities of a foreign corporation under Sec. 354 (or 106 Sec. 356) will be treated for purposes of Treas. Reg. Sec. 1.367(a)-3 as having made an indirect stock transfer of the stock or securities of a foreign corporation (and not of a domestic corporation) to a foreign corporation subject to the strictures of Treas. Reg. Sec. 1.367(a)-3(b) (but not Treas. Reg. Sec. 1.367(a)-3(c)), if the following requirements are met: The acquired domestic corporation must be a subsidiary member (within the meaning of Treas. Reg. Sec. 1.1502-1 (c)) of a consolidated group (within the meaning of Treas. Reg. Sec. 1.1502-1(h)) immediately before the transaction, and the transaction must fit into one of two categories: 1) it must be a forward subsidiary merger, a subsidiary G reorganization, or a subsidiary C reorganization, as described in Treas. Reg. Secs. 1.367(a)-3(d)(1)(i) and (iv), and the acquiring corporation must foreign; or 2) it must be an asset reorganization other than a forward subsidiary merger, a subsidiary C or G reorganization, a reverse subsidiary merger, or a same-foreign-country F reorganizations, followed by a drop-down/CAT of assets, as described in Treas. Reg. Secs. 1.367(a)-3(d)(1)(v), but only to the extent that the drop-down/CAT is to a foreign corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(vii)(A). This recasting of domestic stock or securities as foreign stock or securities applies only if the transferred stock or securities remain in foreign corporate solution. If they are retransferred to a domestic controlled corporation in one or more successive transfers as part of the same transaction, then the recharacterization of this rule does not occur, and the entire indirect stock transfer remains subject to Treas. Reg. Sec. 1.367(a)-3(c). Treas. Reg. Sec. 1.367(a)-3(d)(2)(vii)(B). 107 4. Examples illustrating the rules of Treas. Reg. Secs. 1.367(a)-3(d) Of the twenty-seven examples in Treas. Reg. Sec. 1.367(a)-3(d)(3) that illustrate the application of the rules in Treas. Reg. Secs. 1.367(a)-3(d), the following eleven are particularly interesting and include all the examples added by the 2005 proposed and 2006 final regulations. Like all the examples in Treas. Reg. Sec. 1.367(a)-3(d)(3), these eleven assume that I.R.C. Sec. 7874 does not apply. 108 a. Example 2: Reverse subsidiary reorganization Facts: As the diagrams below show, Newco merges into W, and stock of W is distributed to F. A, W's parent & sole shareholder, gets 40 percent of F's stock in an exchange described in Sec. 354. After the transaction, A is a shareholder of F, which owns W, which contains the former assets of Newco (if any). Result: F is treated as the transferee, and the surviving subsidiary, W, is treated as the transferred corporation. Because this is an indirect stock transfer under Treas. Reg. Sec. 1.367(a)-3(d)(1)(ii) (i.e., A is considered to have transferred its W stock to F), taxation of the exchange under Sec. 367(a)(1) will apply unless the requirements of Treas. Reg. Sec. 1.367(a)-3(c)(1) are satisfied, including execution of a GRA by A. Treas. Reg. Sec. 1.367(a)-3(d)(3) Ex. 2. Comment: There were no examples of a reverse triangular merger in the prior regulations. This example, along with Example 11, fills that void. Before After A US S/Hs Foreign F Foreign W US 40% perce nt 100% A US W US Newco US F Foreign F Stock W Stock 100% 100% Merger 109 b. Example 5A: Subsidiary B reorganization Facts: As the diagrams below show, acquiring parent F is domestic, and it owns all of acquiring subsidiary S, which is foreign. S acquires all the stock of Y, wholly owned by U, in exchange for10 percent of F's voting stock. Before After U US S/Hs F US S Foreign Y US 10% 90% 100% 100% U US Voting Stock F US Y US S Foreign 100% 100% Y Stock Result: Although F would usually be the transferee foreign corporation (and although the 2005 proposed regulations made that happen with a truly obtuse, domestic- deemed-foreign rule), under the 2006 final regulations, S is the transferee foreign corporation (see Treas. Reg. Sec. 1.367(a)-3(d)(2)(i)(B)), and Y is the transferred corporation. U's exchange of its Y stock for stock of F is treated as an indirect transfer of Y stock to a foreign corporation, S, under paragraph (d)(1)(iii)(B). This exchange is not taxable under Code Sec. 367(a)(1) provided the requirements of Treas. Reg. Sec. 1.367(a)-3(c)(1) are satisfied. In determining whether the 50-percent-or-less ownership 110 requirement of Treas. Reg. Secs. 1.367(a)-3(c)(i) and (ii) is satisfied, U's indirect ownership of S stock (through its direct ownership of F stock) is taken into account. U must file a GRA to prevent the exchange from being taxed under Sec. 367(a)(1). If Y sold substantially all of its assets (within the meaning of Sec. 368(a)(1)(C)), the gain recognition agreement would be terminated because U owned an amount of stock in Y described in Sec. 1504(a)(2) (at least 80% by vote and value) immediately before the transaction and Y is a domestic corporation. See Treas. Reg. Sec. 1.367(a)-8T(g)(2). In addition, if F disposed of the stock of S in a taxable transaction the gain recognition agreement would be terminated if the principles of Treas. Reg. Sec. 1.367(a)-8T(g)(1)(i)(A) and (B) are satisfied (i.e., the basis for S stock does not exceed the aggregate basis of the Y stock S received in the initial transfer and all realized gain is recognized currently). Treas. Reg. Sec. 1.367(a)-3(d)(3) Ex. 5A. 111 c. Example 6: Subsidiary C reorganization This is an old example (it was Example 5 in the prior, 1998 regulation), but it is important to discuss it briefly because its facts are the basis for five of the nine new examples. Facts: As the diagrams below show, domestic target Z transfers its assets to foreign acquiring parent F's domestic subsidiary R, and Z's domestic parent V gets 30 percent of the stock of F in return. R operates an historical business. Before After A&Ls V US F Foreign Z US R US Stock 100% 100% V US F Foreign R Z A&Ls US 30% 70% S/Hs Result: This exchange is an indirect stock transfer under Treas. Reg. Sec. 1.367(a)-3(d)(1)(iv), so V can avoid taxation under Sec. 367(a) only if the transaction complies with the requirements of Treas. Reg. Sec. 1.367(a)-3(c)(1) and V files a GRA. F is the transferee corporation, and R is the transferred corporation. The GRA will be triggered if F disposes of its R stock, or if R disposes of substantially all the assets it acquired from Z. To determine whether R has made a sub all disposition under Treas. Reg. Sec. 1.367(a)-8T(d)(2) (which imports the sub all rules of I.R.C. Sec. 368(a)(1)(C)), see Treas. Reg. Sec. 1.367(a)-3(d)(2)(v)(A). Treas. Reg. Sec. 1.367(a)-3(d)(3) Ex. 6. 112 d. Example 6A: Straight C reorganization followed by a drop-down/CAT Facts: The facts are the same as in Example 6 with the following changes and additions: the transaction is differently structured; F's subsidiary R is now foreign; V and Z file a consolidated Federal income tax return; and V's subsidiary, Z, has three businesses -- A, B, and C. Businesses A and B qualify for the active business exemption in Sec. 367(a)(3); business C does not. Z transfers all three businesses to F, and F, in turn, transfers businesses B and C in a drop-down/CAT to its wholly-owned subsidiary R. Before After F Foreign A R Foreign B, C V US S/Hs 30% 70% V US Z US A B C* F Foreign R Foreign ABC B&C 100% Voting Stock * Z has 3 separate businesses: A, B, and C. A and B are active under Code sec. 367(a)(3); C is not. 100% c o n s Result: As in Example 6, F is the transferee corporation, and R is the transferred corporation. The transfer of the Business A assets by Z to F does not constitute an indirect stock transfer under Treas. Reg. Sec. 1.367(a)-3(d), and subject to Sec. I.R.C. Sec. 367(a)(5), the Business A assets qualify for the Sec. 367(a)(3) active trade or business exception and are not subject to Sec. 367(a). Z must recognize gain on the transfer of Business C because it does not qualify for an exception under Sec. 367(a)(1). 113 Business B may qualify for the exception under Sec. 367(a)(3) and Treas. Reg. Sec. 1.367(a)-2T(c)(2) for assets that will be used by R in an active trade or business outside the U.S. Pursuant to Treas. Reg. Secs. 1.367(a)-3(d)(1) and (d)(2)(vii)(A)(2), V is deemed to transfer the stock of a foreign corporation to F in a Sec. 354 exchange subject to the rules of Treas. Reg. Secs. 1.367(a)-3(b) and (d). Therefore, to avoid tax under I.R.C. Sec. 367(a)(1), V must execute a GRA. Treas. Reg. Sec. 1.367(a)-3(d)(3) Ex. 6A. Comment: This new example illustrates the application of new Treas. Reg. Sec. 1.367(a)-3(d)(2)(vii), which deems a domestic acquired corporation (here, Z) to be a foreign corporation if it is a subsidiary in a consolidated group and is transferred in a Treas. Reg. Sec. 1.367(a)-3(d)(1)(i), (iv), or (v) indirect stock transfer to a foreign transferred corporation. Note: In the context of indirect stock transfers, the term "foreign transferred corporation" does not mean "the corporation that was transferred," or "the corporation whose assets were transferred." See Treas. Reg. Secs. 1.367(a)-3(d)(2)(ii) and 1.367(a)- 8T(a)(1)(viii). In most cases, it means the corporation that, at the end of the day, is still in existence and owns something new. 114 e. Example 6B: Straight C reorganization followed by a drop-down/CAT to a domestic controlled corporation illustrating application of Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi)(B)(i) Facts: Example 6B uses the same facts as Example 6A, except that R is a domestic corporation. Before After F Foreign A R US B, C V US S/Hs 30% 70% V US Z US A B C* F Foreign R US ABC B&C 100% Voting Stock * Z has 3 separate businesses: A, B, and C. A and B are active under Code sec. 367(a)(3); C is not. 100% c o n s Result: Business B continues to qualify for the Code Sec. 367(a)(3), "active conduct of trade or business" exception. The fact that R is now domestic allows Business C to escape Sec. 367(a) taxation, too, thanks to the exception in Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi)(B). The exception has two parts: one (in subparagraph (i)) that is available for domestic acquired corporations controlled by five or fewer domestic corporations, and another (in subparagraph (ii)) that applies if control is more diverse or is not corporate. Because Z is controlled by V, it qualifies for the subparagraph (i) exception. That notwithstanding, V is still deemed under paragraph (d) to have made an indirect stock transfer, this time of both Business B and C, and so must execute a GRA. The GRA is larger here than in Example 6A because Business C's escape from Sec. 115 367(a) brings it within the indirect stock transfer rules and therefore requires the gain on its assets to be included. Treas. Reg. Sec. 1.367(a)-3(d)(3) Ex. 6B. 116 f. Example 6C: Straight C reorganization followed by a drop-down/CAT to a domestic controlled corporation illustrating application of Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi)(B)(ii) Facts: The facts here are the same as in Example 6B with the following exceptions: 1) V, Z's domestic parent, has been replaced by an unstated number of individuals, none of whom qualify as 5 percent shareholders of Z pursuant to Treas. Reg. Sec. 1.367(a)-3(c)(5)(iii); 2) no U.S. persons who are officers or directors of Z own F stock immediately after the transfer; and 3) F is engaged in an active trade or business outside the U.S. that satisfies the requirements of Treas. Reg. Sec. 1.367(a)-3(c)(3). Before After No 5% S/Hs Z US A B C* F Foreign R US ABC B&C 100% Voting Stock * Z has 3 separate businesses: A, B, and C. A and B are active under Code sec. 367(a)(3); C is not. 100% F Foreign A R US B, C Former Z S/Hs S/Hs 30% 70% Result: First, Business A assets are now taxable under Sec. 367(a)(1) because the Sec. 367(a)(3) exception is blocked by Sec. 367(a)(5). (The internal exception in Sec. 367(a)(5) does not apply as it did in Exs. 6A and 6B because there is no domestic corporation controlling Z.) Second, unless the requirements in paragraph Treas. Reg. Sec. 1.367(a)- 3(d)(2)(vi)(B) are met, Businesses B and C are tested under Secs. 367(a) and (d) before they are examined under Treas. Reg. Sec. 1.367(a)-3(d). The requirements in Treas. Reg. 117 Sec. 1.367(a)-3(d)(2)(vi)(B)(i) cannot be met because Z is not owned by domestic corporations. However, the Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi)(B)(ii) requirements (namely, compliance with Treas. Reg. Secs. 1.367(a)-3(c)(1)(i), (ii), (iv), (c)(6), and (d)(2)(vi)(C)) are or can be met. Therefore, the gain on both Business B and C is eligible for nonrecognition. No GRA is necessary because Z will execute the Required Statement mandated by Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi)(B)(ii). Treas. Reg. Sec. 1.367(a)- 3(d)(3) Ex. 6C. 118 g. Example 9: Indirect stock transfer by reason of a drop- down/CAT, illustrating Treas. Reg. Sec. 1.367(a)-3(d)(2)(vii)(B) Facts: This example uses the same basic, subsidiary C reorganization fact pattern as Example 6 with the variations added by Example 8 and a few additional changes. As the diagrams below show, acquiring subsidiary R is now foreign, domestic target Z and its domestic parent V file a consolidated return, and Z owns two businesses, A and B. Business B qualifies for the Code Sec. 367(a)(3) exception, but Business A does not. V receives 30 percent of the stock of F when Z transfers A and B to R. R, as part of the same transaction, transfers Business A to its wholly-owned domestic subsidiary M in a CAT. Result: The transaction is an indirect stock transfer in which more than 5 percent of transferee corporation F is received by U.S transferor V. The transferred corporation is M. As in Example 6C, unless the requirements in Treas. Reg. Sec. 1.367(a)- 3(d)(2)(vi)(B) are met, the transfer of Businesses A and B will be tested under Secs. 367(a) and (d) before they are examined under the indirect stock transfer rules of Treas. Reg. Sec. 1.367(a)-3(d). Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi)(B) can only apply to Business A, and because its requirements can be met, Business A's built-in gain is eligible for non-recognition. Because the "domestic-deemed-foreign" rule in Treas. Reg. Sec. 1.367(a)-3(d)(2)(vii)(A) cannot apply (R's drop-down/CAT to domestic corporation M vitiates it pursuant to Treas. Reg. Sec. 1.367(a)-3(d)(2)(vii)(B)), the gain attributable to Business A will be subject to the Treas. Reg. Sec. 1.367(a)-3(c) requirements regarding transfer of domestic stock. 119 Before Drop-down/CAT F Foreign R Z's A&Ls Foreign V US 100% M US 100% S/Hs 70% 30% Business A F Foreign R Business B Foreign V US 100% M Business A US 100% S/Hs 70% 30% V US Z US A B F Foreign R Foreign 100% 100% stock A&L c o n s After Drop-down/CAT Business B is subject to the general coordination rule, and it also escapes taxation because, when examined first under the asset transfer rules, it qualifies for the Sec. 367(a)(3) exception. Because the "domestic-deemed-foreign" rule in Treas. Reg. Sec. 1.367(a)-3(d)(2)(vii)(A) does apply to the transfer of Business B, the gain attributable to 120 Business B will be subject to the Treas. Reg. Sec. 1.367(a)-3(b) requirements regarding transfer of foreign stock. V must execute a GRA for all the unrecognized gain pursuant to Treas. Reg. Secs. 1.367(a)-3(b), (c), and (d). Three events will be able to trigger the GRA: disposition of R stock by F, disposition of M stock by R, and a Treas. Reg. Sec. 1.367(a)-8T(d)(2) disposition of substantially all the Business A and B assets by M and R. Treas. Reg. Sec. 1.367(a)-3(d)(3) Ex. 9. Comment: Like Example 6C, this example demonstrates the order of precedence in the coordination of the asset transfer and indirect stock transfer rules. The general coordination rule is that transactions are tested against the Sec. 367(a) rules first, and only if they are not taxed at that point does the possibility of taxation under the indirect stock transfer rules arise. However, if the "drop-down/CAT to a domestic subsidiary" exception in Treas. Reg. Sec. 1.367(a)-3(d)(2)(vi)(B) applies, it does not rescue gain that has already been deemed taxable under the general rule; rather, it steps in front of the general rule and prevents it application entirely. 121 h. Example 10: Concurrent application of asset transfer and indirect stock transfer rules in a forward subsidiary reorganization Facts: The facts are, again, the same as in Example 8 (which draws many of its facts from Example 6). F owns R; V and Z file a consolidated return; Business B qualifies for the Sec. 367(a)(3) exemption, and Business A does not. Business A has a fair market value (FMV) of $90 and a basis of $50; Business B has a FMV of $110 and a basis of $50; and V's Z stock has a FMV of $200 and basis of $100. The only change is that the transaction is a forward subsidiary merger instead of a subsidiary C reorganization. Before After 100% V US Z US A B F Foreign R Foreign 100% stock A&L c o n s F Foreign R Z's A&L Foreign V US 100% S/Hs 70% 30% Result: As in Example 8, the transfer of assets directly from Z to R is tested under Sec. 367(a) first. There is no Sec. 367(a) exception for Business A, so a $40 gain must be recognized. Because V and Z file a consolidated Federal income tax return, that $40 is added to V's basis in its Z stock, creating a new basis of $140. Sec. 367(a)(3) exempts Business B from the purview of Sec. 367(a)(1) because the application of Sec. 367(a)(5) is blocked by its internal exception (Z is owned by one domestic corporation, V). 122 The "domestic-deemed-foreign" rule in Treas. Reg. Sec. 1.367(a)-3(d)(2)(vii)(A) applies to the transfer of Business B, so the gain attributable to Business B will be subject to the Treas. Reg. Sec. 1.367(a)-3(b) requirements regarding transfer of foreign stock. Therefore, if the requirements of Treas. Reg. Secs. 1.367(a)-3(b) and (d) are met, including execution by V of a GRA for $60 (the $200 FMV of V's Z stock minus V's updated $140 basis), the transfer of Business B will be nonrecognition. Only if F sells some of its R stock, or R disposes of substantially all of the Business B assets before the GRA expires, will V be required to pay tax. Only the Business B assets will count with respect to the "disposition of substantially all assets" GRA trigger because the Business A assets were taxed under Sec. 367(a). Treas. Reg. Sec. 1.367(a)-3(d)(3) Ex. 10. Comment: The basic fact pattern in the example -- a domestic corporation and a foreign corporation participating in a statutory merger described in Code Sec. 368(a)(1)(A)/(a)(2)(D) -- illustrates the new Treas. Reg. Sec. 1.368-2(b)(1)(ii), which expands the definition of mergers under Code Sec. 368(a)(1)(A) to include transactions effected pursuant to non-U.S. statutes and thus brings those transactions within the purview of Sec. 367(a). Two other examples -- 11 (a reverse triangular merger) and 15 (another forward triangular) -- also involve statutory mergers between domestic and foreign corporations. 123 i. Example 11: Concurrent application of Sec. 367(a) and (b) in a reverse subsidiary reorganization Facts: The facts are new, but the pattern is still fairly familiar. As the diagrams show, F owns D, which is identified as an "operating corporation," and V owns Z. D, which has a basis of $60 and FMV of $100, merges into Z in a reverse subsidiary reorganization, and V swaps its Z stock for 55 percent of F. In the end, V is a controlling shareholder of F, which owns Z. Before After V US S/Hs Foreign F Foreign Z/D Foreign 55% perce nt 100% V US Z Foreign D US F Foreign F Stock 100% 100% Merger Z Stock Result: First, this transaction falls under the purview of Treas. Reg. Sec. 1.367(a)-3(b) because it is a foreign-to-foreign indirect stock transfer. The transferee foreign corporation is F and Z is the transferred corporation. If V does not execute a GRA, its exchange of Z stock for F stock will be taxable under Sec. 367(a)(1) and Sec. 1248 will be applicable. If V executes a GRA, then the exchange will be subject to the provisions of Sec. 367(b) and the regulations promulgated thereunder as well as Sec. 367(a). 124 Second, assuming execution of a GRA, no income inclusion is required under Treas. Reg. Sec. 1.367(b)-4(b) because after the exchange, both the merging subsidiary's foreign parent F (which gives up 55 percent of its stock) & foreign target Z (which was a controlled foreign corporation (CFC) before transaction) end up as CFCs as to which V is a Sec. 1248 shareholder. Third, the GRA may be triggered if V disposes of F stock (Treas. Reg. Sec. 1.367(a)-8T(d)(3)), if F disposes of Z stock (Treas. Reg. Sec. 1.367(a)-8T(d)(1)), or if Z disposes of substantially all the assets it had prior to the transaction (see Treas. Reg. Secs. 1.367(a)-8T(d)(2) and 1.367(a)-3(d)(2)(v)(B)). Finally, the transfer of D's assets to Z is taxable under Sec. 367(a) because Sec. 367(a)(5) blocks application of the Sec. 367(a)(3) "active trade or business" exception. Therefore, D must recognize $40 of gain. Treas. Reg. Sec. 1.367(a)-3(d)(3) Ex. 11. Comment: This is a particularly interesting example because there are two separate but overlapping exchanges that have Sec. 367(a) consequences: first, the transfer of D to Z, and second, the transfer of Z stock to F. As noted above in the comments following Example 10, this is one of three new examples that are predicated on new Treas. Reg. Sec. 1.368-2(b)(1)(ii), which expands the definition of mergers under Code Sec. 368(a)(1)(A) to include transactions effected pursuant to non-U.S. statutes and thus brings those transactions within the purview of Sec. 367(a). 125 j. Example 12: Concurrent application of direct and indirect stock transfer rules Facts: As the diagrams below show, the example posits a subsidiary C reorganization in which domestic subsidiary E (owned by domestic parent D) transfers both stock of E's wholly-owned subsidiary N and the assets of Business X to O, a foreign subsidiary of foreign parent F. Both D's gain on the indirect stock transfer of E's stock and E's gain on the transfer of N may qualify for nonrecognition. However, because D, E, and N file a consolidated return, both GRAs must be executed by consolidated parent D. Before After D US S/Hs Foreign F Foreign O/E Business X Foreign N US 40% 60% 100% 100% D US E US Business X N US O Foreign F Foreign A&Ls Voting Stock 100% 100% 100% c o n s Result: E's transfer of its assets, including the N stock, must be tested under the general rules of Sec. 367(a) before consideration of D's indirect transfer of the stock of E. E's transfer of the assets of Business X qualifies for nonrecognition under Sec. 367(a)(3). E's transfer of its N stock could qualify for nonrecognition treatment if D satisfies the 126 requirements in Sec. 1.367(a)-3T(e). The explanation in the example says that, in this portion of the analysis, O is the transferee foreign corporation and N is the transferred corporation. However, calling O the transferee foreign corporation contravenes Treas. Reg. Sec. 1.367(a)-3(d)(2)(i) because, according to the facts, no one receives stock of O in any part of transaction. The analysis accompanying the example should acknowledge this and provide an appropriate explanation. Pursuant to Treas. Reg. Secs. 1.367(a)-3(d)(1) and (d)(2)(vii)(A)(1), D is deemed to transfer the stock of a foreign corporation to F in a Sec. 354 exchange subject to the rules of Treas. Reg. Secs. 1.367(a)-3(b) and (d), and therefore may enter into a gain recognition agreement for such indirect stock transfer as provided in Treas. Reg. Sec. 1.367(a)-3(b) and Treas. Reg. Sec. 1.367(a)-8T. As to this transfer, F is the transferee foreign corporation; O is the transferred corporation. The amount of the GRA is $60. See also Sec. 367(a)(5) and any regulations issued thereunder. Treas. Reg. Sec. 1.367(a)- 3(d)(3) Ex. 12. 127 k. Example 15: Alternate concurrent application of indirect stock transfer rules and Sec. 367(b) illustrating Treas. Reg. Sec. 1.367(a)-3(b)(2)(i)(B) Facts: As the diagrams below show, F owns Newco, and P owns FC. P's basis in FC is $50, FC's FMV is $100, and FC's all earnings and profits amount ("all E&P") is $60. In a forward subsidiary merger, Newco gets the assets of FC, and P exchanges its FC stock for 20 percent of F's stock. Before After 100% P US FC Foreign A B F Foreign Newco US 100% stock A&L F Foreign Newco FC's A&L US P US 100% S/Hs 80% 20% Result: As noted in Sec. I.C above, in the 1998 final regulations, taxation under Sec. 367(a) preempted taxation under Sec. 367(b) in cases where both sections could apply. That meant that if greater tax would be due under Sec. 367(b), the U.S. transferor could "choose" the lesser taxation under Sec.367(a) by foregoing a GRA. That result undermined the policy underlying Sec. 367(b), and the rule now (in Treas. Reg. Sec. 1.367(a)-3(b)(2)(i)(B)) requires that Sec. 367(b) apply first in the case of inbound subsidiary reorganizations if, as in this example, the all E&P amount is greater than the gain subject to Sec. 367(a). 128 P's Sec. 354 exchange is considered an indirect stock transfer under Treas. Reg. Sec. 1.367(a)-3(d)(1)(i). Further, because the assets of foreign corporation FC are acquired by Newco, a domestic corporation, in an asset reorganization, the transaction is also subject to Secs. 1.367(b)-3(a) and (b). This overlap between Treas. Reg. Sec. 1.367(b)-3 and the indirect stock rules of Treas. Reg. Sec. 1.367(a)-3(d), plus the fact that FC's relevant all E&P amount ($60) is greater than the gain subject to Sec. 367(a) ($50), means that the Sec. 367(b) rules, and not the Sec. 367(a) rules, apply to the exchange. See Sec. 1.367(a)-3(b)(2)(i)(B). The fact that Sec. 367(a) does not apply here means that there is no need for a GRA. That is a sensible result because, if the transaction were secondarily subject to Sec. 367(a) (that is, if Sec. 367(b) and Sec. 367(a) applied sequentially in this situation, instead of alternatively), there would be no gain to report. The $60 gain reported and taxed under Sec. 367(b) would be added to P's $50 basis in its FC stock, and the resulting new basis of $110 would be greater than FC's $100 fair market value. Result: zero tax due under Sec. 367(a). If FC's relevant E&P amount had been less than the potential Sec. 367(a) gain, then P could have either paid tax on the gain under Sec. 367(a), foregone a GRA, and been free of Sec. 367(b) taxation forever, or it could have paid tax on the lesser all E&P amount under Sec. 367(b), adjusted its basis in the FC stock pursuant to Treas. Reg. Sec. 1.367(b)-2(e)(3)(ii), and then executed a GRA for the remaining gain from the transaction. Treas. Reg. Sec. 1.367(a)-3(d)(3) Ex. 15. 129 5. Transfers by a domestic corporation to a foreign corporation in a Sec. 361 exchange -- new Treas. Reg. Sec. 1.367(a)-3T(e) On Feb. 5, 2007, two new paragraphs -- (e) and (f) -- were added to Treas. Reg. Sec. 1.367(a)-3 by Treas. Reg. Sec. 1.367(a)-3T. T.D. 9311, 2007-10 I.R.B. 635, 72 Fed. Reg. 5174, 5183 (Feb. 5, 2007). Paragraph (f) states the effective date for paragraph (e): in general, March 7, 2007. Treas. Reg. Sec. 1.367(a)-3T(e) is a repositioning and expansion of a provision that was in Treas. Reg. Sec. 1.367(a)-8(f)(2)(i) and that was modified in Section 4.01 of Notice 2005-74. That provision addressed the avoidance of gain recognition under Sec. 367(a)(1) when the U.S. transferor goes out of existence as part of a transaction that would qualify for a GRA. Under new Treas. Reg. Sec. 1.367(a)-3T(e), if a U.S. transferor is a domestic corporation that transfers stock or securities to a foreign corporation in a Sec. 361 exchange that would otherwise be taxable under Sec. 367(a)(1), that transfer will not be subject to Sec. 367(a)(1) if four conditions are met. The limitation to a transfer of stock or securities seems odd in light of the fact that Sec. 361 applies to transfers of property, which can include but would not be limited to stock or securities. That notwithstanding, the four conditions are: a. First, the U.S. transferor has to satisfy the conditions set forth in the second sentence in Sec. 367(a)(5) and any regulations promulgated thereunder, such as that the U.S. transferor is controlled (within the meaning of Sec. 368(c)) by 5 or fewer domestic corporations and that appropriate basis adjustments are made. Treas. Reg. Sec. 1.367(a)-3(e)(1)(i). Although only the second sentence of Sec. 130 367(a)(5) is mentioned, Sec. E of the preamble to T.D. 9311 indicates that the last sentence of Sec. 367(a)(5), which provides that all members of a Sec 1504 affiliated group shall be treated as one corporation, is also intended to apply. b. Second, "[i]n the case of transferred property that is stock or securities of a domestic corporation, the conditions set forth in [Treas. Reg. Sec. 1.367(a)-3(c) must be] satisfied." Treas. Reg. Sec. 1.367(a)-3(e)(1)(ii). The quoted language suggests that the specific mention of "stock or securities" in the front language of 1.367(a)-3(e)(1) may not be intended to be limiting. The reference to "transferred property" is troubling because that term is undefined except in the context of indirect stock transfers, where it means the stock or securities of the transferred corporation. Treas. Reg. Sec. 1.367(a)-3(d)(2)(ii). The term "transferred corporation," in turn, is defined, in the context of indirect stock transfers, as the acquiring corporation. Id. What is probably meant in Treas. Reg. Sec. 1.367(a)-3(e)(1)(ii) is "a transfer of stock or securities of a domestic corporation," which is the predicate for application of Treas. Reg. Sec. 1.367(a)-3(c). However, until the term "transferred property" is clarified, taxpayers and their advisors would do well to be cautious in interpreting it. c. Third, all domestic corporate shareholders of the U.S. transferor immediately before the transaction that own 5 percent or more (pursuant to the attribution rules of Sec. 318 as modified by Sec. 958(b)) of the voting power or total fair market value of the stock of the transferee corporation immediately after the transaction must enter into gain recognition agreements (GRAs) for their pro rata share of the gain realized but not recognized in the transaction. In addition, those GRAs must designate the corporate shareholders as U.S. transferors for purposes of Treas. Reg. Sec. 1.367(a)- 131 3(b) and (c) and 1.367(a)-8T. Each corporation's pro rata share is determined by the fair market value of the U.S. transferor stock or securities owned. Treas. Reg. Sec. 1.367(a)- 3(e)(1)(iii). d . Fourth, each of the GRAs must contain the election described in Sec. 1.367(a)-8T(b)(1)(vii) to recognize gain in the year the GRA is triggered, rather than in the year of the transaction. Treas. Reg. Sec. 1.367(a)-3(e)(1)(iv). If a transaction addressed by Treas. Reg. Sec. 1.367(a)-3T(e)(1) is a forward subsidiary merger, a subsidiary C reorganization, a reverse subsidiary merger, or a subsidiary G reorganization, the GRAs must include, as an additional triggering event, the indirect dispositions of the transferred stock or securities. Treas. Reg. Sec. 1.367(a)- 3(e)(2). Treas. Reg. Sec. 1.367(a)-3(e)(3) provides the following example: US1 and US2, two unrelated domestic corporations, own 60% and 40% respectively of UST, another domestic corporation that owns 100% of FC, a foreign corporation. In Year 1, UST transfers all of its FC stock to foreign corporation FA in a reorganization described in Sec. 368(a)(1)(A). After the transfer, US1 and US2 own 6% and 4% respectively of the stock of FA. (Unstated but apparent are the additional facts that the stock of FC is the entirety of UST's assets, and that after the transfer of all its assets to FC, UST goes out of existence, as required by Treas. Reg. Sec. 1.368-2(b)(ii)(B).) The Sec. 1248 amount in Year 1 with respect to the FC stock is $0. The notice requirement under Sec. 1.367(b)-1(c) is satisfied. Sec. 7874 does not apply to the transaction. US1 and US2 satisfy the conditions set forth in the second sentence of Sec. 367(a)(5), including making appropriate basis adjustments. 132 With respect to GRAs, US1 must comply with the paragraph (e)(1)(iii) requirements because it owns more than 5% of FA after the transaction, or else pay tax pursuant to Sec. 367(a)(1) on its 60% share of the gain realized on the transfer of the FC shares. Not surprisingly, it executes a five-year GRA pursuant to Treas. Reg. Sec. 1.367(a)-8T. US2, which ends up with only 4% of FA, has no GRA obligation. In Year 4, FA triggers US1's GRA by selling 30% of the FC stock for cash. Pursuant to the GRA, US1 must recognize 18% of the original, realized-but-unrecognized gain on the FC shares (30% of its 60% share of UST) in Year 4, plus interest. If in Year 1 US1 and US2 had been part of a consolidated group with common parent USP, then USP would have filed a GRA on behalf of both US1 and US2. (US2 would have been included because its stake in FA after the transfer of FC would have exceeded 5% after application of the Sec. 318 attribution rules, modified by Sec. 958(b).) Therefore, when the GRA was triggered in Year 4, both US1 and US2 would have had to recognize gain, with US2's portion being 12% of the original, total gain on the FC shares (i.e., 30% of its 40% share of UST). 6. Expatriation Under Treas. Reg. Sec. 1.367(a)-3(c) The rules of Treas. Reg. Sec. 1.367(a)-3(c) have been the basis of many high- profile foreign acquisitions of U.S. corporations. For example, the acquisition of Chrysler by DaimlerBenz, a German corporation, the acquisition of AirTouch by Vodafone, a U.K. corporation, and the acquisition of ARCO by BP Amoco, also a U.K. corporation, were non-recognition transactions designed to qualify under Treas. Reg. Sec. 1.367(a)-3(c). 133 Treas. Reg. Sec. 1.367(a)-3(c) transactions replace the U.S. parent corporation of a multinational group with a foreign parent corporation. They offer financial and U.S. securities law advantages, as well as U.S. corporate tax advantages. For this reason, Treas. Reg. Sec. 1.367(a)-3(c) has attracted much attention. a. U.S. Corporate Tax Advantages The U.S. corporate tax advantages of Treas. Reg. Sec. 1.367(a)-3(c) transactions are greatest when the foreign subsidiaries of the foreign acquirer undertake overseas expansion in low tax jurisdictions that would otherwise have been undertaken by foreign subsidiaries of the acquired U.S. target. If the acquired U.S. target's foreign subsidiaries undertook that expansion, the U.S. target would be subject to U.S. corporate tax on the resulting income, if not currently under Subpart F, at least upon repatriation of the profits or on disposition of the expanded business, sheltered only to the extent of available foreign tax credits. By contrast, if the foreign acquirer of the U.S. target establishes a foreign subsidiary to undertake the foreign expansion, no U.S. corporate tax would be owed with respect to the foreign subsidiary's earnings. The U.S. corporate tax base of this foreign income disappears. As noted in "News Analysis: Last Corporate Taxpayer Out The Door, Please Turn Out the Lights," 1999 TNT 30-5: Daimler Chrysler . . . raises the question of the effect of cross-border investments on U.S. tax collections. . . . [C]ross-border tax collection is not a zero-sum game in which income not taxed by one country is taxed by another. 134 It may be taxed nowhere, due to tax arbitrage, income shifting, and tax havens. That is, in the AirTouch/Vodafone combination, Britain will not necessarily collect the tax that the United States will be foregoing. The combined companies will operate in 23 of the roughly 185 countries in the world. . . . Extensive planned future expansion into the rest of the world's countries will be out of U.S. tax jurisdiction, whereas if AirTouch had pursued these opportunities alone, the new businesses might have been CFCs. AirTouch currently operates in 13 foreign countries; foreign operations provide 40 percent of its revenue. Vodafone and AirTouch expect after-tax cost savings of $330 million annually, to be achieved through cost savings and something called "application of global best practices." Tax savings can arise in various ways at different levels. Sometimes the foreign merger partner is incorporated in a European or other foreign country with an integrated tax system that, unlike the U.S., provides a reduced rate of tax on, or a deduction for, income distributed as dividends. Certain other foreign countries integrate the tax system by allowing the shareholders of a corporation an imputation credit for the local country income tax paid by the corporation. Having the foreign corporation be the surviving 135 parent prevents the loss of this tax benefit for the shareholders resident in that foreign country. This tax benefit may or may not be provided for U.S. shareholders, depending on the foreign country's tax law and the provisions of the country's income tax treaty with the United States. To the extent that foreign expansion takes place in low or no tax countries, another tax advantage of having a foreign corporate parent arises when the foreign corporation is a tax resident of a foreign country that either does not tax foreign business income or allows a participation exemptions for the business income of a foreign subsidiary. In such a case, the corporate parent's tax on the profits from the foreign expansion is eliminated, potentially providing a significant advantage over having a U.S. corporation remain the parent of the world-wide group. Alternatively, if the foreign parent's country of residence has more lax tax laws than the U.S. with respect to controlled foreign corporations, indefinite parent-level tax deferral may be more easily obtained than if a U.S. corporation served as the group's parent. Some of the expatriation transactions have involved shifting the pre-expatriation foreign subsidiaries of the expatriated U.S. parent to the post-expatriation foreign parent. This is accomplished by the U.S. former parent (now a U.S. subsidiary of a foreign parent) exchanging its shares in its foreign subsidiaries for stock of the tax-haven foreign parent. In that way, the former foreign subsidiaries of the U.S. parent become sister foreign subsidiaries, to that U.S. subsidiary, of the new foreign parent. This transaction is generally taxable to the former U.S. parent (see Treas. Reg. Sec. 1.367(b)-4(b)(1)), except to the extent deemed paid tax credits are available under Secs. 1248 and 902. However, following the transfer, future foreign income of those foreign subsidiaries can 136 avoid being subject to the U.S. anti-deferral rules and indeed escapes all future U.S. corporate taxation. Despite the U.S. corporate tax advantages, the empirical evidence on whether past pure inversion transactions of publicly traded U.S. companies have enhanced the stock price by more than the tax toll charge seems inconclusive. See "Market Nonreaction to Inversions," 2003 TNT 9-49. The benefit of eliminating the U.S. parent level tax on future foreign expansion afforded by Treas. Reg. Sec. 1.367(a)-3(c) transactions can be offset, however, by other considerations. First, to the extent that the acquiring foreign parent is subject to its home county tax on the earnings of a new low-tax foreign subsidiary, the advantage is of avoiding parent level tax is lost. Moreover, to the extent that the acquiring foreign parent's home country tax system has its own anti-deferral rules, the advantage of escaping the U.S. anti-deferral rules are reduced. A second potential adverse tax consequence of having a foreign corporate parent is a potential corporate level tax on income from the acquired U.S. target. For example, post-acquisition dividends paid by the acquired U.S. target to the new foreign parent are, in the absence of an applicable treaty, subject to 30% U.S. dividend withholding tax. In addition, to the extent that such dividends are included in the foreign parent's income and not sheltered from the parent's home country tax by credits or otherwise, the U.S. target's earnings are again subject to a corporate level tax. However, the foreign parent often qualifies for a significantly reduced rate of tax on dividends under a U.S. income tax treaty. Furthermore, the foreign parent may qualify for a foreign tax credit for the withholding tax and a deemed paid foreign tax credit for the U.S. corporate tax paid by 137 the U.S. target. This would be the case, for example, where the acquiring foreign parent is a U.K. corporation. In the case of a German foreign parent, the U.S. withholding tax on dividends would be reduced to 5% under the U.S.-German income tax treaty, and this additional tax would be mitigated since the German parent is subject to little or no German corporate tax on those dividends due to a participation exemption or alternative tax credit for the U.S. corporate income and withholding taxes. A third offsetting aspect is the U.S. transfer price regulations. If the new foreign subsidiary uses intangible assets of the U.S. target, the acquired U.S. target will be required to include in income an arms' length charge for those intangibles, determined under the U.S. transfer pricing rules. b. Financial Advantages A foreign corporation whose shares were not publicly traded in the United States will usually list its shares on a U.S. stock exchange in connection with a Treas. Reg. Sec. 1.367(a)-3(c) acquisition of a publicly traded U.S. corporation. See, e.g., Ltr. Rul. 200020018, discussed below. There are numerous financial advantages to a foreign corporation listing its shares on NASDAQ-AMEX or the New York Stock Exchange or trading OTC. There are more than 1,000 foreign corporations listed on U.S. stock exchanges. Such exchange listing gives the foreign corporate shares liquidity often available nowhere else. The financial advantages generated by such liquidity include: Providing the foreign corporation access to new equity capital through stock issuances; Permitting the founding shareholders of the foreign corporation to dispose of some or all of their holdings; 138 Making the foreign corporation's shares more desirable to U.S. shareholders of potential corporate targets in current and tax-deferred Treas. Reg. Sec. 1.367(a)-3(c) transactions; Making the foreign corporation's stock more desirable to employee stock option grantees; and Boosting the market value of the stock. c. U.S. Securities Law Advantages A foreign acquirer whose shares are first listed on a U.S. stock exchange in connection with a Treas. Reg. Sec. 1.367(a)-3(c) transaction will typically achieve favorable classification as a "foreign private issuer" for purposes of the U.S. securities laws. A 1997 SEC study concluded that of the more than 1,000 foreign private issuers listed on U.S. securities exchanges, about 35% were listed on the NYSE, 43% were listed on the NASDAQ National Market, NASDAQ Small Cap and AMEX exchanges, and 22% were listed on the OTC. Foreign private issuers are subject to less burdensome and, thus, less costly U.S. securities law compliance obligations than are listed U.S. corporations, including the U.S. target in a Treas. Reg. Sec. 1.367(a)-3(c) transaction. Thus, in an acquisition by a foreign parent of a U.S.-exchange-listed U.S. corporation, there can potentially be significant administrative cost savings. Definition of Foreign Private Issuer Under 17 CFR Sec.240.3b-4, a foreign private issuer includes a corporation incorporated outside the U.S. if a majority of its voting shares are directly and indirectly held of record by non-U.S. residents. Foreign corporate voting stock held in U.S. and certain foreign brokerage accounts is traced through to determine record ownership. 139 Because Treas. Reg. Sec. 1.367(a)-3(c)(1)(i) requires the U.S. transferors to receive not more than 50% of the total voting power and value of the stock of the acquiring foreign parent corporation, this foreign private issuer test is generally met. Since there are some differences in the tests, foreign private issuer status may not be available in every case. For example, Treas. Reg. Sec. 1.367(a)-3(c)(1) generally ignores pre-existing ownership in the acquiring foreign parent by both non-target U.S. stockholders and target U.S. stockholders outside the U.S. target's control group of officers, directors, and 5% shareholders. By contrast, pre-existing U.S. record ownership in the target that becomes U.S. record ownership in the listed foreign acquiring parent can count against foreign private issuer status. There is another way for the foreign parent to qualify as a foreign private issuer, even if a majority of its stock is owned of record by U.S. residents. Under 17 CFR Sec.240.3b-4, such a foreign parent will be viewed as a foreign private issuer if: (1) a majority of the foreign parent's officers and directors are not U.S. citizens or resident; (2) its business is administered outside the United States; and (3) a majority of the foreign parent's business is located outside the U.S. Since Treas. Reg. Sec. 1.367(a)-3(c) generally requires that the acquiring foreign corporation be greater in market value than the U.S. target, it is often feasible to satisfy the alternative test of 17 CFR Sec.240.3b-4. Of course, in some cases there may be difficulties. For example, the acquiring foreign parent in a Treas. Reg. Sec. 1.367(a)-3(c) transaction may already have significant U.S. assets, which, when added to the U.S. target's assets, constitute a majority of the foreign issuer's assets. In that case, the foreign 140 parent cannot rely on this alternative test. Rather, it would have to qualify under the ownership test to achieve its status as a foreign private issuer. Benefits of Foreign Private Issuer Status (1) Foreign private issuers generally file an annual Form 20-F, not an annual Form 10-K. Form 20-F generally requires less disclosure than Form 10-K. Form 20-F is generally due 6 months after year-end, as distinguished from 3 months after year-end for Form 10-K. (2) Foreign private issuers need not file quarterly Form 10-Qs. (3) Foreign private issuers are generally exempt from the proxy rules of Sec. 14(a) of the 1934 Act. In Ltr. Rul. 200406013, the Service ruled that a U.S. company with a foreign parent that was a "foreign private issuer", and its subsidiaries were not subject to the Sec. 162(m) compensation deduction limitation because under the SEC rules neither the foreign parent nor the U.S. company were required to file nor filed a summary compensation table with the SEC. Similarly, Ltr. Rul. 200419013 favorably ruled that Sec. 162(m) was inapplicable to the short year consolidated return of an acquired public U.S. corporation that was acquired by a foreign private issuer before the U.S. corporation's due date for proxy filings, on the grounds that the post-acquisition proxy filings of the foreign private issuer acquirer was neither required to nor did contain the summary compensation schedule for the pre-acquisition compensation of the acquired U.S. company's officers. (4) Foreign private issuers are generally exempt from the Sec. 16(b) rules concerning restitution of certain short-term profits. 141 (e) Foreign private issuers are generally exempt from SEC Regulation FD (2000), prohibiting selective disclosure of material nonpublic information. However, the preamble to SEC Regulation FD, 65 Fed. Reg. 515716 (8/24/2000), states "the Commission has determined to exempt foreign private issuers at this time, as it has in the past exempted them from certain U.S. reporting requirements such as Forms 10-Q and 8-K. Today's global markets pose new regulatory issues. In recognition of this fact, the Commission will be undertaking a comprehensive review of the reporting requirements of foreign private issuers. In the interim, we remind foreign private issuers of their obligations to make timely disclosure of material information pursuant to applicable self-regulatory organization rules and policies, and our expectation that the markets will enforce these obligations. Also, while Regulation FD will not apply, foreign private issuers in their disclosure practices remain subject to liability for conduct that violates, and meets the jurisdictional requirements of, the antifraud provisions of the federal securities laws." d. Practical Difficulties Despite the potential U.S. corporate tax, financial, and SEC advantages, there are several practical difficulties in arranging a Treas. Reg. Sec. 1.367(a)-3(c) transaction. First, U.S. target shareholders are usually reluctant to accept as consideration stock of a foreign corporation, unless that foreign corporation is very well known in the United States and is, or simultaneously with the acquisition becomes, traded on a U.S. or major foreign stock exchange. Second, due to high valuations of some potential U.S. target corporations on the U.S. stock markets, it is often difficult to find complementary foreign acquirers with higher market capitalization. For these two reasons, most of the high 142 profile non-recognition transactions under Treas. Reg. Sec. 1.367(a)-3(c) have involved very large, well-known foreign companies like BP Amoco, Daimler Benz, and Vodafone. Sec. 355(e) generally triggers tax to a U.S. target corporation that spins off a subsidiary in contemplation of being acquired by a foreign or U.S. corporation in a tax- free reorganization. Therefore, such a spin-off is often not feasible, even if it would reduce the value of the U.S. target to below that of the foreign acquirer to satisfy Treas. Reg. Sec. 1.367(a)-3(c). Not all Treas. Reg. Sec. 1.367(a)-3(c) transactions must be of the magnitude of BP Amoco-ARCO, Daimler-Benz-Chrysler or Vodafone-AirTouch, however. For example, the authors are aware of a number of relatively small private U.S. companies that have been acquired in Treas. Reg. Sec. 1.367(a)-3(c) transactions by larger corporations traded on foreign stock exchanges. e. IRS Private Rulings In several situations it has been necessary for taxpayers to incur the delay and expense of obtaining rulings from the IRS concerning substantial compliance under Treas. Reg. Sec. 1.367(a)-3(c)(9). Most commonly, a ruling has been necessitated because of uncertainty as to whether the foreign acquirer is worth more than the U.S. target. Such valuation uncertainty can occur when there are upward movements in the value of the U.S. target stock or downward movements in the value of the foreign acquirer stock between the date on which the terms of the acquisition are agreed and the effective date of the acquisition. Such valuation uncertainty can also arise because of acquisitions of passive assets by the foreign acquirer during the 36 months before the acquisition (such as an initial public offering for cash not undertaken for the purpose of 143 stuffing the foreign acquirer), which, absent an IRS ruling are excluded under Treas. Reg. Sec. 1.367(a)-3(c)(3)(iii)(B)(1)(i)(A) in determining whether the foreign acquirer is worth at least as much as the U.S. target. There have been several favorable private letter rulings issued under Treas. Reg. Sec. 1.367(a)-3(c)(9), including those approving the Daimler-Benz-Chrysler and Vodafone-AirTouch acquisitions. See, e.g. Ltr. Ruls. 200709054 200440009, 200203015, 200122026, 20002018, 199903048, 9849014, and 9720024. Letter Ruling 20002018 A typical ruling under Treas. Reg. Sec. 1.367(a)-3(c)(9) is Ltr. Rul. 20002018. There, a U.S. corporation merged with and into a newly created U.S. subsidiary of a previously privately held foreign corporation in a forward triangular merger (Sec. 368(a)(2)(D)). The U.S. target's shareholders received cash and stock of the foreign acquiring corporation's parent. Simultaneously, the foreign acquirer made an initial public offering pursuant to firm commitments in place before the Treas. Reg. Sec. 1.367(a)-3(c) transaction. Various representations regarding satisfaction of Treas. Reg. Sec. 1.367(a)-3(c)(3) were made. In particular, it was represented that the foreign parent's pre-acquisition value (as determined for purposes of the initial public offering price of the foreign corporate acquirer) would exceed the U.S. target's pre-acquisition value, as required by Treas. Reg. 1.367(a)-3(c)(3)(iii)(A). However, the parties recognized that if the value of the foreign corporate acquirer's post-acquisition shares unexpectedly fell well below the initial public offering price at the close of the merger date, the IRS might argue, contrary to the underwriter's initial public offering valuation, that the U.S. target was worth more 144 than the foreign acquirer. In other words, if the cash received by the U.S. target's shareholders in the forward triangular merger, a fixed dollar amount, exceeded the excess of the closing value of the foreign acquirer shares owned by the pre-acquisition foreign corporate acquirer's shareholders over the foreign acquirer shares issued to the U.S. target shareholders, then Treas. Reg. Sec. 1.367(a)-3(c)(3)(a)(iii)(A) could perhaps cause the transaction to be taxable. Ltr. Rul. 20002018 allowed the use of the underwriter's appraised value of the foreign acquirer established before the merger to value the foreign parent in its initial public offering, even though the foreign parent stock could fall below that value immediately after the transaction. Ltr. Rul. 200020018 also permitted acquisitions by the foreign corporate acquirer of passive assets outside the ordinary course of business within the preceding 36 months, e.g. stock issuances for cash not undertaken for the purpose of stuffing the foreign corporate acquirer, to be included in the value of foreign corporate acquirer's market value in determining whether the value of the foreign corporate acquirer exceeded the value of the U.S. target. (Ltr. Rul. 200252002 permitted issuance of convertible debt within the preceding 36 months not undertaken for purposes of stuffing the foreign corporate acquirer.) Because the aggregate initial public offering price value of the foreign parent stock and the cash issued to U.S. target's shareholders exceeded the value of the foreign corporate acquirer, non-recognition was permitted under Treas. Reg. Sec. 1.367(a)-3(c)(3). f. Criticism of Treas. Reg. Sec. 1.367(a)-3(c) As Too Narrow The approach taken by Sec. 367(a) and Treas. Reg. Sec. 1.367(a)-3(c) to prevent corporate expatriation abuses is to impose a capital gain on the exchange of shares in a 145 non-qualifying expatriation share transaction. Some view gain recognition as an insufficient cost to eliminate the perceived abuse of eliminating the U.S. corporate tax base on foreign income of predominantly U.S.-owned businesses. First, Sec. 367(a) can be avoided by effective initial tax planning. For example, Global Crossings, Ltd., a former NYSE-listed world-wide telecommunications company whose key executives live and work in Los Angeles, was initially established as a tax- haven company, specifically as a Bermuda company. Thus, the Global Crossings, Ltd., corporate parent did not pay U.S. corporate tax on its and its foreign subsidiaries' income to the extent that they avoided having income effectively connected with a U.S. trade or business. A similar approach was taken by Accenture, the former consulting arm of Arthur Andersen, which incorporated in a tax haven at the time of its initial public offering. Second, the consequences of Sec. 367(a) are minimal when the capital gains tax imposed on the shareholders in a taxable share exchange transaction is small. This tax does not apply at all to a tax-exempt exchanging U.S. shareholder of the U.S. target, such as a U.S. pension fund, charity, or IRA, to a U.S. shareholder with a basis in the U.S. target's stock greater than the value of the foreign corporate stock received on the exchange, or to a foreign shareholder. Sometimes some of the U.S. shareholders of the U.S. target will have a low basis in their U.S. target stock, e.g., the founding U.S. shareholders, while other shareholders will either have a relatively high tax basis or be tax exempt or foreign entities. A "partially taxable exchange" is a technique sometimes used to avoid U.S. tax on a transaction not qualifying under Treas. Reg. Sec. 1.367(a)-3(c). An example of such an 146 exchange was the 1998 Fruit of the Loom expatriation transaction, pursuant to which Fruit of the Loom, Inc., a U.S. corporation, became a subsidiary of a newly created Cayman Islands corporation, Fruit of the Loom, Ltd. The goal of the transaction was apparently to avoid future U.S. corporate taxes on Central American income of the Cayman Island corporation's new Central American subsidiaries. The public shareholders of U.S. Fruit of the Loom, other than the founder, William Farley, and his group, exchanged their shares for shares of the Cayman Islands corporation. The transaction was taxable to them under Treas. Reg. Sec. 1.367(a)-3(c) for various reasons, including the newly created Cayman Island parent's lack of a 36-month active business history, its smaller value than that of the U.S. corporation, and its having issued more than 50% of its shares to the target U.S. corporation. However, little shareholder tax was apparently paid since U.S. pension funds owned much of the exchanged shares. The William Farley group received exchangeable participating preferred stock in the U.S. corporation, making the transaction arguably tax-deferred to them under Sec. 1036. In addition, U.S. withholding tax on dividends would be avoided to the extent that they would be paid to the William Farley group rather than to the foreign parent. A third reason why Sec. 367(a) is viewed by some as inadequate to prevent corporate expatriations is that the shareholder level gain triggered under Sec. 367(a) can wholly fail to correspond to the magnitude of the U.S. corporate tax that will be avoided on the future foreign income. Absent Sec. 367(a) recognition, the foreign corporate stock received on the exchange receives a tax basis carried over from the U.S. corporate stock exchanged. As a consequence, Sec. 367(a) accelerates, not creates, U.S. shareholder level tax. This acceleration of shareholder capital gain tax is not related to the permanent 147 elimination of U.S. corporate tax on future foreign income. Although the shareholder level capital gain tax may be increased in amount because of the public's increased valuation of the foreign corporate stock due to the expatriation transaction itself, such increase is still not necessarily related to the permanent elimination of U.S. tax on future foreign income. These inadequacies in Treas. Reg. Sec. 1.367(a)-3 led to the enactment of Sec. 7874, described below, in the American Jobs Creation Act of 2004. Before 2002, there was also some concern that because neither the exchanging U.S. shareholders in a taxable Treas. Reg. Sec. 1.367(a)-3(c) transaction nor the Service received Forms 1099 reporting the U.S. shareholder's gain, such gain was often not reported by the U.S. shareholder. See "Preliminary Report Reviews Corporate Inversion, Implications," 2002 TNT 98-49. Beginning in 2002, various proposed temporary, and final regulations have addressed this problem. See "Corporate Inversion Reporting Under Final Regulations," 104 Journal of Taxation (Jan. 2006). For 2006 and later transactions, Treas. Reg. Sec. 1.6043-4(h) Example (1) generally provides that if the U.S. inverted corporation's stock is valued at more than $100 million, IRS Forms 1099-CAP must be issued by that U.S. corporation to any U.S. individual shareholder receiving more than $1,000 of cash and taxable foreign corporate stock in a wholly or partially taxable Treas. Reg. Sec. 1.367(a)-3(c) transaction. Treas. Reg. Sec. 1.6045-3(a) generally provides that brokers who know or have reason to know that an individual U.S. customer exchanged U.S. corporate stock in a change of control transaction must file an IRS Form 1099-B for that customer. Treas. Reg. Sec. 1.6043-4(a)(1) requires the inverted domestic corporation to file an IRS Form 8806 reporting its acquisition by its foreign parent. The American 148 Jobs Creation Act of 2004 enacted Sec. 6043A, which requires the acquiring foreign corporation (or acquired U.S. corporation, if required by Treasury) to file reports with the Service and furnish information reporting to shareholders with respect to acquisitions that trigger gain to the acquired U.S. corporation's shareholders. Acceleration of the capital gains tax has not proved to be a barrier to expatriation when the projected future income is large. For this reason, several public companies have engaged in expatriation stock exchange transactions that are fully taxable under Treas. Reg. Sec. 1.367(a)-3(c), i.e., they have formed tax-haven shell subsidiaries with U.S. subsidiaries that merge with the publicly-traded U.S. target. The U.S. shareholders of the publicly-traded U.S. target receive shares of the foreign holding company. In such cases, the foreign holding company shares are taxable to all of the exchanging taxable U.S. shareholders. However, the benefit of avoiding future U.S. corporate tax on future foreign earnings has been achieved. Such transactions include the 2001 Ingersoll Rand, and 1999 PXRE Corporation and Everest Reinsurance Holdings expatriation transactions. The 2001 Ingersoll Rand expatriation is discussed in "Ingersoll Rand's Permanent Holiday," 2002 TNT 3-4. See also "U.S. Companies File In Bermuda To Slash Tax Bills," New York Times, February 18, 2002, discussing the proposed 2002 expatriation of Stanley Works, for 159 years a U.S. manufacturer of hammers and wrenches. That news article suggests that perhaps the fear of being viewed as anti-patriotic, more so than the Treas. Reg. Sec. 1.367(a)-3(c) shareholder-level capital gains tax toll-charge, is now the main impediment to far more U.S. public companies expatriating. In an information-based global economy, it is not difficult to arrange to exempt income from U.S. taxation. In the international software, internet sales, consulting, 149 financial services, and communications industries, the source of income from a transaction can often be sourced offshore, even where some of the income producing activity of the transaction takes place in the United States. The Sec. 482 regulations, including the global trading regulations, attempt to capture some U.S. tax on world-wide operations conducted partly in the United States. Nevertheless, significant tax savings can often be achieved. Such an environment can make expatriation transactions attractive, notwithstanding Treas. Reg. Sec. 1.367(a)-3(c). g. Criticism of Treas. Reg. Sec. 1.367(a)-3(c) As Too Broad In contrast to those who believe that Treas. Reg. Sec. 1.367(a)-3(c) is too weak, many have suggested that the criteria for non-recognition in Treas. Reg. Sec. 1.367(a)- 3(c) are too strict. For example, some argue that in lieu of requiring that the foreign acquirer be as larger than the U.S. target, the foreign acquirer should only have to be of significant value as compared to the U.S. target, for example, 25% or even less, as the purpose of looking at values is to provide an indication that something other than a pure inversion transaction has occurred, i.e., a tax-motivated transaction in which a primarily U.S. owned multinational group replaces the U.S. parent corporation with a foreign holding company. Indeed, T.D. 9265 (6/6/06) states that the Treasury is considering amending Treas. Reg. Sec. 1.367(a)-3(c) as result of the enactment of Sec. 7874. Others have argued that the capital structure of the two corporations should not be given the heavy emphasis that it has in Treas. Reg. Sec. 1.367(a)-3(c). For example, if a foreign acquirer's gross assets are far larger than those of the U.S. target, but it utilizes far more debt than the U.S. target to fund its operations, then the foreign acquirer's equity market 150 value may be less than the U.S. target's equity market value, with the consequence that Treas. Reg. Sec. 1.367(a)-3(c)(3)(iii)(B) would preclude non-recognition treatment. Still others criticize that the Treas. Reg. Sec. 1.367(a)-3(c) criteria ignores a key indication of whether the transaction is a tax motivated expatriation, namely the relative sizes of the actual and projected U.S. and foreign operations of the acquired U.S. target. Rather, Treas. Reg. Sec. 1.367(a)-3(c) focuses solely on the combined values of the U.S. and foreign operations and compares this melded figure to the value of the foreign corporate acquirer, which is a value that is irrelevant to future U.S. corporate tax avoidance. Larger, as well as smaller, foreign corporate acquirers have the same incentive to shift foreign income producing operations away from subsidiaries of the acquired U.S. target. The irrelevance of the Treas. Reg. Sec. 1.367(a)-3(c) criteria can be illustrated by the example of a U.S. target with assets located only in the U.S. and no plans for overseas expansion which cannot qualify for a Treas. Reg. Sec. 1.367(a)-3(c) non-recognition transaction with a smaller foreign acquirer, even though there is clearly no anticipated U.S. corporate tax avoidance from placing the U.S. company under foreign ownership since the U.S. company has neither existing nor projected foreign operations. By contrast, Lycos, a U.S. multinational internet company with large expansion potential outside the U.S., qualified under Treas. Reg. Sec. 1.367(a)-3(c) to be acquired by the Spanish international internet company Terra because Terra's market value exceeded that of Lycos. Treas. Reg. Sec. 1.367(a)-3(c) provided non-recognition even though the potential opportunities to avoid U.S. corporate tax on what might otherwise have been the foreign earnings of subsidiaries of a U.S. taxpayer could be great. Indeed, as some have pointed out in connection with the Vodafone and Daimler-Benz transactions, the larger 151 the foreign operations of the foreign acquirer, the easier it is for the acquiring foreign parent's foreign subsidiaries to use the acquired U.S. technology to earn post-acquisition income free of U.S. tax, and, paradoxically, the easier it is to qualify for non-recognition under Treas. Reg. Sec. 1.367(a)-3(c). Treas. Reg. Sec. 1.367(a)-3(c) triggers gain and imposes an interest charge on 5% U.S. target shareholders if the foreign transferor disposes of the U.S. target within five years, even if that U.S. target shareholder has no control of the foreign corporation's post- transaction divestiture policy, a penalty that some view as manifestly unfair. Indeed, many question the continuing validity of the U.S. policy of taxing corporate business profits earned abroad that have otherwise avoided the plethora of anti-tax avoidance provisions which the United States already has in place. h. Section 7874(b) - 80% identity of stockownership - Section 367 transactions The American Jobs Creation Act of 2004 enacted Sec. 7874, concerning corporate expatriations. Sec. 7874 generally applies to covered corporate expatriation transactions completed after March 3, 2003 for taxable years ending after March 3, 2003. Proposed legislation would apply to expatriations that took place between March 20,2002 and March 3, 2003, to treat the expatriated corporation as domesticating in 2007. See "Baucus Praises Passage of Small Business and Work Opportunity Act," 2007 TNT 12-38. Sec. 7874(b) operates to treat as a U.S. corporation, and thus as taxable on its worldwide income, an acquiring foreign corporation where there is at least 80% identity of stockownership with the acquired U.S. corporation. Sec. 7874(b) applies where, 152 pursuant to a plan or a series of related transactions: (1) an acquiring foreign corporation directly or indirectly acquires substantially all the properties held directly or indirectly by a domestic corporation; (2) the former shareholders of the U.S. corporation hold, by reason of holding stock in the U.S. corporation, 80% or more, by vote or value, of the stock of the acquiring foreign corporation after the transaction; and (3) the acquiring foreign corporation, considered together with all foreign and U.S. corporations connected to it by a chain of greater than 50% ownership, does not have substantial business activities in the acquiring foreign corporation's country of incorporation compared to the total worldwide business activities of that chain of corporations. In this situation, the top- tier acquiring foreign corporation is treated a U.S. corporation for all purposes of the Code. Where the acquiring foreign corporation, when recharacterized as a U.S. corporation, becomes the parent of a U.S. consolidated group, Treas. Reg. Sec. 1.1502- 77T (2006) allows the IRS to designate a U.S. corporate member of the affiliated group, rather the foreign parent, as the consolidated group's agent. Expatriations of U.S. partnerships are also covered by Sec. 7874(b). If (1) an acquiring foreign corporation directly or indirectly acquires substantially all the properties constituting a trade or business of the U.S. partnership; (2) the former partners of the U.S. partnership hold, by reason of holding a capital or profits interest in the U.S. partnership, 80% or more, by vote or value, of the stock of the acquiring foreign corporation after the transaction; and (3) the acquiring foreign corporation, considered together with all foreign and U.S. corporations connected to it by a chain of greater than 50% ownership, does not have substantial business activities in the acquiring foreign corporation's country of incorporation compared to the total worldwide business activities 153 of that chain of corporations. In this situation, the top-tier acquiring foreign corporation is treated a U.S. corporation for all purposes of the Code. The Conference Report, at footnote 432, indicates, Treas. Reg. Sec. 1.7874-2T(h) (2006) confirms, that because the acquiring foreign corporation described in Sec. 7874(b) is treated as domestic, the Sec. 367(a) rules do not apply. Thus, for example, Treas. Reg. Sec. 1.367(a)-3(c)(1)(i), which would otherwise trigger recognition on an exchange of U.S. corporation stock for foreign corporate stock because the exchanging U.S. shareholders obtain a majority of stock of the foreign corporate acquirer, apparently will not trigger gain in a transaction described in Sec. 7874(b). Rather, only the U.S.to-U.S. domestic reorganization or similar (e.g., Sec. 351) requirements need be met. Similarly, in the context of an acquisition of a U.S. partnership's business by a foreign corporation covered by Sec. 7874(b), Sec. 367(a)(4) and Treas. Reg. Sec. 1.367(a)-1T(c)(3), which generally trigger gain to U.S. partners with respect to appreciated assets (other than certain assets used by the foreign corporate transferee in an active foreign business) presumably would not apply. Rather, the transaction would be entitled to partner-level non-recognition to the extent allowable under Sec. 351. In determining whether the former shareholders of the U.S. corporation have received the triggering 80% of foreign-acquirer stock, the Service is entitled to exclude from the numerator and denominator of such 80% test stock of the foreign acquirer sold in a public offering related to the expatriation transaction. In addition, the Service can exclude from the numerator and denominator of such 80% test stock in the acquiring foreign corporation held by all foreign and U.S. corporations connected to the foreign acquiring corporation by a chain of greater than 50% ownership. 154 The transfer of assets or liabilities, including by contribution or distribution, may be disregarded by the Service if the transfers are part of a plan the principal purpose is which is to avoid the purposes of Sec. 7874. In addition, the Treasury has authority to prevent avoidance of Sec. 7874 through the use of related persons, pass-through or other non-corporate entities, or other intermediaries, and through transactions designed to qualify or disqualify a corporation as a member of the chain of 50%-or-greater ownership. Similarly, Treasury is granted authority to treat certain non-stock instruments as stock, and certain stock as not stock, where necessary to carry out the purposes of Sec. 7874. Commentators and IRS officials have noted that Sec. 7874(b) has unintended scope because foreign stockholders in the transferred U.S. corporation that continue as stockholders in the transferee foreign holding company may in certain cases be counted in the numerator and denominator of the 80% test. Thus, for example, a foreign individual, who transfers all the stock of a wholly owned U.S. corporation into a newly created wholly owned foreign holding company, will cause that new foreign holding company to be treated as a U.S. corporation under Sec. 7874(b). See 2005 TNT 53-2, "Practitioners Fault Scope of Jobs Act's Anti-Inversion Rule." In 2006, the Treasury issued Treas. Reg. Sec. 1.7874-1T and Treas. Reg. Sec. 1.7874-2T. Treas. Reg. Sec. 1.7874-1T modifies the stockownership computation. Favorably, Treas. Reg. Sec. 1.7874-1T(c)(1) and (e) Examples (2) and (3) generally allows a foreign-owned foreign corporate group to transfer the stock or assets of a U.S. subsidiary to another member of that foreign-owned foreign corporate group without the foreign corporate transferee being recharacterized as a U.S. corporation under Sec. 7874. 155 Conversely, Treas. Reg. Sec. 1.7874-1T(b) and (e) Example (1), stock of the acquiring foreign corporation held by an entity that is at least 50% owned directly or indirectly by the acquiring foreign corporation is ignored in applying the 80% and 60% tests, and therefore is ineffective to prevent the IRS finding that the 80% or 60% tests is met. See "Watch Your Fractions -- Calculating the Reach of the Sec.7874 Anti-Inversion Rules," 35 Tax Mgt Intl J. No. 3 (March 10, 2006); "Section 7874 Temporary Regulations: Treasury and IRS Waive Taxpayers Through the Stoplight," J. Intl. Tax (July 2006). Treas. Reg. Sec. 1.7874-2T(b), provides that acquisitions of U.S. corporate stock, and acquisitions of interests in a U.S. or foreign partnership that own U.S. corporate stock, but not acquisitions of stock in foreign corporations that already own U.S. corporate stock, may be subject to Sec. 7874. Treas. Reg. Sec. 1.7874-2T(c), provides generally that stock of the foreign corporate acquirer is counted in the numerator of the 60% and 80% tests if it is received in exchange for the interest in the U.S. corporation or U.S. partnership. Treas. Reg. Sec. 1.7874-2T(d)(2) provides a safe harbor whereby an acquiring foreign corporation will avoid Sec. 7874 if, after the acquisition, within its country of incorporation, the acquiring foreign corporation's expanded affiliated group maintains at least 10% of the group's employees, assets and sales. See "'Substantial Activity' Under the Anti-Inversion Regs," 2006 TNT 172-33; "Substantial Business Activities: Old Wine in a New Vessel," Tax Mgt. Int'l J. (Feb. 9, 2007). . Where the safe harbor of Treas. Reg. Sec. 1.7874-2T(d)(2) is not available, Rev. Proc. 2007-7, 2007-1 IRB 227, Sec. 4.01(29), provides that private letter rulings ordinarily will likewise not be available. Treas. Reg. Sec. 1.7874-2T(e) generally treats publicly traded foreign partnerships as foreign corporations for purposes of Sec. 7874. Treas. Reg. Sec. 1.7874- 156 2T(f) generally provides that options, convertible securities, and non-vested stock issued by the foreign corporate acquirer in exchange for the acquired U.S. corporation or partnership interests is treated as exercised in applying the 50% and 80% tests. i. Section 7874(a) and Section 4985- 60% to 80% identity of stockownership transactions Sec. 7874(a) covers inversion transactions that would be covered by Sec. 7874(b), except that the 80% ownership threshold is not met. In this case, if a 60% ownership threshold is met, then a second set of rules applies to the transaction. Under these rules, unlike the 80% ownership threshold rules, the acquiring corporation is treated as foreign. Thus, the transaction will be tested under the domestic and Sec. 367 rules. Because Treas. Reg. Sec. 1.367(a)-3(c)(1)(i) generally requires recognition where the exchanging U.S. shareholders receive more than 50% of the stock of the foreign corporate acquirer, if the 60% threshold of Sec. 7874(a) is reached, the transaction will generally be not entitled to non-recognition. Under Sec. 7874(a), any applicable U.S.-corporate-level income or gain required incident to establishing the inverted structure may not be offset by tax attributes such as net operating loss carry-forwards or foreign tax credits. Sec. 4985 generally imposes a non-deductible excise tax, at the highest individual capital gains rates, on certain officers, directors, and 10% or greater owners of private or publicly held corporations with respect to the value of non-qualified stock options and certain other stock-based compensation, in a U.S. corporation expatriating in an acquisition described in Sec. 7874 that triggers gain at the level of the acquired U.S. shareholders. Thus, it appears that transactions entitled to shareholder level non- recognition under Treas. Reg. Sec. 1.367(a)-3(c) are not subject to Sec. 4985. 157 j. Commentary on Section 7874. Many commentators have suggested that the Treasury and IRS issue guidance on Sec. 7874 narrowing its scope and concentrating on the abuse to which Sec. 7874 was directed. For example, the NYSBA Tax Section has recommended the following, in 2006 TNT 56-32, "NYSBA Comments on Temporary Regs. on Affiliated Stock Rule": (1) generally allowing non-participating preferred stock in the foreign corporate acquirer, and certain non-in-the-money stock rights in the foreign corporate acquirer, issued to exchanging U.S. shareholders, to be excluded in applying the 80% and 60% tests; (2) eliminating Treas. Reg. Sec. 1.367(a)- 3(c) or else relaxing its 50% upper limit of exchanging U.S. stockholder ownership in view of the 60% test of Sec. 7874 (see also 2005 TNT 80-14 "NYSBA Calls for Removal of Regs on U.S.-Foreign Stock Transfers"; and (4) while endorsing the view that Sec. 7874(g) allows the Treasury to apply Sec. 7874 to acquisitions by foreign pass-through entities, such application should be limited to only treating the acquiring foreign partnership as a U.S. partnership, not as a U.S. corporation. For other commentary on regulatory issues facing the IRS under Sec. 7874, and IRS officials' comments, see, e.g. 2006 TNT 43-11, "IRS Previews Anti-Inversion Guidance;" "News Analysis: More Questions for Inversion Regulations," 2006 TNT 51-11; "New Anti-Inversion Announcement: When Is a Foreign Check-the-Box Partnership a Surrogate Foreign Corporation?," 35 Tax Mgt Intl J. No. 3 (March 10, 2006); "Effective Date Issue for Possible Extension (by Regulation) of Sec.7874 to `Inversions' with a Partnership on Top," 35 Tax Mgt Intl J. No. 3 (March 10, 2006). Cf. "Grassley Promises Scrutiny of Halliburton 's Move to Dubai," 2007 TNT 49-31. The Congressional Research Service observes that Sec. 7874 and other anti-expatriation rules are in effect 158 seeking to lock-in world-wide taxation. They thus may be largely unnecessary if the U.S. were to adopt a territorial tax system. However, if the territorial tax system were limited to excluding from the U.S. tax base active business income, Sec. 7874 may still be necessary to preserve the U.S. tax base on passive income. See "CRS Updates Report on Corporate Inversions, Expatriation, at fn. 32, 2007 TNT 10-73. l. Non-tax, Non-securities Legal Consequences There are several U.S. international trade legal consequences that potentially could change when a foreign parent is substituted for a U.S. parent in a Treas. Reg. Sec. 1.367(a)-3(c) transaction. Compare "Canadian Companies Beware: The U.S. Foreign Corrupt Practices Act Applies To You!," 36 Alberta Law Review 455 (1998), pointing out that under 15 U.S.C. Sec.78dd-1, foreign private issuers of U.S. listed securities are subject to the foreign corrupt practices act to the same extent as U.S. issuers, with 31 CFR Sec.515.201, 515.329 and 555.559(a) (certain Cuban embargo regulations are applicable only to those non-U.S. companies that are controlled by U.S. companies, U.S. citizens, and U.S. residents, and thus are no longer applicable to foreign subsidiaries of a foreign-controlled foreign parent). In evaluating a proposed transaction governed by Treas. Reg. Sec. 1.367(a)-3(c), U.S. laws concerning foreign corporate acquisitions of sensitive U.S. industries must be considered. See, e.g., 47 U.S.C. Sec. 310(b)(3), (4) (Federal Communications Commission can prohibit holding of broadcast licenses by U.S. subsidiaries of foreign corporations); 31 CFR Part 300 (President's power to prevent merger transactions creating foreign control that threaten to impair the national security). Sec. 835 of the Homeland Security Act of 2002 generally prohibits the Secretary of Homeland Security from entering into a contract with a corporation that results from a 159 2003 or later inversion transaction in which shareholders of the former U.S. parent receive at least 80% of the new foreign parent stock. m. Treasury Study Sec. 806(c) of the American Jobs Creation Act of 2004 provides that the Treasury is, before January 2007, to deliver to Congress a study of Secs. 7874 and 4985, and other Code provisions as they relate to corporate expatriations. Treasury is to include any recommendations to improve the effectiveness of such provisions in carrying out their purposes. Secs. 806(a) and 806(b) of that Act require a transfer pricing study and tax treaty study to be delivered to Congress by June 30, 2005. II. OUTBOUND TRANSFERS UNDER SECTION 367(B) The original design of Sec. 367 was for paragraph (a) to apply to outbound transfers by U.S. persons, while paragraph (b) was to apply to inbound and foreign-to- foreign transfers. Historically, the two paragraphs were exclusive, and in an overlap situation, such as a Sec. 368(a)(1)(B) reorganization involving a U.S. person's exchange of stock of a foreign corporation for stock of another foreign corporation, the transaction was subject only to Sec. 367(b). In 1998, new Sec. 367(a) regulations were adopted that subject such transactions to both paragraphs, requiring a taxpayer to enter into a gain recognition agreement under Sec. 367(a) to the extent that the U.S. transferor's gain is not recognized under Sec. 367(b). Unlike Sec. 367(a), Sec. 367(b) requires the recognition of a deemed dividend of certain amounts in certain transactions to preserve non-recognition treatment. To understand the application of Sec. 367(b), certain basic definitions must be understood: 160 Sec. 1248 Amount The net positive earnings and profits that would have been attributable to the stock of a foreign corporation and includable in gross income as a dividend under Sec. 1248 if the stock were sold by the shareholder; i.e., the net positive post-1962 earnings and profits of a CFC, but not including the earnings and profits of any lower tier subsidiaries. All Earnings and Profits Amount The net positive earnings and profits for all years of the foreign corporation, regardless of whether it was a CFC, but only during the shareholder's holding period, including the time that the shareholder held less than 10% of the stock. Certain adjustments are allowed, such as for previously taxed income and a U.S. effectively connected loss. Sec. 1248 Shareholder - Any U.S. person who owns, directly or indirectly, at least 10% of the voting stock of a foreign corporation. A. Outbound Transactions Covered by both Section 367(a) and (b) The transactions covered by both Section 367(a) and (b) are: 1. Sec. 368(a)(1)(B) reorganizations where the U.S. person exchanges stock of a foreign acquired corporation for voting stock of a foreign acquiring corporation (Treas. Reg. Sec. 1.367(a)-3(b)(2)); 2. Sec. 368(a)(1)(E) recapitalizations of foreign corporations where the U.S. person exchanges either common stock or preferred stock that fully participates in dividends, redemptions and corporate growth for preferred stock that does not fully participate in dividends, redemptions and corporate growth, if the recapitalized foreign corporation is acquired, during the period commencing two years before the recapitalization through two years after, in an exchange in which a domestic corporation 161 meets the ownership threshold specified by Sec. 902(a) or (b) so that it may qualify for a deemed paid foreign tax credit (Treas. Reg. Sec. 1.367(b)-4(b)(3)); 3. Mergers described in Secs. 368(a)(1)(A) and (a)(2)(D) or (a)(2)(E) where the U.S. person exchanges stock or securities of a foreign acquired corporation for stock or securities of the foreign corporation that controls the acquiring corporation, or exchanges stock or securities of a foreign acquiring corporation for stock or securities of the foreign corporation that controls the acquired corporation; 4 . Triangular Sec. 368(a)(1)(B) reorganizations where the U.S. person exchanges voting stock of a foreign acquired corporation for voting stock of a foreign corporation in control of the acquiring corporation; (Under the proposed regulations, this category would also include triangular B reorganizations where the U.S. person exchanges voting stock of a foreign acquired corporation for voting stock of a domestic corporation that controls a foreign acquiring corporation. See Prop. Treas. Reg. Sec. 1.367(a)-3(d)(1)(iii); but see also Prop. Treas. Reg. Sec. 1.367(b)-4(b)(1)(ii).) 5. Triangular Sec. 368(a)(1)(C) reorganization where the U.S. person exchanges stock or securities of a foreign corporation for voting stock of a foreign corporation that controls the acquiring foreign corporation; 6. Sec. 368(a)(1)(C) and (a)(2)(C) reorganizations where the U.S. person exchanges stock or securities of a foreign acquired corporation for voting stock or securities of a foreign acquiring corporation, and the foreign acquiring corporation transfers the stock or securities to a foreign corporation it controls. If less than all of the assets are transferred to the controlled subsidiary, the transaction is subject to Sec. 367(b) to the extent of the assets transferred. Under the proposed regulations, this category 162 would also include A, D and F reorganizations where the U.S. person exchanges stock or securities of a foreign acquired corporation and the foreign acquiring corporation transfers assets to a controlled subsidiary. See Prop. Treas. Reg. Sec. 1.367(a)-3(d)(1)(v). See also Notice 2002-77, 2002-2 C.B. 997 (D reorganization followed by drop- down/CAT treated as an indirect transfer). B. Effect of Section 367(b) If an exchange is described below, the exchanging shareholder must include in gross income as a deemed dividend the Sec. 1248 amount attributable to the stock that it exchanges. Treas. Reg. Sec. 1.367(b)-4(b). If the Sec. 1248 amount is included in gross income by a foreign corporation as a deemed dividend, the deemed dividend is not treated as foreign personal holding company income under Sec. 954(c). 1. Exchange that Results in Loss of Status as a Sec. 1248 Shareholder Deemed dividend treatment is required if the following requirements are met: a. Immediately before the exchange the exchanging shareholder is: A Sec. 1248 Shareholder with respect to the foreign acquired corporation; or A foreign corporation having as a shareholder a Sec. 1248 Shareholder with respect to both the foreign corporation and the foreign acquired corporation; and b. Either: Immediately after the exchange the stock received is not stock in a corporation that is a CFC as to which the U.S. person described in a above is a Sec. 1248 Shareholder; or Immediately after the exchange the foreign acquiring corporation (or, in the case of a reorganization described in Sec. 368(a)(1)(B), the foreign acquired corporation) is not a 163 CFC as to which the U.S. person described in a above is a Sec. 1248 Shareholder. Treas. Reg. Sec. 1.367(b)-4(b)(1). Pursuant to the Sec. 367 regulations proposed on January 5, 2005, inclusion of the Sec. 1248 amount would not be required under Treas. Reg. Sec. 1.367(b)-4(b)(1) if, pursuant to a triangular A, B or C reorganization, the exchanging shareholder receives stock of a domestic corporation and, immediately after the exchange, (i) such domestic corporation is a Sec. 1248 Shareholder of the acquired corporation (in the case of a triangular B reorganization) or the surviving corporation (in the case of a forward or reverse subsidiary merger) and (ii) such acquired or surviving corporation is a CFC. Prop. Treas. Reg. Sec. 1.367(b)-4(b)(1)(ii); see also Prop. Treas. Reg. Sec. 1.367(b)- 4(b)(1)(iii), Ex. 3B. Undoubtedly, it was also intended that the domestic corporation must be a Sec. 1248 Shareholder of the acquiring corporation in a triangular C reorganization in order for the exception to apply, but the proposed regulations appear to omit this requirement. It is understood that the IRS will remedy this omission when the proposed regulations are finalized. As noted in the preamble to the proposed regulations, where these requirements are satisfied, the Sec. 1248 amount need not be triggered, because it can be preserved in the shares of the foreign corporation owned by the domestic corporation. The proposed regulations prescribe detailed rules for preserving the Sec. 1248 amount in reorganization transactions. See Prop. Treas. Reg. Sec. 1.367(b)-13. These rules are discussed in IV, below. 2. Receipt by Exchanging Shareholder of Preferred or Other Stock in Certain Instances 164 Deemed dividend treatment is required if the following requirements are met: a. Immediately before the exchange the foreign acquired corporation and the foreign acquiring corporations are not members of the same affiliated group (as defined in Sec. 1504(a) but without regard to the exceptions set forth in Sec. 1504(b), and substituting the words "more than 50" in place of the words "at least 80" in Secs. 1504(a)(2)(A) and (b)); b. Immediately after the exchange, a domestic corporation meets the ownership threshold specified by Sec. 902(a) or (b) so it may qualify for a deemed paid foreign tax credit if it receives a distribution from the foreign acquiring corporation (directly or through tiers); and c. The exchanging shareholder receives: preferred stock, other than preferred stock that is fully participating with respect to dividends, redemptions and corporate growth, in consideration for common stock or preferred stock that is fully participating with respect to dividends, redemptions and corporate growth; or in the discretion of the Commissioner or the Commissioner's delegate, and without regard to whether the stock exchanged is common stock or preferred stock, receives stock that entitles it to participate (through dividends, redemption payments or otherwise) disproportionately in the earnings generated by particular assets of the foreign acquired corporation or foreign acquiring corporation. 3. Non-Inclusion Exchanges. If deemed dividend treatment is not required under the foregoing rules (a "non- inclusion exchange"), then special earnings and profits calculations are necessary in 165 applying Sec. 367(b) or 1248 to subsequent exchanges. The earnings and profits attributable to stock received in the non-inclusion exchange includes the exchanging shareholder's pro rata interest in the earnings and profits of the foreign acquiring corporation, and in the case of a stock transfer, the foreign acquired corporation, that accumulate after the non-inclusion exchange, as well as its pro rata interest in the earnings and profits of the foreign acquired corporation that accumulated before the non- inclusion exchange. The earnings and profits attributable to the stock received in the non-inclusion exchange, however, does not include any earnings and profits of the foreign acquiring corporation that accumulated before the non-inclusion exchange. If the exchanging shareholder in the non-inclusion exchange was a foreign corporation, the foregoing rules also apply to determine the earnings and profits attributable to the exchanging foreign corporation's shareholders, as well as to determine the earnings and profits attributable to the exchanging foreign corporation, when applying Sec. 964(e) to subsequent sales or exchanges of the stock of the foreign acquiring corporation. The proposed regulations prescribe detailed rules for preserving the Sec. 1248 amount in reorganization transactions. See Prop. Treas. Reg. Sec. 1.367(b)-13. These rules are discussed in IV, below. C. Section 367(b) Notice The Sec. 367(b) Regulations impose notice requirements with respect to all transactions falling within its purview. A U.S. person who is a Sec. 1248 Shareholder of a foreign acquired corporation must file a notice if it realizes income on an overlap transaction. Similarly, a U.S. person who is a Sec. 1248 Shareholder of a foreign 166 corporation that owned a foreign acquired corporation must file a notice if the foreign corporation realizes income on an overlap transaction. Treas. Reg. Sec. 1.367(b)-1(c). The notice must be attached to the U.S. person's timely filed federal income tax return for the taxable year in which the income is realized. A Sec. 1248 Shareholder of a foreign corporation described above must file the notice with its timely-filed Federal income tax return for the taxable year in which income is realized if the U.S. person is required to file a Form 5471 (Information Return of U.S. Person With Respect to Certain Foreign Corporations), by attaching the notice to the Form 5471. The notice must contain the following: 1. A statement that the exchange is one to which Sec. 367(b) applies; 2. A complete description of the exchange; 3. A description of any stock, securities or other consideration received in the exchange; 4. A statement which describes any amount required under Sec. 367(b) to be taken into account as income or loss or as an adjustment to basis, earnings and profits or other tax attributes as a result of the exchange; 5. Any information that is or would be required to be furnished with a federal income tax return pursuant to regulations under Secs. 332, 351, 354, 355, 356, 361, or 369 (whether or not a federal income tax return is required to be filed), if such information has not otherwise been provided; and 6. Any information required to be furnished under Sec. 6038, 6038A, 6038B, 6038C or 6046, if such information has not otherwise been provided. Treas. Reg. Sec. 1.367(b)-1(c)(4). 167 III. REPORTING REQUIREMENTS Sec. 367 has its own reporting and gain recognition requirements. They are discussed in the foregoing paragraphs. In addition, Sec. 6038B imposes general reporting requirements with respect to transactions described in Sec. 367. Further, there are specific reporting and recordkeeping requirements under each of the non-recognition provisions to which Sec. 367 applies. A. Section 6038B Sec. 6038B requires each U.S. person who transfers property to a foreign corporation in an exchange described in Sec. 332, 351, 354, 355, 356, or 361, or who makes a distribution described in Sec. 336 to a person who is not a U.S. person, to provide certain information as required by Regulation. I.R.C. Sec.6038B(a). A U.S. person that transfers stock or securities on or after July 20, 1998, will be considered to have satisfied the Sec. 6038B reporting requirement if either: 1. The U.S. transferor owned less than 5% of both the total voting power and the total value of the transferee foreign corporation immediately after the transfer (taking into account the attribution rules of Sec. 318, as modified by Sec. 958(b)), and either: a. The U.S. transferor qualified for non-recognition treatment with respect to the transfer (i.e., the transfer was not taxable under Treas. Reg. Sec. 1.367(a)-3(b) or (c)); or b. The U.S. transferor is a tax-exempt entity and the income was not unrelated business income; or 168 c. The transfer was taxable to the U.S. transferor under Treas. Reg. Sec. 1.367(a)-3(c), and such person properly reported the income from the transfer on its timely-filed (including extensions) federal income tax return for the taxable year that includes the date of the transfer; or 2. The U.S. transferor owned 5% or more of the total voting power or the total value of the transferee foreign corporation immediately after the transfer (taking into account the attribution rules of Sec. 318, as modified by Sec. 958(b)), and either: a. The transferor (or one or more successors) properly entered into a gain recognition agreement under Treas. Reg. Sec. 1.367(a)-8; or b. The transferor is a tax-exempt entity and the income was not unrelated business income; or c. The transferor properly reported the income from the transfer on its timely-filed (including extensions) federal income tax return for the taxable year that includes the date of the transfer. Treas. Reg. Sec. 1.6038B-1(b)(2)(i). A U.S. person that transfers cash to a foreign corporation must report the transfer if: 1. Immediately after the transfer such person holds directly, indirectly, or by attribution (determined under the rules of Sec. 318(a), as modified by Sec. 6038(e)(2)) at least 10% of the total voting power or the total value of the foreign corporation; or 2. The amount of cash transferred by such person or any related person (determined under Sec. 267(b)(1) through (3) and (10) through (12)) to such 169 foreign corporation during the 12-month period ending on the date of the transfer exceeds $100,000. Treas. Reg. Sec. 1.6038B-1(b)(3) B. Time and Manner of Reporting Any U.S. person that makes a transfer described in Sec. 6038B(a)(1)(A), 367(d) or 367(e)(1), is required to report and must attach the required information to Form 926, "Return by Transferor of Property to a Foreign Corporation." Notwithstanding any statement to the contrary on Form 926, the form and attachments must be attached to, and filed by the due date (including extensions) of, the transferor's federal income tax return for the taxable year that includes the date of the transfer. If the transferor is a corporation, Form 926 must be signed by an authorized officer of the corporation. If, however, the transferor is a member of an affiliated group that files a consolidated federal income tax return, but is not the common parent corporation, then an authorized officer of the common parent corporation must sign Form 926. If two or more persons transfer jointly-owned property to a foreign corporation, then each person must report with respect to the particular interest transferred, specifying the nature and extent of the interest. However, a husband and wife who file a joint federal income tax return may file a single Form 926 with their joint return. Treas. Reg. Sec. 1.6038B-1(b)(1). The date of a transfer is the first date on which title to, possession of, or rights to the use of stock, securities, or other property passes pursuant to the plan for purposes of Subtitle A of the Code. A transfer deemed to occur as a result of the termination of an election under Sec. 1504(d) is considered to occur on the date the contiguous country 170 corporation first fails to continue to qualify for the election. A transfer deemed to occur as a result of a change in the classification of an entity caused by a change in its governing documents, articles, or agreements (as described in Treas. Reg. Sec. 1.367(a)- 1T(c)(6)) is considered to occur on the date that such changes take effect for purposes of Subtitle A of the Code. A transfer made by an alien individual who is considered a U.S. resident by reason of a timely election under Sec. 6013 (g) or (h) is considered to occur for purposes of Sec. 6038B, but not for purposes of Sec. 367, on the later of the date on which the election under Sec. 6013 (g) or (h) is made, or the date on which the transfer would otherwise be considered to occur under the foregoing rules. Treas. Reg. Sec. 1.6038B-1(b)(4). C. Information Required for Section 6038B(a)(1)(A) Transfers A U.S. person that transfers property to a foreign corporation in an exchange described in Sec. 6038B(a)(1)(A), including cash and unappreciated property, must provide the following information, in paragraphs labeled to correspond with the number or letter set forth in the Regulation. If a particular item is not applicable to the transfer, the U.S. person must list its heading and state that it is not applicable. 1. Transferor. The name, U.S. taxpayer identification number, and address of the U.S. person making the transfer. 2. Transfer. The following information concerning the transfer: a. The name, U.S. taxpayer identification number (if any), address, and country of incorporation of the transferee foreign corporation; and 171 b . A general description of the transfer, and any wider transaction of which it forms a part, including a chronology of the transfers involved and an identification of the other parties to the transaction to the extent known. 3 . Consideration received. A description of the consideration received by the U.S. person making the transfer, including its estimated fair market value and, in the case of stock or securities, the class or type, amount, and characteristics of the interest received. 4. Property transferred. A description of the property transferred. The description must be divided into the following categories, and must include the estimated fair market value and adjusted basis of the property, as well as any additional information specified below. 5. Active business property. Describe any transferred property (other than stock or securities) to be used in the active conduct of a trade or business outside of the United States. Provide a general description of the business conducted (or to be conducted) by the transferee, including the location of the business, the number of its employees, the nature of the business, and copies of the most recently prepared balance sheet and profit and loss statement. Property listed within this category may be identified by general type. 6. Stock or securities. Describe any transferred stock or securities, including the class or type, amount, and characteristics of the transferred stock or securities, as well as the name, address, place of incorporation, and general description of the corporation issuing the stock. In addition, provide the following information if applicable: 172 If the stock or securities are considered to be transferred for use in the active conduct of a trade or business outside of the United States under the rules of Temp. Treas. Reg. Sec. 1.367(a)-3T(d)(2), provide information supporting the application of the rule; and If any provision of Treas. Reg. Sec. 1.367(a)-3 applies to except the transfer of stock or securities from the rule of Sec. 367(a)(1), provide information supporting the claimed application of such provision. If the transferor is entering into a gain recognition agreement, attach the agreement and waiver as required by Treas. Reg. Sec. 1.367(a)-8. 7. Depreciated property. Describe any property that is subject to depreciation recapture under the rules of Temp. Treas. Reg. Sec. 1.367(a)-4T(b). Property within this category must be separately identified to the same extent as was required for purposes of the previously claimed depreciation deduction. Specify with respect to each asset the relevant recapture provision, the number of months in which such property was in use within the United States, the total number of months the property was in use, the fair market value of the property, a schedule of the depreciation deduction taken with respect to the property, and a calculation of the amount of depreciation required to be recaptured. 8. Property to be leased. Describe any property to be leased to other persons by the transferee foreign corporation unless the property is considered to be transferred for use in the active conduct of a trade or business and was thus listed under item 1 above. If the rules of Temp. Treas. Reg. Sec. 1.367(a)-4T(c)(2) apply to except the transfer from Sec. 367(a)(1), provide information supporting the claimed application of such provision. 173 9. Property to be sold. Describe any transferred property that is to be sold or otherwise disposed of by the transferee foreign corporation, as described in Temp. Treas. Reg. Sec. 1.367(a)-4T(d). 10. Transfers to FSCs. Describe any property that is subject to the special rule of Temp. Treas. Reg. Sec. 1.367(a)-4T(g) for transfers to FSCs. Provide information supporting the claimed application of that rule. 11. Tainted property. Describe any property that is subject to Temp. Treas. Reg. Sec. 1.367(a)-5T (concerning property that is subject to the rule of Sec. 367(a)(1) regardless of whether it is transferred for use in the active conduct of a trade or business outside of the United States). The description must be divided into the following categories: 12. Inventory, etc. Property described in Temp. Treas. Reg. Sec. 1.367(a)-5T(b); 13. Installment obligations, etc. Property described in Temp. Treas. Reg. Sec. 1.367(a)-5T(c); 14. Foreign currency, etc. Property described in Temp. Treas. Reg. Sec. 1.367(a)-5T(d); 15. Intangible property. Property described in Temp. Treas. Reg. Sec. 1.367(a)-5T(e); and 16. Leased property. Property described in Temp. Treas. Reg. Sec. 1.367(a)-4T(f). 174 If any exception in Temp. Treas. Reg. Sec. 1.367(a)-5T applies to the transferred property (making Sec. 367(a)(1) not applicable to the transfer), provide information supporting the claimed application of such exception. 17. Foreign loss branch. Provide the information specified in item 5 below. 18. Other intangibles. Describe any intangible property sold or licensed by the transferor to the transferee foreign corporation, and set forth the general terms of each sale or license. 19. Transfer of foreign branch with previously deducted losses. If the property transferred is property of a foreign branch with previously deducted losses subject to Temp. Treas. Reg. Sec. 1.367(a)-6T, provide the following information: 20. Branch operation. Describe the foreign branch the property of which is transferred, in accordance with the definition of Temp. Treas. Reg. Sec. 1.367(a)-6T(g). 21. Branch property. Describe the property of the foreign branch, including its adjusted basis and fair market value. For this purpose property must be identified with reasonable particularity, but may be identified by category rather than listing every asset separately. Substantially similar property may be listed together for this purpose, and property of minor value may be grouped into functional categories. 22. Previously deducted losses. Set forth a detailed calculation of the sum of the losses incurred by the foreign branch before the transfer, and a detailed calculation of any reduction of such losses, in accordance with Temp. Treas. Reg. Sec. 1.367(a)-6T(d) and (e). 175 23. Character of gain. Set forth a statement of the character of the gain required to be recognized, in accordance with Temp. Treas. Reg. Sec. 1.367(a)-6T(c)(1). 24. Application of Sec. 367(a)(5). If the asset is transferred in an exchange described in Sec. 361(a) or (b), a statement that the conditions set forth in the second sentence of Sec. 367(a)(5) and any Regulations under that Sec. have been satisfied, and an explanation of any basis or other adjustments made pursuant to Sec. 367(a)(5) and any Regulations thereunder. Temp Treas. Reg. Sec. 1.6038B-IT(c); Treas. Reg. Sec. 1.6038B-1(c). D. Failure to Comply with Reporting Requirements If a U.S. person is required to file a notice or otherwise comply with the requirements of Sec. 6038B and fails to do so, then with respect to the particular property as to which there was a failure to comply: a. That property will not be considered to have been transferred for use in the active conduct of a trade or business outside of the United States for purposes of Sec. 367(a) and the Regulations thereunder; b. The U.S. person must pay a penalty under Sec. 6038B(b)(1) equal to 10% of the fair market value of the transferred property at the time of the exchange, but in no event will the penalty exceed $100,000 unless the failure was due to intentional disregard; and c. The period of limitations on assessment of tax on the transfer of that property will not expire before three years after the date on which the Secretary of the Treasury is furnished the information required to be reported. Treas. Reg. Sec. 1.6038B-1(f)(1). 176 A failure to comply with the requirements of Sec. 6038B is: a. The failure to report at the proper time and in the proper manner any material information required to be reported; or b . The provision of false or inaccurate information in purported compliance with the requirements of this section. Treas. Reg. Sec. 1.6038B-1(f)(2). The foregoing provisions will not apply if the transferor shows that its failure to comply was due to reasonable cause and not willful neglect. The transferor may do so by providing a written statement to the District Director having jurisdiction of the taxpayer's return for the year of the transfer, setting forth the reasons for the failure to comply. Whether a failure to comply was due to reasonable cause will be determined by the District Director under all the facts and circumstances. Treas. Reg. Sec. 1.6038B-1(f)(3). If the transferor fails to qualify for the reasonable cause exception, and if the transferors knew of the rule or Regulation that was disregarded, the failure will be considered an intentional disregard of Sec. 6038B, and the monetary penalty described above will not be limited to $100,000. Treas. Reg. Sec. 1.6038B-1(f)(4). E. General Reporting and Recordkeeping Requirements 1. Section 332 (Treas. Reg. Sec. 1.332-6) Permanent records in substantial form must be kept by every corporation receiving distributions in complete liquidation under the exception in Sec. 332 showing the information required to be submitted with its return. The plan of liquidation must be adopted by each of the corporate parties thereto; and the adoption must be shown by the acts of its duly constituted responsible officers, and appear upon the official records of 177 each corporation. For the taxable year in which the liquidation occurs, or, if the plan of liquidation provides for a series of distributions over a period of more than one year, for each taxable year in which a distribution is received under the plan, the recipient must file with its return a complete statement of all facts pertinent to the nonrecognition of gain or loss, including: a. A certified copy of the plan of complete liquidation, and of the resolutions under which the plan was adopted and the liquidation was authorized, together with a statement under oath showing in detail all transactions incident to, or pursuant to, the plan. b. A list of all the properties received upon the distribution, showing the cost or other basis of such properties to the liquidating corporation at the date of distribution and the fair market value of such properties on the date distributed. c. A statement of any indebtedness of the liquidating corporation to the recipient corporation on the date the plan of liquidation was adopted and on the date of the first liquidating distribution. If any such indebtedness was acquired at less than face value, the cost thereof to the recipient corporation must also be shown. d. A statement as to its ownership of all classes of stock of the liquidating corporation (showing as to each class the number of shares and percentage owned and the voting power of each share) as of the date of the adoption of the plan of liquidation, and at all times since, to and including the date of the distribution in liquidation. The cost or other basis of such stock and the date or dates on which purchased must also be shown. 2. Section 351 (Treas. Reg. Sec. 1.351-3) 178 Every person who receives the stock or securities of a controlled corporation, or other property as part of the consideration, in exchange for property under Sec. 351, must file with its income tax return for the taxable year in which the exchange is consummated a complete statement of all facts pertinent to such exchange, including: a. A description of the property transferred, or its interest in the property, together with a statement of the cost or other basis thereof, adjusted to the date of transfer. b. With respect to stock of the controlled corporation received in the exchange, a statement of: The kind of stock and preferences, if any; The number of shares of each class received; and The fair market value per share of each class at the date of the exchange. c. With respect to securities of the controlled corporation received in the exchange, if any, a statement of: The principal amount and terms; and The fair market value at the date of exchange. d. The amount of money received, if any. e. With respect to other property received, if any: A complete description of each separate item; The fair market value of each separate item at the date of exchanges; and In the case of a corporate shareholder, the adjusted basis of the other property in the hands of the controlled corporation immediately before the distribution of such other property to the corporate shareholder in connection with the exchange. 179 f. With respect to any liabilities of the transferors assumed by the controlled corporation, a statement of: The nature of the liabilities; When and under what circumstances created; The corporate business reason for assumption by the controlled corporation; and Whether such assumption eliminates the transferor's primary liability. Every such controlled corporation must file with its income tax return for the taxable year in which the exchange is consummated: a. A complete description of all the property received from the transferors. b. A statement of the cost or other basis thereof in the hands of the transferors adjusted to the date of transfer. c. The following information with respect to the capital stock of the controlled corporation: (A) The total issued and outstanding capital stock immediately prior to and immediately after the exchange, with a complete description of each class of stock; (B) The classes of stock and number of shares issued to each transferor in the exchange, and the number of shares of each class of stock owned by each transferor immediately prior to and immediately after the exchange, and (C) The fair market value of the capital stock as of the date of exchange, which was issued to each transferor. d. The following information with respect to any securities of the controlled corporation: 180 (A) The principal amount and terms of all securities outstanding immediately prior to and immediately after the exchange, (B) The principal amount and terms of securities issued to each transferor in the exchange, with a statement showing each transferor's holdings of securities of the controlled corporation immediately prior to and immediately after the exchange, (C) The fair market value of the securities issued to the transferors on the date of the exchange, and (D) A statement as to whether the securities issued in the exchange are subordinated in any way to other claims against the controlled corporation. e. The amount of money, if any, which passed to each of the transferors in connection with the transaction. f. With respect to any other property which passed to each transferor: (A) A complete description of each separate item; (B) The fair market value of each separate item at the date of exchange, and (C) In the case of a corporate transferor, the adjusted basis of each separate item in the hands of the controlled corporation immediately before the distribution of such other property to the corporate transferor in connection with the exchange. g. The following information as to the transferor's liabilities assumed by the controlled corporation in the exchange, if any: (A) The amount and a description thereof, (B) When and under what circumstances created, and 181 (C) The corporate business reason or reasons for assumption by the controlled corporation. Permanent records in substantial form must be kept by every taxpayer who participates in an exchange described in Sec. 351, showing the information listed above, to facilitate the determination of gain or loss from a subsequent disposition of stock or securities and other property, if any, received in the exchange. 3. Section 355 (Treas. Reg. Sec. 1.355-5) Every corporation that makes a distribution of stock or securities of a controlled corporation, as described in Sec. 355, must attach to its return for the year of the distribution a detailed statement setting forth such data as may be appropriate to show compliance with the provisions of Sec. 355. Every taxpayer who receives a distribution of stock or securities of a corporation that was controlled by a corporation in which it holds stock or securities must attach to its return for the year in which such distribution is received a detailed statement setting forth such data as may be appropriate in order to show the applicability of Sec. 355. Such statement must include, but is not be limited to, a description of the stock and securities surrendered (if any) and received, and the names and addresses of all of the corporations involved in the transaction. 4. Section 368 (Treas. Reg. Sec. 1.368-3) The plan of reorganization must be adopted by each of the corporate parties thereto, and the adoption must be shown by the acts of its duly constituted responsible officers, and appear upon the official records of the corporation. Each corporation a party to a reorganization must file as a part of its return for its taxable year in which the 182 reorganization occurred a complete statement of all facts pertinent to the nonrecognition of gain or loss in connection with the reorganization, including: a. A copy of the plan of reorganization, together with a statement, executed under the penalties of perjury, showing in full the purposes thereof and in detail all transactions incident to, or pursuant to, the plan. b. A complete statement of the cost or other basis of all property, including all stock or securities, transferred incident to the plan. c. A statement of the amount of stock or securities and other property or money received from the exchange, including a statement of all distributions or other disposition made thereof. The amount of each kind of stock or securities and other property received must be stated on the basis of the fair market value thereof at the date of the exchange. d. A statement of the amount and nature of any liabilities assumed upon the exchange, and the amount and nature of any liabilities to which any of the property acquired in the exchange is subject. Every taxpayer, other than a corporation a party to the reorganization, who receives stock or securities and other property or money on a tax-free exchange in connection with a corporate reorganization must incorporate in its income tax return for the taxable year in which the exchange takes place a complete statement of all facts pertinent to the nonrecognition of gain or loss, including: a. A statement of the cost or other basis of the stock or securities transferred in the exchange, and 183 b. A statement in full of the amount of stock or securities and other property or money received in the exchange, including any liabilities assumed on the exchange, and any liabilities to which property received is subject. The amount of each kind of stock or securities and other property (other than liabilities assumed upon the exchange) received must be set forth upon the basis of the fair market value thereof at the date of the exchange. Permanent records in substantial form must be kept by every taxpayer who participates in a tax-free exchange in connection with a corporate reorganization showing the cost or other basis of the transferred property and the amount of stock or securities and other property or money received (including any liabilities assumed on the exchange, or any liabilities to which any of the properties received were subject), to facilitate the determination of gain or loss from a subsequent disposition of such stock or securities and other property received from the exchange. IV. PROPOSED BASIS AND HOLDING PERIOD RULES Prop. Treas. Reg. Sec. 1.367(b)-13 sets forth detailed basis and holding period rules ("BAHP rules") designed to preserve the Sec. 1248 amount in connection with certain tax-free transactions involving foreign corporations. These rules generally apply if an exchanging shareholder of stock of a foreign corporation is either (i) a Sec. 1248 Shareholder with respect to the foreign corporation or (ii) a foreign corporation that has a Sec. 1248 Shareholder that is also a Sec. 1248 Shareholder with respect to the foreign corporation whose shares are exchanged. An exchanging shareholder that falls within either category is referred to herein as a "Section 367(b) Shareholder." 184 As noted in the preamble to the proposed regulations, the latter category is needed to preserve the application of Sec. 964(e). Sec. 964(e) treats a CFC's gain from the sale or exchange of shares of another foreign corporation as a dividend to the extent that such amount would have been so treated under Sec. 1248(a) if the CFC were a U.S. person. B. Shareholder's Exchange of Foreign Target Stock for CFC Stock 1. Scope Prop. Treas. Reg. Sec. 1.367(b)-13(b) generally applies to any shareholder who exchanges stock of a foreign corporation (target) for stock of a CFC in an exchange to which Sec. 354 (or Sec. 356) applies if: a. Immediately before the exchange, the exchanging shareholder was a Sec. 367(b) Shareholder with respect to the foreign target; b . The exchange is not taxable under Treas. Reg. Sec. 1.367(b)-4(b). Notwithstanding the foregoing, however, Prop. Treas. Reg. Sec. 1.367(b)-13(b) does not apply to any exchange that is described in both Sec. 351 and Sec. 354 (or Sec. 356) if, in connection with the exchange, the shareholder exchanges property for stock in an exchange to which neither Sec. 354 nor Sec. 356 applies or any liabilities of the exchanging shareholder are assumed in the exchange. Prop. Treas. Reg. Sec. 1.367(b)- 13(b)(4). As explained in the preamble to the proposed regulations, the purpose of this limitation is to avoid a conflict with the basis rules applicable to Sec. 351 exchanges (including the application of Sec. 357(c)). Treasury and the IRS are considering approaches for the preservation of the Sec. 1248 amount in Sec. 351 exchanges in which 185 liabilities are assumed or other property is received and the preamble requests comments in this regard. In the case of a triangular reorganization, Prop. Treas. Reg. Sec. 1.367(b)-13(b) applies only to the shareholder's exchange of target stock for stock of the parent of the surviving corporation. The parent corporation's basis and holding period for each share of stock of the surviving corporation is determined under Prop. Treas. Reg. Sec. 1.367(b)- 13(c), discussed below. 2. BAHP Rules If Prop. Treas. Reg. Sec. 1.367(b)-13(b) applies, then the basis and holding period of each share of stock received in the exchange will be the same as the basis and holding period of the share(s) exchanged therefor, as adjusted under Treas. Reg. Sec. 1.358-1, so that the Sec. 1248 amount in the shares exchanged will be preserved in the shares received. Prop. Treas. Reg. Sec. 1.367(b)-13(b)(2)(i). Each share received will also reflect the target corporation's previously accumulated earnings and profits (or deficits in earnings and profits), as determined for purposes of Sec. 1248 (referred to below simply as "E&P" or "E&P deficits") to the extent allocable to the share(s) exchanged. Prop. Treas. Reg. Sec. 1.367(b)-13(d)(2). Thus, for example, if an exchanging Sec. 367(b) Shareholder owns two blocks of stock of the target, the shares received in the exchange will be divided into two blocks that reflect the bases, holding periods and E&P of the target shares exchanged therefor. See Prop. Treas. Reg. Sec. 1.367(b)-13(e), Ex. 1. If the exchanging Sec. 367(b) Shareholder subsequently disposes of any shares received in the exchange, and is not otherwise able to identify which shares were 186 received for particular shares surrendered in the exchange, the shareholder may designate which shares were received for which surrendered shares, provided that such designation is made on or before the first date on which the basis of such shares is relevant (e.g., on or before the date of the disposition). Prop. Treas. Reg. Sec. 1.367(b)-13(b)(2)(ii). C. P's Stock of S or T Following A Triangular Asset Reorganization Prop. Treas. Reg. Sec. 1.367(b)-13(c) sets forth BAHP rules applicable to the parent corporation's stock of the surviving corporation following a triangular asset reorganization, i.e., a triangular C reorganization, forward triangular merger or reverse triangular merger. These rules purport to apply to all "triangular reorganizations" but that term is defined (misleadingly) to exclude triangular B reorganizations. See Prop. Treas. Reg. Sec. 1.367(b)-13(a)(2)(iii). 1. Terminology: P, S and T In the case of a triangular asset reorganization, the terms P, S and T are defined as follows: a. P is a corporation (i) that is party to the reorganization, (ii) that is in control of another party to the reorganization, and (iii) whose stock is transferred pursuant to the reorganization. b. S is a corporation that is party to the reorganization and that is controlled by P. c. T is the other corporation that is party to the reorganization. Prop. Treas. Reg. Sec. 1.367(b)-13(a)(2)(iii). 2. Scope a. Certain Reverse Triangular Mergers 187 The rules of Prop. Treas. Reg. Sec. 1.367(b)-13(c) apply to a reverse triangular merger if: (A) Immediately before the transaction, P was a Sec. 367(b) Shareholder with respect to S; and (B) P's exchange of S stock is not taxable under Treas. Reg. Sec. 1.367(b)-3(a) and (b) or Sec. 1.367(b)-4(b). b. Other Triangular Asset Reorganizations The rules of Prop. Treas. Reg. Sec. 1.367(b)-13(c) also apply to any other triangular asset reorganization (whether or not a reverse triangular merger) if: (A) Immediately before the transaction, T had at least one Sec. 367(b) Shareholder; and (B) With respect to at least one Sec. 367(b) Shareholder of T, the exchange is not taxable under Treas. Reg. Sec. 1.367(b)-3(a) and (b) or Sec. 1.367(b)-4(b). 3. BAHP Rules a. General Rule Under the BAHP rules for triangular asset reorganizations, each share of stock of the surviving corporation (S or T) held by P must be divided into "portions" attributable to the S and T shares held immediately before the exchange. Prop. Treas. Reg. Sec. 1.367(b)-13(c)(2). The manner in which such shares are divided into portions depends on the type of reorganization. b. Forward Subsidiary Merger or Triangular C Reorganization In a forward subsidiary merger or a triangular C reorganization, each share of S stock owned by P after the exchange generally will be divided into: 188 (A) one portion that reflects the basis, holding period and E&P of such share prior to the reorganization, and (B) one portion for each block of T stock surrendered by the former T shareholders pursuant to the reorganization, with each such portion reflecting the former T shareholder's basis, holding period and E&P in the T stock allocable thereto, provided that immediately prior to the merger T had at least one Sec. 367(b) Shareholder. See Prop. Treas. Reg. Sec. 1.367(b)-13(c)(2)(i)(A) and (ii)(A); see also Prop. Treas. Reg. Sec. 1.367(b)-13(d)(2). For this purpose, however, all shares of T stock exchanged by non-Sec. 367(b) Shareholders of T are aggregated. Prop. Treas. Reg. Sec. 1.367(b)-13(d)(1)(i). If, immediately prior to the reorganization, T had no Sec. 367(b) Shareholders, then the basis of the portion attributable to the T stock surrendered by the former T shareholders is determined under the "over-the- top" basis rules of Treas. Reg. Sec. 1.358-6(c). Prop. Treas. Reg. Sec. 1.367(b)- 13(c)(2)(ii)(B). Note: The proposed regulations divide the "apportioning" process into two steps. In the first step, each post-reorganization S share is divided into an "S portion" and a "T portion." In the second step, if there is more than one block of T stock to be taken into account, the T portion is then subdivided into additional portions. These steps are combined in the discussion above. c. Reverse Subsidiary Merger In the case of a reverse subsidiary merger, each T share received by P generally will be divided into: 189 (A) one portion for each block of S stock surrendered by P in the merger, with each such portion reflecting P's basis, holding period and E&P in the S stock allocable thereto, and (B) one portion for each block of T stock surrendered by the former T shareholders in the merger, with each such portion reflecting the former T shareholder's basis, holding period and E&P in the T stock allocable thereto, provided that immediately prior to the merger T had at least one Sec. 367(b) Shareholder. Prop. Treas. Reg. Sec. 1.367(b)- 13(c)(2)(i)(B) and (ii)(A); see also Prop. Treas. Reg. Sec. 1.367(b)-13(d)(2). For this purpose, however, shares of T stock exchanged by non-Sec. 367(b) Shareholders of T are aggregated. Prop. Treas. Reg. Sec. 1.367(b)-13(d)(1)(i). If, immediately prior to the merger, T had no Sec. 367(b) Shareholder, then the basis of the portion attributable to the T stock surrendered by the former T shareholders in the merger is determined under the "over-the-top" basis rules of Treas. Reg. Sec. 1.358-6(c). Prop. Treas. Reg. Sec. 1.367(b)- 13(c)(2)(ii)(B). Note: The proposed regulations divide the "apportioning" process into two steps. In the first step, each post-reorganization T share is divided into an "S portion" and a "T portion." In the second step, if there is more than one block of S or T stock to be taken into account, the S or T portion (as the case may be) is further divided into separate portions. These steps are combined in the discussion above. d. De Minimis Rule If the value of the S stock immediately before the reorganization is less than 1% of the value of the surviving corporation immediately thereafter, then P may use a 190 simplified method to determine the basis and holding period of its shares of the surviving corporation. Under the simplified method: (A) The rules above are first applied without treating any portion of the stock of the surviving corporation as attributable to the S stock owned by P immediately before the exchange, and (B) P's basis in its S stock (as determined immediately before the exchange) is then aggregated, and an allocable portion of such aggregate basis is added to the basis of each share (or portion of a share) of stock of the surviving corporation. Prop. Treas. Reg. Sec. 1.367(b)-13(c)(2)(i)(C). D. Examples The proposed regulations include a number of examples illustrating the operation of the BAHP rules. The examples below are drawn from (but are not identical to) the examples in Prop. Treas. Reg. Sec. 1.367(b)-13(e). Example 1. (i) Facts. US1, a domestic corporation, owns all the stock of FT, a foreign corporation with 100 shares of stock outstanding. Each FT share is valued at $10x. US1 owns a 60-share block of FT stock with a basis of $300x, a holding period of 10 years, and $240x of E&P, and also a 40-share block of FT stock with a basis of $600x, a holding period of 2 years, and $80x of E&P. US2, a domestic corporation, owns all of the stock of FP, a foreign corporation, which owns all of the stock of FS, a foreign corporation. FT merges into FS with FS surviving in an A reorganization. Pursuant to the reorganization, US1 receives 50 shares of FS stock with a value of $1,000x for its 100 FT shares. 191 (ii) Application of BAHP Rules. The BAHP rules of Prop. Treas. Reg. Sec. 1.367(b)-13(b) apply to the FS shares received by US1 in the reorganization, because US1 was a Sec. 367(b) Shareholder of FT before the exchange, US1 receives CFC shares in the exchange, and the exchange is not taxable under Treas. Reg. Sec. 1.367(b)-4(b). Under those rules, 30 of the FS shares received by US1 in the reorganization are attributable to the 60-share block of FT stock exchanged by US1 and therefore have a basis of $300x ($10x per share), a 10-year holding period, and $240x of E&P ($8x per share). Similarly, 20 of the FS shares received by US1 in the reorganization are allocable to the 40-share block of FT stock exchanged by US1 and therefore have a basis of $600x ($30x per share), a 2-year holding period, and $80x of E&P ($4x per share). Example 2. (i) Facts. The facts are the same as in Example 1, except that the reorganization is a forward triangular merger and US1 receives 50 shares of FP stock, instead of FS stock. Prior to the transaction, FP owned two blocks of FS stock. Each block consisted of 10 shares with a value of $200x ($20x per share). The shares in the first block had a basis of $50x ($5x per share), a holding period of 10 years, and $50x ($5x per share) of E&P. The shares in the second block had a basis of $100x ($10x per share), a five-year holding period, and $20x ($2x per share) of E&P. (ii) Application of BAHP Rules. The application of the BAHP rules of Prop. Treas. Reg. Sec. 1.367(b)-13(b) to the FS shares received by US1 is the same as in Example 1. The BAHP rules of Prop. Treas. Reg. Sec. 1.367(b)-13(c) apply to FP's FS shares, because FT had a Sec. 367(b) Shareholder before the 192 exchange (US1) and US1's exchange of FT shares for FP shares in the reorganization is not taxable under Treas. Reg. Sec. 1.367(b)-3(a) and (b) or Sec. 1.367(b)-4(b). Under those rules, each share of FS stock owned by FP includes (A) a portion that reflects FP's basis and holding period in, and the E&P allocable to, such FS share prior to the reorganization, i.e., with a basis of $5x, a value of $20x, a 10-year holding period, and $5x of E&P for each FS share in the first block, and a basis of $10x, a value of $20x, a holding period of 5 years, and $2x of E&P for each FS share in the second block, (B) a portion that reflects US1's basis and holding period in, and the E&P allocable to, the 60-share block of FT stock exchanged in the reorganization, i.e., with a basis of $15x ($300x / 20 FS shares), a value of $30x ($600x / 20 FS shares), a holding period of 10 years, and $12x of E&P ($240x / 20 FS shares), and (C) a portion that reflects US1's basis and holding period in, and the E&P allocable to, the 40-share block of FT stock exchanged in the reorganization, i.e., with a basis of $30x ($600x / 20 FS shares), a value of $20x ($400x / 20 FS shares), a holding period of 2 years, and $4x of E&P ($80x / 20 FS shares). (iii) Assume that, immediately after the reorganization, FP sells one FS share from the first block for $70x. FP is treated as disposing of each divided portion of such share, and the amount realized is allocated among the portions based on the relative fair market values at the time such portions were created. Prop. Treas. Reg. Sec. 1.367(b)-13(d)(1)(ii). Upon such disposition, FP recognizes a gain of $15x ($20x value - $5x basis), $5x of which is treated as a dividend under Sec. 1248, on the first portion; a gain of $15x ($30x value - $15x 193 basis), $12x of which is treated as a dividend under Sec. 1248, on the second portion; and a capital loss of $10x ($20x value - $30x basis) on the third portion. Example 2A. (i) Facts. The facts are the same as in Example 2, except that FS merges into FT with FT surviving in a reverse triangular merger. Pursuant to the merger, US1 receives 50 shares of FP stock with a value of $1,000x in exchange for its two blocks of FT stock, and FP receives 10 shares of FT stock with a value of $1,400x in exchange for its two blocks of FS stock. Immediately after the exchange, US1 is a Sec. 1248 Shareholder of FP and FT. (ii) BAHP Rules. (A) The basis and holding period of the FP shares received by US1 and the stock of the surviving corporation held by FP are the same as in Example 2, except that each share of the surviving corporation (FT, instead of FS) will be divided into four portions instead of three portions. Each FT share received by FP in the exchange will include (in addition to the two portions reflecting the basis, holding period and E&P of the two blocks of FT shares surrendered by US1) one portion (reflecting basis, holding period and E&P) for each block of FS stock exchanged by FP. (B) The portion attributable to the first block of FS stock will have a basis of $5x ($50x / 10 FT shares), a value of $20x ($200x / 10 FT shares), a 10-year holding period, and $5x of E&P ($50x / 10 FT shares). The portion attributable to the second block of FS stock will have a basis of $10x ($100x / 10 FT shares), a value of $20x ($200x / 10 FT shares), a five-year holding period, and $2x of E&P ($20x / 10 FT shares). The portion attributable to the first block of FT stock 194 exchanged by US1 will have a basis of $30x ($300x / 10 FT shares), a value of $60x ($600x / 10 FT shares), a 10-year holding period, and $24x of E&P ($240x / 10 FT shares). The portion attributable to the second block of FT stock exchanged by US1 will have a basis of $60x ($600x / 10 FT shares), a value of $40x ($400x / 10 FT shares), a 2-year holding period, and $8x of E&P ($80x / 10 FT shares). Example 3. (i) Facts. USP, a domestic corporation, owns all the stock of FS, a foreign corporation with 10 shares of stock outstanding. Each share of FS stock has a value of $10x, a basis of $5x, a holding period of 10 years, and $7x of E&P. FP, a foreign corporation, owns all the stock of FT, another foreign corporation. Neither FP nor FT has any Sec. 1248 Shareholders. FT's assets have a value of $100x, a basis of $50x, and no liabilities. FP's FT shares have a value of $100x and a basis of $75x. FT merges into FS with FS surviving in a forward triangular merger. Pursuant to the reorganization, FP receives USP stock with a value of $100x in exchange for its FT stock. (ii) Application of BAHP Rules. (A) As written, Prop. Treas. Reg. Sec. 1.367(b)-13(c) does not apply, because the transaction is not a reverse triangular merger and T had no Sec. 367(b) Shareholders immediately before the exchange. See Prop. Treas. Reg. Sec. 1.367(b)-13(c)(1). This clearly was an oversight, however, and it is apparent from Example 3 (and informal discussions with the drafter of the proposed regulations) that Treasury and the IRS intended Prop. Treas. Reg. Sec. 1.367(b)- 13(c) to apply. This glitch likely will be remedied when the proposed regulations are finalized. Such amendment is assumed for purposes of the discussion below. 195 (B) Each share of FS stock is divided into (i) a portion that reflects the basis and holding period of, and the E&P allocable to, such FS share immediately before the exchange, i.e., a basis of $5x, a value of $10x, a 10-year holding period, and $7x of E&P and (ii) a portion that reflects the basis of FT's net assets immediately before the exchange, i.e., a basis of $5x ($50x / 10 FS shares) and a value of $10x. The basis of FT's net assets (and not FP's basis in the FT stock) is used (pursuant to the "over-the-top" basis rules of Treas. Reg. Sec. 1.358-6(c)) because FT did not have a Sec. 367(b) Shareholder immediately before the transaction. No E&P is attributed to the second portion. Consequently, if USP sells one FS share for $20x immediately after the reorganization, USP recognizes $5x of gain ($10x value - $5x basis) on the first portion, all of which is treated as a dividend under Sec. 1248, and $5x of gain ($10x value - $5x basis) on the second portion, none of which is treated as a dividend under Sec. 1248 (because no E&P is allocable thereto). Example 4. (i) Facts. US, a domestic corporation, owns all of the stock of FT, a foreign corporation. The FT stock constitutes a single block of stock with a value of $1,000x, a basis of $600x, and holding period of 5 years. USP, a domestic corporation, forms FS, a foreign corporation, pursuant to the plan of reorganization and capitalizes it with $10x of cash. FS merges into FT with FT surviving in a reverse triangular merger (which is also a B reorganization). Pursuant to the reorganization, US receives USP stock with a value of $1,000x in exchange for its FT stock, and USP receives 10 shares of FT stock with a value of $1,010x in exchange for its FS stock. 196 (ii) Application of BAHP Rules. (A) The BAHP rules of Prop. Treas. Reg. Sec. 1.367(b)-13(c) apply to USP's FS shares because (i) the reorganization is a reverse triangular merger, (ii) USP was a Sec. 367(b) Shareholder of FS immediately before the merger, and (iii) USP's exchange of FS stock for FT stock is not taxable under Treas. Reg. Sec. 1.367(b)-3(a) and (b) or Sec. 1.367(b)-4(b). Alternatively, the BAHP rules of Prop. Treas. Reg. Sec. 1.367(b)-13(c) would apply because (i) US was a Sec. 367(b) Shareholder of FT immediately before the merger, and (ii) US's exchange of FT stock for USP stock is not taxable under Treas. Reg. Sec. 1.367(b)-3(a) and (b) or Sec. 1.367(b)-4(b). (B) Pursuant to Prop. Treas. Reg. Sec. 1.367(b)-13(c), because FT had a Sec. 367(b) Shareholder immediately prior to the merger (US), each FT share received by USP must include one portion that corresponds to the FT stock surrendered in the merger, i.e., with a basis of $60x ($600x / 10 FT shares), a value of $100x ($1,000x / 10 FT shares), and a five-year holding period. (C) Because the value of the FS stock immediately before the exchange ($10x) is less than 1% of value of the FT stock immediately after the exchange ($1,010x), the de minimis rule applies. Thus, USP may determine its basis in each share of FT stock by (i) first applying the BAHP rules of Prop. Treas. Reg. Sec. 1.367(b)-13(c) without treating any portion of such share as attributable to the FS stock owned by USP immediately before the exchange and (ii) increasing the basis of each FT share (or portion of an FT share) by a proportionate amount of USP's aggregate basis in its FS shares (as determined immediately before the 197 exchange). If USP chooses to use this method, its basis in each FT share will equal $60x (as determined above) plus $1x ($10x / 10 FT shares) for a total basis of $61x and a total value of $101x. The entire share will have a five year holding period. (D) Although not stated in the example in the proposed regulations, the BAHP rules of Prop. Treas. Reg. Sec. 1.367(b)-13(b) do not apply to US's exchange of FT shares for USP shares. Those rules only apply to an exchanging shareholder who receives shares of a CFC in exchange for shares of a foreign target corporation. Example 5. (i) Facts. US, a domestic corporation, owns all of the stock of FT, a foreign corporation. The FT stock held by US constitutes one block of stock with a basis of $170x, a value of $200x, a holding period of 5 years, and $10x of E&P. FP, a foreign corporation, owns all the stock of FS, a foreign corporation. FS has 10 shares of stock outstanding. No U.S. person is a Sec. 1248 Shareholder of FP or FS. The FS stock held by FP has a basis of $50x ($5x per share) and a value of $100x ($10x per share). FT merges into FS with FS surviving in a forward triangular merger. Pursuant to the merger, US receives 20 shares of FP stock with a value of $200x for its FT stock in an exchange that qualifies for nonrecognition under Sec. 354. Immediately after the exchange, FP is a CFC and US is a Sec. 1248 Shareholder of both FP and FS. (ii) Application of BAHP Rules. (A) The BAHP rules of Prop. Treas. Reg. Sec. 1.367(b)-13(c) apply to FP's stock of FS because (i) US was a Sec. 367(b) Shareholder of FT immediately 198 before the merger, and (ii) US's exchange of FT stock for USP stock is not taxable under Prop. Treas. Reg. Sec. 1.367(b)-3(a) and (b) or Sec. 1.367(b)-4(b). (B) Under the BAHP rules, each share of FS is divided into (i) an "FS portion" that reflects the basis, holding period and E&P of the FS stock held by FP immediately before the exchange i.e., a basis of $5x, a value of $10x, a five- year holding period and $1x of E&P and (ii) an "FT portion" that reflects the basis, holding period and E&P of the FT stock surrendered by US in the exchange, i.e. a basis of $17x ($170x / 10 FS shares), a value of $20x ($200x / 10 FS shares) a five-year holding period and $1x of E&P ($10x / 10 FS shares). (iii) Subsequent disposition. (A) Several years after the merger, FP sells all of its FS stock in a transaction governed by Sec. 964(e) for $210x (i.e., $21x per share), and FS has incurred a post-merger E&P deficit of $30x (i.e., $3x per share). Note that the value of the FS stock has declined by $90x since the merger. (B) With respect to each share of FS, FP is treated as disposing of each divided portion of the share, and the amount realized is allocated among the portions based on the relative fair market values at the time such portions were created. Prop. Treas. Reg. Sec. 1.367(b)-13(d)(1)(ii). At that time, each FS share, which had a value of $30x, had an "FS portion" with a value of $10x, representing one-third of the total share value, and an "FT portion" with a value of $20x, representing two-thirds of the total share value. Accordingly, for each share, one- third of the $21x amount realized (i.e., $7x) is allocated to the "FS portion" and two-thirds (i.e., $14x) is allocated to the "FT portion". These ratios may 199 alternatively be arrived at by comparing the value of the FS stock to the total value of the FS and FT stock ($100x / $300x, i.e., one-third) and the value of the FT stock to the total value of the FS and FT stock ($200x / $300x, i.e., two-thirds) immediately prior to the reorganization. (C) Pursuant to Prop. Treas. Reg. Sec. 1.367(b)-13(d)(3), any E&P (or E&P deficit) accumulated by the surviving corporation, FS, after the reorganization is attributed to the divided portions of shares of stock in proportion to their relative fair market values (as of the time such portions were created). Accordingly, for each FS share, one-third of the $3x-per-share post-merger E&P deficit (i.e., $1x) is allocated to the "FS portion" and two-thirds (i.e., $2x) is allocated to the "FT portion". (D) When FP disposes of its FS stock, FP is treated as disposing of each divided portion of each share. With respect to each "FS portion", FP recognizes a gain of $2x ($7x value - $5x basis), which is not recharacterized as a dividend under Sec. 1248 because the $1x of post-reorganization E&P deficit allocable to such portion offsets the $1x of pre-merger E&P allocable to such portion. With respect to each "FT portion", FP recognizes a loss of $3x ($14x value - $17x basis).
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