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For the second time this summer, the IRS attacks a loophole that allows "effective repatriation" of profits without reporting the associated income.
Robert Willens, CFO.com | US
July 29, 2008
The Internal Revenue Service has issued new guidance on so-called Killer B transactions, the triangular reorganizations that involve foreign controlled corporations. For the second time since early June, the IRS has taken decisive steps to prevent what it obviously considers one of the most objectionable tax outcomes in the tax adviser's arsenal. That is, the effective repatriation of a controlled foreign corporation's earnings and profits without the U.S. corporation reporting related income. (See, The Willens Report, Volume 2 Issue 166, June 2, 2008, subscription needed, "I.R.S. Eliminates the Utility of Killer 'B's".)
The transaction the IRS is seeking to ban involves, for example, a United States corporation which owns 100 percent of the stock of each of two United States corporations (AmericaOne and AmericaTwo). AmericaOne, in turn, owns 100 percent of the stock of a foreign corporation (OverseasCorp.) In the transaction, AmericaTwo issues $10 million worth of its stock to OverseasCorp. In exchange, OverseasCorp hands over to AmericaTwo $1 million in stock and $9 million in cash. The transaction gives rise to the following tax consequences:
AmericaTwo, immediately after the exchange, is in control of OverseasCorp. within the meaning of the IRS code's Section 368(c). That's because AmericaTwo's transfer to OverseasCorp is governed by Section 351 of the code, the section that applies when one company transfers property to another using stock. In the case of AmericaTwo, the requisite control was present because under the consolidated tax return's "aggregation rules" (See Regulation Section 1.1502-34) the stock in OverseasCorp that was owned by AmericaOne is attributed to AmericaTwo under Section 351.
AmericaTwo recognizes no gain on the receipt of stock and cash in exchange for its stock because under another section of the law — (Section 1032) — no gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for its stock.
OverseasCorp recognizes no gain on the issuance of its stock under Section 1032.
OverseasCorp's basis in the AmericaTwo stock is zero under Section 362(a). That section says that if property is acquired by a corporation in connection with a Section 351 transaction, the basis of the property when it is in the hands of the transferee should be the same as if it was in the hands of the transferor — plus the amount of gain recognized by the transferor. (See Revenue Ruling 74-503, 1974-2 C.B. 117. )
In its example, the IRS notes that AmericaOne and AmericaTwo have no "income inclusion" as defined by the tax code ( See Section 951(a)(1)(B), despite the fact that OverseasCorp holds AmericaTwo stock. As a result, the agency went to work to tighten the rules around "effective" repatriation that allowed companies to sidestep reporting related income.
Ordinarily, the tax law doesn't allow companies to get away with dodging the income inclusion rule. Indeed, according to Section 956, each "U.S. shareholder" of a controlled foreign corporation must include in its gross income that is the lesser of, (1) the excess of the shareholder's pro-rata share of the average amounts of "U.S. property" held by the controlled foreign corporation. 1; or (2) the U.S. shareholder's pro-rata share of the "applicable earnings" of the controlled foreign corporation.
With respect to the first item, the amount taken into account is generally considered the basis of such property.
In this case, U.S. property includes, with exceptions not relevant here, stock of a domestic corporation and an obligation of a U.S. person. So, the fact that OverseasCorp acquired a zero basis in the stock of AmericaTwo meant, in effect, that the foreign company, even though it acquired stock in the American company, had not made an investment of its earnings and profits in U.S. property. Accordingly, the U.S. shareholders of OverseasCorp did not suffer an income inclusion as a result of the transaction.
Service Proposes Remedies
To combat the abuse, the IRS, on June 23, issued temporary regulations which are surgically designed to address the particular problem depicted in the OverseasCorp example. As a result, updated rules were introduced to determine the tax basis solely for purposes of Section 956 (See Regulation Section 1.956-1T(e)(6)2).
For purposes of the new rules, the term U.S. property, includes stock of a domestic corporation or an obligation of a domestic corporation that is acquired by the controlled foreign corporation from the domestic issuing corporation. Further, the basis of the U.S. property shall be no less than the fair market value of the property transferred by the controlled foreign corporation in exchange for such U.S. property. In addition, the term property is defined in based on Section 317(a) , and therefore includes money, securities, and any other property, except that such term does not include stock in the corporation making the distribution. It also includes any liability assumed by the controlled foreign corporation in connection with the exchange, notwithstanding the application of Section357(a).
So, it follows that under the new regulations — which are effective immediately — the basis of OverseasCorp in the stock of AmericaTwo shall be no less than $9 million. To be sure, the OverseaCorp stock that was used as payment in exchange for AmericaTwo stock does not constitute property under Section 317. As a result, the U.S. shareholders of OverseasCorp would have an income inclusion amounting to $9 million.3 And that result, it seems safe to say, is what the IRS intended when it issued the June rules. To be sure, the effect of the rule is that it rendered the Killer B transactions impractical.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 That so-called property value is calculated as of the close of each quarter of the taxable year over specific amounts of earnings and profits, and attributable to amounts previously included in income by the U.S. shareholder.
3 Unless the pro-rata share of OverseasCorp's applicable earnings is smaller.