United States: Notice Modifies The Application Of Section 367 To Certain Triangular Reorganizations And Inbound Transactions

The IRS on Dec. 2 issued Notice 2016-73 announcing that the government intends to issue regulations under Section 367 modifying the rules relating to the treatment of property used to acquire parent stock or securities in certain triangular reorganizations involving one or more foreign corporations. The notice further announces that the IRS and Treasury intend to issue regulations under Section 367 to modify the amount of an income inclusion required for certain inbound nonrecognition transactions.   

Section 367 and the regulations promulgated thereunder impose limitations on a U.S. person's ability to transfer property—including stock—to a foreign corporation in a tax-free manner. Section 367(b) provides that in the case of certain tax-free transactions to which Section 367(a) is not applicable, regulations may be issued as necessary or appropriate to prevent the avoidance of federal income tax.  

The final regulations, under Treas. Reg. Sec. 1.367(b)-10, apply to certain triangular reorganizations in which a subsidiary (S) acquired stock or securities of its parent corporation (P) in exchange for property, where S exchanges the stock or securities in P for stock, securities or property of a target corporation (T). When applicable, the final regulations require that adjustments be made that have the effect of a distribution of property from S to P under Section 301. Importantly, Treas. Reg. Sec. 1.367(b)-10(a)(2)(iii) provides that the regulations do not apply to certain exchanges where one or more U.S. persons exchange stock or securities of T and the amount of gain in the T stock or securities recognized by such persons under Section 367(a)(1) is equal to or greater than the deemed dividend and gain that would be recognized by P in the regulations otherwise applied. A similar rule turns off the application of Section 367(a)(1) where the Section 367(b) income equals or exceeds the Section 367(a)(1) amount. These rules are generally referred to as the priority rules.      

Treas. Reg. Sec. 1.367(b)-3 applies to certain inbound transactions where a foreign corporation transfers assets to a domestic corporation. In defined instances, the provisions require certain shareholders of that foreign acquired corporation to include in income, as a deemed dividend, the "all earnings and profits" amount with respect to their stock. The regulations provide specific rules for determining the "all earnings and profits" amount by reference to Section 1248 with certain modifications.   

Notice 2016-73 states that Treasury and the IRS are aware that taxpayers are engaging in certain transactions designed to repatriate earnings and basis of foreign corporations without incurring U.S. tax under the current regulations. The notice identifies three specific transactions in which taxpayers exploit the Section 367(a) priority rule in transactions in which the gain recognized under Section 367(a)(1) is minimal. The effect of Section 367(a) priority rule is the nonapplication of Treas. Reg. Sec. 1.367(b)-10 in those triangular reorganizations. Those transactions are described in detail in the notice. 

In response to these perceived tax avoidance transactions, Treasury and the IRS intend to modify the current regulations. First, the Section 367(a) priority rule will be modified to apply only when T is a domestic corporation. Accordingly, when T is a foreign corporation, the final regulations, as modified by the rules described in the notice, will apply to triangular reorganizations described in Treas. Reg. Sec. 1.367(b)-10(a)(1), subject to limited exceptions. Second, Treasury and the IRS intend to modify the Section 367(b) priority rule to provide that in certain exchanges, Section 367(a)(1) will no longer apply; rather the modified rules under Treas. Reg. Secs. 367(b)-4 and 1.367-4T will apply.  

The notice also provides detailed rules on adjustments to be made to the all earnings and profits amount with respect to stock of a foreign acquired corporation in certain inbound nonrecognition transactions. The rules provide that to the extent there is excess basis with respect to a foreign acquired corporation, then, in the case of an exchanging shareholder the all earnings and profits amount is increased by the specified earnings with respect to such stock. The notice provides significant detail on the determination of such amounts for inclusion purposes.  

The regulations described in the notice will apply to transactions completed on or after Dec. 2, 2016, and to any inbound transactions treated as completed before Dec. 2, 2016, as a result of an entity classification election that is filed on or after Dec. 2, 2016.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.