Can a Foreign Corporation be Reorganized into a U.S. Corporation for QSBS Purposes?

Section 1202 of the Internal Revenue Code permits investors in “qualified small business stock” (“QSBS”) to exclude up to $10 million in taxable gains. Despite the Section 1202 tax incentive, in the past, many investors shied away from QSBS stock because of the inherent double tax consequence of subchapter C corporations. Internal Revenue Code Section 1202 was originally enacted in 1993. It was enacted as an incentive for the public to invest in small businesses. Currently, Internal Revenue Code Section 1202 allows taxpayers to exclude up to 100 percent of the gain realized from the sale or exchange of QSBS stock held for more than five years. However, the amount of taxable gain which is excludable depends largely on the year that the QSB stock was issued. If the QSBS was issued before February 18, 2009, the gain exclusion is 50 percent. If the QSBS stock was issued between February 18, 2009 and September 27, 2010, the gain exclusion is 75 percent. QSBS shares issued after September 27, 2010 may qualify for a 100 percent exclusion of the total taxable gain.

Section 1202 limits the “eligible gain” to the greater of:

1. $10 million reduced by any amount an individual excluded from the sales of exchange of QSBS stocks from the same issuer in prior years; or
2. 10 times the aggregate adjusted basis of the QSBS stocks issued by the corporation disposed of by the individual taxpayer during the taxable year, as measured on the original issue date.

The amount of gain excluded by Internal Revenue Code Section 1202 is also not subject to the 3.8 percent Medicare tax and is not subject to the Alternative Minimum tax. Besides the tax benefits of Section 1202 discussed above, Internal Revenue Code Section 1045 permits investors to possibly roll-over gains from the sale of QSBS stock that has been held for more than six months.

Requirements of Section 1202

Investors should know that four requirements must be met in order to exclude gains from the sale of stock under Section 1202. Below, each of these requirements are discussed in detail. If the four requirements mentioned below are not satisfied, the stock will not qualify for Section 1202 treatment.

1. Stock of a Subchapter C Corporation Acquired at an “Original Issuance”

Sections 1202(c)(1) and 1202(c)(1)(B) of the Internal Revenue Code state that QSBS stock is stock in a C corporation which is originally issued after the enactment of the Revenue Reconciliation Act of 1993, if such stock is acquired in exchange for money or other property, or as compensation for services performed for such a corporation. According to Internal Revenue Code Section 1202(c)(1)(B), QSBS stock must be acquired at “original issue” (directly or through an underwriter) in exchange for money or other property, or as compensation for services performed for such corporation. In other words, the original purchaser of the QSBS stock must be the seller claiming the Section 1202 tax benefit.

Section 1202 provides that QSBS stock must generally be required by the holder of the original issue for cash, certain other property or services. This requirement means that shares of QSBS stock must be acquired directly from the issuer in exchange for money or other property, or as compensation for services performed from the issuing corporation. The definition of money is straightforward. For Section 1202 purposes, “property” is generally defined to include most tangible and intangible assets. This includes cash, capital assets, inventory, accounts receivable, patents, and, in certain circumstances, nonexclusive licenses and industrial know-how. Stock issued as compensation for services (i.e. subject to the rules promulgated under Internal Revenue Code Section 83) may also qualify as QSBS stock.

2. Qualified Small Business Requirement

Sections 1202(c)(1) and 1202(c)(2)(A) provide that as of the date of issuance, the issuing corporation must be a “qualified small business.” Internal Revenue Code Section 1202(d)(1) defines a “qualified small business” as a domestic corporation if: 1) the aggregate gross assets of such corporation, at all times on or after the date of the enactment of the Revenue Act of 1993 and before the issuance of the stock being tested for potential qualification as QSBS stock, do not exceed $50 million; 2) the aggregate gross assets of such corporation immediately after the issuance of the stock being tested for potential qualification as QSBS stock do not exceed $50 million; and 3) such corporation agrees to submit to the IRS and its shareholders and “reports” that the IRS may “require to carry out for the purposes of Section 1202.”

The corporation issuing the QSBS stock must be a qualified small business immediately prior to and immediately after the issuance of the QSB stock. This means that the issuing corporation must not have aggregate gross assets in excess of $50 million. The term “aggregate gross assets” discussed above means the sum of the amount of cash and the aggregate value of all property of the corporation. Stock that otherwise qualifies as QSBS stock as of the date of issuance will not lose that status solely by virtue of the fact that a corporation exceeds $50 million at a future date. However, once a corporation’s aggregate gross assets exceed $50 million, the corporation cannot issue QSBS stock, even if the aggregate gross assets fall below $50 million. It should also be noted that for purposes of aggregate gross asset test of Section 1202(d)(1), corporations that are part of a “parent-subsidiary controlled group” shall be treated as one corporation.

3. Active Business Requirement

Internal Revenue Code Section 1202(c)(2) provides that stock in a corporation cannot be treated as QSBS stock unless, during substantially all of the taxpayer’s holding period, such a corporation meets the “active business requirements” of Internal Revenue Code Section 1202(e) and such corporation is a subchapter C corporation. For purposes of Internal Revenue Code 1202(c)(2)(A), a corporation shall be treated as satisfying the “active business requirement” of section 1202(e) for any period if during such period (i) at least 80 percent of the assets of such corporation are used by such corporation in the active conduct of one or more ‘qualified trades or businesses’ and (ii) such corporation is an ‘eligible corporation.’

Under Section 1202(e)(3), the term “qualified trade or business” means any trade or business other than:

• Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees;
• Any banking, insurance, financing, leasing, or similar business;
• Any farming business.
• Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under Section 613 or 613A; and
• Any business of operating a hotel, motel, restaurant, or similar business.

Just about any trade or business with the exception of the practice of law, accounting practices, medical practice, brokerage services, banking, investing, leasing, insurance, farming, oil and gas extraction, or operating a hotel or restaurant will be considered an active trade or business for the purpose of Internal Revenue Code Section 1202. Internal Revenue Code Section 1202(e)(2) also provides an exception to start-up business. Under Section 1202(e)(2), activities associated with a “start-up” business such as research or experimental activities will be classified as an active trade or business. However, in order to satisfy the active trade or business test, a corporation issuing QSBS stock must make sure that at least 80 percent of its assets are involved in an active trade or business.

A corporation will fail the 80 percent asset test if its aggregate investment assets (i.e. stocks and cash) plus non-trade assets make up more than a certain percent of the issuing corporate assets. Section 1202 provides a special working capital rule which does not necessarily utilize the above discussed 80 percent threshold. For example, Internal Revenue Code Section 1202(e)(7) states that a corporation shall not be treated as being in the active trade or business if more than 10 percent of its value is real estate.

4. Five Year Holding Period

Internal Revenue Code Section 1202(b)(2) requires that QSBS stock must be held for at least five years in order to exclude gains. In most cases, satisfying the five-year holding period will be simple. This is because, in general, the holding period of QSB stock begins on the date of issuance whether or not the QSB stock was received in a taxable or non-taxable transaction. Special tacking rules, however, apply to the computation of the holding period if the QSBS stock is converted into other stock of the same corporation, or if the stock is acquired as a gift, by inheritance, or as a transfer from a partnership.

Section 1202 Basis Rules

If an investor acquires QSBS shares through a cash transaction, the investor’s taxable basis will be the value of the money transferred in exchange for the QSBS stock. When an investor acquires QSBS stock through the transfer of property, the investor’s basis in the QSBS shares will be the fair market value of the property exchanged. One important fact that must be considered by any investor who elects to exchange appreciated property is that the like-kind exchange rules do not apply to the acquisition of QSBS shares. For example, suppose A receives $100 of QSB stock in exchange for his asset with a $10 basis, Section 1202(i) will require A to recognize $90 of realized gain.

Section 1045 Rollover Rules

Internal Revenue Code Section 1045 allows an investor to defer recognition of taxable gain from the sale or exchange of QSBS stock if he or she acquires replacement of the QSBS stock within a 60-day period beginning on the date of the sale of the shares. The following elements must be satisfied in order to defer the recognition of QSB stock: 1) gain recognition from the sale of QSBS stock is limited to the extent to which the amount realized (i.e., gross proceeds) on the sale exceeds the cost of replacement QSBS stock purchased by the taxpayer, and 2) the replacement QSB stock is reduced by the amount of the unrecognized gain.

Section 1045 also specifically mentions special basis rules in Section 1202. Under this special basis rule, the amount of any gain attributable to periods prior to the receipt of the QSBS stock is not eligible for roll over and these taxable gains must be recognized at the time of the sale or exchange of the shares. In other words, only gains that accrued after the time the shares can be classified as QSBS stock can be deferred for federal income tax purposes. Internal Revenue Code Section 1045 also incorporates the special tacking rules of Section 1202. This means that the six-month holding period will be extended when the QSBS stock is received upon conversion, by gift, by death, or from a former QSBS shareholder.

Can Stock from a Foreign Corporation be Restructured into a U.S. Corporation for QSBS Purposes?

In order to gain access to U.S. capital markets, foreign corporations (particularly foreign corporations that have one or more U.S. shareholders) often restructure into U.S. corporations through so-called Type D corporate “spin-off” reorganizations or “inbound Type F” organizations. If done properly, these types of reorganizations can avoid U.S. tax. A foreign corporation can also establish a U.S. entity tax-free under Section 351 of the Internal Revenue Code. Although in most cases, a foreign corporation can restructure or establish a U.S. corporation tax-free for U.S. federal tax purposes, having the shareholders of the newly formed U.S. entity being able to qualify for the Section 1202 exclusion is another issue.

As discussed above, Section 1202(c)(1)(B) provides that stock in QSBS can only be issued “in exchange for money or other property (not including stock) or as compensation for services.” Cross-border reorganizations often involve the exchange of stocks. Stock issued in exchange for stock is categorically excluded from being QSB. In order for a shareholder of a QSBS to qualify for the exclusion, cannot simply receive shares from a reorganization. The shareholders of the newly formed U.S. corporation must exchange money, property, or exchange services to the shares in order to qualify for the Section 1202 exclusion. Section 1202 is only a consideration for U.S. persons because foreign persons do not typically pay capital gains tax on the appreciation of U.S. stock. However, if the newly formed U.S. entity has or will have U.S. investors or U.S. shareholders, Section 1202 eligibility must be considered prior to the establishment of the U.S. corporation. Planning options may include the contribution of assets to the newly formed U.S. corporation which permits the issuance of property rather than stock or the issuance of additional stock for something other than stock.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding of the taxation of QSBS when a cross-border reorganization is involved. It should be evident from this article that this is an extremely complex subject. It is important to note that this area is constantly subject to new development and changes, as Congress continually entertains new tax laws, the Treasury promulgates new regulations, and federal courts issue new opinions that impact the subject matter discussed in this article. As a result, it is crucial that a competent tax attorney be consulted prior to the establishment of a U.S. entity that intends to take advantage of the QSBS exclusion.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is the author of a number of published articles addressing cross-border taxation. Anthony also frequently provides continuing educational programs regarding various international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.