International Corporate Tax-Free Spinoffs in the U.S. Inbound Context

There are a number of reasons why a foreign corporation with U.S. shareholders may decide to “split-up” or “spin-off” and form a new U.S. corporation. The main reason foreign corporations form U.S. corporations is to gain access to U.S. capital markets. A foreign corporate transaction that involves the establishment of a U.S. corporation raises a number of difficult U.S. tax issues, particularly when the foreign parent corporation is owned by one or more U.S. shareholders. This article discusses how a foreign corporation that is owned by one or more U.S. shareholders may spin-off a U.S. subsidiary tax-free.

Introduction U.S. taxation of U.S. Shareholders of Foreign Corporations

In today’s global economy, foreign corporations have operations all over the world. In many cases, foreign corporations own a group of subsidiary corporations formed throughout the world. If foreign corporation wishes to establish a U.S. domestic corporation, there are a number of issues that must be considered. This is particularly the case if the foreign corporation is owned directly or indirectly by one or more U.S. shareholders. Net Tested Income (“NCTI”) or Subpart F income could be assessed against U.S. direct and indirect U.S. shareholders when a foreign corporation establishes a subsidiary. Under NCTI and Subpart F, certain types of foreign income earned by a controlled foreign corporation (“CFC”) is taxable to the CFC’s U.S. shareholders in the year earned even if the CFC does not distribute the income to its shareholders in that tax year. Section 957(a) of the Internal Revenue Code define a CFC as a foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote (or value of all outstanding stock) is owned, directly, indirectly, or constructively under the Section 958 ownership rules, by U.S. shareholders on any day during the foreign corporation’s tax year. The inclusion of NCTI or Subpart F income of a CFC in the U.S. taxable gross income of U.S. shareholders under Section 951(a)(1) occurs only of the corporation at any time during its tax year.

If this test is met, every person who is a U.S. shareholder of the corporation (as defined in Section 951(b)) must include its pro rata share of the corporation’s NCTI or Subpart F income. A U.S. shareholder’s pro rata share is determined by going through a hypothetical dividend distribution of the CFC’s NCTI or Subpart F income is the amount of the distribution that the U.S. shareholder would have received with respect to the stock owned in the CFC if, on the last day of its tax year on which it was a CFC, the corporation had distributed pro rata to all of its shareholders a dividend in an amount equal to the NCTI or Subpart F income for the tax year. In the case of a CFC’s demerger (the corporation splits into two or more separate independent entities) in which a U.S. entity is formed, it is possible that the transaction can be treated as a distribution of stock or assets to the extent of the CFC’s earnings and profits for purposes of NCTI or Subpart F income. Even if the foreign corporation is not treated as a CFC for U.S. purposes, the creation and funding of a newly-formed U.S. subsidiary may be treated as a taxable distribution of stocks or assets to its U.S. shareholders.

Negative U.S. tax implications to U.S. shareholders associated with a foreign corporation’s division may potentially be avoided if the transaction qualifies for a Type D reorganization pursuant to Section 355. A Type D reorganization is a corporate division for U.S. tax purposes. Corporate divisions are transactions in which a single corporation is divided into two or more separate corporations that remain under the same ownership. A division is accomplished when a parent corporation known as the distributing corporation distributes to its shareholders stock of one or more so-called controlled subsidiaries. If a number of requirements are satisfied, the transaction is tax-free to the distributing corporation and its shareholders. The rationale is that a corporation is merely a change in the form of businesses which continue to be owned and operated by the same shareholders. Corporate divisions tend to come in three basic forms: spin-offs, split-off, or split-up. In a spin-off, the distributing corporation distributes stock of a controlled corporation (a subsidiary) to its shareholders. This subsidiary may be either a recently created subsidiary “spun off” through the parent corporation’s transfer of assets in return for stock or an existing subsidiary. The shareholders in a spin-off generally receive a pro rata share of the controlled corporation’s stock and do not transfer anything in return for this stock. If the transaction fails to qualify for nonrecognition under Section 355, the distribution is treated as a dividend to the shareholder distributees to the extent of the corporation’s earnings and profits.

A split-up is very much like a spin-off except that the parent’s shareholders receive stock in the subsidiary in return for some of their stock in the parent corporation. In a split-up, the corporation transfers all of its assets to two or more new corporations (controlled corporations) in return for stock, which is then distributed to the shareholders of the parent corporation in return for all of the parent stock. The split-up effectively liquidates the original parent corporation. In many cases, a foreign corporation (the distributing corporation) will transfer shares to a newly formed U.S. entity. This type of transaction is considered a spin-off under Section 355. In order for a spin-off to qualify as a tax-free reorganization for U.S. tax purposes, Internal Revenue Code Section 355 requires:

1. Control immediately before the distribution- the distributing corporation must distribute solely stock or securities of a corporation which it controls immediately before the distribution;
2. Distribution requirement– the distributing corporation must distribute all of the stock and securities in the controlled corporation held immediately before the distribution;
3. Trade or business requirement– both the distributing corporation and the controlled corporation must be engaged immediately after the distribution in the active conduct of a trade or business;
4. Non-device requirement– the transaction was not used principally as a device to distribute earnings and profits of the distributing corporation, the controlled corporation, or both.

In addition to these statutory requirements, Section 367 of the Internal Revenue Code must be considered. When applicable, Section 367 causes a corporation not to be treated as a corporation under U.S. tax law. In order to qualify for a Type D tax-free reorganization, it is essential that the entity being reorganized be classified as a corporation. Thus, even if the contemplated transaction qualifies for a Type D reorganization, if Section 367 rules apply, the demerger transaction will not qualify for tax-free treatment under U.S. tax law.

This article will now discuss the basic requirements of Section 355 and Section 367 in the context of an inbound tax-free spinoff.

Distributing Corporation Must Control Controlled Corporation Prior to Corporate Division

Internal Revenue Code Section 355(a)(1)(A) provides that in order for a spin-off to qualify for Section 355 treatment, the distributing corporation must distribute stock or securities of “a corporation … which it controls immediately before the [spin-off.]” The stock distributed must consist either of all the stock of the subsidiary, or an amount of stock constituting control within the meaning of Section 368(c). Under Section 368(c), control is defined as ownership of at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of all other classes of stock of the corporation.

Under Section 355, a distributing parent that is a foreign corporation may distribute stock or assets to either a preexisting or a newly created U.S. subsidiary. As long as the foreign corporation owns at least 80% of the U.S. entity.

Transaction Must be Entered for a Valid Business Purpose

In order for a foreign corporation to foreign a U.S. subsidiary through “spin-off” or “spit-up” and qualify for Type D tax-free reorganization (to its U.S. shareholders), the transaction must be carried out for a bona fide corporate business purpose. See Treas. Reg. Section 1.355-2(b). The business purpose requirement under Section 355 will be satisfied if the distribution is motivated, in whole or in part, by one or more corporate business purposes. Such a purpose is a non-federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group of which the distributing corporation is a member. Treasury regulations also provide that if a corporate business purpose can be achieved through a non-taxable transaction that does not involve the distribution of stock of a controlled corporation and which is neither impractical nor unduly expensive, then the distribution is not carried out for that corporate business purpose.

The business purpose requirement is an independent requirement of Section 355, so that even if a spinoff is not used for tax avoidance purposes (e.g., it was not a “device” for the distribution of earnings), the transaction will not qualify under Section 355 if there was no business purpose for the transaction. Moreover, a corporate business purpose will not be treated as sufficient for purposes of Section 355 if the corporate business purpose can be achieved through a nontaxable transaction that does not involve the distribution of controlled corporation stock and which is neither impractical nor unduly expensive. The regulations promulgated under Section 355 of the Internal Revenue Code include a number of examples of valid corporate business purposes including a pro rata distribution motivated by a desire to comply with legal requirements, a non-pro rata distribution permitting different shareholder groups to focus on different business lines and thereby resolve shareholder conflicts, the separation of a regulated business from an unregulated business where it is impossible to achieve the separation without distributing the stock of regulated business, and a pro rata distribution to enable a key employee to invest in the business of either the distributing or controlled entities.

The regulation also identifies corporate business purposes that are not sufficient for Section 355 purposes, including limitation of liability where liability protection could be achieved without a spinoff. In addition to the regulations, Rev. Proc. 96-30, Appendix A, prior to its amendment in Rev. Proc. 2003-48, provided a non-exclusive list of business purposes for a 355 transaction, which include: to facilitate the retention of a key employee, to facilitate a stock offering, to facilitate borrowing, to reduce costs, to enhance the fit and focus of the distributing and controlled corporation’s respective business, to reduce the competition between the businesses, to facilitate an acquisition of the distributing corporation, to be facilitated by the distributing or controlled corporations, and to reduce the risks by separating a risky business from a less risky business. Over the course of time, however, cases and published rules have acknowledged other valid purposes such as reduction of state or foreign tax liability, a desire to resolve or reduce the impact of chronic labor union problems, and decreasing competition between the business for capital. Finally, a “spin-off”or “split-up” will not qualify as tax-free under Section 355 if it is used principally as a device for the distributions of earnings and profits.

In fact, it is in the regulations under Section 355 that one finds the best statement of the underlying concern of the Internal Revenue Service (“IRS”). Treasury Regulation Section 1.355-2(d)(1) states that “section 355 recognizes that a tax-free distribution of the stock of a controlled corporation presents a potential for tax avoidance by facilitating the avoidance of the dividend provisions of the Internal Revenue Code through the subsequent sale or exchange of the stock or one corporation and the retention of the stock of another corporation.” Before a foreign corporation with U.S. shareholders considers transferring stock or assets to a newly formed U.S. corporation tax-free to its U.S. shareholders, careful consideration must be done in order to qualify the transaction as a valid business purpose as per the regulations. In addition, the formation of the U.S. subsidiary cannot be done through a distribution of the foreign parent corporation’s earnings and profits.

Active Business Test

In addition to the requirements already mentioned, Section 355 requires that both the distributing foreign corporation and the newly formed U.S. corporation or corporations be “engaged immediately after the distribution in the active conduct of a trade or business.” In the case of a spin-off, each of the distributing corporations and the controlled corporation must each be engaged in the active conduct of a trade or business immediately after the spin-off. Specifically, Section 355(b) requires that (i) both the distributing corporation and the controlled corporation be engaged, immediately after the distribution, in the active conduct of a trade or business, (ii) each such post-distribution business must have been actively conducted throughout the five-year period ending on the date of the distribution, and (iii) each such post-distribution business must not have been acquired, directly or indirectly, by a purchase or other transaction in which gain or loss was recognized during the five year period.

The “definition” section in Section 355(b)(2) offers virtually no guidance on the meaning of words “active conduct of a trade or business.” Moreover, the regulations make only a modest contribution. Treasury Regulation Section 1.355-3(b)(2)(ii) states a corporation is engaged in a “trade or business” if a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities include in such group include every operation that forms a part of, or step in, the process of earning income or profit. Such a group of activities ordinarily must include the collection of income and the payment of expenses.” The regulations make it clear that the reorganization must be for an active rather than a passive corporate activity in order for the transaction to be tax-free for U.S. tax purposes. Whether or not a corporation is actively, as opposed to passively engage in a trade or business will depend upon the facts and circumstances of the particular transaction.

To be considered an active trade or business, however, the U.S. corporation that is formed in the Type D reorganation generally is “required itself to perform active and substantial management operational functions.” Treas. Reg. Section 1.355-3(b)(2)(iii). Activities performed by persons outside the corporation, such as independent contractors, do not count as activities performed by the corporation. However, a newly formed U.S. corporation can satisfy the active trade or business requirement even though “some of its activities are performed by others.” Treasury Regulation Section 1.355-3(b)(2)(iv) specifically eliminates from the activity conduct of a trade or business definition the hold of stock, securities, land or other property, for investment purposes as well as certain ownership and operation of real or personal property. The pre-distribution active trade or business requirement for the foreign corporation is not clearly defined in the statutory language.

The language in Section 355(b)(1) begins by including only post-distribution trade or business requirements. The definition section that follows in Section 355(b)(2) treats a corporation as engaged in active conduct of a trade or business for purposes of paragraph (b)(1) only if the trade or business “has been actively conducted throughout the five-year period ending on the date of the distribution.” Thus, the particular trade or business relied upon to meet this requirement cannot be a new trade or business, but must have a five-year history. In short, in order for a Type D reorganization to qualify as tax-free inbound transaction, both the foreign corporate parent and the newly formed U.S. corporation should be in the same line of business and that business must be an active conduct of a trade or business. The newly formed U.S. corporation should not be formed to conduct passive business activities such holding securities, land, or real property for investment purposes.

Plan of Reorganization

The Income Tax Regulations provides that a Type D reorganization must occur pursuant to a plan in order to qualify as a reorganization under Section 368. See Treas. Reg. Section 1.368-1(c); Treas. Reg. Section 1.368-2(g). Thus, prior to the implementation of any inbound corporate tax-free reorganization (for U.S. tax purposes) that involves the formation of a U.S. corporation, prior to implementation, a written plan of reorganization should be entered by the parties. Failure to implement a written plan of reorganization prior to the transaction can result in the reorganization not qualifying for a Type D tax-free reorganization.

Other Issues Associated with Foreign Corporate Divisions

Basis, Holding Periods, and Tax Attributes

In most cases, the first step of a Type D spin-off that involves the establishment of a U.S. corporate subsidiary is to transfer the assets of the foreign parent corporation to the controlled U.S. corporation generally in exchange for the issuance of shares by the U.S. corporation to the foreign corporation corporation. The exchange of shares will trigger a number of basis issues for U.S. shareholders of the foreign parent corporation. The U.S. shareholder’s basis of the foreign parent corporation will be allocated between the foreign corporation and the U.S. corporation, based upon relative fair market values of the foreign parent corporation and the newly formed U.S. corporation. Section 358 of the Internal Revenue Code provides the rules for allocating the shareholder’s basis between the distributing and controlled corporation. See generally Internal Revenue Code Sections 358(a).(b)(2) and (c); Treas. Reg. Section 1.358-2. Internal Revenue Code 358(a) and (c) imply that a shareholder of a foreign parent corporation that receives controlled shares in a pro-rata distribution in the U.S. corporate entity must allocate the shareholder’s pre-distribution tax basis in the foreign parent corporation stock between the U.S. corporation stock received in the spinoff. The allocation is made according to the relative fair market value of the foreign parent corporation stock and newly formed U.S. corporation stock held after the spinoff. See Treas. Reg. Section 1.358-2(a)(2)(iv).

Allocation of Earnings and Profits between the Foreign Parent Corporation and the Newly Formed U.S. Corporation

The creation of a newly formed U.S. corporation by a foreign parent corporation through a Type D reorganization will trigger allocation of earnings and profits between the two entities to shareholders of the foreign parent corporation. In cases involving a demerger of a foreign corporation to establish a U.S. subsidiary, Section 312 of the Internal Revenue Code will be triggered. Section 312 is used to determine how various corporate transactions, particularly to shareholders, affect a corporation’s earnings and profits. Section 312(a) of the Internal Revenue Code generally provides that a corporation’s earnings and profits are decreased by the amount of money distributed by such corporation. Section 312(h) of the Internal Revenue Code provides that earnings and profits are to be allocated between the foreign parent corporation and the newly formed U.S. corporation. Thus, in this case for U.S. tax accounting purposes, the earnings and profits of the foreign parent corporation and the newly formed U.S. company will need to be allocated. If the newly formed U.S. corporation will receive assets from the foreign parent, for U.S. tax accounting purposes, the foreign parent corporation as a general rule, will allocate its positive earnings and profits between itself and the newly formed U.S. corporation in the ratio that the fair market value of the distributed assets bears to the retained assets. See Treas. Reg. Section 1.312-10(a). However, for U.S. tax purposes, the foreign parent corporation may not allocate any negative earnings and profits to the newly formed U.S. corporation. See Treas. Reg. Section 1.312-10(c).

Section 367 Considerations

Anytime U.S. shareholders are involved in a cross-border corporation reorganization, Section 367 of the Internal Revenue Code must be considered. Section 367 was originally aimed at preventing tax-free transfers by U.S. taxpayers of appreciated property to foreign corporations that could then sell the property free of U.S. tax. The reach of Section 367 has been broadened over the years to apply to a broad spectrum of transactions involving transfers both into and out of the United States and, as a result of the enactment of a number anti-deferral of the Internal Revenue Code, to a variety of transactions involving only foreign corporations. Section 367(b), Treasury Regulation Section 1.367(b)-4, and Treasury Regulation Section 1.367(b)-5 govern inbound repatriating liquidations of foreign corporations and foreign subsidiaries. The principal purpose of these provisions is to preserve the ability of the United States to tax, either currently or at some future date, the earnings and profits of a foreign corporation attributable to shares owned by U.S. shareholders. Section 367(d) can potentially require gain recognition and income inclusion in certain circumstances to U.S. shareholders of a foreign corporation involved in a Type D spin-off. In order to minimize the possibility of a negative U.S. tax consequence to U.S. shareholders, the earnings and profits of the foreign distributing corporation and newly formed U.S. corporation should be allocated based upon a relative net adjusted basis of the assets contributed in the transaction. Section 367(d) and its regulations discuss the application of Section 1248 to built-in gains in the stock of the distributing corporation or its total earnings and profits. See Treasury Regulation Section 1.367(b)-2(c). Below is a detailed discussion regarding Section 1248 and its potential application to U.S. shareholders.

Potential Section 1248 Considerations to U.S. Shareholders in Connection with an Inbound Type D Reorganization

Before the addition of Section 1248 to the Internal Revenue Code, U.S. shareholders could “cash in” on and realize the economic benefit of the accumulated earnings of a foreign corporation at long-term capital gains tax rates. The capital gain result could be accomplished by selling stock of the foreign corporation at a price that would reflect the accumulated earnings of the controlled foreign corporation. It could also be achieved by liquidating the foreign corporation. In either event, the excess of the amount realized upon the sale or liquidation by the U.S. shareholder over the basis in the stock interest disposed of was usually taxed as long-term capital gain. By contrast, if the U.S. shareholder had repatriated the foreign earnings through dividend distributions, the earnings would have been taxed as ordinary income. Section 1248 prevents this result by, under specified circumstances treating the gain recognized on sale or exchange of the U.S. shareholder’s stock as a dividend to the extent that the gain reflects the shareholder’s interest in post-1962 undistributed earnings attributable to the stock sold or exchanged. Not all U.S. persons owning stock in all foreign corporations are swept into the Section 1248 net. Section 1248 applies only to U.S. persons who owned or were considered to have owned (under the rules of Section 958) ten percent or more of the voting power if the foreign corporation at any time during the five-year period before the sale or exchange when the corporation was a controlled foreign corporation (within the meaning of Section 957).

This means that Section 1248 can apply even though a foreign corporation is not a CFC at the time that the shareholder sells the corporation’s stock if the corporation met the definition of a CFC at any time during the five years before the stock sale at a time when the selling shareholder met the definition of a “U.S. shareholder” in Section 951(b). It also means that Section 1248 can apply to a U.S. person’s sale of stock in a foreign corporation even if the U.S. person does not at the time of sale meet the definition of a “U.S. shareholder” in Section 951(b) if the U.S. person met that definition at any time during the five years before the sale or exchange of stock when the foreign corporation was a CFC. See Treas. Reg. Section 1.1248-1(a)(4), Ex 2. Thus, a Section 1248 deemed dividend distributions may apply if there are any direct or indirect shareholders U.S. shareholders of the foreign parent corporation utilizing a Type D reorganization to establish a U.S. subsidiary if they were any “U.S. shareholders” within the definition of Section 951(b) within five years before planned reorganization. Thus, when a foreign corporation enters into a divisive Type D reorganization, the tax consequences to the U.S. shareholder of the CFC or previously classified CFC will be the foreign parent corporate shareholder’s Section 1248 amount is the lesser of the built-in gain in the stock of the corporation or its total earnings and profits. Under these rules. Treasury Regulation Section 1.367(b)-4 expands the application of Section 1248 to other circumstances which involve cross-border Type D reorganizations. For example, Treasury Regulation Section 1.367(b)-4(b)(1) discusses another method that a Section 1248 deemed dividend may be triggered. Under Treasury Section 1.367(b)-4(b)(1) a deemed dividend may be triggered if a U.S. person loses its Section 1248 status. Treasury Regulation Section 1.367(b)-2(b) states that a Section 1248 shareholder is any U.S. person that satisfies the ownership requirement of Section 1248(a)(2) or (c)(2) of the Internal Revenue Code with respect to the foreign corporation. To be considered a Section 1248 shareholder, a U.S. person must own, directly or indirectly under the definition of Section 958, 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation.

Under these regulations, if, immediately after a Type D reorganization involving a foreign corporation, the U.S. person is no longer a Section 1248 shareholder with respect to the acquiring corporation, the regulations impose a deemed dividend distribution. In another example how a Section 1248 deemed divided may be recognized is discussed in Treasury Regulation Section 1.367(b)-4(b)(2). In this example, a deemed dividend may occur when as the result of a cross-border exchange when (1) immediately before the exchange, the acquired corporation and the acquiring corporation were not members of the same affiliated group; 2) immediately after the exchange, a domestic corporation met the ownership threshold for deemed-paid foreign taxes under Section 902 of the Internal Revenue Code with respect to the acquiring corporation; and 3) the exchanging shareholder or shareholders received preferred stock in consideration for common stock or received tracking stock. (a tracking stock or target stock) is a special class of shares issued by a parent company that reflects the financial performance of a specific division or subsidiary, allowing investors to bet on that segment’s success without buying into the whole corporation). For purposes of this second provision, an affiliated group includes a chain of domestic and/or foreign corporations with a common parent corporation where 50 percent or more of the total voting power and value of the common stock of each member of the group is directly owned by one or more members of the group. See Treas. Reg. Section 1.367(b)-4(b)(2)(a). In any cross-border reorganization, the regulations under Section 367 and 1248 must be carefully considered.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding of the inbound tax-free corporate “spin-off” or “split-up” demerger. 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 foreign corporations, particularly foreign corporations with one or more U.S. shareholders considering establishing a U.S. subsidiary, review its particular circumstances with a qualified international tax attorney. 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.