By Anthony Diosdi
Whenever a U.S. person decides to establish a foreign corporation (or foreign business entity), it will be necessary to capitalize the foreign corporation with a transfer of cash and other property in exchange for its stock. When appreciated property, such as equipment or certain property rights, is transferred to a foreign corporation, gain will often be realized by a U.S. person. The basic problem is the need to protect the right of the country of residence of the transferor corporation or shareholder to tax gains realized by its taxpayer in the transaction. The concern of that country is that, if not taxed immediately, the gain will escape its tax net permanently. Since 1932, Internal Revenue Code Section 367 has provided the mechanism for protecting the U.S. taxing jurisdiction in transactions involving transfers by U.S. taxpayers of appreciated property in exchange for stock when one or more foreign corporations are involved.
Section 367 of the Internal Revenue Code was originally aimed at preventing tax-free transfers by U.S. taxpayers of appreciated property to foreign corporations that could sell the property free of U.S. tax. The reach of this provision has been broadened over the years to apply to a broad spectrum of transactions involving transfers both into and out of the United States. Today, Internal Revenue Code Section 367(a) provides a general rule of taxability with respect to outbound transfers of property in exchange for other property in transactions described in Section 332, 351, 354, 356 or 361 by stating that a foreign corporation will not be considered a corporation that could qualify for nonrecognition of gain under one of the enumerated Code sections. Section 367 requires U.S. persons transferring appreciated property to a foreign corporation to recognize a gain on the transfer. This result is achieved by denying the foreign corporation corporate status, in which case the general rules for taxable exchanges apply. The types of corporate transactions that typically fall within the scope of Section 367(a) include:
1) Incorporations- A U.S. person’s contribution of property to a foreign corporation in exchange for shares of the foreign corporation;
2) Liquidations- A domestic subsidiary corporation’s distribution of assets in complete liquidation to a foreign parent corporation;
3) Reorganizations- A U.S. person’s transfer of shares or property to a foreign corporation as part of a corporate reorganization.
The character and source of gain produced by Section 367 is determined as if the transferor had sold the property to the transferred in a taxable transaction. Under the pre-2018 rules, Section 367(a) required taxpayers to recognize gain on outbound transfers unless: 1) the transfer qualified for an active trade or business exception, or 2) the assets consisted of stock or securities of a foreign corporation and the U.S. transferor entered into a gain-recognition agreement to preserve gain. In the Tax Cuts and Jobs Act, Congress eliminated the active trade or business exception. This means that it is no longer to incorporate a foreign branch for purposes of a tax-free cross-border reorganization. The only exception to Section 367(a) that now remains for purposes of tax-free cross-border reorganizations is to transfer stock to a foreign corporation by virtue of a gain-recognition agreement.
Gain Recognition Agreements
The general rule of taxability applies to transfers of stock or securities by a U.S. person to a foreign corporation unless an exception is available. One such exception is the execution of a closing agreement between the Internal Revenue Service (“IRS”) and the U.S. transferor under which the transferor must agree to recognize taxable gain on the transferee corporation’s later disposition of the transferred stock or securities (a “gain-recognition agreement”). The gain-recognition agreement requires the U.S. transferor to recognize any realized gain in the transferred stock or securities not recognized at the time of transfer if the transferee foreign corporation disposes of the transferred stock or securities during the five-year gain-recognition period. Gain recognition to the U.S. transferor is also triggered if the corporation (the “transferred corporation”) disposes of substantially all of its assets. If the transferee foreign corporation disposes of the transferred property (or the transferred corporation disposes of substantially all of its assets) during the five-year period in which the gain-recognition agreement is in effect, the U.S. transferor must recognize any previously unrecognized gain plus pay an interest charge. If gain is triggered under the gain-recognition agreement, the U.S. transferor files an amended federal income tax return for the year of the transfer, reporting the previously unrecognized gain and interest charge or the transferor may report the previously unrecognized gain and interest charge on the return in which the triggering event occurs.
A gain-recognition agreement is an agreement to which the U.S. transferor agrees to recognize gain if the transferred foreign corporation disposes of the transferred stock or securities during the term of the gain recognition and pay interest on any additional tax owing if a “triggering event” occurs. For purposes of Section 367(a), the term “United States transferor” includes: 1) a citizen or resident of the United States; 2) a domestic corporation; 3) a U.S. citizen, resident, or domestic corporation that is directly or indirectly a partner in a domestic or foreign partnership that transfers property to a foreign corporation; and 4) any estate or trust (other than a foreign estate or trust under Section 7701(a)(31). A “triggering event” typically takes place when a foreign corporation disposes of the untaxed U.S. property. In most cases, a gain recognition agreement term is 60 months following the end of the taxable year in which the initial transfer is made.
Below, please see Illustration 1. and Illustration 2. which demonstrates typical situations where a gain recognition agreement would be required.
A U.S. parent corporation with two direct foreign subsidiaries (FS1 and FS2) transfers shares of FS1 to FS2 in a transaction that would otherwise qualify as a tax-free reorganization under Section 368 or a tax-free exchange under Section 351.
Foreign Acquirer acquires U.S. Target. U.S. Target’s shares are worth $10 million.
If a gain recognition agreement is not timely filed with the IRS or a U.S. transferor fails to comply with the terms of a gain recognition agreement (i.e., provide the IRS with an annual certification that a triggering event has taken place), the IRS could assess a penalty equal to 10 percent of the fair market value of the property transferred. However, the penalty does not apply if the U.S. person can show that the failure to comply was due to reasonable cause and not due to willful neglect. The total penalty cannot exceed $100,000 unless the failure is due to an intentional disregard of reporting requirements.
A United States transferor must file IRS Form 8838 if it enters into a gain recognition agreement with the IRS pursuant to Section 367(a) with respect to transferred property. A U.S. transferor must agree to extend the statute on transfers described in Section 367(a) for at least eight tax years following the tax year of the transfer on the Form 8938. In the case of domestic liquidating corporations and foreign distributee corporations described in Section 367(e)(2), the U.S. transferor must agree to extend the statute of limitations for at least three years after the date on which all items of property distributed to the foreign distributee are no longer used in a trade or business within the United States.
At a minimum a gain recognition agreement should include the following:
1) The identifying number of the U.S. transferor (i.e., social security number or employer identification number);
2) A list of controlling shareholders if any shares remain in existence after the transfer;
3) The name, address, identifying number or other identifying information, country code, and foreign law jurisdiction of the foreign transferred and the gain recognition agreement should state whether or not the foreign transferee is a controlled foreign corporation;
4) The date of transfer, description of property (i.e., currency, stocks, securities, inventory, intangible property, or property that was previously depreciated in the U.S.), fair market value of the property on the date of transfer, cost basis of the property transferred, and gain realized on the transfer;
5) A definition of a “triggering event.”
A gain recognition agreement provides the parameters under which a U.S. transferor will recognize gain if the foreign corporation sells or disposes transferred property during the 60 month term of the agreement. If a triggering event occurs, the U.S. transferor must: 1) report the taxable gain on an amended tax return on the year of transfer; 2) adjust the basis of the asset or assets for which the gain was realized; and 3) pay any applicable penalties and interest on the tax assessed as a result of the recognition.
The IRS issued Notice 2005-74 to provide guidance regarding gain-recognition agreements. Under Notice 2005-74, a U.S. taxpayer can avoid realizing taxable gain in connection with a gain-recognition agreement if all the conditions are satisfied:
1. The U.S. transferor was a member of a consolidated group in the year in which the gain-recognition agreement was originally entered into (“original consolidated group”), and the common parent of the group (“U.S. parent corporation”) entered into the original gain recommendation agreement.
2. Immediately after the asset reorganization, the successor U.S. transferor is a member of the original consolidated group.
3. The U.S. parent corporation of the original consolidated group enters into a new gain-recognition agreement, modified by substituting the successor U.S. transferor in place of the original U.S. transferor.
4. The successor U.S. transferor includes the new gain-recognition agreement within its next tax return.
Below please see Illustration 3 which discusses how a taxpayer can avoid triggering a taxable gain through a gain recognition agreement by satisfying the above conditions.
USP, a domestic corporation, owns 100 percent of the stock of two foreign corporations, FC1 and FC2. In Year 1, USP transfers 100 percent of the stock of FC1 and FC2 in an exchange described in Section 351 and, pursuant to Treasury Regulation 1.367-3(b)(1)(ii) and 1.367(a)-8, enters into a gain recognition agreement with respect to such transfer. In Year 4, in a reorganization described in Section 368(a)(1)(C), FC1 transfers all of its assets to FC3, an unrelated foreign corporation, in exchange for FC3 stock. FC1 transfers the FC3 stock to FC2 in exchange for the FC1 stock held by FC2 and the FC1 stock is canceled.
Pursuant to condition three discussed above, the transfer of the FC1 assets to FC3 in exchange for FC3 stock and the exchange of the FC1 stock for FC3 stock will not trigger the gain-recognition agreement if, in addition to complying with the reporting requirements of the Internal Revenue Code, USP enters into a new gain-recognition agreement pursuant to which it agrees to recognize gain with respect to the transfer subject to the original gain-recognition agreement, substituting FC3 as the successor transferred corporation in place of FC1, treating FC3 as the original transferred corporation for purposes of Treasury Regulation Section 1.367(a)-8 and treating only the assets acquired by FC3 from FC1 pursuant to Section 368(a)(1)(C) reorganization as assets subject to the deemed disposition of stock rules under Treasury Regulation 1.367(a)-8(e)(3)(i). Thus, for purposes of the new gain-recognition agreement, Treasury Regulation Section 1.367(a)-8, USP continues to be the U.S. transferor, FC2 continues to be the transferee foreign corporation, and FC3 is the successor transferred corporation and is treated as the original transferred corporation. The new gain recognition agreement applies through the close of Year 3 (the remaining term of the original gain recognition agreement filed by USP).
For the most part, when a gain-recognition agreement is in effect, if the original transferee foreign corporation to another foreign corporation (“successor transferee foreign corporation”) in an asset reorganization, the exchange will trigger a taxable event. However, Notice 2005-74 provides that a taxable event will not take place if the following elements are satisfied:
1. The U.S. transferor enters into a new gain-recognition agreement in which it agrees to realize gain during the remaining term of the original gain-recognition agreement. In the new gain-recognition agreement, the successor transferee foreign corporation is substituted in place of the original transferee foreign corporation.
2. The successor U.S. transferor includes the new gain-recognition agreement with its new tax return.
Below please see Illustration 4 which discusses how a U.S. taxpayer can avoid triggering a taxable gain through a gain recognition agreement by satisfying the two above discussed conditions.
USP, a domestic corporation, owns 100 percent of the stock of two foreign corporations, FC1 and FC2. In Year 1, USP transfers 100 percent of the stock of FC1 to FC2 in an exchange described in Section 351 and, pursuant to Treasury Regulations 1.367(a)-3(b)(1)(ii) and 1.367(a)-8, enters into a gain-recognition agreement with respect to such transfer. In Year 2, FC2, FC2 transfers property to FC1 in exchange for newly issued FC1 stock. In Year 4, FC2 distributes all of its FC1 stock to USP in a liquidating distribution that qualifies under Sections 332 and 337.
In determining whether the gain-recognition agreement entered into by the USP is determined, or in the alternative triggered, only the stock of FC1 transferred by USP to FC2 in Year 1 is considered in determining whether immediately following the Section 332 liquidation, USP’s basis in the transferred stock is less than the equal to the basis that it had in such stock immediately prior to the initial transfer that necessitated the gain-recognition agreement. Thus, the basis in the FC1 stock issued to FC2 in Year 2, in exchange for property, is not taken into account. The result in this illustration would remain the same if, instead of FC1 actually issuing stock in FC2 in exchange for the transferred property FC1 was deemed to issue stock to FC2 in exchange for such property.
Anytime domestic property is transferred to a foreign corporation, an international tax attorney should be consulted to determine if informational returns should be filed with the IRS and if a gain recognition agreement should be negotiated with the IRS. Failure to timely informational returns and enter into a gain-recognition agreement with the IRS could result in significant penalties and unnecessary tax liabilities. It should be noted this article does not apply to the outbound transfers of intangible property, including goodwill and going concern value. Internal Revenue Code Section 367(d) treats the transfer of certain intangible property as if the property was sold in exchange for payments that are contingent on the productivity, use or disposition of the intangible. In these cases, the U.S. transferor must, over the useful life of the intangible property, annually include in the gross income an appropriate arm’s-length charge determined in accordance with Internal Revenue Code Section 482 and its applicable regulations. We will discuss Section 367(d) in more detail in future articles.
We have substantial experience advising U.S. persons investing abroad of their compliance obligations. We have provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi advises both U.S. and international individuals in relation to a broad range of personal taxation and estate planning matters. He has extensive experience of advising on complex cross-border estate planning matters. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
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.