By Anthony Diosdi
Whenever a U.S. person decides to establish a business outside offshore that will be conducted through a foreign corporation, it will likely be necessary to capitalize the foreign corporation with a transfer of cash and other property in exchange for corporate stock. When appreciated assets, such as equipment or intangible property rights (i.e., patents, trademarks, copyrights, and other intangible property), is transferred to a foreign corporation, the U.S. transferor may be subject to taxable gain. This taxable gain will be realized by the transferor unless one of the tax-free exchange provisions of the Internal Revenue Code applies.
The same applies to U.S. corporations. If a U.S. corporation is liquidated and its assets are distributed to a foreign corporation, U.S. tax will be imposed on the gains recognized by the distributing corporation. That is, unless a tax-free exchange provision contained in the Internal Revenue Code applies. If the stocks or assets of a U.S. corporation are acquired by a foreign corporation in exchange for stock of the foreign corporation, taxable gain may also be realized by the U.S. corporation unless the gain is sheltered by a tax-free exchange provision contained in the Internal Revenue Code.
Properly planned, under the Internal Revenue Code, most taxable gains realized in exchanges of appreciated property in connection with a variety of transactions involving U.S. corporations will qualify for tax-free exchange treatment. As a result of Internal Revenue Code Section 367, these tax-free exchange rules do not apply to cross border transactions. Section 367 was enacted to prevent tax-free transfers by U.S. transferors of appreciated property to foreign corporations that could then sell the property tax free. Section 367 has two basic rules. First, Section 367 ensures that (with certain exceptions) a tax liability or “toll charge” is imposed when property with untaxed appreciation is transferred abroad. This is accomplished by treating foreign transferred corporations as not qualifying as a “corporation” for purposes of the tax-free exchange provisions of the Internal Revenue Code. Second, Section 367 provides that the earnings of a controlled foreign corporation (“CFC”) do not avoid U.S. tax as a result of shifting assets to an entity that is not a CFC.
All outbound transfers by U.S. persons of appreciated property to foreign corporations and to certain other foreign persons will give rise to recognized gain provided in Internal Revenue Code Section 367(a) and (b). This article will discuss the complexities of Sections 367 and potential planning options.
Section 367(a) of the Internal Revenue Code
Internal Revenue Code Section 367(a) requires a U.S. person transferring appreciated property to a foreign corporation to recognize a gain on the transfer. The transaction subject to Section 367(a) that is most commonly encountered is probably a transfer of property to a foreign corporation in exchange for its stock under Internal Revenue Code Section 351. A liquidation of an 80-percent owned U.S. subsidiary into its foreign parent corporation is also encompassed by the terms of Section 367(a) but specifically dealt with in Section 367(e)(2).
Other transactions that less obviously involve outbound transfers of property are also subject to Section 367(a). Acquisition of the stock or assets of a U.S. corporation in exchange for stock of a foreign corporation in a reorganization described in Section 368(a) is normally within the scope of Section 367(a). Triangular Type A mergers, whether in the form of a forward triangular merger described in Section 368(a)(2)(E), in which the shareholder of the acquired U.S. corporation exchange their stock in the U.S. corporation for stock in a foreign corporation, are treated as an indirect transfer of stock by the U.S. shareholder to the foreign corporation. The same analysis applies to a triangular Type B reorganization in which a U.S. person transfers stock in the acquired U.S. corporation to a U.S. subsidiary of the foreign corporation in exchange for stock of the foreign corporation. A U.S. shareholder is also deemed to make a transfer of stock of a U.S. corporation if substantially all of its assets are acquired by a U.S. subsidiary of a foreign corporation in exchange for stock of the foreign corporation in a Type C reorganization and the U.S. acquired corporation is then liquidated.
The outbound toll charge does not apply to property transferred to a foreign corporation if the following requirements are satisfied:
1) The foreign corporation actively conducts a trade or business;
2) The trade or business is conducted outside the United States; and
3) The foreign corporation uses the property in that trade or business.
Of the aforementioned three prong tests such, the element most subject to abuse is the “trade or business” requirement. A foreign corporation conducts a “trade or business” outside the U.S. only if its officers and employees “carry out substantial managerial and operational activities.” This requirement may be met even though independent contractors carry out “incidental activities” of the trade or business on behalf of the foreign corporation. However, only the activities of the foreign corporation’s officers and employees are taken into account in determining whether the corporation’s officers and employees perform substantial managerial and operational activities. To meet the requirement that the trade or business be actively conducted outside the United States, “the primary managerial and operational activities of the trade or business must be conducted outside the United States and immediately after the transfer the transferred assets must be located outside the United States.”
To meet the requirement that the trade or business be actively conducted outside the United States, “the primary managerial and operational activities of the trade or business must be conducted outside the U.S. and immediately after the transfer the transferred assets must be located outside the United States.” The regulations further explain this as a requirement that substantially all the transferred assets be located outside the United States, not that every item of transferred property be used outside of the United States.”
Property is treated as used or held for use in a foreign corporation’s trade or business if it is:
1) Held for the principal purpose of promoting the present conduct of the trade or business;
2) Acquired and held in the ordinary trade or business; or
3) Held in a direct relationship to the trade or business.
The regulations treat property as held in a direct relationship to a trade or business if it is held to meet the present needs of the trade or business and not its future needs.
Internal Revenue Code Section 367(a) also imposes a tax or toll charge on the income realized on transfers of certain tainted assets even though they will be used in the active conduct of a foreign trade or business. Categories of tainted assets under Section 367(a) include 1) property described in Section 1221(a)(1) or 1221(a)(3) – relating to inventory and certain narrowly defined intellectual property (i.e., a copyright held by the creator of work); 2) installment obligations, accounts receivable or similar property to the extent that the taxpayer has not previously included the principal amount in income; 3) property with respect to which the transferor is a lesser at the time of the transfer, unless the transferred was the lessee; 4) foreign currency and other property denominated in foreign currency; and 5) depreciable property to the extent that gain reflects depreciation deductions that have been taken against U.S.-source income. Recapture gain is required as ordinary income on the transfer of depreciable property used in the United States to the extent that depreciation deductions previously claimed by the taxpayer with respect to the transferred property would be recaptured if the property were sold.
The regulations provide an exception to Section 367(a). The drafters at the Department of Treasury and the Internal Revenue Service recognized that when an outbound transfer of shares occurs and the owners of the U.S. corporation whose shares are transferred are minority shareholders, the Section 367(a) outbound toll charge should not apply because there is little chance for abuse. As a result, a “limited-interest” exception provision under Treasury Regulation Section 1.367(a)-3(c) was added to the regulations. A limited-interest exception provides for the nonrecognition of gain on the transfer of U.S. shares to a transferee foreign corporation provided five tests are met:
Branch Loss Recapture Rules
A major exception to the active foreign business use exception is the branch loss recapture rule. Under this provision, a U.S. person must recognize gain on the incorporation of a foreign branch to the extent the U.S. person has previously deducted branch losses against its other taxable income. A foreign branch is defined for this purpose as an integral business operation carried on by a U.S. person outside the United States. The amount of gain to be recognized is the sum of the previously deducted ordinary losses and the sum of the previously deducted capital losses.
Section 367(d) of the Internal Revenue Code
Congress recognized that transfers of manufacturing and marketing intangibles to a foreign corporation presented special problems. At one time, a U.S. taxpayer would develop intangibles and deduct the costs of such development against U.S. income. The U.S. taxpayer would then transfer the intangible to a foreign corporation for use in an active trade or business abroad tax-free. Even if a toll charge were imposed on the U.S. taxpayer at the time of transfer, it would not necessarily remedy the tax-avoidance potential inherent in these transfers. The value of the intangible at the time of transfer was often uncertain and speculative, resulting in an amount of gain recognition at the time of transfer that would not reflect the ultimate value of the intangible. To deal with these problems, special rules for intangibles were adopted by tax legislation set forth in Section 367(d) and 482.
Under Section 367(d), marketing and manufacturing intangibles, as broadly defined in Section 936(h)(3)(B), are treated as a special class of tainted assets. Intangible property is defined in Section 936(h)(3)(B) as any 1) patent, invention, formula, process, design, pattern or knowhow; 2) copyright, literary, musical or artistic composition; 3) trademark, trade name or brand name; 4) franchise, license or contract; 5) method, program, system, procedure, campaign , survey, study, forecast, estate, customer list or technical data, or 6) any similar item, which property has substantial value independent of the services of any individual.
In every case involving the transfer of such assets in a transaction falling within Section 351 or 361, the transferor will be treated as having sold the property in exchange for payments that are contingent on the productivity, use or exchange for payments that are contingent on the productivity, use or disposition of such property. These imputed or constructive royalty payments must reflect the amounts that would have been received annually in the form of such payments over the useful life of such property. See IRC Section 367(d)(2)(A)(ii)(I). These imputed or constructive royalty payments must reasonably reflect the amounts that would have been received annually in the form of such payments over the useful life of such property. Internal Revenue Code Section 367(d) provides that in the case of intangible property in a Section 351 or 361 exchange, the royalty income with respect to such transfer is to be commensurate with the income attributable to the intangible. This means that the constructive royalty is calculated in an amount that represents an arm’s length charge for the use of the property under the regulations of Section 482. Under certain circumstances, a U.S. transferor may transfer intangibles to a foreign corporation taxed entirely at the time of transfer as a taxable sale if certain circumstances are satisfied.
Actual Royalties Under License Agreement as Alternative to Constructive Royalty Treatment Under Section 367(d)
As an alternative to constructive royalties under Section 367(d) of the Internal Revenue Code, a U.S. transferor may prefer to enter into a license agreement with the transferred foreign corporation providing for actual royalties to the transferor for the use of the intangible. The U.S. tax treatment of actual and constructive royalties may qualify for favorable rates under the foreign derived intangible income (“FDII”) tax regime of merely 13.125%. On the foreign side, the actual royalty may be deductible for foreign tax purposes.
Gain Recognition Agreements
If the U.S. transformer owns 5 percent or more of the stock in a foreign corporation receiving foreign stock or securities in a foreign entity (i.e., the transferred property) and enters into a gain recognition agreement with the Internal Revenue Service (“IRS”), the taxpayer will be allowed to receive non-recognition treatment on the transfer of such stock. See Treas. Reg. Section 1.367(a)-3(b). A gain recognition agreement provides parameters under which the U.S. transferor, in a Section 367(a) applies, will recognize gain if the foreign corporation disposes of transferred property during the five-year term of the gain recognition agreement. The terms of a gain recognition agreement discuss “triggering events” that could cause an early termination of the gain recognition agreement and trigger recognition of gain on the transfer. If a trigger event occurs, the U.S. transferor must: 1) report the gain on an amended return for the year of transfer; 2) adjust the basis of assets on which the gain was recognized; and 3) pay additional penalties and interest on the tax assessed from the recognition event.
Examples of 367 in the Inbound and Outbound Acquisition and Reorganizations
The policy behind taxing the U.S. shareholder is to tax the appreciation in the shares before the shares leave the U.S. taxing jurisdiction. However, the regulation writers at the Internal Revenue Service recognized that when an outbound transfer of shares occurs and the owners of the U.S. corporation whose shares are transferred are minority shareholders, the outbound toll charge should not apply because there is little chance for abuse. As a result, a limited-interest exception provides for the nonrecognition of gain on the transfer of U.S. shares to a transferee foreign corporation provided five tests are met:
The U.S. transferor receive 50 percent or less of the shares of the transferred foreign corporation in the exchange;
1) The U.S. transferor receive 50% or less of the shares of the transferee foreign corporation in the exchange;
2) There is not a control group of U.S. persons with respect to the transferee foreign corporation immediately after the transfer. Under this control group test, officers, directors, and 5 percent or greater shareholders of the domestic corporation may not, in the aggregate, own more than 50 percent of the voting power or value of the transferred foreign corporation immediately after the transfer;
3) The transaction satisfies the active trade or business test, which is comprised of two parts, both of which must be satisfied: i) The transferred foreign corporation has engaged in an active trade or business outside the United States for 36 months; and ii) At the time of the exchange, neither the transferor nor the transferred foreign corporation intend to discontinue or dispose of the trade or business.
4) A U.S. transferor who owns 5 percent or more of the transferred foreign corporation immediately after the exchange must enter into a five-year gain recognition agreement. See Treas. Reg. Section 1.367(a)-8. Under the gain recognition agreement, the U.S. transferor must recognize any gain deferred on the initial transfer if the transferred foreign corporation disposes of the transferred shares within five years and
5) The value of the transferred foreign corporation is, at the time of the exchange, equal to or greater than the value of the domestic corporation.
Below, please find illustrations one through eleven which discusses how Section 367 applies to cross-border reorganizations and acquisitions.
Illustration 1.
Skipper, a U.S. citizen, wholly-owns and is the only officer of USMinnow, a domestic corporation in the cruise business. In what would otherwise constitute a tax-free share-for-share transaction, Skipper exchanges 100% of his shares of USMinnow for 3% of the voting shares of CANwhale, a Canadian corporation, which has operated a cruise business specializing in three-hour tours for years.
Skipper, who wants to stay in the cruise business, does not recognize gain as a result of satisfying the limited-interest exception as follows:
1) Skipper receives less than 50% of CANwhale (only 3%);
2) As the only shareholder, officer or 50% shareholder of USMinnow, Skipper does not own more than 50% of CANwhale, the transferee foreign corporation, immediately after the transfer (Skipper only owns 3%).
3) CANwhale has operated for more than 36 months and neither Skipper not CANwhale intends to discontinue or dispose of CANwhale’s trade or business;
4) By acquiring only 3% of CANwhale, Skipper does not need to enter a gain recognition agreement. However, if Skipper acquires between 5% and 40% of CANwhale, he would have to file a five-year gain recognition agreement; and
5) Considering that CANwhale is a substantially larger company than USMinnow, the transferred foreign corporation is, at the time of the exchange, greater than the value of the domestic corporation. See Practical Guide to U.S. Taxation of International Transactions, Robert J. Misery, Jr. and Michael S. Schadewald, 2007 CCH.
Cross-Border Type A Reorganizations Under the 367 Tax Regime
Type A reorganizations is a “statutory merger or consolidation.” These are mergers or consolidations effected pursuant to state corporate law. One corporation retains its existence and absorbs the other or others. Type A mergers or reorganizations are typically tax-free. In the context of international corporate acquisitions, tax-free statutory mergers often take the form of forward triangular mergers, in which the acquired corporation is merged into a subsidiary of the acquiring corporation. To avoid the loss of the U.S. taxing jurisdiction, the U.S. shareholders of a foreign corporation merged out of existence must include their share of the foreign corporation’s earnings and profits as a deemed dividend. See Treas. Reg. Section 1.367(b)-3(b)(3). Below, please find Illustration 2 and Illustration 3 which provides examples of Type A reorganizations in the international context taking into consideration Section 367.
Illustration 2. Inbound Type A Merger
Assume that Foreign Target merges with and into U.S. Acquiror. Further assume that Foreign Target’s shares are worth $1 million at the time of the merger and that Foreign Target’s U.S. shareholders have a $100,000 tax basis in their Foreign Target shares. Finally, assume that the merger consideration received by Foreign Target’s shareholders consists of U.S. Acquiror shares with a fair market value of $1 million. Although the merger occurs with a foreign corporation, the merger now qualifies as a Type A merger. The individual U.S. shareholders of Foreign Target must include in income as a dividend the earnings and profits of Foreign Target. See Treas. Reg. Section 1.367(b)-3(b)(3)(i).
Illustration 3. Outbound Type A Merger
Assume that Foreign Target merges with and into Foreign Acquiror. Further assume that Foreign Target’s shares are worth $1 million at the time of the merger and that Foreign Target’s U.S. shareholders have a $100,000 basis in their Foreign Target shares. Finally, assume that the merger consideration received by Foreign Target’s shareholders consists of Foreign Acquiror’s shares with a fair market value of $1 million. If the former Foreign Target would not be a CFC or the individual U.S. shareholders would not be U.S. shareholders, the individual U.S. shareholders must include a dividend to the extent of their share of Foreign Target’s earnings and profits.
Cross-Border Type B Reorganizations Under the 367 Tax Regime
A Type B reorganozation is a stock-for-stock transaction in which one corporation (the acquiring corporation) acquires the stock of another corporation (the target corporation). Only voting stock of the acquiring corporation or its parent may be used in the acquisition. A Type B share-for-share acquisition is tax-free as long as there is no other consideration and the acquiring corporation has control of the target corporation immediately after the transaction. Below, please find Illustration 4 and Illustration 5 which provides examples of Type B reorganizations in the international context taking into consideration Section 367.
Illustration 4. Inbound Share-For-Share Acquisition
Assume that U.S. Acquiror wishes to acquire Foreign Target. Further assume that Foreign Target’s single class of shares is worth $1 million. Finally, assume that U.S. Acquiror issues $1 million worth of U.S. Aquiror’s voting shares to Foreign Target’s U.S. shareholders in exchange for their Foreign Target shares. The share-for-share exchange should qualify as a Type B acquisition. Foreign Target’s U.S. shareholders should not recognize gain because both 1) they are acquiring property (the U.S. Acquiror’s shares) within the U.S. taxing jurisdiction.
A Type B share-for-share acquisition is tax-free as long as there is no other consideration and the Acquiror has control of the target immediately after the transaction. Because this could be considered an outbound tax-free incorporation, the outbound toll charge rules must be analyzed. If the outbound toll charge applies, the analysis ends and the U.S. shareholders will recognize gain. If the outbound toll charge does not apply, such as due to the limited-interest exception, then a U.S. shareholder of a CF who receives shares of a non-CFC or shares of a CFC in which the U.S. person would not be a U.S. shareholder must include the earnings and profits of target as dividend.
Illustration 5. Outbound Share-For-Share Acquisition
Skipper, a U.S. citizen, wholly-owns FMinnow, a foreign corporation engaged in the shipped business. In what would otherwise constitute a share-for-share acquisition, Skipper exchanges 100% of his shares of FMinnow for 3% of the shares of CANwhale, a publicly-held Canadian corporation on the Toronto Stock Exchange. This transaction satisfied the Type B rules and the limited-interest exception should apply to avoid the outbound toll charge. However, Skipper must include a dividend to the extent of FMinnow’s earnings and profits.
Cross-Border Type C Reorganizations Under the 367 Tax Regime
A Type C reorganization is where a target corporation (“target”) transfers “substantially all” of its properties to an acquiring corporation solely in exchange for all or a part of Acquiror’s voting stock. To avoid the loss of the U.S. taxing jurisdiction, the U.S. shareholders of a foreign corporation gone out of existence must include their shares of the foreign corporation’s earnings and profits as a deemed dividend. See Treas. Reg. Section 1.367(b)-3(b)(3)(3)(ii) (Ex. 5).
Illustration 6. Inbound Share-For-Asset Acquisition
Assume that U.S. Acquiror acquires Foreign Target’s assets for U.S. Acquiror’s voting shares. Further assume that Foreign Target subsequently distributes the U.S. Acquiror’s shares to its U.S. shareholders in liquidation. This transaction should qualify as a Type C acquisition. Depending on the circumstances, any U.S. shareholders of Foreign Target should recognize a dividend to the extent of earnings and profits of the Foreign Target. Even if Foreign Target had significant liabilities incurred in the ordinary course of business, the transaction would still be a good Type C acquisition.
Illustration 7. Outbound Share-For-Asset Acquisition
Skipper, a U.S. citizen, wholly-owns FMinnow, a foreign corporation engaged in the shipping business. In what would otherwise constitute a tax-free shares-for-assets acquisition, CANwhale, a publicly held Canadian corporation traded on the Toronto Stock Exchange, acquires all of FMinnow’s assets for 3% of CANwhale’s voting shares. Further assume that FMinnow subsequently distributes the CANwhale shares to Skipper in liquidation. As a result, the transaction should qualify as a Type C acquisition. However, because Skipper, who was formerly a U.S. shareholder in a CFC now owns only 3% of the shares of a non-CFC (CANwhale), Skipper must include the earnings and profits of FMinnow as a dividend.
Inbound Forward Triangular Reorganizations
A forward triangular reorganization occurs when an acquiror uses the shares of its parent as the target merges into the acquiror, resulting in the acquiror receiving substantially all the target’s assets. To avoid the loss of the U.S. taxing jurisdiction, the U.S. shareholders of a foreign corporation merged out of existence must include their shares of the foreign corporation’s earnings and profits as a deemed dividend. See Treasury Regulation Section 1.367(b)-3(b)(3)(i).
Illustration 8. Inbound Forward Triangular Reorganization
Assume that U.S. Parent, a publicly-traded domestic corporation, wishes to acquire Foreogn Target’s business, but does not want to incur the expense of obtaining its shareholders’ approval for a straight merger of Foreign Target into U.S. Parent. Further assume that U.S. Parent owns a wholly-owned subsidiary, U.S. acquiror, for the purpose of obtaining Foreign Target’s business. Finally, assume that Foreign Target merges with and into U.S. Acquiror, with Foreign Target’s U.S. shareholders receiving U.S. Parent shares as the merger consideration and U.S. Acquiror surviving the merger while obtaining Foreign Target’s assets. If the various requirements are satisfied, the merger would qualify as a forward triangular reorganization. Although the forward triangular reorganization rules require a merger that “would have qualified” as a Type A merger, the IRS has provided guidance that this qualifies as a Type A merger. See Treas. Reg. Section 1.368-2(b)(1)(iii)(Ex. 13). The individual U.S. shareholder of Foreign Target must include in income as a dividend the earnings and profits of Foreign Target.
Inbound Reverse Triangular Reorganizations
A reverse triangular reorganization is similar to a forward triangular reorganization, except that the surviving entity is the target and not the acquiror. More specifically, after the transaction, the surviving target holds substantially all of its own and the Acquiror’s assets and the former shareholders of the surviving target exchange their shares of the Acquiror’s parent.
Illustration 9. Reverse Triangular Reorganization
Assume that U.S. Parent, a publicly-traded corporation, wishes to acquire Foreign Target’s business, but does not want to incur the expense of obtaining its shareholders’ approval for a straight merger of Foreign Target into U.S. Parent. Further assume that U.S. Parent forms a wholly owned subsidiary, U.S. Acquiror, as an acquisition vehicle. Finally, assume that U.S. Acquiror merges with and into Foreign Target, with Foreign Target’s shareholders receiving U.S. Parent shares as the merger consideration and with Foreign Target surviving the merger. Because Foreign Target, with its earnings and profits, remains in existence, any income inclusion is unnecessary. See Treas. Reg. Section 1.367(b)-3(b)(3).
Foreign-To-Forward Triangular Reorganizations
A forward triangular reorganization occurs when an acquiror uses the shares of its parent as the target merges into the acquiror, resulting in the acquire receiving substantially all of the target’s assets. As with the foreign-foreign Type B acquisition, because this could be considered an outbound tax-free incorporation, the outbound toll charge rules must be analyzed. If the outbound toll charge applies, the analysis ends and the U.S. shareholders will recognize gain. See Treas. Reg. Section 1.367(a)-3(b)(2). If the outbound toll charge does not apply, such as due to the limited-interest exception, then a U.S. shareholder of a CFC who receives shares of a non-CFC or shares of a CFC in which the U.S. person would not be a U.S. shareholder must include the earnings and profits of the target as a dividend. See Treas. Reg. Section 1.367(b)-1(a).
Illustration 10. Foreign-To-Forward Triangular Reorganization
Assume that Foreign Parent, a foreign corporation, wishes to acquire Foreign Target’s business, but does not want to incur the expense of obtaining its shareholders’ approval for a straight merger of Foreign Target into Foreign Parent. Further assume that Foreign Parent wholly owns a subsidiary, Foreign Acquiror, for the purpose of obtaining Foreign Target’s business. Finally, assume that Foreign Target merges with and into Foreign Acquiror, with Foreign Target’s U.S. shareholders receiving Foreign Parent shares as the merger consideration and Foreign Acquiror surviving the merger while obtaining the assets of Foreign Target. If the various requirements are satisfied, the merger qualifies as a forward triangular reorganization . If this transaction satisfies the limited interest exception, the outbound toll charge should not apply. Because the transaction is also covered by the inbound rules, the individual U.S. shareholders that are no longer U.S. shareholders of a CFC (Foreign Target) must include a dividend to the extent of their shares of the earnings and profits of Foreign Target. See Treas. Reg. Section 1.367(a)-3(d)(1)(i).
Foreign-To-Foreign Reverse Triangular Reorganizations
A reverse triangular reorganization is similar to a forward triangular reorganization, except that the surviving entity is the target and not the acquiror. More specially, after the transaction, the surviving target holds substantially all of its own and the acquiror’s assets and the former shareholders of the surviving target exchange their shares for shares of the acquiror’s parent. Because this could be considered an outbound tax-free reorganization, the outbound toll charge rules must be analyzed. If the outbound toll charge applies, the analysis ends and the U.S. shareholders will recognize gain. See Treas. Reg. Section 1.367(a)-3(b)(2). If the outbound toll charge does apply, such as due to the limited-interest exception, then a U.S. shareholder of a CFC who receives shares of a non-CFC or shares of a CFC in which the U.S. person would not be a U.S. shareholder must include the earnings and profits of the target as a dividend. See Treas. Reg. Section 1.367(b)-1(a).
Illustration 11. Foreign-To Foreign Reverse Triangular Reorganizations
Assume that Foreign Parent, a publicly-traded foreign corporation, wishes to acquire Foreign Target’s business, but does not want to incur the expense of obtaining its shareholders’ approval for a straight merger of Foreign Target into Foreign Parent. Further assume that Foreign Parent forms a wholly-owned subsidiary, Foreign Acquiror, as an acquisition vehicle. Finally, assume that Foreign Acquiror merges with and into Foreign Target, with Foreign Target’s shareholders receiving Foreign Parent shares as the merger consideration and with Foreign Target surviving the merger. This transaction could be covered by the outbound rules, but if the transaction satisfies the limited interest exception, the outbound toll charge should not apply. Because Foreign Target, with its earnings and profits, remains in existence, any dividend inclusion under the inbound rules is unnecessary. See Treas. Reg. Section 1.367(a)-3(d)(1)(ii).
Foreign Reporting Requirements
So that the IRS will be informed of outbound transfers covered by Section 367, Section 6038B requires the U.S. persons involved to notify the IRS of the existence of these transactions. In order to assist the Internal Revenue Service police outbound transfers of U.S. property, a U.S. person who transfers property to a foreign corporation must attach Form 926, Return by Transferor of Property to a Foreign Corporation, to their U.S. federal tax return for the year of the transfer. The penalty for a failure of a U.S. person to properly report a transfer to a foreign corporation equals to 10% of the fair market value of the property transferred. The penalty cannot exceed $100,000 unless the failure is due to an intentional disregard of the reporting rules.
Conclusion
In response to changing business conditions, U.S. corporations routinely organize new subsidiaries and divide, merge, and liquidate existing subsidiaries. With proper planning, these corporate adjustments may be tax-free transactions, based on the principle that the transactions involve a change in the form of the corporation’s investment. However, if the subsidiary is a foreign corporation, then the ultimate disposition of any appreciated property may occur outside the U.S. taxing jurisdiction and could be subject to a so-called toll-charge. In these cases an international tax attorney should be consulted to determine how this toll-charge could be eliminated or mitigated. In addition, to help the IRS to better police the outbound transfers of “property,” a U.S. person who transfers “property” to a foreign corporation must attach Form 926, Return by Transferor of Property to a Foreign Corporation, to their regular tax return for the year of the transfer and comply with other requirements. This reporting requirement applies to outbound transfers of both tangible and intangible property. Failure to comply with these rules may result in significant penalties. A qualified international tax attorney can advise you how to avoid these penalties.
Anthony Diosdi is an international tax attorney with the firm of Diosdi Ching & Liu, LLP. Anthony Diosdi is a member of the California and Florida bars. He provides international tax advice to individuals, closely held entities, and publicly traded corporations. Anthony Diosdi has written numerous articles and spoken on a number of panels discussing international taxation at continuing education programs.
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: 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.