By Anthony Diosdi
In general, Section 367 governs corporate restructurings under Sections 332, 351, 354, 355, 356, and 361 (Subchapter C nonrecognition transactions) in which the status of a foreign corporation as a “corporation” is necessary for the application of the relevant subchapter C nonrecognition provisions. Other provisions in subchapter C (subchapter C carryover provisions) apply to such transactions in conjunction with the enumerated provisions and detail additional consequences that occur in connection with the transaction. For example, Sections 362 and 381 govern the carryover of basis and earnings and profits from the transferor corporation to the transferee corporation in applicable transactions.
The subchapter C carryover provisions generally have been drafted to apply to domestic corporations and U.S. shareholders. As a result, those provisions often do not fully take into account the cross-border aspect of U.S. taxation. For example, Section 381 does not specifically take into account source and foreign tax credit issues that arise when earnings and profits move from one corporation to another.
Congress enacted Section 367(b) to ensure that international tax considerations in the Internal Revenue Code were adequately addressed when the Subchapter C provisions apply to an exchange involving a foreign corporation. A primary consideration in this regard is to prevent the avoidance of U.S. taxation. Internal Revenue Code Section 367(b)(2) provides in part that the regulations “shall include (but shall not be limited to) regulations providing the extent to which adjustments shall be made to earnings and profits, basis of stock or securities, and basis of assets.”
Inbound Nonrecognition Transactions
Treasury Regulation Section 1.367(b)-3 addresses acquisition by a domestic corporation (domestic acquiring corporation) of the assets of a foreign corporation (foreign acquired corporation) in a Section 332 liquidation or an asset acquisition described in section 368(a)(1), such as an A, C, D, or F reorganization (inbound nonrecognition transaction). Regulations applying Section 367 and Section 368 to cross border A reorganization were issued.
As a general policy matter, the importation of various tax attributes in inbound transactions is carefully scrutinized by the income tax regulations. Treasury Regulation 1.367(b)-7 applies to an acquisition by a foreign corporation (foreign acquiring corporation) of the assets of another foreign corporation (foreign target corporation) in a transaction described in Section 381 (foreign Section 381 transaction) and addresses the manner in which earnings and profits and foreign income taxes of the foreign acquiring corporation and foreign target corporation carry over to the surviving foreign corporation (foreign surviving corporation).
Regulations Related to Foreign Section 381 Transactions
Section 1.367(b)-7 applies to an acquisition by a foreign corporation (foreign acquiring corporation) of the assets of another foreign corporation (foreign target corporation) in a transaction described in Section 381 (foreign Section 381 transaction) and addresses the manner in which earnings and profits and foreign income taxes of the foreign acquiring corporation and foreign target corporation carry over to the surviving foreign corporation (foreign surviving corporation).
Historically, the principal Internal Revenue Code sections implicated by the carryover of earnings and profits and foreign income taxes in a foreign Section 381 transaction were Sections 381, 902, 904, and Section 959. Internal Revenue Code Section 381 permitted earnings and profits (or deficit in earnings and profits) to carry over to a surviving corporation, thus enabling “the successor corporation to step into the ‘tax shoes’ of its predecessor. *** [and] represent the economic integration of two or more separate businesses into a unified business enterprise.” H. Rep. No. 1337, 83rd Cong., 2nd Sess. 41 (1954). However, a deficit in earnings and profits of either the transferee or transferor corporation could only be used to offset earnings and profits accumulated after the date of transfer. See IRC Section 381(c)(2)(B). This is commonly known as the “hovering deficit rule.” The hovering deficit rule is a legislative mechanism designed to deter the trafficking of favorable tax attributes that the IRS and courts had repeatedly encountered. See Commissioner v. Phipps, 366 U.S. 410 (1949). These regulations generally adopt the principles of Section 381 in the crossborder context, but adapt its operation in consideration of the international provisions that address foreign corporations’ earnings and profits and their related foreign income taxes, such as Sections 902, 904, and 959.
Thus, for example, these regulations apply the Section 381 earnings and profits combination and deficit rules be reference to the separate categories of income described in Section 904(d) and elsewhere (baskets) that are used to compute foreign tax credit limitations. Section 902 provides that a deemed foreign tax credit is available to a domestic corporation that receives a dividend from a foreign corporation in which it owns 10 percent or more of the voting stock. The Internal Revenue Code provides for the computation of deemed-paid taxes with regard to dividends from the relevant foreign corporations first out of multi-year pools of earnings and profits accumulated (and related foreign income taxes paid or deemed paid) in taxable years beginning after December 31, 1986, or beginning with the first year in which a domestic corporation owns 10 percent or more of the voting stock of a foreign corporation, whichever is later. See IRC Section 902(c). (The Internal Revenue Code and regulations refer to pooled earnings and profits and foreign income taxes as post-1986 undistributed earnings and post-1986 foreign income taxes even though a particular corporation).
Congress enacted the pooling rules because it believed that blending foreign income taxes and earnings and profits into “pools” from which distributions are made was fairer and more appropriate than computing deemed-paid taxes with reference to annual layers of earnings and profits (and foreign income taxes). Averaging foreign income taxes through these blended pools prevented taxpayers from inflating their foreign subsidiary’s effective tax rate for a particular year in order to obtain artificially enhanced foreign tax credits. Averaging also prevents the trapping of foreign income taxes in years in which a foreign subsidiary has no earnings and profits for U.S. tax purposes. However, Congress enacted pooling on a limited basis. Earnings and profits accumulated (and related foreign income taxes paid or deemed paid) in taxable years before the first year a foreign corporation qualifies as a pooling corporation and pre-1987 earnings and profits accumulated (and related foreign income taxes paid or deemed paid) by a pooling corporation are not pooled. Rather, such earnings and profits are maintained in separate annual layers. See IRC Section 902(c)(6).
A distribution of earnings and profits was first out of pooled earnings and profits and then, only after all pooled earnings and profits have been distributed, out of annual layers of earnings and profits on a LIFO bases. See IRC Section 902(a) and (c). The retention of annual layers beneath pooled earnings and profits limited the need to recreate tax histories. The foreign tax credit limitation ensured that taxpayers could use foreign tax credits only to offset U.S. tax on foreign source income. The limitation was computed separately with respect to different baskets of income derived from different types of activities. (From 1987 through 2006, section 904 provided for eight different baskets of income; for tax years beginning after December 31, 2006, all but two Section 904(d) baskets of income were eliminated. The American Jobs Creation Act of 2004, Public Law 108-357, 118 Stat. 1418 (AJCA), Section 404(a). The purpose of the baskets was to limit taxpayers’ ability to cross-credit taxes imposed with respect to different categories of income. Congress was concerned that, without separate limitations, cross-crediting opportunities would distort economic incentives to invest in the United States versus abroad.
Regarding the application of the hovering deficit rule on a “basket-by-basket” basis, under the regulations, a pre-transaction deficit in a particular basket is generally subject to the hovering deficit rule of Section 381. As a result, that deficit is not taken into account in determining the current or accumulated earnings and profits of the surviving corporation for any purpose, including for purposes of determining dividends under Section 316 and for determining foreign tax credits under Section 902. However, any such pre-transaction deficits in earnings and profits may be used to offset a foreign surviving corporation’s accumulated (but not current) post-transaction earnings and profits in the same basket as the deficit.
The purpose of the hovering deficit in the domestic context is to prevent trafficking in deficits in earnings and profits. Absent this rule, a corporation with positive earnings and profits could acquire or be acquired by another corporation with a deficit in earnings and profits and immediately reduce the amount of earnings and profits, thereby reducing the amount of potentially taxable distributions.
The Tax Cuts and Jobs Act of 2017 repealed Internal Revenue Code Section 902 and its associated tax pools. Section 902 has been replaced with a single year indirect credit for the foreign income taxes “attributable to” the item of income under new Section 960(a). At this point, the IRS has not issued any guidance exactly how to address a surviving foreign corporation’s earnings and profits after a merger or reorganization for purposes of the hovering deficit rule. This leaves tax planners with questions as to how to treat a surviving corporation’s accumulated earnings and losses.
Another international provision implicated by the movement of earnings and profits in foreign Section 381 transactions is Section 959. Section 959 governs the distribution of earnings and profits that represent income that has been previously taxed to U.S. shareholders. After studying the interaction of Section 367(b) and the previously tax income (“PTI”) rules, the Treasury Department and the IRS determined that more guidance under Section 959 would be useful before issuing regulations to address PTI issues that arise under Section 367(b). As of this date, the IRS has not issued any meaningful guidance the carryover of earnings and profits and foreign income taxes in a foreign acquisition transaction.
The preamble to the final and temporary regulations under Section 367 acknowledges that the rules regarding carryover or separation of a foreign corporation’s E&P do not adequately consider the international aspects of the Code, most notably the foreign tax credit. In addition, the preamble states that “[until] the IRS and Treasury promulgate such regulations, taxpayers should use a reasonable method (consistent with existing law and taking proper account of the purposes of the foreign tax credit regime) to determine the carryover and separation of earnings and profits and related foreign taxes.” The preamble does not indicate that the method used must be the “most reasonable” or that it be “as reasonable” as any other available method. See The Tax Advisor, Allocating Previously Taxed Income in a Sec. 355 Tax-Free Distribution, by Kyle Colonna and Julie Allen. There is currently no definition to the term “as reasonable” for purposes of allocating the income and losses of an acquired foreign entity for purposes of the hovering deficit rule and Section 959. Until specific guidance is issued, taxpayers should heed the current position of the IRS and Treasury by applying a reasonable method that is consistent with existing law and takes into account the purpose of the foreign tax credit regime. This may include utilizing the now-repealed Section 902 regulations to source the losses of an acquired foreign corporation.
The rules discussed above are extraordinarily complex. Any U.S. shareholder of a CFC should consult with a qualified international tax professional should they have any questions regarding their U.S. tax compliance requirements.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. 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.