By Anthony Diosdi
In response to changing business conditions, U.S. corporations routinely organize new subsidiaries and divide, merge, and liquidate existing subsidiaries. These routine corporate adjustments generally are tax-free transactions, based on the principle that the transactions involve a change in the form of the corporation’s investment, not the parent corporation’s investment or the parent corporation’s ultimate control of the investment. For example, in non-international context, if a domestic corporation transfers appreciated property to a newly organized subsidiary in exchange for all of the shares of that subsidiary, the gain realized on that exchange is not recognized immediately, but is instead the tax consequence is postponed by having the subsidiary take a carryover basis in the property received. See IRC Sections 351(a) and 362.
In cases of cross-border acquisitions and transfers, Internal Revenue Code Section 367 closes this loophole by requiring a U.S. corporation or person transferring appreciated property to a foreign corporation to recognize a gain on the transfer. 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 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 as a result of the enactment of Subpart F and GILTI, to a variety of transactions involving foreign corporations. Internal Revenue Code Section 367 has two basic purposes. First, it ensures that (with a few exceptions) that a U.S. Federal tax liability (sometimes called a “toll charge”) is imposed when property with untaxed appreciation is transferred beyond U.S. taxing jurisdiction. It generally accomplishes this objective by treating the foreign transferred corporation as not qualifying as a “corporation” for purposes of certain tax-free exchange provisions. Second, Section 367 ensures that the earnings of a controlled foreign corporation (“CFC”) (to the extent they are not currently taxed to U.S. shareholders) do not avoid U.S. Federal tax because they are shifted to an entity that is not a CFC as a result of some corporate reorganization or other transaction.
A tax or outbound toll charge applies to transfers of appreciated property by a U.S. corporation or person to a foreign corporation.The character and source of the gain produced by the outbound toll charge is determined as if the transferor had sold the property to the transferee in a taxable transaction. See Temp. Reg. Section 1.367(a)-IT(b)(4)(i)(A).
The types of corporate transactions governed by the outbound toll charge provisions include:
1) Incorporations- A U.S. person’s contribution of property to a foreign corporation in exchange for shares of the foreign corporation, where immediately after the exchange for shares of the foreign corporation, where immediately after the exchange, the U.S. person controls the foreign corporation.
2) Liquidations- a domestic subsidiary corporation’s distribution of assets in complete liquidation to its foreign corporation.
3) Reorganizations- A U.S. person’s transfer of shares, securities, or property to a foreign corporation as part of a corporate reorganization.
However, there are several special exceptions that apply to the outbound toll charge, including:
1) Active foreign business use exception- the outbound toll charge does not apply to certain types of property transferred to a foreign corporation for use by that corporation in the active conduct of a trade or business located outside the United States.
2) Branch loss recapture rule- a U.S. person must recognize a gain on the incorporation of a foreign branch to the extent that a U.S. person has previously deducted branch losses against its other taxable income.
3) Deemed royalty regime for intangible property- an outbound transfer of intangible property is treated as a sale in return for a series of payments that are both received annually over the useful life of the intangible and are contingent upon the productively, use, or disposition of the intangible.
4) Transfers of shares and securities- outbound transfers of shares and securities as outbound liquidations and acquisitions reorganizations, are subject to special rules.
These exceptions to the outbound toll charge are discussed below.
Active Foreign Business Use Exception
Under Internal Revenue Code Section 367(a)(3)(A), except as provided in the regulations and in Section 367(a)(3)(B), gain will not be recognized with respect to any property transferred for use by a foreign corporation in the active conduct of a trade or business outside the United States. The theory underlying this provision is that the business purpose for the transfer overrides the concern of Congress that the property may be transferred outside the U.S. taxing jurisdiction. In effect, if the transfer meets the requirements of the active foreign trade or business exception, the transfer is presumed not to be for tax-avoidance purposes.
The temporary regulations deal in some detail with what constitutes the active conduct of a trade or business outside the United States. To determine whether property qualifies for the active conduct of a trade or business exception, four questions must be answered:
1. What is the transferee’s trade or business?
2. Do the transferee’s activities constitute the active conduct of that trade or business?
3. Is the trade or business conducted outside of the United States?
4. Is the transferred property used or held for use in the trade or business?
See Temp. Reg. Section 1.367(a)-2T(b)(1). Making each of these determinations requires a consideration of all the facts and circumstances.
A trade or business is “a specific unified group of activities that constitutes an independent economic enterprise carried on for profit.” To meet the definition of a trade or business for this purpose, a group of activities “must ordinarily include every operation which forms a part of, or a step in, a process by which an enterprise may earn income or profit,” and must normally include both the collection of income and the payment of expenses. However, the holding of investments in stock, securities, land or other property for one’s own account and the casual sales of such investments are not a trade or business for this purpose. If the activities of the transferred foreign corporation do not constitute a trade or business, then the active trade or business exception does not apply to any transfer of property to such corporation. See Temp Reg. Section 1.367(a)-2T(b)(2).
A foreign corporation actively conducts a trade or business 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 in account in determining whether the corporation’s officers and employees perform substantial managerial and operational activities. See Temp Reg. Section 1.367(a)-2T(b)(3). To satisfy the requirement that the business be conducted outside the United States, the primary managerial and operational activities of the trade or business must be conducted abroad and, immediately after the transfer, substantially all of the transferred assets must be located abroad. See Temp. Reg. Section 1.367(a)-2T(b)(4).
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 course of the 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 business to a trade or business if it is held to meet the present needs of the trade or business and not its future needs. Accordingly, property is not treated as held in a direct relationship to a trade or business if it is held for the purpose of future diversification into a new trade or business, future expansion of the trade or business, or future business contingencies. See Temp. Reg. Section 1.367(a)-2T(b)(5).
Section 367(a) imposes a 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. These tainted assets include the following:
1. Inventories, including raw materials and supplies, work-in-process, and finished goods;
2. Installment obligations, accounts receivables, and similar property;
3. Foreign currency or other property denominated in foreign currency, such as an installment obligation, forward contract, or account receivable;
4. Intangible property, and
5. Property that the transferor is leasing at the time of the transfer, with certain exceptions.
Recapture gain is required to be recognized 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. See Temp Reg. Section 1.367(a)-4T(b). Temp Reg Section 1.367(a)-4T(c)(1) treats tangible property transferred to a foreign corporation that the corporation will lease to others as transferred for use in the active conduct of a trade or business outside of the United States only if three requirements are met. The requirements are:
1. The transferee’s leasing of the property constitutes the active conduct of a leasing business;
2. The lessee of the property is not expected to, and does not, use the property in the United States; and
3. The transferee has need for substantial investment in assets of the type transferred.
For the transferee’s leasing to constitute the active conduct of a leasing business, the foreign corporation’s employees must perform substantial marketing, customer service, repair and maintenance and other substantial operational activities with respect to the transferred property outside the United States.
Below, please see Illustration 1 which demonstrates how the toll charge is assessed under the active foreign business use exception.
During the current year, U (a domestic corporation) organizes M, a manufacturing subsidiary incorporated in mexico. U then transfers inventory and some machinery and equipment to M in exchange for all of M’s shares. At the time of the transfer, the basis and the fair market value of the transferred assets are as follows:
Basis Fair Market Value
Inventory $5 million $7 million
Machinery and equipment $10 million $15 million
The machinery and equipment were purchased two years ago for $14 million and U took $4 million of depreciation deduction on the machinery prior to the transfer. The machinery was used solely in U’s U.S. factory.
Assuming M’s foreign manufacturing operation satisfies the active foreign business requirement, the outbound transfer does not trigger U.S. taxation of the $1 million of appreciation in the value over the original cost of the machinery and equipment ($15 million fair market value – $14 million original cost). However, because U previously used the machinery and equipment in its U.S. factory, U must recognize $4 million of depreciation recapture income.The inventory is a tainted asset and, therefore, U must recognize $2 million of gross income ($7 million market value – $5 million basis) on its transfer. In sum, U must recognize $6 million of income on the incorporation of M.
The active foreign business use exception will not apply if, at the time the property is transferred, it is reasonably believed that the transferee foreign corporation will soon dispose of the transferred property other than in the ordinary course of business. If the transferred foreign corporation transfers the property to another person as part of the same transaction, the active foreign business use exception will not apply to the initial transfer. Furthermore, any subsequent transfer to a third party in the next six months is presumed to be part of the initial transfer. A facts and circumstances test applies to subsequent transfers that occur more than six months after the original transfer. See Temp Reg. Section 1.367(a)-2T(c)(1).
Branch Loss Recapture Rule
Under the branch loss recapture rules, a U.S. person that transfers part or all of the assets of a foreign branch to a foreign corporation in a Section 367(a)(1) exchange must recognize as recapture gain certain of the previously deducted losses of the branch. A foreign branch is defined for this purpose as an integral business operation carried on by a U.S person outside the United States. See Temp. Reg. Section 1.367(a)-6T(g)(1). 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. See Temp Reg. Section 1.367(a)-6T(b)(1). Previously deducted losses are recaptured as ordinary income and previously deducted capital losses are recaptured as capital gain. These branch loss recapture rules must be separately applied to each foreign branch. The previously deducted losses of one branch may not be offset by the income of another branch for purposes of determining the amount of gain that must be recognized under these rules. See Temp Reg. Section 1.367(a)-6T(g)(2).
Deemed Royalty Regime for Intangible Property
The market value of patents, trademarks, and other intangibles often is highly uncertain, due to the inherent uniqueness of these assets. This uncertainty significantly weakens the deterrent effect of a one-time toll charge imposed at the time of the transfer, since new technologies and products can turn out to be far more successful than originally anticipated. As a consequence, a special deemed royalty regime for intangibles treats an outbound transfer of an intangible as a sale in return for a series of royalty payments that are received annually over the useful life of the intangible and that are contingent o the productively, use, or disposition of the intangible and that are contingent on the productivity, use, or disposition of the intangible. This income is characterized as royalty income that is foreign source income.
The deemed royalty regime applies to a U.S. person’s contribution of intangible property to a foreign corporation in exchange for shares of the foreign corporation, where immediately after the exchange the US person controls the foreign corporation. The deemed royalty regime also applies to a U.S. person’s transfer of intangible property to a foreign corporation as part of a corporate reorganization. However, the deemed royalty regime does not apply to a domestic subsidiary corporation’s distribution of intangible property in complete liquidation to its foreign parent corporation. In addition, a limited exception to the deemed royalty regime is available for transfers operating intangibles if the U.S. transferor elects to reorganize, in the year of the transfer, U.S. source income equal to the excess of the intangible’s fair market value over its basis.
For purpose of the deemed royalty regime, intangible property includes any patent, invention, formula, process, design, pattern, know-how, copyright, literary, musical, or artistic composition, trademark, trade name, brand name, franchise, license, contract, method, program, system, procedure, customer list or similar. The deeded royalty transfer must be an arm’s-length amount, computed in accordance with the provisions of Internal Revenue Code Section 482 (transfer pricing rules) and the regulations thereunder. See Temp Reg. Section 1.367-1T(c)(1). The deemed royalty amount also must “commensurate with the income attributable to the intangible.” In other words, the royalty amounts must reflect the actual profit experience realized subsequent to the outbound transfer outside the United States. Under certain circumstances, a U.S. transferor may prefer having the transfer of the intangible to the foreign corporation taxed entirely at the time of transfer as a taxable sale of the intangible for its fair market value at a fixed price, rather than taxed as royalties over the life of the intangible. The regulations permit the taxpayer to elect to treat the transfer of the intangible as a sale at its fair market value if certain requirements are met.
Liquidation of a Domestic Subsidiary into Its Foreign Parent
This area is an area where the inversions rules typically apply. We will discuss the inversion rules in detail in an upcoming article. With that said, under general U.S. tax principles, the complete liquidation of a corporation is a taxable transaction for both the corporation distributing the assets and the shareholders receiving those assets. See IRC Section 336(a). However, the income tax regulations provide an exception for taxation for transfers of the stock or securities of a foreign corporation by a U.S. person to a foreign corporation. The U.S. transferor will obtain nonrecognition of gain treatment on the transfer under the normal domestic recognition rules if an exception applies. The requirements for the exception vary for U.S. transferors owning less than five percent of the voting power and value of the stock of the transferee foreign corporation and those owning five percent or more of the voting power or value of the transferee corporation stock. For purposes of determining the ownership of the transferee corporation, the constructive ownership rules of Section 318, as modified by Section 958 of the controlled foreign corporation provisions apply.
If the U.S. transferor owns less than five percent of the total voting power and total value of the stock of the transferred foreign corporation, the U.S. transferor will obtain nonrecognition of gain treatment on the transfer of the stock or security of a foreign corporation. A U.S. transferor owning five percent or more of either the total voting power or total value of the transferee corporation’s stock will obtain nonrecognition of gain treatment on the transfer only by entering into a five-year, gain-recognition agreement with the IRS. See Treas. Reg. Section 1.367(a)-3(b)(1).
Transfers by a U.S. person of stock and securities of a U.S. corporation to a foreign corporation are generally taxable under Internal Revenue Code Section 367(a)(1), unless the exception for U.S. transferors with no more than 50 percent ownership of the transferee. Under Treasury Regulation Section 1.367(a)-3(c)(1), a transfer of stock or securities of a U.S. person to a foreign corporation is not taxable under Section 367(a)(1) if all of the following five conditions are met:
1. The U.S. corporation of the stock or securities of which are transferred (the U.S. target company”) complies with certain reporting requirements of Treasury Regulation Section 1.367(a)-3(c)(6);
2. No more than 50 percent of each of the total voting power and the total value of the transferee foreign corporation’s stock is received in the transaction, in the aggregate, by U.S. transferors;
3. No more than 50 percent of each of the total voting power and the total value of the transferee foreign corporation’s stock is owned, in the aggregate, immediately after the transfer by U.S. persons who are either officers, directors or five-percent or more shareholders (by value) of the U.S. target company immediately before the transfer;
4. The transferee foreign corporation or an affiliate of the transferee foreign corporation has been engaged in the active conduct of a trade or business that is substantial in comparison to the U.S. target company’s trade or business, for the entire 36 month period before the date of the transfer and, at the time of transfer, neither the transferor not the transferee foreign corporation have an intention to substantially dispose of or discontinue that trade or business. A foreign corporation is treated as meeting this substantiality requirement, if, at the time of the transfer, the fair market value of the transferee foreign corporation is equal to or greater than the fair market value of the U.S. target company. See Treas. Reg. Section 1.367(a)-3(c)(3); and
5. Either i) the U.S. transferor owns less than five percent of both the total voting power and the total value of the transferred foreign corporation’s stock immediately after the transfer or ii) a five-percent or more U.S. transferor enters into a five-year, gain recognition agreement with the IRS.
For purposes of determining the owners of stock, securities or other property in applying these requirements, the constructive ownership rules of Section 318 as modified by Section 958 apply.
Beow, please see Illustration 2 which demonstrates a typical liquidation of a domestic subsidiary into a foreign parent.
F, a corporation incorporated in a foreign country, owns all the shares of U, a domestic C corporation. U’s assets have a basis of $5 million and a fair market value of $7, Despite the profitability of U, F desires to liquidate U to eliminate this business in a manner that is consistent with F’s world-wide business plan. As a result, F liquidates U. Because this is the last opportunity for the $2 million of appreciation of U’s assets to be taxed, U must recognize $2 million of gain.
To help the IRS better police outbound transfers, a U.S. person who transfers property to a foreign corporation must attach Form 929, Return by Transferor of Property to a Foreign Corporation, to their regular tax return for the year of the transfer. See Treas. Reg. Section 1.6033B-IT(b)(i). This reporting requirement applies to outbound transfers of both tangible and intangible property. The penalty for a failure of a U.S. person to properly report a transfer to a foreign corporation equals 10 percent of the fair market value of the property transferred.
The area of cross-border transfers and reorganizations is an incredibly complicated area. The professionals at Diosdi Ching & Liu, LLP have substantial experience assisting our clients with international tax transactions.
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.