By Anthony Diosdi
One would think that the acquisition of one foreign corporation by another foreign corporation would not trigger a U.S. tax consequence. However, in today’s world of cross-border investing, a foreign-to-foreign corporate acquisition or reorganization may trigger U.S. tax consequences. In particular, the liquidation of a foreign corporation into another foreign corporation could result in taxable gain on the distribution of any property used by the distributing foreign corporation in the conduct of a U.S. trade or business at the time of liquidation. See Treas. Reg. Section 1.367(e)-2(c)(2)(i)(A). An exception to this recognition-of-gain rule applies if the distributee foreign corporation continues for a ten-year period to use the property in the conduct of a trade or business (other than U.S. real property interests) and the distributing and distributee corporations file an appropriate statement with the Internal Revenue Service (“IRS”). See Treas. Reg. Section 1.367(e)-2(c)(2)(i)(B).
The second and far more common way the liquidation or reorganization of a foreign corporation can trigger a U.S. tax consequence is if the foreign corporation (being acquired or reorganized) can be classified as a controlled foreign corporation (“CFC”). The type of transactions of foreign-to-foreign corporate acquisition or reorganization that may trigger U.S. tax consequences are discussed below.
Foreign-To-Foreign Type A Merger
Pursuant to the relaxed Type A merger rules, a merger may include foreign corporations. See Treas. Reg. Section 1.368-2(b)(1)(iii)(Ex. 13). Instead of taxing the merger as a sale, the policy of these rules is to tax a U.S. shareholder of a CFC, as those terms are defined in Subpart F, on the earnings and profits of the CFC that will cease to exist.
Below, please see Illustration 1. which demonstrates a foreign-to-foreign Type A merger for U.S. tax purposes.
Illustration 1.
Assume that Foreign Target merges with and into Foreign Acquiror. Further assume that Foreign Target’s shares are worth $10 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. In addition, assume that the Foreign Acquiror’s shares with a fair market value of $10 million. If the Foreign Target was not a CFC or the individual U.S. shareholders would not be U.S. shareholders (within the meaning of the Internal Revenue Code), the individual U.S. shareholders would not be required to include a dividend to the extent of their individual share of Foreign Target’s earnings and profits.
Foreign-To-Foreign Type B Share-For-Share Acquisitions
A Type B share-for-share acquisition is tax-free for U.S. tax purposes as long as there is no other consideration and the acquiror has control of the target immediately after the transaction. Because a Foreign-To-Foreign corporate acquisition could be considered an outbound tax-free incorporation in certain cases, the outbound toll charge rules must be analyzed in each case to determine if U.S. shareholders of a foreign corporation involved in the transaction should recognize taxable gain. 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, the U.S. shareholder must include the earnings and profits of the target as a dividend.
Below, please see Illustration 2. which demonstrates a foreign-to-foreign Type B merger for U.S. tax purposes.
Illustration 2.
Henry Ford, a U.S. citizen, wholly-owns Lotus, a foreign corporation engaged in building sports cars. In what would otherwise constitute a share-for-share acquisition, Henry Ford exchanges 100 percent of his shares of Lotus for three percent of the shares of Porsche, a publicly-held German corporation on the German Stock Exchange. This transaction satisfies the Type B rules and the limited-interest exception should apply to avoid the outbound toll charge. However, to prevent the loss of the U.S. taxing jurisdiction (Henry Ford is no longer a U.S. shareholder of a CFC), Henry Ford must include a dividend to the extent of Porsche’s earnings and profits.
Foreign-to-Foreign Type C Shares-For Assets Acquisitions
A Type C acquisition allows an acquiror, for all or part of its voting shares, to acquire substantially all the assets of the target. The policy is to tax U.S. shareholders of a CFC, as those terms are defined in Subpart F, on the earnings and profits that cease to exist.
Below, please see Illustration 3. which demonstrates a foreign-to-foreign Type C merger for U.S. tax purposes.
Illustration 3.
Henry Ford, a U.S. citizen, wholly-owns Lotus, a foreign corporation engaged in building sports cars. In what would otherwise constitute a tax-free shares-for-assets acquisition, Porsche, a publicly-held German corporation traded on the German Stock Exchange, acquires all of Lotus’ assets for three percent of Porsche’s shares. Further assume that Lotus subsequently distributes the Porsche shares to Henry Ford in liquidation. As a result, the transaction should qualify as a Type C acquisition. However, because Henry Ford, who was formerly a U.S. shareholder in a CFC now owns 3 percent of the shares of a non-CFC, Henry Ford must include the earnings and profits of Lotus as a dividend.
Foreign-To-Foreign Forward Triangular Reorganization
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 of the target’s assets. As with the foreign-to-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. 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 dividend.
Below, please see Illustration 4. which demonstrates a foreign-to-foreign triangular reorganization
Illustration 4.
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. Although the forward triangular reorganization rules require a merger that “would have qualified” as a Type A merger, the IRS has provided guidance that the above example qualifies as a Type A merger. See Treas. Reg. Section 1.368-2(b)(1)(iii)(Ex. 13). If this transaction satisfies the limited interest exception, the outbound toll should not apply. However, any individual any U.S. shareholders of the now defunct Foreign Target corporation must include a dividend to the extent of their share 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 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 aquiror’s assets and the former shareholders of the surviving target exchange their shares for shares of the acquiror’s parent. Any U.S. shareholder must include the earnings and profits of the target as a dividend.
Below, please see Illustration 5. which demonstrates a foreign-to-foreign triangular reorganization.
Illustration 5.
Assume that Foreign Parent, a publicly-traded foreign corporation, wishes to acquire Foreign Target’s business. In addition, 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, See Treas. Reg. Section 1.367(a)-3(d)(1)(ii). Because Foreign Target, with its earnings and profits, remains in existence, any dividend inclusion is unnecessary. See Treas. Reg. Section 1.367(b)-3(b)(3).
Conclusion
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: 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.