By Anthony Diosdi
There are many good business reasons that a corporate group may decide to enter a corporate division transaction to separate one or more trades or businesses from another distinct trade or business. The three types of corporate divisions are commonly known as spinoffs, split-offs, and split-ups. Such corporate divisions are also referred to as demergers or Type D reorganizations. To illustrate the elements of these transactions, assume that Alexis and Bob each own 50 percent of the stock of Diverse Corporation (“D”), which for many years has operated a winery and a cattle ranch as separate divisions. For reasons to be elaborated below, the shareholders wish to divide the business into two separate corporations on a tax-free basis. From a tax perspective, the possibilities are:
Spin-off, Assume that to comply with new state regulations, D is required to operate the chicken ranch and winery as separate corporations. To accomplish the division, D forms a new corporation, Steak, Inc., contributing the assets of the cattle ranch. It then distributes the stock of Steak pro rata to Alexis and Bob, who emerges as equal shareholders in each corporation. Because a spin-off involves a distribution of property to shareholders without the surrender of any stock, it resembles a dividend.
Split-off. Alexis and Bob desire to part company, with Alexis operating the winery and Bob the cattle ranch. To help them go their separate ways, D again forms a new corporation, Steak, Inc., contributing the assets of the cattle ranch. D then distributes the stock of Steak to Bob in complete redemption of his D stock. Alexis becomes the sole shareholder of D, which now owns only the winery, and Bob is the sole owner of the cattle ranch. If Alexis and Bob did not want to part company, D could have made a pro rata distribution of the cattle stock in redemption of an appropriate amount of D stock. A Split-offs often resembles corporate redemptions of stock.
Split-up. To comply with a new state regulation, D is required to terminate its corporate existence and divide up its two businesses. The fission is accomplished by D forming Vineyard, Inc. and Steak, Inc., contributing the winery assets to Vineyard and the cattle ranch assets to Steak. D then distributes the stock of the two new corporations pro rata to Alexis and Bob in exchange for all their D stock. Because D had distributed all of its assets and dissolved, this transaction resembles a complete liquidation.
As these examples demonstrate, spin-offs, split-offs, and spin-offs can be classified for tax purposes in two different ways: as a tax-free corporate division or as a taxable transaction. In order to qualify as tax-free to the shareholders, the division must satisfy the requirements of Section 355 and its accompanying judicial doctrines. In general, Section 355 allows a corporation with one or more businesses that have actively conducted for five years or more to make a tax-free distribution of the stock of a controlled subsidiary (or subsidiaries) provided that the transaction is being carried out for a legitimate business purpose and is not being used principally as a device to bail out earnings and profits. In the absence of Section 355, a spin-off likely would be treated as a dividend under Section 301; a split-off would be tested for dividend equivalency under the redemption rules in Section 302; and a split-up ordinary would be treated as a complete liquidation under Section 331.
There is one more piece to this introduction to the puzzle. In each of the examples above, Diverse Corporate was a domestic corporation. In today’s global economy, corporations have operations all over the world. Thus, demergers often take place in the foreign context. As its name suggests, a demerger is the converse of a merger; whereby a single corporation divides into two or more corporations with each corporation taking a portion of the assets and liabilities that were held by the single corporation immediately prior to the demerger.
A corporate division in the case of such a multinational group raises difficult issues because the goal is for the parent corporation to be able to spin off a subsidiary that owns a group of companies and to retain the other business line directly or through a series of subsidiary corporations. Specifically, the question raised is how best to disentangle the business in each local country subsidiary. Dividing a foreign corporate subsidiary entails the complete transfer of one business line to a new sister corporation of the subsidiary. There are a plethora of issues that must be considered. To better understand the technical requirements for a tax-free corporate division, it is helpful to understand the background of Section 355 before diving into the international tax issues such transactions often raise.
Basic Requirements of a Section 355
Tax-free spinoffs or demergers under Section 355 allows certain distributions by one corporation (the “distributing corporation”) to its shareholders of stock or securities in another corporation (the “controlled corporation”) to be tax-free to the shareholders, and also to be tax-free to the distributing corporation. In order for a corporate division to be accomplished on a tax free basis, it must meet the requirements of Section 355 and 368. The distributing corporation must distribute to its shareholders the stock or securities of a “controlled corporation” – a corporation that the distributing corporation “controls” immediately before the distribution. See IRC Section 355(a)(1)(A). For this purpose, “control” is defined by Section 368(c), which requires ownership of 80 percent of the total combined voting power and 80 percent of the total number of shares of all classes of stock, including nonvoting preferred stock.
The distributing corporation must distribute all the stock or securities of the controlled corporation that the distributing corporation holds or, alternatively, an amount of stock sufficient to constitute “control” within the meaning of Section 368(c). See IRC Section 355(a)(1)(D). If any stock or securities of the controlled corporation are retained, the distributing corporation must establish to the satisfaction of the IRS that the retention is not pursuant to a plan having tax avoidance as one of its principal purposes.
Both the distributing corporation and the controlled corporation – or in a split up, both controlled corporations- must be engaged immediately after the distribution in an actively conducted trade or business which has been so conducted throughout the five-year period ending on the date of the distribution. See IRC Section 355(a)(1)(C); (b). That business must not have been acquired within the five-year predistribution period in a taxable transaction. Moreover, the distributing corporation must not have purchased a controlling stock interest in a corporation conducting the business in a taxable transaction during the five-year predistribution period.
A Section 355 transaction must also satisfy the “active conduct” of trade or business test. “Active conduct” of a trade or business requires the corporation to perform “active and substantial management and operational functions.” See Treas. Reg. Section 1.355-3(b)(2)(iii). Activities performed by outsiders, such as independent contractors, are not considered as performed by the corporation. “Active conduct” does not include the holding of stock, securities, raw land or other purely passive investments, or the ownership of real or personal property used in a trade or business unless the owner performs significant services with respect to the operation and management of the property.
In addition, to qualify for tax-free treatment under Section 355(a)(1)(B) of the Internal Revenue Code, a spin-off transaction must not be used principally as a device for the distribution of earnings and profits of the distributing or controlled corporation. Whether a transaction is a “device” is determined based upon all the facts and circumstances, including, but not limited to, the existence or absence of specified “device factors” and “non-device factors” set in the regulations. Specifically, Section 355 explicitly demands that “the transaction was not used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both.” Frequently described as the “device requirement,” this condition is a nutshell statement of the general concern of Section 355. In fact, it is in the regulations pursuant to the “device” requirement that one finds perhaps the best statement of the underlying concern. The regulation states that “Section 355 recognizes that a tax-free distribution of the stock of a controlled corporation presents a potential for tax avoidance by facilitating the avoidance of the dividend provisions of the Internal Revenue Code through the subsequent sale or exchange of stock of one corporation and the retention of the stock of another corporation.” See Treas. Reg. Section 1.355-2(d)(1).
Finally, the corporate separation must satisfy the continuity of interest rules. As applied in the tax-free separation context, continuity requires that one or more prior owners own, in the aggregate, “an amount of stock establishing a continuity of interest in each of the modified corporate forms in which the enterprise is conducted after the separation.” See Treas. Reg. Section 1.355-2(c)(1). In other words, if one corporate enterprise is separated into three distinct corporations, the continuity of interest requirement must be met with regard to each of the three entities resulting from the separation.
Issues Associated with Foreign Corporate Demergers
Step-Transaction Doctrine
In order for the Internal Revenue Service (“IRS”) to recognize a tax-free corporate division in the international or domestic context, the transaction must be able to survive the step-transaction doctrine. Under this doctrine, a distribution otherwise qualifying for non-recognition treatment under Section 355 may be disqualified if the distribution is considered part of a larger, integrated transaction that fails to meet Section 355 requirements. The Treasury Department (“Treasury”) offered a reminder of this possibility in a ruling in which the distributing corporation D distributed stock of a wholly owned subsidiary C to its shareholders in a distribution meeting the requirements of Section 355. See Rev. Rul. 96-30, 1996-1 C.B. 36. Shortly thereafter, C was merged into another corporation Y in a Type A reorganization. Immediately after the merger transaction, the D shareholders, also now the C shareholders, held only a 25% interest in Y. The Treasury pointed out that if the two steps were viewed as an integrated whole, D’s distribution of C stock would not qualify for Section 355 nonrecognition since the corporation ultimately acquiring C’s assets Y was not controlled by the transferor corporation or its shareholders immediately after the transfer.
In the end, the ruling concludes that the step-transaction doctrine should not apply to the particular facts described in the ruling because there had been no negotiations regarding C’s merger with Y at the time of D’s distribution of the C stock. Although the doctrine was not actually invoked under the particular facts and circumstances described, Rev. Rul. 96-30 serves as an important reminder that the step-transaction doctrine retained its vitality in connection with Section 355 corporate divisions.
The Interplay Between Section 368(a)(1)(D) and Section 355
Many, but not all, distributions of stock in a controlled corporation will simultaneously be “reorganized” under Section 368(a)(1)(D) and also be distributions under Section 355. A Type D reorganization involves transfer of “all or a part of [a corporation’s] assets to another corporation if immediately after the transfer, the transferor, or one or more of its shareholder…., or any combination thereof, is in control of the corporation to which the assets are transferred.” A Type D reorganization includes both acquisitive and divisive reorganizations. In general, acquisitive Type D reorganizations involve a transfer of all of the assets and a subsequent distribution of stock or securities pursuant to the requirements for nonrecognition purposes. On the other hand, a divisive reorganization involves a transfer of part of the assets and a subsequent distribution of stock or securities pursuant to the requirements for nonrecognition under Section 355.
The IRS has provided guidance on the distribution requirements for Section 368(a)(1)(D) reorganizations when no stock of the controlled corporation is transferred by the distributing corporation to its shareholders. Under a literal reading of Section 368(a)(1)(D), such a distribution would be required. However, as indicated above, the IRS takes a substance over form approach to the distribution requirement and instead deems the transaction to have followed the literal steps found in the statute. The IRS has provided guidance on transactions where cash is contributed by the shareholders to the controlled corporation, which is used to purchase assets from the distributing corporation and finally distributed back to the shareholders. As discussed below, the circular flow of cash generally is disregarded when analyzing whether the transaction qualifies as a Section 368(a)(1)(D) transaction.
In determining whether a transaction meets the requirements of Section 355 and 368(a)(1)(D), the IRS has ruled that the substance of the overall transaction, and not the particular form of any one aspect of the transaction or order of the steps, will control the treatment of the exchange as a spin-off entitled to nonrecognition treatment. For example, in Rev. Rul. 77-191, 1977-1 C.B. 94, the taxpayer corporation had been engaged in two active businesses. In order to remove restrictions imposed on one business by certain federal laws, the taxpayer distributed all of the assets of that business to its shareholders,in redemption of part of their stock of the taxpayer. Immediately following the distribution and pursuant to an integrated plan, the taxpayer’s shareholders transferred all of the assets received to a newly-organized corporation. Thereafter, the newly-formed recipient corporation conducted the business formerly conducted by the taxpayer.
The form of the taxpayer corporation’s distribution of business assets to its shareholders in Rev. Rul. 77-191 did not technically satisfy the requirement under Section 355(a)(1)(D) that the distributing corporation distribute all of the outstanding stock of the controlled corporation, as the purported “controlled corporation” did not yet exist at the time of the distribution. The distribution would, rather, meet the technical definition of a taxable liquidation under Section 311. The IRS held that, while the distributing corporation did not actually distribute stock of a controlled corporation, the transaction when viewed together with the immediate contribution of those assets to a newly formed controlled corporation should be treated as a Section 355 spinoff. The IRS observed:
“The tax consequences of a business transaction are properly determined by the substance of the transaction and not by the form in which it is cast. A transaction must be viewed as a whole. The true nature of a transaction cannot be disguised by mere formalisms that exist solely to alter tax liabilities.” See Commissioner v. Court Holding., 324 U.S. 331 (1945).
Additionally, the IRS noted that the statutory intent of the Internal Code would be frustrated by such a formalistic interpretation of the facts under review, as Section 331 was not intended was not intended to apply to a divisive transaction that ultimately resulted in splitting a single corporation into two or more corporations owned by the shareholders of the original corporation. “Under these circumstances,” the IRS held, “Section 355 is the governing provision.” The IRS determined that the new corporation as a wholly-owned subsidiary, transferred the assets of the business to the new corporation, and then distributed the stock of the new corporation pro rata to the taxpayer’s shareholders in exchange for part of their stock in the taxpayer, and that this series of steps “is a typical corporate split-off described in Section 368(a)(1)(D) and 355 of the Internal Revenue Code. See Tax-Free Spinoffs in the International Context, Baker & McKenzie, Miami (2016).
The IRS has applied Rev. Rul. 77-191 in private letter rulings to determine that the overall substance of a transaction, as evidenced by the final result of the step and not the particular steps undertaken to effect the transaction, should determine whether a transaction is treated as a Section 355 spinoff entitled to nonrecognition treatment. In Priv. Ltr. Rul. 200703030, the taxpayer, the common parent of a consolidated group, owned a disregarded limited liability company (LLC 1) and all of the stock of the distributing corporation. The distributing corporation owned three disregarded limited liability companies (LLCs 2, 3, and 4), which, in turn, owned a number of controlled corporations. The taxpayer proposed to achieve the ultimate effect of a Section 355 spinoff by merging LLCs 2, 3 and 4 with and into LLC 1, with LLC 1 surviving. These mergers resulted in the parent corporation owning, for U.S. federal income tax purposes, all of the stock of the controlled corporations. The IRS held that Rev. Rul. 77-191 applied and that the transaction would be treated as though the distributing corporation distributing corporation distributed all of the stock of the controlled corporations to its parent, notwithstanding the fact that no actual distribution of the controlled corporations’ stock to the parent occurred.
Circular Cash Flow Issues
One very specific application of the substance over form theory is the circular flow of cash doctrine. Under the circular flow of cash doctrine, cash moves amongst a group of interrelated companies, usually to accomplish a business purpose, but, at the end of the series of transactions, the cash (or notes) ends up where it began. Generally, circular cash flow transactions do not affect the economic position of the parties, because the cash circulates back to where it started. Therefore, the intermittent steps of the transaction are disregarded. The IRS has consistently ruled that circular flows of cash and notes should be disregarded as transitory steps in various types of corporate reorganizations.
In Revenue Ruling 74-564, 1974-2 C.B. 124, a parent corporation (“Parent”) contributed cash, to satisfy capitalization requirements, and shares of its voting common stock to Z, a corporation formed by Parent for the purpose of merging Z into corporation R. S corporation owned ninety-eight percent of the stock of R corporation. Parent owned all of S corporation’s outstanding stock. The cash transferred by Parent to Z corporation and then by Z corporation to R corporation, was then transferred from R corporation to S corporation and finally from S corporation to Parent.
In PLR 9746053, the IRS ruled that transfers of an unsecured interest bearing note through a chain of holding companies were circular and transitory steps and would be disregarded for U.S. federal income tax purposes. In the ruling, the taxpayer circulated a note with its stock transfer to avoid certain adverse consequences under foreign income tax law.
For a circular cash transfer to be disregarded and treated as transitory for U.S. federal tax purposes, the transferor generally must receive the same amount of cash back as it originally contributed. This point is illustrated by Revenue Ruling 83-142. That ruling involved, X, a U.S. corporation, which owned all of the stock of FY, a corporation formed under the laws of foreign country FC. For valid business reasons, FY proposed to transfer one of its businesses to FZ, a newly-formed FC corporation, in exchange for all of the FZ stock. Immediately thereafter, FY distributed all of the FZ stock to X in a transaction that was intended to qualify under Section 355. The exchange of the FY business for the FZ stock was intended to qualify as a reorganization within the meaning of Section 368(a)(1)(D). The Ruling states that under FC law, X was required to purchase the FZ stock from FY at its fair market value rather than being able to receive the FZ stock as a distribution from FY. Therefore, as part of the transaction, X paid to FY an amount of money equal to the fair market value of the FZ stock (the “FMV Amount”). FY then made a cash distribution to X that under FC law was treated as a dividend and subject to withholding tax. The amount of the distribution to X was great enough to allow X to receive, after payment of the withholding tax to FC, the FMV amount. Thus, to enable payment of the FC withholding tax, the distribution was grossed up. The withholding tax imposed by FC was a creditable income tax under the Internal Revenue Code that would be claimed by X, subject to limitations under Section 904.
The IRS ruled that the payment by X to FY equaled the fair market value of the FZ stock and the dividend distribution by FY to X was a circular flow of cash to the extent that X’s payment was returned by FY. This circular flow of cash was a transitory step that had no federal income tax consequences. However, FY’s distribution included the additional cash gross up so that X received the FMW amount. This additional cash gross up was a distribution deemed to be received by X along with the FZ stock and constituted cash by FY to X was disregarded to the extent it represented a return of cash received by FY from X. The deemed return included country FC withholding tax. The amount of the distribution represented the gross-up to allow X to receive the FMV amount, after deduction to the FC withholding taxes was a distribution of money subject to the rules of Section 301 by application of Section 356(b). Thus, if FY had made a distribution of the FMV amount with no gross up so that X would have received a distribution of FMV amount with no gross up so that X would have received a distribution equal to the FMV amount less the FC withholding tax, the dividend should have been avoided under the rationale of Rev. Rul. 83-142.
The IRS has also held that transactions that involve transitory steps to comply with the laws of a foreign jurisdiction, but that ultimately achieve the result of a spinoff under Section 355, will be treated according to the ultimate result as a Section 355 transaction entitled to nonrecognition treatment. In Rev. Rul. 83-142, 1983-2 C.B. 68, X, a domestic corporation, owned all of the stock of FY, a corporation formed under the laws of foreign country FC. FY was engaged in the active conduct of two businesses and had been for each of the past five years. FY proposed to transfer one of its businesses to FZ, a newly formed FC corporation, in exchange for all of the FZ stock. Immediately thereafter, FY would distribute all of the FZ stock to X in a transaction that was intended to qualify under Section 355. The exchange of the FY business for the FZ stock was intended to qualify as a reorganization within the meaning of Section 368(a)(1)(D).
A distribution described in Section 355, however, would not qualify for tax-free treatment under FC law. Rather, under FC law, X was required to purchase the FZ stock from FY at its fair market value. To satisfy this requirement, X had to pay to purchase the FZ stock from FY at its fair market value. To satisfy this requirement, X had to pay FY an amount of money equal to the fair market value of the FZ stock, after which FY would then make a cash distribution to X that under FC law was treated as a dividend and subject to withholding tax. The amount of the distribution to X was grossed up such that X received, after payment of the withholding tax to FC, an amount equal to the fair market value of the FZ stock.
The IRS held that, while the payment of cash from FY to X would ordinarily constitute boot under Section 356(b), the cash flow was circular and therefore transitory. The IRS noted that it was “a well established principle of tax law that transitory steps occurring as part of a plan of reorganization are disregarded where allegedly disqualifying interim steps are undertaken in order to comply with applicable law.” See Rev. Rul. 78-397, 1978-2 C.B. 150. Thus, the payment by X to FY and immediate distribution of the same amount by FY to X was a circular flow of cash and a transitory step with no U.S. federal income tax consequences. However, the amount of the distribution constituting a gross-up (the amount of the withholding taxes paid to FC) was a distribution deemed to be received by X along with the FZ stock and constituted boot under Section 356(b).
Tax Consequences to Shareholders
If all of the requirements for a tax-free division or tax-free reorganization are met, the shareholders will not report gain or loss on any income upon receipt of stock or securities in the transaction.
1. Receipt of Boot
In a Section 355 distribution, the shareholders of a distributing corporation do not recognize gain or loss or dividend income on the receipt of the stock of a controlled corporation, except to the extent of any boot received in the transaction. Any stock of the controlled corporation acquired by the distributing corporation within five years prior to the distribution in a transaction in which gain or loss was recognized is treated as boot. See IRC Section 355(a)(2))B).
Section 356 applies if any property is received that is not permitted to be received under Section 355(a). Such property is referred to as “boot.” Specifically, cash that is distributed in connection with a Type D reorganization is treated as boot. If boot is received in a Section 355 transaction in which the shareholders of the distributing corporation exchange shares in the distributing corporation for shares in the controlled corporation and the boot (i.e., transactions known as split-offs and split-ups), its tax results are prescribed by Section 356(a). On the other hand, if boot is received in a Section 355 transaction in which the shareholders of the distributing corporation receive interests in the controlled corporation and boot as a distribution from the distributing corporation (i.e., transactions known as spin-offs), Section 356(b) is the operative provision. Section 356(b) requires that the boot be treated as a distribution from the distributing corporation to which Section 301 applies.
Section 301(c) provides that a distribution from a corporation to its shareholders is treated as a dividend, which means that the distribution is treated as a dividend to the extent of the distributing corporation’s accumulated and current E&P. The amount of the distribution (if any) that is in excess of the dividend amount is treated as a return of capital that is applied against and reduces the shareholder’s adjusted basis in the distributing corporation stock. Finally, any amount of distribution in excess of dividend plus basis is treated as gain to the shareholder from the sale or exchange of the stock in the distributing corporation.
If the distributing corporation is classified as a foreign controlled corporation (“CFC”), then the boot or dividend received will have special tax consequences to the U.S. shareholder or U.S. shareholders. Pursuant to Section 957(a), a foreign corporation is a CFC if more than 50% of the total combined voting power of all classes of stock of such corporation entitled to vote or the total value of the stock of such corporation is owned (within the meaning of Section 958(a)), or is considered to be owned by applying the rules of ownership of Section 958(b) by United States shareholders on any day during the taxable year of such foreign corporation. Where the distributing corporation or corporations are owned, either directly or indirectly by U.S. parent corporations or U.S. persons within the meaning of Section 7701, they will be classified as CFCs. A U.S. shareholder of a CFC is required to realize gain in the current year of its pro rata share of 1) Global Intangible Low-Tax Income (“GILTI”), 2) the CFC’s subpart F income, and 3) the CFC’s amount of investment of earnings in U.S. property for the taxable year of the CFC, which ends with or within the taxable year. These negative U.S. tax implications should not apply if the division of the transaction qualifies as a tax-free demerger under Section 355.
2. Basis in the Stock
In the case of split-offs and split-ups, each of which involves an exchange of stock or securities by the shareholder, Section 358(a) provides that the basis of the stock received shall be the same as the stock surrendered, decreased in the amount of any boot received and increased by the amount of gain or amount treated as a dividend. In addition, liabilities of the distributing corporation are often contributed to the controlled corporation. As discussed in more detail below, tax attributes such as net operating losses of the distributing corporation do not transfer from the distributing corporation to the controlled corporation. However, earnings and profits of the distributing corporation generally do transfer from the distributing corporation to the controlled corporation. In the second step of a pro rata divisive Type D reorganization, the distributing corporation distributes its interests in the controlled corporation to the distributing corporation’s shareholders. Generally, the shareholder’s basis in the distributing corporation is allocated between the distributing corporation and the controlled corporation, based upon relative fair market values of the distributing corporation and the controlled corporation regardless of the basis amount that the distributing corporation held in the controlled corporation.
Tax Consequences to the Distributing and Controlling Corporations
A corporation distributing stock of a controlled entity in a transaction satisfying the requirements of Section 355 generally will not recognize gain or loss upon the distribution. Section 355(c) provides such nonrecognition for Section 355 distributions that are “not in pursuance of a plan of reorganization.” Section 355(c)(3) goes on to say that the general recognition rules that would otherwise apply to corporate distributions will not apply to Section 355 distributions. Thus, if a Section 355 distribution is part of a reorganization plan, the distributing corporation does not recognize gain on the distribution to its shareholders of stock. Thus, in the typical spin-off or split-off, where the distributing corporation’s basis in the stock of the controlled corporation is ordinarily less than its fair market value, no corporate-level gain is recognized on the distribution. Gain must be recognized, however, on the distribution of appreciated property that is not stock or securities. However, any stock of the controlled corporation that is acquired by the distributing corporation in a taxable transaction within the five-year period preceding the distribution will constitute boot.
Section 367 Considerations and E&P
The method of allocating the earnings and profits (“E&P”) of the various parties to a corporate division depends on the form of the transaction. If a division is preceded by a Type D reorganization, the E&P of the distributing corporation are allocated between the distributing and controlled corporations in proportion to the relative fair market values of the assets retained by each corporation. See IRC Section 312(h). In no event may any deficit of the distributing corporation be allocated to the controlling corporation. E&P are the only tax attributes affected by a corporate division. E&P may be allocated between the distributing and controlled corporations in proportion to the net basis of assets transferred and of the assets retained, as opposed to the proportion of the assets’ fair market value. See Treas. Reg. Section 1.312-10(a).
A distribution by a controlled foreign corporation of the stock of another foreign corporation under Section 355 is subject to Section 367(b). 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 asset. 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, estimate, 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, the transferor will be treated as having sold the property in exchange for payments that would have been received annually in the form of such payments over the useful life of such property.Thus, Section 367(b) can require gain recognition, income inclusion, or other adjustments in certain circumstances, notwithstanding otherwise applicable nonrecognition provisions.
The regulations under Section 367(b) applicable to this transaction do not provide a methodology for allocating E&P, but permit the use of a “reasonable method” of allocation. Proposed Regulations of Treasury Regulation Section 1.312-10(a) should apply to divisive Type D reorganizations using an allocation based on relative net adjusted tax basis. However, because these proposed regulations have not been finalized, they should not be controlling. Thus, an allocation of earnings and profits based upon the relative net fair market value of the Distributing and Controlled Corporation should be considered a reasonable method, although other reasonable methods such as relative net adjusted tax basis or others may also be acceptable. Furthermore, neither Treas. Reg. Section 1.312-10 or Proposed Treas. Reg. Section 1.367(b)-8 provide a mythology for allocating of E&P in a divisive Type D reorganization where the controlled corporation is not newly-formed. In such a case, a reasonable allocation should be based upon the relative fair market value of the distributing corporation and the assets contributed by the distributing corporation to the controlled corporation, or alternatively based on the relative net adjusted tax basis of such assets, or otherwise.
Treas. Reg. Section 1.367(b)-5
If a distribution is made by a foreign corporation that is not a controlled foreign corporation to a U.S. shareholder, Treasury Regulation Section 1.367(b)-5 does not apply. In such a case, the normal rules applying to a Section 355 distribution are applicable, and no gain is recognized to the distributing corporation or the exchanging shareholder.
If the distribution is made by a controlled foreign corporation, then the distributee’s Section 1248 amount must be taken into account to the extent that the distributee shareholder’s Section 1248 amount (determined on a hypothetical exchange of its stock in the distributing or controlled corporation) decreases after the distribution with respect to either the distributing or controlled corporation. See Treas. Reg. Section 1.367(b)-5(c), (d). Under Section 1248(a), gain recognized on a U.S. shareholder’s disposition of stock in a CFC is treated as dividend income to the extent of the relevant E&P accumulated while such person held the stock. For corporate sellers, this conversion of gain into dividend generally triggers an exemption from tax for such U.S. corporate shareholders pursuant to Section 245A dividends received deduction. For individual shareholders, the situation is different. With respect to individual U.S. shareholders who dispose of stock in a CGFC, recharacterization under Section 1248(a) is significant due to the rate differential between long-term capital gains, including “qualified dividend income” (maximum 23.8%) and ordinary income, including non-qualified dividends (40.8%) realized by individual taxpayers.
In the case of a pro rata distribution to the distributing corporation’s shareholders, the reduction in the Section 1248 amount with respect to stock in the distributing or controlled corporation reduces the basis of the distributee’s income as a deemed dividend. See Treas. Reg. Section 1.367(b)-5(c)(2). Under a basis redistribution rule, the distributee’s basis in the stock of the distributing or controlled corporation (whichever is applicable) is increased by the amount of the required decrease in basis in the other stock. However, the distributee’s basis in such stock cannot be increased above the fair market value of the stock and cannot be increased to the extent that the decrease reduces the distributee’s post distribution Section 1248 amount with respect to the stock. See Treas. Reg. Section 1.367(b)-5(c)(4).
If the distribution is non-pro rata to the distributing corporation’s shareholders, each distributee must include in income as a deemed dividend the amount of any reduction in the Section 1248 amount with respect to either the distributing or controlled corporation. This rule applies even to a shareholder of the distributing corporation who receives no stock but whose Section 1248 amount decreases after the distribution (a so-called “non-participating shareholder”). See Treas. Reg. Section 1.367(b)-5(d).
The Proposed Treasury Regulations Guidance on Allocation and Carryover Tax Attributes; Basis and Holding Period Rules
The Treasury and IRS issued proposed regulations concerning the carry-over of tax attributes, such as earnings and profits and foreign income tax accounts, when two corporations combine in a Section 367(b) transaction. The proposed regulations also deal with the allocation of certain tax attributes when a corporation distributes the stock of another corporation in a Section 367(b) transaction.
Prop. Reg. Section 1.367(b)-3 provides that net operating loss and other loss carryovers and E&P that are not included in income as an “all earnings and profits amount” or a deficit in earnings and profits generally do not carry over from a foreign acquired corporation to a U.S. acquiring corporation. They do carry over, however, if they are effectively connected to a U.S. trade or business or, in the context of an applicable U.S. income tax treaty, are attributable to a permanent establishment.
Prop. Reg. Section 1.367(b)-8 provides rules that apply in divisive reorganizations and provide that rules of Treasury Regulation Section 1.312-10 apply generally to allocate E&P between a distributing and controlled corporation. However, these rules are modified to reflect international tax policy concerns. Finally, Prop. Reg. Section 1.367(b)-9 provides rules that apply to foreign-to-foreign reorganizations and foreign Section 381 transactions in which either the foreign acquired corporation or foreign acquired corporation is newly created. This proposed regulation also includes rules for divisive reorganizations involving a foreign distributing corporation and a foreign controlled corporation and in which either corporation is newly created.
Finally, Prop Reg. Section 1.367(b)-13 provides special basis and holding period rules for certain Section 367(b) transactions involving a foreign corporation with 1248 shareholders. The purpose of these proposed rules is to preserve relevant Section 1248 amounts.
Conclusion
Corporate divisions of stock may prove that the value of two or more corporate groups are more valuable than the value of one larger corporation. However, there are a plethora of issues this creates, including the following that must be considered:
1. How to structure such a division in the most efficient manner; and
2. Whether the chosen method to divide the foreign corporation will trigger any adverse U.S. tax consequences (namely GILTI, subpart F tax regime, Section 367(b) or Section 1248).
These negative U.S. tax implications should not apply if the division of the foreign corporation or corporations are tax-free pursuant to Section 355 and careful planning is started well before the demerger.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. 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.