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A Brief Look at the Hurdles Involved in a Type F Cross-Border Reorganization

A Brief Look at the Hurdles Involved in a Type F Cross-Border Reorganization

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By Anthony Diosdi


In the corporate tax context, the term “reorganization” is a statutory term of art. Rather than providing a general definition, the Internal Revenue Code attempts to provide precise definitions for the term “reorganization” in Section 368(a)(1) with an exclusive list of seven specific types of transactions that will be considered “reorganizations.” Subparagraphs (A) through (G) of Section 368(a)(1) each provide a description of a particular reorganization transaction. Unless a transaction fits into one of the seven categories stated in subparagraphs (A) through (G), it is not a corporate reorganization.

A Type F reorganization involves “a mere change in identity, or place of organization of one corporation, however effected.” See IRC Section 368(a)(1)(F). The major tax advantage to classification as a Type F reorganization is a preferential set of rules that will apply after the reorganization regarding loss carryovers. For example, after a Type F reorganization, in many cases, the new corporation has an opportunity to use net operating losses of an old corporation against its income.

An example of a Type F reorganization is a corporate reincorporation in another state. A California corporation may decide that it is more advantageous to incorporate in Florida. Upon reincorporation in Florida, the shareholders of the old California corporation will be issued shares in the new Florida corporation. If the shareholders receive virtually identical interests in the new corporation that they previously held in the old corporation, the reorganization will qualify as a tax-free Type F reorganization. 

Treasury Regulation Section 1.368-2(m) requires the following in order for a Type F reorganization to be tax-free:

1) Immediately after the transaction, all stock of the resulting corporation must be distributed in exchange for stock of the transferor corporation;

2) The same person or persons must own the resulting corporation in the same proportion as they owned the transferor corporation in the same proportion as they owned the transferor corporation;

3) The resulting corporation cannot have prior assets or tax attributes;

4) The transferor corporation must be completely liquidated;

5) The resulting corporation must be the only acquiring corporation;

6) The transferor corporation must be the only transferring corporation. 

Not surprisingly, satisfying the above discussed elements can be complicated in the international context. Even if the reorganization prongs discussed in Treasury Regulation Section 1.368-2(m) are satisfied in a Type F reorganization, Internal Revenue Code Section 367 must be considered. Internal Revenue Code Section 367 has provided the mechanism for protecting the U.S. taxing jurisdiction in transactions involving transfers by U.S. taxpayers of appreciated property in exchange for stock when one or more foreign corporations are involved.

Introduction to Internal Revenue Code Section 367(a)

Section 367 of the Internal Revenue Code was originally aimed at preventing tax-free transfers by U.S. taxpayers of appreciated property to foreign corporations that could 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. Today, Internal Revenue Code Section 367(a) provides a general rule of taxability with respect to outbound transfers of property in exchange for other property in a Type F reorganization. The character and source of gain produced by Section 367 is determined as if the transferor had sold the property to the transferred in a taxable transaction. Under the pre-2018 rules, Section 367(a) required taxpayers to recognize gain on outbound transfers unless: 1) the transfer qualified for an active trade or business exception, or 2) the assets consisted of stock or securities of a foreign corporation and the U.S. transferor entered into a gain-recognition agreement to preserve gain. In the Tax Cuts and Jobs Act, Congress eliminated the active trade or business exception. This means that it is no longer to incorporate a foreign branch for purposes of a tax-free cross-border reorganization. The only exception to Section 367(a) that now remains for purposes of tax-free cross-border reorganizations is to transfer stock to a foreign corporation by virtue of a gain-recognition agreement.

Gain Recognition Agreements in the Context of Cross-Border Type F Reorganizations

The general rule of taxability applies to transfers of stock or securities by a U.S. person to a foreign corporation unless an exception is available. One such exception is the execution of a closing agreement between the Internal Revenue Service (“IRS”) and the U.S. transferor under which the transferor must agree to recognize taxable gain on the transferee corporation’s later disposition of the transferred stock or securities (a “gain-recognition agreement”). The gain-recognition agreement requires the U.S. transferor to recognize any realized gain in the transferred stock or securities not recognized at the time of transfer if the transferee foreign corporation disposes of the transferred stock or securities during the five-year gain-recognition period. Gain recognition to the U.S. transferor is also triggered if the corporation (the “transferred corporation”) disposes of substantially all of its assets. If the transferee foreign corporation disposes of the transferred property (or the transferred corporation disposes of substantially all of its assets) during the five-year period in which the gain-recognition agreement is in effect, the U.S. transferor must recognize any previously unrecognized gain plus pay an interest charge. If gain is triggered under the gain-recognition agreement, the U.S. transferor files an amended federal income tax return for the year of the transfer, reporting the previously unrecognized gain and interest charge or the transferor may report the previously unrecognized gain and interest charge on the return in which the triggering event occurs.

A gain-recognition agreement is an agreement to which the U.S. transferor agrees to recognize gain if the transferred foreign corporation disposes of the transferred stock or securities during the term of the gain recognition and pay interest on any additional tax owing if a “triggering event” occurs. For purposes of Section 367(a), the term “United States transferor” includes: 1) a citizen or resident of the United States; 2) a domestic corporation; 3) a U.S. citizen, resident, or domestic corporation that is directly or indirectly a partner in a domestic or foreign partnership that transfers property to a foreign corporation; and 4) any estate or trust (other than a foreign estate or trust under Section 7701(a)(31). A “triggering event” typically takes place when a foreign corporation disposes of the untaxed U.S. property.  In most cases, a gain recognition agreement term is 60 months following the end of the taxable year in which the initial transfer is made. This means, in certain cases, with a properly drafted gain-recognition agreement, the adverse tax federal income consequences associated with a cross-border Type F reorganization can be deferred up to five years, interest-free.

Special Rules for Intangibles

A Type F reorganization presents special problems if the transferring corporation wishes to transfer intangibles to a foreign corporation. Under Section 367(d), as broadly defined in Section 936(h)(3)(B) are treated as a special class of a tainted asset. Section 936(h)(3)(B) defines the term “intangible property” to include a patent, invention, formula, process, design, process, know-how, copyright, literary, musical, artistic composition, trademark, trade name, brand name, franchise license, contract, method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, technical data, goodwill, going concern value, or workplace.

In the context of a Type F cross-border reoganzation (or any other type of cross-border reorganization), the transferor will be treated as having sold “intangible property” discussed above in exchange for payments that are contingent on the productivity, use or disposition of such property. Section 367(d) provides that in the case of any transfer of intangible property in a Type F (or any other type of cross-border reorganization), the transferor must recognize royalty income with respect to such transfer to be commensurate with the income attributable to the property. This means a constructive royalty must be calculated in an amount that represents an arm’s length charge for the use of the intangible property (as per the regulations under Section 482 of the Internal Revenue Code).

An example as to how Section 367(d) operates in a typical cross-border reorganization is discussed below.

DC, a U.S. corporation, owns all of the stock of FS, a foreign corporation. (FS is a controlled corporation (within the meaning of Section 957(a)). DC incurs and deducts under Internal Revenue Code Section 162 and 174 various expenses relating to the development of a patented invention. After completing development of the patented invention, DC transfers the patent to FS in a transaction that, in the absence of Internal Revenue Code Section 367(d), would qualify for nonrecognition treatment under the Internal Revenue Code. FS will use the patent in its trade or business. Section 367(d) will treat DC as having sold the property to FS in exchange for payments that are contingent on the productivity, use or disposition of the patent. These constructive royalty payments are calculated in an amount which reflects an arm’s length charge for the use of the patent.

Special considerations must be given in any case involving the transfer of intangible property through a cross-border Type F or any other cross-border reorganizations. 

Conclusion

While not appropriate in all circumstances, a cross-border Type F reorganization can be useful to U.S. corporate shareholders seeking reorganization in a foreign jurisdiction and defer adverse U.S. federal tax consequences for up to 60 months.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals. He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or 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.

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