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U.S. Acquisitions by Foreign Corporations and Section 367 Considerations

U.S. Acquisitions by Foreign Corporations and Section 367 Considerations

U.S. corporations are routinely acquired by foreign corporations. Once a U.S. corporation is acquired by a foreign corporation, the ultimate disposition of the U.S. corporation’s appreciated property may occur outside the U.S. taxing jurisdiction. Section 367 was enacted to prevent tax-free transfers by U.S. taxpayers of appreciated property to foreign corporations that could then sell the property free of U.S. tax. Section 367 stands sentinel to ensure that (with certain exceptions) a U.S. 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 objection by treating the foreign transferred corporation as not qualifying as a “corporation” for purposes of certain tax-free-exchange provisions.

When property is transferred to a corporation in exchange for stock, recognition of gain or loss is governed by Section 351 and, if gain on a transfer to a foreign corporation is involved, Section 367 may reclassify the transaction. Under Section 351, no gain or loss is recognized 1) if property is transferred to a U.S. corporation by one or more persons solely in exchange for stock in the corporation and 2) if immediately after the exchange such person or persons are in control of the corporation. “Control” for this purpose means ownership of at least 80 percent of the total combined power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of each other class of stock. Section 351 thus may come into play whenever property with a value greater or less than its basis is transferred to a newly formed corporation by the initial subscribers to its stock. It may also operate to prevent recognition of gain or loss when such property is transferred to an existing corporation. However, as discussed above, where a transfer of property to a foreign corporation in exchange for its stock is involved, the nonrecognition of gain under Section 351 will apply only to the extent provided in Section 367.

For example, let’s assume a domestic corporation owns inventory with an adjusted basis of $100,000. The inventory has a fair market value of $200,000. Let’s also assume that the domestic corporation transfers the inventory to a foreign corporation, in exchange for all of the foreign corporation’s stock. Under Internal Revenue Code Section 351, the transaction would be tax-free and the foreign corporation would obtain a basis of $100,000 in the inventory. However, Section 367(a) prevents this result by treating the foreign corporation as not a corporation for purposes of Section 351. Under Section 367(a), domestic corporations would realize a gain of $100,000 on the transfer and be subject to U.S. income tax at the time the inventory is transferred to the foreign corporation.

Section 368 Reorganizations

The Internal Revenue Code provides for nonrecognition of gain or loss realized in connection with a number of corporate organizational changes.  The basic types of reorganization found in Section 368 of the Internal Revenue Code are:

  • Type A reorganization. In a Type A reorganization, the assets and liabilities of a target corporation are transferred to an acquiring corporation in a statutory merger or consolidation, and the target corporation is dissolved. The consideration received by the target’s shareholders is determined by the merger agreement. Internal Revenue Code Section 368(a)(1)(A) does not expressly limit the permissible consideration in a merger or consolidation. The IRS requires that at least 50% of the consideration paid must consist of stock. In the context of international corporate acquisitions, tax-free mergers may take the form of forward triangular mergers, in which the acquired corporation is merged into a subsidiary of the acquiring corporation.
  • Type B reorganization. A Type B reorganization takes place when a purchaser acquires the stock of a target corporation solely in exchange for the purchaser’s voting stock, provided that the purchaser is in “control” of the target immediately after the acquisition. See IRC Section 368(a)(1)(B). For this purpose, “control” is ownership of 80% or more of the target’s voting power and 80% or more of the total shares of each class of the target’s nonvoting stock.
  • Type C reorganization. A Type C reorganization generally takes place when the purchaser acquires substantially all of the target’s assets solely in exchange for the purchaser’s voting stock (or voting stock of the purchaser’s parent).
  • Type D reorganization. A Type D reorganization takes place when there is a transfer by a corporation of part or all of its assets to another corporation if immediately after the transfer the transferor and/or its shareholders are in control of the transferee corporation and if the stock of the transferred corporation are distributed in transaction qualifying under Section 354, 355, or 356.
  • Type E reorganization. A Type E reorganization is recapitalization of a corporation.
  • Type F reorganization. A Type F reorganization is a mere change in identity, form, or place of organization of one corporation, however effected. 
  • Type G reorganization. A Type G reorganization is a transfer by one corporation of all or part of its assets to another corporation in a bankruptcy proceeding or a similar proceeding. 

Internal Revenue Code Section 367(a) may prevent any of the tax-free reorganization discussed above on the theory that it prohibits tax-free transfers by U.S. taxpayers of appreciated property to foreign corporations. However, the regulation writers at the Internal Revenue Service (“IRS”) and the Department of Treasury (“Treasury”) recognize that when an outbound transfer of shares occurs and the owners of the U.S. corporation whose shares are transferred are minority shareholders, Section 367(a) should not apply because there is little chance for abuse. The regulations promulgated by the IRS and the Treasury have carved out an exception to Section 367(a) known as the “limited-interest exception.” The limited-interest exception provides for the nonrecognition of gain on the transfer of U.S. shares to a transferee foreign corporation provided the following tests are met.

  1. The U.S. person owns less than 5 percent (by both vote and value) of the stock of the transferee foreign corporation immediately after the transfer. Otherwise, the U.S. person must enter into a five-year gain recognition agreement with the IRS.
  2. 50 percent or less (by both vote and value) of the stock of the transferee foreign corporation is received, in the aggregate, by U.S. persons in the transaction.
  3. Immediately after the transfer, 50 percent or less (by both vote and value) of the stock of the transferee foreign corporation is owned, in the aggregate, by U.S. persons who (i) are officers or directors of the U.S. target company or (ii) owned 5 percent or more (by vote and value) of the stock of the U.S. target company immediately before the transfer.
  4. Satisfaction of the active trade or business test, which requires that (i) for the 36-month period immediately before the transfer, the transferee foreign corporation was engaged in an active trade or business outside the United States, (ii) at the time of the transfer, neither the U.S. persons nor the transferee foreign corporation intend to substantially dispose of, or discontinue, such trade or business, and (iii) at the time of the transfer, the value of the transferee foreign corporation is at least equal to the value of the U.S. target company. An active trade or business generally does not include the making or managing of investments for the account of the transferee foreign corporation.

See Treas. Reg. Section 1.367(a)-3(c).

Even if an acquisition o0f a U.S. corporation qualifies under the limited-interest exception discussed above, Section 367(d) may impact the transaction. 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 assets. 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 in a transaction (such as a merger or reorganization), the transferor will be treated as having sold the property in exchange for payments that are contingent on the productivity, use, or disposition of such property. These imputed or constructive royalty payments must reasonably reflect the amounts that would have been retained annually in the form of such payments over the useful life of such property. See IRC Section 367(d)(2)(A)(ii)(I). The constructive royalty is calculated in an amount that represents an arm’s length charge for the use of the property (as determined under the Section 482 regulations).

Under Section 367(d) of the Internal Revenue Code, the U.S. transferor is treated as having sold the intangible property to the foreign corporation in return for annual royalty payments received over the property’s useful life. These royalty payments are classified as ordinary income and are taxed to the U.S. transferor at ordinary, rather than capital gain rates. 

For example, USAco (a domestic corporation) incorporates ASIAco, a manufacturing subsidiary incorporated in a foreign country by transferring a patent to ASIAco in exchange for all of ASIAco’s shares. USAco had a zero basis in the patent because it had deducted the related research and development expenditures as these expenditures were incurred. Ignoring Section 367(d), USAco’s outbound transfer to ASIAco is not subject to U.S. tax because it is part of a tax-free incorporation transaction. However, Section 367(d) recharacterizes the transaction as a sale in return for foreign-source royalty received annually over the life of the patent. The deemed royalty regime applies to a U.S. person’s contribution of intangible property to a foreign corporation as part of a corporate reorganization. See IRC Section 367(d)(1). A limited exception to the deemed royalty regime may not be available to avoid the 367(d) intangible property recognition rules. However, in certain cases, a forward triangular merger can potentially be used as a planning option to mitigate the impact of Section 367(d).

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi & 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.