Treasury Issues Proposed Regulations Under Section 367(b)

The Treasury Department and the IRS on October 5 issued proposed regulations providing guidance under Internal Revenue Code Section 367(b) related to some triangular reorganizations and inbound nonrecognition transactions.

The proposed regulations incorporate, with modifications, the guidance provided in IRS Notice 2014-32 and IRS Notice 2016-73. Specifically, the proposed regulations address some transactions that were perceived to exploit the previously issued final regulations. Additionally, the proposed regulations take into account the increased prevalence of previously taxed earnings and profits (PTEP) and the impact of Section 245A as a result of the Tax Cuts and Jobs Act (TCJA).

Background

Section 367(b) was enacted to ensure that international tax policy implications were considered regarding certain nonrecognition transactions involving a foreign corporation. Specifically, the Section 367(b) final regulations were issued in 2011 to address the avoidance of U.S. tax on the repatriation of foreign earnings in connection with some triangular reorganizations.

Final Regulations – General Rule

The final regulations, found in Treas. Reg. §1.367(b)-10, apply to cross-border triangular reorganizations in which:

1. A subsidiary (S), in connection with the reorganization, purchases stock or other securities of its parent corporation (P) in exchange for property.
2. S exchanges the P stock or securities for the stock, securities, or other property of a target corporation (T). This regulation applies only if either P or S (or both) is a foreign corporation.

If the final regulations apply to the transaction, adjustments must be made that have the effect of a distribution of property from S to P under Section 301 (“deemed distribution”) equal to the fair market value of the money and other property used to acquire the P stock, followed by a contribution from P to S of an amount equal to the deemed distribution (“deemed contribution”). The deemed distribution is treated as a dividend to the extent of S’s earnings and profits.

Final Regulations – Exceptions

Several exceptions apply to the final regulations. Under the Section 367(a) priority rule, the general rule does not apply if the amount of gain that T’s shareholders would recognize under Section 367(a)(1) equals or exceeds the sum of the deemed dividend and the Section 301(c)(3) gain were the general rule to apply.

Along the same lines, the Section 367(b) priority rule provides an exception to the general rule of Section 367(a) if the amount of Section 367(a) income that T’s shareholders would recognize under Section 367(a) is less than the amount of the deemed distribution under Section 367(b). These rules were intended to subject a cross-border triangular reorganization to whichever Section 367 regime gives rise to the most income under Section 367.

The no-U.S.-tax exception, found in Treas. Reg. §1.367(b)-10(a)(2)(ii), turns off the general rule if S is a domestic corporation and P would not be subject to U.S. tax on a dividend received from S. Additionally, the Section 367(b) regulations contain an anti-abuse rule that requires “appropriate adjustments” if the cross-border triangular reorganization is undertaken “with a view” to avoid the purpose of the final regulations.

Treas. Reg. §1.367(b)-3

Treas. Reg. §1.367(b)-3 does not directly apply to cross-border triangular reorganizations, but it does include rules on the repatriation of foreign corporate assets in a Section 332 liquidation or an inbound asset acquisition under Section 368(a)(1). Under these rules, if an exchanging shareholder is a U.S. shareholder of the foreign acquired corporation, it is required to include the all E&P amount attributable to the stock of the foreign acquired corporation. The all E&P amount is generally the net positive amount of E&P that is attributable to the U.S. shareholder’s stock in the foreign acquired corporation and does not include the E&P of the foreign acquired corporation’s subsidiaries. The proposed regulations and Notice 2016-73 (discussed below) modify the application of these rules in some instances.

IRS Notice 2014-32

On April 25, 2014, the IRS issued Notice 2014-32, which identified transactions designed to exploit the exceptions in the final regulations. Specifically, the notice described transactions in which taxpayers applied the Section 367(a) priority rule, the Section 367(b) priority rule, and the no-U.S.-tax exception in a way that, contrary to the rules’ intended operation, resulted in the taxpayer being subject to the more favorable of the Section 367 tax regimes.

Notice 2014-32 announced that regulations would be issued under Section 367(b) to:

• Modify the Section 367 priority rules so that only Section 367(b) income that would actually be subject to U.S. tax would be considered.
• Narrow the scope of the no-U.S.-tax exception.
• Remove the deemed contribution rule.
• Clarify the application of the anti-abuse rule.

IRS Notice 2016-73

On December 2, 2016, the IRS issued Notice 2016-73, which identified additional transactions designed to exploit the Notice 2014-32 modified final regulations. These transactions included an example of a two-step transaction whereby a cross-border triangular reorganization is followed by a purportedly unrelated inbound nonrecognition transaction to which Treas. Reg. §1.367(b)-3 applies. The desired effect of the overall transaction is a repatriation of property from S to P without a corresponding income inclusion attributable to untaxed earnings and profits of S.

The notice announced that additional regulations would be issued under Section 367(b) to address these types of two-step transactions, as well as other transactions. The additional anti-abuse concepts of Notice 2016-73 have been largely adopted in the proposed regulations.

Proposed Regulations

The proposed regulations focus on inbound transactions that result in the repatriation of non-PTEP foreign earnings. The preamble to these regulations acknowledges that the TCJA resulted in an increase in the amount of foreign corporation E&P that is not taxable on distribution to the U.S. (either through Section 245A or the Section 959 PTEP rules). However, despite these changes, the IRS and Treasury believe that updated regulations under Section 367(b) remain necessary to carry out the policies of Section 367(b). Therefore, the proposed regulations would formalize the guidance found in Notice 2014-32 and Notice 2016-73, taking into account the changes made by the TCJA.

Priority Rules

The proposed regulations generally adopt the priority rule guidance in Notice 2014-32 and Notice 2016-73. Under this more restrictive approach, the Section 367(a) priority rule would not apply when T is foreign; instead, the modifications found in Notice 2014-32 (described above) would apply. As a result, certain T shareholders would be subject to Treas. Reg. §1.367(b)-4, which could result in an income inclusion or gain recognition event with respect to their exchange of T stock.

Excess Asset Basis (EAB) Rules

As discussed above, certain U.S. shareholders of a foreign acquired corporation in an inbound nonrecognition transaction are required to include the all-E&P amount as a deemed dividend. The IRS and Treasury have identified some scenarios where the all-E&P amount, as calculated in Treas. Reg. §1.367(b)-3, does not properly reflect the basis of its assets. Therefore, the proposed regulations would modify Treas. Reg. §1.367(b)-3 to include a new set of excess asset basis (EAB) rules that require a foreign acquired corporation to be treated as having received a deemed distribution of the “specified earnings” under Section 301, from its foreign subsidiaries (including PTEP), immediately before the inbound nonrecognition transaction.

EAB is generally the amount by which the inside asset basis of the foreign acquired corporation exceeds the sum of:

• The E&P attributable to the stock of the foreign acquired corporation using modified Section 1248 principles.
• The aggregate basis in the stock of the foreign acquired corporation immediately before the inbound transaction (without regard to any basis increase resulting from the inbound transaction).
• The aggregate liabilities assumed by the domestic acquirer in the inbound transaction.

The specified earnings are equal to the lesser of either the EAB amount or the “lower-tier earnings.” The lower-tier earnings are generally the aggregate E&P (including deficits) of all foreign subsidiaries of the foreign acquired corporation as if the foreign acquired corporation was a Section 1248 shareholder (if it were a U.S. person).

The proposed regulations provide a narrower scope for the EAB rules compared to Notice 2016-73. Under the updated proposed regulations, an adjustment to the all-E&P amount in an inbound nonrecognition transaction is required if (i) S previously acquired stock or securities of P in exchange for property in connection with a triangular reorganization and adjustments were not made that have the effect of a distribution of property from S to P under section 301, or (ii) EAB was previously created in connection with a transaction other than a triangular reorganization if the principal purpose of such other transaction was to create EAB.

In addition to the rules above, there are anti-abuse rules relating to EAB and additional notice requirements under Section 367(b) with regard to EAB.

Other Changes

• The proposed regulations contain three new examples to show the broad application of the anti-abuse rule found in the final regulations.
• The proposed regulations would repeal the deemed contribution rule and no longer require an adjustment for a deemed contribution.
• The proposed regulations implement a narrower scope of the no-U.S.-tax exception, which would not apply if P were a CFC.
• Additional reporting requirements.

The proposed regulations have different applicability dates:

• For rules described in Notice 2014-32, the proposed regulations would generally apply to transactions completed on or after April 25, 2014.
• For rules described in Notice 2016-73, the proposed regulations would generally apply to transactions completed on or after December 2, 2016.
• For any other rules, the proposed regulations would generally apply to transactions completed on or after October 6, 2023.

Insights

Taxpayers considering cross-border triangular reorganizations should carefully consider the impact of these rules, specifically when the target is foreign. The proposed regulations could make these types of cross-border triangular reorganizations tax inefficient.

The narrowing of the scope of the Treas. Reg. §1.367(b)-3 EAB rules reduces the burden on taxpayers undertaking an inbound nonrecognition transaction.

All taxpayers that have undergone a cross-border triangular reorganization within the applicability dates of the proposed regulations should review their transactions to understand the impact.