Category: International Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Background Mr. X and Ms. Y owned 80% and 20% respectively of ABC, Inc., a Nevada corporation, and XYZ, Inc., a Guam corporation. Mr. X and Ms. Y transferred their ABC, Inc. (ABC) stock to XYZ, Inc. (XYZ) as a contribution to capital. No additional XYZ stock was issued as a result of the contribution. Immediately after the contribution to capital, ABC was liquidated into XYZ (according to the accompanying agreement) under Section 336--and presumably Section 331. Subsidiary liquidations are normally within the ambit of Sections 337 and 332; however, as discussed below, it appears that the reference to Section 336 in the agreement is intentional and warranted by virtue of the operation of Section 367.] Contribution to Capital 367(a) by its terms applies to property transferred by a U.S. person to a foreign corporation in an exchanged governed by Sections 332, 351, 355, 356, or 361. Here there are two transactions: the contribution of ABC stock to the capital of XYZ and the subsequent liquidation of ABC into XYZ. It appears that both transactions are subject to Section 367. In general, Section 367(a) is triggered by a transfer of property by a U.S. person to a foreign corporation if the transfer is covered by various enumerated tax-favored transfer provisions. The required elements under Section 367(a) are the following. · a transfer of property; · the transfer is made by a U.S. person; · the transferee is a foreign corporation; and · the exchange is governed by Sections 332, 351, 355, 356, or 361. Turning now to the first transaction, the contribution to capital, it is completely clear the ABC stock transferred to XYZ is property for purposes of Section 367 and the transferors, Mr. X and Ms. Y, are U.S. persons. It also seems clear that XYZ, the transferee corporation, is a foreign corporation. Section 367 references Section 7701 for its definition of the word foreign. Sec. 7701(a)(5) says foreign means not domestic. Section 7701(a)(4) says the term domestic when applied to a corporation or partnership means created or organized in the U.S. or under the law of the U.S. or any state. Section 7701(a)(10) says the term state includes the District of Columbia where that construction is necessary to carry out the provisions of Title 26. Reg. Sec. 301.7701-5 provides in pertinent part as follows. A domestic corporation is one organized or created in the United States, including only the States (and during the periods when not States, the Territories of Alaska and Hawaii), and the District of Columbia, or under the law of the United States or of any State or Territory. A foreign corporation is one which is not domestic. Guam is not a state or territory of the United States. Thus, XYZ is a foreign corporation for purposes of Section 367. In this case, there is no issuance of additional XYZ stock in respect of the contribution of the stock of ABC. As such, Section 351 arguably does not apply. However, Section 367(c)(2) provides that Section 367(a) applies if a U.S. person makes a contribution of property to the capital of a foreign corporation. The amount subject to Section 367(a) is the gain that would have resulted from the sale of the contributed property at fair market value. Note that Section 367 applies on an asset-by-asset basis; and, while gain must be recognized, losses generally are not allowed. See Revenue Ruling 67-192, 1967-2 CB 140, and Reg. Sec. 1.367(a)-1T(b)(3)(ii). In this case, I understand that there was no overall gain or loss on the transfer of stock by Mr. X and Ms. Y. If, however, the various shares transferred were acquired at different times or through different means such that some shares have a different basis from others, it is possible that the transfer could give rise to gain with respect to some of the shares and loss with respect to others. Section 367 requires recognition of the gain but prohibits recognition of the offsetting loss. The plain language of Sections 367(a) and 367(c)(2) lead rather simply to the conclusion that the initial contribution of ABC shares to XYZ is a taxable event. These general provisions are operative with respect to virtually any type of property transfer, but Section 367 was enacted as an anti-abuse or "loophole closing" device. As such, Congress and Treasury created extremely complex rules aimed at closing every potential abusive practiceboth real and imaginary. The result is an amazingly complex and overlapping web of statutory and regulatory provisions. Despite the apparent simplicity of the determination that the rules of Section 367(a) and 367(c)(2) apply to the transfer, these other rules must also be examined, if only to rule them out. There are special rules dealing with the transfer of a intangible assets to a foreign corporation. See Section 367(d). Since stock is an intangible asset, it is important to determine whether these rules apply. For purposes of Section 367(d), the term intangible asset is defined by reference to Section 936(h)(3)(B) and includes such items as patents, copyrights, trademarks, trade names, and other such intellectual property. Stock does not qualify as an intangible for this purpose; thus, these rules do not apply to the transfer of ABC stock to XYZ. There are special rules dealing with expatriation of stock or securities which rules directly address the type of stock transfer here at issue. Regulation Section 1.367(a)-3 and 1.367(a)-3T. Among other things, the so-called expatriation rules mitigate the broad rules of Sections 367(a) and 367(c)(2) by allowing certain taxpayer to avoid immediate gain recognition by entering into an agreement to subject any pre- contribution gain to U.S. taxation should the distributee entity dispose of the contributed interest within a certain time period. Such an agreement is referred to as a Gain Recognition Agreement (GRA). These rules also create various disclosure obligations. Significant penalties apply if a taxpayer fails to make the required disclosure. Generally, the expatriation rules provide the opportunity to avoid gain recognition through a GRA if the transferors do not own more than 50% of the transferee corporation immediately after the transfer. In this case, the transferors own 100% of the transferee immediately after the transfer. Thus, these mitigating provision along with their required disclosures do not apply to this situation. Liquidation of ABC Although Section 367(a) specifically mentions liquidations under Section 332, the provision controlling the shareholder-level tax effect of the liquidation of an 80%-or- more owned subsidiary into its corporate parent, Section 367(e)(2) provides a more specific rule. Except as provided by regulations, Section 337(a) and 337(b)(1) shall not apply to liquidations subject to Section 332 if the 80%-distributee is a foreign corporation. Sections 337(a) and 337(b)(1) in general allow an 80%-or-more owned subsidiary to be liquidated into its corporate parent without gain recognition at the subsidiary level. Without these provisions, the general liquidation rules of Section 336 apply to the effect that the liquidation is treated at the subsidiary level as a sale at fair market value of all the subsidiary's assets. The regulations mentioned at Section 367(e)(2) contain no relevant exceptions. Regulation Section 1.367(e)-2T. Accordingly, the liquidation of ABC into XYZ is a taxable event at ABC's level and should be treated and reported as if ABC had sold all its assets. Unlike the general rule under Section 367(a), losses can be recognized on outbound subsidiary liquidations. The amount of recognized loss is subject to two limitations set forth at Regulation Section 1.367(e)-2T(b)(2)(ii). The total capital loss recognized on the liquidation cannot exceed the total recognized capital gain. The total recognized ordinary loss cannot exceed the total recognized ordinary gain. At XYZ's level, the liquidation should be reported on Schedule D as receipt of ABC's assets (at fair market value) in a taxable exchange for ABC's stock. Disclosure Section 6038B and its regulations require Mr. X and Ms. Y to file Form 926 as part of their income tax returns for the year of the transfer. The statute of limitations with respect to any taxes related to Section 367 does not begin to run until this form is filed. Mr. X and Ms. Y are required to file Form 5471 as well. This disclosure reports ownership of a foreign corporation by a U.S. persona and various transactions between such owners and their foreign corporations. Form 5471 is filed as part of the income tax return. I very much suspect that Form 5471 would be required (and will be required annually in the future) irrespective of the capital contribution. Section 6038B and its regulations require ABC to file Form 926 to report the liquidation into XYZ. Again, Form 926 is part of ABC's income tax return for the year of the transfer. Again, the statute of limitations with respect to any taxes related to Section 367 does not begin to run until this form is filed. ABC is required (and as I understand it has already filed) Form 966 within 30 days of its adoption of a plan of liquidation. ABC should file Forms 1099-DIV and 1096 to report the distribution of cash and other property in complete liquidation. Form 1099-DIV provides the opportunity to distinguish a liquidating distribution from an ordinary dividend. |
