Section 367 Adrift

21 Pages·2016·0.24 MB·English

tax notes
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Reprinted from Tax Notes, May 30, 2016, p. 1207 a
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Section 367 Adrift: Old Statute, theRevenueActof1962,2thegeneralprinciplesthat 20
1
would govern not only future administrative guid- 6
NByePwetAerpMp.liDcaautbions apnrecceebputsthalasvoesitnaftourtmoreydammoesntdsmecetinotns3w6e7rgeusiedt.aTnhceostoe . All righ
this day. ts
Beginning in 1994 and accelerating rapidly 12 res
e
Peter M. Daub is a part- yearslater,however,theIRShasissuednoticesand rv
e
ner at Morgan, Lewis & proposed regulations under three of section 367’s d. T
Bockius LLP. He thanks his subsections that greatly deviate from these prin- a
x
colleagues F. Scott Farmer, ciples and arguably conflict with the statutory lan- A
n
DanielV.Stern,andJohnD. guage.Section367historicallyfunctioned—andfor aly
Barlow for their invaluable s
the most part continues to function — as a house- ts
assistance.Apriorversionof keepingprovisionthatadaptstheoperationofspeci- do
this report was presented to e
fied subchapter C nonrecognition provisions to s
ameetingoftheWashington n
cross-border and foreign-to-foreign transactions. o
International Tax Study t c
PeterM.Daub Group. Lately,however,whentheIRShasdetectedabuse,it laim
has seized on its broad but not unlimited authority
In this report, which is the first of two parts, under section 367 to negate the operation of basic cop
Daub traces the development of section 367 policy y
athnedIRadSdhraesssaeltserheodwthienarpepcleincattiaonntioafbusescetiognui3d6a7nctoe ceoffdeectrouflheosaoruytUsi.dSe.insucobmcheatpatxeprrCincainpdless.uIstpheansddothnee right in
cross-border and foreign-to-foreign transactions. so in furtherance of its own (and Treasury’s) con- a
n
ceptionofproperU.S.taxingjurisdiction,oftheap- y
Copyright 2016 Peter M. Daub. propriate time for levying tax on funds remitted pu
b
All rights reserved. fromforeignsubsidiaries,andofwhenforeignsub- lic
d
sidiary earnings should be subject to tax without o
m
actual distribution. As might be inferred from this a
Table of Contents in
statement,Congresshasfurnishednoevidencethat o
I. DA.evTehloep1m93e2nAt octf S.e.c.ti.on. .3.6.7.P.o.li.cy. . .. .. .. .. .. 11220088 iftaialugrreeetos ewniathcttahdamticnoinstcreaptitoionnp.rIonpdoeseadls, rCeoflnegctreedssi’ns r third p
B. The Guidelines . . . . . . . . . . . . . . . . . . 1210 the guidance suggests just the opposite. arty
The first part of this report addresses the devel- c
C. The Tax ReformAct of 1976 . . . . . . . . . 1212 o
D. TEFRA . . . . . . . . . . . . . . . . . . . . . . . 1213 opment of section 367 policy. It starts with the nte
E. The Deficit ReductionAct of 1984 . . . . . 1213 enactment of the statute’s ultimate predecessor in nt.
1932, close on the heels of the enactment of the
F. TAMRA . . . . . . . . . . . . . . . . . . . . . . . 1216
current income tax and even closer to the adoption
G. Other Legislation and Summary . . . . . . 1217
of subchapter C’s remote antecedents. As demon-
H. AdministrativeActivity . . . . . . . . . . . . 1217
strated by the discussion, section 367 has had a
I. Conclusion . . . . . . . . . . . . . . . . . . . . . 1220 single purpose from its inception: to call off or
II. New Uses for Section 367 . . . . . . . . . . . . 1220 modify the application of specified subchapter C
A. Inversions . . . . . . . . . . . . . . . . . . . . . 1221 provisions (such as section 351 or 332) to a cross-
Except for relatively minor changes, section 367 border or foreign-to-foreign transaction when ap-
remains in the form the 1988 Technical and Miscel- plying them would thwart the application of any
laneous Revenue Act (TAMRA)1 left it. Indeed, the basictaxpoliciesorprovisions.Thus,ashistorically
legislativehistoryofthestatute’sultimate1932pro- understood, section 367 applies only when (1) the
genitor already reflected the basic rationale for the satisfaction of a basic policy or provision, such as
provision.Onecouldarguethat,withtheIRS’sfine- the clear reflection of income or the prevention of
tuning of its approach to section 367 in the wake of assignment of income, is at stake; and (2) the
1P.L.100-647. 2P.L.87-834.
TAXNOTES,May30,2016 1207
COMMENTARY/SPECIALREPORT
unmodifiedapplicationofasubchapterCprovision this period largely refine policy positions estab-
specifiedinsection367toacross-borderorforeign- lished by legislation, regulations, and other guid-
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to-foreigntransactionwouldfrustrateorinhibitthat ance issued by the IRS by the early 1990s. Set forth ) T
basic policy or provision. below are the milestones in section 367 history that a
x
As described below, this general principle reflect the policies now reflected in section 367(a), An
a
evolved over the years. For example, section 367 at (b), and (d). ly
s
first applied only when the taxpayer had a subjec- ts
A. The 1932 Act 2
tive motive to avoid the application of a tax policy, Section 112(k) of the Revenue Act of 19324 in- 016
suchastherecognitionofrealizedgainonanasset, cluded the common predecessor of current section . A
tthoroaucgrhosths-ebaoprdpelircattriaonnsoacftaiosnu.bcLhaateprtetrhCepcroovveirsaiogne 367(a), (b), and (d). Its single sentence provided: ll righ
epxropvainsdioendstotocaallcorfofstsh-eboarpdpelrictartaionnsaocftisounbcwhhapatteevreCr Irnecdoegtneirzmediniinngththeeceaxsteeonfttaonwyhoifcthhgeaeixncshhaanllgbees ts rese
the taxpayer’s motivation, as long as that applica- or distributions...described in...[among rve
tion could frustrate or undermine the policy. The otherprovisions,currentsections354,361,351, d. T
scope of section 367 grew with the development of and 356], a foreign corporation shall not be ax
tax policy outside section 367 generally. Thus, it considered as a corporation unless, prior to An
served as a backstop to section 1248 before serving such exchange or distribution, it has been es- aly
s
the same function for General Utilities repeal. tablished to the satisfaction of the Commis- ts
Untilthereleaseofantiabuseguidancebeginning sionerthatsuchexchangeordistributionisnot doe
in pursuance of a plan having as one of its s
in 1996, however, neither the courts nor the IRS n
principal purposes the avoidance of Federal o
understood section 367 as applying unless the un- t c
modified application of a subchapter C provision income taxes. laim
specifiedinsection367toacross-borderorforeign- Despiteitsbrevity,theoriginallanguagesuggests c
o
to-foreign transaction would thwart a basic tax features that guided the legislative and administra- py
policy or provision. The second part of this report tive development of section 367 over the next 84 rig
h
addresseshowinrecentantiabuseguidancetheIRS years. t in
has,withoutjustificationinthestatute’stextorleg- First, the provision invests the IRS with the au- an
y
islativehistory,selectivelyrelaxedthisrequirement. thority to suspend the operation of only the cited p
u
nonrecognition provisions of subchapter C regard- b
lic
I. Development of Section 367 Policy inggain,andonlywhenaforeigncorporation’ssta- d
o
Since 1932 Congress and the IRS have tried to tus as a corporation is critical to the provision’s m
a
tailor the statute and the regulations ever more operation.Forexample,section351,oneofthecited in o
preciselytotheunderlyingprinciplesofthesection provisions, requires nonrecognition of gain or loss r th
367 provisions now found in subsections (a), (b), only for a transfer of property to a corporation in ird
and (d).3 The mind-numbing complexity of the exchange for its stock. It does not provide for non- pa
regulations understandably can, but should not, recognition of gain arising from the exchange of rty
obscure the themes that have consistently reap- propertyforaninterestinanyothertypeofentityor co
n
peared over several decades.Admittedly, the many indeed any other type of property. Section 367, at ten
changesintheregulationstestifytothedifficultyof least in its initial form, had no relevance to such t.
drafting rules to implement the principles, and exchanges.
overbreadth and underbreadth have characterized At the same time, section 367 does not give the
manyintermediatepositions.Nonetheless,by1994, IRS authority to call off the application of nonrec-
whentheIRSbeganissuingguidanceundersection ognition provisions not cited, even when the status
367attackingparticulartransactions,thelineaments of a corporation as a corporation is critical to their
ofsection367policyandrules,ifnotallthedetails, operation.Thus,astheIRShasitselfacknowledged,
were fairly clear. section 367 does not suspend the application of
section 1036, which provides that no gain or loss
Atleastsince2000,theIRShasissuedsection367
will be recognized if common or preferred stock in
guidance in most years and occasionally more than
a corporation is exchanged solely for common or
once in a year. Yet the regulations released during
preferred stock, respectively, in the same corpora-
tion.5 Similarly, as discussed below, although the
3For general discussion of section 367 policy, see Charles I.
Kingson, ‘‘Seven Lessons on Section 367,’’ Tax Notes, Sept. 13,
2004,p.1015;Kingson,‘‘TheNewTheory&PracticeofSection 4P.L.72-154.
367,’’69Taxes1008(1991);andKingson,‘‘TheTheory&Practice 5In Rev. Rul. 72-420, 1972-2 C.B. 473, obsoleted by Rev. Rul.
ofSection367,’’37N.Y.U.Inst.onFed.Tax’n,section22.01(1979). 78-381,1978-2C.B.347,aDutchcorporationamendeditsarticles
(Footnotecontinuedonnextpage.)
1208 TAXNOTES,May30,2016
COMMENTARY/SPECIALREPORT
IRS has now claimed otherwise, section 367 should Americancitizen,owns100,000sharesofstock
not affect the operation of section 1032(a), which in corporation X, which originally cost him
(C
provides for the nonrecognition of gain to a corpo- $1,000,000 but now has a market value of ) T
ration on the receipt of money or other property in $10,000,000. Instead of selling the stock out- a
x
exchange for its stock. More basically, section 367 rightAorganizesacorporationunderthelaws A
n
a
does not give the IRS authority to require the of Canada to which he transfers the 100,000 ly
s
recognition of gain that has not been realized or sharesofstockinexchangefortheentirecapital ts
2
gain or income that does not exist, since that stock of the Canadian company. This transac- 0
1
recognitionisobviouslynotfundamentaltaxpolicy. tion is a nontaxable exchange. The Canadian 6. A
TIRhSusa,uftohroerixtaymtoplree,qsuecirteiotnhe36r7ecsohgonuiltdionnootfgiinvceotmhee c$o1r0p,0o0r0a,t0i0o0nsinellcsatshhe.sTtohcekloafttceorrptroarnastaiocntioXnfoisr ll rig
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fromthereceiptofmoneyinexchangeforproperty exempt from tax under the Canadian law and ts re
when the amount of money received does not isnottaxableasUnitedStatesincomeunderthe s
e
exceed the seller’s basis in the property. present law. The Canadian corporation orga- rv
e
Second, as the statute’s language indicates, sec- nizes corporation Y under the laws of the d. T
tion 367, at least in its initial form, applied only UnitedStatesandtransfersthe$10,000,000cash ax
when it had not been established to the IRS’s receiveduponthesaleofcorporationX’sstock An
satisfaction that the transaction was ‘‘not in pursu- inexchangefortheentirecapitalstockofY.The aly
s
ance of a plan having as one of its principal Canadian corporation then distributes the ts
d
purposestheavoidanceofFederalincometaxes’’— stock of Y to Ain connection with a reorgani- o
e
that is, when the taxpayer had a subjective motive zation.Bythisseriesoftransactions,Ahashad s n
to avoid tax. Albeit tersely, the reports of the thestockofXconvertedintocashandnowhas ot c
taxwriting committees illuminate the type of tax it in complete control. la
im
avoidance that animated the provision and contin- While it is probable that the courts will not co
ues to do so: p
hold all transactions of this nature to be tax- y
rig
Property may be transferred to foreign corpo- free exchanges, the committee is convinced h
rations without recognition of gain under the that the existing law may afford opportunity t in
a
exchangeandreorganizationsectionsoftheex- for substantial tax avoidance. To prevent this ny
isting law. This constitutes a serious loophole avoidance the bill withdraws the transaction pu
b
foravoidanceoftaxes.Taxpayershavinglarge from the operation of the nonrecognition sec- lic
unrealized profits in securities may transfer tions where a foreign corporation is a party to do
m
such securities to corporations organized in the transaction, unless prior to the exchange a
countriesimposingnotaxuponthesaleofcapi- the commissioner is satisfied that the transac- in o
tal assets. Then, by subsequent sale of these tionisnotinpursuanceofaplanhavingasone r th
assetsintheforeigncountry,theentiretaxupon of its principal purposes the avoidance of ird
thecapitalgainisavoided.Forexample,A,an taxes.6 pa
rty
Onthebasisofthefactsintheexample,Congress c
o
n
concluded that the taxpayer’s outbound transfer of te
n
of association to change from a naamloze vennootschap to a securities had as one of its principal purposes the t.
besloten vennootschap. The IRS concluded that even though the avoidanceofthetaxpayer’srecognitionofgainfrom
exchangewasasection368(a)(1)(F)reorganizationinwhichthe thedispositionofthesecuritiesunderthepredeces-
shareholders (but for section 367) would not have recognized sor of section 1001 through the assignment of that
gainorlossundersection354,theexchangingshareholdersalso
gaintoaforeigncorporation.Someofthefactsthat
would not have recognized gain or loss under section 1036.
apparently led to this conclusion were that (1) the
Since, according to the IRS, ‘‘the shareholders do not need to
relyonsection354oftheCodefornonrecognitionofgainupon taxpayer was about to realize the gain from the
theexchangeofstock,’’theydidnotrecognizegainorlosseven securities (‘‘instead of selling the securities out-
though they failed to comply with the ruling requirement in right’’) and, because the taxpayer owned all its
section367.AlthoughtheIRSlaterobsoletedRev.Rul.72-420in
shares,couldcausetheCanadiancorporationtosell
light of the elimination of the ruling requirement for transac-
the securities; (2) the assets were liquid; and (3)
tionsnowcoveredbysection367,theprinciplethatnonrecog-
nition of gain or loss under section 1036 does not depend on given that the Canadian corporation sold the secu-
compliance with section 367 remains. Of course, other rules rities, the taxpayer did not need to locate them
couldcallofftheapplicationofanonrecognitionrule.See,e.g., outsidetheUnitedStatesforbusinessorinvestment
reg. section 1.367(a)-7(b)(2), which, under the authority of
section337(d)(investingtheIRSwiththeauthoritytoprescribe
regulations carrying out General Utilities repeal), provides for
thenonapplicationofanonrecognitionrulenotenumeratedin
section367(a)(1)togainorlossrealizedonthetransferbyaU.S. 6H.R. Rep. No. 72-708, at 20 (1932); S. Rep. No. 72-665, at
corporationofpropertytoaforeigncorporation. 26-27(1932).
TAXNOTES,May30,2016 1209
COMMENTARY/SPECIALREPORT
reasons. Thus, in this case, by calling off the appli- complished this objective.7 Effectively, section 1248
cation of section 351, a subchapter C provision, deems a selling shareholder meeting the control re- (C
section367satisfiedtheassignmentofincomeprin- quirements to have received, just before the sale, a ) T
ciple by preventing, through the expedient of a dividenddistributionfromthecorporation(andin- ax
cross-border transaction, the taxpayer’s permanent directly from its subsidiaries) partially or wholly in An
a
avoidance of tax on gain in the assets that arose lieu of consideration from the buyer. Thus, section ly
s
duringthetaxpayer’sholdingperiod.Theprovision 1248 protects the shareholder-level tax on foreign ts 2
corporate earnings when the control requirements 0
thus perfectly illustrates the point of section 367 to 1
call off the application of a specified subchapter C are met. 6. A
papropvliicsaiotinontowaouclrdosus-nbdoerrdmerinteraanbsaacstiicotnaxwphoelnicyt.hat IRSInerxepspanodnesedtothtehesceonpaectmofenwthoaftseisctinoonw12s4e8c,titohne ll righ
367(b) to prevent the avoidance of section 1248 ts re
Thetransferofthecashproceedsfromthesaleto through the subchapter C nonrecognition provi- s
e
adomesticcorporationisanotherillustration.Since sions.Ineffect,section367wastooperateasaback- rv
e
d
Aowned all the stock of the Canadian corporation, stop to other provisions, in this case section 1248, . T
even without having the Canadian corporation whatever the taxpayer’s subjective motive. The ex- ax
transfer the cash to the domestic corporation, A ample in the 1932 legislation had suggested that An
a
wouldhave‘‘hadthestockofXconvertedintocash section 367 should call off a nonrecognition provi- ly
s
and[wouldhavehad]itincompletecontrol.’’What sionwhenataxpayer’sactualtaxavoidancemotive ts
d
wastroublingaboutthetax-freetransferofthecash could have been inferred — when, in the language oe
to Y and the distribution of the stock to Awithout of the statute, the transaction had been ‘‘in pursu- s n
o
gain recognition (under the predecessor of section ance of a plan’’ to avoid tax that was about to be t c
imposed. Now the existence of a plan would effec- la
355) to the Canadian corporation or A was that Y, im
unlike the Canadian corporation, was subject to tively be presumed if a nonrecognition transaction c
o
byitsnaturepermanentlyavoidedtheapplicationof p
U.S. tax. The domestic corporation could use the y
a clearly stated policy, such as the policy of section rig
cash to purchase a depreciable asset for which it h
couldclaim$10millionofdepreciationdeductions, 1248. t in
In Rev. Proc. 68-23,8 the IRS provided guidelines a
even though only $1 million (the amount that A n
originallypaidforthesecurities)waseversubjectto describing the circumstances under which it would y pu
ordinarily grant an advance private letter ruling to b
U.S. tax. Thus, section 367 satisfied the clear reflec- the effect that a nonrecognition exchange specified lic d
tion of income principle by calling off the applica- o
insection367wasnotinpursuanceofaplanhaving m
tion of section 355 to the cross-border spinoff. a
as one of its purposes the avoidance of federal in
B.NTohteuGntuilidtheeliTnaexsReformActof1976didCongress itenixoccnohsmantehgaetat,xtewhseo.uUOldnnieteegndusuSidtraeetleitnsheawti,odueanlsdtiafnieordtesltouhslete octaofxnitdnhige- or third p
a
make any substantive changes to the statute as it jurisdiction over the earnings that the exchanging rty
appeared in 1932. Even before TRA1976, however, shareholder would have included under section c
o
n
theIRSdeterminedthatotherlegislationwarranted 1248 had it sold the shares rather than exchanged te
n
therefinementofsection367’srole.Theintroduction them in a nonrecognition transaction. For example, t.
ofsection1248bytheRevenueActof1962ledtheIRS theIRSwouldgrantafavorablerulingonaforeign-
toexpandthetaxavoidancefunctionofsection367. to-foreign asset reorganization in which the transf-
Ingeneralterms,section1248characterizesasadivi- eror corporation was a controlled foreign
dend the gain that a U.S. person (whether an indi- corporation9atanytimeduringthefive-yearperiod
vidual or a corporation) recognizes on the sale of
stock in a foreign corporation based on the corpo-
ration’s earnings, including its subsidiaries’ earn-
7S.Rep.No.87-1881,1962-3C.B.707,813(1962).
ings, allocable to the person’s shares during the 81968-1C.B.821.
period in the previous five years when the corpo- 9Seesection957(a)(definingaCFCas‘‘anyforeigncorpora-
ration was controlled by 10 percent U.S. sharehold- tionifmorethan50percentofthetotalcombinedvotingpower
ofallclassesofstockofsuchcorporationentitledtovoteorthe
ers, if the selling person was such a shareholder at
totalvalueofthestockofsuchcorporation,isowned(withinthe
any time during that period. The taxwriting com-
meaningofsection958(a)),orisownedbyapplyingtherulesof
mittees declared that the legislation had ‘‘as one of ownership of section 958(b), by United States shareholders
its objectives in the foreign income area the impo- (‘U.S.Shareholders’)onanydayduringthetaxableyearofsuch
corporation’’); and section 951(b) (providing that a U.S. share-
sitionofthefullU.S.taxwhenincomeearnedabroad
holder ‘‘means, with respect to any foreign corporation, a
is repatriated.’’ They believed that section 1248 ac- United States person (as defined in section 957(c)) who owns
(within the meaning of section 958(a)), or is considered as
(Footnotecontinuedonnextpage.)
1210 TAXNOTES,May30,2016
COMMENTARY/SPECIALREPORT
ending with the exchange only if the exchanging in connection with the sale of goods manufactured
shareholders agreed to include in their gross in- in the United States.15 This was evidently because (C
come as a dividend the amount that they would there was no apparent business reason for the ) T
have included under section 1248 had they sold transfer of these intangibles abroad, and thus a tax ax
their shares at the time of the exchange.10 avoidance purpose could be inferred. An
a
As that provision illustrates, the guidelines of ly
Rev. Proc. 68-23 were sometimes overbroad in the In an acknowledgment of the clear reflection sts
coverage of section 367’s objective. As the current principle, the guidelines excluded from the active 20
1
regulations under section 367(b) recognize, the foreign trade or business rubric ‘‘property, such as 6. A
UthneiteexdchSatantgeisngwislhlanroethololdseert’asxsinecgtijounris1d2i4c8tioamn oouvnert arecscpoeucnttosfrwecheiicvhaibnlceomoreihnasstablelmeneneatrnobedli,guantiloensss,thine ll righ
in the foreign-to-foreign asset reorganization if the income attributable to such property has been or ts re
acquiring corporation is itself a CFC in which the will be included in the gross income of the transf- s
e
exchanging shareholder satisfies the section 1248 eror for Federal income tax purposes.’’16 Similarly, rv
e
d
ownership requirements. So the provisions do not inventory did not qualify, presumably because the . T
require an inclusion in that case.11 transferee could be expected to sell it quickly.17 ax
A
Overbreadth also characterized the guidelines’ n
The guidelines set forth a rule addressing Con- a
approach to matters not bearing on section 1248. ly
For example, outbound transfers of stock could gress’s concern (expressed in the example in the sts
1932 committee reports) that a tax-free inbound d
qualify under section 351 only if the stock was of a o
e
transaction in which a domestic corporation inher- s
foreign corporation organized in the same foreign n
ited a foreign corporation’s tax attributes could o
jurisdiction as the transferee corporation.12 Al- t c
though an exchange of stock in a domestic corpo- result in the distortion of income. Thus, under the la
guidelines, section 332 applied to any gain realized im
ration for stock of a foreign corporation could c
byadomesticcorporationonitsreceiptofproperty o
qualify under section 354, it could do so only if the p
y
former shareholders of the domestic corporation incompleteliquidationofaforeignsubsidiaryonly rig
didnotownmorethan50percentofthetotalvoting if the domestic corporation included in its income ht in
poweroftheforeignacquirer’sshares.13Thus,even theaccumulatedearningsattributabletoitsstockin a
n
if the domestic corporation was an operating com- the subsidiary.18 Similarly, section 354 applied to y p
anygainrealizedbyadomesticcorporationowning u
panyorwidelyheld(factssuggestingthatitsshares b
were not transferred to the foreign corporation to at least 20 percent of the stock of a foreign corpo- lic d
ration on the exchange of that stock for stock in o
avoidtaxonanygainontheshares),arulingwould m
anotherdomesticcorporationthathadacquiredthe a
not be forthcoming if the former shareholders met in
the 50 percent test. fdoormeigesnticcorcpoorpraotriaotnio’snaisnsecltusdoendlyinif tihtse ienxccohmanegitnhge or th
In most other respects, the guidelines of Rev. accumulatedearningsattributabletoitsstockinthe ird
Proc. 68-23 conformed reasonably well to the poli- p
cies described above. They generally countenanced foreign subsidiary.19 The current section 367(b) arty
a U.S. person’s transfer of property that the trans- regulationscontainsimilarrulesregardinginbound co
liquidations and reorganizations.20 n
fereeforeigncorporationwoulddevotetotheactive te
n
conduct of a trade or business in a foreign country, Most important, in distinctions that survive in t.
presumably because tax avoidance was not a prin- the current section 367(b) regulations, the guide-
cipal purpose for the transfer.14 But a favorable lines’ mechanics reflected the separate policies of
ruling would not be issued when the property was
U.S. patents, trademarks, or similar intangibles to
be used in connection with (1) the conduct of a
trade or business in the United States or (2) the 15Id.atsection3.02(1)(b)(iii)and(iv).
manufacture of goods for sale or consumption in 16Id.atsection3.02(1)(a)(ii).
17Id.atsection3.02(1)(a)(i).
the United States; or foreign intangibles to be used
18Id.atsection3.01(1).
19Id.atsection3.03(1)(b).
20Reg.section1.367(b)-3(b)and-3(c).Onemightobjectthat
the application of these provisions when the includable accu-
owningbyapplyingtherulesofownershipofsection958(b),10 mulated earnings exceeded the gain that the corporate share-
percentormoreofthetotalcombinedvotingpowerofallclasses holder would recognize if section 332 or 354 did not apply
ofstockentitledtovoteofsuchforeigncorporation’’). violatestheprinciplethatsection367grantstheIRSauthorityto
10Rev.Proc.68-23,section3.03(1)(c). suspend the operation of only the cited nonrecognition provi-
11Reg.section1.367(b)-4(b)(1)(i)(B)(1). sions.Perhapstheresponse,notwhollysatisfactory,isthatthe
12Rev.Proc.68-23,section3.02(1)(a)(iii)(B)(2). required inclusion put the corporate shareholder in the same
13Id.atsection3.03(1)(d). position in which it would have been had it conducted the
14Id.atsection3.02(1). foreigncorporation’sbusinessitselfinthefirstinstance.
TAXNOTES,May30,2016 1211
COMMENTARY/SPECIALREPORT
section 1248 protection and clear reflection of in- does not exist or where the amount of any section
come. The section 1248 policy was to prevent con- 367 toll charge can be ascertained without a ruling (C
trolling shareholders from permanently avoiding request.’’23 ) T
the shareholder-level tax on the earnings of corpo- TRA 1976 eliminated the ruling requirement en- ax
rations under their control. Thus, in the foreign-to- tirely for transactions governed by section 367(b) An
a
foreign asset reorganization, an exchanging andinsteadprovidedthatthesubchapterCnonrec- ly
s
shareholder meeting the control requirements, ognition rules would apply unless the IRS deter- ts 2
mined otherwise in regulations. Having survived 0
whether an individual or a corporation, was re- 1
quired to include in income earnings of a corpora- without amendment to this day, section 367(b) 6. A
tion, whether directly or indirectly controlled. The provides as follows: ll rig
clear reflection of income policy, however, was to (1) Effect of section to be determined under h
ts
prevent the distortion of the U.S. corporate income regulations. In the case of any exchange de- re
tax base through the allowance of deductions scribedinsection332,351,354,355,356,or361 se
against unrelated income. Thus, the toll charge in connection with which there is no transfer rved
imposedonaninboundliquidationorassetreorga- of property described in subsection (a)(1), a . T
a
foreigncorporationshallbeconsideredtobea x
nizationappliedonlytoadomesticcorporateshare- A
corporation except to the extent provided in n
holder of the foreign corporate transferor. Since a
regulations prescribed by the Secretary which ly
onlythetaxattributes(suchasbasisinassets)ofthe are necessary or appropriate to prevent the sts
liquidated or reorganized foreign corporate transf- d
avoidance of Federal income taxes. oe
eror were made available or repatriated to the s
(2) Regulations relating to sale or exchange of n
domestic corporate shareholder, only the earnings o
stock in foreign corporations. The regulations t c
that gave rise to those attributes — the earnings of la
prescribed pursuant to paragraph (1) shall im
tshuebsfiodrieairginesco—rpworearteerteraqnusifreerdortoanbdeninoctluthdoesde.oCfoitrs- include (but shall not be limited to) regula- cop
tions dealing with the sale or exchange of y
rectlyunderstood,thetollchargewasthusnotatax stockorsecuritiesinaforeigncorporationbya righ
on distributed earnings (which is the function of a United States person, including regulations t in
shareholder-level tax, such as the tax imposed on a a
providing — (A) the circumstances under n
dividend inclusion under section 301(c)(1) or an which—(i)gainshallberecognizedcurrently, y p
iinncvleusstimonenutncdoemr pthaenysurbepgaimrteFs)orbuptasasivneecfoesresaigrny oasraamdoiuvnidtsenindc,luodrebdoitnhg,roorss(iiin)cogmainecourrroetnhtelyr ublic d
complement to the repatriation of beneficial corpo- amounts may be deferred for inclusion in the om
rate tax attributes under section 381 or, for basis, grossincomeofashareholder(orhissuccessor ain
section334(b).Asanothermanifestationofthebasic o
purpose of section 367, the toll charge modifies the ininterest)atalaterdate,and(B)theextentto r th
which adjustments shall be made to [earnings ird
operation of other subchapter C provisions (sec- and profits], basis of stock or securities, and pa
tions 332 and 354) to prevent the inheritance of tax basis of assets. rty
attributes in a manner that does not clearly reflect c
o
income. The broad language of paragraph (2) might sug- nte
gest that Congress intended to grant the IRS unfet- n
C. The Tax Reform Act of 1976 tered discretion in the tax treatment of transactions t.
covered by section 367(b). Yet again, the statute
TRA 197621 made significant changes to section
authorizes the nonapplication of only specified
367.Structurally,itestablishedthefamiliarseparate
nonrecognition provisions. While several times ex-
coverage by section 367(a) of outbound transfers
pressing concern about the tax-free repatriation of
and by section 367(b) of all other transfers. It
previouslyuntaxedforeignearnings,thecommittee
substituted for the advance ruling requirement ap-
reportssuggestthat,ifanything,theguidelinesmay
plicable to outbound transfers a requirement to
have gone a bit too far:
obtain a ruling within 183 days of the transfer,22
although it gave the IRS authority (which it never Whileitisrecognizedthatthepresentrules[as
used) to promulgate regulations dispensing with set forth in Rev. Proc. 68-23] are necessarily
the requirement in what the taxwriting committees highly technical and largely procedural and
described as ‘‘certain clear-cut situations involving while it is essential to provide against tax
outboundtransferswheresignificanttaxavoidance avoidance in transfers...upon the repatria-
tion of previously untaxed foreign earnings,
21P.L.95-455,section1042(a).
22Formersection367(a)(1)(1976). 23S.Rep.No.94-938,at265(1976).
1212 TAXNOTES,May30,2016
COMMENTARY/SPECIALREPORT
unnecessary barriers to justifiable and legiti- D. TEFRA
mate business transactions should be In the 1982 Tax Equity and Fiscal Responsibility (C
avoided.24 Act,30 Congress cut back significantly on the pos- ) T
a
Perhaps most important, Congress provided for sessiontaxcreditundersection936.Thecommittee x A
reports noted that Congress was aware that some n
a
judicial review of the new section 367(b) regula- taxpayers had indicated that, as a result of the lys
tions: ts
cutback, they would remove intangibles owned by 2
0
a possession corporation to a foreign affiliate. Ac- 1
These regulations are to be subject to normal 6
cording to the committee reports, the IRS already . A
cnoeucerstsraervyieowr aapsptorowprhieattheefrorthteherepgruelvaetniotniosnaoref had the authority under section 367(a) to require ll rig
gain recognition on the transfer of intangibles by a h
avoidance of federal income taxes. Thus, a ts
U.S. person (such as a possession corporation, a re
taxpayermaychallengeaproposeddeficiency s
domestic corporation for which a section 936 elec- e
with respect to an exchange dealt within the rv
tion was in effect) to a foreign corporation in an e
d
regulations by arguing in the courts that the exchange in which gain would otherwise not be . T
regulations, as applied in the taxpayer’s case, recognized under subchapter C. Yet the guidelines ax
A
arenotnecessaryorappropriatetopreventthe requiredthatrecognitiononlywhentheintangibles n
a
avoidanceoffederalincometaxes.Ifthecourt were to be used in connection with (1) a trade or lys
should agree with the taxpayer, it is to apply business in the United States or (2) manufacturing ts d
the balance of the regulations to the extent for sale or consumption in the United States. By oe
s
appropriate.25 inference,theguidelinesthussuggestedthatsection n
o
367 would not apply to an outbound transfer of an t c
Temporaryregulationspublishedayearafterthe intangible used in connection with a foreign trade laim
legislation’s enactment,26 and thus written by per- or business or with manufacturing of a product for c
o
sons presumably familiar with what Congress in- saleorforconsumptionoutsidetheUnitedStates.31 py
tended, corrected some of the guidelines’ Accordingly, new section 367(d) required a posses- rig
h
overbreadth. Like the current section 367(b) regula- sioncorporationtorecognizegainuponthetransfer t in
tions27 but unlike the guidelines, the temporary of any intangible property (as defined) to a foreign an
y
regulations did not require an exchanging share- corporation. p
u
holder in a foreign-to-foreign asset reorganization b
The TEFRA version of section 367(d) is largely lic
to include in income its section 1248 amount if the d
only of historical interest except for its incorpora- o
acquiringcorporationwasitselfaCFCinwhichthe m
tion by reference of the section 936(h)(3)(B) defini- a
exchanging shareholder satisfied the section 1248 in
tion of intangible property used for section 936 o
ownership requirements.28 Also, the temporary purposes,32 an incorporation that survives in sec- r th
regulationspreservedtheguidelines’mechanicsfor tion 367(d) to this day. The provision sets out a ird
distinguishingbetweensection1248avoidanceand p
laundrylistofmanufacturing,process,andmarket- a
cstleaaturtere.2f9lection of income policies underlying the ingintangibles—notincludinggoodwillandgoing rty co
concernvalue(GWGCV)—andconcludeswiththe n
te
catchallphrase‘‘anysimilaritem.’’Ineachcase,the n
t.
intangible must have ‘‘substantial value indepen-
dent of the services of any individual.’’
24S.Rep.No.94-938,at263(1976);H.R.Rep.No.94-658,at
241(1976). E. The Deficit Reduction Act of 1984
25S.Rep.No.94-938,at268(1976);H.R.Rep.No.94-658,at
245(1976). The Deficit Reduction Act of 1984 (DEFRA)33
26T.D.7530(Dec.27,1977). mademajorchangestosection367(a)and(d).With
27Reg.section1.367(b)-4(b).
28Formerreg.section7.367(b)-7(b)(1977).
29Compareformerreg.sections7.367(b)-7(b),-2(b),and-2(d)
(1977)(requiringinclusionoftheE&Pofdirectlyandindirectly
owned CFCs by an exchanging U.S. shareholder (whether an 30P.L.97-248.
individualoracorporation)thatmeetsthecontrolrequirements 31Rev.Proc.68-23,section3.02(1)(b)(iii)and(iv).
when the transaction threatens loss of taxing jurisdiction over 32Section936(h)(3)(B)definesintangiblepropertyasany(1)
the shareholder’s section 1248 amount), with former reg. sec- patent, invention, formula, process, design, pattern, or know-
tions7.367(b)-5(b),-7(c)(2),and-2(f)(1977)(requiringinclusion, how;(2)copyright,orliterary,musical,orartisticcomposition;
byadomesticcorporateshareholderuponitsreceiptofproperty (3)trademark,tradename,orbrandname;(4)franchise,license,
in complete liquidation of a foreign subsidiary or upon its orcontract;(5)method,program,system,procedure,campaign,
exchange of stock in a foreign corporation for stock in a survey,study,forecast,estimate,customerlist,ortechnicaldata;
domesticcorporationacquiringtheforeigncorporation’sassets or(6)anysimilaritemthathassubstantialvalueindependentof
in an asset reorganization, of the allocable E&P of the foreign theservicesofanyindividual.
corporationandnotofitssubsidiaries). 33P.L.98-369(1984).
TAXNOTES,May30,2016 1213
COMMENTARY/SPECIALREPORT
some later refinements, the provisions as amended able treatment of installment obligations, accounts
by DEFRAare the statute we know today. receivable, and other assets on which income had
(C
Intheirdescriptionofthereasonsforthechanges been earned. ) T
to section 367(a), the committee reports indicated DEFRA guarded the clear reflection principle in ax
A
that while section 367(a) ‘‘has generally worked two additional ways. In Rev. Rul. 78-201,36 the IRS n
a
wellovertheyears,’’aseriesofTaxCourtdecisions had ruled that when a U.S. corporation had in- ly
s
restrictively interpreting the requirement for gain curred a loss through a foreign branch that offset ts 2
recognitionof‘‘aplanhavingasoneofitsprincipal the corporation’s worldwide income, the later in- 01
6
purposes the avoidance of Federal income taxes’’ corporation of the branch operations was deemed . A
hOande coofnvthinocseedcCasoensgrheasds orfeftehreredneetod aforprrienfcoirpmal. tporinbecipinalppuurrspuoasnecsethofeaavpoliadnanhcaevoinfgtaaxsuonndeerofseicts- ll righ
purpose as a purpose ‘‘first in rank, authority, tion 367(a) because the U.S. corporation would not ts re
importance or degree.’’34 The reports stated: include in its worldwide income the operations’ se
income produced after incorporation.According to rv
e
ThisnarrowinterpretationbytheTaxCourtof d
the principal purpose test has caused the In- the IRS, the U.S. corporation could avoid recogni- . T
tion of gain on its assets only if it recognized as a
x
ternal Revenue Service difficulty in adminis- ordinary foreign-source income in the year of the A
n
tering section 367(a) in a way which restricts a
transfer an amount equal to the branch losses ly
the types of tax avoidance transfers that the s
previously incurred. The Tax Court agreed with a ts
provisions of that section were intended to d
taxpayer whose facts were similar to those in Rev. o
combat. This restrictive interpretation, with Rul. 78-201 that its incorporation of a foreign loss es n
which the committee disagrees, threatens to o
undermine the utility of section 367, with the bpruarnpcohsed.3i7d Tnhotehcaovuerttaxthauvsoidcoannccleudaseda pthriantcipthael t cla
result being an incentive for foreign invest- im
branch’s loss or income was clearly reflected in c
ment. The committee has no intention of con- o
income because it was clearly reflected annually. p
doning such a result.35 Accordingtothecourt,theclearreflectionprinciple yrig
h
To address this concern, Congress dispensed did not apply to the branch’s lifetime income and t in
with the ruling requirement and the principal pur- loss considered in the aggregate. a
n
pose test and prescribed that a U.S. person would The committees viewed the Tax Court as incor- y p
u
generally avoid gain recognition only if the person rectlyendorsingtheallowanceofadoublebenefit.38 b
transferred the property for use by the foreign DEFRA thus provided that the active trade or lic d
o
corporation in the active conduct of a trade or businessexceptiondidnotapplytogainrealizedon m
a
business outside the United States. thetransferoftheassetsofaforeignbranchofaU.S. in
greAsssstuhbesqtiutuotteeddtlhanegauctaigveestruagdgeeostrsb,ualstihnoeussgthesCtofonr- pdeerdsuocntibtolealofsosreesiginncucorrrepdorbaytiothnetboratnhcehebxetefonrteththaet or third
the principal purpose test, it still, as it had since transfer exceeded its aggregate taxable income for p
a
1932, viewed as a major policy of section 367 the the years after the tax year in which the loss was rty
deterrenceoftheoutboundtransferofpropertyina incurredandthroughthecloseofthetaxyearofthe co
n
nonrecognition transaction for the purpose of transfer.39 te
n
avoiding the tax that would otherwise be imposed In its second and far more important application t.
on a sale of the property. DEFRA’s active trade or of the clear reflection principle, Congress greatly
business exception thus could be interpreted as expanded the scope of section 367(d). The taxwrit-
providing a bright-, or at least a brighter-, line test, ing committees noted:
more susceptible of administration than a test ex-
plicitlybasedonasubjectivetaxavoidancemotive.
Consistent with the continuing importance of pur-
pose, the legislation generally excluded from quali- 361978-1C.B.91.
37HersheyFoodsInc.v.Commissioner,76T.C.312(1981).
ficationundertheactivetradeorbusinessexception
38H.R. Rep. No. 98-432, at 1317-1318 (1984); 1984 Senate
assets(suchasforeigncurrency)thatweregenerally report,supranote35,at362.
not needed in an active business. In harmony with 39Section 367(a)(3)(C). Also based on the clear reflection
the guidelines’ application of the clear reflection principle,underregulations,aU.S.personthattransfersdepre-
principle, the statute also continued the unfavor- ciable property that has been used in the United States to a
foreigncorporation,evenforthepurposeofusingtheproperty
inanactiveforeignbusiness,mustincludeinincomeintheyear
of the transfer ordinary income equal to the gain realized that
would have been includable in income as ordinary income
34DittlerBros.Inc.v.Commissioner,72T.C.896(1979). underthecode’srecaptureprovisions(suchassections1245and
35H.R.Rep.No.98-432,at1315(1984).SeealsoS.Prt.98-169, 1250) if at the time of the transfer the transferor had sold the
Vol.I,at360(1984)(1984Senatereport). propertyforitsfairmarketvalue.Reg.section1.367(a)-4T(b)(1).
1214 TAXNOTES,May30,2016
COMMENTARY/SPECIALREPORT
Under its published ruling guidelines, the IRS Except in the case of an incorporation of a
generallyissuedfavorablerulingsfortransfers foreign loss branch, the Congress did not
(C
ofpatentsandsimilarintangiblesforuseinan believe that transfers of goodwill, going con- ) T
active trade or business of the foreign trans- cern value, or certain marketing intangibles a
x
feree corporation. The only exceptions were should be subject to tax. Goodwill and going A
n
a
transfersofcertainintangiblesusedinconnec- concern value are generated by earning in- ly
s
tion with a U.S. trade or business or in con- come, not by incurring deductions. Thus, or- ts
2
nection with goods to be manufactured, sold dinarily, the transfer of these (or similar) 0
1
or consumed in the United States. In light of intangibles does not result in avoidance of 6. A
tchoimspfaavnoierasbaledorputliendgapoplriacyc,tiacenoufmdbeevreolofpUin.Sg. Federal income taxes.43 ll rig
patents or similar intangibles at their facilities U.SC.opnegrrseosns tthoubseetnraecatteedd a—ruulpeo44nththaet trreaqnusifreerdoaf hts re
in the United States, with a view towards s
intangible property (as defined in section e
using the intangibles in foreign operations. rv
936(h)(3)(B))toaforeigncorporationinanexchange e
When these intangibles were ready for profit- described in section 351 or 361 that section 367(a) d. T
able exploitation, they were transferred to a a
manufacturing subsidiary incorporated in a wouldotherwisecover—asreceivingamountsthat x A
reasonably reflect the amounts that would have n
low-tax foreign jurisdiction (or in a high-tax beenreceivedannuallyunderanexclusivelicensing alys
jurisdictionthatofferedataxholidayforspeci- ts
agreement over the useful life of the property. The d
fied local manufacturing operations). By en- o
reports also provided: e
gaging in such practices, the transferor U.S. s n
companies hoped to reduce their U.S. taxable TheAct contemplates that, ordinarily, no gain ot c
income by deducting substantial research and willberecognizedonthetransferofgoodwill, la
im
experimentation expenses associated with the going concern value, or marketing intangibles c
developmentofthetransferredintangibleand, (such as trademarks or trade names) devel- op
y
by transferring the intangible to a foreign oped by a foreign branch to a foreign corpo- rig
h
corporation at the point of profitability, to ration (regardless of whether the foreign t in
ensure deferral of U.S. tax on the profits gen- corporation is newly organized). Thus, where a
n
erated by the intangible. By incorporating the appropriate, it is expected that regulations y
p
transferee in a low-tax jurisdiction, the U.S. relating to tainted assets and the special rule u
b
companies also avoided any significant for- forintangibleswillprovideexceptionsforthis lic
d
eign tax on such profits.40 type of property.45 om
a
ForGWGCV,theHousereporthadthefollowing Finally, the new statute cut back on the in
o
to say: guidelines of Rev. Proc. 68-23 in one important r th
The committee does not anticipate that the rreessptreicctti.vAesruinledsicfaotredth,ethoeutgbuoiudnedlinterasnhsafedrporfosvtiodcekds ird pa
transfer of goodwill or going concern value and securities, especially shares in a domestic rty
developed by a foreign branch to a newly c
corporation. The committee reports indicated that o
organized foreign corporation will result in all exchanges involving transfers of stock and nte
abuse of the U.S. tax system.41 securities were to be tested under the active trade nt.
The Senate report continued: or business exception. Stock transferred under
circumstances resembling those in Kaiser46 was to
Thecommitteedoesnotanticipatethetransfer
of goodwill or going concern value (or certain
similar intangibles) developed by a foreign
branch to a foreign corporation will result in 43JCT,‘‘GeneralExplanationoftheRevenueProvisionsofthe
abuse of the U.S. tax system (regardless of DeficitReductionActof1984,’’JCS-41-84,at428(1984).
whether the foreign corporation is newly or- 44Section367(d).
ganized).42 45SeeJCS-41-84,supranote43,at435.SeealsoH.R.Rep.No.
98-432, at 1320 (1984) (similar); and 1984 Senate report, supra
Initsreportonthelegislation,theJointCommit- note35,at365(similar).
46KaiserAluminum&ChemicalCo.v.Commissioner,76T.C.325
tee on Taxation went yet further:
(1981).InKaiser,theTaxCourtheldthataU.S.person’stransfer
of a 4 percent interest in a foreign corporation to a non-CFC
corporatetransfereeinwhichtheU.S.person’sparentcorpora-
tionowneda45percentinterestwasnotinpursuanceofatax
40H.R. Rep. No. 98-432, at 1316 (1984); 1984 Senate report, avoidance plan when the corporation whose stock was trans-
supranote35,at361. ferred acted as a source of supply of alumina used by the
41H.R.Rep.No.98-432,at1317(1984). transferee in the production of aluminum. Given the business
421984Senatereport,supranote35,at362. integration of the two companies, the transferred stock was
(Footnotecontinuedonnextpage.)
TAXNOTES,May30,2016 1215