The IRS recently proposed regulations under section 367(a)(5) on the treatment of outbound asset transfers under section 361. The regulations will be effective 30 days after they are published as final in the Federal Register.

The general rule under section 367(a)(1) is that an otherwise tax-free exchange will be taxable if property is transferred by a US person to a foreign corporation. Sections 367(a)(2) and (3) provide exceptions to the general rule of section 367(a)(1). Section 367(a)(2) provides that, except to the extent provided in regulations, section 367(a)(1) will not apply to the transfer of stock or securities of a foreign corporation that is a party to the reorganisation. Section 367(a)(3) provides that, except to the extent provided in regulations, section 367(a)(1) will not apply to the transfer of property used in an active foreign trade or business.

These exceptions are extremely important, as most tax advisers know. Section 367(a)(5), however, provides that the exceptions to the general rule of section 367(a)(1) provided under section 367(a)(2) and (3) will not apply in the case of a transfer of property by a domestic corporation to a foreign corporation in an exchange described in section 361(a) or (b). An example would be a US subsidiary that transfers assets to a foreign subsidiary and then liquidates. Under the general rule of section 367(a)(5), the gain on the transfer is taxable.

Section 367(a)(5), however, further provides that subject to the basis adjustments and other conditions that regulations provide, the general rule of section 367(a)(5) will not apply (and therefore the exceptions to the general rule of section 367(a)(1) may be available) if the US transferor is controlled (within the meaning of section 368(c)) by five or fewer domestic corporations. An example would be when the transferor US subsidiary is 100% owned by a US parent company.

Proposed Treasury Regulation section 1.367(a)-7 provides an important elective exception to the general rule under section 367(a)(5) pursuant to which the exceptions provided by section 367(a) may be available. The proposed regulations apply to all property transferred by the US transferor in the section 361 exchange, other than property to which section 367(d) applies (intangibles). At the time of the section 361 exchange, the US transferor must be controlled (within the meaning of section 368(c)) by at least one, but no more than five, domestic corporations.

Even if the exception provided by the proposed regulations applies, in two instances the US transferor must recognise gain on the transfer of the section 367(a) property in the section 361 exchange. First, the US transferor must recognise gain equal to the aggregate amount of the inside gain allocable to non-control group members (non-US corporations or individuals, for example).

Second, the US transferor must recognise gain to the extent any control group member cannot preserve its share of inside gain in the stock received that is allocable to the section 367(a) property transferred in the section 361 exchange. The amount of a control group member's share of inside gain that cannot be preserved in the stock received is the amount by which the control group member's share of inside gain exceeds the fair market value of the stock received by the control group member that is allocable to section 367(a) property.

Under the election (which otherwise can prevent immediate gain recognition), each control group member's basis in the stock received in the transaction that is allocable to the section 367(a) property transferred by the US transferor in the section 361 exchange must be reduced to the extent necessary to preserve the control group member's share of inside gain.

The US transferor must also include a statement with its US income tax return for the year of the section 361 exchange certifying that if the foreign acquiring corporation disposes of a significant amount (greater than 40%) of the section 367(a) property transferred in the section 361 exchange in one or more related transactions entered into with the principal purpose of avoiding the US tax that would have been imposed on the sale of that property by the US transferor at the time of the section 361 exchange, the US transferor will file a US income tax return (or amended US income tax return) for the year of the section 361 exchange reporting the gain realised but not recognised on the section 361 exchange.

In addition, the US transferor and the control group members must enter into a written agreement to make the election on or before the due date for the US transferor's timely-filed return for the taxable year in which the section 361 exchange occurs. Each party to the written agreement must also include a statement with its timely-filed return for the year of the section 361 exchange reporting the election and other specified information.

An example illustrating the operation of the proposed regulations is as follows:

Section 367(a)(5) Example

Result: DC must recognise $60 gain on the inventory transferred to FA. FA's basis in the inventory is $100. DC also must recognise $90 on the transfer of business A, notwithstanding the application of section 351 or section 361, unless Proposed Treasury Regulation section 1.367(a)-7(c), issued under section 367(a)(5), applies.

Under Proposed Treasury Regulation section 1.367(a)-7(f)(6), the $90 inside gain is taxed to the extent of FP's 20% interest ($18).

DP-1's share of inside gain ($45) is not taxed to DC as the FMV of the FA stock received by DP-1 exceeds that amount. DP-1's section 358 basis ($80) is reduced by $25, the amount by which DP-1's share of inside gain ($45) exceeds its outside gain ($20). Thus, DP-1's basis in its FA stock is $55.

A similar analysis applies with respect to DP-2.

Proposed regulations relating to distributions of foreign corporations stock

The IRS also recently proposed regulations under section 1248(f) providing for an exception to gain recognition in respect of tax-free distributions of shares of stock in a foreign corporation by a domestic corporation.

Section 1248(f)(1) provides that, except as provided in regulations, if a domestic corporation that is a section 1248 shareholder (generally a 10% US shareholder of a CFC) with respect to a foreign corporation distributes the stock of the foreign corporation in a tax-free distribution (a parent-subsidiary liquidation or a tax free spin-off), then notwithstanding any other provision of the code, the domestic distributing corporation must include in income as a dividend the section 1248 amount attributable to the stock.

The section 1248 amount is equal to the earnings and profits accumulated while the shareholder held the foreign corporation's stock, limited however, to the amount by which the value of the stock exceeds the shareholder's basis in the stock. An inclusion is required because the section 1248 amount attributable to the stock distributed may not be preserved in the hands of the distributee shareholders following the distribution. They might have a higher basis in the distributed CFC stock.

The general rule of section 1248(f) does not apply in the case of a section 332 liquidation of a US corporation if immediately after the distribution the 80% plus corporate distributee is a section 1248 shareholder with respect to the foreign corporation, the distributee's holding period in the stock received in the distribution is the same as the domestic distributing corporation's holding period in the stock at the time of the distribution, and the distributee's basis in the stock received in the distribution is not greater than the domestic distributing corporation's basis in the stock at the time of the distribution.

The proposed regulations provide an elective exception to the general rule for a section 355 spin-off distribution of stock in a foreign corporation (not received by the domestic distributing corporation in a reorganisation) to a domestic corporation that is a section 1248 shareholder with respect to the foreign corporation immediately after the distribution. The election to apply the exception is irrevocable and must be made by the domestic distributing corporation and all section 1248 shareholders. If the election is made, adjustments may be made to each section 1248 shareholder's section 358 basis and holding period in the stock received to preserve the section 1248 amount attributable to that stock at the time of the distribution.

The domestic distributing corporation and the section 1248 shareholders also must enter into a written agreement on or before the due date (including extensions) of the domestic distributing corporation's tax return for the taxable year during which the section 355 distribution occurs. The domestic distributing corporation and each section 1248 shareholder must include a statement with its tax return reporting that the election has been made and any required adjustments to stock basis or holding period.

An elective exception to the general rule also applies to a section 355 distribution or a section 361 distribution of stock of a foreign corporation received by the domestic distributing corporation in a reorganisation that precedes the distribution to a domestic corporation that is a section 1248 shareholder with respect to the foreign corporation immediately after the distribution.

An example illustrating the operation of the proposed regulations is as follows:

Section 1248(f) Example

Result: USD must recognise $10 of gain on the distribution, $5 each (10% each x $50) due to the distributions to FP and X. Of the $10 gain, $5 is 1248 amount (20% x $25).

USD's distribution to DP-1 is described in section 1248(f)(1) and Proposed Treasury Regulation section 1.1248(f)-1(b)(2). USD must include in income the 1248 amount of $20.

However, if DP-1 and USD elect, then immediately thereafter DP-1 will have, for purposes of section 1248, a three-year holding period in its FC stock, and DP-1's section 358 basis in the FC stock ($70) will be reduced by $10 to preserve the 1248 amount ($20).

Proposed section 367(b) regulation

In a helpful modification to the section 367(b) rules, regulations were proposed that would preclude an inclusion of the section 1248 amount when a domestic corporation transfers the stock of a foreign corporation to a foreign corporation in a section 361 transaction in which the foreign acquiring and acquired corporations are CFCs in respect of which the domestic transferor is a US shareholder.

Current regulations require an inclusion of the section 1248 amount because the domestic transferor is not treated as a section 1248 shareholder with respect to the foreign acquiring corporation immediately after the transfer due to the fact that the US transferor goes out of existence as a part of the overall transaction. The proposed regulations, by contrast, respect the transitory holding period of the domestic transferor.

The proposed regulations will become effective in respect of transfers or distributions occurring on or after the date that is 30 days after the date they are published as final regulations in the Federal Register.

Section 956

As a result of the recent liquidity problems, the IRS has issued helpful section 956 guidance. The Service announced in Notice 2008-91 that, to facilitate liquidity in the near term, it would issue regulations stating that for purposes of section 956 a CFC may choose to exclude, from the definition of the term obligation, an obligation held by a CFC that would constitute an investment in US property provided the obligation is collected within 60 days from the time it is incurred.

An investment in US property is treated as a Subpart F dividend to the US shareholders of a CFC. The exclusion does not apply if the CFC holds for 180 or more calendar days during its taxable year obligations that, without regard to the 60-day rule, would constitute an investment in US property.

The Notice applies only for the taxable years of a foreign corporation ending after October 3 2008 but not beginning after December 31 2009. The Notice does not affect the application of Notice 88-108 (which provides a similar exception but with 30-day and 60-day periods), but a CFC may apply only one of Notice 2008-91 or Notice 88-108, and not both. Some taxpayers have requested that the time be extended to 180 days for the loans because of the severity of the liquidity problems.

Important subpart F exceptions extended

Section 954(c)(6), enacted in 2004, provides a look-through rule in determining the Subpart F income of a CFC in respect of dividends, interest, rents and royalties received from a related CFC in certain circumstances. For calendar year taxpayers, this provision was to expire at the end of 2008 but was extended for one year. It now applies to tax years beginning before January 1 2010. A similar rule for active foreign financing business income also was extended for one year.

Foreign tax credit generators

Treasury and the IRS issued temporary regulations applicable in the context of so-called foreign tax credit (FTC) generator transactions. The IRS's goal is to treat these foreign tax credits as noncreditable. The IRS plans to litigate with taxpayers that have engaged in such transactions. (See The Wall Street Journal, May 9 2008, discussing AIG.) Most of these transactions to date would seem to have involved financial services companies.

Without discussing or commenting on the propriety of these regulations, we thought it would be helpful to address some of the issue-spotting necessary for a tax adviser to address issues raised by the new regulations, for example, in the context of a generic joint venture. The regulations are overly broad, and care may be necessary to avoid accidentally stumbling into one of the traps set by these new regulations.

The six characteristics of an FTC generator transaction are: (i) a special purpose vehicle is utilised, substantially all of whose gross income is passive investment income and substantially all of whose assets are held to produce such income; (ii) a US party would be able to claim a foreign tax credit for tax paid on the SPV's income; (iii) the tax is substantially greater than the foreign tax credits the US party would be able to claim as credits if it directly owned its share of the SPV's assets; (iv) there is a counterparty; (v) the counterparty is entitled to a foreign tax benefit; and (vi) there is an inconsistent US and foreign tax treatment.

One of the exceptions in the new regulations involves holding companies. A joint venture often involves a holding company. Holding companies generally earn passive income (dividends). The exception applies if the US party and the counterparties share in substantially all of the holding company's opportunity for gain and risk of loss. In this case, the holding company will be entitled to look-through treatment. Issues can arise if the holding company has issued debt or equity to third parties or where management employees hold stock options or a special class of stock. This could prevent application of the holding company exception.

Another important exception is the 10% overlap provision. The foreign tax benefit must correspond to 10% or more of the US party's share of the foreign tax payment or 10% of more of the foreign tax base with respect to which the US party's share of the foreign payment is imposed. Example 10 illustrates this with a 50-50 foreign joint venture.

The entity is a partnership for US tax purposes and a corporation for foreign tax purposes (the inconsistent treatment). It earns passive income (perhaps it failed to qualify for the holding company exception). However, there is no overlap of rights to income. Income is split 50-50. Thus, there is no foreign tax benefit.

Xilinx

In perhaps the most important US section 482 transfer pricing case in decades, the Ninth Circuit Court of Appeals recently requested additional briefing. One of the issues with respect to which additional briefing was requested involves the relationship of treaties and the arm's-length standard thereunder to the IRS's section 482 arguments.

This is an important development but may delay the court's decision in this very important case. The holding in the tax court was that the arm's-length standard is paramount and applies to the IRS as well as taxpayers.

David Forst
		Fenwick & West Tel: +1 650 335 7254 Fax: +1 650 938 5200 Email: dforst@fenwick.com David Forst is the practice group leader of the tax group of Fenwick & West. He is included in Euromoney's Guide to the World's Leading Tax Advisers and was named one of the top tax advisers in the Western US by the International Tax Review. Forst's practice focuses on international corporate and partnership taxation. He teaches international taxation at Stanford Law School and is an editor of and regular contributor to the Journal of Taxation. He has published articles on international joint ventures, international tax aspects of M&As, and the proposed dual consolidated loss and section 987 currency regulations. Forst has chaired and spoken at numerous tax seminars, including the NYU Tax Institute, various TEI meetings, and the San Jose State Tax Institute. Forst graduated with an AB, cum laude, Phi Beta Kappa, from Princeton University's Woodrow Wilson School of Public and International Affairs, and received his JD, with distinction, from Stanford Law School.

James Fuller
		Fenwick & West Tel: +1 650 335 7205 Fax: + 1 650 919 0942 Email: jpfuller@fenwick.com Website: www.fenwick.com James Fuller is a partner in the tax group at Fenwick & West in Mountain View, California. He has appeared five times in Euromoney's Best of the Best as one of the world's top 25 tax advisers. He has also written for International Tax Review. Fenwick & West has one of the Word's Top Tax Planning and Tax Transactional Practices, according to International Tax Review (2008) and is a first-tier firm in tax according to World Tax 2009.