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On December 28, 2007, the IRS published Notice 2008-10, 2008-3 I.R.B. 277, informing taxpayers that new regulations would be issued under §367(a) to prevent U.S. parent corporations from using the existing regulations to repatriate cash or other property from foreign subsidiaries without the recognition of gain or a dividend inclusion. The new regulations will “clarify” how the two existing exceptions in Regs. §1.367(a)-3(d)(2)(vi)(B) (the so-called “coordination rule”) apply to certain outbound §368 reorganizations followed by inbound “drops” of the outbounded property under §351. The notice was issued “in response to certain transactions designed to avoid U.S. income tax.” The government apparently “caught” these transactions fairly early in the so-called “marketing cycle.” The new regulations will apply to transactions occurring on or after December 28, 2007, but no inference is intended as to the treatment of prior transactions under existing law, and the IRS may, where appropriate, challenge such transactions “under applicable provisions or judicial doctrines.” Moreover, the IRS said it is continuing to study other transactions and structures that “have the effect of repatriating earnings” of foreign corporations without the recognition of gain or a dividend inclusion.

To this reader, the notice is clearly “result oriented.” It seeks to stop certain transactions that arguably are technically correct under the existing regulations but that may appear, at least to the government, to permit tax-free repatriations of cash without an appropriate non-tax business purpose for the transaction. In my view, the existing regulations were written with quite different transactions in mind--namely, business-motivated outbound reorganizations involving previously unrelated acquiring companies. It remains unclear whether transactions now being targeted, that were effected prior to December 28, can be defeated under “applicable provisions or judicial doctrines.”

Here are the two transactions described in the notice. In the first example, domestic corporation USP owns 100% of the stock of foreign corporation FA, and USP's basis in its FA stock is $100x. USP also owns 100% of the stock of domestic corporation UST, and USP's basis in its UST stock equals its fair market value of $100x. All of UST's property consists of property with zero tax basis, such as self-created intangibles or fully depreciated tangible property. (Query how UST's outside stock basis can equal the fair market value of its zero basis inside property?) UST sells its property to FA in exchange for $100x cash, UST liquidates, and FA transfers all the property acquired from UST to U.S. Newco, a newly formed domestic corporation, in exchange for 100% of the U.S. Newco stock.

In the second example, FA purchases the stock of UST from USP for $100x, and UST merges into a domestic LLC that is a disregarded entity wholly owned by FA. FA contributes all of LLC to U.S. Newco, a newly formed domestic corporation, in exchange for 100% of U.S. Newco's stock.

The notice is unfortunately almost completely opaque as to how these transactions could or should be characterized under the existing regulations. A practitioner who has not previously analyzed such transactions will have a fairly difficult time understanding what is going on. This lack of clarity from the government is unfortunate, because greater explanation would have been quite useful in helping to justify the IRS's technical and tax policy analysis. Presumably, the IRS believes that a strictly technical interpretation of existing law would lead one astray, especially if the transaction has the “effect” of a tax-free repatriation (a result the government seems inclined to fight, whenever and wherever).

Apparently, both transactions are characterized as outbound “all cash D reorganizations” under §368, followed by §351 inbound drops. Note that to qualify as tax-free under those sections, the transaction must have the requisite business purpose without regard to §367. (The notice provides no discussion of this fairly fundamental issue.) Taking the first example, because USP already owns 100% of FA (i.e., FA is not an unrelated acquirer as presumably contemplated by the drafters of the existing regulations), FA's acquisition of all the property of UST for cash is not what one might at first think, namely a taxable purchase followed by a liquidation. Instead, under subchapter C “theology” (and existing regulations), the acquisition is a D reorganization with boot. FA is deemed to issue “nominal stock” (see Regs. §1.368-2T(l)) plus the cash to UST in exchange for the property; UST then liquidates, the cash goes to USP, and USP is deemed to exchange its stock in UST for the deemed stock of FA. There is no gain on the cash “boot,” because of the “boot within gain” rule of §356(a).

The notice says that some taxpayers have taken the position that, pursuant to Regs. §1.367(a)-3(d)(2)(vi)(B)(1)(i), UST's transfer of property to FA is not subject to §367(a) or (d), because the basis adjustment requirement of §367(a)(5) is satisfied if USP reduces by $100x its basis in the FA stock that it held prior to the transaction. That basis reduction presumably “preserves” for theoretical later recognition the amount of the cash. Voila, the cash has come home with no current tax.

The notice explains that the existing exception generally applies if FA inbounds the originally outbounded property to U.S. Newco. The exception applies, however, only if U.S. Newco's basis in the inbounded property is not greater than the basis that UST had in such property (zero in the case presented) and, in addition to certain other requirements, basis adjustments as provided in §367(a)(5) are made to the stock FA held by USP (which can be satisfied in this case). Basis reduction would not be needed, and could not exist, with respect to the theological “nominal” share of FA stock “deemed” issued.

Well, this is indeed what the existing regulations seem to say. So, in order to stop such a transaction, the new regulations will state instead that the basis adjustment required as provided in §367(a)(5) must be made to the stock of FA that is “received by” USP, such that the appropriate amount of unrecognized gain in the outbounded/inbounded property is reflected in such stock.

The new dispositive words are “received by.” In other words, you can't avoid current gain by preserving it through a basis adjustment in pre-existing stock of the foreign acquirer held by the U.S. parent, you can avoid gain only by a basis adjustment in stock newly “received” in the transaction. The “all cash D” theology does not provide for actual stock to be received but relies instead on the fiction of deemed stock. And deemed stock doesn't have a basis that can be reduced.

Sounds very peculiar, doesn't it? What the IRS is getting at, in a quite indirect and inarticulate way it seems to me, is to distinguish a “real” (i.e., not tax-motivated) acquisition by an unrelated foreign acquirer, in which stock will be received for the first time by the disposing U.S. corporation, from an engineered, structured “acquisition” by a foreign corporation that is already owned by the U.S. parent and, thus, no new stock is received. And the IRS assumes that in the wholly owned situation, no U.S. parent would ever create a sandwich of U.S.-foreign-U.S., except for tax avoidance reasons, whereas an unrelated foreign acquirer might well issue its stock to the U.S. parent and then drop the U.S. property into a new U.S. subsidiary. There is a sandwich here, too; but it has been created for valid business reasons by an unrelated party (thinks the IRS), not in a tax-motivated cash repatriation.

Well, probably the IRS is right about this. Maybe it's right. Maybe a U.S. parent would never ever create a sandwich for valid business reasons--for example, business reasons required to justify application of §368 and §351. What do you think?

This commentary also will appear in the March 14, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Davis, 919 T.M., Outbound Transfers Under Section 367(a), and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.