Subscribers Login  

On June 23, 2008, Treasury and the IRS issued temporary and proposed regulations to shut down yet one more alleged “repatriation strategy,” this one aimed at getting around §956. It is remarkable that, after all these many years of living with §956, we learn yet another “trick” that many never knew before, but it is too late. The door is closed. Bravo, Treasury and IRS!

T.D. 9402 amends Regs. §1.956-1 and Temporary Regs. §1.956-1T, regarding the determination of basis in certain types of “United States property,” as defined in §956(c), which is acquired by a controlled foreign corporation (CFC) from a U.S. affiliate in certain non-recognition transactions. The Preamble to the regulations states, without nuance or other explanation, that the targeted transactions “are intended to repatriate earnings and profits of the controlled foreign corporation without United States income taxation.” In other words, the regulations adopt a per se “you're bad” rule, apparently based on a peremptory conclusion of malevolent “intent.”

The regulations are effective for property acquired by CFCs in exchanges occurring on or after June 23, 2008. To drive home the point, the government has determined that the regulations are “necessary to prevent abusive transactions of the type described,” and, accordingly, “good cause is found for dispensing with notice and public procedure” as otherwise required by the Administrative Procedure Act. Needless to say, “no inference” is intended as to these transactions under existing law, and the IRS may, where appropriate, challenge them under applicable provisions or judicial doctrines.

Here is the paradigm: USP, a domestic corporation and the common parent of an affiliated group that files a consolidated tax return, owns 100% of the outstanding stock of US1 and US2, both domestic corporations that join with USP in filing a consolidated return. US1 owns 100% of the stock of CFC. US2 issues $100x of its stock to CFC in exchange for $10x of CFC stock and $90x of cash. USP takes the position that: (1) US2's transfer of its stock to CFC in exchange for $10x of CFC stock and $90x cash is an exchange to which §351 applies; (2) US2 recognizes no gain on the receipt of $10x of CFC stock and $90x cash in exchange for its stock pursuant to §1032(a); (3) CFC recognizes no gain on the issuance of its stock to US2 under §1032(a); (4) CFC's basis in the US2 stock is zero pursuant to §362(a); and (5) US1 and US2 do not and will not have an income inclusion under §951(a)(1)(B) as a result of CFC holding the US2 stock (which constitutes “United States property” under §956(c)).

The regulations change the §956 results stated above. Interestingly, there is no challenge to the application of §351, so presumably a business purpose is assumed to be present--although the regulations do not hint at what it might be. Under the regulations, the US2 stock acquired by CFC in the exchange constitutes “United States property,” because CFC acquires the US2 stock from US2, the issuing corporation. Therefore, because CFC's basis in the US2 stock is determined under §362(a), then solely for purposes of §956, CFC's basis in the US2 stock will now be treated as not less than $90x, the fair market value of the property exchanged by CFC for the US2 stock (the $10x of CFC stock issued in the exchange does not constitute property for purposes of the regulations). Therefore, CFC is treated as acquiring its basis of not less than $90x in the US2 stock at the time of its transfer of property to US2 in exchange for the US2 stock. If there are earnings and profits in CFC, then there will be an income inclusion under §956 to the extent of that basis amount.

Somewhat remarkably, the regulations waiver slightly their evaluative language. We just learned above that the targeted deals are “abusive” and must be stopped without advance public notice or comment. But the government also says it believes “these transactions raise significant policy concerns because the transactions may have the effect of repatriating earnings and profits of a CFC without a corresponding dividend inclusion, or an income inclusion under §951(a)(1)(B) by reason of the CFC's investment in United States property.” (Emphasis added.) Policy “concerns” are raised, and the transactions “may” have a tax avoidance effect. Nevertheless, they must be shut down immediately.

Well, I for one cannot disagree. It is hard to imagine why--other than tax avoidance--a U.S. group would create an “upside down” ownership of stock of a domestic subsidiary by a CFC and, further, do so mostly for cash. It is hard, but not impossible. Suppose, for example, CFC happens to be located in Country X. An unrelated Country X buyer wishes to purchase CFC for sound business reasons. Suppose US2 is in the same line of business, and the buyer wishes to acquire US2 also, and hold it under CFC. No reason for an ownership sandwich as to Country X. Suppose further that US2 needs cash to grow its business. So, USP, the seller, agrees to undertake the “abusive” transaction to satisfy the buyer and set up a structure the buyer is willing to acquire. By the way, cash is moved up pre-closing (or, from the buyer's perspective, moved down). Was avoidance of §956 “intended”? Probably. Were there other, non-tax (or at least non-U.S. tax) business motives at play? Perhaps. Shoot first, no comments later, please!