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PLANNING FOR OUTBOUND TRANSFERS UNDER

THE SECTION 367(A) AND 367(B) REGULATIONS, INCLUDING

EXPATRIATIONS

Bobbe Hirsh, Alan S. Lederman, and Martin B. Tittle

May 15, 2007

2007 Bobbe Hirsh, Alan S. Lederman, and Martin B. Tittle

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PROFESSIONAL BIOGRAPHIES

BOBBE HIRSH

Bobbe Hirsh (telephone 312-781-6809, e-mail [email protected]) is a partner

in the law firm of Bell, Boyd & Lloyd LLP, located in its Chicago office. She graduated

cum laude from Harvard Law School, where she was articles editor of the Harvard

International Law Journal. She holds an M.S.B.A. in accounting from the University if

Denver. Bobbe is also a CPA.

Bobbe publishes extensively in the field of international taxation and has

contributed to a number of PLI publications, including Foreign Investment in the United

States after the Tax Reform Act of 1986 (1987),International Tax Planning for the U.S.

Multinational Corporation (1988), Foreign Investment in the United States 1988,

Foreign Investment in the United States 1989, Foreign Investment in the United States -

A Practical Approach for the 1990s(1990), Transfer Pricing and the Foreign Owned

Corporation: Sections 482 and 6038A & C (1991), andTax Planning for Domestic and

Foreign Partnerships, LLCs, Joint Ventures and Other Strategic Alliances (1999-2007).

She is also a frequent contributor to The Journal of Taxation, The Journal of

International Taxation, and various other professional publications. She co-authored,

with Mr. Lederman, The NAFTA Guide, published by Harcourt Brace.

Bobbe serves on the Board of Advisors of theJournal of International Taxation

and the Journal of Taxation of Financial Productsand is a member of the Board of

Directors of International Tax Forum. In addition to writing, Bobbe is a frequent speaker

at professional conferences on a variety of international tax and trade issues.

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ALAN S. LEDERMAN

Alan S. Lederman, P.A., is of counsel in the Miami office of the Florida law firm

of Akerman Senterfitt (telephone 305-349-4528, e-mail [email protected]).

He graduated cum laude from Harvard Law School and received an M.B.A. from

Harvard Business School. Mr. Lederman also is a CPA. Mr. Lederman has taught in the

masters program at the University of Miami law school.

Alan often speaks at conferences for professionals. These conferences include

those sponsored by the NYU Institute on Federal Taxation, the American Bar

Association, the Florida Bar, the American Law Institute, and the American Management

Association. His articles have often appeared in The Journal of Taxation, The Journal of

International Taxation, TAXES, The AICPA Tax Adviser, The ABA Tax Lawyer, The

Proceeding of the NYU Annual Tax Institute, BNA Tax Management International

Journal, Airfinance Journal, and other professional periodicals. He has also written two

BNA Tax Management Portfolios.

In addition to the area of taxation, Alan practices in the field of international law.

In this connection, he has lectured on topics such as the euro currency, the Helms Burton

law, and the money-laundering statutes to such groups as the ABA International Law

Section. He co-authored with Ms. Hirsh The NAFTA Guide, published by Harcourt

Brace.

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MARTIN B. TITTLE

Martin B. Tittle (telephone 202-344-7592, e-mail [email protected]) is an

independent consultant who practices in Washington, D.C. and Ann Arbor, Michigan.

He works with foreign and U.S. multinationals on a wide range of tax issues pertaining to

their cross-border activities. Martin graduated magna cum laudefrom the University of

Michigan Law School.

Martin's articles have been published by Tax Notes International, The IBFD

Bulletin of International Taxation, and the Inter-American Development Bank. He is

also a contributor to The Canada-U.S. Tax Treaty, a treatise that Thomson Carswell will

be publishing in fall 2007. In 2005, Martin worked closely with Nardi Bress as vice-

chair of the ABA Tax Section's report on the proposed Sec. 367(a) regulations. In

addition to writing, Martin frequently speaks at professional conferences on a variety of

tax-related topics.
mailto:[email protected]:[email protected]:[email protected]

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EXPATRIATIONS

I. SECTION 367(A) OUTBOUND TRANSFERS ......... 1

A. Transfers.................................................................. 4

B. Tax Consequences Under Sec. 367(a)..................... 9

C. Sec. 367(a)(2) - Foreign Stock or Securities Exception 11

D. Section 367(a)(3) - Active Trade or Business Exception 13

E. Treas. Reg. Sec. 1.367(a)-3 ................................... 30

II. OUTBOUND TRANSFERS UNDER SECTION 367(B) 159

A. Outbound Transactions Covered by both Section 367(a) and (b) 160

B. Effect of Section 367(b) ...................................... 162

C. Section 367(b) Notice.......................................... 166

III. REPORTING REQUIREMENTS .......................... 167

A. Section 6038B ..................................................... 167

B. Time and Manner of Reporting ........................... 169

C. Information Required for Section 6038B(a)(1)(A) Transfers 170

D. Failure to Comply with Reporting Requirements 175

E. General Reporting and Recordkeeping Requirements 177

IV. PROPOSED BASIS AND HOLDING PERIOD RULES 184

B. Shareholder's Exchange of Foreign Target Stock for CFC Stock 184

C. P's Stock of S or T Following A Triangular Asset Reorganization 186

D. Examples ............................................................. 190

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EXPATRIATIONS

Bobbe Hirsh, Alan S. Lederman, and Martin B. Tittle

I. SECTION 367(A) OUTBOUND TRANSFERS

Internal Revenue Code Secs. 61 and 368 express sometimes conflicting goals that

mesh and are resolved, at least in part, in Sec. 367(a). Sec. 61 expresses a policy of

worldwide, as opposed to territorial, income taxation. Sec. 368 expresses a policy of

facilitating corporate restructurings as required by business exigencies by exempting

certain corporate reorganizations from taxation. Treas. Reg. Sec. 1.368-1(b). As has

been noted by some commentators, it is possible to utilize Sec. 368 tax-free exchanges,

along with Sec. 351 tax-free organizations and Sec. 332 tax-free liquidations, in the

cross-border context in a manner that does not advance any business interest other than

an escape from U.S. taxation. See, e.g., Samuel C. Thompson, Jr., "Impact of Code

Section 367 and the European Union's 1990 Council Directive on Tax-Free Cross-Border

Mergers and Acquisitions, " 66 U. Cin. L. Rev.1193, 1209-11 (1998).

The purpose of Sec 367(a) is generally to prevent the tax-free removal of property

from United States taxing jurisdiction when the ability of the U.S. to tax the profits from

that property cannot be preserved, even in cases when the transaction advances a business

interest. Sec. 367(a)(1) denies corporate status to the foreign transferee in Secs. 332, 351,

354, 356, and 361 exchanges when a U.S. person transfers property to a foreign

corporation. Because corporate status is required by those provisions for the transaction

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to qualify for nonrecognition treatment, Section 367(a)(1) causes the transaction to be

taxable by the U.S.

There are two primary exceptions to the application of Sec. 367(a)(1), but each of

them are subject to certain exceptions, and there are also exceptions to those exceptions

that may negate their effect. These nested levels of exceptions will be classified as

primary, secondary, and tertiary.

The first primary exception, the stock or securities exception, is found in Sec.

367(a)(2), which provides that, except as provided by regulations, Sec. 367(a)(1) does not

apply to the transfer of stock or securities of a foreign corporation that is a party to an

exchange or reorganization. .

The second exception, the active trade or business exception, is found in Sec.

367(a)(3), which provides that, except as provided by regulations, Sec. 367(a)(1) "shall

not apply to any property transferred to a foreign corporation for use by such corporation

in the active conduct of a trade or business outside of the United States." Sec. 367(a)(4)

states that, unless the regulations provide otherwise, a transfer of a partnership interest by

a U.S. person to a foreign corporation is treated as a transfer of that person's "pro rata

share of the assets of the partnership." Not qualifying for this exception are tainted

assets, including Sec. 1221(a) and (c) property (inventory and taxpayer created

copyrights, compositions, and similar property), installment obligations, accounts

receivable, and similar property, foreign currency and foreign currency denominated

property, and property transferred by the lessor of the property. Also not included is

intangible property, the transfer of which is generally subject to its own special rules

under Sec. 367(d) except for outbound Sec. 332 liquidations.

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Sec. 367(a)(5) is the source of the secondary exception to the Sec. 367(a)(2) and

(3) exceptions. It states that even if the exceptions in Secs. 367(a)(2) or (3) would

otherwise apply, the qualifying outbound transfer will nevertheless be subject to tax

under Sec. 367(a)(1) if it involves "an exchange described in subsection (a) or (b) of

section 361." This secondary exception was initially limited to C, D, F and G asset

However, now that the proposed expansion of A reorganizations to include mergers with

foreign corporations has been made final, this exception applies to them as well. Sec.

367(a)(5) is subject to its own tertiary exception where the transferor is controlled (within

the meaning of Sec. 368(c)) by five or fewer domestic corporations and regulations basis

adjustments and other conditions are complied with. In applying the "five or fewer" test,

all members of the same Sec. 1504 affiliated group are treated as one corporation. Sec.

367(a)(5).

Finally, Sec. 367(a)(6) is a catchall provision that allows the Secretary of the

Treasury to exempt additional transactions from the purview of Sec. 367(a)(1) by

regulation. Sec. 367(a)(5) does not contain any reference to Sec. 367(a)(6) and,

therefore, the limitations in 367(a)(5) would not apply to an exception authorized under

Sec. 367(a)(6).

For purposes of these provisions, a "U.S. person" includes U.S. citizens or

residents and domestic partnerships, corporations, trusts and estates. SeeTreas. Reg.

Secs. 1.367(a)-3(c)(5)(iv) and 1.367(a)-1T(d)(1); I.R.C. Secs. 6013(g)-(h) and

7701(a)(30). A nonresident alien and a foreign corporation are not U.S. persons even if

they are engaged in a U.S. trade or business.

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A "foreign corporation" is any corporation that is not created or organized in or

under the laws of the United States or a state. I.R.C. Sec.7701(a)(3) and (5); Treas. Reg.

Sec. 301.7701-5. Whether an entity is a corporation is determined under the "check-the-

box" regulations. Treas. Reg. Secs. 301.7701-1 and 301.7701-2. A foreign corporation in

which more than 50% of the stock, by vote or value, is owned directly, indirectly or

constructively by U.S. shareholders, as defined in Sec. 951(b), is a "controlled foreign

corporation" (CFC), although the ownership threshold is reduce to more than 25% in the

case of a foreign insurance company. Sec. 957

Only transfers described in Secs. 332, 351, 354, 356 or 361 are subject to Sec.

367(a). Outbound Sec. 355 distributions are excluded from the coverage of Sec. 367(a).

They are governed by Sec. 367(e)(1). As noted, Sec. 367(a) does not apply to outbound

transfers of intangible property (within the meaning of Sec. 936(h)(3)(B)) as they are

governed by Sec. 367(d). In addition, Sec. 367(a) does not apply to deemed Sec. 351

exchanges resulting from a Sec. 304(a)(1) transaction.

A. Transfers

Transfers include not only direct transfers, but also indirect or constructive

transfers. Direct transfers include B reorganizations (exchanges of stock for voting

stock), A and C reorganizations (exchanges of assets for voting stock), acquisitive D

reorganizations (exchanges of assets for stock of a commonly controlled acquirer) and

transfers to controlled corporations (Sec. 351).

Historically, regulations issued under Sec. 368(a)(1)(A) and its predecessors have

(with minor variations) interpreted the phrase "statutory merger or consolidation" to

apply only to a merger or consolidation effected pursuant to the laws of the United States

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or of a State or the District of Columbia. Based on these regulations, Rev. Rul. 57-465,

1957-2 C.B. 250, held that a merger accomplished under foreign law could not qualify as

an A reorganization.

The requirement that a merger be effected under U.S. law generally was

understood (or at least assumed) to mean that a merger of two corporations could qualify

as an A reorganization only if both corporations were domestic. Where either or both of

the corporations was foreign, it was generally understood (or at least assumed) that the

transaction would qualify for tax-free treatment, if at all, only as a C or D reorganization.

Pursuant to Treas. Reg. Sec. 1.368-2(b)(1)(ii), a statutory merger or consolidation

is now defined as "a transaction effected pursuant to the statute or statutes necessary to

effect the merger or consolidation," provided that, pursuant to such statute or statutes, the

following occur simultaneously: (1) all of the assets (other than those distributed in the

transaction) and liabilities (except to the extent satisfied or discharged in the transaction)

of the target corporation (and its disregarded entities) become the assets and liabilities of

the acquiring corporation (and its disregarded entities), and (2) the target corporation

ceases its separate legal existence for all purposes (except for certain litigation purposes

relating to assets or obligations arising, or relating to activities engaged in, prior to the

transaction).

Under the new regulations, mergers involving foreign corporations can qualify as

A reorganizations. A merger must still satisfy the requirements of Sec. 367(a), however,

to achieve non-recognition treatment. Notably, a shareholder's transfer of stock pursuant

to a merger (or other reorganization) may constitute an indirect transfer subject to Sec.

367(a) in certain circumstances.

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Indirect transfers subject to Sec. 367(a) include certain triangular A, B, or C

reorganizations, as well as certain asset reorganizations followed by a contribution of

assets to a controlled subsidiary. These are discussed in Section E.3, below.

Note: An "asset reorganization," for purposes of Treas. Reg. Sec. 1.367(a)-3, "is

defined as a reorganization described in Sec. 368(a)(1) involving a transfer of assets

under Sec. 361." Treas. Reg. Sec. 1.367(a)-3(a).

Treas. Reg. Sec. 1.367(a)-3(a) directs readers to Treas. Reg. Sec. 1.367(a)-1T(c)

for "rules regarding other indirect or constructive transfers of stock or securities subject

to Sec. 367(a)." The general rule in Treas. Reg. Sec. 1.367(a)-1T(c) is a broad, "catchall"

rule that provides that Sec. 367(a)(1) applies to any "transfer of property by a U.S. person

to a foreign corporation pursuant to an exchange described in Sec. 332, 351, 354, 355,

356, or 361 . . . whether it is made directly, indirectly, or constructively." Sec. 1.367(a)-

1T(c)(1). The intent and effect of this Catchall Rule has been synthesized as: "If, at the

end of the day, assets of the target corporation reside in a corporation other than the

foreign corporation, the stock of which was used to acquire such assets, the stock transfer

rules of Sec. 367(a)(1) should apply to that acquisition with respect to those assets that lie

outside the corporate solution of such foreign corporation." SeeBernard T. ["Nardi"]

Bress, "The New Section 367 Regulations: Going Beyond Form Over Substance," 9J.

Int'l Tax'n10, 21 (October 1998). The Catchall Rule "gives the [I.R.S.] general authority

to recast any asset acquisition, not just those [in Sec. 1.367(a)-3(d)(1)], as indirect stock

transfers for Sec. 367(a)(1) purposes." Id.

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The Catchall Rule ends by directing the reader to five nonexclusive examples, in

subparagraphs (3) through (7) of Sec. 1.367(a)-1T(c), of "indirect or constructive

transfers that are described in Sec. 367(a)(1)."

First, a transfer by a domestic or foreign partnership is treated as an indirect

transfer by the U.S. partners of their proportionate shares of the partnership's property.

The U.S. partners' proportionate shares are determined under Secs. 701 through 761.

Thus, where a partnership has five equal partners, two of whom are U.S. persons, and the

partnership transfers assets to a foreign corporation in an exchange described in Sec. 351,

the exchange is considered an indirect transfer of those assets by each of the partners,

with the consequence that each U.S. partner is treated as transferring 20% of each asset to

the foreign corporation.

If a U.S. partner recognizes gain on the partnership's transfer of property to the

foreign corporation, then the U.S. partner's basis in the partnership is increased by the

amount of gain recognized, the foreign corporation's basis in the assets received is also

increased by the amount of gain recognized, and solely for purposes of determining the

partnership's basis in the stock of the foreign corporation, the U.S. partner is treated as

having newly acquired an interest in the partnership, thereby permitting the partnership to

make an optional adjustment to basis under Secs. 743 and 754. Treas. Reg. Sec. 1.367(a)-

1T(c)(3).

A transfer under Sec. 367(a) by a U.S. partner of an interest in a domestic or

foreign partnership is treated as an indirect transfer of a proportionate share of the

partnership's property in an exchange described in Sec. 367(a). Therefore, the application

of the exceptions to Sec. 367(a)(1) are determined with reference to the property of the

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partnership, rather than the partnership interest itself. A U.S. partner's proportionate

share of the partnership's property is determined under Secs. 701 through 761. Thus, for

example, when a U.S. person who owns a 20% interest in a partnership transfers a 5%

interest in the partnership to a foreign corporation in an exchange described in Sec. 351,

the exchange is treated as an indirect transfer of the partnership's assets, and the partner is

thereby treated as transferring a 5% interest in each of the assets to the foreign

corporation.

If a U.S. partner is treated as transferring a proportionate share of the partnership's

property, then his basis for the stock of the foreign corporation is increased by the amount

of any gain recognized, the foreign corporation's basis in the partnership interest is also

increased by the amount of any gain recognized, and solely for purposes of determining

the partnership's basis in its property, the U.S. partner is treated as having newly acquired

an interest in the partnership for an amount equal to the gain recognized, thereby

permitting the partnership to make an optional adjustment to basis under Secs. 743 and

754. Treas. Reg. Sec. 1.367(a)-1T(c)(3).

The foregoing rule on the transfer of a partnership interest does not apply if the

interest transferred is a limited partnership interest that is regularly traded on an

established securities market. Treas. Reg. Sec. 1.367(a)-1T(c)(3). Instead, the transfer is

treated as a transfer of stock or securities. The partnership must be organized under the

laws of a state or the District of Columbia. An established securities market is a national

securities exchange registered under the Securities Act of 1934, a foreign national

securities exchange that is officially recognized, sanctioned or supervised by

governmental authority, or an over-the-counter market. A class of interests is regularly

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traded if it is regularly quoted by brokers or dealers making a market in such interests. A

class of interests is presumed to be regularly traded if the partnership has 500 or more

partners.

Second, a transfer by a U.S. trust or estate is treated as a transfer by the entity,

not by its beneficiaries. Thus, a transfer by a foreign trust or estate is not subject to Sec.

367(a) even if the beneficiaries of the trust or estate are U.S. persons. However, if the

trust is a grantor trust, whether domestic or foreign, the grantor is treated as the

transferor. Treas. Reg. Sec. 1.367(a)-1T(c)(4).

Third, termination of a Sec. 1504(d) election is treated as a constructive transfer

to a foreign corporation. Treas. Reg. Sec. 1.367(a)-1T(c)(5).

Fourth, if a foreign entity is classified for U.S. tax purposes as an entity that is not

taxable as a corporation, and subsequently a change is made in the entity's governing

documents, articles, or agreements so that it thereafter istaxable as a corporation, the

change in classification is considered a transfer of property to a foreign corporation in

connection with an exchange described in Sec. 351 that may be subject to Sec. 367(a).

Treas. Reg. Sec. 1.367(a)-1T(c)(6).

Finally, a contribution to the capital of a foreign corporation may be a transfer

described in Sec. 367(a)(1) if the foreign corporations is controlled by the contributing

entity See Sec. 367(c)(2) and the regulations thereunder. This provision could be

important if the contributing entity already owns all the stock of the foreign controlled

corporation.

B. Tax Consequences Under Sec. 367(a)

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If a transfer is subject to Sec. 367(a) and an exception does not apply, then the

foreign corporation is not treated as a corporation under any of the nonrecognition

provisions. Accordingly, gain is recognized as if there had been a taxable sale of the

property transferred. No loss, however, may be recognized. Treas. Reg. Sec. 1.367(a)-

1T(b)(3)(ii). The gain required to be recognized, however, cannot exceed the gain that

would have been recognized on a taxable sale computed as if each item of property had

been sold individually and with no offset of individual losses against individual gains.

Treas. Reg. Sec. 1.367(a)-1T(b)(3)(i).

The character and source of the gain are determined as if the property were sold in

a taxable transaction to the transferee foreign corporation. If the realized gain exceeds

the limitation, then the limitation is applied by making proportionate reductions in the

amounts of ordinary income and capital gain. Further, appropriate adjustments to

earnings and profits, basis, and other affected items are to be made, taking into account

the gain recognized. Treas. Reg. Sec. 1.367(a)-1T(b)(4). For example, when a domestic

corporation transfers inventory with a fair market value of $1 million and an adjusted

basis of $800,000 to a foreign corporation in an exchange described in Sec. 351, with title

passing in the United States, the corporation is required under Sec. 367(a)(1) to recognize

a gain of $200,000. This gain is treated as ordinary income under Secs. 1201 and 1221

from sources within the United States. The domestic corporation's basis in the foreign

corporation's stock is increased by the $200,000 gain recognized, and the foreign

corporation's basis in the inventory is also increased by the $200,000 gain recognized.

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C. Sec. 367(a)(2) - Foreign Stock or Securities Exception

The first statutory exception to Sec. 367(a)(1) is for transfers of foreign stock.

Except for certain transfers by corporations described above, a transfer by a U.S. person

of stock or securities of a foreign corporation to another foreign corporation is not subject

to Sec. 367(a)(1) if either of the following conditions is met:

1. The U.S. person owns less than 5% (applying the attribution rules

of Sec. 318, as modified by Sec. 958(b)) of both the total voting power and the total value

of the stock of the transferee foreign corporation immediately after the transfer; or

2.

The U.S. person enters into a five-year gain recognition agreement

with respect to the transferred stock or securities.

Treas. Reg. Sec. 1.367(a)-3(b).

In certain circumstances, a transfer of domestic stock is deemed to be a transfer of

foreign stock. See Section E.3.b(7).

If a transfer of foreign stock or securities is described in both Sec. 367(a) and

Sec. 367(b), the regulations generally provide that the transfer will be subject to both

provisions. Treas. Reg. Sec. 1.367(a)-3(b)(2)(i). This general, "overlap" rule, however, is

subject to two important exceptions.

Under the first exception, Sec. 367(b) will not apply if a foreign corporation is not

treated as a corporation under Sec. 367(a)(1). Treas. Reg. Sec. 1.367(a)-3(b)(2)(i)(A).

Treas. Reg. Sec. 1.367(a)-3(b)(2)(ii) provides the following example: Assume that a

domestic corporation owns all of the stock of a CFC, its basis in the foreign corporation's

stock is $50, the value of the foreign corporation's stock is $100, and the Sec. 1248

amount with respect to the foreign corporation's stock is $30. If an unrelated foreign

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corporation that is not a CFC acquires all of the foreign corporation's stock from the

domestic corporation in exchange for 20% of the voting stock of the unrelated foreign

corporation in a Sec. 368(a)(1)(B) reorganization, the domestic corporation must enter

into a five-year gain recognition agreement, or else it will be required to recognize the

$50 gain that it realized on the exchange, $30 of which will be treated as a dividend under

Sec. 1248. However, if it enters into a five-year gain recognition agreement, although no

gain will be recognized under Sec. 367(a)(1), the exchange will still be subject to Sec.

367(b). Therefore, the domestic corporation will be required to recognize the Sec. 1248

amount of $30 on the exchange. See Section II, below. The deemed dividend of $30 that

is recognized by the domestic corporation will increase its basis in the foreign

corporation's stock that it receives in the exchange. Treas. Reg. Sec. 1.367(a)-3(b)(2)(ii).

Under the second "overlap" exception, only Sec. 367(b) will apply in the case of

an inbound triangular asset reorganization to which the indirect stock transfer rules would

otherwise apply if the "all earnings and profit amount" triggered under Sec. 367(b) is

greater than the gain that would be subject to Sec. 367(a). Treas. Reg. Sec. 1.367(a)-

3(b)(2)(i)(B).

Note: Under prior regulations, Sec. 367(b) and the regulations thereunder did not

apply if the transferee corporation was not treated as a corporation under Sec. 367(a).

Therefore, if the all earnings and profits amount was greater than the Sec. 367(a) gain, an

exchanging shareholder was permitted to choose to trigger gain under Sec. 367(a), by

opting not to enter into a gain recognition agreement, in order to avoid inclusion of the all

earnings and profits amount. The current regulations do not permit taxpayers to avoid

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Sec. 367(b) in this manner. (For a definition of the term "all earning and profits amount,"

see Section II below.)

D. Section 367(a)(3) - Active Trade or Business Exception

The second statutory exception to Sec. 367(a)(1) is for transfers of property that

will be used by the transferee foreign corporation in the active conduct of a trade or

business outside the United States. Sec. 367(a)(3). Although the meaning of "property"

in the context of Sec. 367(a)(3) has been debated in the past, it is now accepted that it

includes stock and securities, and that Sec. 367(a)(3) is the basis for preserving

nonrecognition in the case of outbound transfers of domestic stock. SeePhillip Tretiak,

"U.S. Section 367(a) Stock Transfers in 1998: All You Need to Know!" 17 Tax Notes

Int'l39, 40 n.8 (July 6, 1998); Bernard T. Bress, "The New Section 367 Regulations:

Going Beyond Form Over Substance," 9J. Int'l Tax'n10, 21-22 (October 1998). (Philip

Tretiak was the author of the 1998 final Sec. 367 regulations.)

To qualify for the Sec. 367(a)(3) exception, the Sec. 6038B reporting

requirements must be satisfied. Treas. Reg. Sec. 1.367(a)-2T(a)(2). See Section III.A

below for a discussion of these reporting requirements.

1. Active Conduct of a Trade or Business

Whether property is transferred for use in the active conduct of a trade or business

outside the United States requires four factual determinations:

a. What is the trade or business of the transferee?

b . Do the activities of the transferee constitute the active

conduct of that trade or business?

c. Is the trade or business conducted outside the U.S.?

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d. Is the transferred property used or held for use in the trade

or business?

Treas. Reg. Sec. 1.367(a)-2T(b)(1). Each of these determinations is made taking into

account all facts and circumstances.

A trade or business is a specific unified group of activities that constitute, or could

constitute, an independent economic enterprise carried on for profit. For example, the

activities of a foreign selling subsidiary could constitute a trade or business if they could

be independently carried on for profit, even though the subsidiary acts exclusively on

behalf of, and has operations fully integrated with, its parent corporation. The group of

activities must ordinarily include every operation that forms a part of, or a step in, a

process by which an enterprise may earn income or profit, and must ordinarily include

the collection of income and the payment of expenses. The holding for one's own

account of investments in stocks, securities, land, or other property, including casual sales

thereof, does not constitute by itself a trade or business. Likewise, any activity giving

rise to expenses that would be deductible only under Sec. 212, if the activity were

conducted by an individual, does not constitute a trade or business. Treas. Reg. Sec.

1.367(a)-2T(b)(2). For a trade or business to be actively conducted, the officers and

employees of the corporation must carry out substantial managerial and operational

activities. In making this determination, the activities of independent contractors are

disregarded, although incidental activities may be carried out on behalf of the corporation

by independent contractors. The officers and employees of the corporation include

officers and employees of related entities that are available to, supervised by, and are paid

or reimbursed by the corporation. Whether a trade or business that produces rents or

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royalties is an active trade or business is determined under the principles of Treas. Reg.

Sec. 1.954-2(d)(1), without regard to whether the rents or royalties are received from an

unrelated person. Treas. Reg. Sec. 1.367(a)-2T(b)(3).

For a trade or business to be conducted outside the United States, the primary

managerial and operational activities must be conducted outside the United States, and

the transferred property must be located outside the U.S. immediately after the transfer.

Thus, the active trade or business exception will not apply if the domestic business

continues to operate in the United States after the transfer. As long as the primary

managerial and operational activities of the trade or business are conducted outside the

Unites States and substantially all of the transferred property is located outside the United

States, incidental items of transferred property may be located in the United States. Treas.

Reg. Sec. 1.367(a)-2T(b)(4).

Property is used or held for use in a foreign corporation's trade or business if it is:

a. Held for the principal purpose of promoting the present

conduct of the trade or business;

b. Acquired and held in the ordinary course of the trade or

business, or

c. Otherwise held in a direct relationship to the trade or

business. Property is considered held in a direct relationship to a trade or business if it is

held to meet the present needs of the trade or business, and not its anticipated future

needs. Thus, property held for future diversification into a new trade or business, future

expansion of a trade or business, future plant replacement, or future business

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contingencies is not held in a direct relationship to a trade or business. Treas. Reg. Sec.

1.367(a)-2T(b)(5).

If the transferee foreign corporation transfers the property to another person as

part of the same transaction in which it received the property, the initial transfer will not

qualify for the active trade or business exception. A transfer within six months of the

initial transfer will be considered part of the same transaction. Whether a transfer more

than six months after the initial transfer is considered part of the same transaction will be

determined under the step transaction doctrine. Notwithstanding, the active trade or

business exception will apply if the subsequent transfer is to a controlled corporation

under Sec. 351 or a partnership under Sec. 721, each subsequent transferee is either a

corporation in which the preceding transferor owns common stock, or a partnership in

which the preceding transferor is a general partner, and the ultimate transferee uses the

property in the active conduct of a trade or business outside the United States. Treas. Reg.

Sec. 1.367(a)-2T(c).

2. Exceptions

The Code contains a number of exceptions to the active trade or business

exception. In addition, the Internal Revenue Service has promulgated regulatory

exceptions under the authority granted by Sec. 367(a)(3).

a. Tainted Assets

The active trade or business exception does not apply to transfers of tainted assets,

which are five categories of liquid or passive assets. I.R.C Sec. 367(a)(3)(B).

Inventory, Copyrights and Similar Property.

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Regardless of its use in an active trade or business, Sec. 367(a)(1) applies to the

transfer of stock in trade, property of a kind which would properly be included in

inventory if on hand at the close of the taxable year, and property held primarily for sale

to customers in the ordinary course of business. Inventory includes raw materials and

supplies, partially completed goods, and finished products. Also subject to Sec. 367(a)(1)

are copyrights; literary, musical, or artistic compositions; letters or memoranda; and

similar property held by the person whose personal efforts created such property. In the

case of a letter, memorandum, or similar property, the property must be held by the

person from whom such property was prepared or produced. This property is also subject

to Sec. 367(a)(1) if it is held by a person whose basis for such property is determined, for

purposes of determining gain from a sale or exchange, by reference to the basis of such

property in the hands of the person who created it or from whom it was prepared or

created. Treas. Reg. Sec. 1.367(a)-5T(b).

Installment Obligations.

Regardless of their use in an active trade or business, Sec. 367(a)(1) applies to the

transfer of installment obligations, accounts receivable, or similar property, but only to

the extent that the principal amount of such obligation has not previously been included

by the transferor in its taxable income. Treas. Reg. Sec. 1.367(a)-5T(c).

Foreign Currency.Regardless of its use in an active trade or business, Sec. 367(a)(1)

applies to the transfer of foreign currency or other property denominated in foreign

currency, including installment obligations, futures contracts, forward contracts, accounts

receivable, or any other obligation entitling its payee to receive payment in a currency

other than U.S. dollars. However, if the transferred property is denominated in the

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currency of the country in which the transferee foreign corporation is organized, and was

acquired in the ordinary course of the transferor's business that will be carried on by the

transferee foreign corporation, then Sec. 367(a)(1) will apply only to the extent that gain

is required to be recognized with respect to previously realized income reflected in

installment obligations, as described above. The gain required to be recognized is limited

to the gain realized upon the transfer of foreign currency and property denominated in

foreign currency, minus any loss realized as part of the same transaction upon the transfer

of such property. However, if the result is a loss, it will not be recognized. Treas. Reg.

Sec. 1.367(a)-5T(d).

Intangible Property.Regardless of its use in an active trade or business, a transfer of

intangible property pursuant to Sec. 332 is subject to Sec. 367(a)(1) unless it constitutes

foreign goodwill or going concern value. Treas. Reg. Sec. 1.367(a)-5T(e). Outbound

transfers of intangible property pursuant to Sec. 351 or Sec. 361 are governed by Sec.

367(d).

Leased Tangible Property.Regardless of its use in an active trade or business, Sec.

367(a)(1) applies to a transfer of tangible property leased by the transferor to others at the

time of the transfer, unless either of the following two conditions is met.

(1) If the transferee will not lease the property to third

parties, the transferee was the lessee of the property at the time of the transfer, or

(2) If the transferee will lease the property to third

parties, the transferee satisfies the conditions for an active leasing business described

below.

Treas. Reg. Sec. 1.367(a)-5T(f).

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b. Foreign Branches

The active trade or business exception may not apply to a gain realized on a

transfer of the assets of a foreign branch of a U.S. person if the foreign branch previously

deducted losses. Sec. 367(a)(3)(C). A foreign branch is an integral business operation

carried on by a U.S. person outside the United States. Whether the activities of a U.S.

person outside the United States constitute a foreign branch operation is determined

under all the facts and circumstances. Evidence of the existence of a foreign branch

includes, but is not limited to, the existence of a separate set of books and records and the

existence of an office or other fixed place of business used by employees or officers of

the U.S. person to carry out business activities outside the United States. Activities

outside the United States constitute a foreign branch if the activities constitute a

permanent establishment under the terms of a treaty between the United States and the

country in which the activities are conducted. Treas. Reg. Sec. 1.367(a)-6T(g)(1).

If a U.S. person has more than one foreign branch, then this exception applies

separately to each foreign branch that is transferred to a foreign corporation. Thus, the

previously deducted losses of one foreign branch may not be offset, for purposes of

determining the gain to be recognized, by the income of another foreign branch that is

also transferred to a foreign corporation. Similarly, the losses of one foreign branch are

not recaptured on a transfer of the assets of a separate foreign branch. Whether the

foreign activities of a U.S. person are conducted through more than one foreign branch is

determined under all the facts and circumstances. A separate branch generally exists if a

particular group of activities is sufficiently integrated to constitute a single business that

could be operated as an independent enterprise. Treas. Reg. Sec. 1.367(a)-6T(g)(2).

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The activities of two domestic corporations outside the United States will be

considered a single foreign branch if the two corporations are members of the same

consolidated group of corporations, and the activities of the two corporations in the

aggregate would constitute a single foreign branch if conducted by a single corporation.

Notwithstanding, gains of a foreign branch of a domestic corporation arising in a year in

which that corporation did not file a consolidated return with the second domestic

corporation cannot be applied to reduce the previously deducted losses of the foreign

branch of the second corporation, but may be applied to reduce such losses of the foreign

branch of the first corporation upon the transfer of the two branches to a foreign

corporation, even though the two domestic corporations file a consolidated return for the

year in which the transfer occurs and the two branches are considered at that time to

constitute a single foreign branch. Treas. Reg. Sec. 1.367(a)-6T(g)(3).

A U.S. transferor's failure to transfer any property of a foreign branch to the

foreign corporation is irrelevant to the determination of the previously deducted losses of

the branch that are subject to recapture. Thus, if the activities with respect to property

constituted a part of the branch operation, then the losses generated by those activities

will be subject to recapture, notwithstanding the lack of a transfer of thee property. Treas.

Reg. Sec. 1.367(a)-6T(g)(4).

Gain recognition is required in an amount equal to the sum of the "previously

deducted branch ordinary losses" and the "previously deducted branch capital losses."

Treas. Reg. Sec. 1.367(a)-6T(b). The gains recognized retain their character as ordinary

or capital, all capital gains are long-term, and all are treated as from sources outside the

U.S. The previously deducted branch losses are computed separately for each taxable

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year prior to the transfer (a "branch loss year"), and are calculated separately for the

previously deducted branch ordinary loss and the previously deducted branch capital loss.

Treas. Reg. Sec. 1.367(a)-6T(c).

The previously deducted branch ordinary loss for each branch loss year is then

reduced by the amount of any expired net ordinary loss with respect to that branch loss

year. Expired net ordinary losses arising in years other than the branch loss year reduce

the previously deducted branch ordinary loss for the branch loss year only to the extent

that the previously deducted branch ordinary loss exceeds the net operating loss, if any,

incurred by the transferor in the branch loss year. The previously deducted branch

ordinary losses are reduced in order, proceeding from the first branch loss year to the last

branch loss year. For each branch loss year, expired net operating losses are applied in

the order in which they arose. Treas. Reg. Sec. 1.367(a)-6T(d)(2).

An expired net ordinary loss exists with respect to a branch loss year to the extent

that:

The transferor incurred a net operating loss;

The net operating loss arose in the branch loss year or was available for

carryover or carryback to the branch loss year;

The net operating loss did not result in a net operating loss deduction for any

taxable year prior to the year of the transfer, nor reduce any previously

deducted branch ordinary loss of any foreign branch previously transferred to

a foreign corporation; and

The period during which the transferor can claim a net operating loss

deduction for that net operating loss has expired.

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Treas. Reg. Sec. 1.367(a)-6T(d)(2)(ii).

The previously deducted branch capital loss for each branch loss year is similarly

reduced by the amount of any expired net capital loss with respect to that branch loss

year. Expired net capital losses arising in years other than the branch loss year reduce the

previously deducted branch capital loss for the branch loss year only to the extent that the

previously deducted branch capital loss exceeds the net capital loss, if any, incurred by

the transferor in the branch loss year. The previously deducted branch capital losses are

reduced in order, proceeding from the first branch loss year to the last branch loss year.

For each branch loss year, expired net capital losses are applied in the order in which they

arose. Treas. Reg. Sec. 1.367(a)-6T(d)(3).

An expired net capital loss exists with respect to a branch loss year to the extent

that the transferor incurred a net capital loss, that net capital loss arose in the branch loss

year or was available for carryover or carryback to the branch loss year, the net capital

loss was neither allowed for any taxable year prior to the year of the transfer, nor reduced

any previously deducted branch capital loss of any foreign branch previously transferred

to a foreign corporation, and the period during which the transferor can claim a capital

loss deduction with respect to that net capital loss has expired. Treas. Reg. Sec. 1.367(a)-

6T(d)(3)(ii).

After the reductions for expired net operating and capital losses, the previously

deducted branch ordinary loss and the previously deducted branch capital loss for each

branch loss year are further reduced proportionately by the amount of any expired foreign

tax credit loss equivalent with respect to that branch loss year. The previously deducted

branch losses are reduced in order, proceeding from the first branch loss year to the last

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The previously deducted branch losses are reduced in order, proceeding from the first

branch loss year to the last branch loss year. For each branch loss year, expired

investment credit loss equivalents are applied to reduce the previously deducted branch

loss for that year in the order in which the expired investment credits were earned. Treas.

Reg. Sec. 1.367(a)-6T(d)(5).

An investment credit loss equivalent exists with respect to a branch loss year if:

(A)The transferor earned an investment credit;

(B) The investment credit was earned in the branch loss year or was available

for carryover or carryback to the branch loss year;

(C) The investment credit earned by the transferor in the credit year did not

reduce any previously deducted branch loss of the foreign branch for a preceding

taxable year or of the previously deducted losses of any foreign branch previously

transferred to a foreign corporation; and

(D) The period during which the transferor can claim the investment credit

has expired.

Treas. Reg. Sec. 1.367(a)-6T(d)(5)(ii).

The amount of the investment credit loss equivalent for the branch loss year is 85% of the

amount of the investment credit divided by the highest rate of tax to which the transferor

was subject in the branch loss year. Treas. Reg. Sec. 1.367(a)-6T(d)(5)(iii).

Five additional amounts further reduce the sum of the previously deducted branch

ordinary losses and the sum of the previously deducted branch capital losses as

determined above. Treas. Reg. Sec. 1.367(a)-6T(e). Amounts representing ordinary

income first reduce the sum of the previously deducted branch ordinary losses and then

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the sum of the previously deducted branch capital losses. Similarly, amounts

representing capital gains first reduce the sum of the previously deducted branch capital

losses and then the sum of the previously deducted branch ordinary losses. These five

amounts are as follows:

(A) Any taxable income of the foreign branch recognized through the close of the

taxable year of the transfer, whether before or after any taxable year in which losses were

incurred.

(B) Any amount recognized under Sec. 904(f)(3) due to the transfer.

(C)

Any gain recognized under Sec. 367(a)(1) (other than under this foreign branch

rule) on the transfer of the assets of the foreign branch to the foreign corporation.

(D) Any portion of any amount recognized under Sec. 904(f)(3) upon a previous

transfer of property that was attributable to the losses of the foreign branch, provided that

the amount did not reduce any gain otherwise required to be recognized under Sec.

367(a)(3)(C).

(E) Any amounts previously recognized upon a previous transfer of assets of the

foreign branch.

d. Section 361 Transfers

The active trade or business exception also does not apply to a Sec. 361 exchange

(exchanges by corporations of property for stock). Sec. 367(a)(5). However, the active

trade or business exception will apply if five or fewer domestic corporations control

(within the meaning of Sec. 368(c)) the transferor. All members of the same affiliated

group (within the meaning of Sec. 1504) are treated as one corporation for this purpose.

Sec. 367(a)(5). Although this control group exception is subject to basis adjustments and

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the satisfaction of other conditions to be prescribed in regulations, no regulations have

been issued.

c. Depreciated Property

If depreciated U.S. property is transferred to a foreign corporation in an exchange

described in Sec. 367(a)(1), then the transferor must recognize ordinary income even

though the property will be used in the active conduct of a trade or business outside the

United States. The amount includable in gross income is the amount that would have

been includable in the transferor's gross income as ordinary income under Secs.

617(d)(1), 1245(a), 1250(a), 1252(a), or 1254(a), whichever is applicable, had the

transferor sold the property for its fair market value in a taxable transaction. The active

trade or business exception will apply to any realized gain in excess of the required

depreciation recapture. Treas. Reg. Sec. 1.367(a)-4T(b). Depreciated U.S. property is

mining property defined in Sec. 617(f)(2), Sec. 1245 property, Sec. 1250 property, farm

land defined in Sec. 1252(a)(2), or oil, gas, or geothermal property, any of which was

used in the United States or qualified as Sec. 38 property prior to its transfer. Treas. Reg.

Sec. 1.367(a)-4T(b)(2).

If depreciated U.S. property was used partly within and partly without the United

States, then the amount required to be included in ordinary income is the full recapture

amount times a fraction, the numerator of which is U.S. use and the denominator of

which is total use. The full recapture amount is the amount that would be included in the

transferor's income if the property had been used entirely in the United States. U.S. use is

the number of months that the property either was used in the United States or qualified

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as Sec. 38 property, and total use is the total number of months that the property was used

(or available for use) by the transferor or a related person.

d. Leased Property

Tangible property (including non-U.S. real property) transferred to a foreign

corporation for lease to others will be used in the active conduct of a trade or business

outside the United States only if the following three conditions are met:

(1) The foreign corporation's leasing of the property

constitutes the active conduct of a leasing business;

(2)

The lessee is not expected to, and does not use the

property in the United States; and

(3) The foreign corporation has need for substantial

investment in assets of the type transferred.

The active conduct of a leasing business requires that the employees of the

foreign corporation perform substantial marketing, customer service, repair and

maintenance, and other substantial operational activities with respect to the transferred

property outside of the United States. Treas. Reg. Sec. 1.367(a)-4T(c)(1).

Tangible property that will be used by the foreign corporation in the active

conduct of a trade or business, but will be leased during occasional brief periods when the

property would otherwise be idle, qualifies for the active trade or business exception.

Similarly, real property located outside the United States that is transferred to a foreign

corporation for use primarily in the active conduct of a trade or business qualifies for the

active trade or business exception if no more than 10% of the square footage of the

property will be leased to others. Treas. Reg. Sec. 1.367(a)-4T(c)(2).

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e. Property to be Sold

Property will not qualify for the active trade or business exception if, at the time

of the transfer, it is reasonable to believe that in the reasonably foreseeable future the

foreign corporation will sell or otherwise dispose of any material portion of the

transferred property other than in the ordinary course of business. Treas. Reg. Sec.

1.367(a)-4T(d).

f. Working Interest in Oil and Gas Properties

A working interest in oil and gas properties will be considered to be transferred

for use in the active conduct of a trade or business if:

(1) The transfer satisfies the detailed conditions set

forth in Treas. Reg. Sec. 1.367(a)-4T(e)(2);

(2) At the time of the transfer, the foreign corporation

has no intention to farm out or otherwise transfer any part of the transferred working

interest; and

(3) During the first three years after the transfer there

are no farmouts or other transfers of any part of the transferred working interest as a

result of which the foreign corporation retains less than a 50% share of the transferred

working interest.

Treas. Reg. Sec. 1.367(a)-4T(e)(1).

g. Compulsory Transfers

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Property that was previously used in the country in which the transferee foreign

corporation is organized will be presumed to be transferred for use in the active conduct

of a trade or business outside of the United States, if:

(1) The transfer is legally required by the foreign

government as a necessary condition of doing business in that country; or

(2) The transfer is compelled by a genuine threat of

immediate expropriation by the foreign government.

Treas. Reg. Sec. 1.367(a)-4T(f).

h.

Transfers of Certain Property to Foreign Sales Corporations

("FSCs")

Sec. 367(a) does not apply to a transfer of property by a U.S. person to a foreign

corporation that is an FSC if:

(1) The transferee FSC uses the property to generate

exempt foreign trade income;

(2) The property is not excluded property, as defined in

Sec. 927(a)(2); and

(3) The property consists of a corporate name or

tangible property that is appropriate for use in the operation of an FSC office.

The foregoing rule does not apply if, within three years after the original transfer,

the original transferee FSC (or a subsequent transferee FSC) disposes of the property

other than in the ordinary course of business or through a transfer to another FSC. Treas.

Reg. Sec. 1.367(a)-4T(h).

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As the result of a decision by the World Trade Organization ("WTO") that FSCs

constitute an export subsidy violating WTO agreements, the FSC provisions of the Code

were repealed effective October 1, 2000, for new FSCs and January 1, 2002 for FSCs in

existence on September 30, 2000, except for certain transactions pursuant to a binding

contract that was in effect on September 30, 2000. The Tax Increase Prevention and

Reconciliation Act of 2005 repealed the grandfathering of binding contracts for tax years

beginning after May 17, 2006. SeeSec. 513, Pub.L. 109-222 (2006).

E. Treas. Reg. Sec. 1.367(a)-3

Although Treas. Reg. Sec. 1.367(a)-3 briefly addresses the Sec. 367(a)(2) foreign

stock exception, its main focus lies in implementation of the Sec. 367(a)(3) active

business exception with respect to transfers of domestic stock. As noted in Section I.D

above, although the authority for excluding transfers of domestic stock from Sec. 367(a)

has in the past been attributed to Secs. 367(a)(2) or (6), since 1998 it has been generally

conceded to arise from Sec. 367(a)(3), the active trade or business exception. SeePhillip

Tretiak, "U.S. Section 367(a) Stock Transfers in 1998: All You Need to Know!" 17 Tax

Notes Int'l 39, 40 n.8 (July 6, 1998); Bernard T. Bress, "The New Section 367

Regulations: Going Beyond Form Over Substance," 9J. Int'l Tax'n10, 21-22 (October

1998). (Philip Tretiak was the author of the 1998 final 367 regulations.)

Treas. Reg. Sec. 1.367(a)-3 begins with general statements regarding its purpose

and scope. A transfer of stock or securities by a U.S. person to a foreign corporation that

is described in Sec. 351, 354 (including a reorganization described in Sec. 368(a)(1)(B)

and including an indirect stock transfer described in Sec. 1.367(a)-3(d)), 356 or 361(a) or

(b) is subject to Sec. 367(a)(1) unless an exception in 1.367(a)-3(b), (c), or (e) applies.

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The 1.367(a)-3(b) exception is discussed in Section I.C, above. The exceptions in

1.367(a)-3(c) and (e) are discussed below in paragraphs 1 and 5 of this Section E.

The 2006 final version of 1.367(a)-3 made the following three changes to the

prior regulation:

1) The prior exception for Sec. 354 exchanges of stock that occur in the course of

Code Sec. 368(a)(1)(E) and certain non-indirect-stock-transfer asset reorganizations is

expanded to include exchanges of both stock and securities under both Sec. 354 and 356.

Treas. Reg. Sec. 1.367(a)-3(a). This change is congruent with the expansion of statutory

mergers to include mergers that occur pursuant to foreign law because Sec. 356 addresses

exchanges that would comply with Sec. 354 except for the presence of "boot," or

consideration in addition to approved stock and securities, and boot is more widely used

in statutory mergers than in those reorganizations addressed in the prior version of Sec.

1.367(a)-3. Treas. Reg. Sec. 1.368-2(b)(1)(ii)-(iii); T.D. 9242 (Jan. 26, 2006).

2) The prior exception for Sec. 354 exchanges that occur in the course of those

Code Sec. 368(a)(1)(C), (D), and (F) reorganizations that are not recharacterized by the

indirect stock transfer rules of Treas. Reg. Sec. 1.367(a)-3(d) is reframed as an exception

for "asset reorganizations." Treas. Reg. Sec. 1.367(a)-3(a). The term "asset

reorganization" is defined as a Sec. 368(a)(1) reorganization involving a transfer of assets

under Sec. 361. Treas. Reg. Sec. 1.367(a)-3(a).

3) Because a reverse triangular/reverse subsidiary merger frequently involves a

contribution of parent stock to the merging subsidiary as part of the merger, the

expansion of statutory mergers to include foreign corporations raised the possibility that

Sec. 367(a) would apply to the transfer of this stock to a foreign target under Sec. 361.

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To avoid this result, the 2006 final regulation exempts these transfers. Parent stock not

provided as part of the plan of reorganization will continue to be treated as property of

the subsidiary, and therefore subject to 367(a). Treas. Reg. Sec. 1.367(a)-3(a).

Less than a month following the release of the final Treas. Reg. Sec. 1.367(a)-3

regulations on Jan. 26, 2006, new regulations were issued that amended Treas. Reg. Sec.

1.367(a)-3 to exempt certain Sec. 304(a)(1) transfers by a U.S. person of stock of a

domestic or foreign corporation to a foreign corporation in exchange for stock of such

foreign corporation. Treas. Reg. Sec. 1.367(a)-3(a); T.D. 9250 (Feb. 21, 2006). Sec.

304(a)(1) generally provides that, for purposes of Secs. 302 and 303, if one or more

persons is in control of each of two corporations (i.e., "brother-sister" corporations), and

in return for property, one corporation (the acquiring corporation) acquires stock in the

corporation (the issuing corporation) from the controlling person or persons, then the

property is treated as received as a distribution in redemption of the acquiring

corporation's stock.

To the extent that such distribution is treated as a Sec. 301 dividend, the transferor

is treated as having transferred the stock of the issuing corporation to the acquiring

corporation in a Sec. 351 exchange for stock of the acquiring corporation and the

acquiring corporation is then treated as redeeming the stock that it is treated as having

issued. The distribution is treated as a dividend to the extent of earnings and profits of

the acquiring corporation and then of the issuing corporation. Any remaining portion of

the distribution reduces the adjusted basis of the stock, to the extent that it exceeds such

basis, is treated as gain from the sale or exchange of property. If Sec. 367(a) applied to

the transaction, then a U.S. taxpayer could have multiple income inclusions from the

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same transaction: first, dividend and/or gain under Sec. 304, and second, dividend and/or

gain equal to the built-in gain in the stock of the issuing corporation under Sec. 367. Such

income inclusions could potentially exceed that value of the transferred stock of the

issuing corporation, which is the reason, along with undue complexity, that the IRS gave

as the rationale for the new regulation.

The IRS reasoning is that the income recognized in a Sec. 304(a)(1) transaction

generally equals or exceeds the transferor's inherent gain in the stock of the issuing

corporation. The IRS, in its explanation of the new provision, denies that it is possible

that the income recognized will not equal or exceed the inherent gain. For example, if the

acquiring and issuing corporations (F1 and F2, respectively) have no earnings and profits,

the stock of the issuing corporation has a positive fair market value (say $100) and is

transferred for consideration equal to such value ($100), and the U.S. shareholder has no

basis in F1 but $100 of basis in F2, the IRS maintains that U.S. shareholder would

recognize the $100 of built-in gain in the F1 stock and continue to have $100 of basis in

the F2 stock that the U.S. shareholder continues to hold. The IRS states that it does not

believe that current law allows the U.S. shareholder to recover its basis in the F2 stock

that it holds, but only the F2 stock deemed to have been received in the Sec. 351(a)

exchange, which would take a basis under Sec. 362 equal to the U.S. shareholder's basis

in the F1 stock. The IRS further announced that this issue will be addressed as part of a

project dealing with the recovery of basis in redemptions treated as Sec. 301 dividends.

The final T.D. 9250, like the earlier proposed regulations (REG-127740-04, 2005-

24 I.R.B. 1254), bifurcates a transfer of issuing stock in return for both property and the

stock of acquiring into two transactions: a transfer for property which is treated as a Sec.

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351 exchange by reason of Sec. 304(a)(1), and a transfer for stock which is treated as a

Sec. 351 exchange other than by operation of Sec. 304(a)(1). If the sale of stock is for an

amount less than the fair market value of the transferred stock, the acquiring company is

deemed to issue stock to the transferor other than as a result of Sec. 304(a)(1). In both

cases, Sec. 367 would not apply to only the portion of the transaction in which the stock

is treated as transferred for property (i.e., the portion of the transaction treated as a Sec.

351 exchange by operation of Sec. 304), and Sec. 367 would apply to the portion of the

transaction in which the consideration for the issuing corporation's stock is, or is deemed

to be, stock of the acquiring corporation.

The new provisions in T.D. 9250 apply to Sec. 304(a)(1) transactions occurring

on or after February 21, 2006. Taxpayers can also apply them to transactions that

occurred in all their open tax years, but if they elect to do so, they must apply the new

provisions to all of the Sec. 304(a)(1) transactions that took place during all such open tax

years. Any gain recognition agreements (discussed in Section I.E.2 below) that had been

filed for such transactions will terminate and have no further effect.

1. Transfers of Stock or Securities of Domestic Corporations

The paragraphs in this subsection detail the requirements set forth in Treas. Reg.

Sec. 1.367(a)-3(c), "Transfers by U.S. persons of stock or securities of domestic

corporations to foreign corporations."

a. Introduction

The 2006 final version of Sec. 1.367(a)-3 in T.D. 9243 made only one change to

subparagraph (c): The definition of "transferee foreign corporation" in paragraph

(c)(5)(vi) was changed from "the foreign corporation whose stock is received in the

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exchange by U.S. persons" to "except as provided in [Treas. Reg. Sec. 1.367(a)-3]

(d)(2)(i)(B), . . . the foreign corporation whose stock is received in the exchange by U.S.

persons."

This definition is, unfortunately, at odds with the definition of "transferee foreign

corporation" in 1.367(a)-3(d)(2)(i). That definition reads, "Except as provided in

paragraph [Treas. Reg. Sec. 1.367(a)-3](d)(2)(i)(B), the transferee foreign corporation

shall be the foreign corporation that issues stock or securities to the U.S. person in the

exchange." Treas. Reg. Sec. 1.367(a)-3(d)(2)(i). There does not appear to be any reason

for the omitting the word "securities" in paragraph (c)(5)(vi) when it is included in

paragraph (d)(2)(i), and the version of paragraph (c)(5)(vi) in the 2005 proposed

regulation included the word "securities" and was, in fact, identical to the definition in

paragraph (d)(2)(i).

In light of the implementation of Notice 2005-6, 2005-5 I.R.B. 448, in the 2006

final regulations, it is likely that omission of the word "securities" in paragraph (c)(5)(vi)

was an oversight. See T.D. 9243 (Jan. 26, 2006) at Preamble, Summary of Comments

and Explanation of Provisions, Sec. B.2. Nevertheless, because the I.R.S. stated in the

T.D. 9243 preamble that it intentionally chose to omit "securities" from some provisions

(the example given was Treas. Reg. Sec. 1.367(a)-8(e)(1)(i)), taxpayers and their advisors

would do well to be cautious until guidance is issued addressing this discrepancy in the

definition of "transferee foreign corporation."

There is one unchanged portion of Treas. Reg. Sec. 1.367(a)-3(c) that deserves

mention because it could be confusing to practitioners who are new to this regulation or

who do not deal with it frequently. Paragraph (c) contains two subparagraphs with

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almost identical title phrases. Paragraph (c)(7), titled "Ownership Statements," sets forth

the procedure for rebutting the presumption in paragraph (c)(2) that all target transferors

are U.S. persons. Paragraph (c)(5)(i), titled "Ownership Statement," outlines the form

and factors to be included in a statement submitted pursuant to paragraph (c)(7).

b. The provisions of Treas. Reg. Sec. 1.367(a)-3(c)

(1) Except as provided in Sec. 367(a)(5), a transfer by a

U.S. person of stock or securities of a domestic corporation to a foreign corporation is not

subject to Sec. 367(a)(1) if the following five conditions are met:

(A)

The domestic corporation whose stock or

securities were transferred (the "U.S. target company") complies with the relevant

reporting requirements (see Section I.E.1.b(4) below).

(B) Fifty percent or less of both the total voting

power and the total value of the stock of the transferee foreign corporation is received in

the transaction, in the aggregate, by U.S. transferors (the "50% threshold").

(C) No more than 50% of both the total voting

power and the total value of the stock of the transferee foreign corporation is owned, in

the aggregate, immediately after the transfer by U.S. persons that are either officers or

directors of the U.S. target company or that are 5% target shareholders (i.e., there is no

"control group"). For purposes of this condition, any stock of the transferee foreign

corporation owned by U.S. persons immediately after the transfer is taken into account,

whether or not it was received in the exchange.

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(D) Either the U.S. person is not a 5% transferee

shareholder, or the U.S. person enters into a five-year gain recognition agreement to

recognize gain with respect to the U.S. target company stock or securities it exchanged.

(E) The active trade or business test is satisfied

(see Section I.E.1.b(3) below).

Treas. Reg. Sec. 1.367(a)-3(c)(1).

For purposes of these conditions, any person who transfers stock or securities of

the U.S. target company is presumed to be a U.S. person unless this presumption is

rebutted, as described below.

(2) Definitions

The following definitions apply in determining whether the five conditions set

forth above are satisfied.

Ownership Statement. An ownership statement is used to rebut the presumption

of ownership by a U.S. person. It is a statement, signed under the penalties of perjury,

stating:

The identity and taxpayer identification number, if any, of the person making the

statement.

That the person making the statement is not a U.S. person.

That the person making the statement either owns less than 1% of the total voting

power and total value of the U.S. target company's stock, and that he did not

acquire the stock with a principal purpose of enabling the U.S. transferors to

satisfy the ownership condition to avoid Sec. 367(a)(1); or that the person is not

related to any U.S. person to whom the stock or securities owned by him could be

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attributed under Sec. 958(b), and that he did not acquire the stock with a principal

purpose of enabling the U.S. transferors to satisfy the ownership condition to

avoid Sec. 367(a)(1).

The person's citizenship, permanent residence, home address, and U.S. address, if

any.

The person's ownership (by voting power and by value) in the U.S. target

company prior to the exchange and the amount of stock of the transferee foreign

corporation (by voting power and value) received by him in the exchange.

Treas. Reg. Sec. 1.367(a)-3(c)(5)(i).

5% Transferee Shareholder. A 5% transferee shareholder is a person that owns at

least 5% of either the total voting power or the total value of the stock of the transferee

foreign corporation immediately after the transfer. Treas. Reg. Sec. 1.367(a)-3(c)(5)(ii).

5% Target Shareholder. A 5% target shareholder is a person that owns at least

5% of either the total voting power or the total value of the stock of the U.S. target

company immediately prior to the transfer. Treas. Reg. Sec. 1.367(a)-3(c)(5)(iii).

Qualified Subsidiary. A qualified subsidiary is a foreign corporation at least 80%

owned (by total voting power and total value), directly or indirectly, by the transferee

foreign corporation. A corporation will not be treated as a qualified subsidiary if it was

affiliated with the U.S. target company (within the meaning of Sec. 1504(a)) at any time

during the 36-month period prior to the transfer. Nor will a corporation be a qualified

subsidiary if it was acquired by the transferee foreign corporation at any time during the

36-month period prior to the transfer for the principal purpose of satisfying the active

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trade or business test, including the substantiality test. Treas. Reg. Sec. 1.367(a)-

3(c)(5)(vii).

Qualified Partnership. A qualified partnership is a partnership in which the

transferee foreign corporation has active and substantial management functions as a

partner with regard to the partnership's business, or has at least a 25% interest in the

partnership's capital and profits. A partnership is not a qualified partnership if the U.S.

target company or any affiliate of the U.S. target company (within the meaning of Sec.

1504(a)) held a 5% or greater interest in the partnership's capital and profits at any time

during the 36-month period prior to the transfer. Nor will a partnership be a qualified

partnership if the transferee foreign corporation's interest was acquired at any time during

the 36-month period prior to the transfer for the principal purpose of satisfying the active

trade or business test, including the substantiality test.

Treas. Reg. Sec. 1.367(a)-3(c)(5)(viii).

(3) Active Trade or Business Test

The active trade or business test is satisfied if the following conditions are met:

The transferee foreign corporation, or any qualified subsidiary or qualified

partnership, is engaged in an active trade or business outside the United States,

within the meaning of Treas. Reg. Sec. 1.367(a)-2T(b)(2) and (3), for the entire

36-month period immediately before the transfer;

At the time of the transfer, neither the transferors nor the transferee foreign

corporation (and, if applicable, the qualified subsidiary or qualified partnership

engaged in the active trade or business) have an intention to substantially dispose

of or discontinue such trade or business; and

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The substantiality test described below is satisfied.

Treas. Reg. Sec. 1.367(a)-3(c)(3)(i).

A transferee foreign corporation, qualified subsidiary, or qualified partnership

will be considered to be engaged in an active trade or business for the entire 36-month

period preceding the exchange if it acquires at the time of, or any time prior to, the

exchange a trade or business that has been active throughout the entire 36-month period

preceding the exchange. This special rule does not apply, however, if the acquired active

trade or business assets were owned by the U.S. target company or any affiliate (within

the meaning of Sec. 1504(a)) at any time during the 36-month period prior to the

exchange. Nor does this special rule apply if the principal purpose of the acquisition was

to satisfy the active trade or business test. Further, an active trade or business does not

include managing investments for the account of the transferee foreign corporation or any

affiliate. Treas. Reg. Sec. 1.367(a)-3(c)(3)(ii).

A transferee foreign corporation satisfies the substantiality test if, at the time of

the exchange, the fair market value of the transferee foreign corporation is at least equal

to the fair market value of the U.S. target company. For purposes of this condition, the

value of the transferee foreign corporation includes assets acquired outside the ordinary

course of its business during the 36-month period preceding the exchange only if either of

the following conditions is met:

At the time of the exchange, such assets or, as applicable, the proceeds thereof, do

not produce, and are not held for the production of, passive income as defined in

Sec. 1296(b), and such assets were not acquired for the principal purpose of

satisfying the substantiality test; or

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Such assets consist of the stock of a qualified subsidiary or an interest in a

qualified partnership.

Further, the value of the transferee foreign corporation will not include the value

of the stock of any qualified subsidiary or any interest in a qualified partnership to the

extent that such value is attributable to assets acquired by the qualified subsidiary or

partnership outside the ordinary course of its business and within the 36-month period

preceding the exchange unless those assets satisfy either of the two conditions set forth

above. The value of the transferee foreign corporation also will not include the value of

assets received within the 36-month period prior to the exchange, notwithstanding that

either of the two conditions set forth above are met, if such assets were owned by the

U.S. target company or an affiliate at any time during the 36-month period prior to the

exchange. Treas. Reg. Sec. 1.367(a)-3(c)(3)(iii).

If a partnership (whether domestic or foreign) owns stock or securities in the U.S.

target company or the transferee foreign corporation, or transfers stock or securities in an

exchange described in Sec. 367(a), each partner in the partnership, and not the

partnership itself, is treated as owning or having transferred a proportionate share of the

stock or securities. An option (or an interest similar to an option) will be treated as

exercised and, thus, will be counted as stock for purposes of determining whether the

50% threshold is exceeded or whether a control group exists if a principal purpose for the

issuance or acquisition of the option (or other interest) was the avoidance of Sec.

367(a)(1). Treas. Reg. Sec. 1.367(a)-3(c)(4).

If immediately after the transfer the U.S. target company owns, directly or

indirectly (applying the attribution rules of Secs. 267(c)(1) and (5)), stock of the

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transferee foreign corporation, that stock will not in any way be taken into account (and,

thus, will not be treated as outstanding) in determining whether the 50% threshold is

exceeded or whether a control group exists. The stock attribution rules of Sec. 318, as

modified by the rules of Sec. 958(b), apply for purposes of determining the ownership or

receipt of stock, securities or other property. Treas. Reg. Sec. 1.367(a)-3(c)(4).

(4) Reporting Requirements

Where 10% or more of the total voting power or the total value of the stock of the

U.S. target company is transferred by U.S. persons, a U.S. transferor qualifies for the

exception in Treas. Reg. Sec. 1.367(a)-3(c) only if the U.S. target company complies with

the following reporting requirements. The U.S. target company must attach to its timely

filed U.S. income tax return for the taxable year in which the transfer occurs a statement

titled: "Section 367(a) -- Reporting of Cross-Border Transfer Under Reg. Sec. 1.367(a)-

3(c)(6)." The statement must be signed under the penalties of perjury by an officer of the

corporation to the best of the officer's knowledge and belief, and must disclose the

following information:

A description of the transaction in which a U.S. person or persons transferred

stock or securities in the U.S. target company to the transferee foreign corporation

in a transfer otherwise subject to Sec. 367(a)(1);

The amount (specified as to the percentage of the total voting power and the total

value) of stock of the transferee foreign corporation received in the transaction, in

the aggregate, by persons who transferred stock or securities of the U.S. target

company;

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The amount (if any) of transferee foreign corporation stock owned directly or

indirectly (applying the attribution rules of Secs. 267(c)(1) and (5)) immediately

after the exchange by the U.S. target company;

A statement that there is no control group;

A list of U.S. persons who are officers, directors or 5% target shareholders and

the percentage of the total voting power and the total value of the stock of the

transferee foreign corporation owned by such persons both immediately before

and immediately after the transaction; and

A statement that includes the following:

(A) A statement that the active trade or business

test is satisfied by the transferee foreign corporation and a description of such business;

(B) A statement that on the day of the

transaction, there was no intent on the part of the transferors or the transferee foreign

corporation (or any qualified subsidiary or qualified partnership, if relevant) to

substantially dispose of or discontinue its active trade or business; and

(C) A statement that the substantiality test is

satisfied, and documentation that such test is satisfied, including the value of the

transferee foreign corporation and the value of the U.S. target company on the day of the

transfer, and either one of the following:

(D) A statement demonstrating that the value of

the transferee foreign corporation 36 months prior to the acquisition, plus the value of

any assets acquired by the transferee foreign corporation within the 36-month period, less

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the amount of any liabilities acquired during that period, exceeds the value of the U.S.

target company on the acquisition date; or

(E) A statement demonstrating that the value of

the transferee foreign corporation on the date of the acquisition, reduced by the value of

any assets acquired by the transferee foreign corporation within the 36-month period,

exceeds the value of the U.S. target company on the date of the acquisition.

Treas. Reg. Sec. 1.367(a)-3(c)(6).

An income tax return will be considered timely filed if it is filed, together with the

required statement, on or before the last day for filing the federal income tax return

(including extensions) for the taxable year in which the transfer occurs. If a return is not

timely filed, the District Director may make a determination, based on all facts and

circumstances, that the taxpayer had reasonable cause for its failure to timely file a return,

and if such a determination is made, the timely-filed requirement will be waived. Treas.

Reg. Sec. 1.367(a)-3(c)(6).

To rebut the ownership presumption, the U.S. target company must obtain

ownership statements from a sufficient number of persons that transfer U.S. target

company stock or securities that are not U.S. persons to demonstrate that the 50%

threshold is not exceeded. In addition, the U.S. target company must attach to its timely

filed U.S. income tax return (as described above) for the taxable year in which the

transfer occurs a statement titled: "Section 367(a) - Compilation of Ownership Statements

under Reg. Sec. 1.367(a)-3(c)." The statement must be signed under the penalties of

perjury by an officer of the corporation, and must disclose the following information:

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(A)The amount (specified as to the percentage of total voting power and total value) of

stock of the transferee foreign corporation received, in the aggregate, by U.S. transferors;

(B) The amount (specified as to the percentage of total voting power and total value) of

stock of the transferee foreign corporation received, in the aggregate, by foreign persons

that filed ownership statements; and

(C) A summary of the information tabulated from the ownership statements, including:

The names of the persons that filed ownership statements stating that theywere not U.S. persons;

The countries of residence and citizenship of such persons; and

Each of such person's ownership (by voting power and by value) in theU.S. target company prior to the exchange and the amount of stock of thetransferee foreign corporation (by voting power and value) received bysuch persons in the exchange.

Treas. Reg. Sec. 1.367(a)-3(c)(7).

(5) Private Letter Rulings

The Internal Revenue Service may, in limited circumstances, issue a private letter

ruling to permit a taxpayer to qua

Documents

367 Outline