International Tax Issues New York City...

© Practising Law InstituteTAX LAW AND ESTATE PLANNING SERIES

Tax Law and PracticeCourse Handbook Series

Number D-479

To order this book, call (800) 260-4PLI or fax us at (800) 321-0093. Ask our Customer Service Department for PLI Order Number 186472, Dept. BAV5.

Practising Law Institute1177 Avenue of the Americas

New York, New York 10036

International Tax Issues New York City

2017

ChairMichael A. DiFronzo

© Practising Law Institute

9

Formation and Use of Hybrid Entities in Cross Border Transactions (November 18, 2016)

T. Timothy Tuerff Reed Kirschling

Deloitte Tax LLP

If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.

181


182


BIOGRAPHICAL INFORMATION

Name: Timothy Tuerff Position/Title: Partner Firm or Place of Business: Deloitte Tax LLP

Address: Washington, D.C. Phone: (202) 378-5223 Fax: (202) 661-1934 E-Mail: [email protected]

Primary Areas of Practice: International Tax Education Mr. Tuerff is a graduate of Indiana University School of Law and School of Business. Work History Tim Tuerff is an international tax partner in the Washington National Office, serving U.S.-based multinational clients involved in cross-border transactions. His practice involves consulting related to structuring of international business operations, mergers and acquisitions, financing inter-national operations, repatriation and utilization of foreign tax credits.

Mr. Tuerff brings over twenty years of experience providing inter-national tax consulting services to multinational corporations as well as a senior level government service to his client engagements. This experience includes practicing in the national office of international accounting firms, the practice of law in Washington D.C. and government service as Special Assistant to the Chief Counsel of the Internal Revenue Service. Mr. Tuerff’s variety of experience allows him to provide practical tax plan-ning advice taking into account transactions that are currently executed in the marketplace as well as the position of global taxing authorities.

He is a frequent contributor to tax periodicals, including Tax Notes and Tax Notes International and the Practicing Law Institute journal, Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances and the American Bar Association, Interna-tional Franchising Journal. These periodicals stress the importance of comprehensive tax planning for global transactions.

183


4

Professional Memberships Mr. Tuerff is a member of the American Bar Association and the District of Columbia Bar Association. Mr. Tuerff is also a District of Columbia certified public accountant.

184


5

BIOGRAPHICAL INFORMATION

Name: Reed Kirschling Position/Title: Senior Manager Firm or Place of Business: Deloitte Tax LLP

Address: Washington, D.C. Phone: (202) 220-2704 Fax: (202) 879-5309 E-Mail: [email protected]

Primary Areas of Practice: International Tax Education: J.D., Marquette University School of Law (2007); B.B.A. in Finance, Investment, and Banking from the University of Wisconsin – Madison (2003) Work History Reed Kirschling is a senior manager in the Washington National Office, serving U.S.-based multinational clients involved in cross-border trans-actions. His practice involves consulting related to cross-border mergers and acquisitions, cash repatriation, foreign tax credit issues, and subpart F. Professional Memberships Mr. Kirschling is a member of the State Bar of Wisconsin and is also a Wisconsin and District of Columbia certified public accountant.

185


186


7

Table of Contents

I. STRUCTURING CROSS BORDER TRANSACTIONS WITH HYBRID ENTITIES ....................................................................................... 9

A. Introduction .................................................................................... 9 B. General .......................................................................................... 9 C. Examples of Benefits Derived From Structuring With

Hybrid Entities ............................................................................. 11 D. Reporting Requirements: Form 8858 and

Country-by-Country Reporting .................................................... 17 II. OVERVIEW OF THE CHECK-THE-BOX REGULATIONS

APPLICABLE TO INTERNATIONAL OPERATIONS ................................ 18 A. General Principles ....................................................................... 18 B. Election of Entity Status ............................................................... 22

III. CONVERSION OF ENTITY STATUS: U.S. TAX ISSUES RELATED TO CHANGING STATUS OF FOREIGN ENTITIES FOR U.S. TAX PURPOSES ...................................................... 24

A. Conversion From Corporation to Branch ..................................... 25 B. Liquidation of ForCo into US ....................................................... 25 C. Conversion From Corporation to Partnership .............................. 27 D. Liquidation of ForCo Into US ...................................................... 27 E. Conversion From Partnership to Corporation .............................. 29 F. Conversion From Branch to Corporation ..................................... 29 G. Addition of an Equity Holder to a Hybrid Branch ......................... 30 H. Conversion from Partnership to Foreign Branch ......................... 31

IV. CHARACTERIZATION RULES FOR FOREIGN PARTNERSHIPS ........... 32 A. General Application of Subchapter K Rules ................................ 32 B. Partnership Share of Foreign Tax Expenses .............................. 34 C. Brown Group Regulations ........................................................... 35 D. Notice 2007-9 .............................................................................. 35 E. Section 956 .................................................................................. 36

V. TREAS. REG. § 1.1248-1(a)(4) .................................................................. 37 VI. OUTBOUND ASSET TRANSFERS TO FOREIGN ENTITIES ................... 38

A. Outbound Transfers to Foreign Corporations.............................. 38 B. Outbound/Other Transfers to Partnerships ................................. 49 C. Filing Requirements ..................................................................... 53

VII. CURRENCY GAINS AND LOSSES UNDER SECTION 987 ..................... 56 A. Introduction .................................................................................. 56 B. General Rule ............................................................................... 56 C. Reasonable Method .................................................................... 56 D. Form 8858 ................................................................................... 56

VIII. SPECIAL RULES APPLICABLE TO INBOUND HYBRID STRUCTURES ............................................................................ 57

A. Payments to Hybrid Entities ........................................................ 57 B. Payments By Domestic Reverse Hybrid Entities......................... 60

187


8

IX. SECTION 385 REGULATIONS: FINAL/TEMPORARY REGULATIONS ADDRESS TREATMENT OF CERTAIN INTERESTS IN CORPORATIONS AS STOCK OR INDEBTEDNESS ...... 61

A. Scope ........................................................................................... 62 B. Documentation Rules .................................................................. 63 C. Debt Recast Rules ....................................................................... 65 D. Certain Debt Instruments Excluded ............................................ 65 E. Expanded and Added Exceptions ............................................... 66 F. Other new exceptions .................................................................. 67 G. Treatment of Controlled Partnerships ......................................... 67 H. Effective Dates ............................................................................ 68 I. Consolidated Group Rules .......................................................... 68 J. State Tax Implications ................................................................. 69

X. PROPOSED AND FINAL SECTION 956 REGULATIONS ........................ 70 A. Overview ..................................................................................... 70 B. Structures Impacted .................................................................... 70 C. Changes to Section 954(c) Active Trade or Business

Exception ..................................................................................... 71 D. Section 956 Anti-abuse ............................................................... 71 E. Assets (Including Obligations) Held by a Partnership ................. 71 F. Obligations of a Partnership ........................................................ 72 G. Anti-Abuse Distribution Rule........................................................ 73 H. Guarantees .................................................................................. 73 I. Factoring Transactions ................................................................ 73 J. Effective Dates ............................................................................ 74

188


9

I. STRUCTURING CROSS BORDER TRANSACTIONS WITH HYBRID ENTITIES

A. Introduction

While the use of a flow-through entity (i.e., a partnership or branch) in multinational corporate structures may be beneficial from a U.S. tax perspective, the use of flow-through entities organized in another country may raise a number of different opportunities, issues, and practical problems. These differences are caused by a number of factors some of which are peculiar to the conduct of international busi-ness. In analyzing the use of flow-through entities, the following con-siderations should be taken into account: 1. Operations’ personnel often want to establish locally organized

corporate entities to achieve commercial objectives such as image, local market acceptance, and employability of local personnel.

2. The laws of most countries provide for a number of different types of entities, and the choice of a specific entity will depend on com-mercial objectives, legal constraints and tax considerations.

3. The foreign tax regime will often differ from the tax principles applicable to partnerships under U.S. tax law. For example, in many cases, the country may impose tax at the entity level even though under U.S. principles the entity would not be a taxpayer.

4. Foreign legal principles applicable to locally organized entities will often differ depending on the type of entity used, and these principles may differ substantially from legal principles applicable to U.S. corporations, LLCs, and partnerships.

5. A foreign joint venturer may have different tax, commercial and cultural objectives than the U.S. investor. Conflicts between the U.S. investor and the foreign co-venturer may arise in selecting the most appropriate entity for a specific business.

B. General

1. The use of hybrid entities can provide significant flexibility in structuring cross border transactions. A hybrid entity is an entity that is treated as a corporation for local country purposes, but treated as a flow-through entity (i.e., partnership or branch) for U.S. tax purposes.

189


10

2. Entity Symbols

3. The following benefits may be obtained through the use of hybrid entities: a. Obtain a current U.S. tax benefit for losses incurred in offshore

entities, while operating through a limited liability entity. b. Obtain direct foreign tax credits versus section 9021 deemed

paid foreign tax credits. c. Satisfy section 902 ownership requirements in order to claim

deemed paid foreign tax credits. d. Combine earnings and profits pools for section 902 purposes. e. Avoid gain recognition agreements for contributions of stock

under section 367. However, see Notice 2003-46, 2003-2 C.B. 53.

f. Avoid subpart F income for transactions involving related parties.

Corporation

Partnership

Branch

Hybrid Partnership:Local Corporation/U.S. Partnership

Hybrid Branch:Local Corporation/U.S. Branch

Corporation

Partnership

Branch

Hybrid Partnership:Local Corporation/U.S. Partnership

Hybrid Branch:

U.S. Branch

Reverse Hybrid Entity:

Local Partnership/U.S. Corporation

190


11

g. Obtain general limitation income on the disposition of the interest in a foreign hybrid entity, provided the entity is engaged in the conduct of a trade or business and the assets of the hybrid entity are characterized as assets used in that trade or business.2

C. Examples of Benefits Derived From Structuring With Hybrid Entities

1. Obtain U.S. Tax Benefit for Foreign Losses a. Direct U.S. Benefit

Hybrid status allows flow-through of losses for U.S. tax

purposes, creating a U.S. tax deduction. The losses generally will reduce the section 904(d) limitation. Dual consolidated loss issues under section 1503(d), and currency gains and losses under section 987 must be considered. Subsequent con-version from branch to subsidiary may result in a recapture of prior losses under sections 367(a)(3)(C) or 904(f), as well as income inclusions under section 367(d) and gain recognition under section 367(a).

b. Indirect Benefit of Foreign Losses

US

CFC

US

CFCCFC

CFC Opco

CFC Loss Co

US

CFC Opco

CFC Loss Co

CFC Loss Co

US

191


12

Hybrid status allows the losses at CFC Loss Co to reduce the earnings and profits at the CFC Opco level. The losses will increase the effective rate of tax at the CFC Opco level for purposes of calculating section 902 deemed paid foreign tax credits. See hovering deficit rule in Treas. Reg. § 1.367(b)-7.

2. Utilize Hybrids to Receive Direct Foreign Tax Credits Under Section 901

By utilizing a hybrid entity, US can eliminate the section 902

pooling of foreign taxes and obtain direct section 901 credits. This structure would also allow a foreign tax credit if US owned less-than-10 percent of CFC.

3. Section 902 Ownership Requirements

US

CFC

US

CFC

Sec. 902 Pooling ofForeign Taxes

Sec. 901 DirectForeign Taxes

US

CFCCFC

US

CFC

Sec. 902 Pooling ofForeign Taxes

Sec. 901 DirectForeign Taxes

US

CFC1

CFC2

CFC3

FJV

FC

80%

100%

100%

100%

20%

US

CFC1

CFC2

CFC3FC

80%

100%

100%

100%

20%

US

CFC1

CFC2

CFC3

FJV

FC

80%

100%

100%

100%

20%

US

CFC1

CFC2

CFC3FC

80%

100%

100%

100%

20%

192


13

US owns 100 percent of CFC1 which owns 100 percent of CFC2 which owns 100 percent of CFC3 which owns a 20 percent interest in a foreign joint venture corporation. The remaining 80 percent of FJV is owned by an unrelated foreign corporation.

Under section 902, no deemed paid credit is allowed because FJV is not a controlled foreign corporation. If FJV is a part-nership for U.S. tax purposes, foreign income taxes imposed at the FJV would be eligible for section 902 treatment.3

4. Avoid Gain Recognition Agreements.

Under sections 367(a) and 367(b), US is required to enter into a

5-year gain recognition agreement (“GRA”) to avoid recognizing gain on the contribution of the stock of CFC2 to CFC1. Treas. Reg. § 1.367(a)-3. If however, CFC2 is contributed to CFC1 and CFC2 is immediately converted to a hybrid branch of CFC1, then the transaction may qualify as a D reorganization. See e.g., Rev. Rul. 2004-83, 2004-32 I.R.B. 157 (transfer of stock for cash); Rev. Rul. 67-274, 1967-2 C.B. 141; and Rev. Rul. 70-240, 1970-1 C.B. 81. Under the section 367(a) regulations, a GRA would not be required if the transaction is treated as a D reorganization. See Treas. Reg. § 1.367(a)-3(a). But See Notice 2003-46, 2003-2 C.B. 53.

US

CFC2

CFC1 CFC2

US

CFC2CFC2

CFC1 CFC2

193


14

5. Avoid Subpart F Income on Related Party Transactions.

Dist. Co purchases product from Mftg. Co and resells to customers. The sales income reported by Dist. Co is not subpart F income if the tax rate disparity test of Treas. Reg. § 1.954-3(b) does not result in the application of the subpart F branch rule. In contrast, if Mftg. Co or Dist. Co were taxable as corporations for U.S. tax purposes, the income on the sales by Dist Co. might constitute subpart F foreign base company sales income because the transaction would be regarded for U.S. federal income tax purposes.

All earnings from this structure would be reported in CFC Holdco. As a result, “dividends” from Finance Co, Mftg. Co, or Dist. Co would not constitute subpart F, foreign personal holding company income. However, this aggregation of earnings and profits would result in a single section 902 pool; thereby preventing the segregation of high-taxed and low-taxed pools. Further, section 987 must be considered to determine whether currency gains and losses are recognized as a result of transfers from the disregarded entities to CFC Holdco. Note, the need for this structure has been temporarily reduced following the enactment of section 954(c)(6), which limits the application of the foreign personal holding company income provisions with respect to certain payments between related CFCs. While future legislation could change this, as of the date of this article, this provision is applicable to taxable years of CFCs beginning after 2005 and before 2020.

Interest, rents, royalties and amounts paid as compensation for services to the Finance Co, Mftg. Co, or Dist. Co by CFC Holdco would not constitute subpart F income under the existing regulations. But See Prop. Treas. Reg. § 1.954-9, with a delayed effective date for payments made five years after the regulations are published as final regulations). See also Notice 2007-13, 2007-1 C.B. 410, narrowing the application of the substantial assistance rules under Treas. Reg. § 1.954-4(b)(2).

194


15

6. Disposition Planning Utilizing Hybrid Entities a. Sale of Stock

CFC1 sells the stock of CFC2. Section 964(e) applies to the

sale, allowing the gain to be characterized as a dividend to the extent of CFC2’s earnings and profits (but the same–country dividend exception does not apply). Section 964(e) (2). But see Notice 2007-9, 2007-1 C.B. 401, which provides that the related party exception of section 954(c)(6) will apply to amounts included in the income of a CFC under section 964(e).

b. Sale of Partnership Interest

CFC1 and CFC2 sell their interests in FP. Gain from sale by a CFC of a 25% partnership interest is

not passive FPHCI to the extent the partnership engaged in an active business. In such cases, the gain is treated as

CFC1

US

CFC2

CFC1

US

CFC2

CFC1

US

CFC2

FP

90% 10%

CFC1

US

CFC2

FPFP

90% 10%

195


16

recognized on the sale of a proportionate share of partnership assets attributable to such interest. See section 954(c)(4). See also Treas. Reg. § 1.904-5(h)(3).

For taxable years beginning before December 31, 2004, Treas. Reg. § 1.904-5(h)(3) provided that gain recognized on the sale or exchange of a partnership interest would be treated as passive income, unless the income is considered high-taxed under section 904(d)(2)(A)(iii)(II).

c. Sale of Hybrid Branch

Alternatively, assume CFC2 is converted to a foreign hybrid

branch. If CFC1 sells its 100 percent interest in CFC2, the sale would generally be treated as an asset sale for U.S. tax pur-poses. See Treas. Reg. § 1.954-2(e)(3). To the extent the assets of the branch are active trade or business assets, the gain would likely be treated as non-subpart F, general limitation income. However, the subpart F recapture provisions of section 952(c)(2) must be considered.

In Notice 2003-46, 2003-2 C.B. 53, Treasury withdrew Prop. Treas. Reg. § 301.7701-3(h), which would disregard an election to convert a corporation to a hybrid entity if a 10 percent interest in the entity is disposed of within the period commencing one day before the section 7701 election and ending 12 months after the election. In the notice, Treasury preserves the right of the IRS to challenge the characteri-zation of the sale of the interest in CFC2 as a sale of assets used in the conduct of an active trade or business. However, see Dover v. Comm’r, 122 TC 324 (2004) where a taxpayer had been granted relief under Treas. Reg. §§ 301.9100-1 through -3 to make an election, effective immediately prior

CFC1

CFC2

US

CFC1

CFC2CFC2

US

196


17

to the sale of a U.K. subsidiary by a U.K. holding company, to treat the U.K. subsidiary as a disregarded entity. The Tax Court held that the U.K. holding company succeeded to the business history of the U.K. subsidiary, and thus, U.K. holding company’s deemed sale of the U.K. subsidiary’s assets con-stituted a sale of property used in U.K. holding company’s own business. But see, Comm’r v. Court Holding, 324 U.S. 331 (1945).

D. Reporting Requirements: Form 8858 and Country-by-Country Reporting

Certain U.S. persons are required to file Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities. Form 8858 is required to be filed by U.S. persons that own a foreign disregarded entity (FDE) directly or, in certain circumstances, indirectly or constructively (for example, U.S. persons that own a 10 percent or greater interest in an FDE indirectly through a CFC or controlled foreign partnership). An FDE is an entity that is created or organized in a foreign jurisdiction and that is disregarded as separate from its owner for U.S. income tax purposes under Treas. Reg. § 301.7701-2 and -3. The reporting of information on Form 8858 is required under the authority of sections 6011, 6012, 6031 and 6038. See Announce-ment 2004-4, 2004-4 I.R.B. 357.

Under proposed regulations (REG-109822-15) issued under section 6038 on December 21, 2015, country-by-country reporting is required for a U.S. entity that is the ultimate parent of a multinational enterprise (“MNE”) group with annual revenue of $850 million or more. Generally, a U.S. entity will be the ultimate parent of an MNE group if: (i) it owns an interest in a business entity that is organized or tax resident outside the United States (foreign business entity), and (ii) such interest is sufficient to require the U.S. entity to consolidate the accounts of the foreign business entity with its own accounts under United States generally accepted accounting principles. For this purpose, a business entity includes an entity that is disregarded as separate from its owner under Treas. Reg. § 301.7701-3. The country-by-country reporting information must be submitted on an IRS form and filed with the U.S. entity’s timely-filed tax return. The proposed regulations apply to taxable years of a U.S. entity that is the ultimate parent of an MNE group that begins on or after the date of publication of the Treas-ury decision adopting these regulations as final. For calendar year taxpayers, 2017 is the first taxable year to which the reporting would

197


18

apply. It should be noted that other countries are implementing these reporting requirements for the 2016 tax year. Thus, an issue exists for U.S. multinationals as to whether this reporting will be imposed by these countries for the 2016 tax year. The country-by-country reporting is required under the authority of sections 6001, 6011, 6012, 6031, 6038, and 7805. See Prop. Treas. Reg. § 1.6038-4 for the specific filing requirements.

II. OVERVIEW OF THE CHECK-THE-BOX REGULATIONS APPLICABLE TO INTERNATIONAL OPERATIONS

A. General Principles

1. The regulations set forth a country-by-country list of specific foreign entities that are to be treated as corporations, and thus cannot elect U.S. tax treatment (called “per se” entities). Gener-ally, there is one “per se” entity in each country. The list of foreign per se corporate entities as of November 15, 2011 is as follows:

American Samoa, Corporation Argentina, Sociedad Anonima Australia, Public Limited Company Austria, Aktiengesellschaft Barbados, Limited Company Belgium, Societe Anonyme Belize, Public Limited Company Bolivia, Sociedad Anonima Brazil, Sociedade Anonima Bulgaria, Aktsionerno Druzhestvo Canada, Corporation or Company. A Nova Scotia Unlimited

Liability Company and any other company or corporation all of whose owners have unlimited liability pursuant to federal or provincial law are not per se entities.

Chile, Sociedad Anonima People’s Republic of China, Gufen Youxian Gongsi Republic of China (Taiwan), Ku-fen Yu-hsienKung-szu Colombia, Sociedad Anonima Costa Rica, Sociedad Anonima Cyprus, Public Limited Company. A Public Limited Company

includes any Limited Company that is not defined as a private company under the corporate laws of this jurisdiction. In all other cases, where the term Public Limited Company is not defined,

198


19

the term shall include any Limited Company defined as a public company under the laws of this jurisdiction.

Czech Republic, Akciova Spolecnost Denmark, Aktieselskab Ecuador, Sociedad Anonima or Compania Anonima Egypt, Sharikat Al-Mossahamah El Salvador, Sociedad Anonima Estonia, Aktsiaselts European Economic Area/ European Union, Societas Europaea Finland, Julkinen Osakeyhtio/Publikt Aktiebolag France, Societe Anonyme Germany, Aktiengesellschaft Greece, Anonymos Etairia Guam, Corporation Guatemala, Sociedad Anonima Guyana, Public Limited Company Honduras, Sociedad Anonima Hong Kong, Public Limited Company. A Public Limited Company

includes any Limited Company that is not defined as a private company under the corporate laws of this jurisdiction. In all other cases, where the term Public Limited Company is not defined, the term shall include any Limited Company defined as a public company under the laws of the this jurisdiction.

Hungary, Reszvenytarsasag Iceland, Hlutafelag India, Public Limited Company. A company deemed to be a public

limited company solely by operation of certain provisions of Indian law relating to corporate ownership of the company, annual average turnover or ownership interests in other companies is not treated as a per se entity.

Indonesia, Perseroan Terbuka Ireland, Public Limited Company Israel, Public Limited Company Italy, Societa per Azioni Jamaica, Public Limited Company. A Public Limited Company

includes any Limited Company that is not defined as a private com-pany under the corporate laws of this jurisdiction. In all other cases, where the term Public Limited Company is not defined, the term shall include any Limited Company defined as a public company under the laws of this jurisdiction.

199


20

Japan, Kabushiki Kaisha Kazakhstan, Ashyk Aktsionerlik Kogham Republic of Korea, Chusik Hoesa Latvia, Akciju Sabiedriba Liberia, Corporation Liechtenstein, Aktiengesellschaft Lithuania, Akcine Bendroves Luxembourg, Societe Anonyme Malaysia, Berhad (a per se corporation) does not include a

Sendirian Berhad (an eligible entity). Malta, Public Limited Company Mexico, Sociedad Anonima or Sociedad Anonima de Capital

Variable Morocco, Societe Anonyme Netherlands, Naamloze Vennootschap New Zealand, Limited Company Nicaragua, Compania Anonima Nigeria, Public Limited Company Northern Mariana Islands, Corporation Norway, Allment Aksjeselskap Pakistan, Public Limited Company Panama, Sociedad Anonima Paraguay, Sociedad Anonima Peru, Sociedad Anonima Philippines, Stock Corporation Poland, Spolka Akcyjna Portugal, Sociedade Anonima Puerto Rico, Corporation Romania, Societe pe Actiuni Russia, Otkrytoye Aktsionernoy Obshchestvo Saudi Arabia, Sharikat Al-Mossahamah Singapore, Public Limited Company Slovak Republic, Akciova Spolocnost Slovenia, Delniska Druzba South Africa, Public Limited Company Spain, Sociedad Anonima Surinam, Naamloze Vennootschap Sweden, Publika Aktiebolag Switzerland, Aktiengesellschaft or Societe Anonyme Thailand, Borisat Chamkad (Machachon) Trinidad and Tobago, Limited Company

200


21

Tunisia, Societe Anonyme Turkey, Anonim Sirket Ukraine, Aktsionerne Tovaristvo Vidkritogo Tipu United Kingdom, Public Limited Company United States Virgin Islands, Corporation Uruguay, Sociedad Anonima Venezuela, Sociedad Anonima or Compania Anonima

Note: In general, the rules of this section apply as of January 1, 1997, however, certain exceptions exist in Treas. Reg. § 301.7701-2(e).

2. In general, any foreign entity that is not listed as a “per se” entity may elect to be treated as either a corporation or a flow-through entity.

3. An entity with more than one owner can elect to be classified as either a corporation or a partnership.

4. An entity with only one owner may be classified as an associa-tion taxable as a corporation or disregarded as an entity separate from its owner (i.e., to be treated as a branch or division of the electing taxpayer). Treas. Reg. § 301.7701–3(a) and (c).

5. An election is made by filing Form 8832. The election rules are described at B below.

6. The regulations prescribe default rules, which apply if no election is made.

7. Default Rules a. If a foreign eligible entity makes no election, it will be treated

as a partnership if it has more than one owner and there is any owner which does not have limited liability.

b. A foreign eligible entity will be treated as an association if all owners have limited liability.

c. A foreign eligible entity will be disregarded if it has a single owner and that owner does not have limited liability. Treas. Reg. § 301.7701-3(b).

d. The regulations define “limited liability” of a member as personal liability for the debts or claims against the entity by reason of being a member. A member has personal liability if the creditors of the entity may seek satisfaction of all, or

201


22

any portion, of the debts or claims against the entity from the member as such.

8. The regulations prescribe certain transition rules that apply to entities that were in existence on January 1, 1997. See Treas. Reg. § 301.7701-2(d).

B. Election of Entity Status

1. An eligible entity may elect to be classified other than under the default rules or elect to change its status by filing Form 8832, Entity Classification Election. The election will not be accepted unless all information required by the Form and its instructions is provided. See Treas. Reg. § 301.6109-1.

2. For an entity electing to be disregarded from its owner, the electing entity must use the EIN of its direct owner. See Treas. Reg. § 301. 6109-1(h)(2)(i) (“Except as otherwise provided in regulations or other guidance, a single owner entity that is disregarded as an entity separate from its owner under Treas. Reg. § 301.7701-3, must use its owner’s taxpayer identifying number (EIN) for federal tax purposes.”). If either entity does not have an EIN, a Form SS-4 should be filed an EIN obtained prior to filing the Form 8832. If applicable, this Form SS-4 should indicate that the entity will not have a U.S. filing requirement (e.g., “No ECI, Form 8832 only”).

3. Attach Form 8832 to Return: An eligible entity required to file a federal tax or information return for the taxable year for which an entity election is made must attach a copy of its Form 8832 to its federal tax or information return for that year. If the electing entity is not required to file a return, a copy must be attached to the federal income tax or information return of any direct or indirect owner of the entity for the taxable year of the owner that includes the date on which the election is effective. Failure to attach a copy to the return may not invalidate the election, but it may subject the nonfiling party to penalties.

4. Effective Date of the Election a. An election will be effective on the date specified on the

Form 8832 or on the date filed if no date is specified on the election.

202


23

b. The effective date cannot be more than 75 days prior to the date on which the election is filed and cannot be more than 12 months after the date on which the election is filed. Note: If an election specifies an effective date more than 75 days prior to the date the election is filed, it will be effective 75 days prior to the filing date. If the election specifies an effec-tive date more than 12 months after the date of filing, the election will be effective 12 months after the date it was filed. Treas. Reg. § 301.7701-3(c).

5. Existing Entities – Section III addresses the tax consequences of the elective change in classification. In general, the tax conse-quences occur at the close of the day before the election is effective. See Treas. Reg. § 301.7701-3(g).

6. Authorized Signatures: An election must be signed by each member of the electing entity who is an owner at the time the election is filed or by any officer, manager, or member of the electing entity who is authorized to make the election and who represents to having such authorization under the penalties of perjury. If an election is retroactive for any period prior to the time it is filed, each person who was an owner between the date the election is to be effective and the date the election is filed and who is not an owner at the time the election is filed, must also sign the election. Treas. Reg. § 301.7701-3(c)(2).

7. Limitation on Changes of Status a. 60 Month Limitation: In general, an eligible entity that elects

to change its classification cannot change its classification by election again during the 60 months succeeding the effec-tive date of the election. The Commissioner may permit a change in classification by election if more than fifty percent of the ownership interests in the entity as of the date of the subsequent election are owned by persons that did not own interests in the entity on the filing date of the prior election. Treas. Reg. § 301.7701-3(c)(1)(iv).

b. Initial Elections: The 60-month limitation applies to changes in classification, not to an initial election. See Treas. Reg. §§ 301.7701-3(c)(1)(iv) and (vi), Example 1.

8. Deemed Elections for Exempt Organizations, REITs and S Cor-porations: An eligible entity claiming an exemption from taxation under section 501(a) is treated as having elected to be classified

203


24

as an association. In addition, an eligible entity that files an election to be treated as a REIT is treated as an association. Similarly, an eligible entity that meets all the other requirements to qualify as a small business corporation under section 1361(b), shall be treated as having made an election to be an association. See Treas. Reg. § 301.7701-3(c)(1)(v)(A) - (C).

9. Overview of the Regulations Including Pre-1997 Entities

III. CONVERSION OF ENTITY STATUS: U.S. TAX ISSUES RELATED TO CHANGING STATUS OF FOREIGN ENTITIES FOR U.S. TAX PURPOSES

The conversion of an entity to a corporation, a partnership or a branch could have significant U.S. tax consequences. See Treas. Reg. § 301.7701-3(g). The impact of sections 367, 901, 904, and 987 must also be evaluated.

204


25

A. Conversion From Corporation to Branch

Liquidation under section 332 if US owns 80 percent or more of the vote and value of ForCo and other requirements of section 332 (e.g., solvency) are satisfied. Treas. Reg. § 301.7701-3(g)(1)(iii). But see Rev. Rul. 69-617, 1969-2 C.B. 57, under which such transaction may be treated as a reorganization if a portion of the assets received by US are contributed to a subsidiary corporation. See also Treas. Reg. § 1.368-2(k).

Under Treas. Reg. § 301.7701-3(g)(3), the transactions are deemed to occur as a result of a change in status and occur at the close of the day before the election is effective.

Thus, if calendar year ForCo files an election to convert to a branch on January 1, the deemed liquidation occurs immediately before the close of December 31 of the preceding year.

A plan of liquidation is deemed to have been adopted immedi-ately before the liquidation occurs such that the technical requirements of section 332 would be satisfied in certain liquidations. Treas. Reg. § 301.7701-3(g)(2)(ii). PFIC provisions will apply if ForCo is a grandfathered PFIC.

B. Liquidation of ForCo into US

1. The U.S. shareholder must include in income the “all earnings and profits” amount of ForCo. Treas. Reg. § 1.367(b)-3(b)(3). Deemed paid foreign tax credits are available for taxes imposed on the “all earnings and profits” amount. For exchanges occurring prior to February 24, 2001, See Temp. Treas. Reg. § 1.367(b)-3T(b)(4).

2. Worthless Stock Deduction: If the company is insolvent, a loss may be recognized under section 165, which may qualify as an ordinary loss under section 165(g)(3). See Rev. Rul. 2003-125, 2003-2 C.B. 1243. As a general rule, these losses are sourced according to the residence of the disposing shareholder; however,

US

ForCo

US

ForCo

US

ForCoForCo

US

ForCo

205


26

several exceptions apply. See Treas. Reg. § 1.865-2(a)(1). Separate rules address the allocation of bad debt losses with respect to out-standing debt from the liquidated corporation to the shareholder. See Treas. Reg. § 1.865-1(a).

3. Earnings and Profits: Only earnings and profits that are effectively connected with a U.S. trade or business are carried over to the U.S. parent company. See Treas Reg. § 1.367(b)-3(f).

4. Net operating loss and capital loss carryovers: A net operating loss or capital loss of the foreign corporation is only eligible to carry over to the domestic acquiring corporation to the extent the loss is effectively connected with the conduct of a U.S. trade or business. See Treas Reg. § 1.367(b)-3(e)

5. Note: a possible step down in the basis of assets that are brought into the U.S. tax system may occur if the aggregate basis of the assets transferred into the United States exceeds the aggregate fair market value of those assets. Sections 334(b)(1) and 362(e) (1). This appears to be the case irrespective of the requirement to include in income as a deemed dividend the all earnings and profits amount.

6. Reporting/Future Operations: a. Reporting Requirements: Reporting requirements under

sections 367(b) and 332 must be satisfied. (1) Section 987 currency gains and losses generally will apply

prospectively to branch operations. Prop. Treas. Reg. §§ 1.987-1 through -11 provide a regime for applying section 987 on a prospective basis.

(2) Taxpayers must file Form 8858, which imposes signifi-cant reporting requirements for disregarded foreign entities. Form 8858 applies to all U.S. persons that are indirect or direct owners of foreign disregarded entities (FDEs) and, among other things, requires reporting of section 987 gains and losses.

(3) If future losses are incurred, then under the dual consol-idated loss rules of section 1503(d), a current year domestic use election and future annual certifications must be filed in order to use the losses in the U.S. See Treas. Reg. § 1.1503(d)-4(b) and 6. See also, AM 2009-011 (Oct. 9, 2009) concluding that the provisions of

206


27

section 1503(d) and the regulations thereunder may operate to limit the use of post-liquidation losses.

(4) Also note that section 165 loss transactions may be subject to reporting requirements under the tax shelter reporting regulations. See Treas. Reg. § 1.6011-4(b)(5).

C. Conversion From Corporation to Partnership

Upon conversion to a partnership, ForCo is treated as liquidating

into its shareholders followed by a capital contribution to the new foreign partnership. Treas. Reg. § 301.7701-3(g)(1)(ii).

Under Treas. Reg. § 301.7701-3(g)(3), the transactions that are deemed to occur as a result of a change in status and occur at the close of the day immediately before the election is effective.

D. Liquidation of ForCo Into US

1. “All earnings and profits” amount: The U.S. shareholder must include in income the “all earnings and profits” amount of ForCo. Treas. Reg. § 1.367(b)-3(b)(3). Deemed paid foreign tax credits are available for taxes imposed on the “all earnings and profits” amount. For transactions prior to February 24, 2001, see Temp. Treas. Reg. § 1.367(b)-3T(b)(4).

2. Worthless Stock Deduction: If ForCo is insolvent, a loss may be recognized under section 165, which may qualify as an ordinary loss under section 165(g)(3). See Rev. Rul. 2003-125, 2003-2 C.B. 1243. As a general rule, this loss would be sourced according to the residence of the disposing shareholder; however, several exceptions apply. See Treas. Reg. § 1.865-2(a)(1). Separate rules address the allocation of bad debt losses with respect to outstand-ing debt from the liquidated corporation to the shareholder. See. Treas. Reg. § 1.865-1(a).

207


28

3. Contribution of ForCo Assets to New Foreign Partnership: Under the regulatory authority of section 721(c), the IRS and Treasury issued Notice 2015-54, 2015-34 I.R.B. 210, which announced forthcoming regulations that would subject certain partnership con-tributions of built-in gain property to immediate gain recognition if such built-in gain property is contributed by a U.S. person to a partnership with a related foreign partner. To avoid immediate gain recognition on such contributions, the Gain Deferral Method must be adopted with respect to the built-in gain property. When issued, these regulations are to apply to contributions occurring on or after August 6, 2015, and to contributions occurring before August 6, 2015 that result from entity classification elections filed on or after August 6, 2015.4 In addition, section 367(d)(3) grants regulatory authority to treat transfers of intangible assets to foreign partnerships as outbound transfers subject to section 367. To date, no regulations have been issued under this section. Additionally, the provisions of subchapter K of the Code must be considered, including the ramifications of the deemed transfer to the part-nership under the disguised sale rules of Treas. Reg. § 1.707.

4. Reporting/Future Operations a. Reporting Requirements: Reporting requirements under

sections 367(b) and 332 and for contributions to a foreign partnership must be satisfied. In addition, if a partnership contribution is subject to the rules of Notice 2015-54 and the Gain Deferral Method is adopted with respect to the built-in gain property contributed, the U.S. transferor of the built- in gain property must comply with certain filing requirements. See Treas. Reg. § 1.6038B-2(a)(1) and Notice 2015-54, 2015-34 I.R.B. 210. Form 8865 must also be filed.

b. Section 987 consequences must be considered with respect to transfers from the partnership to the partners. See Prop. Treas. Reg. § 1.987-2

c. Taxpayers must file Form 8865, which imposes significant reporting requirements for foreign partnerships. Form 8865 applies to certain U.S. persons that own interests in a foreign partnership.

d. If future losses are incurred, under the dual consolidated loss rules a current year domestic use election and future annual certifications must be filed in order to use the losses in the

208


29

U.S. See Treas. Reg. § 1.1503(d)-4(b) and 6. See also, AM 2009-011 (Oct. 9, 2009), concluding that the provisions of section 1503(d) and the regulations thereunder may operate to limit the use of post-liquidation losses.

e. As noted above, section 165 loss transactions may be subject to reporting requirements under the tax shelter reporting regulations. See Treas. Reg. § 1.6011-4(b)(5).

E. Conversion From Partnership to Corporation

F. Conversion From Branch to Corporation

The conversion from branch to corporation results in an outbound transfer of assets under section 367. Treas. Reg. § 301.7701-3(g) (1)(iv). 1. Transfer of Assets:

a. Section 351 should apply to this transfer. As a result, the out-bound transfer rules of section 367(a) apply. See Treas. Reg. § 1.367(a)-3; Temp. Treas. Reg. §§ 1.367(a)-4T and 5T; Prop Treas. Reg. §§ 1.367(a)-1 through 1.367(a)-7. In addition, section 367(d) may apply to the extent the disregarded entity owns intangibles (as defined in section 936(h)(3)(B)). In such a case, consider licensing intangibles rather than contributing them. See Temp. Treas. Reg. § 1.367(d)-1T. Under proposed regulations (REG-139483-13) that when finalized apply to transfers occurring on or after September 14, 2015, a U.S. transferor can elect to apply section 367(d) rather than section 367(a) to the transfer of certain property (e.g., foreign goodwill and other qualifying intangible property resulting from incorporation of a foreign branch) to a foreign corporation.5

US

ForCo

US

ForCo

US

ForCoForCo

US

ForCo

209


30

b. Prior branch losses are subject to recapture under section 367 (a)(3)(C) to the extent of the gain on the assets transferred. Temp. Treas. Reg. § 1.367(a)-6T.

c. Gain recognized on the outbound transfer of assets to extent of overall foreign loss and separate limitation loss under section 904(f).

2. Branch Termination: a. Section 987 gain or loss is recognized on branch termination.

Prop. Treas. Reg. § 1.987-8. b. Possible recapture of dual consolidated losses that were

subject to a certification under the Treas. Reg. §§ 1.1503-2(g)(2)(iii) and 1.1503(d)-6(e).

3. Reporting/Future Operations: Reporting requirements under Treas. Reg. § 1.351-3 as well as under Treas. Reg. § 1.6038B-1(b) must be satisfied. Reporting of section 987 gains and losses would be required on Form 8858. Form 5471 must be filed in the future.

G. Addition of an Equity Holder to a Hybrid Branch

1. Assume ForCo is an eligible entity. The addition of a new owner

to ForCo results in the conversion to a foreign partnership as of the date the entity has more than one member. Treas. Reg. § 301.7701-3(f)(2).

2. The conversion of ForCo into a partnership can occur in one of two ways: a. US can sell an interest in ForCo to F, or

US

ForCo

US F

ForCo

Wholly-ownedhybrid is treated as

a foreign branch

Addition of anotherequity holder createsa foreign partnership

100% 99% 1%

US

ForCoForCo

US F

ForCoForCo

Wholly-ownedhybrid is treated as

a foreign branch

Addition of anotherequity holder createsa foreign partnership

100% 99% 1%

210


31

b. F can contribute funds to ForCo in exchange for a new interest in ForCo.

3. US sells an interest in ForCo to F: This transaction is treated as a purchase by F of an interest in each asset of ForCo from US. Immediately thereafter US and F are treated as contributing their respective interests in the assets to a new foreign partnership. US recognizes gain or loss on the deemed sale of each asset. See Rev. Rul. 99-5, 1999-1 C.B. 434 (Note: Rev. Rul. 99-5 pertains to a domestic LLC, but the analysis should also apply to a foreign entity). Form 8865 reporting requirements and reporting require-ments under Treas. Reg. § 1.6038B-1(b) must be satisfied.

4. F contributes funds to ForCo in exchange for a new interest: F is treated as contributing property to a new foreign partnership in exchange for an ownership interest. US is treated as contributing the assets of ForCo to the new partnership in exchange for an own-ership interest. In general, neither US nor F recognizes gain or loss. Rev. Rul. 99-5, 1999-1 C.B. 434. Reporting requirements must be satisfied for contributions to foreign corporations and for dis-position of interests in partnerships. See Treas. Reg. §§ 1.6038B-1(b)(2)(i)(A) and 1.6046A-1. In addition, Form 8865 reporting requirements must be satisfied.

5. Section 987 gain or loss may be recognized. Prop. Treas. Reg. § 1.987-2(c)(9), Example 6 and 7.

H. Conversion from Partnership to Foreign Branch

1. US purchases F’s interest in ForCo leaving ForCo as an eligible entity with a single member. The entity is converted to a branch as of the date the entity has only one member. Treas. Reg. § 301.7701-3(f)(2). Note: the consequences of a partnership termination are not specifically addressed in the regulations.

US

ForCo

USF

ForCo

US

ForCoForCo

USF

ForCoForCo

211


32

2. Under the proposed 987 regulations, this transfer should not result in a termination of the branch of US. However, it may result in the termination of the branch of F, to the extent such a transaction would be relevant in determining the U.S. federal income taxa-tion of F or its shareholders. See Prop. Treas. Reg. § 1.987-8

3. If F were subject to U.S. tax it would have to report gain or loss on the sale of its interest in ForCo under section 741. See Rev. Rul. 91-32, 1991-1 C.B. 107. From the perspective of US, ForCo is treated as making a liquidating distribution of its assets and US must recognize any gain or loss as required under section 731(a). US is then deemed to purchase F’s assets from F. See Rev. Rul. 99-6, 1999-1 C.B. 432.

4. Form 8858 must be filed after the conversion to the branch.

IV. CHARACTERIZATION RULES FOR FOREIGN PARTNERSHIPS

A. General Application of Subchapter K Rules

1. The Subchapter K rules of the Code apply to foreign entities treated as partnerships for U.S. tax purposes. These rules represent a com-bination of the “aggregate” and “entity” views of partnerships.

2. Even though the entity may itself be subject to tax in a foreign country, it is not subject to U.S. income tax. Section 701.

3. Under section 702, each partner takes into account separately his distributive share of: a. Eight specifically enumerated items of income, deduction,

losses or credits, b. Other specific items to the extent provided in regulations, and c. Net taxable income from all other items not specifically

accounted for. 4. Under Treas. Reg. § 1.702-1(a)(8), each partner must take into

account separately his distributive share of any partnership item which, if separately taken into account by any partner, would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately. a. This rule represents the point at which the aggregate and

entity theories converge for non-listed items.

212


33

b. For example, in Brown Group, Inc. v. Comm’r, 77 F3d 217 (8th Cir. 1996), vacating and remanding, 104 T.C. 105 (1995), the argument was made that an item need not be separately taken into account because the partner’s income tax liability would not be affected because it was a CFC which is not itself subject to U.S. income tax.

c. Treas. Reg. § 1.702-1(a)(8)(ii), provides that in the case of a CFC partner, items that would be subpart F income at the partner level must be separately stated for all partners.

5. Application of these principles in the international context reflects a mixture of the aggregate and entity concepts.

6. Where a U.S. taxpayer conducts foreign operations through a partnership, the partnership results must be accounted for.

7. Foreign tax credits a. Each partner takes into account his distributive share of

creditable foreign taxes. Treas. Reg. § 1.702-1(a)(6). b. Election of credit or deduction is made at the partner level.

Treas. Reg. § 1.702-1(a)(6). 8. Source and basket of income is generally determined at the part-

nership level. Treas. Reg. § 1.904-5(h)(1). However, if a limited or corporate partner owns less than 10 percent of the partnership his distributive share of income is generally classified in the passive basket.

9. Interest expense of the partnership (other than that which is directly allocable under Temp. Treas. Reg. § 1.861-10T) is separately reported by the partner and apportioned at the partner level based on the partner’s assets. Temp. Treas. Reg. § 1.861-9T(e)(1).

10. Assets of the partnership: a. In apportioning interest expense, a corporate partner whose

partnership interest is at least 10 percent takes into account his pro rata share of partnership assets. Temp. Treas. Reg. § 1.861-9T(e)(2).

b. The same rule applies to individual general partners and limited partners with an interest of at least 10 percent. Temp. Treas. Reg. § 1.861-9T(e)(3). Other partners (i.e., less than 10 percent limited partners and less than 10 percent corporate partners) allocate partnership interest expense directly to the partnership

213


34

income. Such partner’s asset is its interest in the partnership and not the entity’s assets. Temp. Treas. Reg. § 1.861-9T(e)(4).

B. Partnership Share of Foreign Tax Expenses

Effective for partnership years beginning on or after October 19, 2006, IRS and Treasury issued final regulations under Treas. Reg. § 1.704-1 (T.D. 9292). 1. General Rule: The regulations provide rules concerning the appli-

cation of section 704 to creditable foreign tax expenditures (CFTEs) for which the partnership bears legal liability under Treas. Reg. § 1.901-2(f). Under Treas. Reg. § 1.704-1(b)(4)(viii) allocations of CFTEs do not have substantial economic effect. Instead, such expenditures must be allocated in accordance with the partners’ interests in the partnership. Under a safe harbor in the regulation, an allocation of CFTEs will be deemed to be in accordance with the partners’ interests in the partnership if: (1) the CFTEs are allocated (whether or not pursuant to an express provision of the partnership agreement) and reported on the partnership return in proportion to the distributive shares of income to which the CFTEs relate and (2) allocations of all other partnership items that, in the aggregate, have a material effect on the amount of the CFTEs allocated to the partner are valid.

2. Effective Date: The final regulations are effective for partnership taxable years beginning on or after October 19, 2006. For taxable years beginning on or after April 21, 2004 and before October 19, 2006, see T.D. 9121. Transition relief is available for certain partnership agreements entered into before April 21, 2004.

3. In addition, a partner allocating CFTEs in accordance with the provisions of section 704(b), must also consider section 909, added by the Education Jobs and Medicaid Assistance Act (“EJMAA”), enacted on August 10, 2010 (P.L. 111-226, 124 Stat. 2389 (2010)),. For partnership taxable years beginning on or after January 1, 2012, see Treas. Reg. § 1.909-2T(b)(4) regarding the application of section 909 to foreign taxes attributable to inter-branch payments. A transition rule applies for certain partnerships where the part-nership agreement was entered into prior to February 14, 2012. See Treas. Reg. § 1.909-2(b)(4) for foreign taxes attributable to inter-branch payments paid or accrued in taxable years ending on or after February 9, 2015. Note that Temp. Treas. Reg.

214


35

§ 1.909-2T(b)(4) can be applied for the first taxable year ending after February 9, 2015.

C. Brown Group Regulations

1. General Rule The Brown Group regulations under sections 702, 952 and 954

address the treatment of a CFC’s distributive share of partnership income. See Brown Group, Inc. v. Comm’r, 77 F3d 217 (8th Cir. 1996), vacating and remanding, 104 T.C. 105 (1995). These Brown Group regulations generally provide for an aggregate rather than an entity approach to partnerships for purposes of determining if the distributive income is subpart F income. Thus, a CFC’s dis-tributive share of partnership income would be treated as if it were earned by the CFC directly for purposes of testing whether the income is subpart F income.

The Brown Group regulations, however, depart from the aggre-gate approach when dealing with certain exceptions to subpart F income. The regulations require that the requirements for the same-country exception for related party dividends, interest and royalties and the active rents and royalties must be satisfied at the partner-ship level. Treas. Reg. § 1.952-1(g). In addition, the regulations provide that to determine the extent to which a controlled foreign corporation’s distributive share of any item of gross income of a partnership would have been foreign base company sales income if received by it directly, property sold will be considered to be manufactured, produced or constructed by the controlled foreign corporation, only if the manufacturing exception of Treas. Reg. § 1.954-3(a)(4) would have applied to exclude the income from foreign base company sales income if the controlled foreign corporation had earned the income directly, determined by taking into account only the activities of, and property owned by, the part-nership and not the separate activities or property of the controlled foreign corporation or any other person. See Treas. Reg. § 1.954-3(a)(6).

D. Notice 2007-9

In Notice 2007-9, 2007-1 C.B. 401, Treasury adopted an aggre-gate approach to the application of section 954(c)(6) to payments made by partnerships to CFCs and to payments made from CFCs to partnerships.

215


36

E. Section 956

In the preamble to proposed regulations under section 954(i), the Treasury requested comments on situations in which a loan to a foreign partnership should be considered an obligation of its partners for pur-poses of section 956. On September 2, 2015, temporary regulations (T.D. 9733, 80 FR 52976-01) and proposed regulations (REG-155164-09) were issued, and on November 3, 2016, final regulations (T.D. 9792, 81 FR 76497) were issued under section 956 that treat certain foreign partnership obligations as obligations of a U.S. partner. Spe-cifically, where a controlled foreign corporation holds (or is treated as holding because of a pledge or guarantee) an obligation of a foreign partnership with a U.S. partner, that obligation will be treated as an obli-gation of the U.S. partner by reference to the U.S. partner’s liquidation value percentage (generally defined as the percent of total cash each partner would receive from the partnership if the partnership were to sell all its assets, satisfy all its liabilities, and distribute its remaining cash) of the partnership. In determining the U.S. partner’s liquidation value percentage, special allocations are not to be taken into account. The U.S. partner’s liquidation value percentage is to be determined on the date of the partnership’s formation, upon a revaluation event, and when the liquidation value percentage determined for any partner on the first day of the partnership’s taxable year would differ from the most recently determined liquidation value percentage of that partner by more than 10 percentage points. However, if neither the lending con-trolled foreign corporation nor any partner of the partnership are related (within the meaning of section 954(d)(3)), then the partnership’s obligation will be treated as an obligation of the partnership and not an obligation of its partners. In addition to the general rule, the final regulations include a special funded distribution rule that applies where a controlled foreign corporation makes a loan to a partnership with a U.S. partner, the partnership makes a distribution to that U.S. partner, the distribution would not have been made but for the funding of the partnership, and the U.S. partner and the CFC are related (within the meaning of section 954(d)(3)). In such a case, the U.S. partner’s share of the partnership liability is the greater of (i) its share under the liquidation value percentage method, or (ii) the lesser of the amount of the distribution that would not have been made but for the funding and the amount of the obligation. The final regulations also provide that an obligation of a domestic partnership is treated as an obligation of a U.S. person. Generally, these rules are to apply to taxable years of a controlled foreign corporation ending on or after November 3, 2016

216


37

with respect to obligations acquired, or pledges or guarantees entered into, on or after September 1, 2015.

In addition, the final regulations expand the application of the anti-abuse rule of Treas. Reg. § 1.956-1T(b)(4) to certain transactions involving partnerships and their controlled foreign corporation partners. The expanded anti-abuse rule applies to a controlled foreign corpo-ration’s taxable years ending on or after September 1, 2015, with respect to property acquired on or after September 1, 2015.

In addition, under the final regulations, a controlled foreign corporation will be treated as holding an obligation of a U.S. person when the controlled foreign corporation pledges or guarantees an obli-gation of a foreign partnership that is treated as an obligation of a U.S. partner under the rules described immediately above. However, a controlled foreign corporation partner in a foreign partnership will not be treated as pledging or guaranteeing an obligation of a foreign partnership merely because the controlled foreign corporation partner is treated as owning its proportionate share of partnership assets. These rules apply to taxable years of controlled foreign corporations that end on or after November 3, 2016, with respect to obligations held on or after November 3, 2016.

Under the final regulations, a controlled foreign corporation is treated as holding its share of U.S. property directly held by a foreign partnership in accordance with its liquidation value percentage (described above). Generally, special allocations with respect to such property are to be taken into account. However, proposed regulations (REG-114734-16, 81 FR 76542) have been issued that would elimi-nate the ability to take into account special allocations when applying the liquidation value method with respect to any partner that controls the partnership. In addition, Rev. Rul. 90-112, which allowed taxpay-ers to rely on the outside basis limitation (i.e., limit a controlled foreign corporation’s investment in U.S. property to its outside basis in its partnership interest) for purposes of determining the amount of U.S. property held by a controlled foreign corporation through a part-nership, has been obsoleted. These rules apply to the taxable years of a controlled foreign corporation that end on or after November 3, 2016, with respect to property acquired on or after November 3, 2016.

V. TREAS. REG. § 1.1248-1(a)(4)

In regulations effective for income inclusions occurring on or after July 30, 2007, the Treasury provided that section 1248 applies to the sale

217


38

by a foreign partnership of stock subject to section 1248 to the extent it would have applied had each partner sold its proportionate share of such stock directly.

However, the regulations do not provide for aggregate treatment in the case of the sale of an interest in a foreign partnership that holds stock subject to section 1248. See section 1248(g)(2)(B). See also section 751(b).

VI. OUTBOUND ASSET TRANSFERS TO FOREIGN ENTITIES

A. Outbound Transfers to Foreign Corporations

1. General Rule: Section 351 generally provides tax-free treatment on a capital contribution to a corporation. However, when appre-ciated property is transferred from a U.S. party to a foreign cor-poration in an otherwise tax-free exchange, the foreign corporation is not treated as a corporation for purposes of determining whether the transfer of the appreciated property is tax free. In such a case, the transaction will be taxable since corporate status is a pre-requisite to obtaining tax-free treatment on the transfer under section 351. Section 367(a)(1).

2. Tangible Assets: a. Active conduct of a trade or business exception: The foreign

corporation is treated as a corporation if the appreciated prop-erty is transferred for use in the active conduct of a trade or business outside the U.S. Consequently, if this exception for an active conduct of a trade or business is satisfied, appreciated property may be transferred tax-free to a foreign corporation in a certain organizations or reorganizations. Section 367(a) (3)(A); See also Temp. Treas. Reg. § 1.367(a)-2T.

The existing final regulations provide that all property is eligible for the active conduct of a trade or business exception unless otherwise excluded. Proposed regulations (80 FR 55568-01; REG-139483-13) issued on September 16, 2015 however provide that only certain enumerated property is eli-gible for this exception (known as “eligible property”). Eligible property includes tangible property, a working interest in oil and gas property, and certain financial assets. In addition, the proposed regulations provide that certain “tainted” assets can-not constitute eligible property. These tainted assets include inventory, installment obligations, foreign currency, and

218


39

certain leased tangible property. Note that under the existing final regulations, foreign currency denominated instruments are not tainted assets if denominated in the currency of the foreign corporate transferee and were acquired in the ordinary course of business of the U.S. transferor that will be con-tinued by the foreign corporate transferee. The proposed regu-lations have removed this exception. The proposed regulations do provide that to the extent property does not qualify for the active conduct of a trade or business exception, the U.S. transferor can elect to apply section 367(d) (described below), as opposed to section 367(a), to such property, provided the property is not eligible property. For this limited purpose, eligible property includes tainted assets, to the extent the tainted assets would otherwise constitute eligible property. If this election is made, the U.S. transferor and all other related U.S. transferors must apply this rule consistently to all prop-erty transferred to foreign corporations pursuant to a plan. Note that the election to apply section 367(d) must be made as prescribed by Prop. Treas. Reg. § 1.6038B-1(d)(1)(iv) and (v). These proposed regulations apply when finalized, but apply retroactively to all transfers occurring on or after September 14, 2015, and to transfers occurring before September 14, 2015 that result from entity classification elections. However, the removal of the foreign currency excep-tion described above applies only to transfers of nonfunctional currency denominated property occurring on or after the date the regulations become final.

Most noticeably absent from the list of eligible property is foreign goodwill and going concern value. The preamble to the proposed regulations makes clear it was the intention of the IRS and Treasury to subject the outbound transfer of foreign goodwill and going concern value to immediate gain recognition, either under section 367(a) or section 367(d). Sub-jecting foreign goodwill and going concern value to immediate gain recognition however seems contrary to Congress’ inten-tion that outbound transfers of an active foreign business may be exempt from immediate gain recognition.6

b. Tainted assets: Under the existing final regulations, certain “tainted” assets will not qualify for the active conduct of a trade or business exception and are ineligible for tax-free treatment. The amount of gain recognized on the transfer of

219


40

tainted assets is referred to as a “toll charge.” However, if non-tainted assets are transferred along with the tainted assets, nonrecognition treatment is available for the “non-tainted” assets as long as they meet the active trade or business excep-tion. Section 367(a)(3)(B); See also Temp. Treas. Reg. § 1.367 (a)-5T. Included in the category of tainted assets are intangible property (but see section 367(d)(1) discussed below), inven-tory, installment obligations, foreign currency and certain leased property. Under the existing final regulations, transfers of foreign goodwill and going concern value are not subject to the toll charge. Temp. Treas. Reg. §§ 1.367(a)-5T(e) and -1T(d)(5)(iii). But see Prop. Treas. Reg. §§ 1.367(a)-1(b)(5) and 1.367(a)-2.

3. Intangible Assets – Section 367(d) 4. Section 351 or section 361 transfers: As discussed above, intan-

gible property is generally treated as a “tainted” asset. However, if the intangible property is transferred to a foreign corporation in a section 351 (formation of a foreign corporation) or section 361 (reorganization) exchange, under section 367(d) the transfer is treated as a deemed sale of the intangible on an installment sale basis. After August 5, 1997, this deemed sale is taxable as foreign source income over the useful life of the intangible (not to exceed 20 years). The 2004 AJCA clarified that this deemed income shall be treated as a royalty for look-through purposes.

5. Definition of intangible property: a. For purposes of section 367(d), intangible property is broadly

defined under section 936(h)(3)(B) to include: b. A patent, invention, formula, process, design, pattern or

know-how, c. Copyright, literary, musical or artistic composition, d. Trademark, trade name, or brand name, e. Franchise, license, or contract, f. Method, program, system, procedure, campaign, survey, study,

forecast, estimate, customer list, or technical data, or g. Any similar item, which has substantial value independent

of the services of any individual.

220


41

The definition of intangibles is further expanded to include knowledge, rights and documents, but specifically excludes a working interest in oil and gas properties. Temp. Treas. Reg. § 1.367(a)-1T(d)(5)(i).

h. Intangible property is subject to section 367(d) regardless of whether it is used or developed in the U.S. or in a foreign country or whether it is used in manufacturing activities or in marketing activities. Temp. Treas. Reg. § 1.367(a)-1T(d) (5)(i).

i. An operating intangible, which may be subject to a special election discussed below, is defined as any intangible property of a type not ordinarily licensed or otherwise transferred in transactions between unrelated parties for consideration con-tingent upon the licensee’s use of the property. For example, long-term purchase or supply contracts, surveys, studies and customer lists are operating intangibles. Temp. Treas. Reg. § 1.367(a)-1T(d)(5)(ii).

j. Foreign goodwill or going concern value, defined as the residual value of a business operation conducted outside the U.S. after all other tangible and intangible assets have been identified and valued, is not property subject to section 367(d). Temp. Treas. Reg. § 1.367(a)-1T(d)(5)(iii). But see Prop. Treas. Reg. § 1.367(a)-1(b)(5), which would impose gain recognition for transfers on or after September 14, 2015. The value of the right to use a corporate name in a foreign country is treated as foreign goodwill or going concern value. The corporate name is distinguished from trademarks and trade-names and other marketing intangibles. Temp. Treas. Reg. § 1.367(a)-1T(d)(5)(iv).

6. Deemed royalty income: The income from the deemed sale of the intangible is computed under section 367(d) in the following manner:

The U.S. transferor is treated as receiving annual payments con-tingent on the productivity or use of the transferred property over its useful life (regardless of whether such payments are in fact made by the transferee). Section 367(d)(2).

The deemed royalty income from the transferred intangible shall “be commensurate with the income attributable to the intan-gible.” The royalty rate must be reviewed annually to determine

221


42

whether it is “commensurate” with the income attributable to the intangible. This provision adversely impacts the U.S. tax treatment of an intangible transferred to a foreign subsidiary that becomes highly profitable at some future date, resulting in an increase in the deemed royalty income above what would clearly be an arm’s-length rate under industry standards or what could have been foreseen at the time of the transfer.

For estimated tax purposes, the deemed income is treated as received by the transferor on the last day of its taxable year (i.e., in the fourth quarter). Temp. Treas. Reg. § 1.367(d)-1T(c)(1).

Under the existing final regulations, the useful life of the intan-gible is the entire period during which the property has value, but not exceeding 20 years. Temp. Treas. Reg. § 1.367(d)-1T(c)(3). However, the proposed regulations issued on September 16, 2015 remove the 20-year life limit and provide that the useful life of intangible property is the full period during which it is reasonable to expect the intangible will be exploited. This is determined as of the date of the transfer. Prop. Treas. Reg. § 1.367(d)-1(c)(3).

The deemed royalty included in the transferor’s income may not be treated as deferrable income for purposes of the blocked foreign income rules provided in Rev. Rul. 74-351, 1974-2 C.B. 144. Temp. Treas. Reg. § 1.367(d)-1T(c)(4).

If the transferor receives stock along with consideration that would give rise to gain under section 351(b), the IRS has held that such non-qualifying consideration is treated as a prepayment of the deemed royalty for purposes of section 367(d). See ILM 200610019 (Mar. 10, 2006).

7. Interaction between sections 482 and 367(d): a. Section 482 provides that any transfer or license of intangible

property (within the meaning of section 936(h)(3)(B)) between controlled entities must be “commensurate” with the income attributable to the intangible.

b. Section 367(d) does not apply to an actual sale or license of an intangible by a U.S. person to a foreign corporation. Temp. Treas. Reg. § 1.367(d)-1T(g)(4)(i). Further, any adjustment made under section 482 with respect to an actual sale or license is not subject to section 367(d). It is important to differen-tiate between transfers under sections 482 and 367(d) even though both require a commensurate adjustment. Section 482 only applies to all transfers of rights to use intangible assets

222


43

between controlled entities, while section 367(d) applies to a transfer of property subject to section 351 or section 361.

c. The IRS may disregard a “sham” license or sale and treat it as a transfer of property subject to section 367(d). Temp. Treas. Reg. § 1.367(d)-1T(g)(4)(ii).

8. Special rules: a. Establishment of an account receivable - If a U.S. person is

required to recognize deemed income, and the amount is not actually paid by the transferee foreign corporation, then the U.S. person may establish an account receivable from the transferee foreign corporation for that amount. Temp. Treas. Reg. § 1.367(d)-1T(g)(1). See also Rev. Proc. 99-32, 1999-2 C.B. 296. (1) A separate account receivable must be established for

each year. Payments received from the transferee foreign corporation must be designated as payments upon a par-ticular account and must be deducted from that account.

(2) If any portion of the account remains unpaid as of the last day of the third taxable year following the year the account relates to, such portion is deemed to have been paid on that date and the U.S. transferor is deemed to have made a capital contribution to the transferee foreign corporation. As a result, the U.S. transferor’s basis in the stock of the transferee foreign corporation will be increased by the unpaid receivables. Temp. Treas. Reg. § 1.367(d)-1T(g)(1)(ii).

(3) Election to treat a transfer as a sale – In certain cir-cumstances, a U.S. transferor may elect to recognize, in the year of the transfer, U.S. source, ordinary income in an amount equal to the difference between the fair market value of the intangible and its adjusted basis. See Temp. Treas. Reg. § 1.367(d)-1T(g)(2). Only operating intan-gibles qualify for this election. An operating intangible is defined in 1.367(a)-1T(d)(5)(ii) as an intangible that is not ordinarily transferred for use between unrelated parties in exchange for consideration that is contingent on the use of the intangible.

223


44

b. Anti-abuse – An anti-abuse rule is provided where an intan-gible is first transferred to a U.S. corporation and the U.S. person transfers the stock of that U.S. corporation to a related foreign corporation. Temp. Treas. Reg. § 1.367(d)-1T(g)(6).

9. Property status: Whether or not a transfer of an intangible in an exchange described

in sections 351 or 361 will be subject to the section 367(d) deemed income rule is dependent upon whether the intangible has prop-erty status. Generally, the transfer of all the legal rights and risk of loss in an intangible to a controlled corporation will be treated as a transfer of property. For purposes of determining whether the rights transferred have property status, see Rev. Rul. 64-56, 1964-1 C.B. 133 and Rev. Proc. 69-19, 1969-2 C.B. 301 (know-how), Rev. Proc. 74-36, 1974-2 C.B. 491 (computer software); Rev. Rul. 79-288, 1979-2 C.B. 139 (corporate name); Hospital Corporation of America v. Comm’r, 81 T.C. 520 (1983) (right to enter into a contract); and Rev. Rul. 69-156, 1969-1 C.B. 101 (patents).

10. Stock Transfers (1) Outbound transfers of U.S. stock: Section 367(a) regulations prescribe the circumstances under

which stock of a U.S. corporation may be transferred to a foreign corporation in a nonrecognition transaction under section 367. Treas. Reg. § 1.367(a)-3(c) imposes the following requirements (in addition to those requirements otherwise imposed for nonrecognition treatment):

(2) The U.S. transferors receive no more than 50 percent of the voting power and value of the transferee in exchange for the transfer of the stock of the U.S. corporation;

(3) U.S. officers, directors and 5 percent or greater shareholders of the U.S. target company own 50 percent or less of the voting power and the value of the transferee corporation immedi-ately after the transfer;

(4) A U.S. person that is a 5 percent transferee shareholder must enter into a five-year gain recognition agreement;

(5) The active trade or business test requirement is satisfied. To satisfy this test, the transferee foreign corporation must be actively engaged in business outside the U.S. for the 36 months

224


45

preceding the transfer and the fair market value of the trans-feree foreign corporation (exclusive of the U.S. target and its affiliates) must at least equal the value of the U.S. target company. Specific rules are provided in the regulations that remove assets acquired by the transferee foreign corporation within 36 months prior to the transfer. Treas. Reg. § 1.367-3(c)(3)(iii).

The regulations contain presumptions of U.S. ownership that must be rebutted by obtaining ownership statements from foreign shareholders. Treas. Reg. § 1.367(a)-3(c)(2) and (7).

Section 367(a)(1) will not apply to the extent that the transfer of the domestic corporation’s stock is in connection with the performance of personal services, if the transfer is considered to be to a foreign corporation solely by reason of Treas. Reg. § 1.83-6(d)(1).

11. Outbound transfers of foreign stock: a. General Rule

(1) Section 367(a) regulations prescribe the circumstances under which stock of a foreign corporation may be trans-ferred to another foreign corporation in a nonrecognition transaction. The regulations require a taxpayer that owns more than a de minimis amount (less than 5 percent of vote or value) of stock following the exchange to execute a gain recognition agreement. Under this agreement, the taxpayer agrees to retroactively recognize gain on the initial exchange of stock if at any time during the 5-year term of the agreement the taxpayer disposes of the stock received in the nonrecognition transaction.

(2) Except to the extent that the transferee foreign corporation is not treated as a corporation under section 367(a)(1), a transfer of stock or securities that is described in both sections 367(a) and 367(b) is concurrently subject to both sections and the regulations thereunder. See Treas. Reg. § 1.367(a)-3(b)(2).

(3) However, the IRS amended Treas. Reg. § 1.367(a)-3 to provide that both a section 354 exchange resulting in a section 368(a)(1)(E) reorganization and a section 354 transaction resulting in a section 368(a)(1) asset reorgani-zation, that is not treated as an indirect transfer under

225


46

Treas. Reg. § 1.367(a)-3(d), will not be subject to section 367(a). See Notice 2005-6.

(4) Treasury regulations provide that sections 367(a) and 367(b) generally will not apply to a deemed section 351 exchange governed by section 304(a)(1). However, for all transactions occurring on or after February 10, 2012, Notice 2012-15 provides that sections 367(a) and (b) apply to deemed section 351 transactions and related redemptions under section 304. The taxpayer may enter into gain recognition agreements for the deemed contri-bution and distribution, to the extent otherwise allowed by the regulations.

(5) However, Treas. Reg. § 1.367(a)-9T provides a special rule where the transferor in the section 304(a)(1) trans-action receives a distribution that is applied against and reduces basis in shares of the transferee corporation, other than the shares deemed issued in the section 304 transaction. In such a case, under Treas. Reg. § 1.367(a)-9T, the U.S. transferor will be required to recognize gain in an amount equal of the built in gain in the shares transferred in the section 304(a)(1) transaction, less the amount of any distribution that is included in gross income as a dividend under section 301(c)(1).

(6) In addition, under Treas. Reg. § 1.367(b)-4T, if the trans-feror in the section 304(a)(1) transaction receives a dis-tribution that is applied against and reduces basis in shares of the transferee corporation, other than the shares deemed issued in the section 304 transaction, the deemed section 351 transaction occurring pursuant to section 304 (a)(1) will be subject to Treas. Reg. § 1.367(b)-4(b).

(7) These regulations are effective for transactions occurring on or after February 10, 2009. For transactions occurring before February 10, 2009, the prior regulations provided that neither section 367(a) nor 367(b) applied to a section 304(a)(1) transaction.

(8) The following example illustrates the application of Treas. Reg. § 1.367(a)-9T:

226


47

a. USCo, a domestic corporation, wholly owns CFC1

and CFC2, each a foreign corporation. CFC1 stock has a $40 basis and a $100 fair market value. CFC2 stock has a $100 basis and a $100 fair market value. As of December 31, year 1, CFC1 has zero earnings and profits, and CFC2 has $20 earnings and profits. On December 31, year 1, in a transaction described in section 304(a)(1), USCo sells the CFC1 stock to CFC2 for $100.

b. Under section 304(a)(1), USCO recognizes a $20 dividend under section 301(c)(1) to the extent of first CFC2’s and then CFC1’s earnings and profits. USCo takes the position that of the remaining $80: (1) $40 is applied against and reduces the basis of the CFC2 stock issued in the deemed section 351 (Block 2) and (2) $40 is applied against and reduces the basis of the CFC2 stock held prior to (and after) the transaction (Block 1).

c. Under Treas. Reg. §1.367(a)-9T, USCo must recog-nize $40 gain on the transfer of CFC1 to CFC2 ($60 gain realized - $20 dividend). The $40 gain is allocated to the CFC1 shares transferred to CFC2

USCo

CFC1 CFC2

CFC1

A/B =$40 FMV=$100

$100

A/B =$100 FMV=$100

E&P = $0 E&P = $20

E&P = $0

227


48

and to the CFC2 stock deemed issued to USCo. CFC1 stock basis in the hands of CFC2 is increased by the $40 gain recognized by USCo. Under section 358, the basis of the CFC2 stock received by USCo in the deemed section 351 is also increased by the $40 gain recognized by USCo. The conse-quences of the section 304(a)(1) redemption are determined after increasing USCo’s basis in CFC2 stock received in the deemed section 351 transaction.

d. Anti- Inversion Rules: (1) General Rule: The 2004 AJCA added

section 7874 which placed severe limitations on the ability of the owners of a domestic entity to exchange their interest in a domestic corporation and become a shareholder of a foreign corporation (an “inverted corporation”) that holds the properties of the former domestic corporation. If the former owners of the domestic entity continue to own at least 80 percent of the inverted corporation, then, under the AJCA, the acquiring foreign corporation is treated as a domestic corporation for U.S. tax purposes. If the ownership is less than 80 percent but at least 60 percent, then the inverted corporation remains “foreign” for tax purposes as under present law, but the acquired domestic corporation is denied the use of credits and deductions to shelter “inversion gains” for at least 10 years. In either case, these consequences only apply if the group does not have “substantial business activities” in the country in which it was created, con-tinued or organized.

(2) Transition Rule: For inversion transactions where 50% or less of the assets have been transferred by March 4, 2003:

-The foreign acquiring company shall be treated as a domestic company if 80% or more of the shares are owned by former owners of the acquired U.S. company and the parent does

228


49

not have substantial business activity in country of incorporation;

-If the former owners of the acquired U.S. company own 60% or more of the shares of the U.S. company and less than 80% of the acquiring company, the inversion shall be respected for U.S. tax purposes but the tax on the “inversion gain” cannot be offset by tax attributes for 10 or more years;

(3) A 15% excise tax is imposed (20% after 2008) on stock-based compensation of insiders of the inverted corporation.

(4) These rules should be carefully reviewed in the context of organizing joint venture operations.

(5) The IRS and Treasury issued Temp. Treas. Reg. § 1.7874-4T on January 16, 2014. Such regulation generally disregards certain stock issued by a foreign acquiring corporation in exchange for passive assets, in determining the ownership continuity fraction. In addition, the IRS and Treasury have issued Notice 2014-52, 2014-42, I.R.B. 712, and Notice 2015-79, 2015-49 I.R.B., which generally tighten the anti-inversion rules of section 7874 and reduce certain benefits of inversion transactions.

B. Outbound/Other Transfers to Partnerships

1. Foreign partnerships: a. Pre-1997 TRA Transfers: Prior to August 5, 1997, transfers

to foreign partnerships were subject to severe restrictions under section 1491.

b. Transfers after August 5, 1997: (1) Generally, no gain or loss is recognized in a contribu-

tion of property to a partnership in exchange for a part-nership interest. Section 721.

(2) The 1997 tax legislation repealed sections 1491-1494; thus, there is no longer an excise tax imposed on trans-fers to foreign partnerships.

229


50

(3) However, under the regulatory authority of section 721(c), the IRS and Treasury issued Notice 2015-54, 2015-34 I.R.B. 210, on August 7, 2015. Notice 2015-54 announced forthcoming regulations that would generally subject the transfer by a U.S. transferor of built-in gain property (known as “section 721(c) property”) to a partnership (known as a “section 721(c) partnership”) with related (within the meaning of section 267(b) or section 707(b)(1)) foreign partners to immediate gain recognition. In other words, the nonrecognition provi-sion of section 721(a) would be effectively shut off in the event of such transfers. Query whether a technical termination of an existing partnership could be subject to Notice 2015-54? Built-in gain property that constitutes cash equivalents, securities (within the meaning of section 475(c)(2), without regard to section 475(c)(4)), and tangible property with a built-in gain of $20,000 or less is not treated as section 721(c) property, and, thus, is excluded from these rules. The rules do provide for an exception to gain recognition: if the Gain Deferral Method is applied with respect to the section 721(c) property transferred, section 721(a) will apply to such transfer. Generally, the Gain Deferral Method require-ments will be satisfied if: (i) the partnership adopts the remedial method under section 704(c) with respect to the section 721(c) property, (ii) the partnership allocates all section 704(b) items of income, gain, loss, or deduc-tion with respect to the section 721(c) property in the same proportion, (iii) certain reporting requirements are satisfied, (iv) the U.S. transferor agrees to recognize any remaining built-in gain in the section 721(c) property transferred if an Acceleration Event occurs, and (v) the Gain Deferral Method is adopted for all built-in gain property contributed to the partnership by a U.S. trans-feror until the earlier of the date on which no built-in gain remains on section 721(c) property initially subject to the Gain Deferral Method or 60 months after the date of the initial contribution of section 721(c) property. An Acceleration Event is defined generally as any trans-action that would reduce or defer the amount of built-in gain the U.S. transfer would be required to recognize

230


51

under the Gain Deferral Method. In addition, an Accel-eration Event is deemed to occur if the U.S. transferor fails to comply with the reporting requirements of the Gain Deferral Method. Note that generally an Accel-eration Event will not occur if a U.S. transferor (or a section 721(c) partnership) contributes its interest in a section 721(c) partnership to a domestic corporation in a nonrecognition transaction under sections 351 or 381(a), provided the Gain Deferral Method will apply as if the domestic transferee corporation is the initial U.S. trans-feror. In addition, an Acceleration Event should not occur if a section 721(c) partnership contributes section 721(c) property to a domestic corporation in a nonrecognition transaction under section 351. If a section 721(c) part-nership contributes section 721(c) property to a foreign corporation, such contribution will not be treated as an Acceleration Event to the extent it is treated a contri-bution of property by a U.S. person to a foreign cor-poration (because the rules under section 367(a) and/or section 367(d) should apply to such transfer). Notice 2015-54 also includes an anti-abuse rule, which provides that a transaction may be recharacterized according to its substance if a U.S. transferor engages in transactions with a principal purpose of avoiding the rules of Notice 2015-54. When finalized, the regulations will apply to all transfers occurring on or after August 6, 2015, and to transfers occurring before August 6, 2015 that result from entity classification elections filed on or after August 6, 2015.

(4) In addition, Treasury has been granted regulatory author-ity under section 367(d)(3) to apply section 367(d) to transfers of intangible property to foreign partner-ships. To date, no regulations have been issued. It is possible that Treasury will apply section 367(d) to trans-fers of intangibles to foreign partnerships given the application of section 367(d) to taxpayers making a section 1492 election under prior law.

(5) Treasury also has been granted regulatory authority to treat a partnership as a domestic or foreign partnership, where such treatment is more appropriate, without regard

231


52

to where the partnership is created or organized. This rule will only apply to partnerships created after Treasury exercises its regulatory authority.

c. Persons contributing property to foreign partnerships must satisfy the reporting requirements of section 6038B (see below).

2. U.S. Partnerships: a. The use of a U.S. partnership as an intermediary entity to invest

in a foreign corporation joint venture is another alternative joint venture structure.

b. Capital contributions by the U.S. and foreign joint ventures to the U.S. partnership are not taxable to the U.S. partnership or the U.S. or foreign partners. Section 721. By interposing a U.S. partnership between itself and the foreign corporation, the U.S. transferor can contribute an intangible to the U.S. partnership tax free in exchange for a partnership interest. At the partnership level, the U.S. partnership could then license, sell or contribute the intangible to a foreign corporation joint venture. However, this structure requires the foreign joint venture entity to become a partner in a U.S. partnership.

c. As the following discussion indicates, the license alternative is attractive in this structure.

d. Contingent and noncontingent sales of intangibles: If the U.S. partnership sold intangible property to the foreign joint venture entity, the entire gain would most likely be taxable to the U.S. transferor under section 704(c). Section 704(c) pro-vides that under regulations, prescribed by the Secretary, income, gain, loss and deduction with respect to property contributed to the partnership by a partner shall be shared among its partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at time of contribution.

e. Contribution to capital: A contribution of capital from a U.S. partnership to the foreign corporation joint venture would be subject to the preceding rules discussing the capital contributions to foreign corporations. Treas. Reg. § 1.367(a)-1T(c)(3). Thus, sections 367(a) and 367(d) would apply.

232


53

f. License: The license of the intangible from the U.S. part-nership to the foreign joint venture corporation would result in foreign source income to the U.S. partnership if the intan-gible is used outside the United States. Section 862(a)(4). Provided the foreign joint venture corporation is owned more than 50 percent (vote or value) by the U.S. partnership and the joint venture corporation is a CFC, the U.S. transferor’s proportionate share of royalty payments received by the U.S. partnership are characterized by reference to the character of the income earned by the foreign corporate joint venture. Treas. Reg. §§ 1.904-5(c)(3).

C. Filing Requirements:

The U.S. filing requirements on the outbound transfer will depend on the characteristics of the transferee entity – i.e., whether it quali-fies as a corporation or a partnership for U.S. tax purposes. 1. Contribution to Foreign Corporation:

a. Generally, the transfer of assets to a foreign corporation under sections 351 and 361 require the transferor to file an infor-mation return, Form 926 (Return by Transferor of Property to a Foreign Corporation, Foreign Estate or Trust, or Foreign Partnership) with its tax return for the taxable year that includes the date of transfer. Treas. Reg. § 1.6038B-1(b)(1). Note that an exception from filing Form 926 exists for transfers occurring after July 19, 1998, of stock and securities under section 367(a) for which a gain recognition agreement is entered into. Treas. Reg. § 1.6038B-1(b)(2)(i)(B)(1). In addition, if under the proposed regulations a U.S. transferor elects to subject the outbound transfer of foreign goodwill or going concern value to section 367(d), additional filing requirements will be necessary.

b. Transfers of cash to a foreign corporation that occur in taxa-ble years beginning on or after February 5, 1999, must also be reported on Form 926 if the transferor owns a greater than 10 percent interest in the foreign corporation or if the total cash transferred during the preceding 12-month period exceeds $100,000. Treas. Reg. § 1.6038B-1(b)(3)(i).

c. Form 926 generally requires: (1) identifying information about both the transferor and transferee; (2) a description of the

233


54

property transferred; (3) the amount of consideration received; and (4) information relating to foreign loss branches. If the reporting requirements of section 6038B are not complied with: (1) the transferred property is not considered used in the conduct of a trade or business under section 367(a); (2) the U.S. person must pay a penalty equal to 10 percent of the fair market value of the property transferred (not to exceed $100,000 if the failure to file is not due to willful neglect); and (3) the statute of limitations will not begin to run until the transferor does comply with the section 6038B require-ments. Treas. Reg. § 1.6038B-1(f).

2. Contribution to Foreign Partnership Tax return filing requirements applicable to foreign partnerships:

a. Under section 6031(e), unless otherwise provided in regu-lations, foreign partnerships are required to file U.S. partnership income tax returns only if the partnership is engaged in a U.S. trade or business or if the partnership earns U.S. source income.

b. Information returns related to foreign partnerships: Numerous reporting requirements apply to transfers of ownership interests in foreign partnerships and the transfer of property to foreign partnerships. (1) Section 6038 Under the section 6038 regulations, a U.S. person that

owns an interest in a “controlled foreign partnership” (a CFP) will be required to file Form 8865, Information Return Of U.S. Persons With Respect To Certain Foreign Partnerships, on an annual basis. Form 8865 is similar to Form 5471, which is currently filed for CFCs. In the case of a CFP, reporting will be required by 10 percent interest holders. Treas. Reg. § 1.6038-3. The penalty for failure to furnish the required information is $10,000 for each annual accounting period to which the failure exists. This amount is increased by $10,000 for each 30 days of continued failure to file (up to an additional $50,000) if the failure to file continues after receipt of notice.

234


55

(2) Section 6038B Final section 6038B regulations address the reporting

requirements for transfers to foreign partnerships. Each U.S. person transferring property (including cash and unappreciated property) to a foreign partnership must report the transaction on the Form 8865 if (1) the U.S. person holds a 10 percent or greater interest in the part-nership immediately after the transfer or (2) if the value of the property transferred within 12 months (when added to related party transfers) exceeds $100,000. Treas. Reg. § 1.6038B-2(a)(1). Failure to furnish this information may result in a penalty equal to 10 percent of the value of the property at the time of the exchange as well as recognition of gain on the property at the time of con-tribution. The 10 percent penalty is limited to $100,000 if the failure to file is not due to willful neglect. Section 6038B(c).

(3) Section 6046A Under final section 6046A regulations, a person whose

ownership interest in a foreign partnership changes by more than 10 percent will be required to report on Form 8865 acquisitions or dispositions of partnership interests as well as substantial changes in the partner’s proportional interest in the partnership. Treas. Reg. § 1.6046A-1(a). Failure to report these changes may result in a penalty equal to that applicable to the section 6038 penalties described above.

c. The statute of limitations is extended until three years after reporting with respect to an item of income that is not reported under sections 6038, 6038A, 6038B, 6046, 6046A or 6048. Section 6501(c). The statute remains open on the item for purposes of all taxes imposed.

d. In addition, if Notice 2015-54 applies to a partnership and the Gain Deferral Method is applied to avoid immediate gain recognition, the U.S. transferor must comply with the filing requirements provided in Notice 2015-54.

235


56

3. Foreign Corporation: If the foreign corporation qualifies as “controlled foreign cor-

poration” (a CFC), Form 5471, Information Return with Respect to a Foreign Corporation, must be filed on an annual basis. Treas. Reg. § 1.6038-2(a). If the foreign corporation joint venture is not a CFC, then the U.S. joint venturer must complete and file certain portions of Form 5471 for the taxable year as described in the instructions to the form.

VII. CURRENCY GAINS AND LOSSES UNDER SECTION 987

A. Introduction

One area of operating partnerships and branches that is often overlooked is the application of the currency rules under section 987. This discussion only serves to highlight the issue for further analysis.

B. General Rule

Under 2006 proposed section 987 regulations, currency gain or loss is recognized upon a remittance of branch assets from the branch to the home office. Prop. Treas. Reg. § 1.987-1.

Gain or loss is also recognized upon a branch-to-branch remittance.

C. Reasonable Method

Proposed regulations issued in 2006 are significantly different from proposed regulations issued in 1991. As both of these regu-lations are proposed to apply prospectively, taxpayers must use any reasonable method to calculate and characterize for foreign tax credit purposes section 987 gain or loss that is consistent with the principles of the section 987 proposed regulations. See Prop. Treas. Reg. § 1.987-1 and Notice 2000-20, 2000-1 C.B. 851.

D. Form 8858

Form 8858 requires significant reporting by the disregarded entity, including section 987 gains and losses.

236


57

VIII. SPECIAL RULES APPLICABLE TO INBOUND HYBRID STRUCTURES

A. Payments to Hybrid Entities

Section 894 was amended in 1997 to address a concern that U.S. income tax treaties were being used to prevent any tax from being imposed on U.S. source income, as opposed to relieving double taxa-tion. In addition to section 894, discussed below, recent changes have been made to the Convention between the United States of America and Canada with respect to Taxes on Income and on Capital which would deny the benefits of certain reduced withholding rates in the case of dividend and interest payments by Canadian disregarded entities to their sole U.S. owner. See also, PLR 200626009 (March 9, 2006) and PLR 200522006 (March 4, 2005). 1. Example 1

Canco owns 100 percent of US Opco. Canco forms US LLC with

cash, which in turn lends the funds to US Opco. US LLC is a hybrid entity, treated as a corporation for Canadian purposes but as a branch of Canco for U.S. purposes. US Opco pays market rate interest to US LLC on the loan. a. Under prior law, for U.S. purposes, the interest payment

from US Opco to US LLC was treated as a payment directly to Canco since US LLC is disregarded from its owner. As Canco is a qualified resident of Canada under the U.S. - Canada income tax treaty, the rate of U.S. withholding tax was reduced from 30 percent to 10 percent. The interest

US LLC

Canco

US OpcoLoan(2)

Interest(3)

Equity(1)

US LLCUS LLC

Canco

US OpcoLoan(2)

Interest(3)

Equity(1)

237


58

expense was deductible for US Opco when paid (assuming section 163(j) did not apply).

b. For Canadian purposes, since US LLC is considered a cor-poration, the interest income is not recognized when received by US LLC. Instead, these earnings are converted to a divi-dend, which is excludable for Canadian tax purposes.

c. Section 894(c) denies treaty benefits where: (1) The income is derived by a foreign person via a hybrid

entity (i.e., an entity that is transparent for U.S. purposes but treated as a corporation for foreign purposes),

(2) The foreign person is not treated as deriving the income under the laws of the treaty jurisdiction,

(3) The applicable treaty does not contain a provision regard-ing the treatment of partnerships (e.g., Canada, Japan, Netherlands), and

(4) The foreign country does not impose tax on a distri-bution of the income from the hybrid to the foreign person.

d. Section 894 regulations allow treaty benefits where: (1) The payment is derived by a treaty country resident (as

determined under foreign law) and subject to tax in the applicable treaty jurisdiction;

(2) The resident is the beneficial owner of the payment, and (3) All other treaty requirements are satisfied. Treas. Reg.

§ 1.894-1(d). (4) In summary, section 894 regulations will deny benefits

if the recipient of the income is not taxed as a resident of the treaty country on that income.

e. Section 894 rules can be beneficial: By looking to foreign law, the new rules can result in treaty benefits where old law would not have, i.e., where the hybrid is a resident of a treaty jurisdiction and is subject to tax in that jurisdiction.

238


59

2. Example 2

TR is a resident of Country X, with which the U.S. has an income

tax treaty. For Country X purposes, Hybrid is considered to be a corporation, and is considered to be the recipient and beneficial owner of the FDAP payment. Hybrid is not subject to Country X tax as a resident of Country X. Thus, the U.S.-Country X treaty does not apply to reduce the rate of withholding on the FDAP payment.

3. Example 3

NTR is a resident of Country X, with which the U.S. does not

have an income tax treaty. Hybrid is a resident of Country Y, with which the U.S. has an income tax treaty. Under Country Y law, Hybrid is considered to be a corporation and is taxed as a resident. Thus, the U.S.-Country Y income tax treaty will apply to reduce the rate of withholding on the FDAP payment.

US

HybridNTR

TR(Country X)

FDAP

Treaty Country = X

TR is a resident of Country XHybrid is not transparentunder Country X laws

Hybrid is resident in a non-treaty jurisdiction

US

HybridNTR

HybridNTR

TR(Country X)

FDAP

Treaty Country = X

TR is a resident of Country XHybrid is not transparentunder Country X laws

Hybrid is resident in a non-treaty jurisdiction

US

Hybrid TRCountry

(Y)

NTR(Country X)

FDAP

Treaty Country = X NTR is a non-treaty resident

Hybrid TR is a resident ofCountry YCountry Y treats Hybrid TR asa corporation subject to tax

US

Hybrid TRCountry

(Y)

Hybrid TRCountry

(Y)

NTR(Country X)

FDAP

Treaty Country = X NTR is a non-treaty resident

Hybrid TR is a resident ofCountry YCountry Y treats Hybrid TR asa corporation subject to tax

239


60

B. Payments By Domestic Reverse Hybrid Entities

Under section 894 generally, an interest payment by a domestic reverse hybrid entity will be characterized as a dividend for all pur-poses of the IRC if it is made to a related foreign interest holder and relates to a dividend received by the domestic reverse hybrid entity. 1. General Rule Under the general rule, U.S. tax law will apply to determine the

character of payments by a domestic reverse hybrid entity to an interest holder in such entity. This means that U.S. tax principles are first applied to characterize the item of income paid by the domestic reverse hybrid entity to the interest holder for purposes of applying an applicable income tax treaty provision. Once the item is so characterized, it is necessary to determine if the interest holder “derives” the item of income. If the interest holder is not fiscally transparent, then it will be considered to have derived the item of income. The general rule is intended to make clear that treaty benefits will generally apply to a payment by a domestic reverse hybrid entity, unless the payment is affected by the special rule, or the anti-abuse rule, both discussed below. Treas. Reg. § 1.894-1(d)(2)(ii)(A).

2. Special Rule Based on the preamble, IRS and Treasury drafted the regulations

to expressly target the following Base Case structure:

FP, a foreign parent that is resident in Country X (a treaty

jurisdiction with no withholding tax on interest and royalties, and a five percent withholding tax on dividends) forms DRH, a domestic reverse hybrid entity with a combination of debt and

FP

US

DRH

2Payment

1Div

FP

US

DRHDRH

2Payment

1Div

240


61

equity. DRH owns all of the stock of US, a U.S. operating company

US makes a payment of $100 to DRH that is treated as a dividend for Country X purposes; and

DRH then makes a payment of $100 to FP that is deductible for U.S. tax purposes (the “Payment”) e.g., an interest or royalty payment, which is eligible for a zero withholding tax rate (notwithstanding this Special Rule).

Under the Base Case, FP will be a “related foreign interest holder” of DRH. Accordingly, under the special rule, the $100 Payment by DRH to FP (the related foreign interest holder) will be characterized as a dividend for all purposes of the Code. Note: The payment will be treated as a dividend to the extent the amount of the payment by DRH does not exceed the total amount of FP’s proportionate share of dividend payments by US to DRH. In this case, the $100 payment does not exceed the $100 prior dividend payment. As such, a U.S. deduction for the payment will be dis-allowed, and the withholding tax rate applicable to dividends shall apply. See Treas. Reg. § 1.894-1(d)(2)(ii)(B).

3. Anti-Abuse Rule The regulations also contain an extremely broad anti-abuse rule,

which provides that “[t]he Commissioner may… recharacterize for all purposes of the Internal Revenue Code all or part of any trans-action (or series of transactions) between related parties if the effect of the transaction (or series of transactions) is to avoid the principles of [these rules].” Treas. Reg. § 1.894-1(d)(2)(ii)(C).

IX. SECTION 385 REGULATIONS: FINAL/TEMPORARY REGULATIONS ADDRESS TREATMENT OF CERTAIN INTERESTS IN CORPORATIONS AS STOCK OR INDEBTEDNESS

On October 13, 2016, the United States Treasury and the IRS released final and temporary regulations under section 385 of the Internal Revenue Code (the “385 Regulations”) that (i) establish threshold documentation requirements that ordinarily must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for U.S. federal income tax purposes; and (ii) treat as stock certain related-party interests that otherwise would be treated as indebtedness for U.S. federal income tax purposes.7

241


62

Although the 385 Regulations were released on October 13, 2016, they were published on October 21, 2016, the date to be used for pur-poses of applying the effective dates described below.

The 385 Regulations follow the issuance of, and are significantly narrower in scope than the proposed regulations issued on April 4, 2016, under section 385 (the “Proposed Regulations”) that would have authorized the IRS to treat certain related-party interests as part stock and part debt for federal tax purposes; (ii) established contemporaneous documentation requirements that must be satisfied for certain related-party debt to be respected for federal tax purposes; and (iii) treated certain related-party debt as stock for all purposes of the Code when issued in connection with certain distributions and acquisitions.8

A. Scope

The 385 Regulations apply to debt instruments issued by a domes-tic corporation to certain related persons. More specifically, the 385 Regulations apply to debt instruments that are: (i) issued by a “covered member,” which is currently defined to mean a domestic corporation, or a disregarded entity of a covered member; and (ii) held by a member of the domestic corporation’s “expanded group,” which generally includes all corporations connected to a common parent that owns, directly or indirectly, 80% of the vote or value of each such corporation. 1. Exclusion of foreign issuers – The term “covered member” is

not currently defined to include foreign issuers (including CFCs) and the 385 Regulations reserve on all aspects of their application to foreign issuers (including CFCs). The preamble to the 385 Regu-lations (the “Preamble”) indicates that any guidance that may sub-sequently be issued with respect to foreign issuers will apply prospectively only.

2. Exclusion of S corporations and non-controlled RICs and REITs – S corporations and non-controlled regulated investment companies (RICs) and real estate investment trusts (REITs) are exempt from all aspects of the 385 Regulations.

3. Exclusion of debt instruments held by a consolidated group member. Debt instruments between members of the same consolidated group are generally outside the scope of the 385 Regulations. The 385 Regulations target the inbound financing of a foreign-

parented multinational group’s domestic subsidiaries, but do not cur-rently address the financing of such group’s U.S. branch operations.

242


63

Further, the 385 Regulations can be expected to have limited appli-cation to U.S.-parented multinational groups, particularly where the group’s domestic corporations join in filing a consolidated return.

Bifurcation Rule Eliminated: Unlike the Proposed Regulations, the 385 Regulations do not include a general bifurcation rule, which would have allowed the IRS to treat a single instrument as part debt and part equity.

B. Documentation Rules

1. Treasury Regulation §1.385-2 (the “Documentation Rules”) imposes contemporaneous documentation requirements on certain related-party debt instruments as a prerequisite to treating such instruments as debt. The rules generally require written documentation of the following four indebtedness factors (the “Indebtedness Factors”): (i) the issuer’s unconditional obligation to pay a sum certain, (ii) the holder’s rights as a creditor, (iii) the issuer’s ability to repay the obligation, and (iv) the issuer’s and holder’s actions evidenc-ing a debtor-creditor relationship, such as payments of interest or principal and actions taken on default. With respect to credit facili-ties, revolvers, omnibus, master and cash pooling arrangements, the Documentation Rules provide special rules to satisfy Indebtedness Factors (i) through (iii).

2. Extension of period required for timely preparation – The 385 Regulations eliminate the Proposed Regulations’ 30-day timely preparation requirement, and instead treat documentation and financial analysis as timely prepared if it is prepared by the time that the issuer’s federal income tax return is filed (taking into account all applicable extensions).

3. Rebuttable presumption based on compliance with documentation requirements – The 385 Regulations provide that, if an expanded group is otherwise generally compliant with the documentation requirements, then a rebuttable presumption, rather than the per se recharacterization as stock, applies in the event of a docu-mentation failure with respect to a purported debt instrument.

4. Annual credit analysis – The 385 Regulations provide that an annual credit analysis may be used to support an issuer’s ability to repay multiple debt instruments, rather than requiring separate credit analyses for each debt issuance. An annual credit analysis cannot be used, however, after the issuer suffers a “material

243


64

event,” which generally includes, but is not limited to, bank-ruptcy, insolvency, and disposition of more than 50% of the FMV of its assets. The rules also provide that the analysis of an issuer’s ability to repay can assume that the principal amount of a debt instrument will be satisfied with the proceeds of another borrowing by the issuer, provided that such assumption is reasonable.

5. Notional cash pooling arrangements are potentially in scope – The 385 Regulations provide that the written documentation require-ments for Indebtedness Factors (i) and (ii) that are otherwise applicable to credit facilities, revolvers, omnibus, master and cash pooling arrangements are also applicable to notional cash pooling arrangements, if such arrangements would be treated as debt issued between expanded group members.

6. Trade payables – The 385 Regulations clarify that master agree-ments can be used to satisfy the written documentation requirements for trade payables.

7. Treatment of disregarded entities – Unlike the Proposed Regu-lations, the 385 regulations provide that if a debt instrument issued by a disregarded entity (“DRE”) is recharacterized as equity due to failure to satisfy the Documentation Rules, then such debt will be treated as equity in the covered member that owns the issuing DRE. In other words, failing the Documentation Rules will not spring a DRE into a partnership.

8. Treatment of debt instruments issued by controlled partnerships – The 385 Regulations also exclude debt instruments issued by con-trolled partnerships from the Documentation Rules, unless issued with a principal purpose of avoiding the application of the Docu-mentation Rules.

9. Effective dates – In general, the documentation rules apply to taxable years ending on or after January 19, 2017. a. Delayed implementation – The 385 Regulations apply only

to debt instruments issued on or after January 1, 2018. b. The 385 Regulations also exclude debt instruments issued

by controlled partnerships from the Documentation Rules, unless issued with a principal purpose of avoiding the appli-cation of the Documentation Rules.

10. As a general matter, the 385 Regulations are less strict and more administrable than the Proposed Regulations. Similar to the

244


65

Proposed Regulations, however, it is unclear how a cash pool header that takes on deposits would evidence its ability to repay. Further, while the 385 Regulations do not automatically disregard notional cash pooling arrangements as conduits, the reference to such arrangements suggests that the government will pay more attention to them in the future; accordingly, taxpayers should recon-sider the documentation and operation of their notional cash pooling arrangements. Finally, despite the delayed implementation date, taxpayers should consider preparing written documentation of the four indebtedness factors for debt instruments issued prior to January 1, 2018 under general U.S. federal income tax principles.

C. Debt Recast Rules:

Treasury Regulation §1.385-3 and Temporary Treasury Regulation 1.385-3T (together, the “Debt Recast Rules”) generally adopt the following operative rules of the Proposed Regulations in targeting debt instruments issued in connection with distributions and certain acquisitions by members of the Expanded Group: 1. A “General Rule” that applies if a domestic corporation distributes a

debt instrument, or issues a debt instrument as consideration to acquire expanded group stock or issues a debt instrument as boot that is received by an expanded group member in an asset reorganization; and

2. A “Funding Rule” that generally recharacterizes certain debt as equity if a domestic corporation distributes property other than debt, acquires stock for property other than debt, or issues boot other than debt in an asset reorganization, if the domestic cor-poration has issued such debt instrument within a 36-month period before or after one of the foregoing transactions, or the debt was otherwise issued with a principal purpose of funding one of the foregoing transactions.

3. As compared to the Proposed Regulations, the 385 Regulations incorporate the following significant changes:

D. Certain Debt Instruments Excluded

The following debt instruments are excluded from the scope of the Debt Recast Rules: (i) debt instruments issued before April 5, 2016; (ii) debt instruments issued by a regulated financial or insurance company, in each case as defined in the 385 Regulations; (iii) certain

245


66

debt instruments that are issued by a domestic corporation to, or acquired by, a dealer in securities; and (iv) certain short-term debt instruments that are either issued for property other than money in the ordinary course of business, or have a short term and meet a number of conditions in the 385 Regulations.

E. Expanded and Added Exceptions

1. Subsidiary stock exception – The 385 Regulations retain and broaden the subsidiary stock exception in the Proposed Regu-lations to cover not only acquisitions of expanded group stock by issuance, but also acquisitions of expanded group stock from other members of the Expanded Group, in each case so long as the acquirer controls the issuer or seller immediately after the acqui-sition. As with the Proposed Regulations, control means direct or indirect ownership of 50 percent of the combined voting power and value of the corporation.

2. Earnings & profits exception – The earnings and profits exception has been retained and continues to apply by reducing the amount of debt reclassified as stock based on the order in which the prohibited transactions occur. However, the exception has been broadened to include not only current earnings and profits but also earnings and profits that were accumulated by the member in taxable years ending on or after April 5, 2016. The exception provides several limitations and anti-avoidance provisions. Pri-marily, the amount of earnings and profits available to reduce pro-hibited transactions engaged in by the domestic corporation is limited to only those earnings and profits that were accumulated by the domestic corporation while it continued to have the same expanded group parent. In addition, there is a “look-through” rule that disregards earnings and profits of lower-tier subsidiaries that are distributed up the chain of ownership if, generally, those earnings and profits were accumulated in taxable years ending before April 5, 2016, or were accumulated while the distributee was a member of a different expanded group.

3. “Net equity” contribution exception – There is a new exception for “net equity” contributions, where contributions of certain types of property to a corporation in exchange for its stock within a specified time frame may be applied to reduce the amount of prohibited transactions undertaken by the transferee corporation.

246


67

The reduction is applied based on the order in which prohibited transactions have been undertaken by the transferee corporation.

4. Threshold exception – The “cliff effect” of the threshold exception under the Proposed Regulations is removed, so that the first $50 million of debt instruments (measured by reference to adjusted issue price) is exempt from recharacterization, regardless of whether a taxpayer has issued more than $50 million of debt instruments that are subject to recharacterization under the 385 Regulations.

F. Other new exceptions –

The 385 Regulations also incorporate a number of new excep-tions, such as (i) acquisitions of stock to be used as equity com-pensation that is delivered to individuals that are employees, directors, and independent contractors as consideration for the provision of services, (ii) deemed distributions or acquisitions resulting from trans-fer pricing adjustments, (iii) acquisitions of stock by dealers in securities, and (iv) an exception to address the “cascading problem” by exempting acquisitions of expanded group stock resulting from the application of the rules as being treated as giving rise to additional prohibited trans-actions that could cause the 385 Regulations to apply again.

G. Treatment of Controlled Partnerships:

1. For purposes of the General and Funding Rules, the 385 Regu-lations adopt an aggregate approach to controlled partnerships. If there is an event that would otherwise result in the treatment of a controlled partnership’s debt instrument as equity, in lieu of rechar-acterizing the debt instrument as stock, the expanded group member that holds the debt instrument is deemed to contribute its receiv-able from the controlled partnership to the expanded group partner that undertook the distribution or acquisition in exchange for stock in that expanded group partner (but only if the expanded group partner is otherwise a covered member). This is known as the “deemed conduit approach.”

2. Scrutiny of partnership preferred equity – The Treasury Department and the IRS state in the Preamble that they intend to closely scrutinize, and may challenge under the anti-abuse rule, trans-actions in which a controlled partnership issues preferred equity to an expanded group member and the Debt Recast Rules

247


68

would have applied had the preferred equity been denominated as a debt instrument issued by the partnership.

H. Effective Dates:

1. Subject to certain transition rules, the Treas. Reg. §1.385-3 gen-erally applies 90 days after the date on which the regulations are published in the Federal Register. For debt instruments that have been issued after April 4, 2016, but on or before January 19, 2017, and where the 385 Regulations would have applied to rechar-acterize them as stock during this period, the debt instruments will not be recharacterized as stock until January 20, 2017.

2. There are additional transition rules that deal with the treatment of certain payments with respect to such debt instruments outstanding during this transition period, as well as a rule that avoids double counting such debt instruments as both within the scope of the General Rule and the Funding Rule.

3. Finally, the 385 Regulations provide an option to taxpayers to elect to apply the Proposed Regulations in lieu of the 385 Regu-lations for specific issuers (and members of its expanded group that are domestic corporations) during the period from April 4, 2016, through October 13, 2016. The option is solely for the pur-pose of determining if a debt instrument is treated as stock and must be consistently applied by the taxpayer.

I. Consolidated Group Rules:

1. Like the Proposed Regulations, the 385 Regulations treat members of a consolidated group as one corporation for purposes of applying the Debt Recast Rules. Generally, the Temporary Treasury Regu-lation§1.385-4T does not apply to issuances of interests and related transactions among members of a consolidated group, because the concerns addressed therein generally are not present when the issuer’s deduction for interest expense and the holder’s corre-sponding interest income offset each other in the group’s con-solidated federal income tax return. Special rules apply, however, when a debt instrument becomes, or ceases to be, a consolidated group debt instrument, or a consolidated group member that is a party to a debt instrument becomes, or ceases to be, a consolidated group member.

248


69

2. Use of Foreign Holding Companies: Although the Preamble to the Proposed Regulations asked for comments on whether to extend the proposed regulations to indebtedness issued by certain “blocker” entities to investment partnerships, the 385 Regulations do not adopt special rules for debt instruments in the context of investment partnerships, including indebtedness issued by certain “blocker” entities. However, Treasury and the IRS noted that they will con-tinue to study these structures and transactions.

J. State Tax Implications:

1. The proposed regulations had required that “all members of a consolidated group (as defined in §1.1502-1(h)) are treated as one corporation” for purposes of applying both the documentation rules and the debt recast rules. The temporary regulations now pro-vide that, for purposes of applying the consolidated group rules and prohibited leveraging rules, “all members of a consolidated group (as defined in §1.1502-1(h)) that file (or that are required to file) consolidated U.S. federal income tax return are treated as one corporation.” For purposes of the documentation rules, the final regulations now exempt from the documentation require-ments an intercompany obligation defined in the consolidated return rules as an obligation between members of the consolidated group (Treas. Reg. §1.1502-13(g)(2)(ii)), or an interest issued by one member of a consolidated group and held by another member of the same consolidated group.

2. According to the Preamble, the change to the language applicable to the prohibited leveraging rules was adopted by the Treasury in response to a commenter’s concern that “if a state applies the one-corporation rule based on the composition of the state filing group rather than the federal consolidated group, transactions could be subject to the regulations for state income tax purposes even when the transactions are not subject to the regulations for federal income tax purposes.” A comment suggesting all domestic cor-porations under common control be treated as one corporation, regardless of whether such corporations elected to file a consoli-dated return, was not adopted. State implications could include: a. Separate entity application of the rules in states with statutory

requirements to compute taxable income beginning with pro forma separate federal taxable income;

249


70

b. Differing combined group filing thresholds, including 50 per-cent ownership requirement, worldwide filings, and inclusion or exclusion of entities with a certain percentage of appor-tionment factors within or outside the U.S. (80/20 companies); and

c. Differing earnings and profits and basis, absent application of the consolidated return regulations.

X. PROPOSED AND FINAL SECTION 956 REGULATIONS

A. Overview:

On November 3, 2016, the Internal Revenue Service (“IRS”) and U.S. Department of the Treasury issued final subpart F regulations (the “Final Regulations”) addressing sections 954 and 956.9 The reg-ulations generally adopt, with amendments, the temporary and pro-posed regulations that were issued on September 1, 2015.10,11 Along with the Final Regulations the IRS and Treasury issued additional proposed section 956 regulations.12

B. Structures Impacted

The following typical transactions and structures are impacted by the Final Regulations: 1. Controlled foreign corporations (“CFCs”) that are partners in part-

nerships that acquire U.S. property and make loans to, or guar-antee debt of, related U.S. persons

2. Taxpayers relying on the outside basis limitation for purposes of determining the amount of U.S. property held by a CFC indirectly through a partnership in accordance with Rev. Rul. 90-112

3. CFCs that make loans to domestic or foreign partnerships with related partners

4. CFCs that engage in related party factoring transactions 5. Taxpayers that rely on the activities conducted pursuant to a cost

sharing agreement to meet the “developer exception” and “active marketing exception” under Treas. Reg. §1.954-2

250


71

C. Changes to Section 954(c) Active Trade or Business Exception

The Final Regulations finalize the changes in the Temporary Reg-ulations regarding the developer exceptions and active marketing excep-tions under Treas. Reg. §1.954-2(c) (for rents) and Treas. Reg. §1.954-2(d)(for royalties) that address, among other things, cost sharing transaction (CST) payments and platform contribution transaction (PCT) payments.

D. Section 956 Anti-abuse

The Final expand the scope of the section 956 anti-abuse rule (addressing the funding by a CFC of a certain related parties followed by such party acquiring U.S. property). In particular and consistent with the temporary regulations, the anti-abuse rule now applies if the CFC funds a controlled partnership.13 In addition, the anti-abuse rule extends to cases where the funding that was done for section 956-avoid-ance purposes was funding “by any means” (i.e., funding through a means other than capital contributions or debt).14 1. Limitations to the Scope of the Anti-Abuse Rule The Final Regulations include examples illustrating that sales of

property for cash in the ordinary course of business or a repay-ment of a note are not subject to the anti-abuse rule.15 In addition, the Final Regulations expand the coordination rule preventing a CFC from being treated as holding duplicative amounts of United States property by reason of the anti-abuse rule of Treas. Reg. §1. 956-1(b)(4) and attribution rules of Treas. Reg. §1.956-4(b) or (c) (see below).16

E. Assets (Including Obligations) Held by a Partnership

1. The Final Regulations provide that the amount of section 956 prop-erty attributed to a CFC partner from a partnership is determined by reference to the partner’s “liquidation value percentage.”17 The Final Regulations retain the rule that applies the liquidation value percentage taking into account special allocations.18 However, this provision does not apply if a principal purpose of the special allocation is to avoid the application of section 956.19 Further, the preamble clarifies that section 704(c) is not a special allocation.20

2. It is important to note that the IRS and Treasury also proposed a new regulation that would eliminate the ability take into account

251


72

special allocations when applying the liquidation value method with respect to any partner that controls the partnership.21

3. Under the 2015 Proposed Regulations, a partner’s liquidation value percentage is determined upon formation and upon a revaluation event.22 The Final Regulations retain these provisions but add an additional rule whereby if the liquidation value percentage deter-mined for any partner on the first day of the partnership’s taxable year would differ from the most recently determined liquidation value percentage of that partner by more than 10 percentage points, then the liquidation value percentage must be redetermined.23 For example, as explained in the preamble, if the liquidation value percentage of a partner was determined upon a revaluation event to be 40 percent and, on the first day of a subsequent year before the occurrence of another revaluation event, the liquidation value percentage would be less than 30 percent or more than 50 percent if redetermined on that day, then the liquidation value percentage must be redetermined on that day.24

4. Under the Final Regulations, the amount of a partnership’s U.S. property that is attributed to its partners is based upon the part-nership’s basis in such property.25 Rev. Rul. 90-112, which limited the amount of U.S. property attributed to the partner to its outside basis in the partnership, is obsolete as of November 3, 2016.26 Accordingly, taxpayers no longer can rely on outside basis to limit the amount of U.S. property held by a CFC indirectly through a partnership.

F. Obligations of a Partnership

1. In general a. The Final Regulations treat the obligation of a foreign part-

nership as an obligation of its partners. The Final Regulations attribute the obligations of a foreign partnership to its part-ners by reference to the partner’s Liquidation Value Percentage (discussed above).27 This is a change from the 2015 Pro-posed Regulations, which attributed obligations of a part-nership based upon a partner’s interest in profits.28

b. Consistent with the 2015 Proposed Regulations, the Final Regulations provide an exception to this general rule where neither the CFC that holds (or is treated as holding) the obli-gation nor any person related to such CFC (within the meaning

252


73

of section 954(d)(3)) is a partner in the partnership on the CFC’s quarterly measuring date under section 956.29

c. The Final Regulations also provide that an obligation of a domestic partnership is treated as an obligation of a United States person.30

G. Anti-Abuse Distribution Rule

1. In addition, the Final Regulations include a special funded dis-tribution rule which applies where a CFC makes a loan to a part-nership and the partnership makes a distribution to a partner (who is related to the CFC within the meaning of section 954(d)(3)) whose obligation would be treated as U.S. property if held by the CFC, if the partnership would not have made the distribution but for the funding of the partnership.31 In such a case, the partner’s share of the partnership’s obligation is the greater of (i) its share under the Liquidation Value Percentage method or (ii) the lesser of the amount of the distribution that would not have been distributed but for the funding and the amount of the obligation.32

2. The Final Regulations add a new rule that provides that a part-nership is treated as if it would not have made the distribution but for the funding of the partnership by a related CFC to the extent that, immediately before the distribution, the partnership does not have sufficient liquid assets to make the distribution without taking the obligations into account.33

H. Guarantees

The Final Regulations finalize rules addressing pledges and guar-antees of a partnership.34 However, the preamble declined to provide a rule to protect a U.S. person from multiple section 956 inclusions with regard to the same loan, where multiple CFCs serve as pledgors or guarantors with regard to the same section 956 loan.35 The pre-amble states that Treasury and the IRS continue to study the issue.

I. Factoring Transactions

1. The Final Regulations finalize the 1988 and 2015 temporary reg-ulations under Treas. Reg. §1.956-3 addressing various factoring transactions. The Final Regulations provide rules for treating indirect acquisitions of trade or service receivables as acquired by a CFC.36 The Final Regulations also treat a CFC as acquiring the

253


74

trade or service receivable of a related U.S. person where unrelated parties engage in swap or pooling arrangements such that the parties engage in reciprocal acquisitions of the trade or service receivable from an unrelated U.S. person that is a party to the arrangement.37

2. A CFC is also treated as indirectly acquiring the trade or service receivable from a related U.S. person where the CFC participates in a lending transaction that results in (i) a loan to a U.S. person who purchases inventory property or services from a related U.S. person or (ii) the purchases of trade or service receivables from a related U.S. person, if the loan would not have been made or main-tained on the same terms but for the corresponding purchase.38 The amount of the U.S. property is the lesser of the amount of the loan and the purchase price.39

J. Effective Dates

1. All but four rules apply with respect to obligations, guarantees or property acquired after September 1, 2015. For these items, the CFC becomes subject to the rules for any taxable year that ends on or after November 3, 2016.

2. The rules with different effective dates are: a. Changes to the “developer exceptions” and “active marketing

exceptions,” which generally apply beginning September 1, 2015

b. The rule providing that an obligation of a domestic part-nership is an obligation of a US person, which applies to prop-erty acquired after November 3, 2016

c. Rev. Rul. 90-112 is obsolete effective November 3, 2016 d. The rules that attribute property held by a partnership that

is attributed to its partners under Treas. Reg. §1.956-4(b) only apply to a CFC’s taxable year that ends on or after November 3, 2016 with regard to property acquired on or after November 3, 2016. Former Treas. Reg. §1.956-3(a)(3) applies for taxable years of a CFC prior to this date.

The 2016 Proposed Regulations addressing special allocations under the Liquidation Value Method are only effective with respect to taxable years of a CFC ending on or after the publication of the final rule adopting the proposed regulation with respect to property acquired on or after such date.40

254


75

1. Unless otherwise provided herein, all section references refer to the Internal Revenue Code of 1986, as amended.

2. See paragraph C.6, below for a more detailed discussion of this issue. 3. See paragraph IV.B, below for a more detailed discussion of the limitations on the

allocations of foreign tax credits by a partnership. 4. See paragraph VI.B, below for a more detailed discussion of this issue. 5. See paragraph VI.A, below for a more detailed discussion of this issue. 6. See House Ways and Means Committee Report on the Tax Reform Act of 1984,

H.R. Rep. No. 432, 98th Cong., 2d Sess. (1984) at 1317; see also Senate Finance Com-mittee Report on the Deficit Reduction Act of 1984, S. Rep. No. 169, 98th Cong., 2d Sess. (1984) at 362; see also Letter from Gretchen Sierra, Chris Trump, and Paul Crispino, Deloitte Tax LLP, to IRS and Treasury (Dec. 15, 2015), available at http://www.taxnotes.com/tax-notes-today/transfer-pricing/deloitte-seeks-withdrawal- proposed-intangible-transfer-regs/2015/12/17/18128.

7. TD 9790. 8. REG 108060-15, 81 Fed. Reg. 20912. 9. T.D. 9792, 81 FR 76497 (Nov. 3, 2016). 10. T.D. 9733, 80 Fed. Reg. 52976 (Sept. 2, 2015) (the “2015 Temporary Regula-

tions”); REG-155164-09, 80 Fed. Reg. 53058 (Sept. 2, 2015) (the “2015 Proposed Regulations”).

11. Id. 12. REG-114734-16, 81 FR 76542 (Nov. 3, 2016) (the “2016 Proposed Regulations”). 13. Treas. Reg. §1.956-1(b)(1)(ii) and (iii). 14. Id. 15. See Treas. Reg. § 1.956-1(b)(4) Examples 4-6. 16. Treas. Reg. §1.956-1(b)(3). 17. Treas. Reg. §1.956-4(b). In general, this percentage is based on a partner’s relative

rights to cash upon a hypothetical partnership liquidation. 18. Treas. Reg. §1.956-1(b)(2). 19. Id. 20. See the preamble to TD 9792 (“the Preamble”), Section 4.D “Special Allo-

cations,” 81 FR at 76500-501. 21. Prop. Reg. §1.956-4(b)(2)(ii) and (3) Examples 2-4. 22. Former Prop. Reg. §1.956-4(b)(2)(i). 23. Treas. Reg. §1.956-4(b)(2)(i)(B). 24. See the Preamble, Section 4.C “Time for determining the liquidation value per-

centage” 81 FR at 76500. 25. Treas. Reg. §1.956-4(b)(1) 26. See the Preamble, “Effect on Other Documents,” 81 FR at 76504. 27. Treas. Reg. §1.956-4(c)(1). 28. Former Prop. Reg. § 1.956-4(c)(1). 29. Treas. Reg. §1.956-4(c)(2). 30. Treas. Reg. §1.956-4(e). 31. Treas. Reg. §1.956-4(c)(3). 32. Id. 33. Treas. Reg. §1.956-4(c)(3)(ii). 34. Treas. Reg. §1.956-2(c). 35. See the Preamble, Section 6 “Comments concerning multiple inclusions,” 81 FR

at 76503.

255


76

36. Treas. Reg. §1.956-3(b)(2). 37. Treas. Reg. §1.956-3(b)(2)(iii). 38. Treas. Reg. §1.956-3(b)(2)(iv). 39. Id. 40. Prop. Reg. §1.956-4(f)(1).

256


NOTES

257


NOTES

258

International Tax Issues New York City...

Documents

Transcript of International Tax Issues New York City...