Cash D Reorganizations

Cash D Reorganizations–Selected International Issues

By Lowell D. Yoder, Esq. McDermott Will & Emery LLP, Chicago, IL

Cash D Reorganizations–Selected International Issues

By Lowell D. Yoder, Esq. McDermott Will & Emery LLP, Chicago, IL

A U.S. multinational may restructure its foreign subsidiaries through asset reorganizations to achieve certain business objectives, such as integrating newly-acquired businesses with existing businesses. Such transactions may be implemented by one foreign subsidiary acquiring the assets of another foreign subsidiary in exchange for its stock, followed by the target liquidating into its parent, distributing the stock of the acquirer. Pursuant to §368(a)(1)(D), such a reorganization should be tax-free.

Alternatively, the acquiring subsidiary may purchase the target’s assets for cash and other property, followed by the liquidation of the target. This transaction also should qualify as a reorganization under §368(a)(1)(D) (a “cash D reorganization”). The target’s transfer of its assets for cash or other property should be tax-free. On the other hand, the target’s distribution of the cash or other property (“boot”) in liquidation may result in taxable income to the target’s shareholder.

This commentary discusses certain international tax issues with respect to cash D reorganizations where the acquiring and target corporations are controlled foreign corporations (CFCs). Under scenario one, both CFCs are directly owned by a U.S. parent corporation (USP). Under scenario two, the acquiring CFC (CFCA) is owned by USP, and the target CFC (CFCT) is owned by a domestic subsidiary of USP (DS). CFCA acquires all of the assets of CFCT for cash, and CFCT distributes the cash in liquidation to USP or DS. The transactions are carried out for important business purposes.

D REORGANIZATION

Case law and IRS rulings hold that, where the acquirer and target are directly owned by the same corporation (i.e., scenario one), the purchase by the acquirer of the assets of the target solely for cash followed by a liquidation of the target into its parent will not be treated as a §1001 sales transaction followed by a liquidation. Rather, such transaction is treated as a reorganization within the meaning of §368(a)(1)(D), even though the acquirer does not issue any stock in the transaction.¹

The authorities recognize that §368(a)(1)(D) contemplates an issuance of stock and securities by the acquirer for the target’s assets and a distribution of such stock by the target to its shareholder. Nevertheless, since USP already owns all of the stock of CFCA, the issuance of additional shares by CFCA is considered a “meaningless gesture.” Accordingly, any stock distribution requirement is deemed satisfied.

Temporary regulations issued in December of 2006 expressly address the above transaction, and provide that it satisfies the §368(a)(1)(D) requirements. With respect to the stock distribution requirement, the regulations provide that CFCA is deemed to issue a nominal share of stock to CFCT and the nominal share is then deemed distributed to USP.²

The temporary regulations also provide that §368(a)(1)(D) can apply where an acquirer purchases for cash the assets of a company that does not have the same direct shareholder, but where the acquirer and target are owned, directly or indirectly, by the same persons in identical proportions; i.e., a cross-chain transaction. Accordingly, in scenario two where CFCA is owned by USP and CFCT is owned by DS, the purchase of the assets of CFCT by CFCA solely for cash, followed by CFCT’s liquidation, should qualify as a D reorganization.³

When the target and acquirer are CFCs, §367 might require income recognition beyond what is provided in the Subchapter C provisions that apply to reorganizations involving only domestic corporations. The above transactions involve the merger of two CFCs that are both directly owned by U.S. shareholders. Section 367(a) should not apply under these circumstances because there is no transfer of stock or property from a U.S. person to a CFC.⁴ Section 367(b), which may apply to cause the earnings of a target CFC to be taxed currently, should not cause income recognition with the reorganizations addressed herein because the gain with respect to the CFCT stock is taxable.⁵

The above analysis should apply equally if CFCA acquired the stock of CFCT from USP or DS, followed by a liquidation of CFCT (or an election to disregard CFCT as separate from its owner). The IRS treats such a transaction as if CFCA acquired the assets of CFCT, followed by CFCT’s liquidation into USP or DS.⁶

TREATMENT OF BOOT

While the transfer by CFCT of its assets to CFCA for cash should be tax-free,⁷ the distribution of the cash by CFCT to its parent may result in taxable income.⁸ Such boot is taxable to the owner of CFCT to the extent of its gain in the CFCT stock (referred to herein as “§356(a)(1) gain” or “gain recognized under §356(a)(1)”).

Example. Assuming the ownership structures above, CFCA buys the assets of CFCT for $1,000, their fair market value. Thereafter, CFCT liquidates into USP (or DS) distributing the $1,000. USP (or DS) has a basis in the stock of CFCT of $700. Accordingly, USP (or DS) will recognize $300 of §356(a)(1) gain.⁹

Therefore, the amount included in income of the domestic shareholder of CFCT in a cash D reorganization is not the amount of cash ($1,000) or the amount of earnings and profits of CFCA and/or CFCT. Rather, it is the amount of gain the target’s shareholder would have recognized upon the sale of the CFCT stock (the §356(a)(1) gain).

The §356(a)(1) gain may be treated as a dividend or as capital gain. Where both the acquirer and target are directly or indirectly wholly owned by the same corporation, the amount characterized as a dividend depends on the earnings and profits of the target, and possibly those of the acquiring company. Although corporate tax rates are the same for ordinary income and capital gain, the character of the §356(a)(1) gain can have significantly different tax results. For example, capital gains may be offset by capital losses. On the other hand, as discussed below, U.S. tax on dividends may be reduced by foreign tax credits, and dividends may be treated as non-taxable distributions of previously taxed income.

It is clear that the earnings and profits of the target are taken into account for purpose of determining the character of the §356(a)(1) gain, but there is some uncertainty whether the earnings and profits of the acquirer also are taken into account. The IRS takes the position that the earnings and profits of both the target corporation and the acquiring corporation are taken into account, at least where the corporations are directly owned by the same shareholders.¹⁰ Some case law, however, supports looking only to the target’s earnings and profits.¹¹

Example. Assume the facts above, and, in addition, that CFCT has earnings and profits of $180 and CFCA has earnings and profits of $400. If only CFCT’s earnings and profits are taken into account, $180 of the §356(a)(1) gain would be treated as a dividend and $120 as capital gain. On the other hand, if CFCA’s earnings and profits also are taken into account, USP (or DS) would have $300 of dividend income.¹²

A taxpayer may be able to take either position under the current state of the law.¹³

To the extent a portion of the §356(a)(1) gain is treated as dividend income, one must consider the application of the foreign tax credit provisions. The IRS has expressly ruled that boot characterized as a dividend should be treated as a dividend for purposes of the foreign tax credit rules.¹⁴ Dividends received from a CFC normally are considered as foreign-source income¹⁵ that fall within the general limitation basket.¹⁶ Accordingly, §356(a)(1) gain in the above reorganizations, to the extent treated as a dividend from CFCT and CFCA, generally should be foreign-source, general basket income.

On the other hand, capital gain realized by a U.S. corporation generally is U.S.-source income.¹⁷ While under certain circumstances gain with respect to stock can be foreign-source income,¹⁸ it nevertheless would fall within the passive basket,¹⁹ and normally U.S. tax on the gain would not be reduced by foreign tax credits.

Dividends received by a domestic corporation from a CFC generally bring deemed-paid foreign tax credits. In order to qualify for deemed-paid credits, a U.S. corporation that receives the dividend must directly own 10% or more of the voting stock of the CFC.²⁰ For this purpose, a member of a consolidated group is not considered as owning shares in a CFC owned by other members of the group.²¹

In scenario one above (i.e., USP owns both CFCA and CFCT), any deemed dividends from CFCT and CFCA’s earnings and profits should be eligible to bring deemed-paid foreign tax credits, because USP satisfies the 10% ownership test with respect to both CFCs.

Example. Assume the facts above, and, in addition, CFCT has $20 of foreign tax credits associated with the $180 of earnings and profits. CFCA has earnings and profits of $400 and associated foreign tax credits of $400. If only CFCT’s earnings and profits are taken into account, such that only $180 of the §356(a)(1) gain is treated as a dividend, USP would be entitled to $20 of deemed-paid foreign tax credits. If CFCA’s earnings and profits also are taken into account, such that the entire $300 of the §356(a)(1) gain is a dividend, additional deemed-paid foreign tax credits should be available to USP.²²

Where the earnings and profits of both CFCs are taken into account, the ordering rules may effect the amount of deemed-paid credits. If CFCT’s earnings and profits are considered as distributed first, then only $140 of foreign tax credits are available ($20 + $120²³). On the other hand, if CFCA’s earnings and profits are taken into account first, then the amount of deemed-paid taxes should be $300 (300/400 x 400). Some commentators have suggested that CFCT’s earnings and profits are considered first, but there is no direct authority supporting that conclusion.²⁴

With respect to scenario two (DS owns CFCT and USP owns CFCA), the 10% voting stock requirement should be satisfied to the extent the §356(a)(1) gain is treated as a dividend sourced to the earnings and profits of CFCT. On the other hand, DS does not directly own any stock in CFCA, and there is no express authority addressing the 10% ownership test in the context of a cross-chain D reorganization. While deemed-paid credits should be available in scenario two from a policy perspective, and there are arguments that support such position,²⁵ the lack of express authority creates a degree of uncertainty.²⁶

The acquirer and target CFCs may have previously taxed income (PTI) as a result of the application of Subpart F. A U.S. shareholder that included Subpart F amounts in its income is not taxed again when the already-taxed earnings (i.e., PTI) are distributed to such U.S. shareholder (or its successor).²⁷

In scenario one, USP owns the stock of both CFCT and CFCA. Accordingly, any §356(a)(1) gain that is treated as a dividend sourced to the PTI of CFCT or CFCA generally should be excluded from USP’s income, since it would have included the corresponding Subpart F amounts in its gross income (or USP would be a successor-in-interest).²⁸

Whether the acquirer’s earnings and profits are taken into account, and if so the order earnings and profits are considered as deemed distributed as between CFCT and CFCA, will determine the amount of the recognized gain excluded from USP’s income as PTI. As indicated above, there are no clear ordering rules, although some commentators suggest that CFCT’s earnings are taken into account first.

Under scenario two (cross-chain transaction), §356(a)(1) gain treated as a distribution sourced to the PTI of CFCT should be excluded from the income of DS, since DS would have included the underlying Subpart F amounts in its gross income (or would be a successor-in-interest). On the other hand, under the current regulations, there does not appear to be express support for excluding from income the portion of §356(a)(1) gain that is treated as a distribution from CFCA’s PTI because DS is not the direct or indirect U.S. shareholder that included the CFCA Subpart F amounts in its gross income, nor is it a successor-in-interest.²⁹ Furthermore, even if CFCA’s PTI is excluded under §959(a), there is no rule to take into account the corresponding stock basis related to CFCA’s PTI (a distribution of PTI in excess of basis is gain).³⁰

The IRS issued proposed regulations that address various PTI issues. They generally treat a U.S. consolidated group as one U.S. shareholder for purposes of excluding PTI from gross income and taking into account basis associated with PTI.³¹ The proposed regulations should provide the same result as under the current regulations of excluding from gross income PTI deemed distributed by CFCT in scenarios one and two, and excluding from gross income PTI of CFCA in scenario one (although they do not provide ordering rules). The proposed regulations, however, do not expressly address whether §959 would apply to a deemed distribution of CFCA’s PTI to DS in scenario two, although the rationale of the proposed regulations of treating members of a consolidated group as one U.S. shareholder should apply the PTI and basis rules to such a distribution. The literal language of the regulations appears to require that DS directly or indirectly own some stock in CFCA to qualify for exclusion of PTI, and therefore, in the absence of owning such stock, the answer is not completely clear.³²

In summary, while the Subchapter C treatment of cash D reorganizations is now clearly established, there remains uncertainty concerning important international tax questions. Taxpayers should consider whether these questions are relevant to their particular circumstances, and take steps to structure the reorganization in a manner that addresses any concerns.

This commentary also will appear in the February 8, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Carr and Moetell, 902 T.M., Indirect Foreign Tax Credits, Davis, 920 T.M., Other Transfers Under Section 367, and Yoder & Kemm, 930 T.M., CFCs — Sections 959-965 and 1248, and in Tax Practice Series, see ¶7130, U.S. Persons’ Foreign Activities.

¹ See, e.g., Atlas Tool Co. v. Comr., 70 T.C. 86 (1978), aff’d, 614 F.2d 860 (3rd Cir. 1980); James Armour, Inc. v. Comr., 43 T.C. 295 (1964); Rev. Rul. 2004-83, 2004-32 I.R.B. 157; Rev. Rul. 70-240, 1970-1 C.B. 81.

² T.D. 9303, 71 Fed. Reg. 75879 (12/19/06); Regs. §1.368-2T(l)(1) & (2); see also (3), Ex. 1.

³ See Regs. §1.368-2T(l)(2)(ii) & (3), Ex. 3.

⁴ Regs. §1.367(a)-3(a). Section 367(a) would apply if CFCA dropped assets of CFCT down to a second-tier CFC. Regs. §1.367(a)-3(d)(1)(v). In such event, gain recognition could be avoided by filing a five-year gain recognition agreement. Regs. §1.367(a)-3(d)(1), -8. Note that the asset drop does not disqualify the D reorganization. Regs. §1.368-2(k)(1)(ii)(B)(1); Rev. Rul. 2002-85, 2002-2 C.B. 986, 989.

⁵ See Regs. §1.367(b)-4(b); see also Regs. §1.367(b)-2(c) (any potential income inclusion under Regs. §1.367(b)-4(b) is limited to the amount of gain with respect to the CFCT stock, which gain is otherwise subject to taxation under §356(a)(1)).

⁶ Rev. Rul. 2004-83, 2004-32 I.R.B. 157; Rev. Rul. 67-274, 1967-2 C.B. 141. Alternatively, if CFCT remained in existence, the transaction should be treated as a related party stock acquisition subject to §304. For an analysis of international issues concerning §304 transactions, see Yoder, “International Planning Using Code Sec. 304,” 33 Int’l Tax J. 3 (July-August 2007).

⁷ §361.

⁸ §356(a).

⁹ Under certain circumstances, it may be possible that additional gain could be recognized under §356(a)(1). The IRS has held that where a shareholder exchanges two blocks of stock having different basis amounts for cash or other non-stock property, gain or loss with respect to each block must be separately computed. SeeRev. Rul. 68-23, 1968-1 C.B. 144. As a result, a loss on one block may not offset the amount of gain recognized under §356(a)(1) with respect to another block of stock. In addition, under §356(c), the loss may not be separately recognized. Assume that in the above example USP (or DS) holds two blocks of CFCT shares with an equal number of shares in each block. Further assume that the blocks have an aggregate basis amount of $700 and $0 respectively. Under these circumstances, USP would realize a loss of $200 with respect to the high-basis block ($500 – $700) and gain of $500 with respect to the low-basis block ($500 – $0). Rev. Rul. 68-23 and §356(c) could potentially prevent USP from using the $200 loss to offset the $500 of gain, such that $500 of gain may be recognized under §356(a)(1). Note that §356(a)(1) gain could potentially be eliminated if CFCA acquires the CFCT assets for cash of $500 (rather than $1,000) and $500 of its stock. Regs. §1.358-2(a)(2)(ii) indicates that USP should be permitted to allocate the $500 of stock consideration to its low-basis block of stock and the $500 of cash consideration to its high-basis block of stock, such that no gain is recognized under §356(a)(1).

¹⁰ Rev. Rul. 70-240, 1970-1 C.B 81; Davant v. Comr., 366 F.2d 874 (5th Cir. 1966). These authorities address the scenario one structure, although the rationale may also apply to the scenario two structure (despite the “ratable share” language of §356(a)(2)). The recently issued §368 temporary regulations may support this view by looking to indirect ownership in applying the “meaningless gesture” principle to cross-chain cash D reorganizations. Regs. §1.368-2T(l)(2)(ii).

¹¹ American Mfg. Co. v. Comr., 55 T.C. 204, 229-331 (1970); Atlas Tool Co. v. Comr., 70 T.C. 86 (1978), aff’d, 614 F.2d 860 (3rd Cir. 1980); James Armour Inc. v. Comr., 43 T.C. 295 (1964). See also§356(a)(2), which appears to refer to the undistributed earnings and profits of the target corporation, rather than the earnings and profits of the acquiring corporation or both corporations.

¹² Any earnings and profits not deemed distributed should carry over to CFCA under §381, along with any associated foreign tax credits. Regs. §1.367(b)-7(b)(1).

¹³ The IRS should be bound by the position expressed in its revenue ruling. Dover v. Comr., 122 T.C. 324, 350 (2004); Rauenhorst v. Comr., 119 T.C. 157, 170-71 (2002).

¹⁴ Rev. Rul. 74-387, 1974-2 C.B. 207.

¹⁵ §§861(a)(2), 862(a)(2).

¹⁶ §904(d)(3); Regs. §1.904-5(c)(4)(i), (iv) Ex. 2

¹⁷ §865(a)(1), (g)(1)(A).

¹⁸ §865(f), (h).

¹⁹ Regs. §§1.904-4(b)(1)(i)(A), 1.904-5(c)(4)(iv), Ex. 2.

²⁰ §902(a).

²¹ First Chicago Corp. v. Comr., 96 T.C. 421 (1991), aff’d,135 F.3d 457 (7th Cir. 1998); Rev. Rul. 85-3, 1985-1 C.B. 222.

²² The amount of income of USP (or DS) would be increased by the amount of the deemed-paid taxes, i.e., grossed up. §78.

²³ 120 = 120/400 x 400.

²⁴ Another possible approach is to calculate the amount of deemed-paid taxes as if the earnings and profits of CFCT are combined with those of CFCA, and the §356(a)(1) dividend is treated as coming out of the combined pool, and such amount might be determined as of the end of CFCA’s taxable year. This would result in deemed-paid foreign tax credits of $217 (300/580 x 420). See Comr. v. Clark, 489 U.S. 726 (1989) (construct articulated in this case may support treating the distribution as made by CFCA out of the combined earnings). But see Regs. §1.381(c)(2)-1(c).

²⁵ The IRS has deemed the 10% ownership requirement to be satisfied in cross-chain §304 transactions (Rev. Rul. 91-5, 1991-1 C.B. 114; Rev. Rul. 92-86, 1992-2 C.B. 199, and it would seem appropriate to apply a similar analysis for cross-chain cash D reorganizations. See also Comr. v. Clark, supra (provides a redemption construct for cash D reorganizations similar to the §304 construct).

²⁶ See also Regs. §1.902-1T(a)(8) (foreign tax credits generally are removed from the post-1986 pool when the corresponding earnings are treated as being distributed). To address the 10% ownership issue, CFCA might issue 10% of a class of voting stock to CFCT in the D reorganization (or USP might contribute 10% of a class of voting stock in CFCA to DS prior to the reorganization).

²⁷ §959(a).

²⁸ The IRS has privately ruled that §959 applies to §356(a) distributions of boot out of PTI. PLRs 9349008, 9327010, 9117053, 8952048, and 8952041. An issue not expressly addressed is how the basis rules of §961 apply in the context of a PTI distribution pursuant to a “D” reorganization.

²⁹ In the context of a distribution in redemption of stock that was treated as a dividend, the IRS privately ruled that §959(b) did not apply to exclude PTI attributable to another chain of ownership, even though the two chains apparently were owned by different members of a consolidated group. PLR 9802018. On the other hand, the IRS has privately ruled that §959 applies to cross-chain §304 deemed dividends. PLR 9210031; PLR 9131059.

³⁰ §961(b)(2).

³¹ Prop. Regs. §1.959-3(g), REG-121509-00, 71 Fed. Reg. 51155 (8/29/06). See Yoder, “PTI Sharing Under the Proposed §959 Regulations,” 35 Tax Mgmt. Int’l J.636 (12/8/06).

³² Prop. Regs. §1.959-1(b)(4)(iii). It may be possible to take the position that the nominal share deemed issued under Regs. §1.368-2T(l) should satisfy this requirement. Alternatively, USP might transfer some shares of CFCA to DS prior to the reorganization to satisfy the ownership test in the proposed regulations. Note that the proposed regulations expressly apply the PTI rules to cross-chain §304 distributions of PTI. Prop. Regs. §1.959-2(b).