CFC Controlled Foreign Corporation Tax Problem?

Regs crack down on tax avoidance repatriations of CFC earnings
Preamble to TD 9402, 06/23/2008; Reg. § 1.956-1T; Preamble to Prop Reg 06/23/2008; Prop Reg § 1.956-1

Mike Habib, EA

IRS has issued temporary and proposed regs to determine the basis of certain U.S. property acquired by a controlled foreign corporation (CFC) in certain nonrecognition transactions that are intended to repatriate earnings and profits of the CFC without income inclusion by the U.S. shareholders of the CFC under Code Sec. 951(a)(1)(B).

Background. IRS is aware that certain taxpayers are engaging in certain nonrecognition transactions in which a CFC acquires certain U.S. property (within the meaning of Code Sec. 956(c)) without resulting in an income inclusion to the U.S. shareholders of the CFC under Code Sec. 951(a)(1)(B).

    Illustration: USP, a domestic corporation and the common parent of an affiliated group that files a consolidated tax return, owns 100% of the outstanding stock of US1 and US2, both domestic corporations that join USP in the filing of a consolidated tax return. US1 owns 100% of the stock of CFC, a controlled foreign corporation. US2 issues $100 million of its stock to CFC in exchange for $10 million of CFC stock and $90 million cash. USP takes the position that: (i) US2’s transfer of its stock to CFC in exchange for $10 million of CFC stock and $90 million cash is an exchange to which Code Sec. 351 applies; (ii) US2 recognizes no gain on the receipt of $10 million of CFC stock and $90 million cash in exchange for its stock under Code Sec. 1032(a) ; (iii) CFC recognizes no gain on the issuance of its stock to US2 under Code Sec. 1032(a) ; (iv) CFC’s basis in the US2 stock is zero under Code Sec. 362(a) ; and (v) US1 and US2 do not and will not have an income inclusion under Code Sec. 951(a)(1)(B) as a result of CFC holding the US2 stock (which constitutes U.S. property under Code Sec. 956(c) ). (Preamble to TD 9402, 06/23/2008)

IRS believes these transactions raise significant policy concerns because the transactions may have the effect of repatriating earnings and profits of a CFC without a corresponding dividend inclusion, or an income inclusion under Code Sec. 951(a)(1)(B) by reason of the CFC’s investment in U.S. property.

Code Sec. 956 was enacted to require an income inclusion by U.S. shareholders of a CFC that invests certain earnings and profits in U.S. property on the ground that the investment is substantially the equivalent of a dividend being paid to them.

Under Code Sec. 951(a)(1)(B), each U.S. shareholder (as defined in Code Sec. 951(b)) of a CFC (as defined in Code Sec. 957(a)) must include in its gross income for its tax year in which or with which the tax year of the CFC ends, the amount determined under Code Sec. 956 with respect to such shareholder for such year (but only to the extent not excluded from gross income under Code Sec. 959(a)(2)).

Regs under Code Sec. 367(b) prevent the repatriation of a U.S. person’s share of earnings and profits of a foreign corporation through what would otherwise be a nonrecognition transaction.

Under Code Sec. 362(a), for property acquired by a corporation in connection with a Code Sec. 351 transaction (relating to transfer of property to corporation controlled by transferor), the basis is the same as it would be in the hands of the transferor, increased by the amount of any gain recognized to the transferor on the transfer.

No gain or loss is recognized to a corporation on the receipt of money or other property in exchange for stock of that corporation. (Code Sec. 1032)

Temporary regs. When a CFC acquires stock or obligations of a domestic issuing corporation, that constitute U.S. property under Code Sec. 956(c), from such corporation pursuant to an exchange in which the CFC’s basis in the property is determined under Code Sec. 362(a), the temporary regs apply. As a result, solely for Code Sec. 956 purposes, the temporary regs cause the CFC’s basis in the property to be no less than the fair market value of the property transferred by the CFC in exchange for the property. For this purpose, “property” has the meaning set forth in Code Sec. 317(a), but includes any liability assumed by the CFC in connection with the exchange notwithstanding Code Sec. 357(a). (Reg. § 1.956-1T(e)(6))

The temporary regs also apply when property whose basis is determined under the regs is transferred to a related person (related person transferee), or by a related person transferee to another related person, pursuant to an exchange in which the related person transferee’s basis in the property is determined, in whole or in part, by reference to the transferor’s basis in the property. This rule is intended to prevent taxpayers from attempting to avoid the general rule of the temporary regs by subsequently transferring the property to a related person in another nonrecognition transaction. (Reg. § 1.956-1T(e)(6))

Basis determined under the temporary regs applies only for purposes of determining the amount of U.S. property acquired or held by a CFC under Code Sec. 956 , and accordingly the amount of a U.S. shareholder’s income inclusion under Code Sec. 951(a)(1)(B) with respect to the CFC. (Reg. § 1.956-1T(e)(6))

The temporary regs apply only to determine the basis of U.S. property acquired by a CFC pursuant to an exchange that is within their scope. All other basis determinations are made under the rules in Reg. § 1.956-1(e)(1)(4). (Preamble to Prop Reg 06/23/2008)

    Illustration: Applying the facts from Illustration (1), the results are as follow under the temporary regs. The US2 stock acquired by CFC in the exchange constitutes U.S. property under Reg. § 1.956-1T(e)(6)(ii) because CFC acquires the US2 stock from US2, the issuing corporation. Therefore, because CFC’s basis in the US2 stock is determined under Code Sec. 362(a), then for purposes of Code Sec. 956, CFC’s basis in the US2 stock is, under Reg. § 1.956-1T(e)(6)(iii) no less than $90 million, the fair market value of the property exchanged by CFC for the US2 stock (the $10 million of CFC stock issued in the exchange does not constitute property for purposes of Reg. § 1.956-1T(e)(6)(iii)). Under Reg. § 1.956-1T(e)(6)(iv), for purposes of Reg. § 1.956-2(d)(1)(i)(a), CFC is treated as acquiring its basis of no less than $90 million in the US2 stock at the time of its transfer of property to US2 in exchange for the US2 stock. The result would be the same if, instead of CFC transferring $90 million of cash to US2 in the exchange, CFC assumes a $90 million liability of US2. Reg. § 1.956-1T(e)(6)(vi), Example 1.

Effective date. The temporary regs apply to U.S. property acquired in exchanges occurring on or after June 24, 2008. No inference is intended as to the basis of U.S. property acquired by a CFC pursuant to a comparable transaction occurring before that date. IRS may, where appropriate, challenge such pre-June 24 transactions under applicable provisions or judicial doctrines. (Reg. § 1.956-1T(f), Preamble to TD 9402, 06/23/2008)