SERVICE PROVIDES GUIDANCE FOR REORGANIZATIONS AND LIQUIDATIONS INVOLVING FOREIGN CORPORATIONS THAT OWN U.S. REAL PROPERTY.

Rev. Rul. 87-66

The following examples apply section 897(d) and (e) of the Internal Revenue Code, in the absence of regulations under section 897(d)(1)(B) and (e)(2) to certain reorganization and liquidation transactions involving foreign corporations that own United States real property interests.

EXAMPLE (1)

A, a nonresident alien, organized FX, a Country W corporation, in September 1980 to invest in U.S. real estate. In 1986, FX's only asset is Parcel P, a U.S. real property interest with a fair market value of $600,000 and an adjusted basis to FX of $200,000. Parcel P is subject to a mortgage with an outstanding balance of $100,000. The fair market value of the FX stock is $500,000, and A's adjusted basis in the stock is $100,000. FX does not have liabilities in excess of the adjusted basis in Parcel P. The United States does not have a treaty with Country W that entitles FX to nondiscriminatory treatment as described in section 1.897-3(b)(2) of the Income Tax Regulations.

In 1986, A transferred the FX stock to a domestic corporation (USRPHC) solely in exchange for USRPHC stock. Following the transfer, USRPHC is a U.S. real property holding company. FX is immediately "liquidated" by USRPHC, end all of the FX assets are transferred to USRPHC.

The transfers are characterized as a reorganization under section 368(a)(1)(D) of the Code. FX is treated as transferring its assets to USRPHC in exchange for USRPHC stock which FX distributes to A (in exchange for A's FX stock) pursuant to the plan of reorganization. Under section 897(e)(1), FX is entitled to nonrecognition treatment granted under sction 361(a) on the transfer of its U.S. real property interest (Parcel P) to USRPHC because FX receives a U.S. real property interest (USRPHC stock) in the exchange. Under section 362(b), USRPHC takes FX's basis of $200,000 in Parcel P. Under section 358(a)(1), FX takes a $100,000 basis in the USRPHC stock because FX's substituted basis of $200,000 in the USRPHC stock is reduced by the $100,000 of liabilities to which Parcel P is subject. See section 358(d)(1).

Section 897(d)(1)(A) of the Code provides that, unless provided otherwise in regulations, gain shall be recognized by a foreign corporation on the distribution of a U.S. real property interest in an amount equal to the excess of the fair market value of such interest at the time of the distribution over its adjusted basis.

Under section 897(d)(1)(A) of the Code, FX generally must recognize gain on the distribution of the USRPHC stock received in exchange for FX's assets equal to the difference between the fair market value of the USRPHC stock ($500,000) and FX's adjusted basis in the USRPHC stock prior to the distribution ($100,000). This results in a potential gain of $400,000.

Section 897(d)(1)(B) of the Code provides that gain will not be recognized under section 897(d)(1)(A) if at the time of the receipt of the distributed property, the distributee would be subject to taxation on a subsequent disposition of the distributed property, and if the basis of the distributed property in the hands of the distributee is no greater than the adjusted basis of such property before the distribution, increased by the amount of gain recognized by the distributing corporation.

Under section 358(a)(1) of the Code, A takes a basis in the USRPHC stock equal to its basis in the FX stock of $100,000. No gain is recognized by FX on the distribution of the USRPHC stock under the exception to the general rule of section 897(d)(1)(A) provided in section 897(d)(1)(B) because A's basis in the USRPHC stock ($100,000) does not exceed FX's adjusted basis in the USRPHC stock ($100,000) immediately prior to the distribution and because A, at the time of receipt of the USRPHC stock, would be subject to U.S. taxation on a subsequent disposition of the stock.

The FX stock in the hands of A is not a U.S. real property interest because FX is a foreign corporation that has not elected to be treated as a domestic corporation under section 897(i) of the Code. Accordingly, the exchange of the FX stock by A for USRPHC stock is not a disposition of a U.S. real property interest under section 897(a).

This transaction may also be recast as a reorganization under section 368(a)(1)(F) of the Code. See Rev. Rul. 87-27, 1987-15 I.R.B. 5. In such case, the same analysis under section 897(d) and (e) would apply to the section 361 exchange and to the distribution of the USRPHC stock.

EXAMPLE (2)

Assume the facts are the same as in Example 1, except that A purchased the FX stock in September 1983 for $100,000 from S, a nonresident alien. S had a basis of $40,000 in the FX stock at the time of the sale to A. The results are the same as in Example 1.

EXAMPLE (3)

The facts are the same in Example 1, except that A's adjusted basis in the FX stock prior to the reorganization is $300,000. Following the distribution, A takes its basis of $300,000 in the FX stock as its basis in the USRPHC tock.

Unless otherwise provided in regulations, section 897(d)(1)(A) of the Code requires that FX recognize a gain on the distribution of the USRPHC stock equal to the difference ($400,000) between the fair market value of the USRPHC stock ($500,000) and FX's adjusted basis in the USRPHC stock prior to the distribution ($100,000).

EXAMPLE (4)

The facts are the same as in Example (3), except that the United States has an income tax treaty with Country W entitling FX to nondiscriminatory treatment under section 1.897-3(b)(2) of the regulations. A valid election under section 897(i) of the Code is made to treat FX as a U.S. corporation.

FX is treated as a domestic corporation for purposes of section 897 of the Code and is not required to recognize gain under section 897(d)(1) on the distribution of the USRPHC stock as described in Example 3. (If a valid section 897(i) election were not made, the result would be the same as in Example (3).)

The FX stock in the hands of A is a U.S. real property interest because an election was made under section 897(i) of the Code to treat FX as a U.S. corporation. The exchange of the FX stock for USRPHC stock by A is a disposition of a U.S. real property interest. Under section 897(e)(1), A does not recognize gain on the exchange because there is an exchange of a U.S. real property interest (the FX stock) for another U.S. real property interest (the USRPHC stock). Under section 358(a)(1), A takes as its basis in the USRPHC stock A's basis in the FX stock.

EXAMPLE (5)

B, a nonresident alien, organized FX, a Country W corporation, in September 1980 to invest in U.S. real estate. Immediately thereafter, FX purchased Parcel P, a U.S. real property interest. In June 1983, B transferred all of the FX stock to USRPHC in exchange for USRPHC stock.

(a) In September 1986, FX liquidates and transfers Parcel P, its only asset, to USRPHC. At that time, Parcel P has a fair market value of $500,000 and an adjusted basis of $100,000. USRPHC has an adjusted basis of $300,000 in the FX stock which has a fair market value of $500,000. Country W does not have a treaty with the United States that entitles FX to nondiscriminatory treatment as described in section 1.897-3(b)(2) of the regulations, and therefore, FX cannot make an election under section 897(i) of the Code. It is assumed that the "step transaction" doctrine would not apply based on all facts and circumstances surrounding these transactions.

USRPHC does not recognize any gain under section 332(a) of the Code on the receipt of Parcel P. In addition, subject to the application of section 897(d), FX would not recognize gain under section 336(a) (as in effect prior to its amendment by the Tax Reform Act of 1986) on the distribution of Parcel P.

Under section 897(d)(1)(A) of the Code, FX generally must recognize gain on the distribution of Parcel P equal to the difference between the fair market value of Parcel P ($500,000) and FX's adjusted basis in Parcel P prior to the distribution ($100,000). This recognition to FX is required even though USRPHC would otherwise take FX's adjusted basis in Parcel P under section 334(b)(1) because, pursuant to sections 336 and 337 as in effect prior to the Tax Reform Act of 1986, USRPHC would not necessarily be subject to U.S. income taxation if USRPHC immediately disposed of Parcel P in a transaction in which the transferee received a fair market value basis in Parcel P. FX therefore cannot meet the exception to gain recognition provided in section 897(d)(1)(B).

(b) The facts are the same as in paragraph 5(a) except that Country W has an income tax treaty with the United States that entitles FX to nondiscriminatory treatment as described in section 1.897-3(b)(2) of the regulations, and FX makes a valid section 897(i) election prior to the liquidation.

Neither section 897(d)(1)(A) nor section 897(e)(1) of the Code is applicable to the transaction because FX will be treated as a domestic corporation for purposes of section 897. In this case, no gain or loss will be recognized by FX on the liquidation under section 336(a) (as in effect prior to its amendment by the Tax Reform Act of 1986) or by USRPHC under section 332(a).