Internal Revenue Code section 367(b) authorizes the U.S. Treasury secretary to write regulations necessary or appropriate to prevent the avoidance of U.S. federal income taxes in nonrecognition transactions involving foreign corporations not covered by section 367(a). Over the last 20 years, the IRS and Treasury have spent a lot of time and effort trying to figure out how best to use that authority. They’ve recently interpreted the scope quite broadly in a series of guidance projects to address what they consider abusive transactions.
The Tax Cuts and Jobs Act (P.L. 115-97) contains several provisions that question the premise of the regulatory authority granted by section 367(b) and how that authority has historically been interpreted by Treasury and the IRS. That’s because it’s no longer clear whether the reorganization provisions of the code still provide an effective tool for taxpayers to avoid U.S. income taxes in a cross-border setting. Whether any of the section 367(b) regulations make sense after enactment of the TCJA is an open question that has mostly escaped public notice.
Background
Section 112(k) of the Revenue Act of 1932 included the predecessor to section 367, providing that a foreign corporation generally shouldn’t be considered a corporation in specific nonrecognition transactions unless, before the transaction, it was “established to the satisfaction of the Commissioner” that the transaction was not in pursuance “of a plan having as one of its principal purposes the avoidance of Federal income taxes.”
That general grant of authority to ensure that the nonrecognition provisions of the code couldn’t be used for tax avoidance was expanded after section 1248 was enacted in 1962 to ensure “the imposition of the full U.S. tax when income earned abroad is repatriated” (S. Rep. No. 87-1881 (1962)). The IRS issued guidance in 1968 that presumed the existence of a plan of tax avoidance “if a nonrecognition transaction by its nature permanently avoided the application of a clearly stated policy, such as the policy of section 1248” (Peter Daub, “Section 367 Adrift: Old Statute, New Applications,” Tax Notes, May 30, 2016, p. 1207, citing Rev. Proc. 68-23, 1968-1 C.B. 821).
Under the 1968 guidelines, a nonrecognition provision such as section 332 applied to the gain realized by a domestic corporation on the inbound liquidation of a foreign subsidiary only if the shareholder included in income an amount of earnings attributable to its stock. The section 367(b) regulations reflect the policies of the 1968 guidance.
In 1976 Congress enacted the current version of section 367(b), which establishes a presumption that a foreign corporation is treated as a corporation in nonrecognition exchanges unless regulations provide otherwise (P.L. 95-455, section 1042(a)). The IRS has struggled to adopt implementing regulations, and it first issued proposed and temporary regulations in 1977. Subsequent guidance updated and amended the temporary regulations several times, with the IRS issuing prop. reg. sections 1.367(b)-1 through 1.367(b)-6 in 1991. In 1998 final regulations implementing sections 367(a) and (b) were released, with the preamble stating that guidance would be issued to address the portions of the 1991 proposed 367(b) regs not addressed in the final regs.
The IRS fulfilled that commitment in 2000 by adopting as final reg. sections 1.367(b)-1 through 1.367(b)-6 (T.D. 8862). In the preamble to those final regs, the IRS explained what it saw as the policy behind section 367(b) — namely, that it functions “to prevent the avoidance of U.S. tax that can arise when the Subchapter C provisions apply to transactions involving foreign corporations.” The preamble further states that the potential for tax avoidance arises because of differences in how the United States taxes foreign corporations and their shareholders and how it taxes domestic corporations and their U.S. shareholders.
The preamble also explains why special rules were needed to prevent the avoidance of U.S. tax in the cross-border context through nonrecognition transactions generally sanctioned by the rules of subchapter C:
The Subchapter C provisions generally have been drafted to apply to domestic corporations and U.S. shareholders, and thus do not fully take into account the cross-border aspects of U.S. taxation (such as deferral, foreign tax credits, and section 1248). Section 367(b) was enacted to help ensure that international tax considerations in the Code are adequately addressed when the Subchapter C provisions apply to an exchange involving a foreign corporation.
The preamble also says the purpose of section 367(b) is “to prevent the material distortion of income that can occur when the Subchapter C provisions apply to an exchange involving a foreign corporation,” a reference to backstopping the recharacterization of a portion of foreign earnings as a dividend on some sales of foreign company stock.
Inbound Liquidations and Reorganizations
The 1991 proposed regs were intended to implement what the IRS believed to be the policy behind section 367: The repatriation of foreign earnings should generally be subject to current U.S. tax. The IRS said those rules were necessary because the United States generally does not tax a foreign corporation on foreign-source earnings and profits. According to the 1991 preamble, the rules were based on the principle that the repatriation of a U.S. person’s share of a foreign corporation’s E&P through what would otherwise be a nonrecognition transaction “should generally cause recognition of income by the foreign corporation’s shareholders.”
The proposed regulations were also concerned with potential abuses in cases involving the carryover of attributes in inbound nonrecognition transactions, stating that a “domestic acquirer of the foreign corporation’s assets should not succeed to the basis or other tax attributes of the foreign corporation except to the extent that the United States tax jurisdiction has taken account of the United States person’s share of the E&P that gave rise to those tax attributes.”
The concerns over ensuring U.S. taxation of foreign E&P, which had been deferred under general U.S. tax principles, are intertwined with concerns about ensuring proper carryover of asset basis. According to the 2000 preamble:
The requirement to include in income the all earnings and profits amount results in the taxation of previously unrepatriated earnings accumulated during a U.S. shareholder’s (direct or indirect) holding period. This income inclusion prevents the conversion of a deferral of tax into a forgiveness of tax and generally ensures that the section 381 carryover basis reflects an after-tax amount.
In furtherance of IRS policy goals, reg. section 1.367(b)-3 generally requires the inclusion of all the E&P amount by an exchanging shareholder as a deemed dividend of its stock in a foreign acquired corporation. Reg. section 1.367(b)-2 explains that a deemed dividend described in reg. section 1.367(b)-3 is to be treated as a dividend under the code.
Foreign-to-Foreign Reorganizations
When the IRS proposed regulations governing the taxation of foreign E&P in an inbound transaction, it also proposed regs governing foreign-to-foreign reorganizations. That was meant to backstop section 1248, or prevent a material distortion in income, which includes “a distortion relating to the source, character, amount or timing of any item, if such distortion may materially affect the United States tax liability of any person for any year” according to the 1991 preamble. The section 1.367(b)-4 regs are therefore necessary to prevent the avoidance of section 1248, which requires inclusion of some types of gain on the disposition of stock as a dividend.
In the 2000 preamble, the IRS explained the purpose of reg. section 1.367(b)-4 and -5 (regarding foreign-to-foreign reorganizations and section 355 transactions involving foreign corporations):
The historic policy objective of section 367(b) in both of these contexts has been to preserve the potential application of section 1248. Thus, the amount that would have been recharacterized as a dividend under section 1248 upon a disposition of the stock (section 1248 amount) generally must be included in income as a dividend at the time of the section 367(b) exchange to the extent such section 1248 amount would not be preserved immediately following the section 367(b) exchange.
Temp. reg. section 1.367(b)-4T provides that if a foreign corporation acquires the stock of a foreign corporation in a section 351 exchange or the stock or assets of a foreign corporation in a section 368(a)(1) reorganization, an exchanging shareholder must, if the exchange is described in reg. section 1.367(b)-4, include in income as a deemed dividend the section 1248 amount attributable to the stock that it exchanges. The definition of dividend in reg. section 1.367(b)-2 that’s relevant for including all E&P in reg. section 1.367(b)-3 is also relevant for including the section 1248 amount in reg. section 1.367(b)-4 generally.
Killer B’s and Deadly D’s
The 2000 final regulations are far from the last chapter in the section 367(b) story. Fairly soon after those regulations were issued, taxpayers figured out how to access subchapter C rules and apply them together with the section 367(b) regulations to structure cross-border reorganizations that allowed for the tax-free repatriation of overseas cash. Starting in 2006, the IRS repeatedly tried to shut down those transactions and prevent that use of the rules; the guidance illustrates the government’s expanded vision of the scope of its authority under section 367(b). It also provides a cautionary tale about the government’s ability to adopt antiabuse rules in this area.
In Notice 2006-85, 2006-2 C.B. 677, the IRS said it knew taxpayers were engaging in triangular reorganizations involving foreign corporations that resulted in “a tax-advantaged transfer of property.” It said it believed taxpayers’ characterizations of those transactions raised important policy concerns because the transactions could repatriate foreign earnings without a corresponding dividend subject to U.S. income tax, or repatriate U.S. earnings to foreign parent companies with no U.S. withholding tax.
In announcing its intent to issue regulations to prevent those tax-free repatriations, the government rooted its authority in section 367, saying that “in enacting section 367(b), Congress noted that ‘it is essential to protect against tax avoidance in transfers to foreign corporations and upon the repatriation of previously untaxed foreign earnings’” (H.R. Rep. No. 658 (1975)).
It didn’t take long for the government to see the flaws in — and for taxpayers to take advantage of — Notice 2006-85. As a result, Treasury soon issued Notice 2007-48, 2007-1 C.B. 1428, which expanded the scope of the antiabuse rule in the 2006 notice to include public transactions. Final regulations were issued in 2011 (reg. section 1.367(b)-10).
But the government ran into problems with the way taxpayers applied a deemed contribution rule developed in that guidance, with reg. section 1.367(b)-10 essentially backfiring by permitting taxpayers to engage in even more aggressive tax-efficient repatriations. As a result, the IRS issued yet another notice to stop tax-free repatriation transactions that use the reorganization provisions (Notice 2014-32).
In 2016 the government issued Notice 2016-73, 2016-52 IRB 908, the most recent attempt to prevent taxpayers from using subchapter C nonrecognition rules to achieve tax-free cash repatriations. The primary target of the 2016 notice — as with all section 367 guidance issued over the past decade — was the repatriation of overseas cash or property without the imposition of U.S. income tax.
Priority Guidance Plan
On February 7 the IRS issued an updated 2017-2018 priority guidance plan that reflects the addition of 29 projects, including those that have become near-term priorities as a result of the TCJA. It includes two items related to section 367: a proposed modification of the December 2016 regulations (to curb inversions) regarding some transfers of property to foreign corporations and an item concerning the issuance of section 367 regs, particularly regarding notices 2014-32 and 2016-73.
Missing from the guidance plan is any indication of a broader review of the section 367(b) regulations in light of the international tax law changes made by the TCJA and the various incentives taxpayers now have to structure cross-border investments and engage in cross-border reorganizations. But as noted, the section 367(b) regs are generally intended to ensure taxation as a deemed dividend of foreign earnings in specific transactions involving foreign corporations. At the same time, the taxation of dividends from foreign corporations, and of foreign earnings of U.S.-owned foreign companies generally, has been dramatically altered by the TCJA.
TCJA and Section 367
While the TCJA made changes to section 367(a) and (d) (repealing the active trade or business exception; requiring gain recognition on incorporations of branches with losses; and repealing the exception for foreign goodwill and going concern value), it made no changes to section 367(b). But that doesn’t mean it didn’t significantly modify the legislative purpose of section 367(b), and, as a corollary, its implementing regulations.
The government has explained that the section 367(b) regulations are meant to prevent the avoidance of U.S. tax by:
taxing the E&P of foreign subsidiaries whose foreign corporate wrapper is disappearing;
ensuring that for dispositions of stock in reorganization transactions, the statutory characterization of the earnings as a dividend is preserved;
taxing distributions or deemed distributions of cash or property in foreign-to-foreign reorganizations that would otherwise allow tax-free repatriations.
As discussed, the section 367(b) regulations implement those purposes by taxing as a deemed dividend all or a portion of the earnings of U.S.-owned foreign corporations in some otherwise nonrecognition transactions.
The TCJA renders the purposes behind section 367(b) and its implementing regulations mostly moot. First, section 245A provides U.S. corporate shareholders of specified foreign corporations with a 100 percent dividends received deduction on repatriation of foreign earnings. There’s no need for regulations to prevent the tax-free repatriation of earnings via a reorganization, if they can be repatriated tax free through the payment of a dividend.
Second, section 951A subjects most of a controlled foreign corporation’s earnings to immediate tax in the hands of U.S. shareholders. That too challenges the notion that an antiabuse statute and implementing regulations are needed to prevent the tax-free repatriation of earnings. If foreign earnings are already taxed, the government shouldn’t need 50 pages of regulations to ensure they are taxed in reorganization transactions.
Third, sections 245A and 951A should prompt the government to question the need for section 367(b) to backstop section 1248, which has been amended (new section 1248(j)) to treat the section 1248 amount on the sale of stock as a dividend qualifying for tax-free treatment under section 245A. At the same time, gain not attributable to earnings is fully taxable as capital gain. As a result, it’s now in a taxpayer’s best interest to maximize the section 1248 amount on sale of stock (including in reorganization transactions), and to maximize basis increases resulting from those inclusions.
The Future of Section 367(b) Regulations
Speaking at an April 9 event hosted by the Urban-Brookings Tax Policy Center in Washington, Lily Batchelder of New York University School of Law said the government should issue broad, aggressive antiabuse regulations to implement the TCJA to prevent taxpayers from gaming the system.(Prior coverage.) But as the history of successive releases of section 367 guidance makes painfully obvious, the government’s attempts to write broad antiabuse rules in this area often backfire.
Most foreign earnings will now be subject to tax in the year earned. But the government has been unable to figure out how to issue regulations regarding the carryover of previously taxed earnings. Reg. section 1.367(b)-7, which provides for the carryover of tax attributes in foreign-to-foreign nonrecognition transactions, reserves on the carryover of previously taxed earnings in those transactions; proposed regulations issued in 2006 under section 959 have yet to be finalized. Yet the carryover of previously taxed earnings will arguably be one of the most important concerns for taxpayers, as will the interaction between the new category of tested income and taxes attributable to income includable under section 951A.
As an examination of the section 367(b) rules illustrates, even provisions not directly modified by the TCJA have been upended by the new rules. Repealing or amending section 367(b) may not be the government’s top priority, given all the other guidance needed to implement the TCJA, but having outstanding rules that function as antiabuse provisions under prior law that might be used by taxpayers in unforeseen ways under current law is risky.
Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, director of its International Tax LLM program, and a contributor to Tax Notes International. Email: herzfeld@law.ufl.edu
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