Both the Revenue Service and the Treasury Department presently believe as enunciated in Notice 2012-15 that the amount of income taken into account as a result of a §304 distribution generally should not affect the application of §367 to a deemed §351 exchange.
In the case of a transfer of stock by a U.S. person to a foreign corporation, the revised gain recognition agreement regulations should substantially reduce the complexity and uncertainty resulting from the filing of a gain recognition agreement in connection with a deemed §351 exchange.
Accordingly, the Revenue Service and the Treasury Department believe it is appropriate to revise the approach to the interaction of §367 and §304 by providing that subsections (a) and (b) of §367 must be applied fully to a deemed §351 exchange.
To the extent that, a U.S. person must be treated as transferring stock of a domestic or foreign corporation to a foreign acquiring corporation in a deemed §351 exchange, the transaction must be subject to §367(a) and the regulations thereunder. This includes the exceptions described in Regs. §1.367(a)-3(b)(1) and (c)(1).
As a consequence, a transferor in a §304 transaction that was a U.S. person may be permitted to enter into a gain recognition agreement pursuant to Regs. §1.367(a)-8 to avoid the recognition of gain under §367(a)(1).
If a U.S. person executed a gain recognition agreement with respect to a deemed §351 exchange, the deemed redemption of the stock of the foreign acquiring corporation deemed issued to the U.S. person pursuant to §304(a)(1) constituted a disposition of the transferee foreign corporation stock under Regs. §1.367(a)-8.
As a result, the deemed redemption must generally be treated as a triggering event within the meaning of Regs. §1.367(a)-8(j).
Nevertheless, consistent with the redemption rules provided in Regs. §1.367(a)-8(n)(1), the redemption must not be treated as a triggering event if the U.S. person that transferred the stock in the deemed §351 exchange entered into a new gain recognition agreement that included appropriate provisions to account for the redemption.
Generally, the requirement to file an initial gain recognition agreement for the deemed §351 exchange and a new gain recognition agreement by reason of the deemed redemption will be satisfied if the U.S. person that transferred the stock in the deemed §351 exchange filed a single gain recognition agreement with respect to the entire §304 transaction.
To the extent that pursuant to §304(a)(1), a foreign acquiring corporation acquired the stock of a foreign corporation in a deemed §351 exchange, the exchange must be subject to §367(b) and the regulations thereunder.
For example, if a deemed §351 exchange resulted in the loss of status as a §1248 shareholder as provided in Regs. §1.367(b)-4(b)(1)(i), the exchanging shareholder must include in income as a deemed dividend the §1248 amount attributable to the foreign stock that had been transferred in the deemed §351 exchange.
To demonstrate the application of Notice 2012-15, suppose USP, a domestic corporation, owned all of the outstanding stock of FT and FA. Both FT and FA were foreign corporations.
USP’s tax basis in the FT stock was $50x, and the FT stock had a fair market value of $100x. The §1248 amount with respect to the FT stock was $10x.
FA had earnings and profits of $200x, which were available for distribution taking into account §304(b)(5).
In a transaction to which §304(a)(1) applied, USP transferred all of its FT stock to FA in exchange for $100x in cash.
Within the ambit of §304(a)(1), USP and FA were treated “as if” USP had transferred its FT stock to FA in a §351(a) exchange solely for FA stock. Next, FA constructively redeemed its deemed newly issued stock in exchange for the $100x in cash.
Redemption of the FA stock deemed issued by FA to USP must be treated as a distribution to which §301 applied. The entire distribution must be treated under §301(c)(1) as a dividend out of the earnings and profits of FA. As a result, USP recognized gain on the transfer under §367(a)(1), unless USP entered into a gain recognition agreement with respect to the transfer.
However, the deemed redemption by FA of the stock it was deemed to have issued to USP constituted a triggering event with respect to such gain recognition agreement.
Nonetheless, the redemption will not constitute a triggering event, if USP executed a new gain recognition agreement that included appropriate provisions to account for the redemption and that was consistent with the principles of the regulations.
After the redemption, USP owned at least 5% of the total voting power and the total value of the outstanding stock of FA.
If USP entered into a new gain recognition agreement, the deemed redemption didl not constitute a triggering event.
In this case, the requirement that an initial gain recognition agreement be filed for the deemed §351 exchange and a new gain recognition agreement be filed by reason of the deemed redemption will be satisfied if USP filed a single gain recognition agreement pursuant to Regs. §1.367(a)-8(d)(2)(ii).
With respect to the application of §367(b), USP was a §1248 shareholder with respect to FT, a controlled foreign corporation, immediately before the exchange. As a result, Regs. §1.367(b)-4(b)(1)(i) did not apply to require USP to include in income the $10x §1248 amount with respect to the FT stock, because FA and FT were both controlled foreign corporations as to which USP was a §1248 shareholder immediately after the exchange.
TAINTED STOCK CHANGED ITS CHARACTER IN AN INTERCOMPANY TRANSACTION
In a spin-off transaction to which §355 would apply but for the fact that a shareholder receives “boot,” along with stock or securities permitted by §355 to be received without the recognition of gain, the sum of money and the fair market value of the “other property” as of the date of the distribution must be treated as a distribution of property.
To illustrate this rule, assume individual A owned all of the outstanding shares of corporation X. Corporation X owned all of the stock of corporation Y. Corporation X had accumulated or current earnings and profits in excess of $100. Without requiring the surrender of any shares of its stock, corporation X distributed all of the shares of Y plus $100 of cash to individual A in a §355 transaction with “boot.” The $100 of cash received by individual A must treated as a distribution of property to which the rules of §301 apply. Regs. §1.356-2(b). The rules of §301 require that the $100 of cash must be included in gross income of individual A, if the distribution represented a dividend. §301(c)(1). In this situation, the $100 cash distribution was equivalent to a dividend.
Recognition stock denotes stock distributed in an otherwise nontaxable spin-off, which did not qualify for nontaxable treatment “inside” or “outside” the distributing corporation. Sometimes, recognition stock is referred to as “hot stock,” due to the adverse tax consequences described in §356 that transpire upon the distribution of recognition stock in a spin-off, split-up, or split-off.
Both recognition stock and hot stock are “tainted” stock as a result of the negative tax consequences at both the corporate level at the time of distribution and at the shareholder level upon receipt of the property. Fortunately, recognition stock is not normally distributed in most corporate separations.
Congress drafted the active trade or business conditions on the premise that all corporations are members of an affiliated group. Due to the interplay of the active trade or business rules with the determination of recognition stock, the basic conditions are unduly complex. Nevertheless, when an affiliated group is not involved in the corporate separation, the rules for a stand-alone corporation forming a newly created corporation to be spun-off are less complex.
When Congress enacted several amendments in the Tax Increase Prevention and Reconciliation Act of 2005, P. L. 109-222; the Tax Relief and Health Care Act of 2006, P. L. 109-432; the Tax Technical Corrections Act of 2007, P. L. 110-172, the rules for tax-free distributions of the stock of certain controlled corporations were enhanced to encompass a new separate affiliated group regime. The legislative action was the commencement of the more complex rules for affiliated groups.
As previously discussed, Congress had provided in §355(a) that, under certain circumstances, a corporation may distribute stock and securities in a corporation it controlled to its shareholders and security holders without causing either the distributing corporation or its shareholders and security holders to recognize income, gain, or loss.
Both the distributing corporation and the controlled corporation must, nonetheless, each be engaged, immediately after the distribution, in the active conduct of a trade or business.
A corporation must be treated as engaged in the active conduct of a trade or business if and only if it had been engaged in the active conduct of a trade or business.
In addition, the trade or business must have been actively conducted throughout the five-year period ending on the date of the distribution (pre-distribution period).
Furthermore, the active trade or business must not have been acquired in a transaction in which gain or loss was recognized, in whole or in part (taxable transaction or taxable acquisition), within the pre-distribution period.
Congress also provided that control of a corporation that — at the time of acquisition of control — was conducting the trade or business must not have been directly or indirectly acquired by any “distributee” corporation or by distributing corporation during the pre-distribution period in a taxable
transaction.
Particularly important, all members of a corporation’s separate affiliated group (SAG) must be treated as one corporation (SAG rule). For purposes of the preceding sentence, a corporation’s SAG denotes an affiliated group which would be determined under §1504(a) if such corporation were the common parent and §1504(b) [relating to certain preferred stock] did not apply.
To determine whether a corporation satisfied the requirements of §355(b)(2)(A), all members of the corporation’s separate affiliated group must be treated as one corporation. This concept is based on the single entity theory that evolved from the consolidated return rules.
An affiliated group is defined in §1504(a) as one or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation if the common parent satisfies a control test in §1504(a)(2) “directly” as to one subsidiary and at least indirectly as to all the other subsidiaries. Restated, the common parent must “directly” own at least eighty percent of the voting power and eighty percent of the value of one of the other includible corporations. Direct ownership in each of the includible corporations, except the common parent, must exist by one or more of the other includible corporations.
Ownership of stock of any includible corporation meets the requirements of §1504(a)(2) if it possesses at least eighty percent of the total voting power of the stock of such corporation and has a value equal to at least eighty percent of the total value of the stock of such corporation.
A separate affiliated group of a “distributing” corporation (DSAG) means an affiliated group that consisted of the distributing corporation as the common parent and all corporations affiliated with the distributing corporation through stock ownership described in §1504(a)(1)(B) (regardless of whether the corporations were included corporations under §1504(b)).
In addition, a separate affiliated group of the “controlled” corporation (CSAG) must be determined in a similar manner (with the controlled corporation as the common parent).
Because the SAG rule treats all SAG members as one corporation, the separate existence of subsidiary SAG members must be disregarded and all assets owned and activities performed by SAG members must be treated as owned and performed by the distributing corporation or the controlled corporation, as the case may be, for purposes of determining whether the distributing corporation or the controlled corporation had been engaged in a five-year active trade or business.
Expressed another way, where one DSAG or CSAG member satisfied the active trade or business requirement, the distributing corporation or the controlled corporation, as the case may be, satisfied the active trade or business requirement.
As an example of hot stock, assume that C and D were corporations, X was an unrelated individual, each of the transactions was unrelated to any other transaction and, but for the issue of whether C stock was treated as “other property” under §355(a)(3)(B), the distributions satisfied all of the requirements of §355.
For more than five years, D had owned eighty percent control but not eighty percent control of the voting stock and eighty percent of the value of the stock of C. In year 6, D purchased additional C stock from X. However, D did not own eighty percent control of the voting stock and eighty percent of the value of the [§1504(a)(2)] stock of C after the year 6 purchase. Therefore, C and D were not members of an affiliated group. After the purchase of additional C stock in year 6, C continued as a stand-alone corporation.
Assume D distributed all of its C stock within five years after the year 6 purchase, the C stock purchased in year 6 was treated as “other property.” Regs. §1.355-2[g][5], Exp. 1.
Congress enacted §355(b)(3) because it was concerned that, prior to a distribution under §355, corporate groups conducting business in separate corporate entities often had to undergo elaborate restructurings to place active businesses in the proper entities to satisfy the active trade or business requirement.
As a result, the effect of §355(b)(3) is to treat a corporation’s separate affiliated group as a single corporation for purposes of the active trade or business requirement. Consistent with this treatment, Congress enacted the Technical Corrections Act of 2007, P. L. 110-172, to clarify that if corporation became a member of a separate affiliated group as a result of one or more transactions in which gain or loss was recognized, in whole or in part, any trade or business conducted by such corporation (at the time that such corporation became such a member) must be treated for purposes of §355(b)(2) as acquired in a transaction in which gain or loss was recognized in whole or in part. Accordingly, such an acquisition must be subject to the provisions of §355(b)(2)(C), and may qualify as an expansion of an existing active trade or business conducted by the distributing corporation or the controlled corporation, as the case may be.
As a consequence, the separate affiliated group regime affords an affiliated group a certain amount of flexibility regarding the satisfaction of the active trade or business requirement.
Assume, for instance, C and D were corporations, and X was an unrelated individual. C became a DSAG member. For more than five years, D has owned eighty percent of C’s stock but had not owned eighty percent of the control and value of the stock of C. In year 6, D purchased additional C stock from X such that D’s total ownership became eighty percent of the control and value of the stock of C.
If D distributed all of its C stock within five years after the year 6 purchase, the distribution of the C stock purchased in year 6 would not have been treated as “other property” because C became a DSAG member.
Furthermore, the result would have been the same if D had not owned any C stock prior to year 6 and D purchased all of the C stock in year 6.
Similarly, if D had not owned any C stock prior to year 6, D purchased twenty percent of the C stock in year 6, and then acquired all of the remaining C stock in year 7, the C stock purchased in year 6 and the C stock acquired in year 7 (even if purchased) would not have been treated as “other property,” because C became a DSAG member. Regs. §1.355-2(g)(5), Exp. 2.
Due to the single entity concept, the “hot stock” rule should not apply to any acquisition of stock of a controlled corporation, where the controlled corporation was a DSAG member at any time after the acquisition (but prior to the distribution of the controlled corporation).
Suppose, for instance, the distributing corporation had acquired all of the controlled corporation’s stock in a taxable transaction that qualified as an expansion of the distributing corporation’s existing trade or business under the separate affiliated group regime, and later distributed all the controlled corporation’s stock within five years of the acquisition in an unrelated transaction.
As expressly stated in TD 9435, the distribution would have satisfied the active trade or business requirement but, absent the rule reflected in the regulations, could otherwise have been fully taxable under the “hot stock” rule. In the Treasury Department’s view, this result seemed inconsistent with the Congressional intent.
To achieve consistency with the separate affiliated group regime, if the controlled corporation had been a DSAG member and the distributing corporation acquired additional stock in the controlled corporation, the acquisition should be disregarded for purposes of §355(a)(3)(B). Preamble to Regs. §1.355-2(g).
Therefore, the regulations provide that controlled corporation’s stock acquired by the DSAG within the pre-distribution period in a taxable transaction constituted “hot stock,” except if the controlled corporation had been a DSAG member at any time after the acquisition — but prior to the distribution of the stock of the controlled corporation.
Assume, for example, that P had owned ninety percent of the sole outstanding class of the stock of D for more than five years. Also, P owned a portion of the stock of C. X, an unrelated individual, had owned during the five year period the remaining ten percent of the D stock.
Throughout this period, D had owned eighty percent of the stock of C, but did not own eighty percent of the voting power and value of the stock in C.
In year 6, D purchased P’s C stock. However, D did not own eighty percent of the voting power and value of the stock in C after the purchase in year 6.
If D had distributed all of its C stock to X in exchange for X’s D stock within five years after the purchase in year 6, the distribution of the C stock purchased in year 6 would not have been treated as “other property,” because the C stock had been purchased from a member (P) of the affiliated group of which D was a member, and P had not purchased the C stock within the pre-distribution period. Regs. §1.355-2(g)(5), Exp. 4.