Proposed Regulations On Imported Built-In Losses Include Some Controversial Aspects

This article is reprinted with permission from the Journal of Taxation.

Proposed Regulations (REG-161948-05, 9/6/13) dealing with the importation of built-in loss properties under Sections 334(b)(1)(B) and Section 362(e)(1) are designed "to prevent erosion of the corporate tax base through the importation" of built-in loss assets in nonrecognition transactions. The Proposed Regulations achieve this result essentially by adjusting the basis of the property in the hands of the acquiring corporation to its FMV if any gain or loss recognized on a hypothetical sale of the property would not be subject to U.S. federal income tax in the hands of the transferor immediately before the transfer but would be subject to U.S. federal income tax in the hands of the transferee immediately after the transfer.

The most controversial aspect of the Proposed Regulations is the treatment of property "imported" into the U.S. by a controlled foreign corporation (CFC). Under the Proposed Regulations, gain on the hypothetical sale of property by a CFC that would be included in income under Subpart F in the hands of the CFC's U.S. shareholders is not considered to be property that would be subject to U.S. federal income tax in the hands of the transferor immediately prior to the transfer. This has the effect of causing built-in loss property that is owned by the CFC as being treated as loss-importation property, and therefore subject to the basis adjustment provisions. A similar rule applies to gain or loss recognized by a passive foreign investment company (PFIC), notwithstanding that it could result in an income inclusion to a U.S. shareholder under the Section 1293(a) qualified electing fund (QEF) provisions.

The Proposed Regulations are intended to be effective for transactions occurring on or after the date they are published as final Regulations. It is also proposed that taxpayers would be permitted to apply the final Regulations (when published) to transactions occurring after 10/22/04.

OVERVIEW: SECTIONS 334(b)(1)(B) AND 362(e)

Generally, no gain or loss is recognized when one or more persons transfer property to a corporation in exchange for stock and immediately thereafter such person or persons "control" the corporation. The transferor's basis in the stock of the controlled corporation is the same as the basis of the property contributed to the controlled corporation, increased by the gain recognized by the transferor on the exchange, and reduced by any money or property received, and by any loss recognized by the transferor.

Similarly, the basis of property received by a corporation, whether from domestic or foreign sources, in a tax-deferred incorporation, reorganization, or liquidation of a subsidiary corporation will be the same as the adjusted basis in the hands of the transferor, adjusted for gain or loss recognized by the transferor. Therefore, any built-in gains or losses inherent in the transferred property generally will be preserved in the hands of the transferee corporation.

In an effort to shut down perceived abuses involving built-in loss assets, Congress enacted a series of provisions in 2004. Section 362(e)(1) applies if three conditions are satisfied:

1. The transaction is a contribution to capital, a Section 351 exchange, or a Section 361 exchange.

2. Gain or loss from the property transferred (referred to as "importation property") would not be subject to U.S. federal income tax in the hands of the transferor immediately prior to the transfer, but would be subject to U.S. federal income tax in the hands of the transferee immediately after such transfer.

3. The transferee's aggregate adjusted bases of the properties transferred would exceed the FMV of such property immediately after such transaction.

If these three conditions are satisfied, the basis of the importation property-even those individual assets that have appreciated in value-will equal its FMV immediately after the transaction. Therefore, the built-in loss that otherwise would carry over under the general basis rules described above will, in effect, disappear under Section 362(e)(1) .

Section 334(b)(1)(B) applies if two conditions are satisfied:

1. There is a distribution of property by a foreign corporation to an 80% domestic corporate distributee in a complete liquidation qualifying under Section 332 .

2. The 80% corporate distributee's aggregate basis in property described in Section 362(e)(1)(B) (i.e., the "importation property" or property the gain or loss from which would not be subject to U.S. federal income tax in the hands of the transferor immediately prior to the transfer, but would be subject to U.S. federal income tax in the hands of the transferee immediately after such transfer) that is received in the liquidation exceeds the property's aggregate FMV after the liquidation.

If these two conditions are satisfied, the basis of any importation property will equal the FMV of the property immediately after such liquidation. Again, this rule applies even to those individual assets that have appreciated in value, so long as the aggregate bases in the imported assets exceed the aggregate FMV of those assets.

Finally, Section 362(e)(2) (an in-depth look at which is beyond the scope of this article) applies if three conditions are satisfied:

1. The property is transferred in a Section 351 transaction or as a contribution to capital.

2. Section 362(e)(1) does not apply to the transfer (e.g., the property transferred is not imported into the U.S. tax system).

3. The transferee's aggregate basis in the property received would exceed the aggregate FMV of the property transferred immediately after the transfer.

If these three conditions are met, then the transferee's aggregate adjusted bases of the property transferred "shall not exceed the fair market value of such property immediately after such transaction."  Therefore, unlike the results under Sections 362(e)(1) and 334(b)(1)(B) , where each imported asset (even those that have appreciated in value) takes an FMV basis, under Section 362(e)(2) a basis adjustment is made only with respect to the built-in loss assets.

As an alternative to the reduction in the basis of the transferred assets, Section 362(e)(2)(C) permits transferors and transferees to elect to reduce the transferor's basis in the stock received in the exchange. If the election is made, Section 362(e)(2)(A) does not apply, and the transferor's basis in the transferee stock received in the exchange will not exceed its FMV immediately after the exchange.

Example. Foreign corporation (FC), which is not a CFC, owns three assets: A1 has a basis of $40 and value of $150, A2 has a basis of $120 and value of $30, and A3 has a basis of $140 and value of $20. On date 1, FC transfers A1, A2, and A3 to a domestic corporation (DC) in a transaction to which Section 351 applies. If FC had sold A1, A2, or A3 immediately before the transaction, no gain or loss recognized on the sale would have been taken into account in determining a U.S. federal income tax liability. Further, if DC had sold A1, A2, or A3 immediately after the transaction, DC would take into account any gain or loss recognized on the sale in determining its U.S. federal income tax liability. Therefore, A1, A2, and A3 are all importation properties.

But for Section 362(e)(1) , DC's aggregate basis in importation properties A1, A2, and A3 would be $300 ($40 + $120 + $140) under Section 362(a) and the properties' aggregate value would be $200 ($150 + $30 + $20). Therefore, the importation properties' aggregate basis would exceed their aggregate value and the transaction is a loss-importation transaction. As a result, DC's basis in A1, A2, and A3 will each be equal to the property's value ($150, $30, and $20, respectively) immediately after the transfer. 

'IMPORTATION PROPERTY' CLARIFIED

As noted above, property is importation property for purposes of Section 362(e)(1) if two conditions are satisfied: (1) any gain or loss recognized on a disposition of the property would not be subject to U.S. federal income tax in the hands of the transferor immediately before the transfer, and (2) any gain or loss recognized on a disposition of the property would be subject to U.S. federal income tax in the hands of the transferee immediately after the transfer. Since the enactment of Section 362(e)(1) , a number of issues have been raised regarding whether property is considered importation property for this purpose. To help clarify these issues, the Proposed Regulations employ a hypothetical sale approach to make this determination, and indicate that all relevant facts and circumstances need to be taken into account for this purpose.

Tax-Exempt Entities

If a tax-exempt entity transfers property to a taxable domestic corporation, the determination whether the property is importation property must take into account whether the transferor, though generally tax-exempt, would be taxable under the unrelated business taxable income (UBTI) provisions on a hypothetical sale of the property immediately prior to the transfer. If the tax-exempt transferor would be subject to U.S. federal income tax under the UBTI provisions on a hypothetical sale of the property, then the property will not be treated as importation property for Section 362(e)(1) purposes, even if the property has a built-in loss at the time of the transfer and the transferor is otherwise exempt from U.S. federal income tax.

Non-CFC Foreign Corporations

A similar analysis would need to be made when a foreign corporation that is not a CFC transfers property to a domestic corporation. Under the Proposed Regulations, whether the property is importation property would be based on whether gain from a hypothetical sale of the property by the foreign corporation immediately prior to the transfer would be subject to U.S. federal income tax under Section 864 or Section 897 as income effectively connected (or deemed to be effectively connected) with the conduct of a U.S. trade or business. If the foreign corporation would be subject to U.S. federal income tax on a hypothetical sale of the property immediately prior to the transfer, then the property will not be treated as importation property for purposes of Section 362(e)(1) . 

In connection with making this determination, the Preamble to REG-161948-05 indicates that it is necessary to examine whether the transferor would be exempt from U.S. federal income tax under an applicable income tax treaty (e.g., under the "business profits" or "gains" provision). Therefore, even if the foreign corporation otherwise would be subject to U.S. federal income tax on a hypothetical sale of property under the Code, the property will not be considered importation property for purposes of Section 362(e)(1) if the gain would be exempt under an income tax treaty.

Partnerships, S Corporations, and Grantor Trusts

While the Proposed Regulations generally look solely to the tax treatment of the hypothetical seller, a different rule applies if that seller is a partnership, S corporation, or grantor trust. In these situations, the Proposed Regulations look to the tax treatment of the gain or loss recognized by the partners, shareholders, or owners of the entities. The reason, of course, is that these types of entities generally are not subject to an entity-level tax. Instead, the gain or loss that would be recognized on the hypothetical sale would be included in income by the partner, shareholder, or owner, regardless of whether any amount is actually distributed to such other person.

The Proposed Regulations recognize, however, that a partnership or trust may allocate gain and loss to partners or beneficiaries in different amounts, including by reason of a special allocation under a partnership agreement. Therefore, the Proposed Regulations make it clear that the hypothetical sale analysis takes into account whether gain or loss is subject to U.S. federal income tax by reference to the person to whom the hypothetical gain or loss would actually be allocated.

Other Pass-Through Entities: Anti-Avoidance Rule

Unlike the tax treatment of partnerships, S corporations, and grantor trusts, the Proposed Regulations recognize that the Code permits distributions by certain entities to cause a shifting of tax consequences. For example, under Sections 651 and 652 , and Sections 661 and 662 , distributions made by a nongrantor trust are deducted from the trust's income and included in the beneficiaries' income. Similar rules apply with regard to distributions made by regulated investment companies (RICs), real estate investment trusts (REITs), and cooperatives taxable under Section 1381 .

As a result, Prop. Reg. 1.362-3(d)(4) contains an anti-avoidance rule that applies to domestic nongrantor trusts, estates, RICs, REITs, and cooperatives that directly or indirectly transfer property in a Section 362 transaction, if the property had been directly or indirectly transferred to or acquired by the entity as part of a plan to avoid the application of the anti-importation provisions. When this rule applies, the domestic entity is subject to a look-through rule where it is presumed to distribute the proceeds of the hypothetical sale, and, to the fullest extent permitted by the terms of its organizing instrument, make the distributions to persons that would not take distributions from the entity into account in determining a U.S. federal income tax liability.

The Preamble contains the following example to illustrate the application of the anti-avoidance rule. Assume 90% of a REIT's shares are owned by persons that would not take into account any gain or loss in determining a U.S. federal income tax liability (e.g., non-U.S. taxpayers), and that each share has an equal right to any distribution by the REIT. The REIT holds property that was acquired by it as part of a plan to avoid the application of Section 362(e)(1) . At a time when the acquired property has a built-in loss, the REIT transfers the property to a domestic corporation in a Section 362 transaction.

In this instance, the anti-avoidance rule would apply. Thus, the REIT is presumed to distribute all the proceeds of the hypothetical sale of the property transferred in the Section 362 transaction, and the determination of whether any gain or loss on that hypothetical sale would be taken into account in determining a U.S. federal income tax liability is made by reference to the REIT shareholders. As a result, 90% of the property transferred in the Section 362 transaction would be importation property.

The Preamble also posits a situation in which property is originally acquired (as part of a plan to avoid the application of Section 362(e)(1) ) by a trust whose trustee has sole discretion to distribute all or a portion of the trust's gain or loss to a person that would not take any amount of such distribution into account in determining a U.S. federal income tax liability. If the trust transfers the property at a time when it has a built-in loss to a domestic corporation in a Section 362 transaction, all of the property transferred would be treated as importation property under the anti-abuse rule. This is because the trustee could distribute all of the proceeds from the hypothetical sale to a person that would not take the distribution into account in determining a U.S. federal income tax liability.

CFCs and PFICs

Perhaps the most controversial aspect of the Proposed Regulations is the application of Section 362(e)(1) to CFCs and PFICs. As noted earlier, property will be considered importation property only if (1) any gain or loss recognized on a hypothetical sale of the property would not be subject to U.S. federal income tax in the hands of the transferor immediately before the transfer, and (2) any gain or loss recognized on a hypothetical sale of the property would be subject to U.S. federal income tax in the hands of the transferee immediately after the transfer.

If a CFC owns property that would generate Subpart F income in the hands of its U.S. shareholders in a hypothetical sale, it would seem that such property should not be considered importation property because gain from such a sale would be subject to U.S. federal income tax in the hands of the CFC's U.S. shareholders. The same logic would seem to apply to property owned by a PFIC, the sale of which would generate income that is included in a U.S. shareholder's hands under the Section 1293(a) QEF regime.

Nevertheless, the Proposed Regulations include an express provision indicating that gain or loss recognized by a CFC is not considered subject to U.S. federal income tax solely by reason of an income inclusion under the Subpart F rules.  A similar provision is included to clarify that gain or loss recognized by a PFIC also will not be considered to be subject to U.S. federal income tax, regardless of whether it could result in an income inclusion under Section 1293(a) .

Example. A U.S. corporation (USP) owns 100% of the outstanding stock of a foreign corporation (FC). Therefore, FC is a CFC. FC owns three assets, A1 (basis $40, value $249), A2 (basis $120, value $30), and A3 (basis $140, value $20). A hypothetical sale of A1 would generate Subpart F income in the hands of USP. On date 1, FC distributes A1, A2, and A3 to USP in a complete liquidation that qualifies under Section 332 .

Under the Proposed Regulations, the fact that any gain or loss recognized by FC may cause an income inclusion under Section 951(a) does not alone cause gain or loss recognized by FC to be treated as taken into account in determining a U.S. federal income tax liability for purposes of Section 362(e)(1) . Thus, if FC had sold either A1, A2, or A3 immediately before the liquidation, no gain or loss recognized on the sale would have been taken into account in determining a U.S. federal income tax liability. Further, if USP had sold A1, A2, or A3 immediately after the transaction, USP would take into account any gain or loss recognized on the sale in determining its U.S. federal income tax liability. Therefore, A1, A2, and A3 are all importation properties.

Accordingly, the basis in each of the importation properties received will be equal to its value immediately after FC distributes the property. USP's basis in A1 will be $249; USP's basis in A2 will be $30; and USP's basis in A3 will be $20.

This will be the result even though the net aggregate built-in loss imported into the U.S. in this example is only $1. The Proposed Regulations confirm that the determination of whether a Section 362 transaction is subject to Section 362(e)(1) is based on an aggregate approach, not a transferor-by-transferor approach. As illustrated by this example, because no de minimis exception is provided, even $1 of net built-in loss that is imported into the U.S. has a "cliff effect" and can have a significant impact on the basis of an asset that has a large built-in loss. As a result, the valuation of assets immediately before they are imported into the U.S. becomes extremely critical.

The Preamble indicates that this approach was taken because the statute generally looks to the treatment of the hypothetical seller (not the seller's owners), and no exceptions apply for CFCs or PFICs. The problem with this logic, however, is that the Proposed Regulations easily could have adopted a look-through rule similar to the approach adopted for partnerships, S corporations, and grantor trusts, at least for property owned by a CFC that would generate Subpart F income on a hypothetical sale or property owned by a PFIC that would result in an income inclusion under the QEF regime. Not surprisingly, Treasury and the IRS are requesting comments on this treatment.

While the approach taken by the Proposed Regulations with respect to CFCs certainly is questionable, it would seem to lead to a planning opportunity whenever a CFC owns both property with a built-in gain and property with a built-in loss, if the CFC intends to sell the appreciated asset in the short term but hold on to the depreciated asset for the long term.

Example. A CFC owns highly appreciated securities that it would like to sell but does not want to generate Subpart F income in the hands of its U.S. shareholders. Also, the CFC owns an asset with a built-in loss, the amount of which exceeds the built-in gain in the appreciated securities; the CFC has no intention of selling the depreciated asset in the near future.

Under this scenario, the CFC could liquidate (either by an actual liquidation or by filing a check-the-box election) into its U.S. corporate parent in a nontaxable Section 332 transaction, and purposely avail itself of the basis adjustment provisions under Section 362(e)(1) . Because the CFC is not considered to be subject to U.S. federal income tax solely by reason of an income inclusion under the Subpart F rules, the U.S. parent will take an FMV basis in the shares of the appreciated securities. As a result, the securities could be sold by the U.S. parent without triggering U.S. federal income tax, whereas a sale of the appreciated securities by the CFC immediately prior to the liquidation would have generated Subpart F income.

Obviously in this example the U.S. parent also will be taking an FMV basis in the depreciated asset, and thus there still will be a loss of basis in the aggregate. Nevertheless, this strategy would seem to make sense if the CFC has no intention of selling the depreciated asset anytime soon.

If a CFC owns property that is used in connection with a U.S. trade or business, a different result would apply. This is because if the CFC had sold the property immediately prior to a Section 362 transaction, any gain or loss recognized on the sale would have been taken into account in determining a U.S. federal income tax liability.

Example. FC is a CFC with 100 shares of stock outstanding. A, a U.S. taxpayer, owns 60 of the shares; F, a non-U.S. taxpayer, owns the remaining 40 shares. FC owns two assets, A1 (basis $70, value $100), which is used in the conduct of a U.S. trade or business, and A2 (basis $100, value $75), which is not used in the conduct of a U.S. trade or business. FC transfers both assets to a domestic corporation (DC) in a Section 351 transaction.

If FC had sold A1 immediately before the transaction, any gain or loss recognized on the sale would have been taken into account under Section 882(a) in determining a FC's U.S. federal income tax liability. Therefore, A1 is not importation property. If FC had sold A2 immediately before the transaction, FC would not take the gain or loss recognized into account in determining its U.S. federal income tax liability, but the gain or loss could be taken into account in determining a Section 951 inclusion for FC's U.S. shareholders.

As noted earlier, however, gain or loss is not deemed taken into account in determining a U.S. federal income tax liability solely because it could affect an inclusion under Section 951(a) . Further, if DC had sold A2 immediately after the transaction, any gain or loss recognized on the sale would have been taken into account in determining a U.S. federal income tax liability. Therefore, A2 is importation property. As a result, DC's basis in A2 will be equal to A2's $75 value immediately after the transfer.

LIABILITIES AND THE VALUE OF PARTNERSHIP INTERESTS

In general, the Section 362(e)(1) provisions do not take liabilities into account in determining the value of transferred property and, therefore, whether the transfer of such property is a transfer of loss property. Some commentators raised concerns about the effect of this rule when the property transferred is an interest in a partnership with liabilities.

Practitioners were concerned that the inclusion of a partner's share of partnership liabilities in outside basis may create the appearance of a built-in loss because partnership liabilities do not correspondingly increase the value of the interest. The commentators were of the view that the amount of cash at which the partnership interest would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts, should be the appropriate measure of FMV for this purpose.

To address this issue, the Proposed Regulations generally adopt the approach proposed by commentators and modify the definition of "value" (generally, FMV) to take liabilities into account when determining whether a partnership interest is a loss asset. The Preamble notes, however, that because there can be differences between a transferor's share of partnership liabilities and the acquiring corporation's share of partnership liabilities, the Proposed Regulations provide that the value of a partnership interest is the sum of cash that the acquiring corporation would receive for such interest, increased by any liabilities under Reg. 1.752-1 of the partnership that are allocated to the acquiring corporation with regard to such transferred interest under Section 752 .

Example. F, a non-U.S. taxpayer, and two other individuals are equal partners in a foreign partnership (FP). F's basis in his partnership interest is $247. F's share of FP's liabilities is $150. F transfers his partnership interest to a domestic corporation (DC) in a transaction to which Section 351 applies. FP has no Section 754 election in effect. If DC were to sell the FP interest immediately after the transfer, DC would receive $100 in cash or other property. In addition, DC's share of FP's liabilities is $145 immediately after the transfer.

If F had sold his partnership interest immediately before the transaction, no gain or loss recognized on the sale would have been taken into account in determining a U.S. federal income tax liability. Further, if DC had sold the partnership interest immediately after the transaction, any gain or loss recognized on the sale would have been taken into account in determining a U.S. federal income tax liability. Therefore, F's partnership interest is importation property.

F's transfer is a Section 362 transaction. DC's basis in the partnership interest would be $242 (F's $247 basis reduced by F's $150 share of FP's liabilities and increased by DC's $145 share of FP's liabilities). Under Prop. Reg. 1.362-3(c)(4)(ii) , the value of the FP interest would be $245 (the sum of $100, the cash DC would receive if DC immediately sold the partnership interest, and $145, DC's share of the FP liabilities). Therefore, the importation property's basis ($242) would not exceed its value ($245), and the transfer would not be a loss-importation transaction.

ACQUIRING'S BASIS IN THE ACQUIRED PROPERTY

As noted above, if a transaction is a loss-importation transaction, the acquiring corporation's basis in each importation property received (including the tentatively divided portions of property determined to be importation property) is adjusted to FMV, regardless of whether the property has appreciated in value. The Proposed Regulations indicate that immediately following the basis adjustments under Section 362(e)(1) (and prior to any application of Section 362(e)(2) ), any property that was treated as tentatively divided for purposes of applying these provisions is no longer treated as divided and is subsequently treated as one undivided property with a basis equal to the sum of the bases of the portions determined under Section 362(e)(1) and the bases of all other portions determined under generally applicable provisions (other than Section 362(e)(2) ). The Preamble notes that if the transaction is described in Section 362(a) , the transferred property is then aggregated on a transferor-by-transferor basis to determine whether a further basis adjustment will be required under Section 362(e)(2) .

Example. A, a U.S. taxpayer, and F, a non-U.S. taxpayer, are equal partners in a foreign partnership (FP). FP owns A1 (basis $100, value $70). Under the terms of the FP partnership agreement, FP's items of income, gain, deduction, and loss are allocated equally between A and F. FP transfers A1 to domestic corporation DC in a transfer to which Section 351 applies. No election is made under Section 362(e)(2)(C) . If FP had sold A1 immediately before the Section 351 transfer, any gain or loss recognized on the sale would be allocated to and includable by A and F equally under the partnership agreement. Thus, A1 is treated as tentatively divided into two equal portions, one treated as owned by A and one treated as owned by F.

If FP had sold A1 immediately before the transaction, any gain or loss recognized on the portion treated as owned by A would have been taken into account in determining A's U.S. federal income tax liability because A is a U.S. taxpayer. Therefore, A's tentatively divided portion of A1 is not importation property.

No gain or loss recognized on the tentatively divided portion treated as owned by F would have been taken into account in determining a U.S. federal income tax liability, however, because F is a non-U.S. taxpayer. Further, if DC had sold A1 immediately after the transaction, any gain or loss recognized on the sale would have been taken into account in determining DC's U.S. federal income tax liability. Thus, F's tentatively divided portion of A1 is importation property.

FP's transfer of A1 is a Section 362 transaction. Furthermore, but for Section 362(e)(1) and Section 362(e)(2) , DC's basis in the importation property-F's portion of A1-would be $50 under Section 362(a) and the property's value would be $35 immediately after the transaction. Therefore, the importation property's basis would exceed its value and the transfer is a loss-importation transaction. Because the importation property (F's tentatively divided portion of A1) was transferred in a loss-importation transaction, Section 362(e)(1) applies and DC's basis in F's portion of A1 will be equal to its $35 value.

Following the application of Section 362(e)(1) , the provisions of Section 362(e)(2) must be taken into account because the transfer is a Section 362(a) transaction. Taking into account the application of Section 362(e)(1) but without taking into account the provisions of Section 362(e)(2) , DC's aggregate basis in A1 would be $85 (the sum of the $35 basis in F's tentatively divided portion of A1 and the $50 basis in A's tentatively divided portion of A1, determined under Section 362(a) ), and A1's value immediately after the transfer would be $70. Therefore, FP has a net built-in loss and FP's transfer of A1 is a loss-duplication transaction.

Accordingly, under the general rule of Section 362(e)(2) , FP's $15 net built-in loss ($85 basis over $70 value) would be allocated to reduce DC's basis in the loss asset, A1, the only loss property transferred by FP. As a result, DC's basis in A1 would be $70 ($85 basis under Section 362(a) , reduced by the $15 net built-in loss). Under Section 358 , FP's basis in the DC stock received in the exchange will be $100.

CONCLUSION

The most controversial aspect of the Proposed Regulations undoubtedly is the treatment of property owned by a CFC or a PFIC for purposes of determining whether such property is importation property. The Proposed Regulations expressly include a provision indicating that gain or loss recognized by either a CFC or a PFIC will not be considered subject to U.S. federal income tax solely by reason of an income inclusion under the Subpart F rules or the QEF rules. While the Preamble indicates that this approach was taken because the statute generally looks to the treatment of the hypothetical seller (not the seller's owners), the Proposed Regulations easily could have adopted a look-through rule similar to the approach adopted for partnerships, S corporations, and grantor trusts, at least for property owned by a CFC that would generate Subpart F income and property owned by a PFIC that would result in an income inclusion under the QEF regime.

Practice Notes

While the approach taken by the Proposed Regulations with respect to CFCs certainly is questionable, it would seem to lead to a planning opportunity whenever a CFC owns both property with a built-in gain and property with a built-in loss, if the CFC intends to sell the appreciated asset in the short term but hold on to the depreciated asset for the long term. For example, assume a CFC owns highly appreciated securities that it would like to sell but does not want to generate Subpart F income in the hands of its U.S. shareholders. Also assume that the CFC owns an asset with a built-in loss, the amount of which exceeds the built-in gain in the appreciated securities, and that the CFC has no intention of selling the depreciated asset in the near future.

Under this scenario, the CFC could liquidate (either by an actual liquidation or by filing a check-the-box election) into its U.S. corporate parent in a nontaxable Section 332 transaction and purposely avail itself of the basis adjustment provisions under Section 362(e)(1) . Because the CFC is not considered to be subject to U.S. federal income tax solely by reason of an income inclusion under the Subpart F rules, the U.S. parent will take an FMV basis in the shares of the appreciated securities. As a result, the securities could be sold by the U.S. parent without triggering U.S. federal income tax, whereas a sale of the appreciated securities by the CFC immediately prior to the liquidation would have generated Subpart F income. Obviously, in this situation the U.S. parent also will be taking an FMV basis in the depreciated asset, and therefore there will still be a loss of basis in the aggregate. Nevertheless, this strategy would seem to make sense if the CFC has no intention of selling the depreciated asset anytime soon.

Topics:  Controlled Foreign Corporations, Foreign Corporations, Income Taxes, Sales

Published In: Business Organization Updates, General Business Updates, International Trade Updates, Mergers & Acquisitions Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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