International Tax Blog

Modifications to Section 367 in Outbound Section 304 Transactions

On February 10, 2009 the I.R.S. and Treasury Department issued temporary regulations in Treasury Decision 9444 regarding the application of Code § 367(a) and (b) with respect to Code § 304 transactions.

Code § 367(a)(1) generally provides that if a United States person transfers property to a foreign corporation in an exchange described in Code § 332, 351, 354, 356, or 361, the foreign corporation shall not be considered a corporation for purposes of determining the extent to which the United States person recognizes gain on such transfer.  Exceptions to the general rule are provided by section 367(a)(2) and (3).

Code § 367(b)(1) provides that in the case of an exchange described in section 332, 351, 354, 355, 356, or 361 in connection with which there is no transfer of property described in section 367(a)(1), a foreign corporation shall be considered to be a corporation except to the extent provided in regulations.  Regulations under Code § 367(b) generally provide that if the potential application of Code § 1248 cannot be preserved immediately following the acquisition of the stock or assets of a foreign corporation (foreign acquired corporation) by another foreign corporation in an exchange subject to Code § 367(b), then certain exchanging shareholders of the foreign acquired corporation must include in income as a dividend the Code § 1248 amount attributable to the stock of the foreign acquired corporation.

Code § 304(a)(1) generally provides that, for purposes of Code §§ 302 and 303, if one or more persons are in control of each of two corporations and in return for property one of the corporations (the acquiring corporation) acquires stock in the other corporation (the issuing corporation [i.e., the target corporation]) from the person (or persons) so in control, then such property shall be treated as a distribution in redemption of the stock of the acquiring corporation. 

To the extent Code § 301 applies to the distribution, the transferor and the acquiring corporation are treated as if (1) the transferor transferred the stock of the target corporation to the acquiring corporation in exchange for stock of the acquiring corporation in a transaction to which Code § 351(a) applies, and (2) the acquiring corporation then redeemed the stock it is deemed to have issued.  Under section 304(b)(2), the determination of the amount of the property distribution that is a dividend (and the source thereof) is made as if the property is distributed by the acquiring corporation to the extent of its earnings and profits, and then by the target corporation to the extent of its earnings and profits.

On February 21, 2006, the IRS and Treasury Department issued final regulations (TD 9250) providing that Code § 367(a) and (b) do not apply to a deemed Code § 351 exchange resulting from a Code § 304(a)(1) transaction, stating:

The IRS and the Treasury believe that the interests of the government are protected, and the policies underlying section 367(a) and (b) are preserved, in a section 304(a)(1) transaction without regard to the application of section 367.  The IRS and Treasury believe that, in most or all cases, the income recognized in a section 304 transaction will equal or exceed the transferor's inherent gain in the stock of the [target] corporation transferred to the foreign acquiring corporation.
An underlying assumption in the 2006 final regulations was that the deemed redemption would provide basis recovery only with respect to the basis in the shares deemed issued in the deemed Code § 351 exchange.  The preamble to the 2009 temporary regulations acknowledges that certain taxpayers may be taking the position that basis recovery is allowed on the stock of the acquiring corporation other than the stock deemed issued in the Code § 304 transaction.

The I.R.S. and Treasury are currently studying whether such basis reduction is allowable.  If such basis recovery is allowable (or claimed), the 2009 temporary regulations provide that gain will be recognized.

Specifically, the 2009 temporary regulations provide an exception to the general rule of nonrecognition if the distribution is applied against and reduces (in whole or in part), pursuant to Code § 301(c)(2), the basis of stock of the foreign acquiring corporation held by the United States person other than the stock deemed issued to the United States person in the deemed Code § 351 exchange. 

The chart below depicts the deemed steps in a Code § 304 transaction.  If, in step 2b below, the taxpayer were to claim that the deemed redemption were to not only recover basis in the deemed issued shares (the blue dotted line between P and X in box 2b), but also were to recover basis in the pre-existing shares of Corp X owned by Corp P (the black solid line between P and X in box 2b), then gain would be recognized by Corp P on the outbound Code § 304 transaction.  The gain realized would reduced by the amount treated as a dividend to Corp P.

 

For a clearer image of the chart click on the chart or see  Outbound 304 Transaction

“Unrelated” Financial Institution Under U.S.-Australia Income Tax Treaty

In Interpretive Decision 2009/2, the Australian Tax Office ruled that an Australian resident taxpayer which is a payer of dividends on redeemable preference shares is “unrelated” to a U.S. resident financial institution for the purposes of Article 11(3)(b) of the U.S.-Australia Income Tax Treaty (the “Treaty”).  Article 11 of the Treaty deals with the payment of interest.  Therefore, the Australian Tax Office must have viewed the redeemable preference shares as debt for Australian tax purposes.

Under the facts of the ruling, the Australian company participated in a financing arrangement with a US financial institution in order to obtain funds at a lower cost for the Australian group of companies.  The Australian company issued redeemable preference shares to the US financial institution.

The redeemable preference shares were mandatorily redeemable 10 years after issue and included the following rights:

• the right to be paid preferential dividends, calculated by reference to an external benchmark interest rate;
• the right to exercise 10% of the voting power at the Australian company’s annual general meeting;
• the ability to appoint one member to the Australian company’s board of directors comprising five directors (with a quorum constituted by two directors). Each director ordinarily has one vote in the board’s meeting with board resolutions being passed by the majority of votes.

The Australian company makes dividend payments to the US financial institution.  Where specified events occur involving compliance with the terms of the redeemable preference shares, the director appointed by US financial institution has five votes on the board of the Australian company (with a quorum constituted by the one director appointed by US financial institution ) but only with respect to any decision or resolution to rectify the specified event.

Article 11(3) of the Treaty provides that Australia will not tax interest arising in Australia where a US financial institution is beneficially entitled to that interest (and satisfies other conditions).  Article 3(2) of the Treaty provides that any term not defined will have the meaning given under the laws of Australia relating to the taxes to which the Treaty applies, unless the context otherwise requires. The term “unrelated” is not defined in the Treaty or in Australian domestic tax law.

The Australian Tax Office ruled that, since the US financial institution has restricted voting and profit participation rights, the redeemable preference shares do not cause the Australian company and the US financial institution to be “related” within the meaning of Article 11(3)(b) of the Treaty.

It is interesting to note that the financing arrangement was structured as redeemable preference shares.  Presumably, the US financial institution was claiming that the redeemable preference shares should be treated as equity for U.S. tax purposes.