As a general proposition, when a United States person makes a transfer of property to a foreign corporation to which Sections 354, 356, and 361 of the Internal Revenue Code, hereinafter the Code, would be applicable the transferee foreign corporation is not considered a corporation for statutory purposes. (1) It is this general rule that provides domestic corporations’ nonrecognition treatment by virtue of Section 354, 356, and 361 of the Code and requires a foreign corporation to recognize gain when it would otherwise be accorded a tax-free reorganization.
Reorganizations are only those transactions constructed in Section 368 of the Code. (2) It is an entirely descriptive section and does not purport to dictate what transactional result might flow as the result of a particularly described reorganization. Reorganization is limited by definition to six kinds of transactions and excludes all others. (3)
The provisions of Sections 354, 356, and 361 generally govern the tax consequences that flow when exchanges occur. These sections are keyed to the conclusion that a reorganization has been consummated. Therefore the appropriate analytical approach is to determine from Section 368 the particular transaction that fits as a qualifying Section 368 reorganization. The business significance of placing the transaction within the framework of one of the six types of transactions is to enable the taxpayer to acquire, reform, and divide corporate interests without it being a taxable event. This is an important tool for a taxpayer pertaining to corporate decisions to expand, realign itself, and make itself marketable, or to sell off corporate interests that may or may not be profitable.
Domestic Acquisitive Reorganizations
Acquisitive reorganizations described as a Type A reorganizations are statutory mergers or consolidations. (4) Transactions of this writing are international in nature and statutory mergers or consolidations are domestic creations that generally are excluded in an international context. Consolidation differs from merger conceptually in that a new corporation is formed and both of the old participating corporations are forged into the new corporation. In this respect, the new corporation acquires the assets and the liabilities both of the old corporations as well as the rights, privileges, and detriments. It has similar features of a merger in that there is one continuing entity. But in both arrangements the old corporations are making exchanges.
A second type of acquisitive reorganization, a Type B reorganization, has a similar affect as a merger but is different conceptually and in result. (5) In a merger one of the companies is eliminated whereas in a Type B reorganization, there is an exchange to the stockholders by an acquiring company of the acquired company’s stock. The acquired company is not a party itself to the exchange.
There are several other differences of the Type B reorganization from a Type A. Type B reorganizations have a restriction of consideration variation. Only voting stock is permitted in the exchange. Subsequent to the reorganization, the acquiring corporation is required to have control of at least eighty percent of the voting stock as well as a like percentage of other stock outstanding. Subsequent to the reorganization, the acquiring corporation owns control of the acquired subsidiary, and the acquired corporation shareholders have received stock of the acquiring corporation’s stock. (6)
Foreign Corporate Reorganizations
To facilitate an understanding of the role foreign corporate reorganizations play in financial planning, it is productive to appreciate the objectives of the transactional consideration. These are instances where the establishment of a new foreign corporate entity may not be desirable. Rather it may be advantageous to acquire an established business in the target foreign location.
There may be practical considerations dictating an acquisition as opposed to a new enterprise. Licensing and other regulatory considerations may have a bearing on such a determination. There may be circumstances where a foreign enterprise seeks to make a market expansion in the United States. However, it may make more financial sense to buy an existing, established United States enterprise to achieve this expansion. The tax consequences of such an acquiring transaction to United States shareholders of a target United States company may be such that an outright sale may not be prudent. Reorganization can remedy tax consequence concerns and promote fluid business activity.
In the organizational sense the acquisitive reorganization can be a significant financial tool in accomplishing these types of objectives. Also during the actual operational phase of corporate activities, corporate reformations and recapitalizations can add important potentials. Reformative reorganizations may not necessarily have the same impact initially as an acquisitive reorganization. However in the duration of operational activities, it can offer important flexibility to the planner whether used to restructure debt and equity to satisfy banks, bondholders, and equity ownership percentages, or to attain various other corporate objectives.
The treatment of exiting or outbound reorganizational transactions in the foreign setting becomes fundamental. The benefits that can be derived are important to the practitioner. A discussion of exit reorganization transactions amounts to a transferring of United States assets to a foreign corporation. Assets in this sense would be the stock of a domestic corporation or its actual assets. This would be an acquisitive reorganization in which a foreign corporation acquires the interest of United States shareholders or domestic corporate assets.
The consideration in return to the United States shareholders can be structured in the form of equity ownership of the foreign corporate transferee. The United States domestic corporate shareholder is in effect transferring appreciated stock in exchange for the stock of a foreign corporate transferee. The United States shareholder exchanges the domestic stock or assets of the domestic corporation and ends up with an equity ownership in a foreign corporation. Is it possible for such a transaction to be accorded nonrecognition treatment to a United States shareholder? It broaches the question of whether shareholders’ appreciated gain of the acquired company or the assets would go untaxed, and the United States shareholder would obtain ownership in a foreign corporation. The carryover cost basis would leave the shareholders with deferred gain on the nonrecognition exchange. A domestic reorganization would receive this type of transactional treatment. A foreign reorganization is treated differently.
As in the organizational consideration, Section 367 of the Code is intertwined with domestic nonrecognition provisions governing reorganizations. Section 367 generally overrides the nonrecognition reorganization provisions. It specifically supercedes the nonrecognition treatment Sections 354, 355, 356, and 361 of the Code provided to domestic transactions. With respect to international reorganizations, it further defines the consequences of corporate acquisition, reformation, and division as it relates to foreign entry and exit taxation.
As with the domestic organization nonrecognition provisions, Section 367 imposes an income tax upon various corporate reorganizations in which transfers exit United States taxing jurisdiction. This Code provision deems transfers of property to a foreign corporation in connection with an exchange otherwise sheltered in Sections 354, 355, 356, and 361 as taxable transfers. These basic nonrecognition Code sections in domestic reorganization provide shelter to Section 368 defined reorganizations. The basic nonrecognition treatment accorded a domestic reorganization is denied in an exiting reorganization. This is accomplished by deeming the transferee corporation, not to have corporate status for purposes of statutory construction. The nonrecognition treatment relies upon the statutory requirement that the transferee must be recognized as a corporation. (7)
A reorganization in which a United States person (8) transfers (9) property (10) to a foreign corporation is not, as a general rule, entitled to nonreocgnition of gain. On the other hand, where a reorganization results in a loss there is no recognition. (11) The gain to be recognized on such a reorganization is not to exceed the gain that would have been recognized on a taxable sale of property as though it were sold individually and without offsetting individual losses against individual gains. (12)
Where United States shareholders in an exiting reorganization are required to recognize gain, the character and source of gain are to be determined as though a taxable exchange occurred. Appropriate corresponding adjustments to earnings and profits, basis to shareholders, and other affected attributes to corporate entities are to be made. (13) Increases in the basis of property received by a foreign corporate transferee are allocated over the transferred property proportionately to the gain which is realized as to each item of property attributable to the United States person on transfer. (14)
Though in accordance with this rule a taxpayer is required to recognize gain, there are several benefits gained by a realization and recognition on reorganization. These benefits include such things as a reduction of a transferor’s accumulated earnings and profits and eventual dividend liability. A transferee corporation receives a stepped-up basis which reflects consideration attributable to the recognition of gain, and that in turn provides depreciation and amortization benefits. (15)
Acquisitive Type B Reorganization Planning Harbors
The most useful exceptions to Section 367 treatment of reorganizations are those provided in Type B, stock for stock, transactions. (16) This acquisitive stock for stock exchange generally requires the acquiring corporation to have control of the acquired corporation. (17) As a tenet, a United States person who exchanges stock of a domestic corporation for voting stock of a foreign corporation is considered to be making a transfer of stock subject to income tax. (18) However, there are useful exceptions to the Section 367 taxable exchange treatment.
First there is a limited interest exception. The exceptions are provided by the treasury regulations. They provide that a transfer of stock or securities of a domestic corporation by a United States person to a foreign corporation is not a taxable event as contemplated by Section 367 under several conditions and circumstances. One such limited interest exception is the five percent exception.
Subsequent to the transfer of stock in a Type B reorganization to a foreign corporation if the shareholder owns less than five percent of the total voting power and the total value of the stock of the foreign corporation, the reorganization is granted nonrecognition treatment. (19) In addition it shall not be deemed a taxable exchange if after the transfer by a United States shareholder, the shareholder owns five percent of the foreign corporation and enters into a five year gain recognition agreement. (20) A five percent shareholder for the application of this provision is a person owning at least five percent of the total voting power or total value of the stock of the United States target company immediately after the transfer. (21)
A similar exception is termed the fifty percent conditional transaction. The Type B foreign reorganization will not be deemed an exchange if four conditions are complied with in connection with the reorganization transfer. First, fifty percent or less of both the total voting power and the total value of the stock of the transferee foreign corporation is received in the transaction, in the aggregate, by United States transferors. (22)
Second, fifty percent or less of each of the total voting power and the total value of the stock of the transferee corporation is owned, in the aggregate, immediately after the transfer by United States persons that are either officers or directors of the United States target company or that are five percent target shareholders. Third the United States person is not a five percent transferee shareholder or the United States person is a five percent transferee shareholder and enters into a five year agreement of gain recognition.
Lastly the condition of an active trade or business is met in accordance with the statute. For purposes of the fifty percent rule, any stock of the transferee foreign corporation owned by United States persons immediately after the transfer will be taken into account, whether or not it was received in exchange for stock or securities of the United States target company. (23)
*****************************Footnotes 1. IRC Section 367 (a) (1) (1986). 2. Section 355 (a) (2) of the Code is treated or differentiated based upon whether or not it is a reorganization. Generally, Section 368 deals only partially with aspects of divisive reorganization. Section 355 of the Code is the principal section dealing with divisive transactions. A Section 355 transaction which qualifies under Section 355 is for all practical purposes treated as a reorganization. 3. See Treas. Reg. Section 1.368-1 (c) of the IRC of 1986 and as thereafter amended. 4. IRC Section 368 (a) (1) (A) (1986). 5. IRC Section 368 (a) (1) (B) (1986). 6. IRC Section 368 (c) (1986). The consideration utilized in reorganization is the most significant difference in contrasting “Type A” and “Type B” reorganizations. Section 368 (a) (1) (A) does not place stipulations on the types of consideration that may be involved in a “Type A” reorganization. The statute is silent (there are limits that do not appear in the statute) and generally speaking a diversity of consideration can be utilized. That is non-voting preferred stock, voting common and voting preferred stock may constitute the “Type A” consideration. It may constitute, in other words, a mix of consideration, whereas the “Type B” reorganization must be in exchange for “voting stock”. In some of the definitions pertaining to a United States person and controlled foreign corporation, this distinction may play a part in financial planning. 7. Treas. Reg. Section 1.367 (a)-1T (b) of the IRC of 1986 and as thereafter amended. 8. Treas. Reg. Section 1.367 (a) – 3 (a) (1) of the IRC of 1986 and as thereafter amended. 9. Treas. Reg. Section 1.367 (a) – 1 (a)(3) of the IRC of 1986 and as thereafter amended. 10. Treas. Reg. Section 1.367 (a) – 5T of the IRC of 1986 and as thereafter amended. 11. Treas. Reg. Section 1.367 (a) – 1T (b)(3)(ii) of the IRC of 1986 and as thereafter amended. 12. Treas. Reg. Section 1.367 (a) – 1T (b)(3)(i) of the IRC of 1986 and as thereafter amended. 13. Treas. Reg. Section 1.367 (a) – 1T(b) (4) of the IRC of 1986 and as thereafter amended. 14. Treas. Reg. Section 1.367 (a) – 1T (c) of the IRC of 1986 and as thereafter amended. 15. IRC Section 1014 (1986). 16. IRC Section 368 (a) (1) (B) (1986). 17. IRC Section 368 (c) (1986) 18. Treas. Reg. Section 1.367 (a) – 3 (a)(1) of the IRC of 1986 and as thereafter amended. 19. Treas. Reg. Section 1.367 (a) – 3 (b) (1) (i) of the IRC of 1986 and as thereafter amended. 20. Treas. Reg. Section 1.367 (a) – 3 (b) (1) (ii) of the IRC of 1986 and as thereafter amended. 21. Id. at note 20. 22. Treas. Reg. Section 1.367 (a) – 3 (c) (1)(i) of the IRC of 1986 and as thereafter amended. (ii) Five-percent transferee shareholder. A five-percent transferee shareholder is a person that owns at least five percent of either the total voting power or the total value of the stock of the transferee foreign corporation immediately after the transfer described in section 367(a)(1). For special rules involving cases in which stock is held by a partnership, see paragraph (c) (4) (i) of this section. (iii) Five-percent target shareholder and certain other 5- percent shareholders. A five-percent target shareholder is a person that owns at least five percent of either the total voting power or the total value of the stock of the U.S. target company immediately prior to the transfer. 23. Treas. Reg. Section 1.367 (a) – 3 (c) (1) (ii) of the IRC of 1986 and as thereafter amended.