Introduction to Section 367(a)(1), Outbound Stock Transfers, and Gain Recognition Agreements

Section 367(a) of the Internal Revenue Code (the “Code”) governs the outbound transfer of property by a U.S. person to a foreign corporation in certain non-recognition transactions. If section 367(a) is triggered the relevant non-recognition provision is “turned off” and the U.S. person that transferred the property outbound must recognize gain on the transfer. The section 367(a) outbound transfer can be of stock or non-stock assets. If the section 367(a) outbound transfer is a stock transfer (“transferred stock”) the U.S. person may be able to avoid gain recognition if: (i) the U.S. person is a five percent or greater shareholder of the recipient corporation (the “transferee foreign corporation”) and (ii) the U.S. person enters into a five-year gain recognition agreement (“GRA”) with respect to the transferred stock.[1] A gain recognition agreement is, in effect, a contract with the IRS, wherein the taxpayer agrees to report certain events with respect to transferred stock, each year, for five full taxable years after the outbound stock transfer.  The ability of a U.S. person to enter into a gain recognition agreement is a valuable tool to avoid (or defer) gain recognition on outbound stock transfers. However, the GRA rules are nuanced and can be difficult to interpret. Additionally, the GRA rules have very specific requirements for what must be included in a gain recognition agreement. If the gain recognition agreement does not comply with the rules, it may be invalid and cause the immediate gain recognition on the outbound stock transfer under section 367(a)(1). This note will briefly discuss an overview of section 367(a), the gain recognition agreement rules, and related compliance filings.

Section 367(a) Overview

Section 367(a)(1) provides that if, in connection with any exchange described section 332, 351, 354, or 361,[2] a U.S. person[3] transfers property,[4] including the stock or securities of another corporation (the “transferred corporation”), to a foreign corporation, such foreign corporation, shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered to be a corporation.[5] In other words, if a U.S. person transfers property outbound, the recipient corporation (the transferee foreign corporation) is not treated as a corporation (i.e., section 367(a)(1) denies non-recognition treatment under the relevant non-recognition provision) and the U.S. transferor must recognize gain on the property transferred unless an exception applies.[6][7] If a U.S. person is required to recognize gain under section 367(a)(1), the character and source of the gain has to be determined as if the property were disposed in a taxable exchange with the transferee foreign corporation.[8]

Exceptions to Gain Recognition

The exceptions to immediate gain recognition as provided in Treas. Reg. § 1.367(a)-3(b)(1) are: (i) the U.S. person owns less than 5 percent (applying the attribution rules of section 318, as modified by section 958(b)) of the vote and value of the stock of the transferee foreign corporation immediately after the transfer, or (ii) the U.S. person owns five percent or more of the vote and value of the stock of the transferee foreign corporation and the U.S. person enters into a gain recognition agreement with respect to the transferred stock or securities as required under Treas. Reg. § 1.367(a)-8. Thus, if the U.S. person is a 5 percent or more shareholder and files a GRA, section 367(a)(1) is turned off and the U.S. person does not have to immediately recognize gain on the outbound stock transfer. This is a significant benefit if there is a large built-in-gain in the stock that was transferred outbound and for U.S. companies that frequently restructure their off-shore operations.

Gain Recognition Agreements under Treas. Reg. § 1.367(a)-8

Introduction to Gain Recognition Agreements

As discussed, a U.S. person that is a five percent or more shareholder with respect to the stock of the transferee foreign corporation is eligible to file a gain recognition agreement to avoid immediate gain recognition under section 367(a)(1). Treas. Reg. § 1.367(a)-8(c)(1) provides the terms of the agreement, including what happens if a gain recognition event (a triggering even without an exception) occurs during the GRA term. The GRA term is defined as the date of the initial outbound transfer and ending as of the close of the U.S. transferor’s fifth full taxable year (not less than 60 months) following the close of the taxable year of the initial outbound transfer.[9] Generally, these rules provide how and when gain should be recognized in the event of a gain recognition event.

Content of Gain Recognition Agreements

Treas. Reg. § 1.367(a)-8(c)(2) provides the specific content that must be included in the gain recognition agreement for it to be valid. The GRA must include several key pieces of information:

• A statement that the document constitutes an agreement by the U.S. transferor to recognize gain in accordance with Treas. Reg. § 1.367(a)-8(c);
• A description of the transferred stock or securities as required by Treas. Reg. § 1.367(a)-8(c)(3);
• A statement that the U.S. transferor agrees to comply with the conditions and requirements of Treas. Reg. § 1.367(a)-8;
• A statement that arrangements have been made to ensure the U.S. transferor is aware of events that affect the GRA, including triggering events or other gain recognition events;
• In the case of a “new gain recognition agreement” a description of the event that gave rise to the new GRA, including: (a) the date of the event, and the TIN of each person that is a party to the event, (b) a description of the class, amount, and characteristics of the stock, securities, or partnership interest received in the transaction, and (c) a calculation of the amount of gain that remains subject to the new GRA;
• A statement that the U.S. transferor elects to include in income any gain recognized under Treas. Reg. § 1.367(a)-8(c)(1)(i) in the taxable year of the gain recognition event;
• A statement whether a gain recognition event occurred during the taxable year of the initial transfer; and
• A statement describing any disposition of assets of the transferred corporation during the taxable year, other than in the ordinary course of business.

Gain Recognition Agreement Filing Requirements and Extending the Period of Limitations on Assessments

Treas. Reg. § 1.367(a)-8(d) contains the filing requirements for a GRA including rules that must be satisfied for the GRA to be timely filed and rules regarding the filing of a new GRA, or multiple events that have occurred within the U.S. transferor’s tax year. Under Treas. Reg. § 1.367(a)-8(e) the GRA must be signed, under the penalties of perjury, by an agent of the U.S. transferor that is authorized to sign under a general or specific power of attorney. Treas. Reg. § 1.367(a)-8(f) contains rules for extending the period of limitations on assessments of tax and requires the U.S. transferor to extend the period of limitations on assessments with respect to the gain realized but not recognized on the initial transfer through the close of the eighth full taxable year after the taxable year of the initial transfer by filing a Form 8838, “Consent to Extend the Time to Assess Tax Under Section 367.” The Form 8838 must be filed with the initial GRA for the taxable year of the outbound stock transfer.

Annual Certifications

In addition to the operative rules for filing a GRA, Treas. Reg. § 1.367(a)-8(g) requires the U.S. transferor to include with its timely-filed return for each of the five full taxable years following the taxable year of the initial transfer an annual certification stating: (i) whether a gain recognition event has occurred, (ii) a description of any event that occurred during the taxable year that has terminated or reduced the amount of gain subject to the GRA, and (iii) whether there was any disposition of assets of the transferred corporation during the taxable year outside of the ordinary course of business. The annual certification must be signed under the penalties of perjury. If, during the taxable year, there has been a triggering event that is subject to an exception and for which the U.S. transferor is entering into a new GRA, the new GRA is filed in lieu of the annual certification that is otherwise required.[10] A commonly misunderstood aspect about the GRA rules is that GRA compliance is an ongoing obligation for the five-year term of the GRA whether it is a new GRA or filing an annual certification.

Gain Recognition Agreement Triggering Events and Exceptions

The underlying policy of section 367 is to maintain the United States’ primary taxing jurisdiction over appreciated property that was held by a U.S. person. Generally, these rules are intended to discourage a U.S. person from transferring appreciated property outbound, tax-free because of the application of the nonrecognition provisions, and then having the transferee foreign corporation, instead of the U.S. transferor, recognize the gain. The GRA regulation drafters determined that a GRA term of five full years following the taxable year of the initial transfer is a sufficient period to discourage transferring appreciated property outbound with the intent of having the transferee foreign corporation sell it.

Accordingly, the core component of the GRA rules is a tracking mechanism where the U.S. transferor must report, each year, certain events that have occurred with respect to the transferred stock (or the transferred corporation’s assets) or any other intermediate entity in the ownership chain between the U.S. transferor and the transferred corporation, including any disposition of the transferred corporation’s assets. Thus, the taxpayer must track any transfers (or deemed transfers) of the stock of any relevant entity (or assets of the transferred corporation) to the GRA and report any such transfers on a new GRA or an annual certification, as required. Treas. Reg. § 1.367(a)-8(j) describes these triggering events and Treas. Reg. § 1.367(a)-8(k) describes triggering event exceptions. If there is a triggering event that is subject to a triggering event exception, the U.S. transferor must file a new GRA with its tax return in the taxable year of the event. The new GRA acts as a replacement of the initial GRA (although the original five full taxable year GRA term remains unchanged).[11] If, during the GRA term there is a triggering event but without an applicable exception, the U.S. transferor must recognize the built-in-gain on the GRA in accordance with Treas. Reg. § 1.367(a)-8(c)(1)(i). These triggering event and exception rules are the operative provisions that ultimately determine whether a taxpayer has transferred relevant stock or assets that triggered the GRA and requires the realized gain to be immediately recognized under Treas. Reg. § 1.367(a)-8(c)(1)(i) and section 367(a)(1).

Note that the definition of a “disposition” in Treas. Reg. § 1.367(a)-8(b)(1)(iii) is very broad and includes any transfer that would constitute a disposition for any purposes of the Code. Therefore, a transaction as simple as a name-change section 368(a)(1)(F) reorganization, or a local law legal entity migration of an entity that is subject to a GRA, should be reported as a triggering event with an applicable exception. Generally, GRA reporting flows from a transaction’s sub-chapter C characterization, including the tax fictions. Even though a name-change section 368(a)(1)(F) reorganization or a local law legal entity migration may be viewed as a “tax nothing,” the section 368(a)(1)(F) tax fictions show that there was a deemed transfer of stock in a section 354 or section 361 exchange. If that deemed transferred stock was subject to a GRA, the U.S. transferor should file a new GRA reporting the transaction and applying the applicable exception.

Gain Recognition Agreement Termination Events

Additionally, Treas. Reg. 1.367(a)-8(o) provides rules for dispositions or events that terminate or reduce the amount of gain subject to the GRA. These include transactions where the transferred stock is distributed or transferred back to certain qualified U.S. persons in distributions or transfers described in section 337, 355, or 361.[12] If the transferred stock is transferred back to a qualified U.S. person,[13] there is an additional requirement that immediately after the transaction, the aggregate basis of the transferred stock or securities received by the qualified U.S. person is not greater than the aggregate basis of the stock or securities at the time of the initial transfer.[14] If the aggregate basis of the transferred stock or securities at the time of the transaction exceeds the aggregate basis of the transferred stock or securities at the time of the initial transfer then each qualified U.S. person may reduce the basis of the transferred stock or securities received in the transaction as necessary to satisfy the basis condition.[15] The qualified U.S. person would do so by filing a compliance statement with its return for the year in which the distribution or transferred occurred.

Failure to Comply with the GRA Regulations

What if a taxpayer fails to report a transaction with respect to an entity that is subject to a gain recognition agreement? Early versions of the GRA regulations contained rules that permitted a taxpayer to submit an application to the IRS for “reasonable cause” relief for GRA compliance failures. The most recent iteration of the regulations promulgated in 2014[16] adopted a “non-willful” standard wherein the taxpayer has to demonstrate that its failure to comply with the GRA regulations was “non-willful.” This was a taxpayer favorable change because it appears to have lowered the threshold for obtaining relief. Absent intentional disregard of the rules, most taxpayers should be able to demonstrate that their failure to comply with the GRA regulations was non-willful. Treas. Reg. § 1.367(a)-8(p) provides the operative rules for taxpayers seeking relief for failures to comply. In addition to demonstrating that the U.S. transferor’s failure to comply with the GRA regulations was non-willful, the U.S. transferor will be subject to a section 6038B penalty if it did not satisfy the section 6038B reporting requirements and if the U.S. transferor does not demonstrate that the failure was due to reasonable cause and not willful neglect.[17] The latter is significant because the penalty for failure to furnish information under section 6038B is ten percent of the fair market value of the property at the time of the exchange but not greater than $100,000 unless the failure was due to intentional disregard. Nonetheless, if a taxpayer fails to file (or files an incomplete) gain recognition agreement or an annual certification it should not result in immediate gain recognition. A taxpayer should be able to remedy any compliance deficiencies with its gain recognition agreement filings through the procedures in Treas. Reg. § 1.367(a)-8(p).

Related Compliance Filings: Form 926, Form 8838, Section 6038B

As noted in our prior post on commonly overlooked tax disclosures, in addition to filing a gain recognition agreement for the year of the initial transfer, the U.S. transferor must file a Form 926, “Return by a U.S. Transferor of Property to a Foreign Corporation” and a Form 8838, “Consent to Extend the Time to Assess Tax Under Section 367.” The U.S. transferor should also file a Treas. Reg. § 1.6038B-1 statement with respect to transfers described in section 6038(a)(1)(A) that includes the information required in Treas. Reg. § 1.6038B-1(c). These compliance statements are important because the failure to file a Form 926 or a section 6038B statement could result in the imposition of the section 6038B penalty described above and result in immediate gain recognition under section 367(a)(1).

Conclusion

A U.S. transferor’s obligation to file a gain recognition agreement is not a simple compliance matter. Determining whether a transaction results in an initial outbound transfer or is a triggering event that is subject to a triggering event exception requires significant analysis and a thorough knowledge of both the gain recognition agreement rules and the sub-chapter C transaction characterization. Any U.S. person that has transferred appreciated stock to a transferee foreign corporation and that U.S. person owned 5 percent or more of the transferee foreign corporation immediately after the transfer, should file a GRA to prevent immediate gain recognition under section 367(a)(1). Additionally, any U.S. person that transferred stock to a transferee foreign corporation and timely filed a GRA with respect to that outbound transfer should closely examine any transactions that may have resulted in a transfer or a deemed transfer of the stock of an entity that is subject to the GRA and file a new GRA reporting the event, or an annual certification, as appropriate. It is important for taxpayers to inventory all transactions that occurred during the taxable year and begin gain recognition agreement preparation, or engage outside counsel to assist, as early as possible. If you need assistance with these matters, please reach out to us.

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[1] Treas. Reg. § 1.367(a)-3(b)(1)(ii).

[2] The reference to section 332 is obsolete. Outbound section 332 liquidations are governed by section 367(e)(2).

[3] As defined in Treas. Reg. § 1.367(a)-1(d)(1) and section 7701(a)(30), the term U.S. person means a domestic corporation, a citizen or resident of the United States, a domestic partnership, and any estate or trust other than a foreign estate or trust.

[4] This note focuses on the outbound transfer of foreign corporation stock that was held first tier by the U.S. person; however, for completeness, there is a corollary set of rules under Treas. Reg. § 1.367(a)-3(c)(6) that apply when the property transferred to a foreign corporation is the stock of a domestic corporation.

[5] Section 367(a)(1); Treas. Reg. § 1.367(a)-3(a)(1).

[6] For completeness, section 367(a)(2) provides a general exception to section 367(a)(1) gain recognition if the outbound transfer was stock or securities of a foreign corporation which is a party to a reorganization (i.e., an outbound asset reorganization). Section 367(a)(3) has a special rule where a U.S. person transfers an interest held by a partnership to a foreign corporation and provides that such a transfer shall be treated as a transfer to the foreign corporation of the U.S. person’s pro rata share of the assets of the partnership. Section 367(a)(4) provides that the exception in section 367(a)(2) does not apply (i.e., the transfer will be subject to gain recognition under section 367(a)(1)), in the case of an exchange described in section 361(a) or (b) (an exchange of property by a corporation that is a party to a reorganization of property solely for stock or securities in another corporation that is a party to the reorganization) unless certain basis adjustments and other conditions provided in the regulations are satisfied. Section 367(a)(5) provides that section 367(a)(1) shall not apply to the transfer of property which the Secretary of the Treasury, in order to carry out the purposes of section 367(a), designates by regulation.

[7] As discussed, section 367(a)(2) provides an exception to the general rule of section 367(a)(1) in the case of certain outbound transfers of stock or securities of a foreign corporation that is a party to the exchange or a party to a reorganization. Treas. Reg. § 1.367(a)-3(2)(a)(ii) provide an exception to gain recognition for section 354 and 356 transfers of stock to foreign corporations pursuant to asset reorganizations. However, this exception is unavailable for certain transactions that are treated as “indirect stock transfers” as defined in Treas. Reg. § 1.367(a)-3(d)(1). Indirect stock transfers are beyond the scope of this note; however, the rules are intended to prevent taxpayers from obtaining a better result through a series of transfers where the use of stock would be economically the same.

[8] Treas. Reg. § 1.367(a)-1(b)(4)(i)(A).

[9] Treas. Reg. § 1.367(a)-8(c)(1)(i).

[10] Treas. Reg. § 1.367(a)-8(d)(2).

[11] Treas. Reg. § 1.367(a)-8(c)(5).

[12] Treas. Reg. § 1.367(a)-8(o)(5)(i).

[13] Treas. Reg. § 1.367(a)-8(o)(5)(ii).

[14] Treas. Reg. § 1.367(a)-8(o)(5)(iii).

[15] Treas. Reg. § 1.367(a)-8(o)(5)(iii)(B).

[16] T.D. 9704 (Nov. 18, 2014).

[17] Treas. Reg. § 1.6038B-1(b)(2) and (f).