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© James P. Fuller & Andrew J. Kim 2016

TAX EXECUTIVES INSTITUTE

WHAT HAPPENS WHEN YOU UNCHECK A FIRST-TIER FOREIGN DISREGARDED? YOU THOUGHT IT WAS SIMPLE?

March 14, 2016

by

James P. Fuller Andrew J. Kim

Fenwick & West LLP Mountain View, California

I. Introduction .............................................................................................. 1 II. Section 351............................................................................................... 1

III. Section 367(a) .......................................................................................... 3 IV. Section 367(d) .......................................................................................... 7 IV-A. Section 367(d) – Proposed Regulations ................................................... 9 IV-B. Section 482 Temporary Regulations ........................................................ 18 V. Dual Consolidated Loss Rules ................................................................. 24

VI. OFLs ........................................................................................................ 27 VII. Section 987............................................................................................... 28

VIII. Section 901(m) ......................................................................................... 32 IX. Coordination and Priority of Rules .......................................................... 34 X. Reporting: § 6038B and Related Rules ................................................... 35

XI. Foreign Law ............................................................................................. 39 XII. Treaties ..................................................................................................... 40

I. INTRODUCTION

A. The fact pattern in issue in this outline involves a U.S. parent corporation (“P”) that owns 100% of a first-tier foreign subsidiary (which we will call “X”). X previously was the subject of a check-the-box election to treat it as a disregarded entity, and now P would like to “uncheck” X so as to treat it as a first-tier controlled foreign corporation (“CFC”).

II. SECTION 351

A. Qualification under § 351 likely is easy in the case of P, which owns 100% of X and unchecks X thus terminating X’s disregarded entity status.

1. X’s basis in the transferred assets will be carryover basis increased by any gain recognized on the transfer. Section 362(a).

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2. Section 362(e)(2), however, could cause an asset basis reduction in the transferred assets (to FMV), unless an election is made to reduce the transferor’s basis in the stock received.

B. Important issues can arise under § 351. If P loaned funds to X while X was a disregarded entity, the debt is disregarded debt. The unchecking election will cause the debt to “spring” into existence, and likely cause the note receivable in P’s hands to constitute § 351(b) boot. The result is that P will have a partially taxable § 351 exchange.

C. A question may arise as to whether the “debt” that springs into existence is debt or preferred stock. If preferred stock it must be tested under § 351(g). Section 351(g) would be repealed under the Obama Administration’s 2016 Budget.

D. Debt owing by P to X, existing previously as disregarded debt, will become regarded and could give rise to § 956 issues. Possibly, basis issues could arise regarding X’s basis in the note “contributed” to X, the new corporation.

E. How about assumed liabilities? Section 357 should apply unless the liabilities are in excess of the assets’ bases.

1. But be careful if the unchecking is part of a larger transaction. LTR 201406005 addressed a lower-tier unchecking transaction that was treated as a reorganization subject to § 368. F-2 owned F-3 and F-3 was unchecked from disregarded entity status into corporate status.

2. The unchecking was treated as a transfer of assets from F-2 to F-3 and an assumption of F-2 debt by F-3.

3. F-2 was deemed to sell the assets to F-3 for a consideration equal to the lesser of the FMV of the assets or the debt assumption. Gain would be recognized; any loss would be deferred under § 267(f).

4. The excess of the debt assumption over the FMV of the assets was treated as a distribution under § 301.

5. In our simple outbound § 351 transaction, § 357 should operate to prevent gain recognition as a result of the assumption of liabilities, unless of course, the liabilities are in excess of the assets’ bases.

6. The unchecking in LTR 201406005 was part of larger transaction:

(a) F-3 in the ruling owned two subsidiaries, F-5, treated as a corporation for U.S. tax purposes, and F-9, a disregarded entity.

(b) As a part of the transaction, F-5 merged into F-9.

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(c) The IRS treated the transaction as a transfer by F-5 of its assets and liabilities to F-3 in exchange for all of the stock of F-3.

(d) Thus, the transaction was characterized as a reorganization. F-3 and F-5 will be parties to the reorganization.

F. What about disregarded license agreements? They probably should be treated as new license agreements, as opposed to “boot” springing into existence, especially if the royalty is at arm’s length.

1. Could the IRS argue in the case of an exclusive license in perpetuity of all rights to the IP that there was a transfer of the IP under § 351 and that the royalties received constitute § 351(b) boot? See Rev. Rul. 69-156, 1969-1 C.B. 101; see also LTR 8723077.

(a) How should the “boot” be treated?

(b) In the context of an outbound § 351 transfer of intangibles in exchange for stock and boot, CCA 200610019 determined that § 367(d) would take precedence over § 351(b).

(c) The boot was treated as an advance payment of the amounts that would be includible under § 367(d).

2. Could the IRS argue that in the case of a non-exclusive license or a license of less than all rights in the IP that some portion of the stock received is taxable as part of the compensation for the intangible property? Under Rev. Rul. 69-156 there would seem not to be a § 351 transfer of the IP if the rights are non-exclusive or otherwise limited. The stock received should not be taxable in part as compensation for the IP if the royalty is at arm’s length.

G. If in an outbound transfer (unlike the facts in LTR 201406005 discussed above), the transaction is characterized as a reorganization, § 367(a)(5) and the new, complex § 367(a)(5) regulations could apply. This could require special elections, etc. An IRS spokesperson called this set of regulations an “International M&A Ph.D course.”

III. SECTION 367(a)

A. The “incorporation” of X involves a constructive transfer of the branch assets of X to a CFC (X as a foreign corporation) in a § 351 exchange, as discussed above. Section 367(a) applies in such a case. See Temp. Treas. Reg. § 1.367(a)-1T(c)(6).

B. Section 367(a) provides that while gain recognition is the general rule, certain assets can be transferred to a foreign corporation U.S. tax free.

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1. Section 367(a)(3)(A) provides a very important exception for transfers of property in such an exchange that is used in the active conduct of a trade or business outside the U.S. See Temp. Treas. Reg. § 1.367(a)-2T.

2. Section 367(a)(3)(B) provides that this exception does not apply (and that the transfer is taxable) in the case of items such as inventory, foreign currency, and, most importantly, intangible property defined in § 936(h)(3)(B). See Temp. Treas. Reg. § 1.367(a)-1T(d)(5) regarding intangible property; see also § 367(d).

3. While gains may be taxed under § 367(a) in certain cases, losses that may be incurred in such a transfer cannot be deducted. Temp. Treas. Reg. § 1.367(a)-1T(b)(2)(ii).

4. Special rules apply when a branch is transferred and the branch has previously deducted losses.

5. Important reporting requirements apply. See § 6038B.

6. Temp. Treas. Reg. 1.367(a)-2T(a) says active trade or business exception is conditioned on complying with § 6038B and the regulations thereunder.

7. Under Treas. Reg. § 1.6038B-1(f)(2)(i), a failure to comply with § 6038B is the failure to report at the proper time and in the proper matter any material information required to be reported under the § 6038B regulations, or the provision of inaccurate information.

C. Intangible Property.

1. Intangible property, as noted above, cannot be transferred U.S. tax free. § 367(a)(3)(B)(iv), § 936(h)(3)(B), Temp. Treas. Reg. § 1.367(d)-1T.

2. Note the important exception in Temp. Treas. Reg. § 1.367(a)-1T(d)(5)(iii) for foreign goodwill and going concern value. These items do not constitute intangible property for this purpose. See also Temp. Treas. Reg. § 1.367(d)-1T(b) and Section IV below.

(a) Foreign goodwill and going concern are defined in the temporary regulation as “the residual value of a business operation conducted outside of the United States after all other tangible and intangible assets have been identified and valued.”

(b) The regulation also states that “the value of the right to use a corporate name in a foreign country shall be treated as foreign goodwill or going concern value.”

3. Intangible property is defined for this purposes in § 936(h)(3)(B).

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(a) The list of assets described there is a closed list except to the extent of “any similar item” but this term is defined by the words associated with it. Microsoft v. Commissioner, 311 F.3d 1178 (9th Cir. 2002).

(b) The Obama Administration budgets for 2015-16 change “similar” to “other”, i.e., to include any other property that has substantial value independent of the services of any individual. This would be very broad.

4. The IRS has challenged a number of taxpayers with respect to what constitutes an intangible for this purpose.

(a) Workforce in place is one of the issues. It’s not stated in § 936(h)(3)(B) to be intangible property, yet the Service argues that it is covered.

(b) The Administration’s budgets in recent years have proposed to codify the Service’s arguments in those cases. The Administration’s budgets for 2015 and 2016 don’t say to “clarify” the law as did past budgets but rather to “provide.”

(c) The pending cases include Medtronics, Inc. v. Commissioner, T.C. Dkt. No. 6944-11; Guidant LLC (formerly Guidant Corp.) v. Commissioner, T.C. Dkt. Nos. 5989-11 and 5990-11 and 10985-11; Boston Scientific Corporation v. Commissioner, T.C. Dkt. No. 26876-11; and Eaton Corporation v. Commissioner, T.C. Dkt. No. 5576-12.

(d) The issue also is of major significance when it comes to disclosing the assets in a § 351 transfer under § 6038B.

(i) Omitting an asset will keep P’s statute of limitations open until the omitted asset is disclosed, § 6501(c)(8), absent qualification under the § 6501(c)(8) reasonable cause exception (discussed separately below).

(ii) It also could cause the active trade or business exception to be lost.

D. Stock in Subsidiaries.

1. If X owns stock in lower-tier foreign subsidiaries, gain recognition agreements will be necessary. Treas. Reg. § 1.367(a)-3; Temp. Treas. Reg. § 1.367(a)-3T; Treas. Reg. § 1.367(a)-8.

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2. GRAs run for 5 years and require annual certifications that a triggering event has not occurred. If there is a subsequent triggering event during the certification period, gain must be recognized on the initial transfer.

3. The regulations contain substantial detail and instructive rules on GRAs. See Treas. Reg. §§ 1.367(a)-3 and 1.367(a)-8.

E. Branch Losses.

1. Section 367(a)(3)(C) and Temp. Treas. Reg. § 1.367(a)-6T address transfers of foreign branches with previously deducted losses.

2. The general rule is that the losses must be recaptured in an outbound § 351 transaction to the extent of gain.

(a) The recapture is effected by causing a recognition of gain on the transferred assets. The gain is treated as foreign source income. Temp. Treas. Reg. § 1.367(a)-6T(b).

(b) The recapture applies without regard to the possible application of the foreign active business exception. That is, that rule does not apply to prevent branch loss recapture. Temp. Treas. Reg. § 1.367(a)-6T(b)(2).

(c) For purposes of this rule, the assets of a foreign branch include foreign goodwill and going concern value related to the branch. Thus, gain on the foreign goodwill and going concern value is taken into account in determining the gain limitation. Temp. Treas. Reg. § 1.367(a)-6T(c)(3).

(d) Similarly, gain on the transfer of intangible property also will be taken into account in computing the gain limitation. Temp. Treas. Reg. § 1.367(a)-6T(c)(4).

3. Recapture Amounts.

(a) The previously deducted total ordinary loss and the total capital loss of the branch are the starting point. Temp. Treas. Reg. § 1.367(a)-6T(d).

(b) The previously deducted branch ordinary and branch capital losses for each branch loss year are reduced by expired net ordinary losses and expired net capital losses, respectively. A further reduction applies to reflect expired foreign tax credits. Temp. Treas. Reg. § 1.367(a)-6T(d). The expirations are based on carry over periods in §§ 172, 1212 and 904(c).

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(c) Under Temp. Treas. Reg. § 1.367(a)-6T(e), certain amounts can further reduce the sum of the previously deducted branch ordinary and capital losses.

i. First, subsequent ordinary income and capital gains can reduce branch ordinary and capital losses for purposes of recapture. Temp. Treas. Reg. §§ 1.367(a)-6T(e)(1) and (2).

ii. Amounts recaptured under § 904(f)(3), gain recognized under § 367(a), and recaptured OFLs under § 904(f) also can reduce the amount of previous branch losses for purposes of recapture.1

iii. Thus, the order would seem to be: a. Taxable income recognized through close of the

year of transfer b. Current year OFL recapture under § 904(f)(3) c. § 367(a) gain recognition d. OFLs recaptured under § 904(f) e. § 367(a)(3)(C) f. DCL recapture (see footnote 2)

(d) See Temp. Treas. Reg. § 1.367(a)-6T(f) Example.

4. “Branch” is defined for this purpose in Temp. Treas. Reg. § 1.367(a)-6T(g) to mean an integral business operation carried on by a U.S. person outside the U.S. All facts and circumstances must be considered. Activities outside the U.S. are a foreign branch if they constitute a permanent establishment under a treaty.

(a) See Temp. Treas. Reg. § 1.367-6T(g)(2), and Rev. Rul. 81-82. Do you have more than one branch, or do you combine into one branch? This can have a material impact on the application of the branch loss recapture rules.

(b) A “transfer” might not be a “branch transfer.” An analysis is necessary. Conversely, a transfer of some branch assets might be a “branch transfer.”

IV. SECTION 367(d)

A. Section 367(d)(1) provides that “if a U.S. person transfers any intangible property (within the meaning of § 936(h)(3)(B)) to a foreign corporation in an exchange described in § 351…”, § 367(a) will not apply but rather § 367(d) will apply.

1 Note the DCL rules are not covered here. Treas. Reg. § 1.1503(d)-5(c)(4)(iii) provides that the § 367(a)(3)(C)

and 904(f)(3) deemed sales rules are applied before the DCL rules. See Section IX below.

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1. The definition of intangible property obviously is important.

2. As discussed above, a number of pending cases involve this issue, and involve among other things, whether workforce in place is an intangible asset for this purpose.

3. Foreign goodwill and going concern value are not. Temp. Treas. Reg. §§ 1.367(a)-1T(d)(5) and 1.367(d)-1T(b).

B. Section 367(d)(2) provides that where intangible property, as defined, is transferred, the U.S. person will be treated as having sold the property in exchange for payments which are contingent on the productivity, use, or disposition of the property.

1. The amounts are to reasonably reflect the amounts that would have been received commensurate with the income attributable to the intangible.

2. The amounts are treated as received annually in the form of payments over the useful life of the property. Determining useful life can present significant issues in the case of certain intangible assets. The § 367(d) regulations cap the useful for this purpose at 20 years. Temp. Treas. Reg. § 1.367-(d)-1T(c)(3). The 20-year limitation would be eliminated under the proposed regulations discussed in Section IV-A below.

3. If the property is disposed of, then the amounts are treated as received (accelerated) at that time.

4. The “sale amount” is treated as ordinary income and sourced as though it was a royalty.

5. The CFC’s E&P is reduced by the “payments.”

C. The temporary regulations under § 367(d) were issued in 1988 and are woefully in need of updating.

1. The NYS Bar Association submitted an excellent set of comments and suggestions for improving the § 367(d) regulations. NYS Bar Association Tax Section Report dated Oct. 2, 2010 (see p. 19 thereof).

2. The modification of these regulations shows up annually as a project on the Treasury/IRS Business Plan, but, so far, nothing has been proposed with respect to improving or otherwise modifying these regulations other than the 2015 proposal regarding primarily goodwill and going concern value.

3. More needs to be done to modernize the 27-year old temporary regulation.

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D. Could the IRS say goodwill and going concern value are intangibles? Legislative history pretty clearly suggests not. Also, the Obama Administration’s 2016 Budget suggests a change in the statute would be necessary. But see section IV-A below.

E. Obviously, valuation and § 482 concepts play an important role here. See section IV-B below.

IV-A. SECTION 367(d) – PROPOSED REGULATIONS

A. Section 367(d).

1. Treasury and the IRS released important proposed regulations on the treatment of transfers of intangible property by U.S. persons to foreign corporations subject to § 367(d). The proposed regulations eliminate the so-called foreign goodwill exception from the § 367(d) regulations, and limit the § 367(a) active trade or business exception to certain tangible property and financial assets. This would be a huge change, and one with a seriously weak legal underpinning. The new regulation was proposed to be effective immediately (transfers occurring on or after Sept. 14, 2015), even before a hearing and comments.

2. Background.

(a) The preamble to the newly proposed regulations starts with a discussion of current law regarding § 367(d) and the legislative history of § 367(d). The discussion notes that Temp. Treas. Reg. § 1.367(d)-1T(b) generally provides that § 367(d) applies to the transfer of any intangible property, but not to the transfer of foreign goodwill or going concern value (“foreign goodwill exception”). Temp. Treas. Reg. § 1.367(a)-1T(d)(5)(i) generally defines “intangible property,” for purposes of § 367, as knowledge, rights, documents, and other intangible items within the meaning of § 936(h)(3)(B). Temp. Treas. Reg. § 1.367(a)-1T(d)(5)(iii) defines “foreign goodwill or going concern value” as the residual value of a business operation conducted outside of the United States after all other tangible and intangible assets have been identified and valued. The value of the right to use a corporate name in a foreign country is treated as foreign goodwill or going concern value.

(b) As discussed in the preamble to the new proposed regulations, in amending § 367 in 1984, Congress identified problems as arising when “transferor U.S. companies hope to reduce their U.S. taxable income by deducting substantial research and experimentation expenses associated with the development of the transferred intangible and, by transferring the intangible to a foreign

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corporation at the point of profitability, to ensure deferral of U.S. tax on the profits generated by the intangible.”

(c) The Senate Finance Committee stated that “The committee contemplates that ordinarily, no gain will be recognized on the transfer of goodwill or going concern value for use in an active trade or business.” The House report contains a similar statement. The Senate Finance Committee and the House Ways & Means Committee each noted that it “does not anticipate that the transfer of goodwill or going concern value developed by a foreign branch to a newly organized foreign corporation will result in an abuse of the U.S. tax system.”

(d) Treasury and the IRS, nonetheless, expressed concern in the preamble regarding how taxpayers interpret § 367 and the regulations thereunder when claiming favorable treatment for foreign goodwill and going concern value.

(e) They say that under one interpretation, taxpayers take the position that goodwill and going concern value are not § 936(h)(3)(B) intangible property and therefore are not subject to § 367(d) because § 367(d) only applies to § 936(h)(3)(B) intangible property. Furthermore, these taxpayers assert that gain realized with respect to the outbound transfer of goodwill or going concern value is not recognized under the general rule of § 367(a) because the goodwill or going concern value is eligible for, and satisfies, the active trade or business exception under § 367(a)(3)(A). This, of course, is stated in the legislative history.

(f) The preamble states that under a second interpretation taxpayers take the position that, although goodwill and going concern value are § 936(h)(3)(B) intangible property, the foreign goodwill exception applies. These taxpayers also assert that § 367(a) does not apply to foreign goodwill or going concern value, either because of § 367(d)(1)(A) (providing that, except as provided in regulations, § 367(d) and not § 367(a) applies to § 936(h)(3)(B) intangible property) or because the active foreign trade or business exception applies.

3. IRS and Treasury’s Reasons for Change.

(a) Treasury and the IRS say they are aware that, in the context of outbound transfers, certain taxpayers attempt to avoid recognizing gain or income attributable to high-value intangible property by asserting that an inappropriately large share (in many cases, the majority) of the value of the property transferred is foreign

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goodwill or going concern value that is eligible for favorable treatment under § 367.

(b) Specifically, Treasury and the IRS say they are aware that some taxpayers value the property transferred in a manner contrary to § 482 in order to minimize the value of the property transferred that they identify as § 936(h)(3)(B) intangible property for which a deemed income inclusion is required under § 367(d), and to maximize the value of the property transferred that they identify as exempt from current tax. Treasury and the IRS say that, for example, some taxpayers (1) use valuation methods that value items of intangible property on an item-by-item basis, when valuing the items on an aggregate basis would achieve a more reliable result under the arm’s length standard of § 482, or (2) do not properly perform a full factual and functional analysis of the business in which the intangible property is employed.

(c) This hardly seems to us like something that would support the major change proposed in the regulations.

(d) Treasury and the IRS say they are also aware that some taxpayers broadly interpret the meaning of foreign goodwill and going concern value for purposes of § 367. Specifically, although the existing regulations under § 367 define foreign goodwill or going concern value by reference to a business operation conducted outside of the United States, some taxpayers have asserted that they have transferred significant foreign goodwill or going concern value when a large share of that value was associated with a business operated primarily by employees in the U.S., where the business simply earned income remotely from foreign customers. In addition, some taxpayers take the position that value created through customer-facing activities occurring within the U.S. is foreign goodwill or going concern value.

(e) Treasury and the IRS have concluded that these taxpayer positions and interpretations raise significant policy concerns and are inconsistent with the expectation, expressed in the legislative history, that the transfer of foreign goodwill or going concern value developed by a foreign branch to a foreign corporation is unlikely to result in the abuse of the U.S. tax system. They considered whether the favorable treatment for foreign goodwill and going concern value under current law could be preserved while protecting the U.S. tax base through regulations expressly prescribing perimeters for the portion of the value of a business that qualifies for the favorable treatment.

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(f) For example, states the preamble, regulations could require that to be eligible for the favorable treatment, the value must have been created by activities conducted outside the U.S. through an actual foreign branch that had been in operation for a minimum number of years and be attributable to unrelated foreign customers. Treasury and the IRS ultimately determined that such an approach would be impractical to administer.

(g) In particular, while new temporary regulations under § 482 (see below) change the application of § 482 in important respects, the preamble states that there will continue to be challenges in administering the transfer pricing rules whenever the transfer of different types of intangible property gives rise to significantly different tax consequences. The preamble states that as long as foreign goodwill and going concern value are afforded favorable treatment, taxpayers will continue to have incentives to take aggressive transfer pricing positions to inappropriately exploit the favorable treatment of foreign goodwill and going concern value, however defined, and therefore erode the U.S. tax base.

4. The IRS and Treasury’s Proposed Solution: Eliminate the Foreign Goodwill Exception and Limit the Scope of the Active Foreign Trade or Business Exception.

(a) The preamble states that the proposed regulations would eliminate the foreign goodwill exception under Temp. Treas. Reg. § 1.367(d)-1T and limit the scope of property that is eligible for the active foreign trade or business exception generally to certain tangible property and financial assets. Accordingly, under the proposed regulations, when there is an outbound transfer of foreign goodwill or going concern value, the U.S. transferor will be subject to either current gain recognition under § 367(a) or the tax treatment provided under § 367(d). This certainly would be a major change in the law, and one that is at odds with the clear legislative history.

(b) Proposed Treas. Reg. § 1.367(d)-1(b) provides that § 367(d) applies to an outbound transfer of intangible property, as defined in proposed Treas. Reg. § 1.367(a)-1(d)(5). Proposed Treas. Reg. § 1.367(d)-1(b) does not provide an exception for any intangible property. Proposed Treas. Reg. § 1.367(a)-1(d)(5) modifies the definition of intangible property. The modified definition facilitates both the elimination of the foreign goodwill exception as well as the addition of a rule under which U.S. transferors may apply § 367(d) with respect to certain other outbound transfers of property that otherwise would be subject to § 367(a) under the U.S. transferor’s interpretation of § 936(h)(3)(B). The proposed

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regulations make certain coordinating changes to Temp. Treas. Reg. § 1.367(d)-1T to take into account the elimination of the foreign goodwill exception and the revised definition of intangible property. The proposed regulations also eliminate the definition of foreign goodwill and going concern value under existing Temp. Treas. Reg. § 1.367(a)-1T(d)(5)(iii) because it no longer will be needed under the new proposed rules.

(c) In addition, the proposed regulations eliminate the existing rule of Temp. Treas. Reg. § 1.367(d)-1T(c)(3) that limits the useful life of intangible property to 20 years. The preamble states that if the useful life of transferred intangible property exceeds 20 years, the limitation might result in less than all of the income attributable to the property being taken into account by the U.S. transferor. Accordingly, proposed Treas. Reg. § 1.367(d)-1(c)(3) provides that the useful life of intangible property is the entire period during which the exploitation of the intangible is reasonably anticipated to occur, as of the time of the transfer.

(d) For this purpose, exploitation includes use of the intangible property in research and development. Consistent with the guidance for cost sharing arrangements in Treas. Reg. § 1.482-7(g)(2)(ii)(A), if the intangible property is reasonably anticipated to contribute to its own further development or to developing other intangibles, then the period includes the period reasonably anticipated at the time of the transfer, of exploiting (including use in research and development) such further development. Consequently, depending on the facts, the cessation of exploitation activity after a specified period of time may or may not be reasonably anticipated.

5. Modifications Relating to the Active Foreign Trade or Business Exception.

(a) The rules for determining whether property is eligible for the active foreign trade or business exception and whether property satisfies that exception currently are found in numerous regulations under § 367. The proposed regulations combine the active trade or business regulations, other than the depreciation recapture rule, into a single regulation under proposed Treas. Reg. § 1.367(a)-2. The proposed regulations retain a coordination rule to which a transfer of stock or securities in an exchange subject to § 1.367(a)-3 is not subject to Treas. Reg. § 1.367(a)-2. The proposed regulations also make conforming changes to the depreciation recapture rule, and the branch loss recapture rule.

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(b) Under existing regulations, all property is eligible for the active trade or business exception, unless the property is specifically excluded. Treasury and the IRS say that, under this structure, taxpayers have an incentive to take the position that certain intangible property is not described in § 936(h)(3)(B) and therefore not subject to § 367(d) and is instead subject to § 367(a) but eligible for the active foreign trade or business exception because the intangible property is not specifically excluded from the exception.

(c) Treasury and the IRS believe that providing an exclusive list of property eligible for the active trade or business exception will reduce the incentives for taxpayers to undervalue intangible property subject to § 367(d).

(d) The proposed regulations provide that only certain types of property are eligible for the active foreign trade or business exception. However, in order for the eligible property to satisfy that exception, the property must also be considered transferred for use in the active conduct of a trade or business outside the U.S. Specifically, proposed Treas. Reg. § 1.367(a)-2(a)(2) provides the general rule that an outbound transfer of property satisfies the active trade or business exception if (1) the property constitutes eligible property, (2) the property is transferred for use by the foreign corporation in the active conduct of a trade or business outside of the U.S., and (3) the reporting requirements under § 6038B are satisfied.

(e) Under proposed Treas. Reg. § 1.367(a)-2(b), eligible property is tangible property, a working interest in oil and gas property, and certain financial assets, unless the property is also described in one of the four categories of ineligible property. Thus, intangible property cannot qualify as eligible property.

(f) Proposed Treas. Reg. § 1.367(a)-2(c) lists four categories of property not eligible for the active trade or business exception, which, in general, are (1) inventory or similar property; (2) installment obligations, accounts receivable or similar property; (3) foreign currency or certain other property denominated in foreign currency; and (4) certain leased tangible property. These four categories of property not eligible for the active trade or business exception include four of the five categories described in the existing regulations. The category for intangible property is not retained because it will no longer be relevant: intangible property transferred to a foreign corporation pursuant to § 351 or § 361 will not constitute eligible property under proposed Treas. Reg. § 1.367(a)-2(b).

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(g) The proposed regulations also eliminate the exception in existing Temp. Treas. Reg. § 1.367(a)-5T(d)(2) that allows certain property denominated in the foreign currency of the country in which the foreign corporation is organized to qualify for the active trade or business exception if that property was acquired in the ordinary course of business of the U.S. transferor that will be carried on by the foreign corporation.

(h) Treasury and the IRS have determined that removing the exception from Temp. Treas. Reg. § 1.367(a)-5T(d)(2) is consistent with the general policy of § 367(a)(3)(B)(iii) to require gain to be recognized in an outbound transfer of foreign currency denominated property. Removing the exception will preserve the character, source, and amount of gain attributable to § 988 transactions that otherwise could be lost or changed if the gain were not immediately recognized but instead were reflected only in the U.S. transferor’s basis in the stock of the foreign corporation.

(i) The general rules for determining whether eligible property is transferred for use in the active conduct of a trade or business outside of the U.S. are described in proposed Treas. Reg. § 1.367(a)-2(d). Paragraphs (e) through (h) provide special rules for certain property to be leased after the transfer, a working interest in oil and gas property, property that is re-transferred by the transferee corporation to another person, and certain compulsory transfers of property.

(j) Proposed Treas. Reg. § 1.367(a)-2(g)(2) does not retain the portion of existing Temp. Treas. Reg. § 1.367(a)-4T(d) that applies to certain transfers of stock or securities. Treasury and the IRS have determined that Treas. Reg. §§ 1.367(a)-3 and 1.367(a)-8 (generally requiring U.S. transferors that own five-percent or more of the stock of the foreign corporation to enter into a gain recognition agreement to avoid recognizing gain on the outbound transfer of stock or securities) adequately carry out the policy of § 367(a) with respect to the transfer of stock or securities.

6. Treatment of Certain Property as Subject to § 367(d).

(a) Treasury and the IRS state that taxpayers take different positions as to whether goodwill and going concern value are § 936(h)(3)(B) intangible property, as discussed above. The proposed regulations do not address this issue. However, the proposed regulations provide that a U.S. transferor may apply § 367(d) to a transfer of property, other than certain property described below, that otherwise would be subject to § 367(a) under the U.S. transferor’s interpretation of § 936(h)(3)(B).

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(b) Under this rule, a U.S. transferor that takes the position that goodwill and going concern value are not § 936(h)(3)(B) intangible property may nonetheless apply § 367(d) to goodwill and going concern value. Treasury and the IRS say this rule will further sound administration by reducing the consequences of uncertainty regarding whether value is attributable to property subject to § 367(a) or property subject to § 367(d).

(c) The application of § 367(d) in lieu of § 367(a) is available only for property that is not eligible property, as defined in proposed Treas. Reg. § 1.367(a)-2(b) but, for this purpose, determined without regard to proposed Treas. Reg. § 1.367(a)-2(c) (which describes four categories of property explicitly excluded from the active trade or business exception). A U.S. transferor must disclose whether it is applying § 367(a) or (d) to a transfer of this property.

(d) To implement this new rule under proposed Treas. Reg. § 1.367(a)-1(b)(5) and the removal of the foreign goodwill exception, the proposed regulations revise the definition of “intangible property” that applies for purposes of §§ 367(a) and (d). As revised, the term means either property described in § 936(h)(3)(B) or property to which a U.S. transferor applies § 367(d) (in lieu of applying § 367(a)). However, for this purpose, and consistent with the existing regulations, intangible property does not include property described in § 1221(a)(3) (generally relating to certain copyrights) or a working interest in oil and gas property.

7. Modifications to Temp. Treas. Reg. § 1.367(a)-1T.

(a) Temp. Treas. Reg. § 1.482-1T(f)(2)(i) (below) addresses the application of the arm’s length standard under § 482 when it is used in conjunction with other Code provisions, including § 367, in determining the proper tax treatment of controlled transactions. Proposed Treas. Reg. § 1.367(a)-1(b)(3) provides that, in cases where an outbound transfer of property subject to § 367(a) constitutes a controlled transaction, as defined in Treas. Reg.§ 1.482-1(i)(8), the value of the property transferred is determined in accordance with § 482 and the regulations thereunder.

(b) This rule replaces existing Temp. Treas. Reg. § 1.367(a)-1T(b)(3), which includes three rules. One of these rules refers to the sale of property “if sold individually.” Treasury and the IRS are concerned this could be viewed as inconsistent with Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(B), which provides that an aggregate analysis of the transactions may provide the most reliable measure of an

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arm’s length result under certain circumstances. The other two rules are eliminated either because they duplicate language elsewhere or are no longer necessary.

8. Proposed Effective/Applicability Dates. The regulations are proposed to apply to transfers occurring on or after September 14, 2015, and to transfers occurring before that date, resulting from entity classification elections that are filed on or after that date. Removal of the exception currently in Temp. Treas. Reg. § 1.367(a)-5T(d)(2) will apply to transfers occurring on or after the date that the rules proposed are adopted as final regulations. No inferences are intended regarding the application of the provisions proposed to be amended by the proposed regulations under current law. The IRS may, where appropriate, challenge transactions under applicable provisions or judicial doctrines.

9. Comments.

(a) The proposed regulation is impossible to reconcile, and is at odds, with the clear, relevant legislative history, as discussed by Treasury and the IRS in the regulation’s preamble. Treasury and the IRS obviously have decided they don’t like the foreign goodwill exception.

(b) The Obama Administration has proposed to change the law to include goodwill, going concern value and workforce-in-place in § 936(h)(3)(B). At first, the Administration’s description referred to this change as a “clarification.” A New York State Bar Association (“NYSBA”) report dated October 12, 2010, stated that calling the change a “clarification” was inconsistent with the legislative history of § 367(d). See the NYSBA report at p. 8. In the two most recent Administration budgets, the assertion that this change would be a “clarification” was dropped. These proposals were never enacted.

(c) In any event, the new regulation effectively forces taxpayers to treat goodwill and going concern value as § 367(d) assets, and precludes them from qualifying for the active trade or business exception.

(d) The legislative history, as discussed in the regulation’s preamble, is clear that “no gain will be recognized on the transfer of goodwill and going concern value for use in an active trade or business.” The proposed regulation obviously is contrary to the statute’s legislative history.

(e) One of the more interesting things about this proposed regulation is that it was issued so closely in time to the Tax Court’s decision in

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Altera Corporation v. Commissioner, 145 T.C. No. 3 (2015). The Tax Court looked to the Administrative Procedure Act (“APA”) to test the validity of a regulation. The standard under the APA is “arbitrary, capricious and an abuse of discretion or otherwise not in accordance with the law.” The reviewing court must ensure that the agency “engaged in reasoned decision making.” There must be “an exchange of views, information and criticism between interested parties and the agency.”

(f) The regulation also could have problems under the U.S. Supreme Court’s 2014 decision in Utility Air Regulatory Group v. Environmental Protection Agency, ___ U.S. ___ (2014), which held that an administrative “agency may not rewrite clear statutory terms to suit its own sense of how the statute should operate.”

IV-B. SECTION 482 – TEMPORARY REGULATIONS

A. Section 482. Treasury and the IRS issued temporary and proposed regulations under § 482 at the same time they proposed the § 367 regulations discussed above. They state the new regulation is to coordinate the application of the arm’s length standard and the best method rule under § 482 with other Code provisions. The coordination rules apply to controlled transactions, including those subject in whole or in part to both §§ 367 and 482.

1. Consistent Valuation of Controlled Transactions.

(a) Section 482 authorizes Treasury and the IRS to adjust the results of controlled transactions to clearly reflect the income of commonly controlled taxpayers in accordance with the arm’s-length standard and, in the case of transfers of intangible property (within the meaning of § 936(h)(3)(B)), so as to be commensurate with the income attributable to the intangible.

(b) While the determinations of arm’s-length prices for controlled transactions is governed by § 482, the tax treatment of controlled transactions is also governed by other Code and regulatory rules applicable to both controlled and uncontrolled transactions. Controlled transactions always remain subject to § 482 in addition to these generally applicable provisions.

(c) The new temporary regulations provide for the coordination of § 482 with those other Code and regulatory provisions. The new coordination rules thus apply to controlled transactions including controlled transactions that are subject in whole or in part to §§ 367 and 482. Transfers of property subject to § 367 that occur between controlled taxpayers require a consistent and coordinated application of both sections to the controlled transfer of property.

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The controlled transactions may include transfers of property subject to § 367(a) or (e), transfers of intangible property subject to § 367(d) or (e), and the provision of services that contribute significantly to maintaining, exploiting or further developing the transferred properties.

(d) Treasury and the IRS say the consistent analysis and valuation of transactions subject to multiple Code and regulatory provisions is required under the best method rule described in Treas. Reg. § 1.482-1(c). A best method analysis under § 482 begins with a consideration of the facts and circumstances related to the functions performed, the resources employed, and the risks assumed in the actual transaction or transactions among the controlled taxpayers, as well as in any uncontrolled transactions used as comparables.

(e) For example, states the preamble, if consideration of the facts and circumstances reveals synergies among interrelated transactions, an aggregate evaluation under § 482 may provide a more reliable measure of an arm’s length result than a separate valuation of the transactions. In contrast, an inconsistent or uncoordinated application of § 482 to interrelated controlled transactions that are subject to tax under different Code and regulatory provisions may lead to inappropriate conclusions.

(f) The best method rule requires the determination of the arm’s-length result on controlled transactions under the method, and particular application of that method, that provides the most reliable measure of an arm’s-length result. The preamble also refers to the “realistic alternative transactions” rule and states that “on a risk-adjusted basis” this may provide the basis for application of unspecified methods to determining the most reliable measure of an arm’s length result.

(g) Based on taxpayer positions that the IRS has encountered in examinations and controversy, Treasury and the IRS are concerned that certain results reported by taxpayers reflect an asserted form or character of the parties’ arrangement that involves an incomplete assessment of relevant functions, resources, and risks and an inappropriately narrow analysis of the scope of the transfer pricing rules. In particular, Treasury and the IRS are concerned about situations in which controlled groups evaluate economically integrated transactions involving economically integrated contributions, synergies, and interrelated value on a separate basis in a manner that results in a misapplication of the best method rule and fails to reflect an arm’s length result.

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(h) Taxpayers may assert that, for purposes of § 482, separately evaluating interrelated transactions is appropriate simply because different statutes or regulations apply to the transactions (for example, with § 367 and the regulations thereunder applying to one transaction and the general recognition rules of the Code applying to another related transaction). Treasury and the IRS believe these positions are often combined with inappropriately narrow interpretations of Treas. Reg. § 1.482-4(b)(6), which provides guidance on when an item is considered similar to the other items identified as constituting intangibles for purposes of § 482. The interpretations purport to have the effect, contrary to the arm’s length standard, of requiring no compensation for some value provided in controlled transactions despite the fact that compensation would be paid if the same value were provided in uncontrolled transactions.

2. Compensation Independent of the Form or Character of Controlled Transaction.

(a) New Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(A) provides that arm’s-length compensation must be consistent with, and must account for all of, the value provided between parties in a controlled transaction, without regard to the form or character of the transaction. For this purpose, it is necessary to consider the entire arrangement between the parties, as determined by the contractual terms, whether written or imputed in accordance with the economic substance of the arrangement, in light of the actual conduct of the parties.

(b) The preamble says this requirement is consistent with the principles underlying the arm’s length standard, which require that arm’s length compensation in controlled transactions equal the compensation that would have occurred if a similar transaction had occurred between similarly situated uncontrolled taxpayers.

3. Aggregate or Separate Analysis.

(a) Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(B) changes (the preamble asserts this is a “clarification”) Treas. Reg. § 1.482-1(f)(2)(i)(A), which provided that the combined effect of two or more separate transactions (whether before, during, or after the year under review) may be considered if the transactions, taken as a whole, are so interrelated that an aggregate analysis of these transactions provides the most reliable measure of an arm’s-length result determined under the best method rule of Treas. Reg. § 1.482-1(c).

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(b) Specifically, a new clause was added to provide that this aggregation principle also applies for purposes of an analysis under multiple provisions of the Code or regulations. A new sentence also elaborates on the aggregation principle by noting that consideration of the combined effect of two or more transactions may be appropriate to determine whether the overall compensation is consistent with the value provided, including any synergies among items and services provided.

(c) The temporary regulation does not retain the statement in Treas. Reg. § 1.482-1(f)(2)(i)(A) that transactions generally will be aggregated only when they involve “related products or services.”

(d) Curiously, the Obama Administration proposed a change in the statute to permit this type of aggregation (a “clarification” of the law said the explanation), but that proposal was never enacted. This would seem to raise some questions about Treasury and the IRS’s changing the law by regulations when Congress has declined to act.

4. Aggregation and Allocation for Purposes of Coordinated Analysis.

(a) Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(C) provides that, for one or more controlled transactions governed by one or more provision of the Code and regulations, a coordinated best method analysis and evaluation of the transactions may be necessary to ensure that the overall value provided (including any synergies) is properly taken into account. A coordinated best method analysis of the transactions includes a consistent consideration of the facts and circumstances of the functions performed, resources employed, and risks assumed, and a consistent measure of the arm’s length results, for purposes of all relevant Code and regulatory provisions.

(b) For example, situations in which a coordinated best method analysis and evaluation may be necessary include: (1) two or more interrelated transactions when either all of the transactions are governed by one regulation under § 482 or all are governed by one subsection of § 367, (2) two or more interrelated transactions governed by two or more regulations under § 482, (3) a transfer of property subject to § 367(a) and an interrelated transfer of property subject to § 367(d), (4) two or more interrelated transactions when § 367(d) applies to one transaction and the general recognition rules of the Code apply to another interrelated transaction, and (5) other circumstances in which controlled transactions require analysis under multiple Code and regulatory provisions.

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(c) Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(D) provides that it may be necessary to allocate the arm’s length result that was properly determined under a coordinated best method analysis described in Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(C) among the interrelated transactions. An allocation must be made using the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result for each allocated amount.

5. Examples of Coordinated Best Method Analysis.

(a) Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(E) provides 11 examples to illustrate the new guidance. Examples 1 through 4 are materially the same as the examples in Treas. Reg. § 1.482-1(f)(2)(i)(B). Treasury and the IRS do not intend for the revisions to those examples to be interpreted as substantive. The rest of the examples are new.

(b) Example 1 is titled “Aggregation of Interrelated Licensing, Manufacturing and Selling Activities.” Example 2 describes an aggregation of interrelated manufacturing, marketing and services activities. Example 3 is titled “Aggregation and Reliability of Comparable Uncontrolled Transactions,” and Example 4 is described as covering non-aggregation of transactions that are not interrelated.

(c) The first new example, Example 5, is titled “Aggregation of Interrelated Patents.” In the example, P owns 10 individual patents that in combination, can be used to manufacture and sell a successful product. P anticipates that it can earn $25 from the patents based on a discounted cash flow analysis that provides a more reliable measure of the value of the patents exploited as a bundle rather than separately.

(d) P licenses all 10 patents to S-1 to be exploited as a bundle. Evidence of uncontrolled licenses of similar individual patents indicates that, exploited separately, each license of each patent would warrant a price of $1, implying a total value for the patents of $10. The example states that it would not be appropriate to use the uncontrolled licenses as comparables for the license of the bundle of patents, because, unlike the discounted cash flow analysis, the uncontrolled licenses considered separately do not reasonable reflect the enhancement to value resulting from the interrelatedness of the 10 patents exploited as a bundle.

(e) Example 6, “Consideration of Entire Arrangement, Including Imputed Contractual Terms,” states that P contributes the foreign rights to conduct a business, including foreign rights to certain IP,

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to newly incorporated S-1. P treats the transaction as a transfer described in §§ 351 and 367. Subsequently, P and S-1 enter into a cost sharing arrangement. P takes the position that the only platform contribution transactions (“PCTs”) in connection with the second transaction (the cost sharing agreement) consist of P’s contribution of the U.S. business IP rights and S-1’s contribution of the rest-of-the-world rights of which S-1 had become the owner due to the prior transaction.

(f) The example states that the IRS may consider the economic substance of the entire arrangement between P and S-1, including the parties’ actual conduct throughout their relationship, regardless of the form or character of the contractual arrangement that the parties have expressly adopted. In the example, the IRS determines that the parties’ formal arrangement fails to reflect the full scope of the value provided between the parties in accordance with the economic substance of their arrangement. Therefore, the IRS may impute one or more agreements between P and S, consistent with the economic substance of their arrangement.

(g) Example 7 is titled “Distinguishing Provision of Value from Characterization.” P developed a collection of resources, capabilities and rights (“Collection”) that it uses on an interrelated basis in ongoing R&D. Under § 351, P transfers certain IP to S-1 related to the Collection. P claims a portion of the property (Portion 1) is subject to § 367(d), and that another portion (Portion 2) is not taxable under § 367. The new temporary regulations are applied to determine the value to P. Whether Portion 2 is characterized as “property” under § 367 is irrelevant because any value in Portion 2 must be compensated by S-1 in a manner that is consistent with the new rules.

(h) Examples 8 and 9 also involve multiple transactions regarding § 351 and a cost sharing agreement.

(i) Example 10, “Services Provided Using Intangibles,” states that P’s worldwide group produces and markets product X and subsequent generations of products that result from research and development activity performed by P’s R&D team. Through this collaboration with respect to P’s proprietary products, the members of the R&D team have individually and as a group acquired specialized knowledge and expertise subject to non-disclosure agreements.

(j) P arranges for the R&D team to provide research and development services to create a new line of products, building on the product X platform to be owned and exploited by S-1 in the overseas market. P asserts that the arm’s-length charge for the services is only a

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reimbursement to P of its associated R&D team compensation costs.

(k) Even though P did not transfer the platform or the R&D team to S-1, P is providing value associated with the use of the platform, along with the value associated with the use of the know-how, to S-1 by way of the services performed by the R&D team for S-1 using the platform and the know-how.

(l) The example states that the R&D team’s use of the intangible property, and any other valuable resources, in P’s provision of services must be evaluated under the § 482 regulations, including the regulations specifically applicable to the controlled services transactions in Treas. Reg. § 1.482-9.

(m) Example 11 deals with “Allocating Arm’s-Length Compensation Determined Under an Aggregate Analysis.” P provides services to S-1. P licenses intellectual property to S-2 and S-2 sublicenses the intellectual property to S-1. The example states that if an aggregate analysis of the service and license transactions provides the most reliable measure of an arm’s-length result, then an aggregate analysis must be performed. If an allocation of the value that results from the aggregate analysis is necessary, for example, for purposes of sourcing the service income that P receives from S-1 or to determine the deductible expenses incurred by S-1, then the value determined under the aggregate analysis must be allocated using the method that provides the most reliable measure of the services income and the deductible expenses.

6. Effective/Applicability Dates. The temporary regulations apply to taxable years ending on or after September 14, 2015. The preamble contains the usual caveat: No inference is intended regarding the application of the provisions amended by the temporary regulations under current law. The IRS may, when appropriate, challenge transactions, including those described in the temporary regulations, under currently applicable Code or regulatory provisions or judicial doctrines.

V. DUAL CONSOLIDATED LOSS RULES

A. Assume that X had losses that were deducted on P’s tax returns, and that “domestic use” elections were made under Treas. Reg. § 1.1503(d)-6(d).

1. The general rule in Treas. Reg. § 1.1503(d)-1(b)(4) has a cross reference to Temp. Treas. Reg. § 1.367-6T(g)(1). This goes to what is a separate unit.

2. Under a special rule, all separate units in the same country are combined. Treas. Reg. § 1.1503(d)-1(b)(4)(ii).

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B. As noted in Section II above, the “incorporation” of X involves a constructive transfer of the branch assets of X to a CFC (X as a foreign corporation) in a § 351 exchange. The DCL rules require a recapture of previously deducted foreign loss if there is a foreign use of the DCL. This occurs if any portion of a DCL is made available under the income tax laws of a foreign country to offset or reduce, directly or indirectly, any item that is recognized as income or gain under such laws; and that is, or would be, considered under U.S. tax principles to be an item of income of a foreign corporation. Treas. Reg. § 1.1503(d)-3(a)(i).

1. Treas. Reg. § 1.1503(d)-7(c), Ex. 16 involves differences in the timing of deductions: Salary is accrued in Year 1 and deducted as part of a DCL for U.S. tax purposes, but is deductible for foreign tax purposes in Year 2, after a transfer. A mismatch in the timing of deductions can result in a foreign use.

2. The example, however, also illustrates an exception: no foreign use will result if the use is solely as a result of an item or deduction or loss composing the DCL being made available following the assumption of liabilities incurred in the ordinary course of business. Treas. Reg. § 1.1503(d)-3(c)(7).

3. Thus, in the example, the taxpayer can rebut the triggering event resulting from the transfer of all of the branch’s assets and liabilities.

C. Treas. Reg. § 1.1503(d)-3(a)(2) provides that an item of deduction or loss will be deemed to be made available indirectly if one or more items are taken into account as deductions or losses for foreign tax purposes and this has the effect of making an item of deduction or loss composing a DCL available for foreign use.

1. An exception may apply absent a tainted principal purpose of § 1503(d) avoidance for items incurred in the ordinary course of business. Treas. Reg. § 1.1503(d)-3(a)(2). See also Treas. Reg. § 1.1503(d)-7(c) Exs. 6-8.

2. This exception appears only to apply in the context of an indirect foreign use.

D. Treas. Reg. § 1.1503(d)-7(c) Ex. 31 illustrates these rules with a difference in the timing of asset depreciation deductions. The DCL includes depreciation expense. In Year 1, $100 of depreciation was claimed for U.S. tax purposes, but for country X purposes, the depreciation is deductible in Year 2, after the transfer. Thus, after the transfer, depreciation that was claimed for U.S. tax purposes in Year 1 can be claimed for foreign purposes. There will be a foreign use.

E. Treas. Reg. § 1.1502(d)-7(c) Ex. 33 illustrates these rules with an asset basis due to U.S. depreciation, but under the foreign country’s rules, depreciation cannot be claimed: the asset is not depreciable. Nonetheless, since an asset basis differential results, a sale of the asset at a loss after the transfer would be a foreign use.

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F. Under Treas. Reg. § 1.1503-6(e)(1)(iv) triggering events requiring the recapture of DCLs include the transfer of 50% or more of the branch’s gross assets (FMV) by sale or otherwise within a 12-month period.

G. Treas. Reg. § 1.1503(d)-6(e)(1)(vi) requires the recapture of DCLs when the branch becomes a foreign corporation, for example, as a result of unchecking it, i.e., electing to be treated as a foreign corporation.

H. Treas. Reg. § 1.1503(d)-6(e)(2) contains rules allowing the taxpayer to rebut the application of the triggering event rules in such a case by proving there can be no foreign use of the DCL during the remainder of the certification period by any means.

I. If X as a branch incurred DCLs for which domestic use elections were made but has had subsequent profits as a branch, the rules in Treas. Reg. § 1.1503(d)-6(h)(2) may apply.

1. The taxpayer may be able to demonstrate that a lessor amount than the DCL should be recaptured. The reduction in the amount of recapture is the amount by which the DCL would have offset other taxable income reported on timely filed U.S. income tax returns if no domestic use election had been made such that it was subject to the domestic use limitation rules of Treas. Reg. §§ 1.1503(d)-4(b) and (c) (a SRLY approach).

2. Treas. Reg. § 1.1503(d)-7(c) Ex. 39 illustrates these rules.

(a) The branch has a $100 DCL in Year 1 and P makes a domestic use election. In Year 2, the branch has $100 of income and P otherwise has $200 of income. At the end of Year 2, there’s a triggering event.

(b) P demonstrates that if a domestic use election had not been made, the Year 1 DCL would have been offset by the $100 of Year 2 income (under the SRLY rules). Thus, there is no amount to recapture.

(c) However, P is still liable for an interest charge because the group had the benefit of the DCL in Year 1, and did not have to wait until Year 2 to use the DCL.

3. Treas. Reg. § 1.1503-7(c) Ex. 40 also illustrates these rules.

J. Midyear Check-the-Box Election.

1. Every midyear unchecking apparently will result in a foreign use as to a current-year DCL absent an exception such as the “assumption” rule in Treas. Reg. § 1.1503(d)-3(c)(7). See V.B. above. This doesn’t seem

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right. Even a YE unchecking can result in a foreign use, but only with things like timing differences such as the salary example (V.B.1. above) or depreciation (V.D and E above), or of course under the general triggering-event rules.

2. In AM 2009-011 Scenario 1, P has owned 100% of X since its formation on January 1, Year 1. Prior to July 1, Year 2, X was classified as a foreign corporation for U.S. tax purposes. X elected to be a disregarded entity on July 1, Year 2. A DCL is attributable to the X separate unit for the period from July 1, Year 2 through December 31, Year 2 (Year 2 DCL). The issue is whether P is permitted to make a domestic use election with respect to the Year 2 DCL.

3. A foreign use of the Year 2 DCL is deemed to occur if two conditions are satisfied. First, any portion of a deduction or loss taken into account in computing the Year 2 DCL is made available under the income tax laws of a foreign country to offset or reduce, directly or indirectly, any item that is recognized as income or gain under those laws. In this scenario, one or more of the deductions or losses taken into account in computing the Year 2 DCL are recognized as deductions or losses under the laws of country Z.

4. Second, the item of income or gain that is able to be offset by deduction or loss of the Year 2 DCL is or would be considered under U.S. tax principles to be an item of a foreign corporation, or an item of a direct or indirect owner of an interest in a hybrid entity that is not a separate unit. Because X is classified as a foreign corporation under U.S. tax principles from January 1, Year 2 through June 30, Year 2, an item of income or gain able to be offset by a deduction or loss of the Year 2 DCL is or would be considered under U.S. tax principles to be an item of a foreign corporation.

5. Therefore, the availability of a deduction or loss of the Year 2 DCL to offset an item of income or gain of X during the period that it was a foreign corporation for U.S. tax purposes gives rise to a foreign use. Consequently, P cannot make a domestic use election.

VI. OFLs

A. The Overall Foreign Loss rules of § 904(f) also need to be considered if P has an OFL. § 904(f)(3) can create taxable gain.

B. Section 904(f)(3) states that if property which has been used predominantly outside the U.S. in a trade or business by a taxpayer with an OFL is disposed of during any taxable year,

1. The taxpayer, notwithstanding any other provision of “this chapter” (§§ 1-1400), shall be deemed to have received and recognized taxable

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income from sources without the U.S. in the taxable year of the disposition, by reason of the disposition, in an amount equal to the lesser of the excess of the FMV of the property over the taxpayer’s adjusted basis in the property, or the remaining unrecaptured amount of the OFL.

2. In determining whether the predominant use of any property has been without the U.S., the taxpayer must take into account use during the 3-year period ending on the date of the disposition (or if shorter, the period during which the property has been used in the trade or business).

3. “Disposition” is defined for this purpose to include a sale, exchange, etc., whether or not gain is otherwise recognized on the transfer. See also Treas. Reg. § 1.904(f)-2(d)(4), dealing with dispositions in which gain would not otherwise be recognized. Treas. Reg. § 1.904(f)-2(d)(5) defines disposition to include, among certain specified transactions, “any other transfer of property whether or not gain or loss is recognized under other provisions of the Code.”

4. Exceptions include a disposition of property which is not a material factor in the realization of income by the taxpayer.

C. Treas. Reg. § 1.904(f)-2(d)(5) also contains definitions of “property used in a trade or business,” “property used predominantly outside the U.S.,” and “property which is a material factor in the realization of income.”

1. The relationship to the trade or business is the relevant consideration in determining whether property is used in a trade or business. Is the property used in the trade or business, or was it acquired with funds generated by the trade or business? Are its earnings used in the trade or business?

2. Under the regulations, stock in another corporation is not property used in a trade or business if a substantial investment motive exists for acquiring and holding the stock. On the other hand, the regulation also states that stock acquired to assure a source of supply for a trade or business is considered property used in that trade or business.

D. Section 904(f)(3)(D) contains special rules for stock in a CFC if immediately before the transfer the taxpayer owned more than 50% of the stock of the CFC.

E. Once the income is recognized, the taxpayer’s OFL is recaptured to that extent by treating the full gain as U.S. source income. § 904(f)(1).

VII. SECTION 987

A. The § 987 rules and regulations also must be considered when transferring a foreign branch to a foreign corporation. The only guidance we have consists of the statute, which is quite brief, and the long-outstanding proposed regulations.

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Under the proposed regulations, the § 987 QBU (X as a disregarded entity) will terminate when X is “unchecked” into CFC status, and § 987 gain or loss will become taxable. See Proposed Treas. Reg. § 1.987-8; see also VII.J. below.

B. The centerpiece of the proposed § 987 regulations is the “Foreign Exchange Exposure Pool Method.” First, the income of a § 987 QBU is determined by reference to the items of income, gain, deduction and loss booked to the QBU in its functional currency, adjusted to reflect U.S. tax principles. Items of income, gain, deduction and loss of a § 987 QBU generally are translated into the functional currency of the QBU’s owner at the average exchange rate for the year. However, the basis of historic assets and deductions for depreciation, depletion, and amortization of those assets are translated at the historic exchange rate.

C. Then the foreign exchange exposure pool method uses a balance sheet approach to determine exchange gain or loss, which is recognized when a remittance is made. Items whose value fluctuates with respect to changes in the functional currency of the owner will enter into this determination and those that do not, will not. Exchange gain or loss with respect to “marked items” is identified annually and is pooled and deferred until a remittance is made. A marked item is generally defined as an asset or liability that would generate § 988 gain or loss if the asset or liability were held or entered into directly by the owner of the § 987 QBU.

D. The source and character of exchange gain or loss recognized under § 987 for all purposes of the Code, including §§ 904(d), 907 and 954, is determined by reference to the source and character of the income derived from the § 987 QBU’s assets.

E. Prop. Treas. Reg. § 1.987-1: Scope, Definitions and Special Rules.

1. An eligible QBU is defined in Prop. Treas. Reg. § 1.987-1(b)(3). Generally, an eligible QBU is an activity of an individual, corporation, partnership or disregarded entity (“DE”): (1) that constitutes a trade or business as defined in Treas. Reg. § 1.989(a)-1(c); (2) that maintains separate books and records and whose assets and liabilities used in conducting its activities are reflected on those books and records; and (3) the activities of which are not subject to DASTM. Corporations, individuals, partnerships, and DEs are not eligible QBUs.

2. Prop. Treas. Reg. § 1.987-1(b)(2)(ii) allows an owner to elect to treat certain § 987 QBU’s with the same functional currency as a single § 987 QBU.

3. Under Prop. Treas. Reg. § 1.987-1(b)(5), a tiered ownership structure of eligible QBUs will not be respected as distinct tiers of QBUs for purposes of § 987. Rather, tiers of eligible and/or § 987 QBUs will be treated as a “flat” structure, with each QBU in the tier considered as owned directly by the ultimate non-QBU owner. For example, if a domestic corporation is

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the holder of interests in a § 987 DE and that DE owns the interest in another § 987 DE, the structure will not be treated as a tier of QBUs for purposes of § 987. Rather, the domestic corporation will be considered the direct owner of the § 987 branches.

4. Marked Items. The definitions of § 987 marked items and § 987 historic items are central to the foreign exchange exposure pool method. A marked item is defined in Prop. Treas. Reg. § 1.987-1(d) as an asset or liability reflected on the books and records of the § 987 QBU that both (1) would generate § 988 gain or loss if held or entered into directly by the owner of the § 987 QBU and (2) is not a § 988 transaction with respect to the § 987 QBU. Marked items give rise to exchange gain or loss under § 987. Historic items are items other than marked items. Historic items do not give rise to exchange gain or loss under § 987.

F. Prop. Treas. Reg. § 1.987-2: Attribution of Items to an Eligible QBU; the Definition of Transfer and Related Rules.

1. The proposed regulations adopt a books and records method for allocating items to an eligible QBU. The proposed regulations provide that, subject to certain exceptions, items are attributable to an eligible QBU to the extent they are reflected on the separate set of books and records of the eligible QBU. These rules apply solely for purposes of § 987.

2. Certain assets and liabilities are not attributable to an eligible QBU, even if those assets and liabilities are reflected on the books and records of the QBU. Non-portfolio stock and interests in partnerships (and liabilities to acquire those assets), even if reflected on the books and records of the eligible QBU, are not attributed to the QBU for purposes of § 987. This is consistent with the principle, states the preamble, that a § 987 QBU cannot be the owner of another § 987 QBU.

G. Prop. Treas. Reg. § 1.987-6: Character and Source.

1. Prop. Treas. Reg. § 1.987-6(b)(2) provides that the owner must use the asset method set forth in Temp. Treas. Reg. § 1.861-9T(g) to characterize and source § 987 gain or loss. This determination applies for all purposes of the Code, including §§ 904(d), 907 and 954.

2. In an example, a CFC, which uses the Swiss franc as its functional currency, has a § 987 branch with significant operations in Germany. The German branch has the euro as its functional currency. The CFC recognizes § 987 gain of CHF10,000. The German branch has total average assets of CHG1,000,000, CHF750,000 of which generate foreign source general limitation income and CHF250,000 of which generate foreign source passive income all of which is Subpart F income, As a result, CHF7,500 of the CFC’s § 987 gain will be treated as foreign source

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general limitation income which is not Subpart F income and CHF2,500 will be treated as foreign source passive income which is Subpart F income.

H. Prop. Treas. Reg. § 1.987-8: Termination of a § 987 QBU.

1. The termination of a § 987 QBU is treated as a remittance of all the gross assets of the § 987 QBU to its owner. A termination occurs when (1) the activities of the § 987 QBU cease, (2) substantially all the assets of the § 987 QBU are transferred to its owner, or (3) the owner of the § 987 QBU ceases to exist. A termination also occurs when a foreign corporation that is a CFC that is the owner of a § 987 QBU ceases to be a CFC.

2. A number of exceptions apply. A termination generally does not occur when other tax attributes under § 381 are carried over in a liquidation under § 332 or an asset reorganization under § 368. However, inbound and outbound liquidations and reorganizations terminate a § 987 QBU. These transactions materially change the circumstances in which § 987 gain or loss is taken into account.

3. An additional exception applies when the distributor and a distributee are both foreign corporations and the functional currency of the distributee is the same as the functional currency of the distributor’s § 987 QBU.

4. Five examples illustrate these rules. In Example 2, DC, a domestic corporation, has a branch in country X that is a § 987 QBU. DC transfers all the assets and liabilities of the Country X branch to DS, a domestic corporation, under § 351. This causes a termination of the Country X branch because it ceases to exist as an eligible QBU of DC.

I. Prop. Treas. Reg. § 1.987-11: Effective Date.

1. The regulations are proposed generally to be effective with respect to taxable years beginning one year after the first day of the first taxable year following the date of publication of a Treasury decision adopting the regulations as final regulations.

2. A taxpayer may elect to apply the regulations to taxable years beginning after the date of publication of a Treasury decision adopting them as final regulations.

J. How Should the Taxpayer Handle § 987 With Regulations Only in Proposed Form?

1. The preamble to the proposed regulations states that the IRS and Treasury will consider positions consistent with the proposed regulations to be reasonable constructions of the statute.

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2. Sections 987(1) and (2) state taxable income should be computed separately for each separate unit in its functional currency and translated to dollars at the appropriate exchange rate.

3. Section 987(3) requires “proper adjustments” as prescribed under regulations for transfers of property between QBUs of the taxpayer having different functional currencies, including treating remittances from a separate unit as made out of post-1986 accumulated earnings, treating the gain or loss as ordinary and sourcing it by reference to the earnings out of which it is distributed.

VIII. SECTION 901(m)

A. Covered Asset Acquisitions.

1. Section 901(m) is entitled, “Denial of Foreign Tax Credit with Respect to Foreign Income Not Subject to United States Taxation by Reason of Covered Asset Acquisitions.” The statutory definition of a CAA includes four categories of transactions:

(a) A qualified stock purchase for which a § 338 election has been made;

(b) Any transaction treated as an asset acquisition for U.S. income tax purposes and as a stock acquisition (or disregarded) for foreign income tax purposes;

(c) Any acquisition of a partnership interest if the partnership has a § 754 election in place; and

(d) Any other similar transaction as identified in regulations.

2. Might an outbound § 351 transfer in an unchecking scenario and in which U.S. gain results with a corresponding basis step up be treated as subject to category “(b)” above?

(a) The JCT’s General Explanation of Tax Legislation Enacted in the 111th Congress (JCS-2-11), at 436 (Mar. 16, 2011) states: A “covered asset acquisition means . . . . For example, the deemed liquidation of a CFC as the result of the making of an entity classification election pursuant to Treas. Reg. Sec. 301.7701-3 may result in a section 331 liquidation for U.S. tax purposes that is disregarded for foreign income tax purposes.”

(b) Could the IRS argue that an unchecking (a § 351 transfer) gives rise to the same issue?

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3. One would hope not, but we have no regulations yet. The fact that U.S. tax was paid to get the basis step up should preclude an application of § 901(m).

4. Under § 901(m), the disqualified portion of any foreign income tax determined regarding the income or gain attributable to the relevant foreign assets is not taken into account in determining the § 901 foreign tax credit, and for a foreign income tax paid by a § 902 corporation, is not taken into account for purposes of §§ 902 and 960.

5. The JCT Technical Explanation illustrates this rule with the following example. Assume US, a domestic corporation, acquires 100% of the stock of FT, a foreign target organized in country F with a “u” functional currency, in a qualified stock purchase for which a § 338 election is made. The tax rate in country F is 25%. The aggregate basis difference in connection with the qualified stock purchase is 200u, including: (1) 150u that is attributable to asset A, with a 15 year recovery period for U.S. tax purposes (10u of annual amortization); and (2) 50u that is attributable to asset B, with a five year recovery period (10u of annual depreciation).

6. In each of years 1 and 2, FT’s taxable income is 100u for local purposes and FT pays foreign income tax of 25u (equal to $25 when translated at the average exchange rate for the year). As a result, the disqualified portion of foreign income tax in each of years 1 and 2 is $5 (10u + 10u of allocable basis difference over 100u of foreign taxable income times $25 foreign tax paid).

7. In year 3, FT’s taxable income is 140u, 40u of which is attributable to gain on the sale of asset B. FT’s country F tax is 35u (equal to $35 translated at the average exchange rate for the year). Accordingly, the disqualified portion of its foreign income taxes paid is $10 ((40u (10u of annual amortization on asset A plus 30u attributable to disposition of asset B) of allocable basis difference over 140u of foreign taxable income) times $35 foreign tax paid)).

8. The disqualified portion of the foreign tax can be claimed as a deduction to the extent otherwise deductible.

B. Observations with Respect to CAAs.

1. Category 2 above is very broad.

(a) It would appear to include every transaction involving a check-the-box election. To take the simplest of examples, suppose USP owns CFC1, which owns CFC2. CFC1 and CFC2 have operated as CFCs for a number of years. CFC2 makes a check-the-box election to be treated as a disregarded entity. The deemed liquidation of CFC2 is a Category 2 CAA: It is treated as an asset

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acquisition for U.S. tax purposes (CFC1 acquired CFC2’s assets) and is disregarded under foreign law.

(b) In this example the transaction’s status as a CAA might not be too great a concern for USP. It probably will not result in a denial of foreign tax credits, as it would not result in any “basis difference.” On the other hand, the existence of a 1% minority shareholder, for example, could create such a basis difference to the extent of that shareholder’s interest in the underlying CFC2 assets.

(c) However, an unchecking as in our fact pattern could result in increased asset bases if § 351(b), the § 367 rules, § 904(f)(3) or other provisions require gain recognition giving rise to basis increases.

C. NYS Bar Comments.

1. The New York State Bar Association Tax Section submitted an excellent report discussing issues that Treasury and the IRS should address in regulations under § 901(m). The report is dated January 28, 2011.

2. The Report suggests among other things that the IRS and Treasury issue guidance addressing the question of whether a transaction should be treated as a CAA if the seller recognizes gain that is subject to U.S. tax.

IX. COORDINATION AND PRIORITY OF RULES

A. Note the significance of determining which of the loss recapture rules applies and in which order: §§ 351(b), 367(a)(3)(C), and 904(f)(3) involve basis step ups to the transferee and implicate § 901(m).

B. The DCL rules do not give rise to a basis step up, but do involve an interest charge.

C. Temp. Treas. Reg. § 1.367-6T addresses the interrelationship of §§ 367(a), 904(f) and 904(f)(3) (see section III E.3. above) but doesn’t mention DCLs.

D. Treas. Reg. § 1.1503(d)-6(h)(2) permits a DCL amount, when recaptured, to be reduced by certain subsequent branch profits, but doesn’t mention § 367(a) or § 904(f). However, Treas. Reg. § 1.1503(d)-5(c)(4)(iii) provides that for purposes of attributing items of gains, etc. recognized on the sale or other disposition of a separate unit, items taken into account on the sale, exchange or other disposition include gain under §§ 367(a)(3)(C) and 904(f)(3). Thus §§ 367(a)(3)(C) and 904(f)(3) come before DCL recapture.

E. None of the provisions coordinates with § 987, and the § 987 proposed regulations do not provide for a coordination in this regard.

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F. What about § 351(b) gain? Section 367(a) gain?

X. REPORTING: § 6038B AND RELATED RULES

A. Section 6038B requires reporting of transfers of property to a foreign corporation in § 351 exchanges.

1. The penalty for failure to furnish the necessary information in a timely manner is 10% of the FMV of the property at the time of the exchange, limited to $100,000 unless the failure was due to intentional disregard.

2. The penalty will not apply if the U.S. person shows the failure was due to reasonable cause, and not to willful neglect.

B. Treas. Reg. § 1.6038B-1 provides further instructions regarding the reporting requirements.

1. Form 926 must be filed by the due date of the transferor’s income tax return (including extensions), and with that return, for the period that includes the transfer.

2. In the case of any information which is required to be reported under § 6038B, the statute of limitations with respect to any tax return, event, or period to which the information relates will remain open until 3 years after the necessary information is furnished to the IRS. § 6501(c)(8). See recent IRS AM 2014-002.

3. If the failure is due to reasonable cause and not willful neglect, the extension of the statute applies only to the item or items related to the failure (and not to the U.S. transferor’s entire tax return). § 6501(c)(8)(B).

4. To prove reasonable cause, the 2010 legislative history states that the “taxpayer must establish that the failure was objectively reasonable (i.e., the existence of adequate measures to ensure compliance with rules and regulations), and in good faith.”

C. Treas. Reg. § 1.6038B-1(c) and Temp. Treas. Reg. § 1.6038B-1T(c) state the information that must be provided.

1. The consideration received (stock) must be described and its FMV estimated.

2. The property transferred must be described and the estimated FMV and adjusted basis of the property provided.

3. The transferred property is divided into categories: active trade or business property; stock or securities; depreciated property subject to recapture under Treas. Reg. § 1.367(a)-4T(b) (U.S. depreciation, likely not

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relevant to our P-X facts); property to be leased; property to be sold; and “tainted” property such as inventory, installment obligations, foreign currency, intangible property, etc.

4. Information must be provided regarding foreign branch losses for purposes of the rules in Treas. Reg. § 1.367(a)-6T (branch loss recapture).

5. Intangible property sold or licensed by the transferor to the transferee foreign corporation must be described, and the terms of each sale or license must be described.

D. If the transfer includes stock in lower-tier foreign subsidiaries, gain recognition agreements will need to be included. Treas. Reg. §§ 1.367-3 and 8.

E. Section 367 GRAs.

1. Treasury and the IRS recently issued final regulations (generally adopting previously proposed regulations) that amend the rules governing failures to file gain recognition agreements and related documents, or to satisfy other reporting obligations, associated with transfers of property to foreign corporations.

2. The § 367(a) regulations provide exceptions to the general income-recognition rule of § 367(a) for certain transfers by a U.S. transferor of stock or securities to a foreign corporation. These exceptions generally require the U.S. transferor to file a GRA and other related documents. Under the terms of a GRA, the U.S. transferor must agree to include in income the gain realized but not recognized on the initial transfer of stock or securities and to pay interest on any additional tax due if a gain recognition event occurs during the five-year term of the GRA.

3. A failure to comply with the GRA rules can trigger gain recognition. An example is the failure to file an annual certification. The previous regulations provided that if there was a failure to comply with the GRA rules, the U.S. transferor would have to recognize the full amount of gain realized on the initial transfer of stock or securities unless the transferor could demonstrate that the failure was due to reasonable cause and not willful neglect under Treas. Reg. § 1.367(a)-8(p). Similarly, if there was a failure to timely file a GRA in connection with the initial transfer, the U.S. transferor must recognize gain with respect to the transfer unless the reasonable cause exception is satisfied.

4. In addition, as discussed above in A and B, a U.S. person who transfers property to a foreign corporation in certain nonrecognition transactions also is subject to the reporting requirements of § 6038B. The U.S. transferor generally is required to file IRS Form 926, “Return by a U.S. Transferor of Property to a Foreign Corporation.” The form must identify the transferee foreign corporation and describe the property transferred.

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5. Under the previous regulations, if a transferor failed to timely file an initial GRA, or failed to comply in any material respect with the § 367(a) GRA regulations with respect to an existing GRA (for example, because it failed to timely file an annual certification), the U.S. transferor was subject to full gain recognition under § 367(a) unless the U.S. transferor later discovered the failure, promptly filed the GRA or other required information with the IRS, and demonstrated that its failure was due to reasonable cause and not willful neglect.

6. Treasury and the IRS were concerned that the previous reasonable cause standard might not be satisfied by U.S. transferors in many common situations even though the failure was not intentional and not due to willful neglect. Treasury and the IRS believe that full gain recognition under § 367(a) should apply only if a failure to timely file an initial GRA or a failure to comply with a § 367(a) GRA regulations with respect to an existing GRA is willful. They believe that the penalty imposed by § 6038B generally should be sufficient to encourage proper reporting and compliance.

7. The new regulations thus revise the § 367(a) GRA regulations to provide that a U.S. transferor seeking either to (1) avoid recognizing gain under § 367(a) on the initial transfer as a result of a failure to timely file an initial GRA, or (2) avoid triggering gain as a result of a failure to comply in all material respects with the § 367(a) GRA regulations or the terms of an existing GRA, must demonstrate that the failure was not a willful failure.

8. For this purpose, the term “willful” is to be interpreted consistent with the meaning of that term in the context of other civil penalties (for example, § 6672), which would include a failure due to gross negligence, a reckless disregard, or willful neglect.

9. Whether a failure is willful will be determined based on all the relevant facts and circumstances. The regulations illustrate the application of this standard to a series of helpful examples. For example, the § 367(a) GRA regulations require a GRA to include information about the adjusted basis and fair market value of the property transferred. Filing a GRA and intentionally not providing this information, including noting on the GRA that this information is “available upon request,” would be a willful failure.

10. The new regulations also provide guidance clarifying when an initial GRA is considered timely filed, and what gives rise to a failure to comply in any material respect with the requirements of the § 367(a) GRA regulations or the terms of an existing GRA. In general, an initial GRA is timely filed only if each document that is required to be filed as part of the initial GRA is timely filed and complete in all material respects. Similarly, in general,

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there is a failure to comply in a material respect with the § 367 GRA regulations or the terms of an existing GRA if a document (such as an annual certification) that is required to be filed is not timely filed, or is not completed in all material respects.

11. The revised regulations also clarify that the § 6038B penalty will apply to a failure to comply in any material respect with the § 367(a) GRA regulations or the terms of an existing GRA, such as a failure to properly file a GRA document (including an annual certification or new GRA). Under the new regulations, a failure to comply has the same meaning for purposes of the § 367(a) GRA regulations and the § 6038B regulations.

12. However, the current reasonable cause standard continues to apply to U.S. transferors seeking relief from the § 6038B penalty.

13. The new final regulations also modify the information that must be reported with respect to a transfer of stock or securities on Form 926. Specifically, the U.S. transferor must include on Form 926 the basis and fair market value of the property transferred. In addition, the new regulations require that a Form 926 be filed in all cases in which a GRA is filed.

14. The final regulations’ examples are helpful, and are the same as or very similar to the examples in the proposed regulations. In Example 1, the taxpayer failed to file a GRA due to an accidental oversight. DC (domestic corporation) filed its tax return for the year of the FS (foreign subsidiary) transfer, reporting no gain with respect to the exchange of the FS stock. DC, through its tax department, was aware of the requirement to file a GRA, and had experience and competency to prepare the GRA. DC had filed many GRAs over the years and had never failed to timely file a GRA. However, although DC prepared the GRA with respect to the FS transfer, it was not filed with DC’s return for the relevant tax year due to an accidental oversight. During the preparation of the following year’s tax return, DC discovered that the GRA had not been filed and prepared an amended return to file the GRA and comply with the necessary procedures. The example concludes that the failure to timely file was not a willful failure to file.

15. In Example 2, the taxpayer’s course of conduct is taken into account in the determination. DC filed its tax return for the year of the FS transfer, reporting no gain with respect to the exchange of the FS stock, but failed to file a GRA. DC, through its tax department, was aware of the requirement to file a GRA in order for DC to avoid recognizing the relevant gain. However, DC had not consistently and in a timely manner filed GRAs in the past, and also had an established history of failing to timely file other tax and information returns for which it had been subject to penalties.

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16. At the time of an FS2 transfer, DC was already aware of its failure to file the GRA required for a prior transfer, but had not implemented any safeguards to ensure that it would timely file GRAs for future transactions. DC’s course of conduct is taken into account in determining whether its failure to timely file a GRA for the FS2 transfer was willful. Based on the facts in this example, including DC’s history of having failed to file required tax and information returns in general, and GRAs in particular, and its failure to implement safeguards to ensure that it would timely file GRAs, the failure to timely a GRA with respect to the FS2 transfer rises to the level of a willful failure to timely file.

17. In Example 3, the GRA was not completed in all material respects. DC timely filed its tax return for the year of the FS transfer, reporting no gain. DC was aware of the requirement to file a GRA to avoid recognizing gain under § 367(a), including the requirement to provide the fair market value of the transferred stock. Instead, the GRA was filed with the statement that the fair market value information was “available upon request.” Other than the omission of the fair market value of the FS stock, the GRA contained all other information required by that section. Because DC knowingly omitted such information, DC’s omission is a willful failure to timely file a GRA. The result would be the same if DC knowingly omitted basis information even if fair market value was included.

18. In Example 4, a GRA is filed as a result of hindsight. At the time DC filed its tax return for the year of the FS transfer, DC anticipated selling Business A in the following year, which was expected to produce a capital loss that could be carried back to fully offset the gain recognized on the FS transfer. DC chose not to file a GRA but to recognize gain on the FS transfer under § 367(a), which it reported on its timely filed tax return. However, a large class action lawsuit was filed against Business A at the end of the following year, and DC was unable to sell the business. As a result, DC did not realize the expected capital loss, and was not able to offset the gain from the FS transfer. DC now seeks to file a GRA for the transfer. Because DC knowingly chose not to file a GRA for the FS transfer, its actions constitute a willful failure to timely file a GRA. Accordingly, the GRA is not considered timely filed and DC must recognize the full amount of the gain realized on the FS transfer.

XI. FOREIGN LAW

A. Foreign law and treaties should be checked to see what issues might arise.

B. Denmark, for example, respects U.S. check-the-box elections and treats them as applying for Danish tax purposes as well. This can give rise to Danish taxable events, for example, with respect to intangibles. In checking into corporate status, this would involve a transfer of assets, including intangibles, to the “new” Danish corporation.

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C. BEPS. Numerous BEPS issues can result. For example, do the relevant country’s hybrid entity rules apply? Do the relevant thin cap rules apply?

D. The European Commission’s BEPS-related proposals (2016), if adopted, could also present issues if EU countries are involved.

XII. TREATIES

A. Will the application of treaties be affected by the unchecking.

B. Consider the hybrid entity provisions of the relevant treaties. Did they apply and will they continue to apply?