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In regulations released 5 October 2023 (REG-117614-14; Proposed Regulations), the United States (US) Department of Treasury and the Internal Revenue Service (IRS) proposed to modify certain aspects of the existing regulations issued under IRC Section 367(b) (Existing Regulations). The Proposed Regulations incorporate, with certain modifications, guidance described in Notice 2014-32 (2014 Notice) and Notice 2016-73 (2016 Notice and collectively, the Notices), each issued in response to transactions perceived to exploit certain aspects of the Existing Regulations.

In response to a comment received on the 2016 Notice, the Proposed Regulations would narrow the scope of the "excess asset basis" (EAB) rules specified in the 2016 Notice. In light of the increased prevalence of previously taxed earnings and profits (PTEP) after the Tax Cuts and Jobs Act (TCJA), the Proposed Regulations would also treat the foreign acquired corporation as receiving a deemed distribution under IRC Section 301 from its foreign subsidiaries instead of adjusting an exchanging shareholder's all earnings and profits (E&P) amount as described in the 2016 Notice. For an in-depth discussion of the 2016 Notice, see EY Tax Alert 2016-2116. Comments on the Proposed Regulations must be received by 5 December 2023.

Detailed discussion

Background

Existing Regulations

The Existing Regulations under Treas. Reg. Section 1.367(b)-10, which address cross-border triangular reorganizations, were issued on May 17, 2011. Substantial modifications to these regulations were subsequently proposed through the Notices, as discussed later. The Existing Regulations apply to certain triangular reorganizations in which a subsidiary (S) (i) purchases, in connection with the triangular reorganization, stock or securities of its parent corporation (P) in exchange for property; and (ii) exchanges the P stock or securities for the stock, securities or property of a target corporation (T) (such stock, tainted P stock or securities), but only if either P or S (or both) is a foreign corporation (cross-border triangular reorganizations). If applicable, the Existing Regulations require adjustments to be made that have the effect of a distribution of property from S to P under IRC Section 301(c) equal to the fair market value of the money and other property used to acquire the P stock (deemed distribution), immediately followed by a contribution by P to S of the property deemed distributed by S to P (deemed contribution).

Several exceptions apply to the Existing Regulations. One such exception is a priority rule, which subjects a transaction to either IRC Section 367(a) or IRC Section 367(b), but not to both (known as either the "IRC Section 367(a) priority rule" or the "IRC Section 367(b) priority rule"). Under the IRC Section 367(a) priority rule, the Existing Regulations do not apply to a cross-border triangular reorganization if the gain recognized by T's US shareholders or security holders under IRC Section 367(a)(1) (IRC Section 367(a) gain) equals or exceeds the sum of the deemed dividend and IRC Section 301(c)(3) gain under the Existing Regulations (IRC Section 367(b) income).

By contrast, the IRC Section 367(b) priority rule "turns off" IRC Section 367(a) with respect to T's US shareholders if the gain they would recognize under IRC Section 367(a) on their exchange of the T stock or securities (without regard to any exceptions) would be less than P's IRC Section 367(b) Income. These rules were intended to work in tandem to give priority to the IRC Section 367 regime that would give rise to the most income. Another exception (the no-US-tax exception) applies if (i) S is a domestic corporation; (ii) P's stock in S is not a US real property interest (under IRC Section 897(c)); and (ii) P's receipt of a dividend from S would not be subject to US tax (e.g., by reason of a tax treaty). An exception also applies if P and S are foreign corporations and neither P nor S is a controlled foreign corporation (CFC) immediately before or immediately after the triangular reorganization.

The Existing Regulations also include an anti-abuse rule, under which "appropriate adjustments" will be made, including by taking into account the E&P of a corporation that has funded the acquiring corporation, to the extent that a transaction is undertaken "with a view" to avoiding the purpose of the Existing Regulations.

The Existing Regulations under Treas. Reg. Section 1.367(b)-3, which were originally issued in 2000 and do not directly apply to cross-border triangular reorganizations, also include rules on the repatriation of foreign corporate assets in a liquidation described in IRC Section 332 or an asset acquisition described in IRC Section 368(a)(1) (inbound nonrecognition transactions). For an exchanging shareholder that is a US shareholder (as defined in IRC Section 951(b)) of the foreign acquired corporation, the Existing Regulations require the shareholder to include in income as a deemed dividend the "all E&P amount" with respect to the stock of the foreign acquired corporation. For this purpose, the all E&P amount is the net positive amount of E&P (if any), with certain adjustments, that is attributable to a US shareholder's stock in the foreign acquired corporation. Under the Existing Regulations, the all E&P amount was limited to the E&P of the foreign acquired corporation and does not include the E&P of its subsidiaries. As discussed later, both the Notices and the Proposed Regulations modify the determination of the all E&P amount in certain circumstances.

The Notices

On 25 April 2014, Treasury and the IRS issued the 2014 Notice and announced their intent to amend the Existing Regulations applying to cross-border triangular reorganizations in response to perceived exploitative transactions. For example, taxpayers were taking the position that the IRC Section 367(b) priority rule applies because P's IRC Section 367(b) income exceeds the IRC Section 367(a) gain recognized by T's US shareholders, even though the IRC Section 301(c)(3) gain taken into account in determining IRC Section 367(b) income is not subject to US tax. Accordingly, the 2014 Notice would amend the priority rules to include IRC Section 301(c) dividend and gain in IRC Section 367(b) income only to the extent that the income would be subject to US tax directly or indirectly through an inclusion under IRC Section 951(a)(1)(A). Additionally, the 2014 Notice would eliminate the deemed contribution of property from P to S, restrict the scope of the no-US-tax exception, and clarify the anti-abuse rule for cross-border triangular reorganizations.

On 2 December 2016, Treasury and the IRS issued the 2016 Notice and stipulated that, notwithstanding the modified rules announced in the 2014 Notice, further amendments would be forthcoming in response to additional transactions they perceived to exploit the Existing Regulations, including those modifications contained in the 2014 Notice. Specifically, as a result of the 2014 Notice, taxpayers were taking the position that S's purchase of P stock did not result in IRC Section 367(b) income if P and S were both CFCs, so the Existing Regulations (as modified by the 2014 Notice) did not apply. Then, subsequent to the cross-border triangular reorganization, taxpayers may have liquidated P and repatriated the property used by S to purchase the P stock without incurring US tax. Therefore, the 2016 Notice announced several changes that would be made to the Existing Regulations, which were largely adopted by the Proposed Regulations with some modifications.

Proposed Regulations

Consistent with the 2016 Notice, the Proposed Regulations focus mainly on inbound transactions that result in repatriation of previously untaxed foreign earnings. The Preamble acknowledges that the TCJA drastically changed the US tax landscape by introducing IRC Section 245A and increasing the amount of foreign earnings or income subject to immediate US taxation. As a result, increased E&P of foreign corporations are not taxable when distributed either because they give rise to a 100% dividends received deduction or constitute PTEP.

Despite the changes made by TCJA, the IRS and Treasury believe that the regulations under IRC Section 367(b) remain necessary because incentives to avoid treating property transfers as distributions remain (e.g., the distribution may not qualify for the dividends received deduction or the taxpayer seeks to preserve PTEP). Accordingly, the Proposed Regulations would formalize the guidance announced in the Notices but update it in light of the changes made by the TCJA.

Cross-border triangular reorganizations

Priority rules

Consistent with the Notices, the Proposed Regulations would adopt more restrictive priority rules. Most notably, the Proposed Regulations would not apply the IRC Section 367(a) priority rule if T is foreign. As a result, the Proposed Regulations would apply IRC Section 367(b), but not IRC Section 367(a), to a cross-border triangular reorganization where a US shareholder exchanges, under IRC Section 354 or 356, its foreign T stock or securities for P stock or securities where S acquired for property those P stock or securities in connection with the transaction (tainted P stock or securities). As explained later, the application of IRC Section 367(b) to such shareholder will result in the exchange being fully taxable.

IRC Section 367(a), however, would continue to apply to exchanging US shareholders that receive P stock or securities not purchased by S in exchange for property under the reorganization. Thus, to avoid gain recognition, those exchanging shareholders would continue filing gain recognition agreements under Treas. Reg. Section 1.367(b)-3 and -8.

If T were not foreign, the Proposed Regulations would modify the priority rules in the 2014 Notice and require the IRC Section 367(b) income to include IRC Section 301(c) dividend and gain only to the extent that such income would be subject to US tax directly or indirectly through an income inclusion under IRC Section 951(a)(1)(A) or IRC Section 951A(a).

Immediate shareholder-level gain recognition

Without significant modifications from the 2016 Notice, the Proposed Regulations would require the immediate recognition of shareholder-level gain on the T stock or securities that are exchanged for tainted P stock or securities in an exchange under IRC Section 354 or 356. Specifically, the exchanging US shareholder must (1) include in income the IRC Section 1248 amount attributable to the exchanged stock; and (2) recognize any excess realized gain on the exchanged stock (after accounting for the inclusion of the IRC Section 1248 amount), regardless of whether the exchanging US shareholder is an IRC Section 1248 shareholder of the foreign T.

The Preamble of the Proposed Regulations indicates that a comment received in response to the 2016 Notice pointed out that the recognition of both shareholder-level gain and the income/gain associated with the deemed distribution from S to P simulates the concurrent application of IRC Section 367(a) and (b), which is contrary to the statute. However, reiterating the underlying policy concerns of IRC Section 367(b), Treasury and the IRS maintained that this approach is consistent with the broad grant of regulatory authority under IRC Section 367 and is warranted to overcome the potential for abuse under the circumstances.

Anti-abuse rule

Under the Existing Regulations, the anti-abuse rule authorized appropriate adjustments under Treas. Reg. Section 1.367(b)-10 if, in connection with a triangular reorganization, a transaction is undertaken with a view to avoiding the purpose of this section. In one example, the Existing Regulations deem S's E&P to include the E&P of a corporation related to P or S for purposes of determining the consequences of the adjustments in the Existing Regulations, if S is created, organized, or funded to avoid application of the Existing Regulations to the related corporation's E&P. The 2014 Notice stated that the Existing Regulations would be clarified to provide that (1) S's acquisition of P stock in exchange for a note may trigger the anti-abuse rule; and (2) S's E&P may be deemed to include another corporation's E&P, regardless of whether that corporation was related to P or S before or after the cross-border triangular reorganization. Thus, although the full scope of the anti-abuse rule has remained unclear despite its broad language, the rule has focused on increasing the E&P of S. The Proposed Regulations, however, contain three new examples intended to illustrate the broad application of the anti-abuse rule.

In the first example (Example 1), USS purchases stock of FP for a note to acquire the stock of unrelated UST in a cross-border triangular reorganization. The example concludes that USS's use of a note was undertaken with a view to avoiding the purposes of this section, so the anti-abuse rule applies. Further, as a result of the anti-abuse rule, USS's E&P is deemed to include the UST's E&P for purposes of USS's deemed distribution to FP under the Proposed Regulations.

In the second new example (Example 2), USP wholly owns FS1, which has $100x of E&P. FS1 forms USS Newco, which then forms FS2 Newco. FS1 contributes $100x of property to USS Newco in exchange for USS Newco stock (an existing note receivable owning from USP). FS1 is then acquired by FS2 Newco in a cross-border triangular reorganization, with USP receiving USS Newco voting stock for its FS2 stock. The example applies to create a deemed distribution from FS1 to USS Newco, which results in a $100x dividend to USS Newco. The example appears to be illustrating the application of an adjustment under the anti-abuse rule beyond increasing S's E&P. Under the facts of the example, it appears that a $100x distribution from FS1 to USP would have been eligible for an IRC Section 245A dividends received deduction.

The third new example (Example 3) illustrates a further expansion of the anti-abuse rule to a foreign subsidiary's acquisition of a domestic target in a triangular reorganization despite the application of the IRC Section 367(a) priority rule, which would have otherwise precluded IRC Section 367(b) from applying to the transaction.

Deemed contributions

Consistent with the 2014 Notice, the Proposed Regulations would repeal the deemed contribution rule and thus, no longer require an adjustment for a deemed contribution from P to S, including no basis increase in the S stock held by P. Under the Proposed Regulations, however, P would generally receive an increase in its S stock equal to T shareholder's basis in its T stock under Treas. Reg. Section 1.358-6, determined as if P provided its stock to S, notwithstanding that S acquired the P stock or securities in exchange for property (see also Treas. Reg. Section 1.367(b)-13).

Other rules

Consistent with the 2014 Notice, the Proposed Regulations implement a narrower scope of the no-US-tax exception, which would not apply if P were a CFC. Furthermore, if P is not a CFC, S is a domestic corporation, and P's stock in S is not a real property interest, the exception would apply under the Proposed Regulations if the deemed distribution would result in a dividend that would not be taxable in the US (e.g., by reason of a tax treaty or the absence of E&P).

Moreover, consistent with the 2016 Notice, the Proposed Regulations would modify the definition of "property" in the Existing Regulations to include S stock that is nonqualified preferred stock (as defined in IRC Section 351(g)(2)).

Lastly, the Proposed Regulations provide additional reporting requirements for cross-border triangular reorganizations, which supplement the existing IRC Section 367(b) reporting requirements. In general, a taxpayer is required to disclose S's acquisition of tainted P stock or securities by attaching a statement (IRC Section 367(b) notice) to its US federal income tax return or Form 5471 (as applicable) in the year of such acquisition. The notice should include a description of the acquisition of tainted P stock or securities and property exchanged by S, any related transactions involving such stock or securities, and whether any adjustments (i.e., a deemed distribution) were made.

Inbound nonrecognition transactions

As noted previously, with respect to inbound nonrecognition transactions, the Existing Regulations require an exchanging shareholder that is a US shareholder of a foreign acquired corporation to include in income as a deemed dividend the all E&P amount of the stock of the foreign acquired corporation, without regard to the E&P of its subsidiaries. The IRS's and Treasury's stated intent underpinning Treas. Reg. Section 1.367(b)-3 is to properly account for the carryover of tax attributes from the foreign acquired corporation to the exchanging shareholder. Treasury and the IRS initially anticipated that the repatriation of E&P without tax and, specifically, the E&P of a foreign acquired corporation would be an effective proxy for this purpose. However, to the extent that E&P of lower-tier foreign corporations gave rise to the foreign acquired corporation's asset basis, the all E&P amount may be an insufficient proxy for purposes of determining the appropriate asset basis carryover as to the exchanging US shareholder.

In consideration of the foregoing, the 2016 Notice required an increase in the all E&P amount by the "specified earnings" attributable to such stock for all inbound nonrecognition transactions, if the foreign acquired corporation has EAB (EAB rules). The EAB is the amount by which the inside asset basis of the foreign acquired corporation, which is the adjusted basis of its assets in the hands of the domestic acquiring corporation immediately after the inbound transaction, exceeds the sum of:

• The E&P attributable to the outstanding stock of the foreign acquired corporation (computed under modified IRC Section 1248 principles)
• The aggregate basis in the stock of the foreign acquired corporation immediately before the inbound transaction (and without regard to any basis increase arising from the deemed dividend resulting from such inbound transaction)
• The aggregate liabilities assumed by the domestic acquirer in the inbound transaction, as determined under the IRC Section 357(d) principles

The Proposed Regulations would generally adopt rules that align with the policy concerns described in the 2016 Notice (including the definition of the EAB), but do so with a narrowed scope of applicability, as described in more detail later.

Introduction of deemed distribution under the EAB rules

As noted, the 2016 Notice required the foreign acquiring corporation to increase the all E&P amount by "specified earnings" attributable to its stock if the foreign acquired corporation had EAB. For this purpose, specified earnings means the least of three amounts, one of which is the sum of the E&P for each foreign subsidiary of the foreign acquired corporation that is attributable under IRC Section 1248(c)(2) to the foreign acquired corporation stock exchanged. Amounts specified in IRC Section 1248(d) (e.g., PTEP) are excluded from the all E&P amount. Given the heightened significance of PTEP after the TCJA, the Proposed Regulations would adopt a modified approach.

Under the Proposed Regulations, if the foreign acquired corporation had EAB, the foreign acquired corporation would instead be treated as receiving a deemed distribution under IRC Section 301(c) from its foreign subsidiaries, including the distribution of PTEP, immediately before the inbound nonrecognition transaction. For indirect lower-tier subsidiaries, the deemed distribution would be treated as being made through intermediate owners. The amount of deemed distribution would be determined by reference to "specified earnings," which is the lesser of (i) the EAB amount, and (ii) "lower-tier earnings" representing the aggregate E&P (including deficits) of all foreign subsidiaries of which the foreign acquired corporation would be an IRC 1248 shareholder if it were a US person. The exchanging shareholders then compute the all E&P amount for its stock, after giving effect to such deemed distribution. If the specified earnings were sourced from the multiple foreign subsidiaries, the portion of E&P of each foreign subsidiary would be determined on a pro rata basis in proportion to its lower-tier earnings. An example included in the Proposed Regulations illustrates that the deemed distribution of specified earnings of the foreign subsidiary may consist entirely of PTEP, which would not affect the exchanging shareholder's all E&P amount.

Narrowed scope of the EAB rules

In contrast to the 2016 Notice, which required an increase in the all E&P amount in all inbound nonrecognition transactions, the Proposed Regulations would require adjustments to the all E&P amount through a deemed distribution in only one of two circumstances: (i) S previously acquired tainted P stock or securities in connection with a cross-border triangular reorganization, and the adjustments for deemed distribution from S to P were not made, or (ii) the EAB is directly or indirectly attributable to property transferred to the foreign acquired corporation by its foreign subsidiary in a transaction other than a cross-border triangular reorganization and the principal purpose of the transaction was the creation of that EAB.

In the Preamble, Treasury and the IRS indicate that the approach of the Proposed Regulations (i) tackles the underlying policy concerns identified in the 2016 Notice more appropriately, (ii) is expected to correspond to the substance of the taxpayer's transaction, and (iii) is consistent with the approach adopted for cross-border triangular reorganizations.

Elimination of the EAB reduction rule

Under the 2016 Notice, if a foreign acquired corporation has EAB, a taxpayer may reduce the EAB to the extent that the EAB is not directly or indirectly attributable to property provided to the foreign acquired corporation by its foreign subsidiary (EAB reduction rule). The Proposed Regulations do not incorporate this relief measure given the diminished scope of the EAB rules.

EAB anti-abuse rule and prohibition against affirmative use

Consistent with the 2016 Notice, the Proposed Regulations would also include an anti-abuse rule to address the transactions that are undertaken with a view to avoiding the purposes of the EAB rules. If the anti-abuse rule applied, appropriate adjustments would be made, including disregarding the effects of transactions. For example, a transaction that a taxpayer undertakes with a view towards reducing EAB by increasing the outside stock basis without a corresponding increase to inside asset basis could be disregarded for purposes of computing EAB. In the Preamble to the Proposed Regulations, Treasury and the IRS indicate that narrowing the EAB rules would also significantly narrow the context in which the anti-abuse rule may apply.

The Proposed Regulations also introduce a new rule to address the concern that the EAB rules may be used affirmatively. The rule, which was not previously included in the 2016 Notice, would prohibit a taxpayer from applying the EAB rules to a transaction if the taxpayer created EAB with a principal purpose of subjecting the inbound nonrecognition transaction to the EAB rules.

Notice reporting

The Proposed Regulations provide additional reporting requirements for inbound nonrecognition transactions by requiring the IRC Section 367(b) notice to include certain information about the EAB (e.g., how it arose and how the amount was determined).

Applicability date

For the rules described in the 2014 Notice, the Proposed Regulations generally would apply to transactions completed on or after 25 April 2014 (the date of the 2014 Notice). For the rules described in the 2016 Notice, the Proposed Regulations generally would apply to transactions completed on or after 2 December 2016 (the date of the 2016 Notice). For those rules included in the Proposed Regulations but not previously announced in the 2016 Notice, the Proposed Regulations would apply to transactions completed on or after 6 October 2023 (the date the Proposed Regulations were published in the Federal Register).

Although the Proposed Regulations render the Notices obsolete, taxpayers and their related parties (within the meaning of IRC Sections 267(b) and 707(b)(1)) may nevertheless choose to apply the rules of both Notices or the Proposed Regulations to any open tax year beginning before the date the proposed regulations are finalized, provided that the rules are applied consistently and in their entirety to all intervening tax years.

Implications

Consistent with the results intended by the 2016 Notice, the consequences of engaging in a triangular cross-border reorganization that is subject to the Proposed Regulation will likely be untenable to most taxpayers. Specifically, where T is foreign, the Proposed Regulations would both treat S's purchase of P stock or securities as a distribution, subjecting T's US shareholder to full and immediate taxation on its T stock (through the combination of an IRC Section 1248 inclusion and gain recognition). Thus, it is unlikely that taxpayers would intentionally structure a cross-border reorganization to fall within the scope of the Proposed Regulations. Given the consequences, however, taxpayers should be cautious of unintentionally subjecting themselves to these rules. For example, consider a case where FS makes an IRC Section 301 distribution to FP, and shortly thereafter, FS acquires FT for FP voting stock in a cross-border triangular reorganization. Could FS's in-form distribution to FP be treated as having been made in exchange for the FP stock used in the subsequent cross-border triangular reorganization, thereby potentially subjecting FT's US shareholder to gain?

Moreover, the additional examples included in Treas. Reg. Section 1.367(b)-10 of the Proposed Regulations may increase difficulty for taxpayers in determining whether their triangular reorganizations fall within the scope of the rule. Furthermore, the inclusion of Example 3 is curious, as a taxpayer today is very unlikely to engage in a similar transaction involving an outbound transfer of a domestic target corporation with the recognition of gain under IRC Section 367(a). This leads one to wonder if the inclusion of such example is potentially to aid the IRS in auditing transactions that occurred before the issuance of the 2016 Notice by demonstrating the breadth of the anti-abuse rule.

The Proposed Regulations also represent a helpful step toward refining and finalizing prior guidance under IRC Section 367(b) that had been outstanding for several years. The narrowed application of the modifications proposed to Treas. Reg. Section 1.367(b)-3 is a positive change for taxpayers since it will alleviate the burden of complying with the new rules when the EAB was created in connection with a transaction other than a triangular reorganization and the principal purpose of such other transaction was not to create EAB. For transactions that are neither undertaken with a principal purpose to create EAB nor involve a cross-border triangular reorganization, taxpayers may affirmatively elect to apply the Proposed Regulations and dispense with calculations under the EAB rules, insofar as the taxpayer applies the entirety of the Proposed Regulations consistently to all intervening years.

In light of the additional complexity introduced into IRC Section 367(b) regulations by the Proposed Regulations, taxpayers would be prudent to carefully review the rules and examples in the Proposed Regulations and start assessing the impact of the proposed rules on their transactions.

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Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor