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Modifications to Section 367 in Outbound Section 304 Transactions


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

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

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

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

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

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

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

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

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

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



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

Tags: 1248 Sales of CFCs, Authority - Treasury Decisions, Charts - Situational Charts