AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
COMMENTS ON NOTICE 2005-74 REGARDING
THE EFFECT OF CERTAIN EXCHANGES
ON GAIN RECOGNITION AGREEMENTS (GRAs)
UNDER SECTION 367(a)
Approved by
International Taxation Technical Resource Panel (TRP)
and
Tax Executive Committee
Developed by
The International Tax TRP’s Cross Border Merger’s and Acquisitions Task Force
Joseph M. Calianno, Chair
Peter H. Blessing
Ron Dabrowski
Atul Deshmukh
Sherry Hawn
Jim Lynch
Joseph Sardella
Neil A.J. Sullivan
Kenneth Wood, International Tax TRP Chair
Eileen R. Sherr, AICPA Technical Manager
Submitted to Treasury and IRS
February 21, 2006
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
COMMENTS ON NOTICE 2005-74 REGARDING
THE EFFECT OF CERTAIN EXCHANGES
ON GAIN RECOGNITION AGREEMENTS (GRAs)
UNDER SECTION 367(a)
EXECUTIVE SUMMARY
Notice 2005-74 announced rules to be included in the current section 367(a) regulations on the treatment of gain recognition agreements (GRAs) resulting from certain common asset reorganizations involving a U.S. transferor, a transferee foreign corporation, and a transferred corporation. Although the Notice provides much needed guidance, it also results in GRAs being triggered in several common corporate restructurings involving a U.S. transferor that previously filed a GRA.
These comments focus on section 3.02 of Notice 2005-74,[1]including an analysis ofhow the Notice applies to certain asset reorganizations and our recommended changes.
The AICPA recommendsthat a successor U.S. transferor in an asset reorganization (or the consolidated group’s parent, where the successor U.S. transferor is a consolidated group member) be permitted to assume the obligations associated with an original GRA for the remaining term of that GRA without triggering gain recognition. We also recommend that, under certain circumstances, a successor foreign corporation in the asset reorganization be permitted to assume the obligations associated with the original GRA for the remaining term of the GRA without triggering gain recognition. Finally, if the IRS and Treasury decide to provide relief for the types of transactions described in these comments, we recommend that taxpayers be allowed to elect the same type of retroactive relief that is provided in section 5 of the Notice.
I. Background
Section 367(a)(1) generally provides that a U.S. person must recognize gain on the transfer of appreciated property (including stock or securities) to a foreign corporation in certain enumerated exchanges (e.g., sections 351, 354, 356 and 361). In the case of transfers of stock or securities, section 367(a)(2) provides that, except to the extent provided in regulations, section 367(a)(1) shall not apply to any transfer of stock or securities of a foreign corporation which is a party to the exchange or a party to the reorganization.
The section 367(a) regulations specifically address the treatment of a U.S. person’s transfer of both foreign stock or securities and domestic stock or securities to a foreign corporation pursuant to a section 367(a) exchange. In general, reg. section 1.367(a)-3(a) reiterates the general gain recognition rule of section 367(a)(1), subject to certain exceptions.[2] The regulations contain separate exceptions to the general gain recognition rule for transfers of foreign stock or securities and domestic stock or securities, if certain conditions are satisfied.[3] One of theconditionsa U.S. transferor may need to satisfy in orderto avoid recognizing gain on the transfer is that it or the U.S. parent of the consolidated group(in the case of a U.S. transferor that is a member of a consolidated group)may need to enter into a 5-year gain recognition agreement (GRA). For instance, reg. section 1.367(a)-3(b) addresses transfers of appreciated foreign stock. It provides in part that, except as provided in section 367(a)(5)[4], a U.S. person that owns 5 percent or more (applying section 318 attribution principles as modified by section 958(b)) of either the voting power or the total value of the transferee foreign corporation’s stock immediately after the transfer must enter into a5-year GRA to avoid gain recognition under section 367(a)(1).
Reg. section 1.367(a)-8 outlines when a GRA will be triggered or terminated. Triggering events underreg. section 1.367(a)-8(e)(1) include a taxable sale or any disposition of the stock of the transferred corporation treated as an exchange. Additionally, any deemed disposition of the stock of the transferred corporationas described in reg. section 1.367(a)-8(e)(3) generally will trigger the GRA. A deemed disposition of stock of the transferred corporation under reg. section 1.367(a)-8(e)(3) will occur if, within the term of the GRA, the transferred corporation makes a disposition of substantially all (within the meaning of section 368(a)(1)(C)) of its assets (including stock of a subsidiary corporation or an interest in a partnership). This rule is subject to an exception contained in reg. section 1.367(a)-8(e)(3)(i)(B).[5] If the transferee foreign corporation disposes of (or is deemed to dispose of) only a portion of the transferred stock or securities, then the U.S. transferor is required to recognize only a proportionate amount of the gain realized but not recognized upon the initial transfer of the transferred property.[6]
When a GRA is triggered, the U.S. transferor must file an amended return for the year of the transfer and recognize the gain realized but not recognized upon the initial transfer, with interest.[7] An election may be made to recognize the gain (with interest) in the year of the triggering event.[8]
Reg. section 1.367(a)-8(g)(1) addresses dispositions of the stock of the transferee foreign corporation by the U.S. transferor in nonrecognition transfers. Specifically, if the U.S. transferor disposes of any stock of the transferee foreign corporation in a nonrecognition transfer and the U.S. transferor complies with reporting requirements similar to those contained in reg. section 1.367(a)-8(g)(2), then the U.S. transferor continues to be subject to the terms of the GRA in its entirety. Reg. section 1.367(a)-8(g)(2) details when certain nonrecognition transfers of the stock or securities of the transferred corporation by the transferee foreign corporation will not be treated as dispositions under reg. section 1.367(a)-8(e).[9]
In Notice 2005-74, the IRS and Treasury elaborated on the treatment of nonrecognition transactions and their impact on previously filed GRAs, including the consequences of a U.S. transferor’s transfer of the stock of the transferee foreign corporation pursuant to an asset reorganization.
II. Notice 2005-74
The Notice announced that the IRS and Treasury will amend the regulations under section 367(a) of the Internal Revenue Code regarding the application of reg. section 1.367(a)-8, including the provisions addressing the treatment of GRAs as a result of certain common asset reorganizations involving the U.S. transferor, the transferee foreign corporation, and the transferred corporation. These amended regulations would supplement the existing rules under reg. section 1.367(a)-8, including the rules under reg. section 1.367(a)-8(f) through (h). Taxpayers could rely on the notice for exchanges occurring on or after July 20, 1998 (the effective date of reg. section 1.367(a)-8).
Section 3.02 of Notice 2005-74 provides a list of specific requirements that must be satisfied in order for the U.S. transferor to avoid triggering the gain (and interest charge) associated with the original GRA when it transfers the stock of the transferee foreign corporation to another corporation in anasset reorganization.[10] That section provides that if, during the period a GRA is in effect, the original U.S. transferor transfers all or a portion of the stock of the transferee foreign corporation to an acquiring corporation (i.e., successor U.S. transferor) pursuant to an asset reorganization, the exchanges made pursuant to such asset reorganization will trigger the GRA, unless the following conditions are satisfied:
(A) In the year of the transfer for which the original GRA was executed, the U.S. transferor was a member of a consolidated group (original consolidated group), and the common parent of such group (U.S. parent corporation) entered into the original GRA pursuant to Treas. Reg. section 1.367(a)-8(a)(3);
(B) Immediately after the asset reorganization, the successor U.S. transferor is a member of the original consolidated group;
(C) The U.S. parent corporation of the original consolidated group (or new U.S. parent corporation, if such corporation became the new common parent of the original consolidated group in a transaction in which the group remained in existence) enters into a new GRA pursuant to which it agrees to recognize gain (during the remaining term of the original GRA), in accordance with the rules of Treas. Reg. section 1.367(a)-8(b), with respect to the transfer subject to the original GRA, modified by substituting the successor U.S. transferor in place of the original U.S. transferor and agreeing to treat the successor U.S. transferor as the original U.S. transferor for purposes of Treas. Reg. section 1.367(a)-8 and the Notice; and
(D) The successor U.S. transferor provides with its next annual certification (described in Treas. Reg. section 1.367(a)-8(b)(5)) the new GRA and a notice of the transfer setting forth the following:
(i) A description of the transfer (including the date of such transfer), and the successor U.S. transferor’s name, address, and taxpayer identification number; and
(ii) A statement that arrangements have been made, in connection with the asset reorganization, ensuring that the successor U.S. transferor will be informed of any subsequent disposition of property with respect to which recognition of gain would be required under the newGRA (and any related information that is necessary to comply with Treas. Reg. section 1.367(a)-8 and this notice).[11]
In section 5 of the Notice, the IRS and Treasury state that the regulations to be issued incorporating the guidance set forth in the Notice will apply to GRAs filed with respect to exchanges of stock or securities occurring on or after September 28, 2005. Additionally, they indicate that taxpayers also may apply the provisions of the Notice to GRAs with respect to transfers of stock of securities, for all open years, occurring on or after July 20, 1998, and before September 28, 2005. Taxpayers applying the notice, however, are required to do so consistently, to all transactions within its scope for all open years. Further, if an exchange that is addressed by the Notice occurred on or after July 20, 1998, but prior to September 28, 2005, and the taxpayer chooses to rely on the Notice for purposes of such exchanges, then the taxpayer shall be treated as having timely satisfied the requirements for filing new GRAs (and related certifications and reporting), as required by reg. section 1.367(a)-8 and described in section 3 of the Notice, if such U.S. person attaches such new GRA (and related certifications and reporting) to its timely filed (including extensions) original tax return for the taxable year that includes September 28, 2005.
Finally, the IRS and Treasury indicate that they are considering issuing subsequent public guidance that addresses additional issues under reg. section 1.367(a)-8 and request comments regarding the application of reg. section 1.367(a)-8, including whether other transactions should be excepted from being treated as triggering events pursuant to rules similar to those contained in the Notice. They specifically request comments as to the most appropriate treatment of asset reorganizations that do not satisfy the conditions described in (A) or (B) above.
III. Analysis and Recommendations
Although the Notice provides much needed guidance, it also results in GRAs being triggered in several common corporate restructurings involving a U.S. transferor that previously filed a GRA. One of the requirements that must be satisfied in order to avoid triggering the GRA is that, immediately after the asset reorganization, the successor U.S. transferor be a member of the original consolidated group. This requirement would never be satisfied if the U.S. transferor is not part of a consolidated group (i.e., the U.S. transferor is a stand-alone domestic corporation). Stated differently,the GRA is triggered anytime a stand-alone U.S. transferor that previously filed a GRA engages in an asset reorganization. Additionally,this requirement generally would not be satisfied when the successor U.S. transferor in the asset reorganization is a stand-alone corporation or a member of another consolidated group (after giving effect to the reverse acquisition provisions). Further, by requiring that the successor be a U.S. corporationthat is a member of the original consolidated group, the Notice eliminates any possibility of relief when the successor in the asset reorganization is a foreign acquiring corporation.
By requiring gain to be recognized in these situations, the IRS and Treasury areimposing a substantial obstacle to corporations that are engaging in legitimate business restructurings. This Notice is likely to have a chilling effect on such transactions. For instance, one common transaction that is impacted by the Notice is an internal restructuring involving the U.S. transferor following the acquisition of the consolidated group of which it was a member. As is often the case, one consolidated group may acquire another consolidated group with the acquiring consolidated group surviving. The original U.S. transferor may, after such an acquisition and during the period of the GRA, transfer its assets, including the stock of the transferee foreign corporation, as part of asset reorganization to a member of the acquiring consolidated group. If this occurs, the GRA would be trigged because the acquiring corporation would not satisfy the above requirement that it be a member of the original consolidated group. This may prevent the transaction from ever occurring, or worse, result in an unforeseen triggering event.
In these types of situations, the government’s interests can be adequately protected without triggering the GRA. This can be achieved,in the case of an acquisition by a U.S. corporation,by having the successor U.S. transferor or the parent of the new consolidated group, as the case may be, file a “new” GRAassuming the obligations associated with the original GRA (e.g., to recognize gain plus an interest charge upon a triggering event) for the remaining term of the original GRA.[12] In such an instance, the successor U.S. transferor or the parent of the new consolidated group, will step into the shoes of the U.S. transferor and will be solely liable for any subsequent transaction or event that triggers the GRA.
The IRS and Treasury have provided similar relief in recently proposed regulations under section 1503(d) dealing with the recapture of dual consolidated losses (DCLs).[13] More specifically, the proposed regulations address several different types of acquisitions by an unaffiliated domestic corporation or new consolidated group, as well as events that result in the disaffiliation of a member of a consolidated group, that normally would result in triggering events requiring a recapture of the DCLs of a consolidated group, unaffiliated dual resident corporation or unaffiliated domestic owner, as the case may be, absent a closing agreement with the IRS in which the respective parties have joint and several liability if there is a subsequent triggering event.[14] Expanding on regulations published in 2003,[15]the IRS and Treasury have proposed regulations that would eliminate the requirement for a closing agreement to avoid a triggering event if (1) the unaffiliated domestic corporation or new consolidated group (a subsequent elector) enters into a domestic use agreement (an agreement which requires the subsequent elector, among other things, to assume the obligations associated with DCLs including recapturing the DCL in income upon a subsequent triggering event); and (2) the corporation or consolidated group that filed the original domestic use agreement (original elector) files a statement with its tax return for the year of the event.[16] Therefore, to avoid a triggering event, the subsequent elector must agree to assume the obligations with regard to the DCL.
We encourage the IRS and Treasury to adopt a similar approach in the GRA context to avoid triggering GRAs in the situations described above by having the successor U.S. transferor or parent of the consolidated group, as the case may be, assume the obligations associated with the original GRA for the remaining term of the GRA. Such a taxpayer can assume such obligations by filing a new GRA. However, in such acquisitions, we encourage having the obligations associated with the GRA be that of only the successor U.S. transferor or parent of the consolidated group, as the case may be. Therefore, we do not recommend the joint and several liability approach taken in the current DCL regulations when there is a closing agreement or the collection procedure established in the proposed regulations(e.g., prop. reg. section 1.1503(d)-4(h)(3)(iv)(B)) which permits the IRS to collect against the original taxpayer in the event a successor fails to pay the income tax liability associated with a subsequent triggering of a DCL.
If, however, the IRS and Treasury determine that some type of secondary liability may be necessary to provide relief, we recommend that such liability only be imposed in limited situations in which, at the time of the asset reorganization, the IRS determines that secondary liability may be requiredto ensure the payment of any tax in the case of a subsequent triggering event. This targeted approach can be patterned after approaches already being taken by the IRS and Treasury in similar contexts.
For example, reg. section 1.367(a)-8(d)provides that U.S. transferor may be required to furnish a bond or other security that satisfies the requirements of reg. section 301.7101-1 of this chapter if the district director determines that such security is necessary to ensure the payment of any tax on the gain realized but not recognized upon the initial transfer. Such bond or security generally will be required only if the stock or securities transferred are a principal asset of the U.S. transferor and the director has reason to believe that a disposition of the stock or securities may be contemplated. Alternatively, secondary liability could be imposed when the transfer of the contingent GRA liability to a successor corporation results in a change in payment expectations with respect to that contingent liability. See generally,reg. section 1.1001-3(e)(4)(the substitution of a new obligor on a recourse debt instrument is not a significant modification if the acquiring corporation [within the meaning of section 381] becomes the new obligor pursuant to a transaction to which section 381(a) applies, the transaction does not result in a change in payment expectations, and the transaction [other than a reorganization within the meaning of section 368(a)(1)(F)] does not result in a significant alteration).
Additionally, we encourage the IRS and Treasury to provide relief in certain asset reorganizations involving a successor foreign corporation. However, in the case of an outbound asset reorganization in which the target is aU.S. transferor subject to a GRA, additional issues would need to be considered.[17] For instance, if the U.S. transferor is required to recognize gain on the transfer of the stock of the transferee foreign corporation, then the GRA associated with the transferred corporation generally will be terminated under reg. section 1.367(a)-8(h).[18] Therefore, as a preliminary matter, the outbound asset reorganization would need to be tested under section 367(a) and, in particular section 367(a)(5)[19] and reg. section 1.367(a)-3(b), to determine whether the U.S. transferor is required to recognize gain on the transfer of the stock of the transferee foreign corporation.Additionally, the possible application of section 367(b) would need to be considered.[20]