Editor: Annette B. Smith, CPA
Foreign Income & Taxpayers
A U.S. corporation may decide initially to run its foreign operations in branch form if those operations are loss-making and later incorporate the foreign branch when it becomes profitable. The U.S. corporation may use the losses incurred by the branch to reduce its U.S. taxable income in the earlier years and then must recapture prior losses upon the foreign branch’s incorporation.
The U.S. corporation thus must consider the applicability of several recapture rules at the time of the incorporation, including the overall foreign loss (OFL) recapture rules of Sec. 904(f)(3), the branch loss recapture rules of Sec. 367(a)(3)(C), and the dual consolidated loss (DCL) recapture rules of Regs. Sec. 1.1503(d)-6. This item discusses the interaction between two of these recapture rules—OFL recapture and branch loss recapture—triggered by a branch incorporation, especially when the losses to be recaptured exceed the gains to be recognized.
Sec. 904(f)(3) Recapture
Sec. 904(f)(1) provides generally that if a taxpayer had a foreign loss that it used to reduce its U.S.-source taxable income and in a later year has foreign-source income, it must treat all or part of the foreign-source income as U.S.-source income. Applied after Sec. 904(f)(1), Sec. 904(f)(3) requires additional recapture in a year in which there is a disposition of trade or business assets used or held for use predominantly outside the United States. Specifically, Sec. 904(f)(3)(A)(i) provides that the taxpayer shall be deemed to have received and recognized taxable income from foreign sources in the tax year of the disposition.
The term “disposition” is defined broadly to include any transfer of property regardless of whether gain or loss otherwise is recognized. Under that definition, the incorporation of a foreign branch constitutes a disposition for purposes of Sec. 904(f)(3), and the U.S. corporation may be required to recognize income to recapture an OFL account. The amount to be recaptured upon a branch incorporation generally is the amount of the built-in gain in the branch assets, limited to the balance in the OFL account (Regs. Sec. 1.904(f)-2(d)(4)(i)).
Sec. 367(a)(3)(C) Recapture
Sec. 367(a)(3)(C) was enacted to prevent a U.S. company from using losses of a foreign branch to offset its taxable income without having to pay U.S. tax on the associated future income after the branch’s incorporation. This provision requires a U.S. corporation to recognize any built-in gain in the branch assets that are transferred outside the U.S. tax jurisdiction to a foreign corporation in an otherwise tax-free transaction (e.g., under Sec. 351). The branch loss recapture rules are normally applied after the OFL recapture. Temp. Regs. Sec. 1.367(a)-6T(e)(3) provides that the previously deducted branch losses are reduced by the amount recognized under Sec. 904(f)(3) on account of the transfer.
Based on the above rules, on incorporation of a foreign branch, both the OFL recapture and the branch loss recapture rules target the built-in gain in the branch assets and appear to be designed to limit potential income recognition to the amount of the built-in gain in the branch assets.
Example: P, a U.S. corporation, conducted its foreign operations in a branch, which incurred losses in years 1–3 totaling $15 million. In year 4, P incorporated the branch and purchased U.S. Sub, which had an OFL account of $8 million. The built-in gain in the branch assets is $20 million, and there is no other foreign-source income. P and U.S. Sub elect to file a consolidated U.S. federal income tax return, and the OFL of U.S. Sub becomes a consolidated OFL under Regs. Sec. 1.1502-9(c)(1).
Because there is a disposition of business assets used predominantly outside the United States, Sec. 904(f)(3) requires recapture in the amount of the built-in gain in the branch assets, limited by the balance of the OFL account, which equals $8 million. This leaves a built-in gain of $12 million to be further recaptured. Sec. 367(a)(3)(C) then is applied, and the branch loss of $15 million is reduced by $8 million (the amount recognized under Sec. 904(f)(3)) to $7 million, which is the amount to be recaptured as branch loss recapture. The total recapture amount under both recapture rules equals $15 million.
If, however, the built-in gain in the branch assets were only $5 million, then the built-in gain of $5 million would be fully recaptured as the OFL recapture. The question becomes whether the U.S. corporation must recapture another $5 million as the branch loss recapture. The answer would be “no” if an upward basis adjustment in the branch assets were made to reflect the income required to be recognized under Sec. 904(f)(3).
While Temp. Regs. Secs. 1.367(a)-6T(i) and -1T(b)(4)(ii) provide for an upward basis adjustment in the branch assets in the amount of the built-in gain (i.e., income required to be recognized) to reflect the branch loss recapture, the OFL recapture rules do not explicitly provide for such a basis adjustment as a general rule. Regs. Sec. 1.904(f)-2(d)(4)(ii) does provide for such an adjustment to basis in the property received by the U.S. corporation, i.e., the stock in the foreign corporation, “in accordance with applicable sections of [subchapter] C.”
That regulation also provides for an adjustment to the basis in the branch assets, but only when the branch assets are transferred by gift. One could argue that this provision suggests that no basis adjustment should be made in cases that do not involve gifts (such as Sec. 351 transfers). However, assets transferred by gift generally do not receive a step-up in basis, while one of the basic principles of subchapter C is that the basis in assets transferred should be stepped up if income is recognized. Thus, it could be argued that there was no need to specifically provide for such a basis adjustment in the Sec. 904(f) regulations. In addition, without such an adjustment to the basis in the branch assets, the taxpayer may be required to recapture the same built-in gain twice, once under Sec. 904(f)(3) and again under Sec. 367(a)(3)(C), and it could be argued that Congress is unlikely to have intended to impose taxes on the same gain twice.
Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.
For additional information about these items, contact Ms. Smith at 202-414-1048 or email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.