Prop. Regs. on the Domestication of Foreign Corporations

Domestication is a process by which a foreign corporation is incorporated in the U.S. in an inbound F reorganization. The process is of particular interest to domestic corporations with foreign-affiliated subsidiaries that expect to incur net operating losses (NOLs). Prop. Regs. Sec. 1.367(b)-3 codifies and simplifies a series of revenue rulings, Code sections and regulations drafted to regulate the treatment of tax attributes that the domestic corporation receives after domestication.

In general, a parent uses a subsidiary's NOLs by converting the subsidiary into an eligible entity, and making a check-the-box election under Regs. Sec. 301.7701-3(a). After the election, the foreign subsidiary becomes a flowthrough entity for Federal tax purposes. However, due to certain stockholder arrangements, conversions of foreign corporations into eligible entities for check-the-box purposes is not always possible. When this happens, domestication of the foreign corporation is an attractive alternative.

Under Rev. Rul. 88-25, as long as the corporation's shareholder continuity, asset continuity or business enterprise remains consistent, the domestication process qualifies as an F reorganization. The transaction's effect is "a mere change in the place of organization" of the foreign corporation. Under Sec. 368(b), a foreign corporation and a domestic corporation are considered "parties to a reorganization."

For Federal tax purposes, the domestication process entails (1) a transfer by the foreign corporation of all its assets and liabilities to a new domestic corporation in exchange for the domestic corporation's stock and (2) a liquidating distribution by the foreign corporation to its shareholders of the domestic corporation's stock.

Sec. 361 affords the transaction nonrecognition status for the foreign corporation. Sec. 361(a) provides that a corporation that is a party to a reorganization cannot recognize gain or loss in its exchange of property solely for stock or securities in another corporation also a party to a reorganization. Under Sec. 361(c), a corporation does not recognize gain on its stock distribution to its shareholders in pursuance of a reorganization plan. Sec. 362(b) provides for carryover basis in the contributed assets. (There are restrictions for U.S. real property interests and branch profit tax.)

Shareholders receive nonrecognition treatment under Sec. 354. For this purpose, they are seen as exchanging their foreign corporation shares for domestic shares with the foreign corporation pursuant to a reorganization plan. However, under Regs. Sec. 7.367(b)-7(c)(2), the U.S. corporate shareholder must include in gross income as a dividend an "all-earnings-and-profits" amount, defined in Regs. Sec. 1.367(b)-2(f) as the net earnings and profits (if any) for all tax years attributed to the stock of the foreign corporation exchanged. The U.S. corporate shareholders may not be able to use the Sec. 243(a) dividends-received deduction on an all-earnings-and-profits amount, because it represents income not originally taxed in the U.S. at the corporate level.

An F reorganization is the only kind of reorganization that permits corporations to use carryovers and carrybacks. Regs. Sec. 1.381(b)-1(a)(2) provides that, in the case of an F reorganization, the acquiring corporation is to be treated (for Sec. 381 purposes) as the transferor corporation would have been treated had there been no reorganization. Further, the tax attributes of the transferring corporation enumerated in Sec. 381(c) are to be taken into account by the acquiring corporation as if there had been no reorganization.

However, under Regs. Sec. 1.882-3 and -4, a nonresident foreign corporation is only allowed deductions properly allocated to a foreign corporation's gross income effectively connected with a U.S. trade or business. Under Sec. 172(c), "net operating loss" means the excess of the deduction allowed by chapter 1 of Subtitle A over gross income. Therefore, under Sec. 172, corporations can take only NOL deductions allowed under the aforementioned regulations. If a foreign corporation has no income effectively connected with a U.S. trade or business, the U.S. parent cannot use the foreign corporation's NOL carryovers when it is domesticated in the U.S. This issue was first addressed by Rev. Rul. 72-421, dealing with a Sec. 332 liquidation of a foreign subsidiary. Recently issued Prop. Regs. Sec. 1.367(b)-3 codifies that ruling.

Prop. Regs. 1.367(b)-3 addresses NOL and capital loss carryovers, and earnings and profits not included in income as an all-earnings-and-profits amount (or a deficit in earnings and profits), in a Sec. 332 liquidation or an asset acquisition (as described in Sec. 368(a)(1)), such as a C, D or F reorganization (an inbound nonrecognition transaction). Generally, those tax attributes do not carry over from a foreign target to a domestic acquirer, unless effectively connected to a U.S. trade or business (or attributable to a permanent establishment, in the context of a relevant U.S. income tax treaty).

Prop. Regs. Sec. 1.367(b)-3 codifies Rev. Rul. 72-421, and simplifies the provisions of Regs. Sec. 7.367(b)-7(c)(2). By requiring a foreign subsidiary's NOL carryovers to a domestic corporation to be effectively connected with a U.S. trade or business, the proposed regulations simplify the analysis of this attribute under Regs. Sec. 1.882-3 and -4 and Sec. 172(c). By requiring a foreign subsidiary's earnings and profits to be effectively connected with a U.S. trade or business to carry over to a domesticated corporation, the proposed regulation obviates the need for a U.S. corporate shareholder to include the all-earnings-and-profits amount as gross income in the form of a dividend.

In summary, Prop. Regs. Sec. 1.367(b)-3 does not change the regulatory environment of the domestication of foreign corporations, but sets forth (in a manner that condenses several rulings, Code sections and regulations) the treatment of the tax attributes that would carry over to the acquiring domesticated corporation.

From Alejandro Ruiz de la Cuesta, J.D., New York, NY