Editor: Mary Van Leuven, J.D., LL.M.
It is not uncommon for affiliated groups that file a consolidated U.S. federal income tax return (U.S. consolidated groups) to have gain that has been deferred under the intercompany rules for U.S. consolidated groups. This item illustrates how transfers of items outside a U.S. consolidated group can trigger a deferred intercompany gain (DIG) and suggests ways to avoid that result in certain situations.
Example 1: USS, a U.S. corporation, distributes stock of a foreign subsidiary FS1 to USP, USS’s parent corporation, in a distribution not qualifying under Sec. 355. The distributed stock (BIG stock) has a built-in gain. USP then contributes the BIG stock to FS2, a foreign subsidiary of USP, in an exchange qualifying under Sec. 351. USS and USP are members of the same U.S. consolidated group; FS2 is not a member of the group.
Intercompany Rules Generally
Under Sec. 311(b), when a corporation distributes appreciated property, the corporation generally is required to recognize gain built into the property as if such property were sold to the distributee at its fair market value (FMV). However, there is an exception to the general rule for transactions between corporations that are members of the same U.S. consolidated group immediately after the transaction (intercompany transactions). Generally, any gain realized on an intercompany transaction is deferred in determining the U.S. federal income tax consequences to the selling member until it is required to be included in income under either the matching rule of Regs. Sec. 1.1502-13(c) or the acceleration rule of Regs. Sec. 1.1502-13(d).
In the example transaction, USS and USP are members of the same U.S. consolidated group immediately after the distribution of the BIG stock from USS to USP; therefore, the distribution is an intercompany transaction. Consequently, the gain built into the BIG stock will become a DIG, which should be deferred until the matching rule or the acceleration rule requires it to be included in income.
The Acceleration Rule
Under the acceleration rule, the intercompany items of a selling member (S) are taken into account immediately before the items can no longer be taken into account to produce the effect of treating S and the buying member (B) as divisions of a single corporation. Regs. Sec. 1.1502-13(d)(1)(i) explains that, for this purpose, the effect cannot be achieved to the extent a nonmember reflects, directly or indirectly, any aspect of the intercompany transaction, e.g., if B’s cost basis in property purchased from S is reflected by a nonmember under Sec. 362 following a Sec. 351 transaction.
An outbound transfer could trigger the recognition of a DIG under the acceleration rule when, for example, the transfer results in a nonmember’s reflecting basis that resulted from an intercompany transaction. Consider the example transaction: USP would take an FMV basis in the BIG stock under Sec. 301(d) when USS distributes the BIG stock to USP. When USP then contributes the BIG stock to FS2 in a Sec. 351 exchange, FS2—which is not a member of the U.S. consolidated group—would receive the BIG stock with a carryover basis under Sec. 362. Thus, the stepped-up basis resulting from the intercompany transaction would be reflected in a nonmember, thereby triggering the DIG that resulted from the earlier distribution from USS to USP.
This result may be avoided, however, if the outbound transfer is structured as an asset reorganization under Sec. 368, rather than a contribution of stock under Sec. 351. In the example transaction, the parties could, for instance, check the box to treat FS1 as a disregarded entity for U.S. federal income tax purposes after the contribution to FS2. Because FS1 would be disregarded for U.S. federal income tax purposes, the transfer would then be treated as an asset transfer, which could qualify as a reorganization under Sec. 368(a)(1)(D) (a D reorganization). Pursuant to Sec. 358, the basis in the BIG stock would be reflected in USP’s basis in FS2, rather than in FS2’s interest in FS1. In other words, the basis from the intercompany transaction would remain in the U.S. consolidated group (i.e., it would not be reflected in a nonmember), and the acceleration rule would not trigger the DIG.
This method should allow the taxpayer to avoid triggering the DIG under the acceleration rule even if the assets are transferred to a lower-tier subsidiary, as may be desired. To illustrate, consider this “restructured” example transaction:
Example 2: Begin with the facts of the transaction in Example 1 and assume that after USP contributes the BIG stock to FS2, FS1 makes a check-the-box election to be treated as a disregarded entity. Then FS2 contributes its interest in FS1 to FS3, a wholly owned subsidiary of FS2.
The restructured example transaction could still qualify as a D reorganization, but with a drop under Regs. Sec. 1.368-2(k). The stepped-up basis in the BIG stock would still be reflected only in USP’s basis in FS2. FS2’s basis in FS3 would reflect only the basis of the inside assets of FS1. Therefore, the basis from the intercompany transaction would not be reflected in a nonmember, and the acceleration rule would not trigger the DIG.
The Matching Rule
Sidestepping the triggering of a DIG under the acceleration rule does not, however, end the analysis. Although the restructured transaction in Example 2 avoids application of the acceleration rule, it could still trigger recognition of a DIG under the matching rule.
Under the matching rule, the separate entity attributes of S’s intercompany items (i.e., S’s income, gain, deduction, and loss from an intercompany transaction) and B’s corresponding items (i.e., B’s income, gain, deduction, and loss from an intercompany transaction, or from property acquired in an intercompany transaction) are redetermined to the extent necessary to produce the same effect on consolidated taxable income as if S and B were divisions of a single corporation, and the intercompany transaction were a transaction between those divisions.
B takes its corresponding items into account under its accounting method, but the redetermination of attributes of a corresponding item might affect its timing. S takes its intercompany item into account to reflect the difference for the year between B’s corresponding item taken into account and the recomputed corresponding item (i.e., the corresponding item that B would take into account if S and B were divisions of a single corporation and the intercompany transaction were between those divisions). Regs. Sec. 1.1502-13(b)(4) explains that “[a]lthough neither S nor B actually takes the recomputed corresponding item into account, it is computed as if B did take it into account (based on reasonable and consistently applied assumptions, including any provision of the Internal Revenue Code or regulations that would affect its timing or attributes).”
An outbound transfer could trigger the recognition of a DIG under the matching rule when the transfer would have given rise to gain if S and B were divisions of a single corporation, e.g., under Sec. 367. Under Sec. 367(a), if a U.S. person transfers property to a foreign corporation in connection with an exchange described in Sec. 332, 351, 354, 356, or 361, the foreign corporation is not considered a corporation for purposes of determining gain recognized on the transaction. These specified Code sections require the transferee to be a corporation for U.S. federal income tax purposes to obtain nonrecognition treatment. Thus, the application of Sec. 367(a) results in gain (but not loss) recognition.
Regs. Sec. 1.367(a)-3(a)(2)(ii) provides an exception to Sec. 367(a) for certain asset reorganizations. However, this exception does not apply when the reorganization is treated as an “indirect stock transfer” under Regs. Sec. 1.367(a)-3(d). Regs. Sec. 1.367(a)-3(g)(1)(iv)(B) indicates that a D reorganization followed by a “controlled asset transfer” is treated as an indirect stock transfer. A controlled asset transfer occurs when the corporation acquiring assets in the asset reorganization transfers all or a portion of the assets to a corporation controlled (within the meaning of Sec. 368(c)) by the acquiring corporation as part of the same transaction. Under this provision, the restructured example transaction in Example 2 should be treated as an indirect stock transfer; therefore, the restructured transaction generally would be subject to Sec. 367.
As discussed above, USP, which functions as B for the purposes of applying the matching rule, would have taken an FMV basis in the BIG stock under Sec. 301(d) when USS distributed the BIG stock to USP. Therefore, when the BIG stock is then transferred to FS2, it would have basis equal to value. Because there would not be any gain built into the BIG stock at that time, this transfer would not give rise to any gain under Sec. 367. This zero gain/loss actually realized would be B’s corresponding item for the purposes of applying the matching rule.
However, the matching rule requires that one determine the gain that would have resulted had S and B been divisions of a single corporation. In the restructured transaction in Example 2, if USS (which functions as S for the purposes of applying the matching rule) and USP were divisions of a single corporation, Sec. 301(d) would not have caused USP to take an FMV basis in the BIG stock when USS distributed the BIG stock to USP, because the distribution would be disregarded. Therefore, when the BIG stock is then transferred to FS2, it would have built-in gain. This transfer could therefore trigger the gain built into the BIG stock under Sec. 367. This gain would be USP’s recomputed corresponding item.
Thus, if the taxpayer were to undertake the restructured transaction in Example 2, the matching rule would require the U.S. consolidated group to take its DIG into account to reflect the difference for the year between the zero gain/loss actually taken into account under Sec. 367 and the fictional gain that would have been taken into account under Sec. 367 if USS and USP were divisions of a single corporation.
This result may be avoided as well, however, by using a gain recognition agreement (GRA). When a U.S. person transfers stock or securities of a foreign corporation to another foreign corporation and is a 5% shareholder of the transferee foreign corporation, Regs. Sec. 1.367(a)-3(b)(1) provides an exception to the Sec. 367(a) rule where the taxpayer enters into a five-year GRA. The GRA functions to defer gain unless and until it is triggered by a gain recognition event specified in Regs. Sec. 1.367(a)-8. If the gain is later triggered, the U.S. transferor must include in income the gain realized but not recognized on the initial transfer by reason of entering into the GRA. Under Regs. Sec. 1.367(a)-8(c)(1)(iii), a U.S. transferor must either report any gain recognized on an amended U.S. federal income tax return for the tax year of the initial transfer or elect to include any gain recognized in the tax year during which a gain recognition event occurs. In either case, Regs. Sec. 1.367(a)-8(c)(1)(v) requires the payment of interest on any additional tax due with respect to gain recognized by the U.S. transferor.
If the fictional transaction under which B’s recomputed item is calculated is of the sort to which the GRA exception would have applied if the transaction had actually occurred (as would be the case in the Example 2 restructured transaction), arguably, the taxpayer should likewise be able to qualify for the exception by filing a GRA based on the fiction. This would seem to be the sort of “reasonable and consistently applied assumption, including any provision of the Internal Revenue Code or regulations that would affect [the] timing or attributes [of a recomputed item]” that Regs. Sec. 1.1502-13(b)(4) explicitly allows taxpayers to apply in calculating their recomputed items.
The GRA would defer the fictional gain, so that B’s recomputed item would be zero gain/loss. The DIG should remain deferred as well, unless and until Regs. Sec. 1.367(a)-8 would apply to trigger the fictional gain that was deferred under Sec. 367 (or the DIG is otherwise triggered under the intercompany rules).
Note that, to maintain the appropriateness of this method, a taxpayer filing a GRA based on the application of Sec. 367 to its recomputed item calculation should not elect to include any gain recognized in the tax year during which a gain recognition event occurs, because there does not appear to be a mechanism to require a taxpayer whose DIG is triggered by a gain recognition event under Sec. 367 to pay interest, unless the taxpayer is required to amend a prior return. Although it is appropriate that a taxpayer be in the same position that it would have been in had its recomputed item been real, it is not appropriate that the taxpayer be in a better position than it would have been in had its recomputed item been real, as would be the case if the taxpayer were not required to pay interest when the gain is later triggered.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.