Global Tax Alert | 13 September 2013

IRS issues proposed regulations addressing limitations on importation of net built-in losses

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The Internal Revenue Service (IRS) has issued proposed regulations (REG-161948-05) under Sections 334(b)(1)(B) and 362(e)(1) (the Proposed Loss Importation Regulations), which apply to certain corporate acquisitions of loss property in nonrecognition transactions that result in an “importation” of a built-in loss property. Sections 334(b)(1)(B) and 362(e)(1) were enacted as part of the American Jobs Creation Act of 2004 to prevent the erosion of the corporate tax base through the importation of loss in nonrecognition transfers. These provisions apply to corporate acquisitions of loss property in complete liquidations under Section 332, corporate reorganizations under Section 368, exchanges under Section 351, and capital contributions.

Proposed regulations

Under the Proposed Loss Importation Regulations, property may be subject to the anti-loss importation provisions if any gain or loss recognized on the disposition of the property (i) would not be subject to federal income tax in the hands of the transferor (Transferor) immediately before the transfer and (ii) would be subject to federal income tax in the hands of the transferee (Acquiring) immediately after the transfer. Property meeting each of these requirements is referred to as “importation property.”

Loss importation property is identified under a hypothetical sale analysis. Under this approach, the actual tax treatment of any gain or loss that would be recognized by both the Transferor and Acquiring upon the sale of such property is analyzed to determine whether the property is importation property. This determination must take into account all relevant facts and circumstances, and the Proposed Loss Importation Regulations contain several examples illustrating this approach. Importantly, the proposed regulations expressly state that gain or loss recognized by a controlled foreign corporation (CFC) is not considered subject to Federal income tax solely by reason of such income impacting an inclusion under Section 951(a). The same is true with respect to qualified electing fund (QEF) inclusions under Section 1293(a) for passive foreign investment companies (PFICs) ay under Section 1293(a). On the other hand, the regulations take into account gain that would be taxable to the foreign corporation transferor itself (for example as income effectively connected with a US trade or business or under Section 897 rules for investments in US real property interests) on the transfer of the property. The preamble notes that in this regard, the determination of whether the foreign corporation is subject to tax on the disposition, would take into account whether the foreign corporation could eliminate US taxation pursuant to the provisions of an income tax treaty. In these circumstances, the property would be loss importation property.

In addition, the Proposed Loss Importation Regulations contain modified rules for applying the hypothetical sale analysis where the Transferor is a partnership, an S corporation, or a grantor trust. In general, because of the flow-through nature of these entities, the determination of the tax treatment on a hypothetical sale is made at the partner, shareholder, or owner level, and must take into account any special allocations that may be in place. Furthermore, the Proposed Loss Importation Regulations also contain an anti-avoidance rule applicable to Transferors that are entities that, although subject to US tax, may be able to effectively shift the consequences of gain or loss to its shareholders or owners through distributions (for example, domestic trusts, regulated investment companies (RICs), real estate investment trusts (REITs), and co-operatives). In this case, if property is transferred by such an entity and such property was acquired as part of a plan to avoid the anti-importation provisions, the entity is subject to a look-through rule. Under this look-through rule, the entity is presumed to distribute the proceeds of the hypothetical sale and, to the fullest extent possible, such distribution is deemed to be made to persons not subject to US federal income tax.

Once the importation property has been identified, Acquiring then determines the aggregate value and tax basis of all importation property acquired in the transaction without regard to the anti-loss importation provisions. This determination is made by reference to all importation property acquired from all Transferors (as opposed to a Transferor-by-Transferor approach found under Section 362(e)(2)). If the aggregate basis of the importation property does not exceed such property’s aggregate value, the transaction is not subject to the anti-loss importation provisions (but may still be subject to loss duplication rules of Section 362(e)(2)). If the aggregate basis of the importation property exceeds such property’s aggregate value, the transaction is a loss importation transaction and Acquiring’s basis in each importation property is equal to its value.

Generally, the “value” of property is its fair market value without regard to any liabilities assumed in the transaction. However, because a partner’s share of partnership liabilities is generally included in its basis in its partnership interest, this may create the appearance of a built-in loss. Accordingly, the Proposed Loss Importation Regulations modify the definition of value for partnership interests to take liabilities into account.

Finally, the Proposed Loss Importation Regulations modify the information statement filing requirements currently required for various corporate nonrecognition transactions. Specifically, information required to be disclosed in statements under Reg. Sections 1.332-6, 1.351-3, and 1.368-3 is expanded to include the aggregate value and basis of (i) loss importation property, (ii) loss duplication property under Section 362(e)(2), (ii) property in which gain was recognized by the transferor (which is not loss importation property or loss duplication property), and (iv) property not described in (i), (ii), or (iii).

Implications

The Proposed Loss Importation Regulations are proposed to apply to transactions occurring on or after the date the regulations are published as final. However, these regulations also propose that taxpayers would be permitted to apply the final regulations (when published) to transactions occurring after 22 October 2004. It is noteworthy that a related set of regulations under Section 362(e)(2) were recently finalized (T.D. 9633), and contain a similar provision allowing taxpayers to apply such regulations to transactions occurring after 22 October 2004.

The Proposed Loss Importation Regulations are interesting in a number of respects. First, as indicated above, no exception applies for CFCs. That is, gain or loss recognized by a CFC is not considered subject to Federal income tax solely by reason of a subpart F income inclusion. Presumably the rationale is that subpart F income inclusions are determined at the shareholder holder, whereas Section 362(e)(1) is focused on whether the transferor would be subject to tax. Although CFCs and PFICs for which a QEF election has been made share some characteristics with pass through entities, in this context the government proposes a relatively hard line that respects the CFC’s status as a separate, foreign transferor although the regulations request comments on this treatment. In contrast, the Proposed Loss Importation Regulations do look to shareholder level consequences for pass through entities such as partnerships, S corporations and grantor trusts. Moreover, the regulations have a more nuanced rule that will separate importation property into its respective “portions,” where, for example, a partnership transferor has a mix of US and foreign partners.

Comments are similarly requested regarding what effect a Section 362(e)(1) basis reduction should have on any earnings and profits inclusion under Reg. Section 1.367(b)-3. For instance it may be appropriate, from a policy standpoint, for a US shareholder to reduce the earnings and profits inclusion under Reg. Section 1.367(b)-3 by the amount of basis reduction required under Section 362(e)(1).

Finally, another interesting aspect of the Proposed Loss Importation Regulations is the modification to the stock basis rules applicable to certain triangular reorganizations under Reg. Section 1.358-6. For example, if P owns S and T merges into S in exchange for P stock in a Section 368(a)(2)(D) reorganization, for purposes of determining P’s basis in S after the merger, Reg. Section 1.358-6 would deem P as having directly acquired T’s assets, and then as having contributed such assets to S. If the assets of T are importation property with an aggregate built-in loss, the Proposed Loss Importation Regulations would, solely for purposes of determining P’s basis in its S stock, cause P to take a basis step-down (to FMV) in the T assets in its deemed acquisition, which in turn would reduce the amount of increase to P’s basis in its S stock. S’s actual acquisition of T’s assets may or may not be subject to Section 362(e)(1) (for example, if S was also foreign, the T property may not be considered importation property). That is, P’s basis adjustment to its S stock under Reg. Section 1.358-6 may be different than the basis S takes in the former T assets. This special proposed rule for stock basis determinations for triangular reorganizations also explicitly applies Section 362(e)(2) (which generally marks down duplicated loss property acquired in a Section 351 exchange or capital contribution) to the extent it would otherwise apply to P’s deemed transfer of property to S.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax Services, Washington, DC
  • Peg O’Connor
    +1 202 327 6229
    margaret.oconnor@ey.com
Ernst & Young LLP, Transaction Advisory Services - National Tax M&A, Washington, DC
  • Don Bakke
    +1 202 327 6103
    donald.bakke@ey.com
  • Brian Reed
    +1 202 327 7889
    brian.reed@ey.com

EYG no. CM3800