Global Tax Alert | 4 February 2013

IRS proposes changes to rules for failure to comply with gain recognition agreements and other filings

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On 31 January 2013, the Treasury Department and the Internal Revenue Service issued proposed regulations (REG-140649-11) that would amend the existing rules under Sections 367(a) and 6038B governing the consequences to US persons for failing to file gain recognition agreements (GRAs) and related documents, or to satisfy other reporting obligations, associated with certain transfers of property to foreign corporations in non-recognition exchanges.

The Proposed Regulations would change the requirement for taxpayers to establish reasonable cause when seeking relief from gain recognition after failing to properly file a GRA to a standard based on willful failure. However, the current reasonable cause standard would continue to apply to US transferors seeking relief from the Section 6038B penalty, which would now also apply to GRAs and associated documents. Additionally, the Proposed Regulations provide for penalties, as well as similar relief from such penalties, for failure to file or comply with the notices required under Section 367(e)(2) for liquidating distributions, as well as the notices required under Treas. Reg. Section 1.367(a)-3 in connection with certain outbound transfers of stock, securities, or assets of domestic corporations. Furthermore, the new rules would now require limited Form 926 (Return by a US Transferor of Property to a Foreign Corporation) reporting with all GRAs.

The proposed regulations are generally proposed to be effective when finalized. They would apply to:

  • GRAs that must be filed with a timely filed return on or after the date that final regulations are published
  • Notices under Section 367(e)(2) and Treas. Reg. Section 1.367(a)-3, that must be filed with a timely filed return on or after the date that final regulations are published
  • Requests for relief for failures to file documents and statements required under these regulations, or failures to comply, if the requests are submitted on or after the date that final regulations are published

The Industry Director Directive, LMSB-4-0510-017 (the Directive) issued in July 2010, which generally provides taxpayers that either filed an incomplete GRA, or failed to make filings during the term of a timely filed GRA, a way to remedy the situation without the need to obtain reasonable cause relief, remains in effect for the time being, although the IRS has been very vocal of late indicating that it will be withdrawn in the near term.

Discussion

Background

Pursuant to Section 367(a)(1), if a US person (US transferor) transfers stock or securities to a foreign corporation in connection with an exchange described in Sections 332, 351, 354, 356 or 361, the US transferor is required to recognize gain unless an exception applies. The provisions under Treas. Reg. Section 1.367(a)-3, as referred to in Treas. Reg. Section 1.367(a)-8 (the GRA Regulations), provide that a US transferor may defer recognizing gain immediately on a transfer of stock or securities to a foreign corporation if it files a GRA and meets certain other requirements. The GRA requires the US transferor to agree to include in income the gain realized, but not recognized, on the initial transfer of the stock and securities, and to pay any applicable interest, upon certain events referred to as “triggering events” that occur before the close of the fifth taxable year following the year of the initial transfer. One of the gain recognition events set forth in the GRA Regulations is a failure to comply in any material respect with any requirement of the GRA Regulations or with the terms of a GRA. As a result, foot faults in GRA compliance may trigger gain recognition.

To continue preserving non-recognition for failures to comply, a US transferor must promptly file the GRA or other required information with the IRS and show that its failure was due to reasonable cause and not willful neglect. In July 2010, the IRS issued the Directive, which generally provides taxpayers that either filed an incomplete GRA, or failed to make filings during the term of a timely filed GRA, a way to remedy the situation without the need to obtain reasonable cause relief.

The required compliance for outbound asset transfers also includes certain reporting requirements under Section 6038B. The penalty for failure to satisfy the Section 6038B reporting requirements, which includes the filing of a GRA for certain outbound transfers of stock or securities, is 10% of the fair market value of the transferred property, up to a maximum of $100,000, unless the failure was due to intentional disregard.1 Taxpayers must demonstrate the failure was due to reasonable cause and not willful neglect in order to avoid the application of these penalties.

Unlike the GRA Regulations, the current Section 367(a) regulations do not address a taxpayer’s failure to file statements connected with:

  • A transfer of stock or securities of a domestic corporation to a foreign corporation under Treas. Reg. Section 1.367(a)-3(c)(6) and Treas. Reg. Section 1.367(a)-3(c)(7)
  • The transfer of the assets of a domestic corporation to a foreign corporation in an exchange described in Section 361, and the subsequent transfer of those assets to a domestic subsidiary as described in Treas. Reg. Section 1.367(a)-3(d)(2)(vi)(B)(1)(ii)

Similarly, for liquidating distributions to foreign parent corporations governed under Section 367(e)(2), the current Section 367(e)(2) regulations do not provide explicit guidance on the treatment of taxpayers who fail to file, or comply with, the necessary documents or information, as required under the regulations.2 The current Section 367(e)(2) regulations also provide no mechanism to obtain relief for such failures.3

Proposed Changes

Under the Proposed Regulations, a US transferor seeking either to (1) avoid recognizing gain under Section 367(a)(1) on the initial transfer as a result of a failure to timely file an initial GRA, or (2) avoid triggering gain as a result of a failure to comply in all material respects with the GRA Regulations or the terms of a GRA, would no longer be required to seek reasonable cause but would be required to demonstrate that the failure was not “willful.” The IRS and Treasury state in the preamble to the Proposed Regulations that the existing reasonable cause standard (given its interpretation under case law) may not be satisfied by US transferors in many common situations, even though the failure was not intentional and not due to willful neglect. Therefore, gain recognition should only apply where the failure is considered willful.

The preamble to the Proposed Regulations states that, for this purpose, “willful” would be interpreted consistent with the meaning of that term in the context of other civil penalties (for example, Section 6672), which would include a failure due to gross negligence, reckless disregard, or willful neglect. Whether a failure is willful is determined based on all the relevant facts and circumstances. Examples4 included in the Proposed Regulations indicate a taxpayer’s failure to file will be considered willful if:

  • The taxpayer has a history of failing to timely file GRAs or other necessary documents
  • The taxpayer fails to implement safeguards to ensure that future GRA filing requirements would be satisfied.

The Proposed Regulations also indicate that filing a GRA, and intentionally not providing adjusted basis and/or fair market value, including noting that information is “available upon request,” constitutes willful failure.5 The IRS has long taken the position that “available upon request” is not acceptable, and the preamble to the Proposed Regulations provides additional clarity on this point by describing an “available upon request” response as “intentional” non-compliance and, therefore, a willful failure.

The Proposed Regulations provide that an initial GRA is considered timely filed only if each document that was required to be filed as part of an initial GRA was timely filed and completed in all material respects. Similarly, in general, there would be a failure to comply in a material respect with the GRA Regulations, or the terms of a GRA, if a document (such as an annual certification) that was required to be filed was not timely filed, or was not completed in all material respects. The Proposed Regulations would also clarify that the Section 6038B penalty would apply to a failure to comply in any material respect with the GRA Regulations or the terms of a GRA, such as a failure to properly file an initial GRA, annual certification or new GRA. Under the Proposed Regulations, a failure to comply would have the same meaning for purposes of the GRA Regulations and the Section 6038B Regulations. However, the current reasonable cause standard would continue to apply for purposes of seeking relief from the Section 6038B penalty and would continue to apply if both a Form 926 was not filed with respect to the initial transfer and there was a failure to file an initial GRA.

Under the current GRA Regulations, the IRS is required to respond to requests for reasonable cause relief within 120 days of notifying the US transferor of receipt of such request. If the IRS does not respond within such 120-day period, then the US transferor is deemed to have established that the failure to timely file or comply was due to reasonable cause and not willful neglect. This process would no longer apply under the Proposed Regulations, the IRS noting in the preamble to the Proposed Regulations that while it is committed to processing requests promptly, it does not believe that the processing time should be determinative of whether the US transferor has satisfied its obligations under the GRA Regulations.

The Proposed Regulations would also require that a Form 926 be filed in all cases in which a GRA is filed, but only Part I and Part II of Form 926 are to be completed if the only asset transferred was stock or securities.6

For the reporting requirements under Treas. Reg. Section 1.367(a)-3 and Section 367(e)(2), the Proposed Regulations would provide similar rules for failure to file the required documents or statements and failures to comply as under the proposed changes to the GRA Regulations and related Section 6038B Regulations. The Proposed Regulations would also require reporting of the basis and fair market value of any liquidating distributions of property.

Implications

The Proposed Regulations would permit a US transferor to avoid gain recognition for failure to comply with the GRA Regulations or the terms of a GRA due to unintentional noncompliance by demonstrating that such failure was not due to willful neglect rather than demonstrating reasonable cause for the failure, as well as provide the consequences and mechanisms for obtaining relief for failures to file and comply with statements and information required under Section 367(e)(2) and Treas. Reg. Section 1.367(a)-3. Although the Proposed Regulations do not apply a reasonable cause standard under the GRA Regulations, the standard still applies for avoiding the application of penalties under Section 6038B, which would apply to failures to comply with the GRA regulations or the terms of a GRA. Therefore, if a willful failure occurs, and a taxpayer is unable to demonstrate reasonable cause, then in addition to triggering gain, the 10% of fair market value penalty under the Section 6038B regulations would also apply.

Additionally, the Proposed Regulations eliminate a required response from the IRS within 120 days of notification of receipt of a request for relief from a failure to file or a failure to comply. While the transition to the willfulness standard appears to be favorable to taxpayers, a potential source of concern arises in the loss of the 120-day response period under the GRA Regulations, in that going forward taxpayers may lose the fairly rapid closure that is afforded by the 120-day period.

Although the Directive remains available to remedy incomplete initial GRAs, or missed or incomplete filings during the term of a timely filed initial GRA, it appears certain that once the Proposed Regulations are finalized the Directive will be withdrawn. At such time, taxpayers will be subject to the willfulness standard as their method of correcting failures in GRA compliance. Accordingly, taxpayers should move immediately to correct covered GRA compliance failures under the Directive.

IRS and the Treasury will consider any written or electronic comments timely submitted before the Proposed Regulations are adopted. IRS and Treasury have requested comments on the clarity of the Proposed Regulations and how they may be made easier to understand. Comments and requests for a public hearing on the proposed rules must be received by 1 April 2013. This is an extremely short comment period and may indicate that IRS and the Treasury will seek to finalize the Proposed Regulation in short order. The effective date of the Proposed Regulations would be for statements and other documents required to be filed with any return that is timely filed on or after the date the Proposed Regulations are published as final regulations in the Federal Register. As a result, the Proposed Regulations, when finalized, will apply to on-going filing requirements involving transactions that occur prior to the effective date of the Proposed Regulations.

Endnotes

1. Treas. Reg. Section 1.6038B-1(f)(1)(ii). For intentional disregard, the monetary penalty is not limited to $100,000. Treas. Reg. Section 1.6038B-1(f)(3).

2. For the statements and other documents required to be filed see Treas. Reg. Section 1.367(e)-2(b)(2)(i)(C) regarding the statement and documents to be filed in connection with a distribution by a domestic liquidating corporation of property used in a US trade or business to a foreign distributee corporation; Treas. Reg. Section 1.367(e)-2(b)(2)(i)(E)(3) regarding the statement to be attached listing any property received in the liquidating distribution that subsequently ceases to be used in the US trade or business; Treas. Reg. Section 1.367(e)-2(b)(2)(i)(E)(4)(ii) regarding the statement to be attached to except from a subsequent triggering event for the acquisition of replacement property by the foreign distribute corporation; Treas. Reg. Section 1.367(e)-2(b)(2)(i)(E)(5)(ii) regarding the statement to be filed to except from triggering gain for a subsequent transfer of the property to a qualified transferee; Treas. Reg. Section 1.367(e)-2(b)(2)(iii)(D) regarding the statement to be filed in connection with a distribution by a liquidating domestic corporation of stock of an 80 percent owned domestic subsidiary corporation; and Treas. Reg. Section 1.367(e)-2(c)(2)(i)(C) regarding the statement to be filed in connection with a distribution of property by a foreign corporation in complete liquidation under Section 332 to a foreign corporation.

3. Treas. Reg. Section 1.367(e)-2(c)(2)(i)(C).

4. Prop. Treas. Reg. Section 1.367(a)-8(p)(3), Example 2.

5. Prop. Treas. Reg. Section 1.367(a)-8(p)(3), Example 3.

6. Prop. Treas. Reg. Section 1.6038B-1(b)(2)(iv).

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

Ernst & Young LLP, International Tax Services, Washington, DC
  • Margie Rollinson
    +1 202 327 5757
    margie.rollinson@ey.com
  • Jose Murillo
    +1 202 327 6044
    jose.murillo@ey.com
  • John Morris
    +1 202 327 8026
    john.morris@ey.com
  • Preya Patel
    +1 202 327 7476
    preya.patel@ey.com
  • David Macall
    +1 202 327 7055
    david.macall@ey.com
Ernst & Young LLP, Transaction Advisory Services, Washington, DC
  • Brandon Hayes
    +1 202 327 6498
    brandon.hayes@ey.com

EYG no. CM3182