Gain Recognition Agreements & Outbound Transfer of Stock

When it comes to property transfers between domestic corporations, there are many IRS tax rules that allow corporations to avoid immediate tax implications. The rules are markedly different when it involves transfers from domestic corporations to foreign corporations. The reason why is that by moving appreciated assets outside of the United States and to a foreign corporation, the IRS may miss its opportunity to tax the income at the time of sale – when the gains are recognized. Similar to the concept of expatriation and the exit tax, the United States does not want to lose the opportunity to tax the increase in value that occurred during the time that the asset holder was a US person. But, while the general proposition is that transfers from US corporations to foreign corporations can be taxable, there are some exceptions and limitations on these rules. Let’s take a brief look at gain recognition agreements and outbound transfer of stock:

USC 367 – Foreign Corporations

(a) Transfers of property from the United States

General rule

- - If, in connection with any exchange described in section 332, 351, 354, 356, or 361, a United States person transfers property to a foreign corporation, such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered to be a corporation.

What does this mean?

It means that the general exception for taxation of assets being moved from one corporation to another does not apply to foreign corporations, because foreign corporations are not considered a ‘corporation’ for these tax purposes.

367 Regulations

The 367 regulations are very dense and complex. We will reproduce a few of the regulations subsections below to help illustrate when the exceptions can apply (so that a transfer to a foreign corporation is not taxable):

Regulation 1.367(a)(1)

- - Scope.
    - Section 367(a)(1) provides the general rule concerning certain transfers of property by a United States person (referred to at times in this section as the “U.S. person” or “U.S. transferor”) to a foreign corporation.
    - Paragraph (b) of this section provides general rules explaining the effect of section 367(a)(1). Paragraph (c) of this section describes transfers of property that are described in section 367(a)(1). Paragraph (d) of this section provides definitions that apply for purposes of sections 367(a) and (d) and the regulations thereunder. Paragraphs (e) and (f) of this section provide rules that apply to certain reorganizations described in section 368(a)(1)(F). Paragraph (g) of this section provides dates of applicability. For rules concerning the reporting requirements under section 6038B for certain transfers of property to a foreign corporation, see § 1.6038B-1.

- - General rules –
    - Foreign corporation not considered a corporation for purposes of certain transfers.
    - If a U.S. person transfers property to a foreign corporation in connection with an exchange described in section 351, 354, 356, or 361, then, pursuant to section 367(a)(1), the foreign corporation will not be considered to be a corporation for purposes of determining the extent to which gain is recognized on the transfer. Section 367(a)(1) denies nonrecognition treatment only to transfers of items of property on which gain is realized.
    - Thus, the amount of gain recognized because of section 367(a)(1) is unaffected by the transfer of items of property on which loss is realized (but not recognized).

- - Cases in which foreign corporate status is not disregarded.
    - For circumstances in which section 367(a)(1) does not apply to a U.S. transferor’s transfer of property to a foreign corporation, and thus the foreign corporation is considered to be a corporation, see §§ 1.367(a)-2, 1.367(a)-3, and 1.367(a)-7.

1.367 Regulations: 1.367(a)-2, 1.367(a)-3, and 1.367(a)-7

The following regulations provide examples of when the transfer to a foreign corporation may avoid tax because the foreign corporation is still considered a ‘corporation’ for deferred tax treatment purposes.

We will focus on the first two regulations.

1.367(a)-2 (Active Conduct Trade or Business)

- - General rule.
    - Except as otherwise provided in §§ 1.367(a)-4, 1.367(a)-6, and 1.367(a)-7, section 367(a)(1) does not apply to property transferred by a United States person (U.S. transferor) to a foreign corporation if –
      - The property constitutes eligible property;
        
        The property is transferred for use by the foreign corporation in the active conduct of a trade or business outside of the United States, as determined under paragraph (d), (e), (f), (g), or (h) of this section, as applicable; and
        
        The U.S. transferor complies with the reporting requirements of section 6038B and the regulations thereunder.

What does this mean?

It means that in a situation in which the property is being used by a foreign corporation for the active conduct of trade or business outside of the United States and section 6038B is adhered to, the foreign corporation would be treated as a foreign corporation (to avoid immediate taxation on the transfer)

What is 6038B?

Section 6038B refers to foreign transfers, and generally requires the US person to file a Form 926 to report the transfer.

- - (a )In general
    - Each United States person who—
      - (1) transfers property to—
        
        (A) a foreign corporation in an exchange described in section 332, 351, 354, 355, 356, or 361, or
        
        (B )a foreign partnership in a contribution described in section 721 or in any other contribution described in regulations prescribed by the Secretary, or
      - (2) makes a distribution described in section 336 to a person who is not a United States person, shall furnish to the Secretary, at such time and in such manner as the Secretary
      - shall by regulations prescribe, such information with respect to such exchange or distribution as the Secretary may require in such regulations.

1.367(a)-3 (Treatment of transfers of stock or securities to foreign corporations)

- - Exceptions for certain exchanges of stock or securities
    - Unless otherwise provided, the following exchanges are not subject to section 367(a)(1) and therefore gain is not recognized under section 367(a)(1).
    - (i) Section 368(a)(1)(E) reorganizations.
      - In an exchange under section 354 or 356, a U.S. person exchanges stock or securities of a foreign corporation in a reorganization described in section 368(a)(1)(E).

(ii) Certain section 368(a)(1) asset reorganizations.

- - In an exchange under section 354 or 356, a U.S. person exchanges stock or securities of a domestic or foreign corporation pursuant to an asset reorganization that is not treated as an indirect stock transfer under paragraph (d) of this section. See paragraph (d)(3) Example 16 of this section. For purposes of this section, an asset reorganization is defined as a reorganization described in section 368(a)(1) involving a transfer of property under section 361.
- (b) Transfers of stock or securities of foreign corporations –
  - General rule.
    - Except as provided in paragraph (e) of this section, a transfer of stock or securities of a foreign corporation by a U.S. person to a foreign corporation that would otherwise be subject to section 367(a)(1) under paragraph (a) of this section will not be subject to section 367(a)(1) if either –
      - Less than 5-percent shareholder.
        
        The U.S. person owns less than five percent (applying the attribution rules of section 318, as modified by section 958(b)) of both the total voting power and the total value of the stock of the transferee foreign corporation immediately after the transfer; or
      - 5-percent shareholder.
        
        The U.S. person enters into a five-year gain recognition agreement with respect to the transferred stock or securities as provided in § 1.367(a)-8.

§ 1.367(a)-8 Gain recognition agreement requirements.

In general, GRAs can be very complex and is still and evolving area of tax law. As provided by the regulation:

- - Content of gain recognition agreement.
    - The gain recognition agreement must be entitled “GAIN RECOGNITION AGREEMENT UNDER § 1.367(a)-8” and include the information described in paragraphs (c)(2)(i) through (viii) of this paragraph with the corresponding paragraph numbers. The information required under this paragraph (c)(2) and paragraph (c)(3) of this section must be included in the gain recognition agreement as filed.
      - (i) A statement that the document constitutes an agreement by the U.S. transferor to recognize gain in accordance with the requirements of this section.
      - (ii) A description of the transferred stock or securities and other information as required in paragraph (c)(3) of this section.
      - (iii) A statement that the U.S. transferor agrees to comply with all the conditions and requirements of this section, including to recognize gain under the gain recognition agreement in accordance with paragraph (c)(1)(i) of this section, to extend the period of limitations on assessment of tax as provided in paragraph (f) of this section, to file the certification described in paragraph (g) of this section, and, as provided in paragraph (j)(8) of this section, to treat a failure to comply (as described in paragraph (j)(8) of this section) as extending the period of limitations on assessment of tax for the taxable year in which gain is required to be reported. (iv) A statement that arrangements have been made to ensure that the U.S. transferor is informed of any events that affect the gain recognition agreement, including triggering events or other gain recognition events.

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