IRS releases guidance related to Section 961 and certain inbound nonrecognition transactions

In detail

Background

Sections 959 and 961, introduced in 1962 with the original enactment of subpart F, work together to allow a US shareholder to recover PTEP without being subject to additional taxation. In general, Section 961(a) provides for a basis increase in stock of a CFC directly held by a US shareholder when the shareholder includes in income its pro rata share of the CFC’s subpart F income. In addition, Section 961(b)(1) requires a decrease in stock basis when PTEP is distributed to a US shareholder and excluded from its income under Section 959(a). If the PTEP distributed exceeds the US shareholder’s basis in the first-tier CFC, gain is recognized under Section 961(b)(2).

Observation: In the Notice, Treasury and the IRS state that one of the purposes of Section 961 is “to prevent double taxation of the same CFC earnings,” citing to the 1962 House Report (H.R. Rep. No. 87-1447 (1962)).

Section 961(c) was added to the Code in 1997 to address double taxation concerns regarding the sale of lower-tier CFCs. Section 961(c) generally provides that, under regulations prescribed by the Secretary, adjustments similar to those under Section 961(a) and (b) should be made with respect to the stock in lower-tier CFCs, but only for the limited purpose of determining subpart F inclusions with respect to an upper-tier CFC. The 1997 House Report explains that where an upper-tier CFC recognizes subpart F income from gain on the disposition of a lower-tier CFC, Section 961(c) grants the Secretary regulatory authority “to reduce the US person’s. . . subpart F inclusion” by the amount of the lower-tier CFC’s subpart F income that was previously included in the US person’s income. H.R. Rep. No. 105-148, at 450 (1997).

Observation: Although regulations have not yet been issued under Section 961(c), many practitioners believe Section 961(c) is ‘self-executing.’

Observation: Because Section 961(c) provides for adjustments “similar to” those under Section 961(a) and (b) and is specifically limited in scope to the determination of a US shareholder’s subpart F inclusion, nothing in the statute or legislative history suggests that Section 961(c) adjustments represent actual basis adjustments for other purposes of the Code (unlike under Section 961(a)).

Definition of covered inbound transaction

Under the announced proposed regulations, a covered inbound transaction would be defined as one of the following types of transactions in which a domestic acquiring corporation acquires all the stock of the acquired CFC from a transferor CFC that, immediately before the transaction and any related transactions, owned (directly or indirectly under Section 958(a)(2)) all the stock of the acquired CFC:

1. Section 332 liquidation or upstream asset reorganization – a liquidation described in Section 332 or a nontriangular reorganization under Section 368(a)(1)(A) or (C) in which all of the stock of the transferor CFC is owned directly by the domestic acquiring corporation immediately before the transaction.
2. Other asset reorganization - a nontriangular reorganization under Section 368(a)(1)(A) or (C), a reorganization described in Section 368(a)(1)(D), or a reorganization described in Section 368(a)(1)(F) in which all of the stock of the transferor CFC is owned directly by a single domestic corporation (or by members of the same consolidated group) immediately before the transaction, and the same domestic corporation (or members of the same consolidated group) directly owns all of the stock of the domestic acquiring corporation immediately after the transaction and any related transactions.

A transaction otherwise described in the Notice would not fail to be a covered inbound transaction solely because, immediately before the transaction, one or more persons other than the domestic corporation (or members of a consolidated group, as applicable) described above owned in the aggregate 1% or less of the total fair market value of the stock of the transferor CFC. Similarly, if less than 1% of the total fair market value of the stock of the acquired CFC is owned by someone other than the transferor CFC immediately before the transaction, such stock generally is disregarded in determining whether a transaction is a covered inbound transaction.

Observation: The Notice’s definition of ‘covered inbound transaction’ can produce unexpected differences depending on the type of inbound transaction and the ownership structure before such transaction. For example, assume USP and USS (members of the same consolidated group) each owned 50% of the stock in CFC1, which wholly owned CFC2, and CFC1 undertakes an inbound transaction. If the inbound transaction is a liquidation under Section 332, the Notice does not appear to apply to the acquisition of CFC2 because the stock of CFC1 was not owned directly by one domestic acquiring corporation immediately before the transaction. However, if the inbound transaction is an asset reorganization under Section 368(a)(1)(F) then the Notice ought to apply because the transactions in the ‘other asset reorganization’ category allow the transferor CFC to be owned by one or more members of a consolidated group. In addition, regardless of the type of inbound transaction, the Notice would not apply if CFC2 is more than 1% owned by minority shareholders (which may be common in the case of joint ventures, certain foreign publicly listed companies, etc.).

The Notice contains several additional limitations, such that covered inbound transactions do not include:

• reorganizations where boot described in Section 356(a) is issued (other than de minimis boot),
• transactions followed by transfers of the acquired CFC stock described in Section 368(a)(2)(C) or Reg. 1.368-2(k)(1) (other than to members of the same consolidated group),
• transactions followed by transfers of the acquired CFC stock to a partnership or foreign corporation as part of the same plan (or within the following two-year period),
• transactions involving an acquired CFC that has basis (including Section 961(c) adjustments) in excess of fair market value, and
• transactions where the domestic acquiring corporation is a regulated investment company, a real estate investment trust (REIT), or a subchapter S corporation.

Taxpayers can rely on the rules described in the Notice for transactions completed on or before the date proposed regulations governing the basis consequences of covered inbound transactions are published in the Federal Register, provided the taxpayer and its related parties follow the rules in their entirety and in a consistent manner.

Observation: Based on the reliance language in the Notice, it appears that taxpayers may rely on the Notice for transactions that occurred many years ago. This could produce surprising results for taxpayers because they would not have been aware of the exceptions drawn by the Notice when entering into prior transactions. For example, a taxpayer that undertook a covered inbound transaction followed by a transfer of an acquired CFC to a foreign corporation more than two years later may be able to rely on the relief provided by the Notice (although such relief would not be available under the Notice to a taxpayer that transferred an acquired CFC to a foreign corporation less than two years later).

Observation: The exclusion for transactions involving built-in-loss CFCs has a cliff effect (causing such transaction to be completely outside of the Notice) rather than limiting the basis increase to the fair market value of the acquired CFC. For example, a transaction involving an acquired CFC that has adjusted stock basis of 0, Section 961(c) basis adjustments of 210, and a fair market value of 200, would not qualify as a covered inbound transaction, and therefore the domestic acquiring corporation could not rely on the Notice.

In addition, individual owners of CFCs will not be eligible for relief under the Notice where a first-tier CFC reorganizes into a domestic acquiring corporation because no domestic corporation owned the transferor CFC immediately prior to the transaction.

The Notice states that no inference is intended regarding the treatment of Section 961(c) basis as a result of transactions that are not ‘covered inbound transactions.’ Comments on the Notice are requested by February 26, 2024, specifically on the extension of the rules described in the Notice to transactions that do not meet the Notice’s definition of ‘covered inbound transactions,’ and the potential additional limitations that might apply in such cases.

Observation: As noted above, the relief provided by the Notice is welcome but limited in scope. Taxpayers may wish to suggest that Treasury and the IRS consider expanding the scope of double tax relief provided under the Notice to other carryover basis transactions discussed above, as well as addressing other Section 961(c) issues in future guidance, such as the application of the Section 961(c) basis adjustments in situations where CFC stock is held through non-CFC entities as a result of the repeal of the prohibition on downward attribution in Section 958(b)(4).