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1 13 December 2016 International Tax Alert US Notice announces amendments to Section 367 regulations applying to certain cross-border triangular reorganizations and inbound nonrecognition transactions EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary On 2 December 2016, the United States (US) Treasury Department (Treasury) and US Internal Revenue Service (IRS) released Notice (the 2016 Notice), announcing their intention to issue new regulations under Internal Revenue Code Section 1 367, modifying the US federal tax treatment of certain cross-border triangular reorganizations and inbound tax-free liquidations or reorganizations (inbound nonrecognition transactions). As it relates to cross-border triangular reorganizations, the regulations to be issued would generally result in immediate income recognition, in certain cases subject to immediate US federal taxation, to certain participants in the reorganization. 2 As it relates to inbound nonrecognition transactions, the regulations to be issued would modify the existing regulations promulgated in 2000 to require, in certain cases, that the income inclusion required in such transactions of certain shareholders include the untaxed E&P of lower-tier foreign subsidiaries. The regulations to be issued would apply to transactions completed on or after 2 December 2016, and to inbound nonrecognition transactions treated as occurring prior to 2 December 2016, as a result of an entity classification election filed under Treas. Reg on or after 2 December 2016.

2 2 International Tax Alert Detailed discussion Background Cross-border triangular reorganizations. In general, the 2011 Final Regulations apply to triangular reorganizations in which the acquiring corporation (S) and/or the issuing corporation (P) are foreign and S acquires, in exchange for property, any or all of the P stock or securities used to acquire the stock, securities, or assets of the target corporation (T) in the reorganization. Because, under Section 1032, P generally does not recognize gain on its issuance of stock or securities for property, when S is foreign and P is domestic, a triangular reorganization could permit tax-free repatriation. This result prompted Treasury to promulgate regulations under Section 367(b), treating, in certain cases, P as generally receiving the property used by S to purchase its stock or securities as a distribution of property under Section 301, which could result in dividend income or gain. 3 This general rule, however, was subject to numerous exceptions. Specifically, the 2011 Final Regulations (as modified by subsequent Notice ) coordinated the application of Section 367 to the reorganization so that either Section 367(a) or (b) applied to the reorganization, but not both (referred to as either the Section 367(a) priority rule or Section 367(b) priority rule ). Under the Section 367(a) priority rule, the 2011 Final Regulations (as modified by Notice ) do not apply if the gain recognized by T s US shareholders or security holders under Section 367(a)(1) (Section 367(a) Gain) equaled or exceeded the sum of the dividend income under Section 301(c)(1) or the gain under Section 301(c)(3) that would be recognized by P and subject to US federal tax, directly to P or to US shareholder(s) of P under Section 951(a)(1)(A), if the 2011 Final Regulations applied to treat P as receiving a property distribution from S (Section 367(b) Income). By contrast, the Section 367(b) priority rule turns off Section 367(a) to the US shareholders of T if the gain they would recognize under Section 367(a) on their exchange of the T stock or securities (without regard to any exceptions) would be less than P s Section 367(b) Income. As discussed later, the regulations to be issued would significantly modify the priority rules to require, in most cases, P to recognize the Section 367(b) Income and T s US shareholders to recognize all the gain realized on their exchange of T stock or securities. Inbound nonrecognition transactions. For inbound nonrecognition transactions, Treas. Reg (b)-3(b) generally requires certain exchanging shareholders of the foreign acquired corporation 4 to include in income as dividends the all earnings and profits (E&P) amount with respect to their stock in the foreign acquired corporation. Inclusion of the all E&P amount is required of an exchanging shareholder that is a United States shareholder of the foreign acquired corporation, as defined in Section 951(b), or a foreign corporation that has at least one United States shareholder. The policy underlying inclusion of the all E&P amount is to ensure that the asset bases to which the domestic acquiring corporation succeeds represents an after US tax amount. Current Treas. Reg (b)-3 limits the all E&P amount to the E&P of the foreign acquired corporation; a limitation, as explained by the 2016 Notice, premised on the assumption that the foreign acquired corporation s asset bases reflect solely its E&P, liabilities and capital acquired from its shareholder (and not that of its subsidiaries). Out of concern that certain transactions could result in the foreign acquired corporation s asset bases exceeding the sum of these three items, the regulations to be issued would increase the foreign acquired corporation s all E&P amount to include E&P of its foreign subsidiaries. These changes would apply in addition to and independent from the changes applicable to cross-border triangular reorganizations. Changes described in the 2016 Notice Cross-border triangular reorganizations. The regulations to be issued would modify the Section 367(a) priority rule to apply only when T is domestic. Accordingly, when T is foreign, the 2011 Final Regulations, as modified by the 2016 Notice, would apply unless one of the remaining exceptions applies, which would generally not be available to US multinationals. In addition, the regulations to be issued would also modify the Section 367(a) priority rule to provide that Section 367(b), but not Section 367(a), will apply to an exchange by US shareholders under Section 354 or 356 of stock or securities of a foreign T for P stock or securities purchased by S in exchange for property (i.e., under a cross-border triangular reorganization otherwise described in Treas. Reg (b)-10(a)). Section 367(a), however, would continue to apply to exchanging US shareholders that receive P stock or securities not purchased by S in

3 International Tax Alert 3 exchange for property under the reorganization. Thus, to avoid gain recognition, those exchanging shareholders would continue to have to file gain recognition agreements under Treas. Reg (b)-3 and -8. Further, the 2016 Notice provides that current Treas. Reg (b)-4 and -4T will be modified to provide that, in connection with a triangular reorganization otherwise described in Treas. Reg (b)-10(a), a shareholder that exchanges stock of a foreign T for P stock or securities acquired by S in exchange for property in connection with the reorganization must: (1) include in income the Section 1248 amount attributable to the exchanged stock; and (2) recognize any excess realized gain with respect to the exchanged stock after accounting for the inclusion of the Section 1248 amount. In summary, in the context of an outbound transfer of foreign T stock or securities, the regulations to be issued would fully tax the built-in gain in the transferred foreign T stock or securities to the extent it is exchanged for P stock acquired by S in exchange for property. In addition, by removing the application of the Section 367(a) priority rule to transactions in which T is foreign, S s purchase of P stock will generally be treated as a distribution from S to P, unless another exception to the 2011 Final Regulations applies (the other exceptions under the 2011 Final Regulations are unlikely to apply to US multinationals). Inbound nonrecognition transactions. As previously noted, in certain cases, current Treas. Reg (b)-3(b) requires an exchanging shareholder of a foreign corporation whose assets are acquired by a domestic corporation (foreign acquired corporation) in a nonrecognition transaction to include in income the all E&P amount attributable to the exchanged stock. To protect against fact patterns in which the foreign acquired corporation s adjusted asset bases carries over to a domestic corporation under Section 381 and does not represent an aftertax amount, Treas. Reg (b)-2(d)(3)(ii) would be modified to increase the all E&P amount attributable to the stock of the foreign acquired corporation by the specified earnings attributable to such stock, but only if the foreign acquired corporation has excess asset basis. Although included as part of the changes otherwise affecting triangular reorganizations described in Treas. Reg (b)-10, the modifications to the all E&P amount would apply to all nonrecognition inbound transactions otherwise subject to Treas. Reg (b)-3(b). Excess asset basis is defined as the amount by which the inside asset basis of the foreign acquired corporation exceeds the sum of the following amounts: The E&P of the foreign acquired corporation attributable to all the outstanding stock of the foreign acquired corporation, determined under modified Section 1248 principles The aggregate basis in the outstanding stock of the foreign acquired corporation determined immediately before the inbound transaction (and without regard to any basis increase described in Treas. Reg (b)-2(e)(3)(ii) resulting from such inbound transaction) The aggregate amount of liabilities of the foreign acquired corporation that are assumed by the domestic acquirer in the inbound transaction determined under the principles of Section 357(d) Inside asset basis means the adjusted basis of the assets of the foreign acquired corporation in the hands of the domestic acquirer determined immediately after the inbound transaction. If the foreign acquired corporation has excess asset basis, the all E&P amount of an exchanging shareholder increases by the specified earnings of the foreign acquired corporation, which means the lesser of the following three amounts: 1. The sum of the E&P (including a deficit) with respect to each foreign subsidiary of the foreign acquired corporation that is attributable under Section 1248(c)(2) to the stock of the foreign acquired corporation exchanged 2. The excess asset basis of the foreign acquired corporation, multiplied by the exchanging shareholder s specified percentage (explained later) 3. The amount of gain that would be realized by the exchanging shareholder if, immediately before the inbound transaction, the exchanging shareholder had sold the stock of the foreign acquired corporation for fair market value, reduced by the exchanging shareholder s all E&P amount (for this purpose, determined without regard to the modifications described in the 2016 Notice) For purposes of (2) above, the specified percentage is to be determined by dividing: (i) the sum of the aggregate of the specified stock gain with respect to all exchanging shareholders to which Treas. Reg (b)-3(b)(3) applies and the aggregate of the gain realized (regardless of whether the gain is recognized) with respect to the stock exchanged by all other exchanging shareholders by (ii) the amount of the exchanging shareholder s specified stock gain.

4 4 International Tax Alert If the specified earnings attributable to the stock of a foreign acquired corporation exchanged by an exchanging shareholder is less than the lower-tier earnings attributable to the stock exchanged, the specified earnings of the exchanging shareholder will be sourced from lower-tier earnings of foreign subsidiaries of the foreign acquired corporation under the principles of Treas. Reg (d)(3). Lastly, and importantly, the 2016 Notice provides that if, a foreign acquired corporation has excess asset basis, a taxpayer may reduce the excess asset basis to the extent that the excess asset basis is not attributable, directly or indirectly, to property provided to the foreign acquired corporation by a foreign subsidiary. For this purpose, the 2016 Notice makes clear that property provided to the foreign acquired corporation (FP) by a foreign subsidiary (FS) to purchase FP stock or securities is treated as property provided to FP by FS. The 2016 Notice provides one example of this concept in which property is transferred to a foreign acquired corporation in a transaction in which a Section 362(e)(2)(C) election is made e.g., a US corporation contributes property with a fair market value of $5 and an adjusted basis of $30. As a result of the Section 362(e)(2)(C) election, FS would succeed to a carryover basis of $30 in the property, while USP would only increase its basis in the FS stock by $5. Thus, this transaction creates excess asset basis in isolation because the inside basis of FS s assets increases by $30, but the outside stock basis of FS increases by $5. Because this property is not provided directly or indirectly by a subsidiary of FS, under the 2016 Notice, the basis in the FS stock may be determined without regard to the Section 362(e)(2)(C) election (i.e., USP s basis in its FS stock would increase by $30 for this purpose). Nonqualified preferred stock In addition, the 2016 Notice provides that the definition of property in Treas. Reg (b)-10(a)(3)(iii) would be modified to include S stock that is nonqualified preferred stock. Anti-abuse rule The regulations issued under Treas. Reg (b)-3, addressing the all E&P amount, would also include an antiabuse rule to address the transactions that are undertaken with a view to avoiding the purposes of the rules in the Notice, which will include allowing for adjustments to be made to disregard the effects of transactions. For example, a transaction in which a taxpayer engages with a view towards reducing excess asset basis by increasing the outside stock basis without a corresponding increase to inside asset basis could be disregarded for purposes of computing excess asset basis. The general standard of this anti-abuse provision is consistent with other anti-abuse provisions in this area (e.g., Treas. Reg (b)-10(d), which contains a similar with a view standard). Implications As shown, the 2016 Notice drastically alters the US federal tax consequences of many cross-border triangular reorganizations and inbound nonrecognition transactions. Given the changes announced in the 2016 Notice, the efficacy of these transactions going forward will be greatly diminished. In fact, in a departure from the general purpose of the 2011 Final Regulations i.e., to treat S s purchase of P stock for property in the same manner as if S had distributed the property to P the 2016 Notice would actually leave taxpayers in a worse position by also requiring T s US shareholders to recognize the gain realized on their exchange of the T stock or securities. Equally as significant are the expanded scope and changes to the computation of the all E&P amount. As noted, the rationale of the Section 367(b) regulations issued in 2000 is that, because E&P creates asset basis, when asset basis is imported to the US in a nonrecognition inbound transaction, that E&P should be subject to US federal tax at that time. The regulations in this area have historically included only the E&P of the foreign acquired corporation, and not that of any of its foreign subsidiaries. The modifications announced in the 2016 Notice, however, take a fundamentally different approach by increasing the all E&P amount to include the E&P of foreign subsidiaries when the foreign acquired corporation has excess asset basis. The underpinnings of this approach appear grounded in the notion of a balanced tax basis balance sheet; that is, asset basis = liabilities + E&P + invested capital. When the tax basis balance sheet is out of balance, the 2016 Notice effectively attributes this excess basis to, and subjects to US federal tax, certain E&P of the foreign acquired corporation s lower-tier foreign subsidiaries. The link between E&P and tax basis has been an underlying principle of the Treasury regulations under Section 367(b), although not a fundamental principal of the tax law.

5 International Tax Alert 5 For example, when promulgating Treas. Reg , Treasury declined to allow a reduction for adjusted basis resulting from a loss importation transaction (i.e., an inbound nonrecognition transaction in which the aggregate basis of the property of FT exceeds the aggregate fair market value of such property) to reduce the all E&P amount recognized by the exchanging shareholder in the inbound transaction. Indeed, there are numerous instances in which a corporation s tax basis balance sheet can fall out of balance and create excess asset basis, as defined in the 2016 Notice. It appears, however, the 2016 Notice intends to target only excess asset basis resulting from property provided, directly or indirectly, by foreign subsidiaries of the foreign acquired corporation by permitting that the amount of any excess asset basis may be reduced to the extent the excess is not attributable to property acquired from a foreign subsidiary. In practice, this will create the additional administrative burden of reviewing of all historic transactions that affected a foreign acquired corporation s inside asset basis, liabilities, E&P, and/or outside adjusted basis of its stock to determine the root cause of such excess basis. Presumably, once a taxpayer can demonstrate that property acquired from sources other than lower-tier subsidiaries created the excess basis, appropriate adjustments can be made. Lastly, taxpayers will need to contend with the very broad antiabuse rule. As an example of a transaction that may be subject to the anti-abuse rule, the 2016 Notice provides an increase to outside stock basis may be disregarded if that increase follows from a transaction engaged in with a view to reduce excess asset basis that does not result in a corresponding increase to inside asset basis. As a general matter, many other common transactions result in disconnects between inside asset basis and outside stock basis. For example, assume USP owns FS, USP buys FT for $100, FT has $10 of inside asset basis, and no Section 338 election is made. If FT is then merged sideways into FS in a Section 368(a) reorganization, USP s FS stock basis will be increased by $100 (i.e., USP s $100 of basis in its FT stock), but FS s inside asset basis will be increased by $10 (i.e., FT s basis in its assets succeeded to by FS). Thus, this transaction leads to $90 of additional outside stock basis in FS, which could presumably reduce or eliminate what was otherwise excess asset basis at FS. Given the prevalence of transactions such as this, and the with a view standard, many taxpayers will face increased difficulty in determining whether a foreign acquired corporation has excess asset basis. Endnotes 1. All Section references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder. 2. The 2016 Notice is the latest in a long line of guidance addressing these transactions and represents a significant departure from the prior guidance see Notice , CB 677 (22 Sept. 2006); Notice , IRB , 1428 (31 May 2007); Reg. Section 1.367(b)-14T (2008); Reg. Section 1.367(b)-10 (2011) (the 2011 Final Regulations); and Notice , IRB 1006 (25 April 2014) (the 2014 Notice). 3. See Treas. Reg (b)-10 generally. 4. The foreign corporation whose assets are acquired by a domestic corporation in a tax-free liquidation under Section 332 or asset reorganization under Section 368. Treas. Reg (b)-3(a).

6 6 International Tax Alert For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, Washington DC Jose Murillo Ernst & Young LLP, Transaction Advisory Services, Washington DC Brian Reed Martin Huck International Tax Services Global ITS, Alex Postma, Tokyo ITS Director, Americas, Jeffrey Michalak, Detroit ITS Markets Leader, Americas, Stephen O Neil, New York Ernst & Young LLP, National Director of ITS Technical Services, Jose Murillo, Washington ITS Regional Contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Chris J Housman, New York Central Mark Mukhtar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Beth Carr, San Jose, CA Canada Ernst & Young LLP (Canada) Albert Anelli, Montreal

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