Client Alert. IRS Relaxes Standard of Relief for Failing to File Gain Recognition Agreements. Background

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1 Number 1464 February 6, 2013 Client Alert Latham & Watkins Tax Department IRS Relaxes Standard of Relief for Failing to File Gain Recognition Agreements The proposed regulations recognize that full gain recognition is an excessive penalty for paperwork mistakes. On January 30, 2013, Treasury and the IRS announced proposed regulations governing the consequences for US taxpayers that fail to file gain recognition agreements (GRAs) and other forms required in connection with nonrecognition transfers of property to foreign corporations. 1 The proposed regulations will generally be viewed favorably by the multinational community as they lower the legal standard necessary to excuse the penalty for such filing omissions, which is full recognition of gain. The IRS has requested comments by April 1, The regulations are proposed to apply with respect to GRAs and other documents required to be filed with a return due on or after the date final regulations are published in the Federal Register. The regulations are also proposed to apply to any requests for relief for failures to file or comply with the requirements of documents required in connection with outbound nonrecognition transfers, if those requests are submitted on or after the final regulations date of publication. Background Under general US corporate taxation principles, a transfer of property (including stock) in exchange for shares of a corporation may qualify for nonrecognition of any gain in that property as a Section 368 reorganization, a Section 332 liquidation, or as exchanges under Sections 351, 354 or In the case of transfers to a foreign corporation, Section 367 generally requires the transferor to recognize gain before the property leaves the US taxing jurisdiction. An important exception to this rule of current tax recognition is where the transferor enters into a GRA with the IRS in connection with an outbound transfer of shares. The GRA essentially serves as a contract between the US transferor and the IRS pursuant to which the transferor does not recognize gain on the initial transfer of shares. As a quid pro quo for not recognizing gain immediately, the transferor agrees to recognize the initial amount of gain later if within five years a triggering event takes place, such as the foreign corporation disposing of the untaxed shares. A GRA is required, for example, when a US parent with two direct foreign subsidiaries (FS1 and FS2) transfers shares of FS1 to FS2 in a transaction otherwise qualifying as tax-free as a Section 368 reorganization or a Section 351 exchange. GRAs are also necessary incident to certain outbound transfers of domestic stock as well as certain indirect transfers of stock to a foreign corporation. 3 Latham & Watkins operates worldwide as a limited liability partnership organized under the laws of the State of Delaware (USA) with affiliated limited liability partnerships conducting the practice in the United Kingdom, France, Italy and Singapore and as affiliated partnerships conducting the practice in Hong Kong and Japan. Latham & Watkins practices in Saudi Arabia in association with the Law Office of Salman M. Al-Sudairi. In Qatar, Latham & Watkins LLP is licensed by the Qatar Financial Centre Authority. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright Latham & Watkins. All Rights Reserved.

2 If a taxpayer fails to file a GRA when necessary, or fails to comply with the terms of an existing GRA (including an annual certification that no triggering event has occurred), existing rules assign a stiff penalty: full recognition of gain. Under current regulations, the IRS will excuse that penalty only if the taxpayer proves to the IRS Director with jurisdiction over the tax return at issue that the failure was due to reasonable cause and not willful neglect. Those regulations also specify that if the Director does not make a decision or request additional time within 120 days of the IRS acknowledgment of the request for relief, then the failure to file is deemed to have been due to reasonable cause. The tax-free transfer of property to a foreign corporation also obliges a US taxpayer to file IRS Form 926, identifying the transferee foreign corporation and the transferred property. However, Form 926 is not currently required with respect to a transfer if a GRA is properly filed. If a taxpayer files neither a GRA nor Form 926, Section 6038B imposes another penalty on top of the recognition of gain equal to 10 percent of the property s fair market value at the time of the exchange, capped at $100,000 unless the failure to file was intentional. If the taxpayer can establish that the failure to file was due to reasonable cause and not to willful neglect, the penalty does not apply. The Proposed Regulations Willfulness Standard The proposed regulations recognize that full gain recognition is an excessive penalty for paperwork mistakes. Accordingly, the proposed regulations would eliminate the requirement that a taxpayer that fails to file a timely GRA (or fails to comply in a material respect with the GRA regulations or the terms of an existing GRA) prove that the failure was due to reasonable cause to avoid gain recognition. Instead, the taxpayer would simply need to demonstrate that the failure was not willful. Under the proposed regulations, a taxpayer s failure to comply would be willful (and subject to full gain recognition) only if the failure were due to gross negligence, reckless disregard or willful neglect. The IRS has construed the reasonable cause standard for GRA failures to require ordinary business care and prudence, a higher standard of conduct. 4 The proposed regulations emphasize that willfulness is based on all the facts and circumstances, but include a series of illustrative examples. For example, if a taxpayer with a history of complying with the GRA regulations fails to file a GRA due to an isolated accidental oversight, the failure would not be considered willful. This change is likely to benefit taxpayers that engage in cross-border transactions, as we are aware of cases where the IRS has asserted a lack of reasonable cause even though the taxpayer s failure to timely file a GRA would be unlikely to qualify as willful under the proposed regulations. Failure to Provide Certain Information Unlike accidental oversights, failing to provide information required by a GRA (such as valuations of property and its basis) while noting that the information is available upon request would be a willful failure. The proposed regulations emphasize that compliance requires that each required document be completed in all material respects. 2 Number 1464 February 6, 2013

3 The proposed regulations direct a taxpayer that discovers a failure to file a GRA or to comply with the terms of an existing GRA to promptly file an amended return for the relevant taxable year including the omitted documents. For relief from gain recognition, a taxpayer should include an IRS Form 8838 extending the statute of limitations and a written statement explaining the reasons for noncompliance. While under current law the IRS would be obligated to respond to requests for relief within 120 days, the proposed regulations would eliminate that requirement. In addition to the filing requirements with respect to GRAs, current regulations require taxpayers to comply with similar filing obligations to secure nonrecognition treatment with respect to: certain liquidations of a domestic subsidiary into a foreign corporate parent and certain foreign-to-foreign liquidations; 5 certain transfers of stock or securities of a domestic target corporation to a foreign corporation with an active trade or business; 6 and certain transfers of assets by a domestic target corporation to a foreign corporation in a Section 368 reorganization or Section 351 exchange, after which the foreign corporation transfers those assets to a domestic subsidiary. 7 The proposed regulations clarify that gain recognition would apply only if the failure to comply with these filing obligations were willful. The IRS and Treasury noted that full gain recognition is unnecessary because the Section 6038B penalty would still apply in the absence of reasonable cause. While the Section 6038B penalty can be substantial, it will not exceed $100,000 unless the failure is due to intentional disregard i.e., disregard of a revenue ruling, notice, regulation or statute of which the taxpayer is aware. The statutory requirement of reasonable cause for relief from the Section 6038B penalty is not affected by the proposed regulations. In the past, the IRS has relied on Treasury regulations relating to information reporting failures to determine whether a taxpayer had reasonable cause for a late-filed Form 926. To demonstrate reasonable cause in this context, the burden may be high: In at least one instance, the IRS has concluded that the taxpayer must establish (i) that either (a) there were significant mitigating factors or (b) the failure arose from events beyond the filer s control and (ii) the taxpayer acted in a responsible manner both before and after the failure occurred. 8 Qualifying for relief from full gain recognition under the not willful standard is likely to be considerably easier than qualifying for relief from the Section 6038B penalty. Finally, unlike current law, the proposed regulations would require filing Form 926 even if a GRA is filed in connection with the same transaction. If the only assets transferred are stock or securities, however, then only Parts I and II of Form 926 need be completed, as the remainder of the required information would be supplied in a GRA. 3 Number 1464 February 6, 2013

4 Endnotes 1 78 FR All references herein to Section are to the Internal Revenue Code of 1986, as amended. 3 See generally Treas. Reg (a)-3. 4 TAM (quoting United States v. Boyle, 469 U.S. 241, 246 (1985)). 5 See Treas. Reg (e)-2(b). 6 See Treas. Reg (a)-3(c). 7 See Treas. Reg (a)-3(d). 8 See FSA (discussing Treas. Reg ). If you have any questions about this Client Alert, please contact one of the authors listed below or the Latham attorney with whom you normally consult: Diana S. Doyle diana.doyle@lw.com Chicago Nicholas J. DeNovio nicholas.j.denovio@lw.com Brian D. Schmalzbach brian.schmalzbach@lw.com 4 Number 1464 February 6, 2013

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