Reconciling the Irreconcilable Earnings and Profits in Cross-Border - - PowerPoint PPT Presentation

Reconciling the Irreconcilable

Earnings and Profits in Cross-Border Separations

Bloomberg BNA Corporate Taxation Advisory Board 16 January 2014

• J. Brian Davis

Ivins, Phillips & Barker Chtd. Devon M. Bodoh KPMG LLP

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Agenda

• Background
• Allocation of E&P in corporate separations
• Corporate separations involving a CFC
• Proposed regulations impacting allocation of E&P in cross-border

corporate separations

• Policy issues

Background

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Background – Significance of E&P

• Earnings and profits (E&P) is primarily relevant for determining

whether a distribution from a corporation to its shareholders is taxed as a dividend

• It is a shareholder relevant attribute
• If the amount of the distribution exceeds the corporation’s E&P, the excess

is treated as a return of basis (to the extent of such basis) and then as an exchange of stock subject to taxation as a capital gain

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Background – Significance of E&P (cont.)

• In the international context, E&P is also used to determine the taxation
• f dispositions of the stock of foreign corporations under sections

367(b) and 1248

• The purpose of these provisions is to ensure previously untaxed E&P of

a controlled foreign corporation (CFC) is taxed in the US

• Dispositions of a foreign corporation’s stock governed by these two

provisions may result in income that is taxed as a dividend depending

• n the CFC’s E&P

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Background – Tax-Free Separations Under Section 355

• Section 355: Basic tax-free corporate separation requirements
• Non-tax business purpose
• Active trade/business conducted by both distributing and controlled
• At least 80% voting power and at least 80% total number all other classes
• f controlled held by distributing immediately prior to distribution and is

distributed in separations

• Separation not a device for distribution of E&P of distributing or controlled
• Certain continuity requirements satisfied
• Section 355(d) – distribution is not a “disqualified distribution”
• Section 355(e) – no prohibited 50%-or-greater acquisitions of stock of

distribution or controlled in connection with separation

• Section 355(g) – neither distributing nor controlled is a “disqualified

investment company”

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Background – Tax-Free Separations Under Section 355 (cont.)

Distributing Controlled Distributing Controlled

Spin off

SH SH

• If Distributing’s distribution of stock of

Controlled to Distributing’s SH (a spin-off) satisfies the requirements of Section 355, the following US fed. income tax consequences are expected to occur:

• No gain / loss to Distributing on distribution of

Controlled stock

• No income to Distributing’s SHs on receipt of

controlled stock

• Distributing’s SHs’ stock basis in Distributing

allocated between Distributing and Controlled stock

• Distributing’s E&P allocated between Distributing

and Controlled

• Special rules may apply in cross-border context

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Background – Tax-Free Separations Under Section 355 (cont.)

• Tax-free corporate separations under section 355 generally take one of

two general forms:

• A distribution of Controlled not preceded by a contribution of assets

(Standalone 355 Transaction)

• A distribution of Controlled preceded by a contribution of assets from

Distributing to Controlled under Section 368(a)(1)(D)/Section 355 (D/355 Transaction), further categorized where:

• Controlled is newly-formed
• Controlled is an existing subsidiary

General Allocations of E&P in Corporate Separations

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General Allocations of E&P – Background

• The section 312 regulations provide rules for adjusting the E&P of

Distributing and Controlled in a corporate separation:

• D/355 Transaction – Distributing’s E&P generally allocated between

Distributing and Controlled

• Standalone 355 Transaction – Distributing’s E&P is reduced and Controlled’s

E&P is potentially increased

• A deficit in E&P is never allocated to Controlled

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General Allocations of E&P – D/355 Involving Newco

• E&P allocation in a D/355 Transaction
• Controlled is Newco – E&P is allocated proportionately between Distributing

and Controlled based on the relative FMVs of their businesses immediately after the separation

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General Allocations of E&P – Ex. of D/355 Involving Newco

Distributing Controlled Distributing Controlled SH SH

• Facts
• Prior to the transaction, Distributing’s SH owned

100% of the stock of Distributing

• Distributing had $60 of E&P and business

assets with FMV of $40

• Step One – Distributing forms Controlled by

transferring business assets with a FMV of $20 to Controlled for Controlled stock in D-reorg

• Step Two – Distributing distributes the Controlled

stock to Distributing’s SH in a spin-off

• Distributing’s E&P allocated between Distributing

and Controlled

• Analysis
• Since Controlled is a Newco, Distributing’s E&P is

allocated proportionately based on FMV of assets

• Thus, $30 of Distributing’s E&P (50%) is allocated

to Controlled; $30 remains with Distributing

Spin off

• f Controlled

 

$20 of D assets Controlled stock FMV: $40 E&P: $60

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General Allocations of E&P – D/355 Involving Oldco

• E&P allocation in a D/355 Transaction
• Controlled is Oldco – “In a proper case, allocation shall be made between

the distributing corporation and the controlled corporation in proportion to the net basis of the assets transferred and the assets retained or by such

• ther method as may be appropriate.” Treas. Reg. Section 1.312-10(a)
• Net basis – the basis of the assets less liabilities assumed or

liabilities to which such assets are subject

• This rule does not expressly provide which transactions it covers,

and the scope of the term “in a proper case” is unclear

• The preamble to the proposed regulations under Section 367(b) (discussed

later) takes the position that this regulation does not address the allocation

• f E&P in a D/355 Transaction involving an Oldco
• If this is true, what transactions does the “in a proper case” language refer to?

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General Allocations of E&P – Ex. of D/355 Involving Oldco

Distributing Controlled Distributing Controlled SH SH

• Facts
• Distributing has two business assets (excluding the

Controlled stock) with equal values of $20. Distributing contributes one of the assets, which has a basis of $10, to Controlled and retains other asset, which has basis of $30

• Additionally, prior to transaction (i) Controlled has

business assets with a value and basis of $20 (thus, the Controlled stock has a value of $20), (ii) Distributing has $60 of E&P, and (iii) Controlled has no E&P

• Analysis
• If this is the “proper case” requiring allocation based on

net basis, $15 of the E&P is allocated to Controlled (25%

• r $10/$40) and the remaining $45 stays with Distributing
• If this is not the proper case, how is E&P allocated?
• FMV of the assets?
• Hybrid Approach (discussed later) under the

proposed Section 367(b) regulations?

Spin off

• f Controlled

 

$20 of D assets Controlled stock Starting FMV: $20 Starting Basis: $20 Starting E&P: $0 FMV: $20/$20 Basis: $10/$30 Starting E&P: $60

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General Allocations of E&P – Standalone 355 Transaction

• E&P allocation in a Standalone 355 Transaction
• Distributing – The E&P of Distributing is decreased by the lesser of:
• The amount by which the E&P of the distributing would have been

decreased if it had transferred the stock of Controlled to a Newco in a D/355 Transaction, or

• The net worth of Controlled (i.e., the sum of the basis of all of the

properties plus cash minus all liabilities)

• Controlled – if the E&P of Controlled immediately before the transaction is

less than the amount of the decrease in E&P of Distributing (including a case in which Controlled has a deficit), the E&P of Controlled will be equal to the amount of the decrease. Otherwise, Controlled’s E&P remains unchanged

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General Allocations of E&P – Ex. of Standalone 355 Txn.

Distributing Controlled Distributing Controlled SH SH

• Facts
• Prior to the transaction, Distributing’s SH owned 100% of

the stock of Distributing which has E&P of $100 and assets (not including the Controlled stock) with a FMV of $120

• Assume Controlled’s net worth is at least $25
• Distributing owns 100% of the Controlled stock, which

has a FMV of $40 and E&P of $15

• Distributing distributes the Controlled stock to

Distributing’s SH

• Analysis
• Distributing’s E&P is reduced by $25, which is the amount

its E&P would have decreased if it had contributed the Controlled stock to a Newco ($40/$160 or 25%, multiplied by $100)

• Because Controlled’s E&P is less than the amount of the

reduction, its E&P is increased to $25

Spin off

• f Controlled

FMV: $40 E&P: $15 FMV: $120 E&P: $100

Separations Involving a CFC (Distributing or Controlled)

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Separations Involving a CFC – Generally

• Significance of E&P and CFCs
• Separations involving a CFC have the potential to terminate a CFC’s status as

a CFC (generally in a non-pro rata distribution)

• Separations involving a CFC may “bail out” previously untaxed E&P of

Distributing to Controlled and potentially shift such earnings outside of the US tax system

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Separations Involving a CFC – Section 1248 General Rule

• If a US person owns more than 10% of the voting stock of a foreign

corporation at any time during the 5-year period (ending on the date of the sale) when the foreign corporation was a CFC, gain recognized on the sale or exchange of such stock is treated as a deemed dividend to the extent of the foreign corporation’s E&P attributable to such stock

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Separations Involving a CFC – Where Distributing is a CFC

• The section 367(b) regulations contain a regime for ensuring untaxed

E&P is taxed in the US with regard to certain corporate separations involving a CFC

• If a CFC distributes either US or foreign Controlled stock in a tax-free

separation under section 355

• The distributee shareholder compares pre- and post-distribution “Section 1248

Amounts” (defined below) as to stock of the distributing CFC and, if applicable, the foreign Controlled

• To the extent the distribution causes a reduction in the Section 1248 Amount
• f the relevant CFC, the distributee makes basis adjustments and/or has income

inclusion (i.e., deemed dividend)

• There are different calculations for spin-offs (pro rata) and split-offs (non-pro rata)

distributions

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Separations Involving a CFC – Relevant Definitions

• Relevant sections 1248 and 367(b) definitions
• Section 1248 Amount – net positive E&P that would have been includible in

income as a dividend under section 1248 if the stock was sold by the SH

• Pre-Distribution Amount – Distributees Section 1248 Amount computed

immediately before the distribution, but only to the extent attributable to Distribution and/or Controlled (as applicable)

• Distributing’s Pre-Distribution Amount determined on stand-alone basis
• Post-Distribution Amount – Distribtuee’s Section 1248 Amount with respect

to Distributing and/or Controlled stock (as applicable) computed immediately after the distribution

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Separations Involving CFCs – Ex. Spin-Off

FD FC FD FC SH USS

• Facts
• USS owns 40% of stock of FD (a CFC)
• FD owns 100% of FC
• USS has a $80 basis in its FD stock, which has FMV $200
• On stand-alone basis, FD has FMV of $250 and E&P $0
• On stand-alone basis, FC has FMV of $250 and E&P $300
• FD makes pro-rata distribution of FC stock
• USS receives FC stock worth $100 (i.e., 40%)
• Application in respect of FC
• Pre-distribution Section 1248 Amount: $120
• If USS had sold its FD stock, it would have recognized $120 gain,

all of which would have been treated as a dividend under section 1248 and all of which attributable to FC’s E&P

• Post-distribution Section 1248 Amount: $60
• Value of FC stock received: $100
• Post-distribution basis in FC stock: $40
• Deemed dividend under section 1248 if FC stock sold: $60
• USS must reduce its basis in FC stock from $40 to $0, and

include $20 in income as a deemed dividend

Spin off

• f FC

FMV: $250* E&P: $300* CFC FMV: $200 Basis: $80 40% FMV: $250* E&P: $0* * Computed on stand-alone basis CFC

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Separations Involving CFCs – Ex. Spin-Off (cont.)

FD FC USS

• Application in respect of FD
• Pre-distribution Section 1248 Amount: $0
• Post-distribution Section 1248 Amount: $0
• Although USS would recognize gain if it sold its FD stock, no gain

would be treated as a dividend under section 1248 (since FD has no E&P attributable to it)

• Since the amounts are the same, no deemed dividend or

basis reduction

• USS increases its basis in FD stock by $60 (i.e., basis reduction

and deemed dividend with respect to FD stock)

Spin off

• f FC

FMV: $250* E&P: $300* CFC FMV: $200 Basis: $80 40% FMV: $250* E&P: $0* * Computed on stand-alone basis

FD FC SH

CFC

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Separations Involving CFCs – Ex. Split-Off

FD FC FD FC US1

• Facts
• US1 and US2 each own 50% of FD (a CFC), worth $750/ea
• Both US1 and US2 have a $500 basis in their shares
• On stand-alone basis, FD has a FMV of $750 and $0 E&P
• On stand-alone basis, FC has a FMV of $750 and $500 E&P
• In a non-pro rata distribution, FD distributes the FC stock

to US2 in exchange for its FD stock

• Application in respect of US1
• FC stock
• Pre-distribution Section 1248 Amount: $250
• Post-Distribution Section 1248 Amount: $0
• US1 must include $250 in income as a deemed dividend
• Unlike pro-rata distribution, no basis adjustment
• FD stock
• Pre-Distribution Section 1248 Amount: $0
• Post-Distribution Section 1248 Amount: $0
• No deemed dividend. US1 increases basis in FD stock by $250

Split off

• f FC

FMV: $750* E&P: $500* CFC FMV: $750 Basis: $500 50% FMV: $750* E&P: $0* * Computed on stand-alone basis

US2

50%

US1 US2

CFC

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Separations Involving CFCs – Ex. Split-Off (cont.)

• Application in respect of US2
• FC stock
• Pre-distribution Section 1248 Amount: $250
• Post-Distribution Section 1248 Amount: $250

(i.e., amount of gain treated as a deemed dividend if US2 had sold FC stock immediately after)

• Since no difference, no deemed dividend
• FD stock
• Pre-Distribution Section 1248 Amount: $0
• Post-Distribution Section 1248 Amount: $0
• Since no difference, no deemed dividend

FD FC FD FC US1

Split off

• f FC

FMV: $750* E&P: $500* CFC FMV: $750 Basis: $500 50% FMV: $750* E&P: $0* * Computed on stand-alone basis

US2

50%

US1 US2

CFC

Proposed Regulations Impacting E&P Allocation in Cross-Border Separations

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E&P Allocations in CB Section 355s – Generally

• The current final regulations under section 367(b) related to a separation

involving either a foreign Distributing or a foreign Controlled mandate an income inclusion that is dependent on the allocation of E&P in a cross-border

• separation. These regulations do not otherwise modify the application of the

section 312 regulations

• The preamble to these regulations state that “forthcoming proposed regulations will more fully

consider the allocation of E&P in section 355 distributions where either (or both) the distributing

• r controlled corporation is a foreign corporation.” It further provides that “[u]ntil the IRS and

Treasury promulgate such regulations, taxpayers should use a reasonable method (consistent with existing law and taking proper account of the purposes of the foreign tax credit regime) to determine the carryover and separation of [E&P] and related foreign taxes.” TD 8862 (Jan. 2000)

• In late 2000, proposed regulations on E&P were issued. See REG-116050-99 (Nov. 2000)
• Despite somewhat recent activity in the area, the 2000 proposed regulations on E&P have not

been updated. See, e.g., TD 9273 (Aug. 2006) (“The Treasury…and the IRS believe that relevant cross-border tax consequences of section 355 transactions [(e.g., E&P)] should be dealt with in a separate guidance project.”)

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E&P Allocations in CB Section 355s – 2000 Proposed E&P Regs.

• Prop. Treas. Reg. Section 1.367(b)-8
• As noted earlier, proposed regulations under section 367(b) were issued in 2000

relating to the allocation of E&P in a cross-border separation – where either or both Distributing or Controlled are foreign corporations (2000 Proposed E&P Regulations)

• The 2000 Proposed E&P Regulations confirm that section 312 regulations generally

apply to corporate separations involving a foreign Distributing or Controlled, but modify the application of the section 312 regulations

• For instance, allocations of E&P in both a D/355 Transaction and a Standalone 355

Transaction use net basis (not FMV) for making calculations

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2000 Proposed E&P Regs. – D/355 Transactions

• In a D/355 Transaction involving Oldco Controlled, E&P is allocated

using the following “Hybrid Approach”

• Distributing’s E&P is reduced by the sum of (a) the reduction relating to the assets

transferred in the D/355 Transaction, and (b) the reduction that would occur relating to the assets held by Controlled prior to the D/355 Transaction

• In this scenario, Controlled’s E&P is increased only by the amount of the reduction in

(a) above

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2000 Proposed E&P Regs. – Ex. of D/355 Txn. with Oldco

FD FC FD FC SH SH

• Facts
• FD has two business assets (not including the FC stock)

with equal values of $20. FD contributes one of the assets, which has a basis of $10, to FC (an oldco) and retains the other asset, which has a basis of $30

• Additionally, prior to transaction (i) FC has business assets

with a value and basis of $20 (thus, the FC stock has value

• f $20), (ii) FD has $60 of E&P, and (iii) FC has no E&P
• Analysis
• Under the 2000 Proposed E&P Regulations, FD’s E&P

would be reduced by $35, which is the sum of:

• $10 – the reduction that would occur under Treas.
• Reg. Section 1.312-10(a) relating to the assets

transferred in the D/355 and

• $20 – the reduction that would occur under Treas.
• Reg. Section 1.312-10(b) relating to the assets held by

FC ($20/$60 (33%) multiplied by $60)

• FC’s E&P would only be increased by $10

Spin off

• f FC

 

$20 of FD assets FC stock Starting FMV: $20 Starting Basis: $20 Starting E&P: $0 FMV: $20/$20 Basis: $10/$30 Starting E&P: $60

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2000 Proposed E&P Regs. – Standalone 355 Transactions

• In a Standalone 355 Transaction E&P is dealt with as follows
• Distributing’s E&P must be reduced by the decrease in E&P that would have occurred

if Controlled was transferred to a Newco in a D/355 Transaction

• Controlled’s E&P is not increased under any circumstances

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2000 Proposed E&P Regs. – Ex. of Standalone 355 Txn.

FD FC FD FC SH SH

• Facts
• FD has owned 100% of FC stock more than 5 years
• The FC stock owned by FD is worth one-half of the FMV of

FD’s net assets

• FD’s basis in FC stock is $30 or one-half of the net basis of

all of FD’s assets (including FC stock)

• Each of FD and FC has $60 of E&P and the net basis of FC’s

assets equals or exceeds $60

• Analysis
• Under the 2000 Proposed E&P Regulations, FD’s E&P

would be reduced as if FC were transferred to a Newco in a D/355 Transaction

• Accordingly, FD’s E&P is reduced proportionately based on the

net basis of the assets of FC and the net basis of all of the assets

• f FD. In this case, FD’s E&P reduction would be $30
• However, FC’s E&P would not be increased, and thus

remains $60

Spin off

• f FC

FMV: $30 Net Basis: ≥ $60 E&P: $60 FMV: $60 Net Basis: $60 E&P: $60

Policy Issues

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Policy Issues – Generally

• Authority regarding E&P allocations in corporate transactions,

particularly in corporate separations under section 355, historically focuses on anti-abuse (i.e., ensuring that a transaction does not prevent the taxation of E&P)

• The Treas. Reg. Section 1.312-10 approach generally reduces

Distributing’s E&P but only increases Controlled’s E&P in certain circumstances (this limited increase generally is to prevent the duplication of E&P)

• For example, in a Standalone 355 Transaction, the decrease in Distributing’s E&P does

not necessarily coincide with an increase of the same amount in Controlled’s E&P

• Thus, there is the potential for a “bail-out” of Distributing’s E&P

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Policy Issues – 2000 Prop. E&P Regs. & Immediate Income

• The 2000 Proposed E&P Regulations attempt to rectify the continued

“bail-out” problem by causing an immediate income inclusion to a CFC’s section 1248 shareholders

• Under the 2000 Proposed E&P Regulations, as described in the Hybrid Approach

and Standalone 355 Transaction examples above, a portion of Distributing’s E&P disappears and results in an income inclusion of such reduction under section 367(b)’s mechanism of using Section 1248 Amounts

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Policy Issues – Appropriateness of Income Inclusion

• The 2000 Proposed E&P Regulations’ immediate income inclusion is a

severe and broad penalty, especially with regard to non-abusive transactions

• This immediate income inclusion occurs even in transactions where the

section 1248 shareholders have not reduced their interest in a CFC

• Such section 1248 shareholders arguably would still be subject to tax on the

previously untaxed E&P

• Thus, any allocation of E&P should reflect this future taxation and defer a recognition of

income until such a shareholder’s interest in the untaxed E&P has been eliminated

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Policy Issues – Alternative Approach

• Even in a regime where Distributing’s E&P continues to be reduced

without a commensurate increase to Controlled’s E&P, there are less harsh solutions to solve the “bail-out” problem

• For example, a reduction of a section 1248 shareholder’s basis in Distributing’s stock

similar to the mechanism used to adjust basis when there is a reduction in a section 1248 amount (without the attendant income inclusion)

• Such an approach preserves the ability to tax a CFC’s E&P while deferring recognition

to a more appropriate recognition event

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Circular 230 Disclaimer

This document was not intended or written to be used, and cannot be used, for the purpose of avoiding US federal, state

• r local tax penalties