Tax

Introduction

On December 28, 2023, the Internal Revenue Service (“IRS”) released Notice 2024-16 (the “Notice”) announcing the intent of the Treasury Department (“Treasury”) and the IRS to issue proposed regulations addressing basis consequences under Section 961(c)¹ relating to certain inbound liquidations and asset reorganizations (collectively “Inbound Non-recognition Transactions”) whereby a U.S. corporation (the “Domestic Acquiring Corporation”) acquires from a first-tier controlled foreign corporation (“Transferor CFC”) all the stock of a second-tier controlled foreign corporation (“Acquired CFC”).

Section 961, Generally

In general, a U.S. shareholder (as defined in Section 958) of a controlled foreign corporation (“CFC”) must take into income their pro-rata share of the CFC’s Subpart F income (under Section 951) and Global Intangible Low-Taxed Income (“GILTI”) (under Section 951A).

Under Section 961(a), a U.S. shareholder increases its basis in the stock of a CFC (or stock in the foreign corporation that owns the stock of the CFC in question) in an amount equal to the Subpart F income and/or GILTI inclusion that the U.S. shareholder has included in their taxable income. When a CFC makes a distribution to a U.S. shareholder, Section 961(b)(1) states that a U.S. shareholder’s basis in the CFC stock is reduced by an amount equal to that portion of the distribution representing the previously taxed earnings and profits (“PTEP”) of the CFC that the U.S. shareholder already took into income (e.g., as Subpart F income and GILTI).  To the extent the distribution of PTEP exceeds tax basis, the U.S. shareholder must recognize gain pursuant to Section 961(b)(2).

Where a U.S. shareholder owns stock of an upper tier CFC that in turn owns stock of a lower-tier CFC, the upper tier CFC may adjust their basis in the lower tier CFC stock pursuant to Section 961(c); however such adjustments to basis are only taken into account for purposes of determining the amount included under section 951 in the gross income of such United States shareholder, e.g., the amount of gain on the disposition of lower tier CFC stock that would be included in the U.S. shareholder’s pro rata share of Subpart F income.

Under current law, it is unclear whether the Section 961(c) basis of Acquired CFC in the hands of the Transferor CFC becomes basis in the hands of the Domestic Acquiring Corporation under Section 334(b) or Section 362(b) as a result of an Inbound Non-recognition Transaction. The Treasury and IRS are concerned that it would thwart the purpose of Section 961(c) (specifically, to avoid double taxation) for the basis of the Acquired CFC to fail to carry-over to the Domestic Acquiring Corporation under this scenario.  Specifically, to the extent the Domestic Acquiring Corporation’s basis in the Acquired CFC’s stock does not reflect the PTEP of the Acquired CFC that were subject to tax in the hands of the Domestic Acquiring Corporation under Section 951(a), upon distribution of such PTEP, the likelihood that the Domestic Acquiring Corporation would pay tax a second time on the same earnings, e.g., under Section 961(b)(2), increases.

Notice 2024-16

The Notice and the new proposed regulations, reduce this risk of double taxation by providing that, as a result of certain Inbound Non-Recognition Transactions (described below and referred to as “Covered Inbound Transactions”), the Domestic Acquiring Corporation’s adjusted basis in the stock of the Acquired CFC under Section 334(b) or Section 362(b) (as applicable) will include the Transferor CFC’s Section 961(c) basis.

Covered Inbound Transactions

Section 3.02(1) defines a Covered Inbound Transaction as any of the following transactions, but only if,  prior to the transaction, the Domestic Acquiring Corporation directly owns all of the stock of the Transferor CFC (collectively, the “Upstream Transactions”):  

• a Section 332 liquidation;
• an upstream “A Reorganization” (i.e., a reorganization under Section 368(a)(1)(A) where the Domestic Acquiring Corporation is the acquirer corporation and the Transferor CFC is the target corporation); and
• an upstream “C Reorganization” (i.e., a reorganization under Section 368(a)(1)(C) where the Domestic Acquiring Corporation is the acquirer corporation and the Transferor CFC is the target corporation).  

Section 3.02(2) further expands the meaning of Covered Inbound Transaction to include the following transactions, provided that immediately before the transaction all of the stock of the Transferor CFC is owned directly by the same single domestic corporation (or by the same members of the same consolidated group) and that same single domestic corporation owns all of the stock of the Domestic Acquiring Corporation immediately after the transaction (and any related transactions):

• A Reorganizations other than upstream A Reorganizations (but excluding triangular reorganizations under Section 368(a)(2)(D) and Section 368(a)(2)(E);
• C Reorganizations other than upstream C Reorganizations (but excluding “triangular” C reorganizations);
• A “D Reorganization” (i.e., a reorganization under Section 368(a)(1)(D) provided that it satisfies the requirements of Sections 354(b)(1)(A) and (B)); and
• An “F Reorganization” (i.e., a reorganization under Section 368(a)(1)(F)).  

De Minims Exceptions

Section 3.03 provides de minimis exceptions relating to the stock ownership rules described above. 

Specifically, an Inbound Non-recognition Transaction may still qualify as a Covered Inbound Transactions notwithstanding that immediately before the transaction, one or more persons, other than the relevant domestic corporation (or members of a consolidated group as applicable) owns stock in the Transferor CFC, so long as such ownership, in the aggregate, equals 1 percent or less of the fair market value of the Transferor CFC. Additionally, a transaction can still qualify as a Covered Inbound Transaction even if immediately before the transaction and any related transactions, one or more persons other than the Transferor CFC own stock of the Acquired CFC, so long as such ownership, in the aggregate, equals 1 percent or less of the fair market value of the Acquired CFC.

Further, Section 3.04(1) provides that an Inbound Non-recognition Transaction may still qualify as a Covered Inbound Transaction notwithstanding the distribution of boot under Section 356(a) if the value of such boot property equals 1 percent or less of the total fair market value of the Transferor CFC’s stock.

Transactions That Are Per Se Not Covered Inbound Transactions

Section 3.04 outlines a number of transactions that are either specifically excluded from the definition of Covered Inbound Transaction or that cause an Inbound Non-recognition Transaction that otherwise qualifies as a Covered Inbound Transaction to fail to be so treated:

• Boot Transactions:  Inbound Non-recognition Transactions with boot (unless the de minimis rule described above applies);
• Built In Loss Transactions:  Transactions involving Acquired CFC stock that has a built in loss (taking into account Section 961(c) basis) in the hands of the Transferor CFC;
• Subsequent Transfers: Inbound Non-recognition Transactions whereby stock of the Acquired CFC is transferred either:
  • pursuant to Section 368(a)(2)(C) or Treasury Regulation Section 1.368-2(k)(1) unless the transferee is (i) a member of the same consolidated group that includes the Domestic Acquiring Corporation and wholly owned by one or more members of that same consolidated group, or (ii) the common parent of the consolidated group; or
  • pursuant to a plan (or series of related transactions), stock of the Acquired CFC is transferred to a partnership or foreign corporation (there is a two year look back period from the completion of the inbound transaction to determine if such plan exists); and
• RICs, REITs and S Corps:  Transactions involving certain types of Domestic Acquiring Corporations such as regulated investment companies (Section 851), real estate investment trusts (Section 856) or S corporations (Section 1361).

Reliance on Notice

Generally, a taxpayer may rely on the guidance in Section 3 of the Notice for any transaction completed on or before the date the proposed regulations are published in the Federal Register, provided that the taxpayer and any of its related parties satisfy the requirements of the Notice in their entirety and in a consistent manner. Additionally, the Notice indicates that no inference is intended with respect to the treatment of Section 961(c) basis in any other transactions that do not qualify as Covered Inbound Transactions. Moreover, the Treasury and IRS indicate that they will consider issuing future guidance with respect to transactions that are outside the scope of a Covered Inbound Transaction. Notably, the IRS indicated that it intends to follow the Notice with a completed, long-awaited regulatory package on PTEP in 2024.