Traps for the Unwary in Loss Recapture
By Dirk J.J. Suringa, Esq.
Covington & Burling LLP, Washington, DC
One item to check off in planning international M&A
transactions is overall foreign loss (“OFL”) recapture,
which can override what would otherwise be tax-free treatment of a
foreign nonrecognition transaction. This commentary discusses how
complicated it has become in recent years to check loss recapture off
the list.
First, the basic trap for the unwary. Section 904(f)(3) requires
recapture of a taxpayer's OFL account even when the transaction in
question would not otherwise be taxable. When the foreign
manufacturing branch of a U.S. corporation incurs a general category
loss, for example, the U.S. corporation can claim the benefit of that
loss on its U.S. tax return, which generates an OFL. If the same
taxpayer later incorporates the branch, contributing to a new foreign
subsidiary property that, if sold, would produce general category
income, then the taxpayer must recognize that gain, notwithstanding
§§351 and 367(a)(3)(A). The rationale for making tax-free
transactions into taxable transactions is that the transferred
property was supposed to produce foreign-source income that the OFL
recapture rules would have converted into U.S.-source income in order
to recapture the benefit of the foreign loss. If the property instead
leaves the U.S. tax system in a tax-free transaction, then recapture
of the taxpayer's U.S. tax benefit might be delayed or even
forgiven.
A somewhat more obscure but no less parlous trap is separate
limitation loss (“SLL”) recharacterization under
§904(f)(5)(F). This provision also overrides nonrecognition
treatment by applying rules “similar to” §904(f)(3),
but it does so merely to recharacterize one category of foreign-source
income as another. An SLL is a foreign-source loss in one foreign tax
credit limitation category that offsets positive foreign-source income
in the other category. For example, a foreign manufacturing (general
category) loss might offset the taxpayer's foreign investment (passive
category) income. Under the general SLL recapture rule, later
foreign-source general category income would be converted into
foreign-source passive category income, up to the amount of the
offset.
The purpose of SLL recharacterization is not to reverse a U.S. tax
benefit but rather to preserve the separateness of the separate
limitation categories and prevent cross-crediting over time. Whatever
the reason, by incorporating rules “similar to”
§904(f)(3), §904(f)(5)(F) overrides nonrecognition treatment
of a transaction that would otherwise have produced income in the loss
category. Checking OFL recapture off the list really also means
checking SLL recapture off the list. Nevertheless, clients may have a
harder time spotting this trap than the OFL recapture trap: clients
usually know whether they are making money abroad or losing money
abroad, but if they are making money abroad they may not automatically
know that their net foreign-source income includes an SLL.
Before the 2004 Act, OFL and SLL recapture applied to the transfer
of active foreign business assets, which generally did not include
stock. The 2004 Act extended OFL and SLL recapture to cover gain from
the transfer of the stock of majority-owned CFCs. The stated reason
for the expansion was that interest expense allocated against the CFC
stock could lead to an OFL, and recapture of the OFL might not occur
if the taxpayer could transfer the CFC stock to an unrelated party in
a tax-free transaction.1 SLL
recapture went unmentioned in the legislative history, but it tagged
along in the statutory cross-reference of §904(f)(5)(F).
Section 904(f)(3)(D) thus overrides nonrecognition treatment on the
transfer of the stock of a majority-owned CFC. There are two
exceptions for internal restructurings. First, the
nonrecognition-override rule generally does not apply to §351 or
§721 contributions, or to other exchange-basis transactions, but
only if the transferor owns the same percentage in the CFC before and
after the transaction. The requirement of ownership parity before and
after the transaction is a pretty significant limitation for joint
ventures between unrelated parties. Second, the
nonrecognition-override rule does not apply to the acquisition of CFC
assets by the taxpayer or an affiliated group member in a §332
liquidation or a §368(a)(1) asset acquisition. For this purpose,
however, the affiliated group appears to include only U.S.
corporations “filing a consolidated return under section
1501.” Liquidation of one foreign corporation into another thus
can implicate SLL recapture and the nonrecognition-override rule, at
least according to the legislative history of
§904(f)(5)(F).2
The complexity does not end here, unfortunately. Taxpayers only are
required to recapture an OFL or recharacterize an SLL if they earn
income in the former loss category. For example, if a taxpayer has a
general category SLL with respect to the passive category, subsequent
passive category income is not recharacterized. Only general category
income has to be recharacterized as passive category income. Thus,
there would be no override of nonrecognition treatment if the taxpayer
transferred an asset with built-in passive category gain.
In the context of §904(f)(3)(D), this principle means that the
taxpayer must determine the limitation category of the income that
would have been recognized had it sold the CFC stock, in order to know
whether OFL recapture or SLL recharacterization will override
nonrecognition treatment. The sale of CFC stock typically produces
passive category gain, because such gain is foreign personal holding
company income, unless the §904 high-tax kick-out
applies.3 However, the gain might
have been subject to §1248 or §964(e), and thus some or all
of the gain might have been treated as a dividend.
The §904(d)(3)(D) look-through rule typically would apply to
determine the limitation category of such a dividend. Hence, a
taxpayer's entitlement to tax-free treatment of its CFC stock transfer
may depend not only on the amount of the realized gain, but also the
relative amounts of general and passive category earnings in the CFC's
post-1986 earnings pools. When a taxpayer with a passive category SLL
contributes its wholly-owned CFC to a foreign joint venture
corporation in exchange for an 80% controlling interest, it must
determine how much of the realized gain would be covered by a deemed
dividend of general category earnings. It may be that in this case an
asset transaction would work better than a stock transaction in
preserving deferral.
This commentary also will appear in the April 2009 issue of
the Tax Management International Journal. For more information,
in the Tax Management Portfolios, see Suringa, 904 T.M., The
Foreign Tax Credit Limitation Under Section 904, and in Tax
Practice Series, see ¶7130, U.S. Persons -- Foreign
Activities.
1
See S. Rep. No. 108-192, at 172 (2004).
2
See S. Rep. No. 99-313, at 323-24 (1986). In the author's view, this is the type of transaction that should be excluded from nonrecognition override, under the regulatory authority granted by §904(f)(5)(F), because it extends preservation of the separate limitation categories beyond the realm of administrability.
3
See §§904(d)(2)(B), 954(c)(1)(B).
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