The IRS has recently issued proposed regulations under Code Section 362(e)(2) dealing with one part of the anti-loss importation and duplication regime enacted as part of the American Jobs Creation Act of 2004.
The proposed regulations address only the loss duplication rules and not the loss importation rule of Code Section 362(e)(1). The two statutory provisions are closely related with each having an impact on the other.Background
Under general tax principles, if an asset is acquired by a U.S. person in a tax-free carryover basis transaction from a foreign person not subject to U.S. income tax, the U.S. person determines its basis in the asset by applying U.S. tax concepts to the foreign person as if the foreign person were a full U.S. taxpayer during its holding period for the asset. Code Section 362(e)(1), however, marks to market (up or down) the basis of each asset imported into the United States in what would otherwise be tax-free carry over basis transactions described in either Sec. 362(a) or 362(b) if the aggregate adjusted bases of the assets transferred in the transaction exceed their fair market value at the time of the transfer, thus putting a stop to aggressive loss importation.
Code Section 362(e)(2), which is the focus of the proposed regulations, is designed to prevent loss duplication in inside asset basis and outside stock basis as a result of transfers described in Code Section 351 (or through contributions to capital) where the transaction is not subject to the anti-loss importation rule. Code Section 362(e)(2) provides that if the aggregate adjusted bases of transferred property in the hands of the transferee corporation exceed their aggregate fair market value, the bases of the assets will be stepped down so that the aggregate adjusted basis of the assets equals their aggregate fair market value. The basis reduction is allocated among the transferred property in proportion to the built-in loss in each item of property. The transferor and the transferee may make an irrevocable election to apply the basis reduction to the transferee stock received by the transferor leaving the transferee with the built-in loss basis of the transferred assets.
Section 362(e)(2) refers to transactions described in Sec. 362(a) (i.e., transactions described in Code Section 351 and capital contributions), not Code Section 362(b), which refers to transfers pursuant to a reorganization. The statute does not address transactions that are described in both Code Section 362(a) and (b) such as a transaction that qualifies as good tax-free Code Section 351 transaction and a B reorganization. The proposed regulations confirm that Code Section 362(e)(2) is applicable in these situations.
Multiple Transferors and Multiple Assets
The proposed regulations clarify gaps in the statute regarding transactions involving multiple transferors and/or multiple assets. With respect to multiple assets, the proposed regulations provide that recognized gain is taken into account “in order to determine the full amount of the loss duplication” by increasing the basis of the transferred assets for purposes of the Code Section 362(e)(2) formula. Thus, in determining whether the aggregate bases of the assets transferred exceeds their fair market value, gain recognized in the transaction is added to the aggregate asset basis.
In the case of multiple transferors, Code Section 362(e)(2) is to apply separately on a transferor by transferor basis (and to the separate property transferred by each). One could well imagine a group of transferors in a transaction qualifying as a good tax-free Code Section 351 exchange combining built-in gain and built-in loss assets to avoid the rule. The response is that each transferor is addressed separately. The proposed regulations also address the interplay between Code Sections 362(e)(1) and 362(e)(2) – a potentially difficult problem in light of the multiple transferors rule. The proposed regulations provide that a single transaction may be bifurcated with Code Section 362(e)(2) applying to some parts of the transaction and Code Section 362(e)(1) applying to other parts of the transaction.
Elective Procedure to Reduce Stock Basis
The proposed regulations contain a comprehensive procedure relating to the transferor and transferee election to reduce stock basis rather than inside asset basis in the case of a loss duplication transaction governed by Code Section 362 (e)(2). The proposed regulations, however, comment upon an apparent ambiguity in the statute. Code Section 362(e)(2)(C) provides that, if the election is made, the transferor’s basis in the transferee’s stock will not exceed its fair market value. Since it is possible that the basis reduction in the stock (or securities) could be larger than the required reduction in the bases of the assets received by the transferee corporation (the preamble cites the example involving contingent liabilities), the proposed regulations make clear that the amount of the stock (or securities) basis reduction is to be no greater than the basis reduction in the hands of the transferee corporation otherwise required under Code Section 362(e)(2), i.e., the stock basis reduction is to equal the asset basis reduction under the general rule.
The proposed regulations also deal with the mechanics of the procedure, including the due date for filing the elections in the case of transactions that may have occurred prior to their becoming relevant and entering into the U.S. system. The proposed regulations also formally adopt the “protective election” in Notice 2005-70. The latter is particularly important for taxpayers who are not clear whether Code Section 362(e)(2) applies to a particular transaction.Application of Code Section 362(e) to Transactions Not Involving U.S. Taxpayers
The proposed regulations confirm that Code Section 362(e)(2) applies in determining basis of property that is not owned by a U.S. taxpayer. If such property is brought into the U.S. tax system in a carryover basis transaction, “basis” is determined by applying U.S. principles to the holder even though the transaction was not subject to U.S. income tax at the time. While this principle is difficult to apply in many circumstances, Code Section 362(e)(2) threatened an administrative nightmare (e.g., property that had been transferred among members of a controlled group in a series of off shore capital contributions will need to be valued at each transfer date to determine if basis should have been stepped down).
The proposed regulations adopt a rule of convenience that applies generally to transactions that occurred more than two years before the property at issue was brought into the U.S. tax system. The presumption is that at the time of the transaction the aggregate fair market value of the transferred property was equal to the aggregate adjusted bases of such property in the hands of the transferee and thus code Section 362(e)(2) is inapplicable. On the other hand, Treasury and the IRS concluded that the administrative burden in respect of transactions occurring within two years of coming into the U.S. tax system is manageable. The presumption is overridden for a transaction undertaken for tax avoidance purposes. It is also inapplicable if the transaction that caused the property to enter the U.S. tax system was undertaken with a tax avoidance motive.
The presumption that fair market value equals basis in transactions occurring more than two years prior to the date property is brought into the United States is a welcome rule. It may be the first instance in which the rule requiring U.S. rules to be applied to determine basis of property brought into the U.S. has been formally relaxed. Nonetheless, other aspects of the regulations may need additional guidance, such as the inconsistent application of Code Section 362 to different transferors.