New rules on covered asset acquisitions will shut down transactions to avoid Sec. 901(m)

In Notice 2014-44, the IRS announced that it would issue regulations to prevent taxpayers from misapplying the statutory disposition rule in cases where the gain or loss from the disposition of the relevant foreign asset (RFA) is recognized for U.S. income tax purposes but not for foreign income tax purposes.

Sec. 901(m)(1) provides that, in the case of a covered asset acquisition (CAA), the disqualified portion of any foreign income tax determined with respect to the income or gain attributable to RFAs is not taken into account in determining the Sec. 901(a) foreign tax credit, and in the case of foreign income tax paid by a Sec. 902 corporation, is not taken into account for purposes of Sec. 902 or 960. Instead, the disqualified portion of any foreign income tax is allowed as a deduction. A CAA is (1) a qualified stock purchase (as defined in Sec. 338 (Section 338 CAA)); (2) any transaction that is treated as an asset acquisition for U.S. income tax purposes and as the acquisition of stock of a corporation (or is disregarded) for purposes of a foreign income tax; (3) any acquisition of an interest in a partnership that has a Sec. 754 election in effect (Section 743(b) CAA); and (4) any other similar transaction the IRS provides.

The IRS said that certain taxpayers are engaging in transactions shortly after a CAA occurs that are intended to invoke application of the Sec. 901(m)(3)(B)(ii) statutory disposition rule to avoid Sec. 901(m)’s purpose. In the IRS’s example, USP, a domestic corporation, wholly owns FSub, a foreign corporation, and FSub acquires 100% of the FT, a foreign corporation’s stock, in a Sec. 338 qualified stock purchase. The acquisition of FT’s stock is a Section 338 CAA, and FT’s assets are RFAs with respect to that Section 338 CAA. Shortly after the acquisition of FT in the Section 338 CAA, FT becomes disregarded as an entity separate from its owner. As a result, FT is deemed, solely for U.S. tax purposes, to distribute all of its assets and liabilities to FSub in a deemed liquidation immediately before the closing of the day before the election is effective. Under Secs. 332 and 337, no gain or loss is recognized on the deemed liquidation by either FT or FSub.

The taxpayers have been taking the position that the deemed liquidation constitutes a disposition of the RFAs under Sec. 901(m)(3)(B)(ii) and that, as a result, all of the basis difference from the RFAs is allocated to FT’s final tax year that occurs because of the deemed liquidation, and that no basis difference is allocated to any later tax year. The IRS intends to issue regulations to prevent this and similar practices.

Under these regulations, for purposes of Sec. 901(m), a disposition means an event (e.g., a sale, abandonment, or mark-to-market event) that results in gain or loss being recognized with respect to an RFA for purposes of U.S. income tax or a foreign income tax, or both.

The portion of a basis difference with respect to an RFA that is taken into account for a tax year as a result of a disposition (disposition amount) will be determined pursuant to one of two rules:

1. If a disposition is fully taxable (i.e., results in all gain or loss, if any, being recognized with respect to the RFA) for purposes of both U.S. income tax and a foreign income tax, the disposition amount is equal to the unallocated basis difference.
2. If a disposition is not fully taxable for purposes of both U.S. income tax and a foreign income tax, generally there will continue to be a disparity in the U.S. basis and the foreign basis following the disposition, and it is appropriate for the RFA to continue to be subject to Sec. 901(m). To the extent that the disparity in the U.S. basis and the foreign basis is reduced as a result of the disposition, however, some or all of the unallocated basis difference should be taken into account.

The regulations will also include special rules for a Sec. 743(b) CAA and rules concerning the continuing application of Sec. 901(m) to the remaining basis difference.

The regulations described in the notice will generally apply to dispositions occurring on or after July 21, 2014. 

— Sally P. Schreiber ( sschreiber@aicpa.org ) is a JofA senior editor.