Rev. Rul. 80-293

ISSUE

Upon a foreign partnership's incorporation of its business, is the amount of ordinary foreign source income that United States persons are required to include in their income in accordance with Rev. Rul. 78-201, 1978-1 C.B. 91, limited to the amount of losses incurred by the partnership after United States persons purchased their partnership interests?

FACTS

P, a foreign partnership that was organized 10 years ago, was engaged in the farming business on land in foreign country Z. A, B, C, and X own percentage interests in P of 63, 7, 10, and 20, respectively, the percentage interests being in both capital and profits. A and B are individuals and are United States residents, C is a nonresident alien individual, and X is a domestic corporation. A and B acquired their partnership interests in 1977, in a bona fide purchase, from unrelated parties who were United States residents. X and C acquired their partnership interests when P was originally formed.

P decided to incorporate its farming business in country Z to benefit from certain tax incentives in country Z. Accordingly, in 1978, P transferred all of the assets associated with its farming business to Y, a newly-formed country Z corporation, solely in exchange for all of the stock of Y and Y's assumption of all of the liabilities associated with the farming business. The fair market value of, and P's basis in, its assets transferred to Y exceeded the sum of the liabilities assumed by Y. P remained in existence and retained certain export licenses and the stock of Y.

Prior to 1977, P incurred net losses that were passed through as deductions to the partners and reduced their basis in the partnership and their other income. For the period subsequent to the purchase of the partnership interests by A and B, P had net profits which were included in income by A, B, and X in proportion to their respective interests.

The transfer of assets in exchange for stock would have fulfilled all of the requirements of section 351 of the Code had the transferee been a domestic corporation. The transfer met the requirements of section 3.02(1) of Rev. Proc. 68-23, 1968-1 C.B. 821. Further, within 183 days of the beginning of the transfer the taxpayer requested a ruling from the Internal Revenue Service that the transaction was not in pursuance of a plan of tax avoidance within the meaning of section 367.

LAW AND ANALYSIS

The applicable Code sections are section 351(a), relating to the nonrecognition of gain or loss on the transfer of property to a corporation controlled by the transferor, and section 367(a)(1), relating to the requirement that a ruling be obtained that an exchange described in section 351 is not in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes in order for a foreign corporation to be considered a corporation for purposes of determining gain on the transfer.

The applicable sections of the Temporary Income Tax Regulations are section 7.367(a)-1(b)(3)(i), which provides that a "transfer described in section 367(a)(1)" of the Code is a transfer of property made by a United States person, directly or indirectly, to a foreign corporation in connection with an exchange described in section 351, and section 7.367(a)-1(b)(3)(iii), which provides that a transfer by a foreign partnership in which a United States person holds an interest shall be considered to have been made by any such United States person who realizes gain or other income (whether or not recognized) on account of the transfer.

Pursuant to section 7.367(a)-1(b)(3)(iii) of the Temporary Regulations, A, B, and X are considered to have made the transfer of property to Y that P made. Since the transfer is described in section 351 of the Code and the transfer of property was made indirectly by a United States person (A, B, and X) to a foreign corporation (Y), the transfer is described in section 367(a)(1). Unless it is established that the transfer to Y was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes, then, pursuant to section 367(a)(1), Y will not be considered to be a corporation for purposes of determining gain recognized on the transfer. The transfer of property to Y qualifies for nonrecognition of gain to P under section 351 (thus no gain is passed through to the partners) if Y is considered to be a corporation.

Rev. Rul. 78-201 required the United States transferor to include in income an amount of ordinary foreign source income (the sum of branch losses previously incurred) as a condition for obtaining a ruling that the exchange was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes within the meaning of section 367(a)(1) of the Code. In the instant situation, the acquisition by A and B in 1977, through a taxable sale, of their 70 percent interest in P's capital and profits created a new partnership for federal income tax purposes. See section 708(b)(1)(B) of the Code. Since P had only net profits during the period subsequent to the purchase of their partnership interests by A and B, those partners did not have any partnership losses from P prior to the incorporation.

X acquired its partnership interest in P 10 years ago. The losses incurred by the foreign farming business of P prior to 1977, and prior to its incorporation, were taken into account by X in proportion to its partnership interest and reduced the amount of X's worldwide income subject to federal income tax. As a result of the incorporation of the foreign farming business of P, the income to be produced by these operations will not be taken into account by X, and thus will not increase the amount of X's worldwide income subject to federal income tax. Accordingly, the transfer by P of all of the assets associated with its farming business to Y will be deemed not to be in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes within the meaning of section 367(a)(1) of the Code only if X (who is considered to be a transferor by application of section 7.367(a)-1(b)(3)(iii) of the Temporary Regulations), pursuant to Rev. Rul. 78-201, recognizes as gain on the transfer an amount of ordinary foreign source income equal to its proportionate share of the sum of the foreign country Z losses previously incurred by P.

HOLDING

Since P incurred only net profits after A and B became partners in a taxable sale or exchange, and thus A and B were unable to utilize P's net losses, Rev. Rul. 78-201 does not require A and B to include the sum of P's prior losses in their income as ordinary foreign source income. However, since X utilized P's net losses, Rev. Rul. 78-201 requires X to recognize as gain on the transfer an amount of ordinary foreign source income equal to X's proportionate share of the sum of the foreign country Z losses previously incurred by P as a condition for obtaining a ruling under section 367(a)(1) of the Code. In addition, X's basis in P, P's basis in the Y stock, and Y's basis in the assets received are increased by the amount of gain that X recognizes, pursuant to Rev. Rul. 78-201, on the transfer.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 78-201 is amplified.