Attorney Suggests Change To Publicly Traded Exception In Foreign Transfer Regs.

Michael Mollerus of Davis Polk & Wardwell, New York, has commented that the publicly traded exception rules in the proposed foreign transfer regs under section 367 are too restrictive. Mollerus explains that to qualify for the exception (1) the distributing corporation must distribute more than 80 percent of the outstanding stock of a domestic controlled corporation, and (2) the stock must be distributed under one or more classes of the distributing corporation's regularly traded stock. He states that the requirements are unwarranted and that the publicly traded exception should apply "to all distributions of the stock of a domestic controlled corporation [concerning] a publicly traded class of stock of the distributing corporation."

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November 5, 1996

Internal Revenue Service

Re: Temporary and Proposed Regulations under Section 367(e)(1)

Dear Mr. Tretiak:

[1] On August 9, 1996, the Internal Revenue Service (the "Service") released temporary and proposed regulations under section 367(e)(1) of the Internal Revenue Code of 1986, as amended (the "Code"), relating to the distribution of stock and securities under section 355 of the Code by a domestic corporation to a person that is not a United States person (the "Temporary Regulations"). I would like to make two comments on one provision in the Temporary Regulations.

[2] Section 1.367(e)-1T(c)(2) of the Temporary Regulations provides an exception (the "Publicly Traded Exception") for certain distributions by publicly-traded corporations to the general rule that corporate-level gain is recognized on a distribution of stock and securities under section 355 of the Code by a domestic corporation to a person that is not a United States person. In order for a distribution to qualify under the Publicly Traded Exception, inter alia,

(i) the distributing corporation must distribute stock of a domestic controlled corporation "with a value of MORE THAN 80% of the outstanding stock" of such corporation; and

(ii) such stock must be distributed "with respect to one or more classes of the outstanding stock of the distributing corporation that are regularly traded" on an established securities market located in the United States.

Section 1.367(e)-1T(c)(2)(i)(A) (emphasis added). The same

[3] For the reasons set forth below, I submit that both of these requirements are unwarranted. The Publicly-Traded Exception should apply without regard to either the total value of the stock of the domestic controlled corporation distributed and or the relative values of such stock distributed with respect to publicly-traded and non-publicly traded classes of stock of the distributing corporation. Rather, the Publicly-Traded Exception should apply to all distributions of the stock of a domestic controlled corporation with respect to a publicly-traded class of stock of the distributing corporation.

1. Although most distributions by publicly traded corporations qualifying under section 355 will meet the first requirement -- the more-than-80% value threshold -- of the Publicly Traded Exception, some distributions will not. The situation I am specifically concerned with here is the one in which the controlled corporation has two classes of voting (usually common) stock: a "high-vote" class, owned by the distributing corporation, which represents more than 80% of the voting power in the controlled corporation but less than 80% of the value of all of the controlled corporation's stock, and a "low-vote" class, owned by shareholders other than the distributing corporation and which represents more than 20% of value but less than 20% of vote. In this case, the distributing corporation, through its ownership of the "high-vote" class of stock, has "control" of the controlled corporation within the meaning of section 368(c), and a distribution of that "high-vote" class of stock to the distributing corporation's shareholders would qualify under section 355, assuming that the other requirements of section 355 are met.

[4] However, notwithstanding the fact such a distribution qualifies for tax-free treatment under section 355, the distribution would fail to satisfy the more-than-80% value threshold in the Publicly Traded Exception, with the result that the distributing corporation would be required to recognize corporate-level gain on the distribution to the extent made to foreign shareholders. This was the result in PLR 9544003 (Nov. 21, 1994), in which the Service ruled that a distribution of high-vote common stock, representing "control" of Controlled within the meaning of section 368(c) but apparently less than 80% of the total value of Controlled's equity, to Distributing's public shareholders qualified under section 355, but also required Distributing to recognize gain on the distribution of Controlled stock to foreign shareholders under Treasury Regulation Section 1.367(e)-1T(b)(1) and (2). Distributing had an unspecified number of foreign shareholders, none of whom owned more than 5% of Distributing's stock.

[5] There is no apparent reason why, once it has been established that a distribution of stock by a publicly traded corporation qualifies under section 355, the value of the stock being distributed, relative to the total value of the controlled corporation's stock, is or should be relevant to the issue whether the distributing corporation should recognize any gain under section 367. That section and the regulations thereunder are presumably motivated by the desire to ensure that, in appropriate cases, assets in domestic corporate solution do not escape both corporate and shareholder-level tax through the mechanism of a section 355 distribution to a foreign shareholder. The Publicly Traded Exception in the Temporary Regulations recognizes that requiring gain recognition by a publicly traded and widely held /1/ corporation is both impractical (because of the difficulty of finding and counting small foreign shareholders, many of whom may hold their stock in "street name" or through other nominees) and arguably unnecessary to achieve the purposes of section 367(e). In the case of non-5% foreign shareholders of a publicly-traded class of stock, the absence of control on the part of such shareholders makes it unlikely that the distribution is being used by such holders principally to avoid the imposition of both corporate- and shareholder-level tax (a concern that is addressed in the context of distributions by nonpublicly traded corporations, or corporations that are publicly-traded but controlled by a few significant foreign shareholders, through mechanisms such as the gain recognition agreement). /2/

[6] In light of the respective rationales for section 367(e) and the Publicly Traded Exception, I cannot discern any reasonable explanation for the inclusion of the more-than-80% value threshold in the Publicly Traded Exception. Once the distributing corporation has established that (i) all or a portion of the distribution is being made with respect to a publicly-traded class of stock, (ii) the distributing corporation does not have any more-than-5% foreign holders of stock of such class (or the distributing corporation complies with the rules applicable to distributions to such shareholders), and (iii) the distribution qualifies under section 355, application of the Publicly Traded Exception is warranted, without regard to the value of the stock being distributed. There is nothing inherent in the distribution of stock with a value that is proportionately lower than its voting power -- which is the only situation to which the more-than-80% value threshold is seemingly directed, in light of the requirement in section 355 that the distributing corporation distribute stock and securities constituting at least "control" of the controlled corporation within the meaning of section 368(c) -- that in any way negates or undermines the reasons, discussed above, for applying the Publicly Traded Exception. It is still impractical to identify and count small foreign public shareholders, and any revenue loss is still likely to be minimal (if anything, the disproportionately low value of the stock being distributed would reduce the revenue loss at the shareholder level, as compared to a distribution of stock with equal relative voting power and value).

2. For many of the same reasons, I believe that the requirement that more than 80% of the value of the stock of the domestic controlled corporation be distributed with respect to publicly-traded classes of stock is unwarranted. The problem here is the not uncommon situation where the distributing corporation, rather than the controlled corporation, has two classes of stock, only one of which is publicly traded. If the distributing corporation distributes 100% of the stock of a domestic controlled corporation, but less than 80% (by value) of such stock is distributed with respect to the publicly- traded class of the distributing corporation's stock, the Publicly- Traded Exception does not apply to ANY portion of the distribution. Again, apart from the issue whether the Publicly-Traded Exception should apply in such a case to the portion of the distribution made with respect to the nonpublicly-traded class of distributing's stock (see the footnote on page 4), there is no reason why the Publicly- Traded Exception should not apply, at least with respect to the portion of the distribution made to the publicly-traded class of stock.

[7] For the foregoing reasons, I therefore recommend that the Service delete any value threshold as a condition to the application of the Publicly Traded Exception when it promulgates final regulations. There is no independent justification for a value threshold under section 367; whatever concerns are raised by a distribution of stock with a value that is disproportionately low to its voting power are not unique to section 367, but rather are best addressed in the context of the qualification of the distribution as a whole for tax-free treatment under section 355.

Very truly yours,

Michael Mollerus

FOOTNOTES

/1/ The Temporary Regulations, like the regulations they replace, appropriately contain special rules for a distribution by a publicly traded corporation with one or more more-than-5% foreign shareholders.

/2/ I recognize that, as currently drafted, if the Publicly- Traded Exception applies to a distribution, even distributions with respect to a nonpublicly-traded class of stock qualify for the exception, such that no gain recognition is required with respect to distributions to less-than-5% foreign holders of that class of stock as well as less-than-5% foreign holders of the publicly-traded class of stock. This is true despite the fact that identification of the holders of a nonpublicly-traded class of stock is presumably much easier than identification of the holders of a publicly-traded class of stock, but presumably the regulation reflects the view that a distribution of significant value to a publicly-traded class of stock both minimizes the potential revenue loss with respect to any distribution to the nonpublicly-traded class of stock and reduces the likelihood that the distribution is motivated principally by tax avoidance. If the Publicly-Traded Exception were modified as I am suggesting, the Service may wish to consider limiting the application of the exception to only the portion of the distribution made with respect to the publicly-traded class of stock (which may represent only a small portion of the value of the distributing corporation's stock, and receive only a small portion of the value of the stock distributed), such that recognition of gain is required with respect to all distributions to foreign holders of the nonpublicly-traded class of stock, regardless of the size of their holdings (unless another exception applies).

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