KPMG LLP Asks Treasury, IRS to Address Problem Within Proposed Regs on Importation of Net Built-In Losses

On September 6, 2013, the Internal Revenue Service ("IRS") and the Department of Treasury ("Treasury") released to the public proposed regulations under § 362(e)(1) of the Internal Revenue Code (the "Proposed Regulations"). The Proposed Regulations contain a set of proposed rules for applying § 362(e)(1) to prevent the importation of built-in losses through nonrecognition transfers of property that is currently not subject to Federal tax to corporations that are subject to Federal tax.

The Proposed Regulations contain certain provisions applicable to the transfer of built-in loss property to a corporation by a partnership. Although we generally agree with the approach to these types of transfers adopted in the Proposed Regulations, we believe there are two instances in which the Proposed Regulations should be clarified. Moreover, we have identified a potential problem with the application of the rules as written that we believe the IRS and Treasury should be aware of, so that it may be rectified in final regulations. We include below a description of the proposed clarifications, and then follow with an illustration of the problem identified.

Background

Section 358(a) provides that a shareholder's basis in stock received in a § 351 contribution generally will equal the basis of the property transferred in the exchange, decreased by the fair market value of any boot received, and increased by the amount of any gain recognized on the exchange. Thus, in a § 351 contribution of unencumbered property to a corporation in which the transferor recognizes no gain, the transferor generally takes a basis in the stock received equal to the transferor's basis in the property at the time of the transfer.

Section 362(a) contains a similar rule applicable in determining a corporation's basis in property received in a § 351 contribution. Under that provision, a corporation's basis in property acquired in a § 351 contribution generally will equal the transferor's basis in the property, increased by the amount of gain recognized by the transferor on the transfer. Thus, in a transfer to a corporation in which the shareholder recognizes no gain, the recipient corporation generally takes the same basis in the transferred property as the transferor had in that property at the time of the transfer.

Prior to enactment of § 362(e), the general rules of § 358 and § 362 permitted the duplication of gain or loss as a result of a § 351 transfer of property to a corporation (i.e., after the transfer of property to the corporation, the economic gain or loss in the transferred property was reflected in both the transferor's basis in its stock in the corporation and the corporation's basis in the transferred assets). Although Congress apparently did not view the duplication of gain as problematic, it felt that the duplication of loss in these situations was inappropriate as a matter of Federal tax policy. To prevent this duplication (as well as the importation of a built-in loss from outside to inside the U.S. tax system), Congress enacted § 362(e) in 2004.

Section 362(e) contains two provisions. The first, § 362(e)(1) applies if there is an "importation of a net built-in loss." An importation of a net built-in loss occurs if the transferee's aggregate adjusted basis of property described in § 362(e)(1) exceeds the fair market value of the property. Property is described in § 362(e)(1) if the gain or loss with respect to such property is not subject to tax in the hands of the transferor immediately before the transfer and gain or loss with respect to such property is subject to Federal tax in the hands of the transferee immediately after the transfer. Thus, for example, § 362(e)(1) may apply if a foreign corporation transfers foreign assets to a U.S. corporation in a contribution to which § 351 applies.² If § 362(e)(1) applies, the transferee corporation takes a basis in each asset transferred in the § 351 exchange equal to that asset's fair market value at the time of the exchange. No election is available to change the result of § 362(e)(1). If the transferor is a partnership, the above rules are applied by treating each partner as holding a proportionate share of the property of the partnership.

If property that is not subject to § 362(e)(1) (e.g., because the property is subject to Federal tax in the hands of the transferor) is transferred in a transaction subject to § 351 contribution and there is a net built-in loss in the property transferred, then § 362(e)(2) provides that the transferee's aggregate basis in the transferred assets generally may not exceed the aggregate fair market value of the assets at the time of the transfer. Note, however, that unlike the impact of § 362(e)(1), the impact of § 362(e)(2) may be changed by election. Specifically, § 362(e)(2)(C) provides that the transferor and transferee can make a joint election (a "§ 362(e)(2)(C) Election") to reduce the transferor's basis in the stock received to its fair market value. If that election is made, no reduction of the transferee's basis in the property received is required; instead, § 1.362-4(d)(2) provides that an amount equal to the portion of the transferor's net built-in loss that would otherwise be applied to reduce asset basis if the § 362(e)(2)(C) Election were not made is allocated among the transferor's shares received and reduces basis accordingly.³

Partnership Provisions in the Proposed Regulations

The Proposed Regulations contain several provisions relating to the application of § 362(e)(1) to transfers by partnerships. Generally speaking, proposed § 1.362-3(b) provides that a corporation's basis in importation property acquired in a loss importation transaction is equal to the value of the property immediately after the transaction. For this purpose, the term loss "importation property" is any property (including separate portions of property tentatively divided under the partnership rules discussed below) with respect to which -- 1) any gain or loss that would be recognized on its sale would not be subject to Federal income tax; and 2) any gain or loss that would be recognized on its sale by the acquiring corporation immediately after the transaction would be subject to Federal income tax. Further, the term "loss importation transaction" is defined as any § 362 transaction in which the acquiring corporation's aggregate basis in all importation property received from all transferors in the transaction would exceed the aggregate value of that property immediately after the transaction.

Proposed § 1.362-3(d)(1) provides that any gain or loss that would be recognized by the transferor or the transferee of property if it were sold in a hypothetical sale generally is considered to be subject to Federal income tax if, taking into account all relevant facts and circumstances, that gain or loss would affect or be taken into account in determining the Federal income tax liability of the transferor or transferee, respectively. This determination is made without regard to whether such person has or would have any actual Federal income tax liability for the taxable year of the transaction.

Consistent with the statutory directive for partnerships, the Proposed Regulations contain a special lookthrough rule applicable in determining whether gain or loss would be taken into account. Specifically, proposed § 1.362-3(d)(2) provides in relevant part that the determination of whether any gain or loss on a hypothetical sale would be treated as subject to Federal income tax is made by reference to the person that would be required to include such gain or loss in its taxable income if the hypothetical seller is a partnership. In the preamble to the proposed regulations, the IRS and Treasury note that:

If property is divided into separate portions under this rule, then immediately after the application of § 362(e)(1) and before the application of § 362(e)(2), each property treated as divided into separate portions for purposes of applying § 362(e)(1) ceases to be treated as tentatively divided, and the transferee corporation will have a single, undivided basis in the property that is equal to the sum of -- 1) the value of each tentatively divided portion that is importation property, if the transaction is a loss importation transaction; and 2) the transferee's basis in each tentatively divided portion that is not importation property received in a loss importation transaction, as determined under the general rules of § 362 without regard to any potential application of § 362(e)(2).

The application of these rules is illustrated by Example 5 in proposed § 1.362-3(f) (Example 5"). As relevant here, in that example, A and F are equal partners in FP, a foreign partnership. FP owns A1 (basis $100, value $70). Under the terms of the FP partnership agreement, FP's items of income, gain, deduction, and loss are allocated equally between A and F. FP transfers A1 to DC, a domestic corporation, in a transfer to which § 351 applies.

If FP had sold A1 immediately before the transaction, any gain or loss recognized on the sale would be allocated to and includible by A and F equally under the partnership agreement. A1 is treated as tentatively divided into two equal portions, one treated as owned by A and one treated as owned by F. If FP had sold A1 immediately before the transaction, any gain or loss recognized on the portion treated as owned by A would have been taken into account in determining a Federal income tax liability (A's), and thus A's tentatively divided portion of A1 is not importation property. However, no gain or loss recognized on the tentatively divided portion treated as owned by F would have been taken into account in determining a Federal income tax liability. Further, if DC had sold A1 immediately after the transaction, any gain or loss recognized on the sale would have been taken into account in determining a Federal income tax liability (DC's); thus, F's tentatively divided portion of A1 is importation property.

FP's transfer of A1 is a § 362 transaction. Furthermore, but for § 362(e), DC's basis in F's portion of A1 would be $50 under § 362(a) and the property's value would be $35 immediately after the transaction. Therefore, the importation property's basis would exceed its value and the transfer is a loss importation transaction. Because F's tentatively divided portion of A1 was transferred in a loss importation transaction, DC's basis in F's portion of A1 will be equal to its $35 value.

Example 5 provides that, following the application of § 362(e)(1), the provisions of § 362(e)(2) must be taken into account because the transfer is a § 362(a) transaction. After the application of § 362(e)(1) but before the application of the provisions of § 362(e)(2), DC's aggregate basis in A1 would be $85 (the sum of the $35 basis in F's tentatively divided portion of A1 and the $50 basis in A's tentatively divided portion of A1); A1's value immediately after the transfer would be $70. Therefore, FP has a net built-in loss and FP's transfer of A1 is a loss duplication transaction. Accordingly, under the general rule of § 362(e)(2), FP's $15 net built-in loss ($85 basis over $70 value) would reduce DC's basis in the loss asset, A1, the only loss property transferred by FP. As a result, DC's basis in A1 would be $70 ($85 basis under reduced by the $15 net built-in loss). Under § 358, FP's basis in the DC stock received in the exchange will be $100.

If FP and DC elect to apply § 362(e)(2)(C) to reduce FP's basis in the DC stock received in the exchange, the $15 reduction to DC's basis in A1 is not made. As a result, DC's basis in A1 remains $85. In such case, however, Example 5 provides that FP's basis in the DC stock received in the exchange is reduced from $100 to $85. It further provides that the $15 reduction to FP's basis in DC stock reduces A's basis in its FP interest under § 705(a)(2)(B).

As noted above, when reviewing the Proposed Regulations and the example described above, we noted two points that we recommend the IRS and Treasury clarify in the final regulations. Moreover, we also noted a problem that the IRS and Treasury should be aware of, such that it can be rectified when the regulations are finalized. We discuss both of these items below.

Recommended Clarifications to the Regulatory Provisions

We recommend that two clarifications be made with respect to the application of § 362(e) to transfers by partnerships. The first relates to language in the Proposed Regulations describing the application of § 362(e)(1) to such transfers. Although raised by an example in the Proposed Regulations, the second actually relates to the application of § 362(e)(2) to those transfers. The clarifications are as follows.

Clarify that § 704(c) Applies in Determining Allocations on Hypothetical Sale

The Proposed Regulations reach the correct policy result by following § 362(e)(1) and looking through a partnership to its partner in determining whether a transfer by a partnership to a corporation results in an importation of a built-in loss. In our view, however, the IRS and Treasury should clarify the language describing the method of determining to whom gain or loss on a hypothetical sale of property by a partnership would be allocated.

The regulations note that whether any gain or loss on a hypothetical sale would be treated as subject to Federal income tax is made by reference to the person that would be required to include such gain or loss in its taxable income if the hypothetical seller is a partnership. In our view, that determination should include any allocations of gain or loss to the partners resulting from application of § 704(c) to the transferred property. However, in both the preamble to the Proposed Regulations and the regulatory language itself, the IRS and Treasury refer to special allocations of gain or loss to the partners pursuant to the partnership agreement. Although a partnership agreement may specify which methods the partners will use in applying § 704(c), a § 704(c) allocation of gain or loss is required by statute -- not the partnership agreement.

By focusing on allocations made in a partnership agreement, the Proposed Regulations may cause confusion as to whether § 704(c) allocations should be taken into account in determining to whom gain or loss would be allocated in the hypothetical sale of property by the partnership required by the Proposed Regulations. In our view, to eliminate confusion and to prevent any taxpayers from taking the position that § 704(c) allocations are not taken into account in making that determination, when the Proposed Regulations are finalized the IRS should include language indicating that allocation of gain or loss required under § 704(c) are taken into account in determining to whom gain or loss with respect to the transferred property would be allocated in the event of a hypothetical sale of that property by the transferring partnership.

Clarify Allocation of § 705(a)(2)(B) Expenditure Resulting from § 362(e)(2)(C) Election

As noted above, the other clarification we believe should be made arises in Example 5 in the Proposed Regulations, but technically relates to a clarification that should be made to the recently finalized regulations interpreting § 362(e)(2) (the "§ 362(e)(2) Regulations"). Specifically, the comment relates to § 1.362-4(e)(1), which provides that if a partnership transfers property in a loss duplication transaction with respect to which a § 362(e)(2)(C) Election is made, the resulting reduction to the partnership's basis in the stock received is treated as an expenditure of the partnership described in section 705(a)(2)(B).⁴ To understand the issue, some background relating to partnership allocations may be necessary.

Under § 704(a) the partners in a partnership generally may agree as to the manner in which the partnership's items of income, gain, loss, and deduction are allocated among the partners in determining the Federal income tax consequences to those partners, provided that the allocations agreed upon have substantial economic effect. If the allocations agreed to by the partners have substantial economic effect, each partner's distributive share of the income, gain, loss, and deduction is determined by taking into account the agreed upon allocations. The partner generally takes into account its distributive share of the items in determining the partner's own taxable income.

Any allocations of gain or loss made to the partners under these provisions ultimately increases or decreases that partner's basis in its partnership interest through application of § 705. That section generally provides that a partner's basis in its partnership interest is increased by the partner's distributive share of the partnership's income and gain items. Similarly, the partner's basis in its partnership interest is reduced by any distributions to the partner by the partnership, as well as the partner's distributive share of the partnership's losses. In addition, under § 705(a)(2)(B), a partner's basis in its partnership interest is decreased by the partner's distributive share of expenditures of the partnership not deductible in computing its taxable income and not properly chargeable to capital account.

Just as the Proposed Regulations do, the § 362(e)(2) Regulations provide special rules applicable in applying § 362(e)(2) to transfers of property by a partnership. As relevant here, the § 362(e)(2) Regulations provide that, if a partnership transfers property to a corporation in a transaction subject to § 362(e)(2) and the partnership and the transferee corporation file a § 362(e)(2)(C) Election with respect to the transfer, then any reduction in the partnership's basis in the stock received in the transfer is treated as a § 705(a)(2)(B) expenditure of the partnership. Because the § 362(e)(2)(C) reduction in stock basis is treated as a § 705(a)(2)(B) expenditure, under the rules discussed above each partner's basis in its partnership interest should be reduced by that partner's distributive share of the expenditure.

In the absence of a rule indicating otherwise, a partner's distributive share of a § 705(a)(2)(B) expenditure should be determined under the partnership agreement, provided that allocation has substantial economic effect. Thus, if a partnership agreement provides that the partnership's items of income, gain, deduction, and loss are allocated equally between two partners, then a § 705(a)(2)(B) expenditure should be allocated equally between the two partners and should result in an equal reduction to each partner's outside basis in its partnership interest. In Example 5, however, that does not appear to be the case.

Recall that the facts in Example 5 provide that, under the terms of the FP partnership agreement, FP's items of income, gain, deduction, and loss are allocated equally between A and F. Thus, in the absence of a rule indicating otherwise, any reduction to the basis of stock in DC received by FP as a result of a § 362(e)(2)(C) Election made with respect to the transfer by FP of assets to DC should be allocated equally between A and F. In the example, however, the IRS and Treasury note that "[t]he $15 reduction to FP's basis in DC stock reduces A's basis in its FP interest under section 705(a)(2)(B)."

We believe the allocation of the entire § 705(a)(2)(B) expenditure to A such that A's basis in its FP interest is reduced is correct as a matter of Federal tax policy. Allocating the expenditure in that manner is necessary to prevent the ultimate recoupment of the basis reduction by A on the liquidation of its partnership interest. However, we are not aware of any rule that would direct the allocation in that manner. Instead, under the facts stated in the example, we believe the § 705(a)(2)(B) expenditure would be allocated equally to A and F, such that A's interest in its FP interest would be reduced by just $7.50. In such a case, A would ultimately recoup $7.50 of the basis reduction required under § 362(e)(2)(C), and thus to that extent the loss inherent in the assets would be duplicated.

In our view, the IRS and Treasury should amend the § 362(e)(2)(C) Regulations such that those regulations provide the result described in Example 5.

Proposed Regulations Permit Loss Duplication in Certain Situations

As described above, the Proposed Regulations provide a lookthrough rule in determining whether § 362(e)(1) applies to a transfer to a corporation by a partnership. In contrast, the § 362(e)(2) Regulations do not adopt a lookthrough approach to a partnership that is a transferor. Moreover, under the § 362(e)(2)(C) Regulations, when a § 362(e)(2)(C) election is made, a transferor's basis in the stock of the transferee is not reduced to fair market value (as seems to be prescribed by the statute), but rather is reduced by the amount by which the transferee's basis in the transferred assets would have been reduced in the absence of a § 362(e)(2)(C) Election. As discussed below, the combined application of these rules in a particular situation leads to a result that may be unintended. We believe the IRS and Treasury should be aware of the issue, so that it can be rectified.

The problem is best illustrated by an example using the same facts as in Example 5. Recall that, in the example, A is a U.S. citizen and F is a foreign individual. A and F are partners in FP, a foreign partnership. FP owns an asset (A1) with a fair market value of $100 and a basis of $70. For illustration purposes, further assume that there is parity between the inside basis of FP's assets and the outside basis of A and F's interests in FP, such that A and F each have a $50 basis in their FP interests.

FP transfers A1 to DC, a domestic corporation, in a contribution to which § 351 applies. Applying the Proposed Regulations, § 362(e)(1) applies to the transfer of half of A1. As a result, the partnership takes a $50 basis in half of the DC stock received; DC takes a $35 basis in that half of A1. Thus, prior to applying § 362(e)(2), DC's basis in A1 would be $85 (the $35 basis in half of the asset stepped down under § 362(e)(1) and the $50 of basis in the other half that would result under the general rule of § 362(e)(1). The fair market value of A1 is $70, and thus A1 still has a built-in loss of $15. Accordingly, § 362(e)(2) also applies to the transfer by FP to DC.

Assume that a § 362(e)(2)(C) election is filed, such that DC has a basis of $85 in A1 ($35 in the half that was stepped down under § 362(e)(1) and $50 in the other half now rejoined to be an $85 basis in the entire asset). FP also has an $85 basis in its DC stock. That basis is equal to the $100 basis FP would have had in the stock if the § 362(e)(2)(C) Election had not been made, reduced by the $15 reduction in basis necessary as a result of the § 362(e)(2)(C) Election. In the example, all $15 of the reduction in basis reduces A's basis in its PRS interest. As noted above, we do not believe that is correct under current law, but we accept that to be the case for illustration purposes. Thus A's basis in its partnership interest is reduced from $50 to $35.

Now assume that, at a later time when the value and basis of the DC stock and A1 are unchanged, DC sells A1 for its $70 fair market value and liquidates. DC recognizes a $15 loss on the sale of A1 (the amount by which DC's $85 basis in A1 exceeds the $70 amount realized). Similarly, FP recognizes a $15 loss with respect to its DC stock as a result of DC's liquidation (the amount by which FP's $85 basis in the DC stock exceeds the $70 distributed to FP in the liquidation).

Note that this $15 loss continues to exist because the § 362(e)(2) Regulations do not adopt the language of § 362(e)(2)(C)(i)(II) in determining the amount of the basis reduction required as a result of the § 362(e)(2)(C) Election. As noted above, § 362(e)(2)(C)(i)(II) provides that, if a § 362(e)(2)(C) Election is made, the transferor's basis in the stock received "shall not exceed its fair market value immediately after the transfer." Applying that language, the FP's basis in its DC stock would be $70. However, the § 362(e)(2) Regulations do not directly adopt the language in § 362(e)(2)(C)(i)(II), but rather provide that stock basis is reduced by the same amount as a asset basis would have been reduced in the absence of a § 362(e)(2)(C) Election. In most instances, the regulatory language will reach the same result as that prescribed in the statute. However, as the example illustrates, when both § 362(e)(1) and § 362(e)(2) apply to a transfer of property by a partnership and a § 362(e)(2)(C) Election is made with respect to the § 362(e)(2) portion of the transaction, the regulatory iteration may have an unintended result.

Assuming the $15 loss described in Example 5 is correct, conceptually that loss is attributable to "F's portion" of FP's stock in DC, because it is that portion of the stock that was not reduced under § 362(e)(1). However, under the facts described in the example, there does not seem to be a rule that would cause that loss to be allocated solely to F. Instead, that loss would be allocated equally to A and F under the FP partnership agreement.

As a result of the loss allocation to A, there is at least temporarily duplication of a $7.50 loss in the Federal tax system. If A's basis in its FP interest was reduced by the full $15 of the stock basis reduction occurring as a result of the § 362(e)(2)(C) Election as described in Example 5, that $7.50 would be recouped if and when the partnership distributed the $70 proceeds to its partners or in other circumstances. However, if A is aware of the issue and FP continues to exist as a partnership with other assets following the liquidation of DC, the recoupment of that loss could be postponed indefinitely. Further, if the $15 § 362(e)(2)(C) reduction in stock basis is allocated equally between A and F, which as described above we believe would be the case in the absence of a change to the § 362(e)(2) Regulations, the $7.50 loss is never recouped because A would have no gain or loss on the liquidation of FP.

At a minimum, this example reveals the need for a clarification with respect to the allocation of the § 705(a)(2)(B) expenditure resulting from a § 362(e)(2)(C) Election as we have described above. In the absence of such a clarification, permanent loss duplication becomes possible. If the § 705(a)(2)(B) allocation issue is resolved in the final regulations, loss may be duplicated indefinitely. We believe this type of temporary duplication should be avoided.

Conclusion

We appreciate your consideration of our views and recommendations with regard to the partnership provisions in the Proposed Regulations. If you have any questions or would like to discuss this letter, please do not hesitate to contact either of us at the numbers listed below.

² Note that § 362(e)(1) may apply to transactions transferred in a reorganization under § 368(a)(1), as well as those transferred in a § 351 contribution. Further, a similar rule in § 334(b)(1) prevents the importation of a built-in loss in a § 332 liquidation. However, the focus of this comment letter is on transfers made by a partnership that are subject to § 362(e)(1). Because a partnership may not transfer its assets in a § 368(a)(1) reorganization and may not receive assets in a § 332 liquidation, we limit our discussion to § 351 contributions.

³ The rule in the regulation differs from that in the statute. Specifically, § 362(e)(2)(C)(i)(II) provides that, if a § 362(e)(2)(C) Election is made, the transferor's basis in the stock received will not exceed its fair market value immediately after the transaction. In most instances, the regulatory language will reach the same result as that prescribed in the statue. However, as illustrated below, when both § 362(e)(1) and § 362(e)(2) apply to a transfer of property by a partnership and a § 362(e)(2)(C) Election is made with respect to the § 362(e)(2) portion of the transaction, the regulatory iteration may have an unintended result.

⁴ This is perhaps the best place to note that there appears to be an error in § 1.705-1(a)(9), which was added in connection with the § 362(e)(2) Regulations. When referring the reader to special rules for basis adjustments necessary to coordinate § 362(e)(2) and § 705, § 1.705-1(a)(9) references "§ 1.362-4(f)(i)." We believe the correct reference should be to "§ 1.362-4(e)(1)."