Kpmg Peat Marwick Says Foreign Transfer Regs Are 'Unnecessarily Restrictive.'

Stanley C. Wiseberg of KPMG Peat Marwick, Washington, has expressed concern about the proposed foreign transfer regs under section 367, stating that the rules are "unnecessarily restrictive on distributing corporations and their foreign shareholders."

Wiseberg says the requirement that a distributing corporation have value at least equal to its deferred gain on all testing dates during the 10-year gain recognition agreement (GRA) period will inhibit the corporation's ability to spin off its subsidiaries to its foreign shareholders. He argues that the distributing corporation should not be the only party to bear the burden of ensuring that there are sufficient U.S.-based assets to satisfy any potential triggering of the GRA. Consequently, he recommends that the controlled corporation be made jointly and severally liable for GRA gain arising from a distribution.

Wiseberg also says the limit in reg. section 1.367(e)- 1T(c)(3)(ii)(A) on the number of foreign persons or corporations that can be qualified foreign distributees will restrict reorganizations of multinational corporations after a spin-off. He suggests that the Service treat all members of a group of corporations as one entity for purposes of the qualified foreign distributee rule. Wiseberg's other comments relate to the extension of the gain recognition period from 5 years to 10 years and the treatment of a transfer of shares of a distributing or controlled corporation to a foreign partnership.

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November 7, 1996

CC:DOM:CORP:R (INTL 0020-96)

Dear Sirs/Madams:

Temporary Regulations Section 367(e)(1) -- Treatment of section 355

[1] On August 9, 1996, temporary regulations were issued under Section 367(e)(1) of the Internal Revenue Code 1986, as amended (Code). The temporary regulations relate to the distribution of stock and securities under section 355 of the Internal Revenue Code of 1986, as amended, by a domestic corporation to a person that is not a United States person.

[2] We are writing to request clarification of, and amendments to, the temporary regulations to alleviate what we believe to be unnecessarily restrictive requirements on US Distributing corporations and their foreign shareholders.

[3] Our concerns include:

o The new requirement that the value of Distributing be at least

o The limitation on the number of foreign individuals or

o The increase in the term of the GRA from 5 years to 10 years

o The need to clarify that a transfer of the shares of the

1. THE NEW REQUIREMENT THAT THE VALUE OF DISTRIBUTING BE AT LEAST

[4] It is our belief that no provision of these regulations will frustrate legitimate business transactions more than the need for the Distributing corporation to retain for the full GRA period a net fair market value in its assets equal to the gain deferred under the GRA -- (Reg. section 1.367(e)-1T(c)(3)(ii)(B)). The imposition of this "value in excess of gain rule" may well impair the ability of a U.S. corporation to effect a spin-off of one of its businesses to its foreign shareholders and in many cases could dictate which business is spun off. The new regulations require that the fair market value of Distributing's assets, less liabilities, /1/ exceed the amount of the gain realized but not recognized on the last day of each taxable year and on any date a section 301(a) distribution is made.

[5] The artificial need for Distributing to retain assets when all of the value of the assets of both Distributing and Controlled are still subject to U.S. tax is not indicative of good U.S. tax policy. We understand the Service's concern that there be sufficient U.S.-based assets to satisfy any potential triggering of the GRA. What we do not understand is why this burden falls on the shoulders of only the Distributing corporation. There is an easy cure for this problem; Namely, making the Controlled corporation jointly and severally liable for the gain deferred through the GRA. This suggestion should be easy to implement as the Controlled corporation must agree, under Reg. section 1.367(e)-1T(c)(3)(iii)(E), to be secondarily liable for the Distributing company's deferred GRA gain. We perceive no problem with making the Controlled corporation also primarily liable as a condition for nonrecognition of gain by the Distributing corporation. The liability of the Distributing and Controlled corporations should also be the burden of each member of the Distributing and Controlled groups as well as their respective successors in interests for the period of time that the GRA is in force.

[6] In addition, the regulations are unclear as to the result when a Distributing corporation effects two spin-off's within the period of the GRA. For example:

[7] Assume a U.S. Distributing group, wholly owned by a foreign corporation, consists of the Distributing corporation with a net fair market value for its directly held assets of $8x and two Controlled corporations each with a $5x gain in their respective shares held by Distributing. The first Controlled corporation is distributed to the sole foreign corporate shareholder of Distributing in a transaction qualifying under section 355 and all the tests for nonrecognition under Reg. section 1.367(e)-1T(c)(3) are met with respect to the distribution. The deferred gain, subject to the GRA, is $5x. Five years later, in a transaction wholly separate from the first spin off, the second Controlled corporation is spun-off in a distribution which also qualifies for tax free treatment under section 355 and for deferral of the gain under Reg. section 1.367(e)- 1T(c)(3). Again the deferred gain is $5x.

[8] In this example it is clear that the assets of Distributing are sufficient to cover the gain deferred on the first distribution but the regulations are silent on how the second deferred gain should be treated. The regulation states that "this requirement will be deemed satisfied for any testing date upon which the adjusted basis of the Distributing corporation's assets, less all liabilities of the Distributing corporation, exceeds the amount of the deferred gain." Arguably the fair market value of Distributing's assets, less liabilities, does exceed the amount of "the deferred gain" if each GRA gain is analyzed separately. However, on a cumulative basis the amount of deferred gain exceeds the remaining value of Distributing's retained assets.

[9] The section further calls into question the issue of determining the fair market value of the assets. The section as it is worded requires that the value of Distributing's assets, less liabilities, exceeds the amount of the deferred gain on the last day of each taxable year the agreement is in effect and on any date a distribution under section 301(a) is made. This determination of value will necessitate an expensive and subjective valuation, one that may easily be subject to unnecessary controversy.

[10] Therefore, in order to resolve these issues and to relieve taxpayers of the need (at a minimum) for an annual valuation of the Distributing corporation, we recommend that the Controlled corporation be jointly and severally liable for the GRA gain arising from the distribution and that the "value in excess of gain" rule be deleted.

2. LIMITATION ON THE NUMBER OF FOREIGN INDIVIDUALS OR CORPORATIONS

[11] The limitation on the number of foreign persons who may be "qualified foreign distributees" for nonrecognition purposes is set at ten. We believe that the choice of the number ten is intended to facilitate the administrative requirements of a GRA under section 367(e)(1) and is, unlike the "five or fewer" test of section 367(a)(5), not a legislative mandate. We contend that this artificial limitation on the number of foreign distributees is unnecessary in certain circumstances. This artificial limitation may be applied to a select 10 shareholders, but should treat all 5% shareholders of the Distributing corporation as one shareholder. Additionally, all persons related under section 318 should be treated as one shareholder (dependent on the level of their direct and indirect ownership, this may also result in their collectively being treated as one of the 5% shareholders of the Distributing corporation). Accordingly, the Distributing corporation would be able to name nine less-than-5% shareholders as qualified foreign distributees. We believe that this change should not impair the Service's ability to "police" recognition events for the GRA, and will allow certain post spin-off reorganizations to take place that would otherwise be restricted.

[12] The limitation on the number of persons (in this case corporations) who may qualify as qualified foreign distributees (Reg. section 1.367-1T(c)(3)(ii)(A)) could restrict the ability of multinational corporations to effect post-spin-off reorganizations. For example: A multinational group undergoing a worldwide reorganization of its various lines of business may often have to reposition corporations within its group, as part of its reorganization, to effect a more efficient organizational structure. If a Controlled U.S. corporation was distributed to the foreign parent of the U.S. Distributing corporation and the shares of Controlled thereafter were transferred to a series of corporations within the group, it is quite possible that the limit on the number of qualified foreign distributees could be breached, thus causing the deferred gain to be recognized. The previous regulations imposed this artificial limit on the number of qualified distributees to facilitate the Distributing corporation's monitoring of subsequent transferees. We believe the Treasury/Service was concerned that if there was no limit on the number of foreign transferees then it would be impossible to ensure compliance with the terms of the GRA. However, while we understand the requirement for a limit on the number of foreign transferees for these purposes, we do not think that the limitation should be imposed on members of the same corporate group. For administrative purposes in ensuring compliance with the terms of the GRA, there is no difference in monitoring the ownership of Distributing or Controlled within a group irrespective of which corporation in the group ultimately owns the stock. We feel that the IRS should amend the regulations to treat all members of a group of corporations as one entity provided that they meet certain ownership requirements (described below). This would provide multinational corporations with the opportunity to effectively restructure their operations, during the term of the GRA, without being unnecessarily penalized. More particularly, we suggest that a group of foreign corporations meeting the definition of an affiliated group, as defined in section 338(h)(5), be treated for the purposes of section 367(e)(1) as one qualified foreign distributee.

3. INCREASE IN THE TERM OF THE GRA FROM 5 YEARS TO 10 YEARS (REG.

[13] We believe the increase of the period for the GRA from 60 months to 120 months is, in some cases, an unnecessary extension of the 60 month GRA period found in the prior two sets of section 367(e) regulations. The rationale behind the increase in the GRA period to 120 months is to conform the new section 367(e)(1) regulations with the section 367(a) regulations covering outbound transfers. The preamble to the regulations provide that "The IRS and Treasury believe that the GRA term under section 367(e)(1) should be no less than the term under section 367(a) when U.S. transferors control the transferee because, once the GRA under section 367(e)(1) expires, the sale of Distributing or Controlled stock by a Qualified Foreign Distributee likely will not be subject to Federal income taxation."

[14] We believe that in certain situations the term of the GRA should remain at 60 months in order for there to be the desired symmetry between the section 367(a) GRA and the section 367(e) GRA. Under Notice 87-85, /2/ as well as proposed Reg. section 1.367(a)- 3T(c)(3), only when the U.S. transferors own 50% or more of the foreign transferee corporation is the section 367(a) GRA increased to 10 years. If the concern is that a sa1e of the majority of the distributed shares would inappropriately escape U.S. tax, then a situation where the foreign distributees in the section 355 transaction own less than 50% of the distributed corporation should a1so be subject to a 60 month GRA.

4. NEED TO CLARIFY THAT A TRANSFER TO A PARTNERSHIP DOES NOT

[15] In order for a subsequent transfer of the shares of either the Distributing corporation or the Controlled corporation to not trigger the GRA, the transfer must be one governed by sections 332, 337, 351, 354, 355, 356, or 361 that does not result in a substantial transformation (Reg. section 1.367(e)-1T(c)(3)(vi)). Noticeably absent is section 721 dealing with the transfer to a partnership. Regulation section 1.367(e)-1T(b)(5) states that "For purposes of this section, stock or securities owned by or for a partnership (whether foreign or domestic) shall be considered to be owned proportionately by its partners." One could, therefore, read Reg. section 1.367(e)-1T(b)(5) as permitting a transfer of the shares of either the Distributing or Controlled corporation to a foreign partnership without triggering the GRA. We believe that a transfer described in section 721 should be included in the chart of transfers that do not necessarily trigger a GRA.

[16] If you or your colleagues have any questions concerning this letter, please do not hesitate to contact me.

Very truly yours,

KPMG Peat Marwick LLP

FOOTNOTES

/1/ We assume that contingent liabilities are not "liabilities" for purposes of this test (see Rev. Rul. 95-74, 1995-2 C.B. 36 where contingent liabilities were not treated as liabilities for purposes of sections 357(c) and 358(d)).

/2/ 1987-2 C.B. 395

END OF FOOTNOTES