Rev. Rul. 81-89

ISSUE

Are the losses and profits incurred by the foreign branches of an affiliated group of corporations that file a consolidated federal income tax return combined for purposes of determining the amount to be included in income upon the incorporation of those branches, pursuant to Rev. Rul. 78-201, 1978-1 C.B. 91?

FACTS

P and S are domestic corporations that are engaged in the manufacture and sale of plastic components for radio and television manufacturers in the United States and foreign countries. In 1977, P and S each established a country A branch, which commenced these same activities in country A. The products and business activities of the two country A branches, were substantially identical,

For each of P's taxable years 1977, 1978, and 1979, its country A branch had a loss of 200x dollars (or a total of 600x dollars for this period) as a result of expenses incurred by branch operations in country A. In each of the years 1977, 1978, and 1979, the country A losses of the branch reduced the amount of P's income subject to federal income tax. During each of the three years P's other foreign branches received income in excess of the losses of the branch in country A.

For each of S's taxable years 1977, 1978, and 1979, its country A branch had a profit of 100x dollars (or a total of 300x dollars for this period). In each of the years 1977, 1978, and 1979, the country A income of the branch increased the amount of S's income subject to federal income tax. In addition, during each of the three years, S's other foreign branches received income in excess of their expenses.

On January 1, 1979, P acquired all of the stock of S in a stock for stock acquisition that qualified as a reorganization within the meaning of section 368(a)(1)(B) of the Code. P and S elected to file a consolidated federal income tax return for 1979 and subsequent tax years. Prior to the election by P and S to file a consolidated return, their respective country A branches conducted separate and independent business operations. However, after P and S elected to file a consolidated return the activities of their country A branches were completely integrated. For example, they had common purchasing, accounting, personnel, and record keeping departments; a common sales force, headquarter staff, and management team; and, a substantial identity of customers, employees, distributions channels, operation facilities and processes.

On January 1, 1980, P and S each transferred all of the property used by its country A branch to Newco, a corporation newly formed under the laws of country A, solely in exchange for all of the stock of Newco. With respect to each transferor (P and S), the fair market value of, and the basis of, the assets transferred to Newco exceeded the sum of the liabilities assumed by Newco plus the amount to which the transferred assets were subject.

Newco was not to be engaged in a trade or business in the United States within the meaning of section 864 of the Code and was to have no income from sources within the United States within the meaning of section 861. The transfer of assets in exchange for stock would have fulfilled all of the requirements of section 351 had the transferee been a domestic corporation. Further, the transfer met the requirements of section 3.02(1) of Rev. Proc. 68-23, 1968-1 C.B. 821 (relating to situations where a favorable ruling under section 367 will generally be issued). Within 183 days of the beginning of the transfer the taxpayers 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.

P agreed to include in income (for itself and S) the amount specified in Rev. Rul. 78-201, but requested that this amount be determined by treating P's and S's country A branches as a single business from the time they commenced their country A operations, which would reduce the total "toll charge" from 600x dollars to 300x dollars. In the alternative, P requested that the two country A branches be treated as a single business for purposes of determining the "toll charge" specified in Rev. Rul. 78-201, upon the election by P and S to file a consolidated federal income tax return and the complete integration of their country A branches. This would reduce the "toll charge" for the 1979 tax year from 200x dollars to 100x dollars.

LAW AND ANALYSIS

The transfer by P and S of their country A properties to Newco solely in exchange for all of Newco's stock is an exchange described in section 351 of the Code. However, unless it is established under section 367(a)(1) that the transfer was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes, Newco will not be considered to be a corporation for purposes of determining the extent to which gain shall be recognized on the transfer. Since the nonrecognition of gain provisions of section 351 apply only if Newco is considered to be a corporation, failure to satisfy section 367(a)(1 would result in recognition of any gain realized by P and S on the transfer.

In Rev. Rul. 78-201 a domestic corporation operated a business as a branch in a foreign country. The domestic corporation incurred losses in connection with its branch that reduced its worldwide income subject to federal income tax. The domestic corporation transferred the assets of its branch to a newly formed corporation in the foreign country in exchange for all of its stock. Since income subsequently earned by the new corporation from these operations will not be included in the domestic corporation's worldwide income subject to federal income tax, the transfer gives rise to a potential mismatching of related income and loss. Therefore, Rev. Rul. 78-201 required the United States transferor (the domestic corporation) to recognize as gain on the transfer an amount of ordinary foreign source income equal to the sum of the 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.

The losses that P incurred in connection with its country A branch had reduced the amount of P's worldwide income subject to federal income tax. As a result of the foreign incorporation of P's country A branch, the income to be produced by the branch, that is indirectly attributable to the losses, will not be taken into account by P and thus will not increase the amount of P's worldwide income subject to federal income tax. The effect of the incorporation will, therefore, be a potential mismatching of revenue and deductions when income is finally produced. Accordingly, P's transfer of its country A branch properties to Newco 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) of the Code, only if P, pursuant to Rev. Rul. 78-201, recognizes a gain on the transfer an amount of ordinary foreign source income equal to the country. A losses incurred by the business being incorporated. In contrast, S's country A branch has always been profitable, and its foreign incorporation will not result in a mismatching of revenue and deductions. P and S are an affiliated group of corporations that file a consolidated federal income tax return, and their country A branches constituted an integrated business when incorporated. The issue is whether the losses of P's branch and the profits of S's branch should be combined for purposes of Rev. Rul. 78-201.

In the instant case, there are three profit and loss histories to be examined: (1) P's country A branch prior to January 1, 1979; (2) S's country A branch prior to January 1, 1979; and (3) the combined results of P's and S's country A branches subsequent to January 1, 1979, the date on which the branches together became a single business and the two corporations became an affiliated group of corporations filing a consolidated federal income tax return.

Prior to P's acquisition of S, the two corporations, and their respective country A branches, were separate and independent tax entities and business operations. For their 1977 and 1978 tax years, there is no relationship between the business activities or the profit and loss histories of P and S, or of their country A branches. Therefore, the 1977 and 1978 losses of P's country A branch are not reduced by the 1977 and 1978 profits of S's country A branch for purposes of Rev. Rul. 78-201. Subsequent to P's acquisition of S, however, the profits and losses of the two corporations (including their branches) were reflected on a consolidated return and the complete integration of their substantially identical country A branches caused those branches to constitute a single business. Consequently, the losses of P's country A branch are properly netted against the profit of S's country A branch for purposes of determining, pursuant to Rev. Rul. 78-201, the amount of gain to be recognized as ordinary foreign source income on the transfer. Thus, the 1979 losses of P's country A branch (200x dollars) are offset by the 1979 profits of S's country A branch (100x dollars) for purposes of Rev. Rul. 78-201. See Rev. Rul. 81-82, page 127, this Bulletin.

HOLDING

The P-S group must include in income, pursuant to Rev. Rul. 78-201, an amount equal to (1) the 1977 and 1978 losses of P's country A branch (400x dollars), plus (2) the excess of the 1979 losses of P's country A branch over the 1979 profits of S's country A branch (200x dollars in losses, less 100x dollars in income, for an excess of 100x dollars in losses).

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 78-201 is amplified.