Reconciling the Irreconcilable Earnings and Profits in Cross-Border - PowerPoint PPT Presentation

Reconciling the Irreconcilable Earnings and Profits in Cross-Border Separations Bloomberg BNA Corporate Taxation Advisory Board 16 January 2014 Devon M. Bodoh J. Brian Davis KPMG LLP Ivins, Phillips & Barker Chtd.

Agenda • Background • Allocation of E&P in corporate separations Corporate separations involving a CFC • Proposed regulations impacting allocation of E&P in cross-border • corporate separations Policy issues • 2

Background

Background – Significance of E&P • Earnings and profits (E&P) is primarily relevant for determining whether a distribution from a corporation to its shareholders is taxed as a dividend It is a shareholder relevant attribute • If the amount of the distribution exceeds the corporation’s E&P, the excess • is treated as a return of basis (to the extent of such basis) and then as an exchange of stock subject to taxation as a capital gain 4

Background – Significance of E&P (cont.) • In the international context, E&P is also used to determine the taxation of dispositions of the stock of foreign corporations under sections 367(b) and 1248 The purpose of these provisions is to ensure previously untaxed E&P of • a controlled foreign corporation ( CFC ) is taxed in the US • Dispositions of a foreign corporation’s stock governed by these two provisions may result in income that is taxed as a dividend depending on the CFC’s E&P 5

Background – Tax-Free Separations Under Section 355 • Section 355: Basic tax-free corporate separation requirements • Non-tax business purpose Active trade/business conducted by both distributing and controlled • At least 80% voting power and at least 80% total number all other classes • of controlled held by distributing immediately prior to distribution and is distributed in separations • Separation not a device for distribution of E&P of distributing or controlled • Certain continuity requirements satisfied Section 355(d) – distribution is not a “disqualified distribution” • Section 355(e) – no prohibited 50%-or-greater acquisitions of stock of • distribution or controlled in connection with separation Section 355(g) – neither distributing nor controlled is a “disqualified • investment company” 6

Background – Tax-Free Separations Under Section 355 (cont.) • If Distributing’s distribution of stock of Controlled to Distributing’s SH (a spin-off) SH satisfies the requirements of Section 355, the following US fed. income tax consequences Spin off Distributing are expected to occur: • No gain / loss to Distributing on distribution of Controlled stock Controlled No income to Distributing’s SHs on receipt of • controlled stock • Distributing’s SHs’ stock basis in Distributing allocated between Distributing and Controlled stock SH Distributing’s E&P allocated between Distributing • and Controlled Distributing Controlled • Special rules may apply in cross-border context 7

Background – Tax-Free Separations Under Section 355 (cont.) • Tax-free corporate separations under section 355 generally take one of two general forms: A distribution of Controlled not preceded by a contribution of assets • ( Standalone 355 Transaction ) • A distribution of Controlled preceded by a contribution of assets from Distributing to Controlled under Section 368(a)(1)(D)/Section 355 ( D/355 Transaction ), further categorized where: Controlled is newly-formed • Controlled is an existing subsidiary • 8

General Allocations of E&P in Corporate Separations

General Allocations of E&P – Background • The section 312 regulations provide rules for adjusting the E&P of Distributing and Controlled in a corporate separation: D/355 Transaction – Distributing’s E&P generally allocated between • Distributing and Controlled • Standalone 355 Transaction – Distributing’s E&P is reduced and Controlled’s E&P is potentially increased A deficit in E&P is never allocated to Controlled • 10

General Allocations of E&P – D/355 Involving Newco • E&P allocation in a D/355 Transaction • Controlled is Newco – E&P is allocated proportionately between Distributing and Controlled based on the relative FMVs of their businesses immediately after the separation 11

General Allocations of E&P – Ex. of D/355 Involving Newco • Facts SH • Prior to the transaction, Distributing’s SH owned  100% of the stock of Distributing FMV: $40 Spin off Distributing E&P: $60 Distributing had $60 of E&P and business of Controlled • assets with FMV of $40  • Step One – Distributing forms Controlled by Controlled $20 of stock D assets transferring business assets with a FMV of $20 to Controlled for Controlled stock in D-reorg Controlled Step Two – Distributing distributes the Controlled • stock to Distributing’s SH in a spin-off Distributing’s E&P allocated between Distributing • and Controlled Analysis • SH • Since Controlled is a Newco, Distributing’s E&P is allocated proportionately based on FMV of assets • Thus, $30 of Distributing’s E&P (50%) is allocated Distributing Controlled to Controlled; $30 remains with Distributing 12

General Allocations of E&P – D/355 Involving Oldco • E&P allocation in a D/355 Transaction • Controlled is Oldco – “In a proper case, allocation shall be made between the distributing corporation and the controlled corporation in proportion to the net basis of the assets transferred and the assets retained or by such other method as may be appropriate.” Treas. Reg. Section 1.312-10(a) Net basis – the basis of the assets less liabilities assumed or • liabilities to which such assets are subject • This rule does not expressly provide which transactions it covers, and the scope of the term “in a proper case” is unclear  The preamble to the proposed regulations under Section 367(b) (discussed later) takes the position that this regulation does not address the allocation of E&P in a D/355 Transaction involving an Oldco  If this is true, what transactions does the “in a proper case” language refer to? 13

General Allocations of E&P – Ex. of D/355 Involving Oldco • Facts SH • Distributing has two business assets (excluding the  Controlled stock) with equal values of $20. Distributing FMV: $20/$20 Spin off Distributing contributes one of the assets, which has a basis of $10, to Basis: $10/$30 of Controlled Starting E&P: $60 Controlled and retains other asset, which has basis of $30  Additionally, prior to transaction (i) Controlled has • Controlled $20 of business assets with a value and basis of $20 (thus, the stock D assets Controlled stock has a value of $20), (ii) Distributing has $60 of E&P, and (iii) Controlled has no E&P Starting FMV: $20 Controlled Starting Basis: $20 Starting E&P: $0 • Analysis If this is the “proper case” requiring allocation based on • net basis, $15 of the E&P is allocated to Controlled (25% or $10/$40) and the remaining $45 stays with Distributing SH • If this is not the proper case, how is E&P allocated? • FMV of the assets? • Hybrid Approach (discussed later) under the Distributing Controlled proposed Section 367(b) regulations? 14

General Allocations of E&P – Standalone 355 Transaction • E&P allocation in a Standalone 355 Transaction • Distributing – The E&P of Distributing is decreased by the lesser of: • The amount by which the E&P of the distributing would have been decreased if it had transferred the stock of Controlled to a Newco in a D/355 Transaction, or The net worth of Controlled (i.e., the sum of the basis of all of the • properties plus cash minus all liabilities) • Controlled – if the E&P of Controlled immediately before the transaction is less than the amount of the decrease in E&P of Distributing (including a case in which Controlled has a deficit), the E&P of Controlled will be equal to the amount of the decrease. Otherwise, Controlled’s E&P remains unchanged 15

General Allocations of E&P – Ex. of Standalone 355 Txn. • Facts SH • Prior to the transaction, Distributing’s SH owned 100% of the stock of Distributing which has E&P of $100 and assets FMV: $120 Spin off Distributing (not including the Controlled stock) with a FMV of $120 E&P: $100 of Controlled Assume Controlled’s net worth is at least $25 • Distributing owns 100% of the Controlled stock, which • has a FMV of $40 and E&P of $15 FMV: $40 Controlled E&P: $15 Distributing distributes the Controlled stock to • Distributing’s SH Analysis • • Distributing’s E&P is reduced by $25, which is the amount SH its E&P would have decreased if it had contributed the Controlled stock to a Newco ($40/$160 or 25%, multiplied by $100) • Because Controlled’s E&P is less than the amount of the Distributing Controlled reduction, its E&P is increased to $25 16

Separations Involving a CFC (Distributing or Controlled)