SECTION 3. BACKGROUND

Section 367(a)(1) provides that if, in connection with an exchange described in section 332, 351, 354, 356, or 361, a United States person transfers property to a foreign corporation, such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered to be a corporation. Section 367(a)(2) provides that, except to the extent provided in regulations, section 367(a)(1) shall not apply to the transfer of stock or securities of a foreign corporation that is a party to a reorganization. Section 367(a)(3) provides that, except to the extent provided in regulations, section 367(a)(1) shall not apply to the transfer of property used in an active foreign trade or business. Section 367(a)(6) grants regulatory authority to provide additional exceptions to the general rule of section 367(a)(1).

Section 367(a)(5) provides that in the case of an exchange described in section 361(a) or (b) (section 361 exchange), the exceptions to section 367(a)(1) provided under sections 367(a)(2) and (a)(3) shall not apply. Therefore, the general rule under section 367(a)(5) is that a transfer of property by a domestic corporation (U.S. transferor) to a foreign corporation in a section 361 exchange is subject to section 367(a)(1). Section 367(a)(5) also provides, however, that subject to basis adjustments and other conditions to be provided in regulations, the general rule will not apply (and the transfer may therefore be eligible for the exceptions under sections 367(a)(2) and (a)(3)) if the U.S. transferor is controlled (within the meaning of section 368(c)) by five or fewer domestic corporations.

Regulations have not been issued under section 367(a)(5). However, the legislative history of section 367(a)(5) explains how the required basis adjustments would have to be made:

It is expected that regulations will provide this relief only if the U.S. corporate shareholders in the transferor agree to take a basis in the stock they receive in a foreign corporation that is a party to the reorganization equal to the lesser of (a) the U.S. corporate shareholders’ basis in such stock received pursuant to section 358, or (b) their proportionate share of the basis in the property of the transferor corporation transferred to the foreign corporation. S. Rep. No. 100–445, 100 ^th Cong., 2d Sess. at 62 (Aug. 3, 1988). Thus, the gain realized, but not recognized, by the U.S. transferor in connection with the section 361 exchange must be preserved in the stock received by certain corporate shareholders of the U.S. transferor in the reorganization.

The rules regarding the treatment of transfers of stock or securities to foreign corporations are contained in §1.367(a)–3. Certain outbound reorganizations followed by transfers to controlled corporations and certain successive transfers of property to which section 351 applies constitute “indirect stock transfers” and are subject to §1.367(a)–3. See §1.367(a)–3(d)(1). Such indirect stock transfers are subject to gain recognition under section 367(a)(1), unless they qualify for the exceptions contained in §1.367(a)–3(b) (for transfers of foreign stock) or –3(c) (for transfers of domestic stock). See §1.367(a)–3(d)(1).

The general coordination rule of §1.367(a)–3(d)(2)(vi)(A) provides, in general, that if, pursuant to an indirect stock transfer, a U.S. person transfers (or is deemed to transfer) property to a foreign corporation in an exchange described in sections 351 or 361, such transfer is subject to sections 367(a) and (d), prior to the application of the indirect stock transfer rules of §1.367(a)–3(d). Section 1.367(a)–3(d)(2)(vi)(A). This general coordination rule, however, is subject to two exceptions (Exception One and Exception Two).

Exception One is available for certain section 361 transfers of property made pursuant to a reorganization to the extent

the foreign acquiring corporation transfers the acquired property (re-transferred property) to a domestic corporation controlled within the meaning of section 368(c) (domestic controlled corporation) as part of the same transaction. However, Exception One applies only if the domestic controlled corporation’s basis in the re-transferred property is no greater than the basis the U.S. transferor had in such property and either (i) the domestic acquired corporation is controlled (within the meaning of section 368(c)) by five or fewer domestic corporate shareholders, appropriate basis adjustments as provided in section 367(a)(5) are made to the stock of the foreign acquiring corporation, and any other conditions provided in regulations under section 367(a)(5) are satisfied; or (ii) the indirect transfer of stock of the domestic acquired corporation satisfies the requirements of §1.367(a)–3(c)(1)(i), (ii), and (iv), and (c)(6), and the domestic acquired corporation attaches a statement to its tax return for the taxable year of the transfer. Section 1.367(a)–3(d)(2)(vi)(B)( 1 )( i ) and ( ii ).

Exception Two is available for transfers described in §1.367(a)–3(d)(1)(vi) where a U.S. person transfers property to a foreign corporation in a section 351 exchange, to the extent that such property is transferred by such foreign corporation to a domestic corporation in another section 351 exchange, but only if the domestic transferee’s basis in the property is no greater than the basis that the U.S. transferor had in such property. See §1.367(a)–3(d)(2)(vi)(B)( 2 ).