Notice 2016-73 also — Internal Revenue Bulletin 2023-44

where the P acquisition is between FP and USP. In this variation of the transaction, FP (which has no earnings and profits) acquires stock of USP in exchange for nonqualified preferred stock of FP, and FP uses the stock of USP to acquire the stock of FT in an applicable triangular reorganization. After the applicable triangular reorganization, the taxpayer causes FP to redeem its nonqualified preferred stock from USP in exchange for cash or a note. The taxpayer takes the position that (i) the Final Regulations do not apply to FP’s transfer of nonqualified preferred stock to USP because nonqualified preferred stock is not “property” under the Final Regulations, and (ii) FP’s redemption of the nonqualified preferred stock does not cause USP to have an income inclusion because FP has no earnings and profits. The desired effect of this variation is similarly a repatriation of property from FP to USP at no U.S. tax cost.

To address this type of transaction, Notice 2016-73 announced that future regulations would modify the definition of property in §1.367(b)-10(a)(3)(ii) to include stock of S that is nonqualified preferred stock (as defined in section 351(g) (2)).

II. Rules Applicable to Inbound Nonrecognition Transactions

A. §1.367(b)-3 and Notice 2016-73

Section 1.367(b)-3 generally applies to an acquisition by a domestic corporation (the domestic acquiring corporation) of the assets of a foreign corporation (the foreign acquired corporation) in a liquidation described in section 332 or an asset acquisition described in section 368(a)(1)

(in each case, an inbound nonrecognition transaction). Upon an inbound nonrecognition transaction, §1.367(b)-3 requires certain shareholders of the foreign acquired corporation to include in income as a deemed dividend the all earnings and profits amount with respect to their stock in the foreign acquired corporation. ¹ Under §1.367(b)-2(d), that amount is generally determined under the principles of section 1248 when computing the amount of earnings and profits attributable to stock, subject to certain adjustments. For example, the all earnings and profits amount does not take into account earnings and profits of subsidiaries of the foreign acquired corporation notwithstanding section 1248(c) (2). See §1.367(b)-2(d)(3)(ii).

Section 1.367(b)-3 is intended to ensure the appropriate carryover of tax attributes from the foreign acquired corporation to the domestic acquiring corporation. The preamble to proposed regulations issued in 1991 describes the section 367(b) principles relevant to inbound nonrecognition transactions and specifically identifies the prevention of “the repatriation of earnings and profits without tax” as one such principle. 56 FR 41993, 41996. The 1991 proposed regulations accordingly introduced the concept of including in income the all earnings and profits amount, which was intended to reflect “the proper measure of the earnings and profits [of the foreign acquired corporation] that should be subject to tax.” Id. The preamble to final regulations issued in 2000 further explained that the inclusion of the all earnings and profit amount “generally ensures that the section 381 carryover basis reflects an after-tax amount” and describes “the appropriate carryover of attributes from foreign to domestic corporations” as “the principal policy consideration of section 367(b) with respect to inbound nonrecognition transactions.” TD 8862, 65 FR 3589, 3590. Section 1.367(b)-3 therefore ensures that when asset basis is repatriated the basis either reflects after-tax earnings and profits or is accompanied by an income inclusion attributable to the untaxed earnings and profits that gave rise to that basis.

As illustrated in Notice 2016-73 and summarized above in Part I.F of the Explanation of Provisions section of this preamble, there are some circumstances where the earnings and profits of the foreign acquired corporation do not accurately reflect the basis in its assets. In particular, the earnings and profits of the foreign acquired corporation may be insufficient to the extent that earnings and profits that gave rise to the foreign acquired corporation’s asset basis reside in lower-tier foreign corporations as a result of an applicable triangular reorganization that does not give rise to a deemed distribution. Because the all earnings and profits amount does not account for the earnings and profits of lower-tier foreign corporations, a deemed dividend of the all earnings and profits amount will not have the intended effect of ensuring the appropriate carryover of asset basis in such cases.

To address this concern, Notice 201673 announced that §1.367(b)-3 would be modified to require certain shareholders of the foreign acquired corporation to adjust their all earnings and profits amount upon an inbound nonrecognition transaction. Specifically, an exchanging shareholder that exchanges stock in a foreign acquired corporation with respect to which there is EAB would increase its all earnings and profits amount by certain earnings and profits of lower-tier foreign corporations, referred to in Notice 2016-73 as “specified earnings.” Notice 2016-73 defined EAB as the amount by which the inside asset basis of the foreign acquired corporation exceeded the sum of its earnings and profits, its outside stock basis, and its liabilities assumed by the domestic acquiring corporation. The EAB concept is in furtherance of a balanced tax-basis balance sheet. In other words, the EAB concept recognizes that the tax basis in a corporation’s assets generally is derived from these three sources, with outside stock basis serving as a proxy for contributed capital. While basis derived from contributed capital reflects after-tax amounts (or, in the case of liabilities assumed by the domestic acquiring corporation, is expected to

1 Certain other shareholders of the foreign acquired corporation may be required to recognize realized gain with respect to their exchanged stock. See §1.367(b)-3(c)(2).

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be satisfied by after-tax amounts of the domestic acquiring corporation), basis derived from a foreign corporation’s untaxed earnings and profits might not be subject to U.S. tax until those earnings are repatriated. For this reason, a foreign corporation’s untaxed earnings and profits are subject to tax via a deemed dividend of the all earnings and profits amount. This deemed dividend inclusion in effect requires that the exchanging shareholder “pay for” the tax basis in repatriated assets before that basis is used within the U.S. tax system.

Specified earnings are defined in Notice 2016-73 as the least of the following amounts: (i) the aggregate earnings and profits of foreign subsidiaries of the foreign acquired corporation attributable to the exchanging shareholder, (ii) the amount of the foreign acquired corporation’s EAB attributable to the exchanging shareholder, and (iii) the exchanging shareholder’s built-in gain in the stock of the foreign acquired corporation. The addition of specified earnings to the all earnings and profits amount is thereby intended to correct the basis imbalance of the foreign acquired corporation by taking into account certain earnings and profits residing in foreign subsidiaries that are presumed to have given rise to the EAB. Thus, the all earnings and profits amount, after taking into account specified earnings, should more accurately reflect the asset basis of the foreign acquired corporation that is repatriated pursuant to the inbound nonrecognition transaction.

The proposed regulations generally would adopt the rules described in Notice 2016-73, modified as discussed in the remainder of this preamble. This preamble uses the term “EAB rules” to refer collectively to the modifications that are proposed to be made to §1.367(b)-3.

B. General scope of the EAB rules

As described in Notice 2016-73, the EAB rules would apply to any inbound nonrecognition transaction regardless of whether the taxpayer had previously engaged in an applicable triangular reorganization. This scope reflected the possibility that EAB policy concerns could arise as a result of other transactions and that

taxpayers may attempt to achieve similar results through such other transactions.

The comment recommended that the EAB rules be applied to a narrower set of transactions, citing, among other reasons, the significant compliance burden that would otherwise be imposed on legitimate business transactions. The comment thus recommended that the EAB rules be applied only to taxpayers that had completed an applicable triangular reorganization before the issuance of Notice 2016-73 that involved a foreign target corporation; did not make adjustments that have the effect of a distribution of property from S to P; and engage in a future inbound nonrecognition transaction. If narrowed in this way, the comment further suggested that the EAB rules apply on only a transitional basis; for example, for the 10-year period following Notice 2016-73. The comment asserted that a broader application of the EAB rules would be unnecessary in light of Notice 2016-73’s proposed modification to the section 367(a) priority rule, which, by requiring adjustments for a deemed distribution whenever the target is a foreign corporation, should prevent taxpayers from separating basis from earnings and profits in future transactions. As an alternative, the comment suggested that the EAB rules be applied only to inbound nonrecognition transactions that follow an applicable triangular reorganization or other specifically enumerated transactions.

The Treasury Department and the IRS agree that it would be appropriate to narrow the scope of the EAB rules for the reasons noted in the comment. In general, the proposed regulations accordingly would limit the application of the EAB rules to those inbound nonrecognition transactions where (i) S previously acquired stock or securities of P in exchange for property in connection with a triangular reorganization and (ii) adjustments were not made that have the effect of a distribution of property from S to P under section 301. See proposed §1.367(b)-3(g)(1)(i). However, to address avoidance situations that would have been subject to the EAB rules under the broad scope announced in Notice 2016-73 (which did not predicate the application of the EAB rules on there having been an applicable triangular reorganization), the proposed regulations

would also provide that the EAB rules apply to inbound nonrecognition transactions where EAB was previously created in connection with a transaction other than a triangular reorganization if the principal purpose of such other transaction was to create EAB. See proposed §1.367(b)-3(g) (1)(ii). This more limited application of the EAB rules is anticipated to relieve taxpayers from the need to comply with the EAB rules with respect to non-tax motivated transactions while still addressing the policy concerns identified in Notice 2016-73. The proposed regulations would not adopt the comment’s suggestion to apply the EAB rules only to situations where an applicable triangular reorganization involving a foreign target was completed before the issuance of Notice 2016-73. The Treasury Department and the IRS are concerned that such a limitation would prevent the application of the EAB rules to future transactions designed to create EAB. For example, a subsequent applicable triangular reorganization could give rise to EAB where the target corporation is domestic because the section 367(a) priority rule continues to apply in that context. EAB could thus arise if the section 367(a) priority rule applies to prevent the application of the Final Regulations and P and S are both foreign corporations. An ongoing application of the EAB rules is also necessary to address the case where the target is a foreign corporation but the taxpayer asserts that its transaction is not subject to §1.367(b)-10 under a novel or unforeseen theory. For this reason, the proposed regulations also would not condition the applicability of the EAB rules on the taxpayer having participated in an applicable triangular reorganization. The proposed regulations instead would provide that the EAB rules may apply to EAB created by any triangular reorganization (provided that the other conditions described in the preceding paragraph are met—that is, S acquired stock or securities of P for property in connection with the reorganization, and adjustments were not made that have the effect of a distribution of property from S to P under section 301) and to EAB created in other transactions that have a principal purpose of creating EAB. See proposed §1.367(b)-3(g)(1).

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C. EAB reduction rule

Under Notice 2016-73, all EAB with respect to a foreign acquired corporation is taken into account upon an inbound nonrecognition transaction, regardless of how the EAB arose. However, if the taxpayer could demonstrate that EAB was not attributable to property provided by a foreign subsidiary, then EAB is reduced to the extent of such EAB (the EAB reduction rule).

The comment asserted that the EAB reduction rule amounted to a presumption that all EAB originated from the earnings and profits of foreign subsidiaries. The comment stated that overcoming this presumption would place a significant burden on taxpayers because it would require a comprehensive review of the foreign acquired corporation’s historic transactions to determine the extent to which EAB should be reduced. The comment therefore recommended that the EAB rules be revised such that taxpayers be permitted to take into account only the EAB created by an applicable triangular reorganization (or any other specifically identified transaction).

The Treasury Department and the IRS expect that the more limited scope of the EAB rules set forth in the proposed regulations would address the concern reflected in the comment. As proposed in these regulations and discussed in Part II.B of the Explanation of Provisions section of this preamble, the EAB rules would apply only to those inbound nonrecognition transactions that follow certain triangular reorganizations (or other transactions having a principal purpose of creating EAB) as opposed to any inbound nonrecognition transaction. This narrower scope would substantially reduce the burden of complying with the proposed EAB rules by eliminating the need for many taxpayers to determine whether EAB exists with respect to a foreign acquired corporation.

This narrowed scope also would obviate the rationale for the EAB reduction rule, which was intended to provide relief where a taxpayer could demonstrate that EAB was not attributable to an avoidance transaction. Such a relief measure would not be appropriate under the proposed regulations, however, because the proposed regulations would apply only

to tax-motivated transactions. The EAB reduction rule would therefore be removed with respect to transactions completed after the issuance of the proposed regulations. But see the EAB reduction rule in proposed §1.367(b)-3(g)(7)(ii)(C) for certain transactions completed before the issuance of the proposed regulations. The proposed regulations accordingly would provide that a taxpayer subject to the EAB rules by reason of having engaged in a triangular reorganization must take into account all EAB with respect to the foreign acquired corporation, regardless of how that EAB arose and without the ability to reduce EAB to the extent it is not attributable, directly or indirectly, to property provided by a foreign subsidiary of the foreign acquired corporation.

D. Treatment of unrelated minority shareholders

As discussed in Part II.A of the Explanation of Provisions section of this preamble, one element of the EAB computation is the amount of aggregate outside basis in the stock of the foreign acquired corporation. An exchanging shareholder that would be subject to the EAB rules would thus potentially need to identify the outside bases of other, unrelated shareholders of the foreign acquired corporation to calculate the amounts of EAB and specified earnings. The comment asserted that it may not be possible for an exchanging shareholder to obtain this information and accordingly suggested that the outside bases of such unrelated minority shareholders be disregarded (along with any related share of inside basis, liabilities, and earnings and profits) when calculating EAB and specified earnings.

The Treasury Department and the IRS recognize that the presence of unrelated minority shareholders may create some uncertainty but expect that narrowing the application of the EAB rules to only a limited set of inbound nonrecognition transactions would appropriately address the concern reflected in the comment. The transactions of which the Treasury Department and the IRS are aware, and which the proposed regulations are generally intended to address, are typically internal restructurings that by their nature are unlikely to involve unrelated

shareholders. See Notice 2016-73, Section 3. Moreover, modifying the EAB rules as the comment suggests would require additional rules to specify how an exchanging shareholder would disregard unrelated minority shareholders, thereby adding complexity to the EAB calculations to accommodate an unlikely fact pattern. Therefore, the proposed regulations would not adopt this suggestion.

E. Computation of specified earnings

As discussed in Part II.A of the Explanation of Provisions section of this preamble, the rules described in Notice 2016-73 seek to correct the basis imbalance of the foreign acquired corporation by increasing an exchanging shareholder’s all earnings and profits amount by the amount of “specified earnings.” Specified earnings are limited, in part, to the sum of the earnings and profits with respect to each foreign subsidiary of the foreign acquired corporation that are attributable under section 1248(c)(2) to the stock of the foreign acquired corporation that is exchanged pursuant to the inbound nonrecognition transaction. Accordingly, specified earnings under the notice are not sourced from PTEP of foreign subsidiaries of the foreign acquired corporation because PTEP is not included in earnings and profits for purposes of section 1248. See section 1248(d)(1). In other words, the rules described in Notice 2016-73 would not allow the foreign acquired corporation’s basis imbalance to be corrected by a deemed distribution of lower-tier PTEP, even though a taxpayer may have created EAB by separating asset basis from earnings and profits that are characterized as PTEP.

In light of the TCJA, which increased the prevalence of PTEP, the Treasury Department and the IRS are of the view that the policies of the EAB rules are better served if, instead of adjusting an exchanging shareholder’s all earnings and profits amount as described in Notice 2016-73, the foreign acquired corporation is treated as receiving a deemed distribution under section 301 from its foreign subsidiaries, and the exchanging shareholder then accounts for the effects of the deemed distribution in the inbound nonrecognition transaction. Such a deemed

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distribution more accurately addresses the basis imbalance of the foreign acquired corporation because the deemed distribution may be sourced from both PTEP and non-PTEP earnings and profits, reflecting that the basis imbalance may be associated with either type of earnings and profits. A deemed distribution from a foreign subsidiary to the foreign acquired corporation is also more likely to align the EAB rules with the substance of the taxpayer’s transaction because EAB generally arises where a taxpayer fails to treat a property transfer as a distribution under section 301. Furthermore, taking into account the effects of a section 301 distribution is consistent with the Final Regulations, which address applicable triangular reorganizations by taking into account the effects of a deemed distribution under section 301 from S to P.

The proposed regulations accordingly would modify the EAB rules by providing that an exchanging shareholder of the foreign acquired corporation computes its all earnings and profits amount after accounting for the effects of a deemed distribution from the foreign subsidiaries of the foreign acquired corporation to the foreign acquired corporation. See proposed §1.367(b)-3(g)(1). The deemed distribution, which occurs immediately before the inbound nonrecognition transaction, would be equal to the amount of “specified earnings.” The term specified earnings would be defined under the proposed regulations as the lesser of (i) the aggregate earnings and profits of foreign subsidiaries of the foreign acquired corporation (with no exclusion for those earnings and profits characterized as PTEP) (collectively, lower-tier earnings), and (ii) the EAB of the foreign acquired corporation. See proposed §1.367(b)-2(g)(2)(vii). The limitations on specified earnings described in Notice 2016-73 and Part II.A of the Explanation of Provisions section of this preamble (other than the EAB limitation, which is retained with modification) are removed because those limitations, which were designed in part to approximate a reasonable allocation of EAB among the shareholders of the foreign acquired corporation, are not necessary where the foreign acquired corporation’s basis imbalance is addressed by a deemed distribution. Thus, for example, the definition

of specified earnings in the proposed regulations would not be limited to the earnings and profits of each foreign subsidiary attributable under section 1248(c)(2) to the stock of the foreign acquired corporation exchanged, but instead would include all of the earnings and profits of lower-tier foreign subsidiaries (and therefore does not exclude PTEP). The proposed regulations would adopt this approach because under the deemed distribution model all such earnings and profits would be available to increase the earnings and profits of the foreign acquired corporation if actually distributed to it through the chain of ownership.

Where specified earnings are drawn from multiple foreign subsidiaries, specified earnings would be drawn from all foreign subsidiaries on a pro rata basis (in proportion to each foreign subsidiary’s share of aggregate earnings and profits of the foreign subsidiaries). See proposed §1.367(b)-3(g)(3). In addition, and consistent with §1.367(b)-2(e)(2), specified earnings drawn from foreign subsidiaries would be treated as being distributed to the foreign acquired corporation through all tiers of intermediate owners, rather than directly to the foreign acquired corporation. See proposed §1.367(b)-3(g) (1).

The Treasury Department and the IRS are aware that limiting the amount of the deemed distribution by the amount of lower-tier earnings would preclude the deemed distribution from giving rise to a return of basis under section 301(c)(2) or gain recognition under section 301(c) (3) and in that respect would differ from the deemed distribution described in the Final Regulations. See §1.367(b)-10(b). The approach taken in the proposed regulations reflects administrability concerns that could arise from adopting a more complete distribution model which could require, for example, rules to allocate the appropriate amount of basis recovery and section 301(c)(3) gain among tiers of foreign subsidiaries. That additional complexity may not be justified when balanced against the limited application of the EAB rules, which apply only where a taxpayer has previously engaged in a transaction described in proposed §1.367(b)-3(g)(1). The Treasury Department and the IRS continue to study transactions that could

give rise to EAB, including whether EAB principles should be applied to other types of inbound nonrecognition transactions.

F. Definition of foreign subsidiary