Notice 2016-73 announced that future

regulations would modify the section 367(a) priority rule such that it would not apply to an applicable triangular reorganization involving a foreign target corporation. Any such applicable triangular reorganization would thus be subject to

the Final Regulations with the result that adjustments would be made that have the effect of a distribution of property from S to P under section 301. A similar modification was announced with respect to the section 367(b) priority rule.

The comment supported the proposed modification to the section 367(a) priority rule. As an alternative, the comment suggested that the existing formulation of the section 367(a) priority rule (that is, without taking into account the modifications described in Notice 2014-32 that would limit the “amount” of section 367(a) income to the amount giving rise to U.S. tax) be retained in cases where the target is a foreign corporation. Under that formulation, the “amount” of section 367(a) income is compared to the “amount” of section 367(b) income, regardless of whether such amounts are subject to U.S. tax. The comment asserted that this formulation would cause a greater amount of section 367(b) income to be taken into account, thereby making it more difficult for taxpayers to exploit the section 367(a) priority rule to avoid the Final Regulations.

The Treasury Department and the IRS expect that the modification to the section 367(a) priority rule described in Notice 2016-73 would best address such exploitation by ensuring that adjustments that have the effect of a deemed distribution of property from S to P are made whenever the target is a foreign corporation. This result would reinforce one of the purposes of the Final Regulations by ensuring that property transfers that are in substance distributions are treated as such, thereby preventing the separation of property from the earnings and profits associated with that property. The comment’s alternative approach could also, as the comment acknowledged, invite the avoidance of section 301(c)(2) basis reduction in situations where a small amount of section 367(a) income is compared to a large amount of section 301(c)(2) basis reduction. Because a return of basis is not considered section 367(b) income, a small amount of section 367(a) income could be sufficient to trigger the section 367(a) priority rule. Accordingly, the proposed

regulations would adopt the modifications to the section 367(a) and section 367(b) priority rules described in Notice 201673. See proposed §§1.367(a)-3(a)(2)(iv) and 1.367(b)-10(a)(2)(iii).

As discussed in Part I.E of the Explanation of Provisions section of this preamble, Notice 2014-32 announced that the section 367(a) and section 367(b) priority rules would be modified to take into account only the portion of a distribution that would be actually subject to U.S. tax, including the extent to which a distribution would give rise to an inclusion under section 951(a) that would be subject to U.S. tax. In light of the TCJA, the proposed regulations also would modify the priority rules to take into account the extent to which a distribution would give rise to an inclusion under section 951A(a) that would be subject to U.S. tax (even though it is unlikely that a distribution from S to P would give rise to a section 951A(a) inclusion).

B. §1.367(b)-4 and Notice 2016-73

1. Overview