INSIGHT: When a Sale Might Not Be a Bargain

Many groups of multinational corporations need to restructure from time to time to better align their global operations. This restructuring can arise when, for example, the group makes a significant acquisition that results in complementary operations that ultimately need to be pared down. One expedient nontax strategy to combine operations in the same country is often to sell one company to another. However, in the U.S., that exchange may not be taxed as a sale in all too common circumstances. Let’s examine a basic case study.

Case Study

Peat Group USA Holding Corp (P-US) is sorting out certain U.S. federal income tax consequences on its purchase for $100 million cash from Fens B.V., a Dutch company (NLCo), of the shares of Gardens Inc., Fens’ wholly owned U.S. subsidiary (USCo). All three companies are wholly-owned, directly or indirectly, by Bogs Plc, a publicly traded Irish company. More specifically, P-US and NLCo are wholly-owned, first-tier subsidiaries of Bogs Plc. NLCo had recently acquired USCo from its founders, so little or no gain was expected to arise from the sale. P-US had recently achieved profitability and expects to have $25 million of U.S. earnings and profits (E&P) this year after several years of startup losses. USCo has a long history of profitability that it brings to the table.

Because P-US and NLCo are both “controlled” by Bogs Plc, the acquisition is governed by tax code Section 304(a)(1). Under that section, sale treatment is turned off and the purchase is recast as if (1) NLCo had contributed all the USCo shares to P-US in exchange for P-US shares of equal (aggregate) value in a putative tax-deferred transaction, immediately followed by (2) P-US’s constructive redemption of its deemed issued shares for cash of $100 million.

As a result of this recast, P-US’s tax basis in the shares of USCo will equal NLCo’s tax basis in those shares immediately before the transaction. It should be noted that if the USCo shares have a built-in loss (i.e., their basis exceeds their fair market value), then P-US will take a fair market value basis in the USCo shares, per Section 362(e)(1).

The constructive redemption of the deemed-issued P-US shares is tested under Section 302 to determine whether it should be treated as an exchange (and, thus, as a capital transaction) or as a distribution (and, thus, potentially qualifying as a dividend). Because the parties are related and assuming there is no plan to break that relationship status, the deemed redemption would be treated as a distribution subject to Section 301 (i.e., a normal distribution of cash subject to dividend treatment). (See Section 302(d).)

P-US’s distribution of $100 million will be treated as a dividend to the extent of the lesser of (1) $100 million and (2) the sum of P-US’s E&P, if positive, and USCo’s E&P, if positive. (See Section 304(b)(2).)

As stated above, P-US’s E&P this year will be $25 million. The fact that P-US’s accumulated E&P might be negative due to its loss history does not affect P-US’s positive E&P amount, as dividends are deemed paid first out of current year earnings. (See Section 316(a), and the regulations thereunder.) Accordingly, the deemed distribution from P-US should be a dividend to the extent of the lesser of $100 million and P-US’s E&P, $25 million.

This $25 million dividend amount will be subject to the U.S. tax withholding at the statutory tax rate of 30%. (See Sections 881 and 1442.) Whether a rate reduction under the US-Netherlands Tax Treaty could apply would need to be confirmed, including whether NLCo is eligible for treaty benefits under the limitation-on-benefits article (an anti-treaty-shopping provision). NLCo’s deemed ownership in P-US shares was fleeting at best, and neither the tax code nor the regulations actually tells NLCo exactly how much of P-US’s total stock (or how much of the stock’s voting power), if any, it purportedly held at the time of the deemed dividend equivalent transaction for treaty purposes. (The technical analysis involved to resolve this issue is beyond the scope of this introductory discussion. It easily could be the topic of a separate article.)

As P-US’s E&P is less than $100 million, and because USCo has positive E&P (either current or accumulated), NLCo will be deemed, for U.S. federal income tax purposes, to have received as a dividend an amount attributed to USCo equal to the lesser of (1) its positive E&P, or (2) $100 million less P-US’s E&P. This dividend sourced from USCo would not be deemed paid through P-US but rather directly from USCo to NLCo. Any proceeds over and above E&P are treated as a return of capital and then as capital gains.

This additional dividend amount will also be subject to the U.S. tax withholding at the statutory tax rate of 30%. Whether a rate reduction under the U.S.-Netherlands Tax Treaty could apply would need to be analyzed. NLCo no longer has direct ownership in USCo shares, and neither the tax code nor the regulations actually tells NLCo how to go about analyzing this situation. Again, the technical analysis involved is beyond the scope of this article.

It is important to record the decrease, if any, in USCo’s positive E&P because it might affect the amount of future dividends flowing from USCo to P-US, or have other effects. Further, to the extent USCo has any related-party debt, a deemed distribution could affect the U.S.-tax characterization of the debt, potentially resulting in unintended consequences. (See Section 385 and the regulations thereunder.)

Analysis

Clearly, Section 304 turned the otherwise U.S. federal income tax consequences of this sale completely off. NLCo is a corporation organized under foreign laws, and we will assume that it is not itself engaged in any U.S. trade or business. As such, in general, NLCo would not have expected to be subject to U.S. federal income tax on U.S.-source capital gains arising from a sale or disposition of shares of a U.S. corporation. (See Section 865.) The pitfalls for the unwary, however, do not stop here.

Under Section 897, a foreign person’s gain from the disposition of a U.S. real property interest (USRPI) is treated as if the gain were income effectively connected with a U.S. trade or business and, therefore, subject to U.S. federal income taxation. In addition, under Section 1445, the transferee (e.g., acquirer) is generally required to withhold 15% on the amount realized on the disposition of any USRPI (i.e., the gross purchase price) and remit it to the IRS. (Section 1445(a). Note the withholding tax under Section 1445 can be applied as an advance payment against the foreign person’s ultimate U.S. federal income tax liability.) A USRPI is defined as (1) any interest in real property located in the U.S. (or the U.S. Virgin Islands), or (2) any interest (other than an interest solely as a creditor) in any U.S. corporation unless the taxpayer establishes that such corporation was not a U.S. real property holding corporation (USRPHC) during the shorter of the period in which the taxpayer held such interest or the five-year period ending on the date of the disposition of the interest in the USRPHC (the testing period). (See Section 897(c)(1)(A).)

A U.S. corporation is a USRPHC if the aggregate fair market value of its USRPI (e.g., land, buildings, certain leases) equals or exceeds 50% of the aggregate fair market value of its total real property worldwide and its other business assets (i.e., USRPIs, interests in real property located outside the U.S., and all other assets used or held for use in its trade or business). (See Section 897(c)(2).)

For purposes of determining whether shares of a U.S. corporation are USRPIs, all U.S. corporations are presumed to be USRPHCs unless the taxpayer can establish that the U.S. corporation was not a USRPHC at any time during the testing period ending on the date of the disposition. (See Treas. Reg. Section 1.897-2(g)(1).)

For NLCo, as explained above, the sale would be recast as if (1) NLCo had contributed all the USCo shares to P-US in exchange for P-US shares of equal (aggregate) value, and immediately thereafter (2) P-US constructively redeemed its deemed-issued shares for cash of $100 million. The initial recast, the deemed contribution, involves a foreign person (NLCo) disposing of the shares in a U.S. corporation (USCo), which activates potential taxation under Sections 897 and 1445. Further, the second step of the recast could result in P-US making a distribution to NLCo that is treated as a return of capital and then as capital gain. These types of distributions are dispositions of the shares in a U.S. corporation (P-US) and activate potential taxation under Sections 897 and 1445. So, the Bogs Plc Group needs to determine the USRPHC status of both USCo and P-US prior to the sale transaction and potentially withhold and remit tax as a result of the two deemed dispositions (depending on the asset profile of each of USCo and P-US).

As we said at the start, many groups of multinational corporations need to restructure from time to time to better align their global operations. For U.S. tax purposes, a realignment of ownership in corporate group members via an exchange for cash (or debt) may not be treated as a “sale,” and the complexities outlined above need to be carefully assessed before undertaking such transactions. If Section 304 would result in significant U.S. tax obligations, alternative structuring options and different forms of consideration used therein should be explored to mitigate tax costs while achieving the business-driven combination objectives.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Steve Jackson is with Ernst & Young LLP’s National Tax Department in New York, Christopher J. Nelson is with Ernst & Young LLP’s National Tax Department in Washington, and Jillian Symes is with Ernst & Young LLP’s EMEIA U.S. Tax Desk in London.

The views expressed are those of the authors and do not necessarily represent the views of Ernst & Young LLP or any other member firm of the global EY organization.