United States: IRS Rules On Termination Of GRA In Certain Inbound Asset Reorganizations

On Sept. 23, the IRS released a private letter ruling (PLR) (PLR 201639014) that held that the acquisition of substantially all the assets of a transferred corporation by a U.S. corporation results in the termination of the associated gain recognition agreement (GRA) under Section 367.  

Section 367 and the regulations promulgated thereunder impose limitations on a U.S. person's ability to transfer property, including stock, to a foreign corporation in a tax-free manner. If a U.S. transferor owns at least 5% of the vote or value of a transferee foreign corporation immediately after an outbound transfer described in Section 367(a), the U.S. person must generally enter into a GRA as a precondition to qualifying for tax-free treatment on the transfer. As a general rule, a GRA will require the U.S. transferor to recognize the gain that was realized but not recognized on the initial transfer if there is a "triggering event" during the term of the GRA. The term of a GRA generally is five full taxable years following the close of the taxable year of the transfer. Upon the occurrence of certain events, a GRA may terminate early, that is, prior to a "triggering event" occurring and prior to the expiration of the 60-month term of the GRA. Early termination events generally involve a disposition of the transferee stock where specific conditions are satisfied. Where an early termination event does not occur, a taxpayer generally must recognize gain upon the occurrence of a "triggering event" with respect to the GRA if such event occurs during its term. The regulations contain numerous provisions that result in triggering events with respect to the stock of the transferred foreign corporation. As a general rule, if the transferee foreign corporation disposes of the stock of the transferred corporation subject to a GRA, or the transferee corporation disposes of substantially all of the assets subject to a GRA, a triggering event occurs.

Under the facts of the PLR, during Year 1, Parent, a U.S. corporation, transferred the stock of FSub1, a foreign corporation, to FSub2, a second foreign corporation, in a transaction to which Section 351 was applicable. Parent entered into a GRA, the Year 1 GRA, in connection with the Year 1 transfer of FSub 1. In Year 2, FSub1 converted to an unlimited liability company under local law. As a result of this conversion, FSub1 became a disregarded entity of FSub2 for U.S. federal income tax purposes. Parent treated the FSub1 liquidation as qualifying under Section 332 and as being unrelated to the FSub1 stock transfer in Year 1. Parent determined that the FSub1 liquidation was not a triggering event pursuant to Reg. Sec. 1.367(a)-8(k)(8) and entered into a new GRA, the Year 2 GRA, as required under said regulation. The Year 2 GRA replaced the Year 1 GRA and the Year 1 GRA terminated without effect.   

During Year 3, FSub2 made an election to be disregarded as an entity separate from its owner, Parent, for U.S. federal income tax purposes. As a result of this transaction (the Inbound Liquidation), Parent was considered as owning all the assets formerly owned by FSub2 as FSub 2 was disregarded as an entity separate from its owner for U.S. federal income tax purposes. Parent treated the Inbound Liquidation as a reorganization under Section 368(a)(1(C). Subsequent to the Inbound Liquidation, and pursuant to further steps in Year 3, Parent transferred substantially all of the historic assets of FSub1 to Partnership, a U.S. partnership, in which parent owned X%.  In Year 3, Parent entered into a GRA, the Year 3 GRA, replacing the Year 2 GRA, with the Year 2 GRA terminating without effect.  

In the transaction proposed in the PLR, Partnership will sell substantially all the assets of FSub1 to an unrelated buyer.  

The IRS determined that the Inbound Reorganization did not result in gain recognition under the Year 2 GRA under Treas. Reg. 1.367(a)-8(k)(14) because (1) the Inbound Liquidation qualified as a nonrecognition transaction, (2) Parent retained a direct or indirect interest in substantially all of FSub1's assets and (3) the Year 3 GRA met the requirements of Treas. Reg. 1.367(a)-8(k)(14). As a result, the Year 3 GRA caused the Year 2 GRA to terminate without effect and avoided gain recognition with respect to the Year 2 GRA.

The IRS also determined the Year 3 GRA immediately terminated upon its filing. The ruling states that because 1.367(a)-8(o) applies to transactions to which Treas. Reg. 1.367(a)-8(j) applies, the principles of paragraph (o) also apply to determine whether the transaction constitutes a triggering event.  Because Parent received substantially all the historic assets of FSub1 with a carryover basis, and any gain on the subsequent disposition of such assets by Parent would be subject to U.S. tax in the hands of Parent, under the principles of Treas. Reg. 1.367(a)-8(o)(5), any gain by Parent on the sale of the FSub1 assets previously held by FSub2 represents the gain on stock of FSub1 described in the Year 1 GRA.

As a general matter, Treas. Reg. 1.367(a)-8(o)(5) provides that a GRA terminates without further effect if the transferred stock is distributed or transferred to the U.S. transferor, a member of the U.S. transferors consolidated group or an individual that is a U.S. person (the "Qualified Recipients") and certain other conditions are met. The primary condition is that the aggregate basis in transferred stock received by the Qualified Recipients is not greater than that aggregate basis of such stock at the time of the initial transfer. However, the regulations do not provide that a GRA terminates without further effect if a qualified recipient acquires substantially all the assets of the transferred corporation.  

Notwithstanding the apparent limitations of the express wording in the regulations, the ruling appears to be taxpayer favorable, providing an argument for termination of a GRA without further effect upon the inbound transfer of substantially all the transferred corporations' assets in similar fact patterns.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.