In PLR 201639014, the IRS ruled that an inbound asset reorganization in which a US corporation (Parent) acquired substantially all the assets of a transferred corporation terminated the gain recognition agreement (GRA) previously entered with respect to the outbound transfer of the transferred corporation. As a result, a subsequent sale of those assets by the Parent do not trigger gain recognition under the GRA.

Facts

Prior to the transactions considered in the PLR, Parent had transferred the stock of one foreign subsidiary (FSub1 or the transferred corporation) to another foreign subsidiary (FSub2 or the transferee corporation) under an exchange described in Section 351. Parent entered into a GRA (Year 1 GRA) for that transfer under Treas. Reg. Sections 1.367(a)-3(b)(1)(ii) and 1.367(a)-8.

In the subsequent tax year, FSub 1 converted into a foreign limited liability company, which changed its classification for US federal tax purposes to an entity disregarded as separate from its owner (disregarded entity). The change of FSub 1's classification to a disregarded entity was treated as a tax-free liquidation of FSub 1 into FSub2 under Section 332 (FSub 1 Liquidation). Under the terms of the Year 1 GRA, FSub 1's liquidation was a triggering event, but did not constitute a gain recognition event under the exception provided by Treas. Reg. Section 1.367(a)-8(k)(8), which required Parent to enter into a replacement GRA (Year 2 GRA) for the initial transfer of the FSub1 stock with its Year 2 tax return (the Year 1 GRA terminated without further effect.)

Finally, in the second year following the year of the initial transfer, FSub 2 elected to be treated as a disregarded entity, resulting in Parent being treated as acquiring all of FSub2's assets (which included FSub 1's assets) in an inbound reorganization under Section 368(a)(1)(C). Under Section 362(a), Parent obtained a carryover basis in the assets acquired in the inbound reorganization.

Following the inbound reorganization, Parent contributed substantially all of FSub 1's historic assets to a US partnership under Section 721 (Partnership Contribution). The Inbound Reorganization and Partnership Contribution did not require gain recognition under the Year 2 GRA. Unsure whether the Inbound Reorganization terminated the Year 2 GRA, however, Parent entered into a replacement GRA (Year 3 GRA) with its Year 3 tax return (the Year 2 GRA terminated without further effect).

Following the Partnership Contribution, the partnership intended to sell substantially all of FSub 1's assets to an unrelated buyer, an event that would require gain recognition under the Year 3 GRA. Accordingly, USP sought a ruling from the IRS that the Inbound Reorganization terminated the Year 2 GRA.

Analysis

The IRS concluded that the Inbound Reorganization did not require gain recognition under the Year 2 GRA under Treas. Reg. 1.367(a)-8(k)(14) because: (1) the disposition of FSub 2 stock and substantially all of FSub 1's assets qualified as nonrecognition transactions; (2) USP retained a direct or indirect interest in substantially all of FSub 1's assets; and (3) the Year 3 GRA, into which Parent entered, met the requirements of Treas. Reg. 1.367(a)-8(k)(14)(iii). Therefore, the Inbound Reorganization did not trigger the Year 2 GRA, which instead terminated without further effect under Treas. Reg. 1.367(a)-8(c)(5)(i).

Under Treas. Reg. 1.367(a)-8(o)(5), a GRA generally terminates without further effect if the transferred stock is distributed or transferred to the US transferor (or a member of its consolidated group), but only if certain conditions are met. Those conditions include that the basis in the transferred stock following the distribution or transfer is not greater than the basis of the stock at the time of the initial transfer (as adjusted for any gain recognized by the US transferor in the initial transfer). The regulations do not, however, specify that a GRA terminates if the US transferor (or a member of its consolidated group) acquires substantially all of the assets of the transferred corporation.

Nonetheless, the IRS ruled that the Year 3 GRA should immediately terminate upon its filing because any gain by Parent on the sale of the FSub 1 assets effectively represented gain on stock of FSub1 for which the Year 1 GRA was filed. To explain its ruling, the IRS initially noted that Parent received substantially all of the historic assets of FSub 1 with a carryover basis, and any gain on Parent's subsequent disposition of the assets would be subject to US tax in the hands of Parent. Further, the IRS noted the general exception in Treas. Reg. 1.367(a)-8(k)(14) incorporates the principles of Treas. Reg. 1.367(a)-8(j) (identifying triggering events), so, by extension, the termination rules of Treas. Reg. 1.367(a)-8(o) are relevant for purposes of a GRA filed under that general exception. As result, because the Parent received a carryover basis in the acquired assets, the gain recognized by the Parent on a subsequent sale of those assets represented the gain on the FSub1 stock described in the Year 1 GRA, thus causing the Year 3 GRA to terminate immediately upon its filing.

Implications

This PLR is taxpayer favorable, allowing for termination of a GRA upon an inbound transfer of substantially all of the transferred corporation's assets, even though the regulation only references inbound transfers of stock. The rationale for this interpretation appears to be that the assets in this case are a proxy for the stock of the transferred corporation, so the interpretation is arguably consistent with Treas. Reg. Section 1.367(a)-8, although not consistent with the literal wording of Treas. Reg. 1.367(a)-8(k)(14).

It will be interesting to see whether the IRS would consider similar rulings (i.e., that a GRA terminates) when gain recognized on a disposition of substantially all of the assets of the transferred corporation is fully taxable in the US under other provisions of the Internal Revenue Code, such as a subpart F income inclusion under Section 951(a)(1)(A). Moreover, what if a loss (but no gain) were recognized on a disposition of those assets? Nonetheless, it is welcome news that the IRS is considering ruling requests in this area, as the regulations themselves do not specifically allow taxpayers to request rulings in this area.¹

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ENDNOTES

¹ Contrast with Treas. Reg. 1.367(a)-3(c)(9), which provides that the IRS will consider requests regarding the substantiality requirement in the case of outbound transfers of domestic stock.