Marcellin Mbwa-Mboma is with Ernst and Young LLP in
New York.
Awo Archampong-Gray is with Ernst and Young LLP in
Washington DC.
Gain Recognition Agreements and
Reasonable Cause Exception
By Marcellin Mbwa-Mboma and Awo Archampong-Gray
1Marcellin Mbwa-Mboma and Awo Archampong-Gray explain
TAM 200919032, which addresses the issue of whether a U.S.
corporation qualifi es for the “reasonable cause” exception and can,
therefore, cure its failure to timely fi le a GRA for an outbound
stock transfer in a reorganization.
O
n May 11, 2009, the Internal Revenue Ser-vice issued a Technical AdSer-vice Memorandum (TAM),2 that addresses the issue of whether a U.S. corporation qualifi es for the “reasonable cause” exception under the Code Sec. 367 regulations such that it is eligible to cure its failure to timely fi le a gain recognition agreement (GRA) for an outbound stock transfer in a reorganization.3Overall, the IRS appears to have set a high stan-dard for the application of the reasonable cause exception in the context of the GRA rules. The TAM underscores the importance of conducting and documenting thorough technical analyses of issues in cross-border transactions and, most importantly, timely fi ling a GRA.
Background
The taxpayer, a publicly traded U.S. corporation and common parent of a consolidated group (“Parent”), owned all of the stock of another U.S. corporation that was a member of the taxpayer’s consolidated group (“Sub”), which, in turn, was the single owner of a U.S. limited liability company (LLC), treated as a disregarded entity for U.S. federal income tax
pur-poses. Parent, together with the LLC, owned all the stock of a foreign corporation (“FC”), with the LLC owning at least 80 percent of FC by vote and value. Since LLC was a disregarded entity, the stock it held in FC was essentially considered to be held by Sub, its owner. Parent also separately owned all of the stock of another foreign corporation (“FC1”).
FC1 engaged in a triangular reorganization under Code Sec. 368(a), widely known as the “Killer B” transaction in which a subsidiary typically acquires its parent stock from either the parent or the parent’s shareholders in exchange for property (e.g., cash, a note) and uses that stock to acquire stock or assets of a target corporation where either the subsidiary or the parent (or both) is foreign.5 Specifi cally, FC1 purchased Parent stock from its public shareholders on the open market. Then, FC1 acquired FC stock from Sub (through LLC) in exchange for Parent stock. This “public” triangular reorganization should have been completed before May 31, 2007, the date on which Notice 2007-486 entered into force.
Prior to May 31, 2007, only “internal” triangular reorganizations involving one or more foreign cor-porations were struck down by the IRS as abusive cross-border repatriations of earnings. The taxpayers did not treat the transfer of property (e.g., cash or note) from the subsidiary to the parent, in exchange for the parent stock, as a Code Sec. 301 distribu-tion.7 However, on September 22, 2006, the IRS and Treasury Department issued Notice 2006-85,8 which e GR ce nical a d A rule co nalyse . The T cting s of is or t pur h ch p hased P ( aren oth toc ) k fromm or g its pu p bl p c
applicaatio
sact r traans t o te ort g t th t pp he c he hor con im rou tex mpo gh ech
provided guidance on the proper U.S. tax treat-ment of such “internal” triangular reorganizations. The IRS announced that regulations to be issued under Code Sec. 367(b) would make adjustments that would have the effect of a deemed distribution of property from the subsidiary to its parent under Code Sec. 301(c). Thus, the parent fi rst would be treated as receiving a dividend to the extent of the earnings and profi ts of the subsidiary (with a cor-responding reduction of the subsidiary’s earnings and profi ts as a result of the dividend distribution), and second parent’s basis in the distributing corpo-ration’s stock would be reduced to the extent the distribution exceeded the subsidiary’s earnings and profi ts. Any amount in excess of the parent’s basis would be treated as gain from the sale or exchange of the subsidiary’s stock.
Notice 2007-48 extended the reach of Notice 2006-85 by targeting “public” triangular reorgani-zations involving one or more foreign corporations. Prior to Notice 2007-48, consistent with case law squarely on point,9 the taxpayers were taking the position that by purchasing parent stock from the public shareholders, the subsidiary did not make a Code Sec. 301 distribution potentially taxable to the parent.10 In Notice 2007-48, the IRS stated that under
regulations to be issued under Code Sec. 367(b), the subsidiary would be deemed to make a Code Sec. 301 distribution of property (e.g., cash, a note) to its parent when purchasing the parent stock from a person other than the parent itself such as from the public shareholders on the open market.
On May 27, 2008, the IRS and Treasury Depart-ment issued temporary regulations impleDepart-menting the rules described in Notice 2006-85 and Notice 2007-48.11 In short, under the temporary
regula-tions, the purchase of parent stock would result in a deemed distribution from the subsidiary to the parent if the acquisition of a target corporation stock or as-sets qualifi ed as a tax-free triangular reorganization. Therefore, the utilization of the subsidiary’s earnings to purchase parent stock to use as currency for the acquisition of a target corporation’s stock or asset may prove benefi cial only if such acquisition is a taxable transaction.
Issues Addressed in TAM
The TAM addressed the issue of whether Sub’s trans-fer of the stock of FC to FC1 (the “Outbound Stock Transfer”) in exchange for Parent’s stock in a tax-free
triangular reorganization was subject to Code Sec. 367(a)(1). Code Sec. 367(a)(1) provides that if, in con-nection with any exchange described in Code Sec. 332, 351, 354, 356 or 361, a U.S. person (U.S. transferor) transfers property to a foreign corporation, such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered to be a corporation. Code Sec. 367(a)(2), (3) and (6) provide exceptions to this general rule and grant regulatory authority to provide additional exceptions and to limit the statutory exceptions.
Exceptions to the general gain recognition rule of Code Sec. 367(a)(1) are provided for certain transfers by a U.S. transferor of stock or securities of a foreign corporation or a U.S. corporation.12 In some cases,
these exceptions require, among other things, that the U.S. transferor fi le a GRA as provided in Reg. §1.367(a)-8.13 Pursuant to a GRA, the U.S. transferor
agrees, among other things, to include in income the gain realized, but not recognized, on the initial transfer of the stock or securities, and pay any appli-cable interest, upon certain events that occur before the close of the fi fth full tax year following the year of the initial transfer.
In the TAM, the taxpayer did not argue that the ex-ception in Reg. §1.367(a)-3(b) for stock or securities of a foreign corporation applied to the Outbound Stock Transfer. Rather, the taxpayer asserted that such trans-fer was not subject to the general gain recognition rule of Code Sec. 367(a)(1) since, in the reorganization, Sub only received stock of Parent, a U.S. corporation. At that time, the regulations did not treat a triangular B reorganization where the acquiring corporation was foreign and the controlling corporation was a U.S. corporation as an indirect stock transfer subject to Code Sec. 367(a). The taxpayer reasoned that the Code Sec. 354 exchange by Sub of FC stock for stock of Parent, a U.S. corporation, in a triangular B reor-ganization was not taxable under Code Sec. 367(a) and, thus, no GRA was required to defer taxation of the gain realized on such exchange.
The TAM, somehow, concedes that the then-current regulations did not work well but suggests it was incum-bent upon the taxpayer to conform these regulations with the policies of Code Sec. 367(a). As the TAM points it out, the indirect stock transfer rules of Treas. Reg. §1.367(a)-3(d) were revised in January of 2006 to close this loophole in two ways. First, a triangular B reorgani-zation where the acquiring corporation is foreign and the controlling corporation is domestic is treated as an indirect stock transfer subject to the general gain recog-pen m S a ulation 200 arket. Tre ns imp 85 ry Dep lemen d oc mpora woul y d rees reg ultt in a o C Cod Co de Sec. 3554 e a). hange by S xp y ub of FCC st han thee p in N ribeed i p th y N he te ho 7, olde 20 emp ib ers o 008, por d i p on , th rary i N re t
nition rule of Code Sec. 367(a)(1) and the exceptions thereof. Second, in such a triangular B reorganization, the transferee foreign corporation means the foreign ac-quiring corporation.14 These regulatory revisions deprive
of practical interest any discussion of the arguments and analysis surrounding this issue in the TAM.
After concluding that the Outbound Stock Transfer was unequivocally subject to the general gain recogni-tion rule of Code Sec. 367, the IRS also ruled that the taxpayer did not qualify for the exception for foreign corporation’s stock in Reg. §1.367(a)-3(b)(1) as the taxpayer did not enter into a GRA. The taxpayer tried to retreat and argue that the transaction should be subject to Code Sec. 304, which would not have required the fi ling of a GRA. However, the IRS quickly dismissed this fall back argument because Code Sec. 367(a)(1) only makes the U.S. transferor recognize gain on the exchange; it does not change the character of the re-organization for other purposes. To cure the taxpayer’s failure to enter into a GRA, the IRS has to determine that such failure was due to a reasonable cause.
The Reasonable Cause Standard
Pursuant to the reasonable cause exception of the 1998 fi nal GRA regulations at issue in the TAM,if a U.S. trans-feror who is permitted under Reg. §1.367(a)-3(b) or (c) to defer gain realized on the initial transfer of a foreign or domestic corporation’s stock or securities fails to fi le a GRA in a timely manner, the deferred gain will not become taxable and no penalty will be assessed if the U.S. transferor (x) is able to show that the failure to fi le a GRA was due to reasonable cause and not willful neglect and (y) fi les the GRA or reaches compliance as soon as he becomes aware of the failure.15Since the 1998 fi nal GRA regulations do not defi ne what constitutes reasonable cause, the IRS considered other areas of the law where the reasonable cause standard is employed, excluding the “prejudice to the government’s interest” standard for Code Sec. 9100 relief (as alleged by the taxpayer) but including the penalty provisions of the Internal Revenue Code and court cases.16 Specifi cally, the IRS result hinged on the Supreme Court’s defi nition of reasonable cause as “ordinary business care and prudence.”17 Also, based on the express language in the 1998 fi nal GRA regula-tions, the penalty regulations and case law,18 the IRS
noted that the determination of reasonable cause is to be made on a case-by-case basis, taking into account all the facts and circumstances. In addition, reasonable cause is determined at the time the tax return was fi led,
or if not fi led, when it was due. Finally, taxpayers bear the burden of proving they have met the reasonable cause standard.
Notwithstanding the case-by-case, facts and cir-cumstances determination of reasonable cause, the IRS relied on case law to provide a list of fi ve factors that may indicate that a taxpayer exercised ordinary care and prudence and concluded that the taxpayer did not satisfy those standards:
(1) taxpayer’s sophistication
(2) contemporaneous documentation, research and analysis
(3) complexity, uncertainty and ambiguity of the law (4) mistaken belief and lack of knowledge
(5) reasonable reliance on professionals
Taxpayer’s Sophistication
The fi rst factor is the taxpayer’s sophistication, experi-ence, knowledge and education. The IRS reasoned that sophistication may factor into a determination of whether a misunderstanding of law was reasonable. The IRS noted that the taxpayer had experienced tax professionals and hired respected accounting and law fi rms to assist it with the structuring, implementation and reporting of the Killer B transaction. In addition, the taxpayer had received advice from its outside counsel recommending it to fi le a GRA. Specifi cally, the taxpayer’s accounting fi rm prepared a draft letter opinion based on draft representations that included the taxpayer’s undertaking to fi le a GRA. Interestingly, the opinion was never fi nalized because “Taxpayer was comfortable with the advice received,” presumably because of the taxpayer’s omission (or decision not) to fi le a GRA. The IRS further noted that no one in the working group, including the taxpayer’s in house tax experts questioned the need for the GRA representation although, in audit, an employee of the accounting fi rm asserted that the draft letter opinion did not focus on the GRA as a “critical aspect” of the Killer B transac-tion, presumably inferring that a different conclusion could have been drawn if a thorough analysis of the Code Sec. 367 regulations was conducted.
Based on the breadth of its in-house tax team, the IRS concluded that the taxpayer was sophisticated but did not exercise ordinary business care and prudence in failing to use its signifi cant resources to “conduct further research and analysis to verify or disprove [its advisors’] advice [to fi le a GRA with respect to the Outbound Stock Transfer] before choosing to disregard it.” w tha e or rea h the fa e ches c il ilure to not w omplia se, ons do e IRS co o n t d sidereed wo exp k er g ts q g uest p, ione lud he g neeed o he r th p e G y GRAA r e annd nno p es a ecoome p to G on y) b r ( due (x) i e to fi le s ab o re es t p ble easo he RA
Contemporaneous
Documentation, Research
and Analysis
The second factor is the existence of contemporaneous documentation, research, analysis and supporting legal authority. As the TAM sums it up, “[t]he extent to which a taxpayer documents the position taken, conducts re-lated analysis, and has supporting legal authority, must be considered because such efforts refl ect a taxpayer’s attempt to properly assess its tax liability.”
In this case, the taxpayer unreasonably relied on undocumented research of complex tax issues con-ducted by an in-house tax expert to disregard the accounting fi rm’s opinion. Such unreasonable reli-ance was indicative of a lack of reasonable cause.
Complexity, Uncertainty
and Ambiguity of the Law
The third factor in a reasonable cause determination pertains to the complexity, uncertainty and ambiguity of the law. One would expect the complexity of law to be the usual circumstance justifying relief for reason-able cause. The IRS, however, relying on a technical reading of the “all facts and circumstances” standard in the GRA regulations goes on to say that complexity of the law is only one of many factors in the reason-able cause determination. In the IRS’s view, weight should be given to the extent to which complexity affects a taxpayer’s decision not to comply with the tax law, a highly subjective test. Not surprisingly, the TAM does not articulate the IRS’s application of this factor to the taxpayer’s facts.
Mistaken Belief and Lack
of Knowledge
The fourth factor is a taxpayer’s mistaken belief and lack of knowledge that is reasonable in light of all the facts and circumstances.
Noting that the taxpayer should have known that its accounting fi rm unequivocally advised that it fi le the GRA, the IRS concluded that any alleged mistaken belief was not reasonable and, thus, not indicative of reasonable cause.
Reasonable Reliance
on Professionals
The fi fth factor consists of a taxpayer’s reliance on advice received from qualifi ed tax professionals. If reasonable, reliance on such advice may be indica-tive of reasonable cause.
The IRS found unreasonable the taxpayer’s reliance on undocumented advice of its in house tax expert which contradicted the accounting fi rm’s opinion that the Outbound Stock Transfer was subject to Code Sec. 367(a) and a GRA should be fi led.
Conclusion
The IRS is required to make a reasonable cause deter-mination under the GRA regulations on a case-by-case basis, after taking into consideration all the facts and circumstances. This means that none of the fi ve fac-tors discussed in the TAM, including the complexity of the law, establishes per se that a taxpayer exercised “ordinary care and prudence” in meeting its tax ob-ligations. However, the TAM shed some light on the high standards for reasonable cause that the govern-ment could apply in audit or in litigation. These high standards could apply not only in the context of the GRA regulations but also in other areas, such as the dual consolidated loss regulations,19 where relief for
failure to timely fi le an election, agreement or other information could only be cured if the taxpayer es-tablishes reasonable cause. Taxpayers are particularly advised that a tax advisor’s opinion recommending the fi ling of a GRA should not be disregarded without a well-reasoned and documented analysis supporting a different reporting position.
1 The authors wish to thank Marnie Metsch, Ernst & Young LLP, Stamford, for her helpful comments.
2 TAM 200919032 (Jan. 29, 2009)
3 The reasonable cause exception could be
found in the 1998 fi nal GRA regulations (Reg. §1.367(a)-8(c) and T.D. 8770, 1998-2 CB 3, in the 2007 temporary GRA regulations (Reg. §1.367(a)-8T(e)(10) and T.D. 9311, 2007-1 CB 635 and in the 2009 fi nal GRA
regula-tions (Reg. §1.367(a)-8(p) and T.D. 9446, IRB 2009-9, 607 (Feb. 9, 2009). Those three sets of GRA rules are still applicable depending on the date on which a U.S. person transferred stock or securities to a foreign corporation.
5 The term “triangular reorganization,” for
this purpose, is not limited to a triangular B reorganization under Code Sec. 368(a)(1)(B). It also encompasses triangular C reorganiza-tion under Code Sec. 368(a)(1)(C), a forward
triangular merger under Code Sec. 368(a)(2) (D), a reverse triangular merger under Code Sec. 368(a)(2)(E) as those terms are defi ned in Reg. §1.358-6(b)(2)(i) through (iv), as well as a triangular reorganization under Code Sec. 368(a)(1)(G).
6 Notice 2007-48, IRB 2007-25, 1428. 7 Under the ordering rule of Code Sec.
301(c), a distribution generally is treated as a dividend to the extent of the earnings
E
NDNOTES t. No RS surpr pp singly ion ofd Lack
nfo ab r ishes reasonna on e c y ause. T c axpayeers ar yer’’s deci tiv fac e th tax y hl ot a y y su arti xpa ubj cul ayer ect late r’s f ctsand profi ts of the distributing corporation, then a return of the shareholder’s basis in the distributing corporation’s stock, and any amount in excess of the shareholder’s basis is treated as gain from the sale or exchange of the distributing corporation’s stock.
8 Notice 2006-85, IRB 2006-41, 677; 2006-2
CB 677.
9 In Rev. Rul. 69-261, 1969-1 CB 94, the
IRS took the position that, whenever a subsidiary acquires its parent stock in a Code Sec. 304(a)(2) redemption, the sub-sidiary must be treated as making a Code Sec. 301 distribution of the property used to acquire the parent’s stock to the parent which the parent then uses to redeem the shares purchased by the subsidiary, after which the parent contributes the purchased shares to the subsidiary. This view initially received limited judicial acceptance (see
Union Bankers Ins. Co., 64 TC 807, Dec.
33,370 (1975), and Broadview Lumber Co.,
Inc., DC Ind., 75-2 USTC ¶9832, rev’d in
part, mod’d in part and aff’d in part, CA-7,
77-2 USTC ¶9615, 561 F2d 698. However,
it was later rejected by the courts in H.M.
Webb, 67 TC 293, Dec. 34,113 (1976), aff’d, CA-5, 78-1 USTC ¶9406, 572 F2d 135,
Virginia Materials Corp., 67 TC 372, Dec.
34,129, aff’d in an unpublished opinion, CA-4, Jun. 20, 1978, and
Broadview Lumber Co., Inc., CA-7, rev’g in part, mod’g in part and aff’g in part, DC Ind.,
75-2 USTC ¶9832. In Rev. Rul. 80-189, 1980-2
CB 106, considered in GCM 38291 (Feb. 22, 1980), the IRS modifi ed Rev. Rul. 69-261 to the extent it held that there is a constructive dividend from the subsidiary to the parent. Thus, the IRS accepted the decisions of the Tax Court in Webb, Virginia Materials, and the appellate decision in Broadview Lumber that no dividend resulted to the parent from a Code Sec. 304(a)(2) redemption of parent stock by its controlled subsidiary.
10 Only the public shareholders could potentially
incur U.S. tax liability in connection with the sale of the parent stock as such a transaction was correctly characterized as a distribution of cash or other consideration to the public share-holders in redemption of the parent stock under Code Sec. 304(a)(2). This could be treated under the redemption rules of Code Sec. 302 either as a Code Sec. 301 distribution or a payment in exchange for the parent stock.
11 Temporary Reg. §1.367(b)-14T.
12 Reg. 3(b) and Reg.
§1.367(a)-3(c) (c).
13 Reg. §1.367(a)-3(b)(1)(ii) and (c)(1)(iii)(B). 14 Reg. §1.367(a)-3(d)(2)(i)(B). See T.D. 9243,
IRB 2006-8, 475; 2006-1 CB 475.
15 The reasonable cause exception of the 1998
fi nal GRA regulations (Reg. §1.367(a)-8(c)) is also included in the 2007 temporary regulations (Temporary Reg. §1.367(a)-8T(e)(10)) and in the 2009 fi nal GRA regulations (Reg. §1.367(a)-8(p)). Thus, the standards set forth in the TAM would apply whenever a GRA is required.
16 Reg. §301.9100-3(b) provides that requests
for relief are granted when the taxpayer provides the evidence to establish to the satisfaction of the IRS that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the Government.
17 R.W. Boyle, SCt, 85-1 USTC ¶13,602, 469
US 241, 246, 105 SCt 687.
18 Reg. §1.6664-4(b)(1) [“The determination
of whether a taxpayer acted with reason-able cause and good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances”]; See also
C. Reynolds, CA-7, 2002-2 USTC ¶50,525, 296 F3d 607.
19 See Reg. §1.1503(d)-1(c)(1).
