Rev. Rul. 80-247

ISSUE

Do the losses recaptured under Rev. Rul. 78-201, 1978-1 C.B. 91, pursuant to incorporation of a branch operation, include expenses directly related to branch property not transferred but abandoned as worthless?

FACTS

P is a domestic corporation that is engaged in the exploration, development, and sale of mineral properties in the United States. P owns certain mineral properties in country A. In 1977 P commenced business operations in country A. These operations were carried on by a branch that P established in country A.

Beginning in 1977, deductions were taken by P under section 167 and certain other sections of the Code for expenses incurred by its branch operations. Because of these deductions the country A branch sustained losses of $100x in 1977, 1978, and 1979 (a total of $300x). P's taxable income from sources within the United States was $1,000x each year for 1977 through 1979, and the branch A losses reduced P's worldwide taxable income for these years. During each of the three years P's other foreign branches had income in excess of the losses of the branch in country A.

On January 1, 1980, P transferred certain assets of its country A branch to Newco, a corporation newly created under the laws of country A, solely in exchange for all of Newco's stock. The assets transferred consisted of certain equipment and those mineral properties located in country A that were expected to produce income in excess of expenses starting in 1982. The mineral properties of P's country A branch that had no commercial value were not transferred and will be abandoned as worthless. Expenses of $200x were directly attributable to the branch A properties transferred. Expenses of $100x were directly attributable to the branch A properties not transferred.

The fair market value of, and P's basis in, the assets transferred exceeded the sum of the liabilities to which the transferred assets were subject. No liabilities were assumed. Newco will continue to conduct the business that P conducted in country A. The foreign transferee, Newco, will not be engaged in a trade or business in the United States within the meaning of section 864 of the Code, and will have no income from sources within the United States within the meaning of section 861. The transfer of assets in exchange for stock would have fulfilled all of the requirements of section 351 had the transferee, Newco, been a domestic corporation. Furthermore, the transfer met the requirements of section 3.02(1) of Rev. Proc. 68-23, 1968-1 C.B. 821. Within 183 days of the beginning of the transfer P requested a ruling from the Internal Revenue Service that the transaction was not in pursuance of a plan of tax avoidance within the meaning of section 367(a)(1).

LAW AND ANALYSIS

Section 367(a)(1) of the Code provides that if, in connection with any exchange described in section 351, there is a transfer of property by a United States person to a foreign corporation, for purposes of determining the extent to which gain shall be recognized on such transfer, a foreign corporation shall not be considered to be a corporation unless, pursuant to a request filed no later than the close of the 183rd day after the beginning of such transfer, it is established to the satisfaction of the Secretary that such exchange is not in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes.

Section 351(a) of the Code provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.

Rev. Proc. 68-23 sets forth guidelines to be used by taxpayers and their representatives in connection with requests for rulings required under section 367 of the Code in respect of certain types of transactions involving foreign corporations. Section 3.02(1) of Rev. Proc. 68-23 relates to transfers to foreign corporations controlled by domestic transferors and provides that such a transfer of property will ordinarily receive favorable consideration where the transferred property is to be devoted by the transferee foreign corporation to the active conduct, in any foreign country, of a trade or business. It is contemplated that the transferee foreign corporation, in addition to the active conduct of a trade or business, will have need for a substantial investment in fixed assets in such business.

Section 2.02 of Rev. Proc. 68-23 provides, however, that in reviewing each request for ruling to determine whether a favorable section 367 ruling should be issued under the guidelines, the Service reserves the right to issue an adverse ruling if, based on all the facts and circumstances of a case, it is determined that the taxpayer has not established that tax avoidance is not one of the principal purposes of the transaction.

P's transfer of certain of its mineral properties to Newco solely in exchange for all of Newco's stock is an exchange described in section 351 of the Code, but unless it is established under section 367(a)(1) that the transfer to Newco was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes, Newco will not be considered to be a corporation for purposes of section 351. Since the nonrecognition of gain provisions of section 351 apply only if Newco is considered to be a corporation, failure to satisfy section 367(a)(1) would therefore result in recognition of any gain realized by P on the transfer.

In Rev. Rul. 78-201 a domestic corporation operated a branch in a foreign country. The domestic corporation incurred losses in connection with its branch that reduced its worldwide income subject to federal income tax. The domestic corporation transferred the assets of its branch to a newly formed corporation in the foreign country in exchange for all of its stock. Income subsequently earned by the new corporation will therefore not be included in the domestic corporation's worldwide income subject to federal income tax. Since the transfer thus gives rise to a potential mismatching of related income and loss, Rev. Rul. 78-201 required the United States transferor (the domestic corporation) to recognize as gain on the transfer an amount of ordinary foreign source income equal to the sum of the branch losses previously incurred, as a condition for obtaining a ruling that the exchange was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes within the meaning of section 367(a)(1) of the Code. Further, if the transferor recognizes the amount set forth in Rev. Rul. 78-201 as gain, then the transferor's basis in the stock received, and the corporation's basis in the property received from the transferor, will each be increased by the amount of gain recognized to the transferor pursuant to sections 358(a)(1) and 362(a), respectively, since the transaction qualifies as an exchange to which section 351 applies. Rev. Rul. 78-201 indicates that the domestic corporation operated a single branch and a single business in the foreign country, that the business of the branch had incurred the losses, and that it was the business of the branch that was being incorporated.

In the instant case the losses that P incurred in connection with its mineral exploration, development, and property sales business in country A had reduced the amount of P's worldwide income subject to federal income tax. As a result of the incorporation of P's country A business (that is, all properties that were not to be abandoned), the income to be produced by P's country A business will not be taken into account by P, and thus will not increase the amount of P's worldwide income subject to federal income tax.

P's mineral exploration, development, and property sales business in country A was a complete business operation in itself, and that business and the losses incurred by that business were unrelated to P's other worldwide business operations. Although the branch A properties that were transferred directly incurred losses of $200x and the branch A properties to be abandoned directly incurred losses of $100x, P's branch A was comprised of both the properties that were transferred and the properties that were not transferred. P effectively incorporated the entire branch A business. It was the business, and not the specific parcels of property, that incurred the losses.

HOLDING

Pursuant to Rev. Rul. 78-201, P must recognize as gain on the transfer an amount of ordinary foreign source income equal to the sum of the country A branch losses previously incurred (that is, $300x) in order for P's exchange of property for Newco stock not to be deemed to be in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes within the meaning of section 367(a)(1) of the Code. This income must be recognized as ordinary foreign source income by P for its taxable year in which the transfer occurred (1980).

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 78-201 is amplified.