Rev. Rul. 80-246

ISSUE

Is the amount of gain that a domestic transferor (P) must recognize as ordinary foreign source income on the incorporation of its foreign branch operations, pursuant to Rev. Rul. 78-201, 1978-1 C.B. 91, because of losses incurred by the foreign operations prior to incorporation, reduced by the amount of taxable income realized and recognized to P, under section 904(f)(3)(A) of the Internal Revenue Code, upon the transfer of the branch assets to the new foreign corporation?

FACTS

P is a domestic corporation that is engaged in the manufacture and sale of plastic components for radio and television manufacturers in the United States. In 1977 P commenced these same activities in country A as a branch operation. For each of P's calendar taxable years, 1977, 1978, and 1979, the country A branch had a loss of 100x dollars (or a total of 300x dollars for this period) as a result of deductions taken by P under section 167 and certain other sections of the Code, for expenses incurred by its branch operations in country A. P had no other foreign operations and no other revenue, or losses, from sources without the United States during this period. In each of the years 1977, 1978, and 1979, the country A branch losses reduced the amount of P's income subject to federal income tax.

On January 1, 1980, P transferred the property used by the country A branch to a new country A corporation (Newco) in exchange for all of the Newco stock and Newco's assumption of P's liabilities attributable to its country A branch.

The fair market value of, and P's basis in, the assets transferred exceeded the sum of the liabilities assumed, plus the amount of the liabilities to which the transferred assets were subject. The excess of the fair market value of such property (assets transferred plus liabilities assumed) over P's adjusted basis therein exceeds P's overall foreign loss. 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 (relating to transfers of property to foreign corporations). 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 having as one of its principal purposes the avoidance of federal income taxes within the meaning of section 367(a)(1).

P agreed to 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, pursuant to Rev. Rul. 78-201. However, P requested that this amount be reduced by the amount of taxable income it would realize and recognize, under section 904(f)(3)(A) of the Code, because of the transfer of its branch property to Newco.

LAW AND ANALYSIS

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 losses, 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, there was not an overall foreign loss, within the meaning of section 904, in Rev. Rul. 78-201.

In the instant case the losses incurred by the country A branch operations prior to its incorporation were taken into account by P and reduced the amount of P's income subject to federal income tax. As a result of the incorporation of P's country A branch operations, the income to be produced by these operations, that is indirectly attributable to the losses, 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. The effect of the incorporation will therefore be a mismatching of revenue, deductions, and credits, when income is finally produced. Accordingly, P must recognize as gain on the transfer, pursuant to Rev. Rul. 78-201, an amount of ordinary foreign source income equal to the sum of the branch A losses previously incurred ($300x), in order for P's exchange of property for Newco stock not 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).

Section 904(f)(1) of the Code provides, generally, that where an overall loss from foreign operations reduces United States tax on United States source income of the taxpayer, the tax benefit derived from this loss is recaptured when the taxpayer subsequently derives income from the foreign operations. In general, the recapture is accomplished by treating a portion of subsequently derived foreign income as taxable income from United States sources. Section 904(f)(3)(A) provides, generally, that for purposes of applying section 904(f)(1), when property that was used predominantly outside of the United States in a trade or business is disposed of, the overall foreign losses not previously recaptured under section 904(f)(1) will be recaptured in an amount equal to the lesser of the remaining losses or the excess of the fair market value of such property over its adjusted basis. This is accomplished by treating the gain realized on the disposition as taxable income from sources without the United States which section 904(f)(1) then treats as income from sources within the United States. Section 904(f)(3)(B)(i) provides that a disposition includes a sale or exchange of property whether or not gain or loss is recognized on the transfer.

In the instant case, P is required, therefore, to include in its taxable income for its 1980 taxable year, as income from sources within the United States, the amount specified in section 904(f)(3)(A) of the Code. Since P's overall foreign loss (300x dollars) was less than the amount realized on the transfer of the branch assets, and since the transfer constituted a disposition, P must realize and recognize 300x dollars in taxable income, for 1980, as foreign source income under section 904(f)(3)(A), and treat that amount as income from sources within the United States, pursuant to section 904(f)(1).

Section 904(f)(3)(A) of the Code and Rev. Rul. 78-201 operate independently of one another. To the extent there is an overlap of Rev. Rul. 78-201 and section 904(f)(3)(A), their effect on the transfer should be integrated in order to prevent double recapture.

HOLDING

The amount of gain that P must recognize as ordinary foreign source income (300x dollars, which is the sum of the branch losses) on the transfer of its branch assets to Newco in exchange for Newco stock, pursuant to Rev. Rul. 78-201, is reduced by the amount of taxable income realized and recognized by P, under section 904(f)(3)(A) of the Code, on the same transfer or disposition (300x dollars, which is the amount of the overall foreign loss).

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 78-201 is amplified.