Rev. Rul. 78-201

Advice has been requested whether the transaction described below is one for which a favorable ruling will be issued under section 367 of the Internal Revenue Code of 1954.

P is a domestic corporation that is engaged in the manufacture and sale of plastic components for the radio and television industries in the United States. In 1975 P commenced business operations in country A. For various business reasons these operations were carried on by a branch that P established in country A by the transfer of cash and newly purchased assets with a value of $100x.

Beginning in 1975, deductions were taken by P under section 167 and certain other sections of the Code for expenses incurred by the branch operations. The income and losses of P and its country A branch for the years 1975, 1976, and 1977, were as follows:

                             U.S. Source     Country A

In late 1977, P transferred the assets of branch A to a corporation newly created under the laws of country A solely in exchange for its stock. The foreign transferee was not to be engaged in a trade or business in the United States within the meaning of section 864 of the Code and was to 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 the requirements of section 351 had the transferee 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.

Section 351 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.

Section 358 of the Code provides that in the case of an exchange to which section 351 applies, the basis of the property permitted to be received under such section without the recognition of gain or loss shall be the same as that of the property exchanged (A) decreased by (i) the fair market value of any other property (except money) received by the taxpayer; (ii) the amount of any money received by the taxpayer; and (iii) the amount of loss to the taxpayer that was recognized on such exchange, and (B) increased by the amount of gain to the taxpayer that was recognized on such exchange (not including any portion of such gain that was treated as a dividend).

Section 362(a) of the Code provides that if property was acquired on or after June 22, 1954, by a corporation in connection with a transaction to which section 351 applies, then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain recognized to the transferor on such transfer.

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 (other than stock or securities of a foreign corporation that is a party to the reorganization) 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 not later than the close of the 183rd day after the beginning of such transfer (and filed in such form and manner as may be prescribed by regulations by the Secretary), 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.

Rev. Proc. 68-23 sets forth guidelines for 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.

The losses incurred by the foreign branch operations prior to its incorporation were taken into account by P and reduced the amount of P's worldwide income subject to Federal income tax. However, as a result of the incorporation of the foreign branch operations, the income to be produced by these operations 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. Therefore, the transfer by P of the assets of the branch to the foreign corporation will 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 of the Code. Accordingly, the transfer by P of the assets of branch A to the foreign corporation will be deemed 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 of the Code, only if the transferor, P, recognizes 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, $90x). This income must be recognized as ordinary income by P for its taxable year in which the transfer occurred.

In addition, because the transaction qualifies as an exchange to which section 351 of the Code applies, pursuant to section 362(a) the basis of the assets transferred will be the same as the basis of such assets in the hands of P immediately prior to the exchange, increased by the amount of gain recognized to P on the transfer. Pursuant to section 358(a)(1), the basis of the stock of the foreign subsidiary received by P will be the same as the basis of the assets transferred in exchange therefor increased by the amount of gain recognized to P on the transfer.