Rev. Rul. 81-82

ISSUE

In the following situation, what is the amount that a domestic transferor is required to include in income, pursuant to Rev. Rul. 78-201, 1978-1 C.B. 91, on the incorporation of part of its foreign business operations?

FACTS

P is a domestic corporation engaged in the manufacture and sale in the United States and foreign countries of garments, plastic components for the automobile industry, and televisions. In 1977 P commenced these same activities in country A. P established a separate division in country A for its garment operations (division #1), its plastic component operation in the eastern province of country A (division #2), its plastic component operation in the western province of country A (division #3), its television component manufacturing process (division #4) and its television set assembly process (division #5). Each division was separate for purposes of financial reporting and for accounting for profits and losses. Divisions #2 and #3 had common purchasing, accounting, personnel, and record-keeping departments; a common sales force, headquarters staff, and management team; identical manufacturing facilities and processes; and, a substantial identity of customers and distribution channels. Division #4's products were sold exclusively to division #5, which in turn purchased its materials exclusively from division #4. Further, divisions #4 and #5 had common purchasing, accounting, record-keeping, and headquarters staff departments; and, a substantial identity of employees, operational facilities, and managements. Division #1 was a complete operation in itself, and its only nexus to the other divisions was common ownership.

Beginning in 1977, deductions were taken by P for expenses incurred by its country A operations. The United States source income of P, and the foreign source income or losses of its country A divisions, for the years 1977, 1978, and 1979, were as follows:

                                    Country A Income and Losses

On January 1, 1980, P transferred all of the property of divisions #1, #2, #3, and #4 to Newco, a corporation newly formed under the laws of country A, solely in exchange for all of the stock of Newco. The fair market value and basis of assets transferred to Newco exceeded the sum of the liabilities assumed by Newco, plus the amount of liabilities to which the transferred assets were subject. Except for division #5, which P continued to operate directly, Newco continued to conduct the same business activities in country A that P formerly conducted through its divisions.

The foreign transferee, Newco, 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 of 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 the taxpayers 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.

LAW AND ANALYSIS

P's transfer of certain of its country A properties to Newco solely in exchange for all of Newco's stock is an exchange described in section 351 of the Code. However, unless it is established under section 367(a)(1) that the transfer 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 determining the extent to which gain shall be recognized on the transfer. 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 single business as a branch in a foreign country. The domestic corporation incurred losses in connection with this business that reduced its worldwide income subject to federal income tax. The domestic corporation transferred the assets of the business to a newly formed corporation in the foreign country in exchange for all of its stock. Since income subsequently earned by the new corporation from these operations will not be included in the domestic corporation's worldwide income subject to federal income tax, the transfer gives rise to a potential mismatching of related income and loss. Therefore, Rev. Rul. 78-201 required the United States transferor (the domestic corporation), 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, to recognize as gain on the transfer an amount of ordinary foreign source income equal to the sum of the branch losses previously incurred.

In the instant situation, the losses incurred by part of P's country A business operations (divisions #2, #4, and #5), prior to their partial incorporation, were taken into account by P and reduced the amount of P's worldwide income subject to federal income tax. Since income subsequently earned by the new country A corporation (Newco) from these operations will not be included in P's worldwide income subject to federal income tax, the transfer gives rise to a potential mismatching of related income and loss. However, the profits incurred by part of P's country A business operations (divisions #1 and #3), prior to their incorporation, were included in P's worldwide income subject to federal income tax. Thus, to the extent that income from these operations included in P's worldwide income subject to federal income tax was derived from the same business which produced the losses, the potential mismatching of related income and loss is reduced. Accordingly, the transfer by P of part of its assets associated with its country A business operations to Newco 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(a)(1) of the Code, only if P, pursuant to Rev. Rul. 78-201, recognizes as gain on the transfer an amount of ordinary foreign source income equal to the sum of the country A losses, less the income, of each business being incorporated.

When, as in the instant case, various business operations (divisions) are conducted in a foreign country, and some or all of those operations are incorporated in a transaction to which Rev. Rul. 78-201 applies, the amount of gain to be recognized on the transfer, as ordinary foreign source income, is determined for each business transferred. If there is a sufficient relationship between a particular group of business activities (divisions) for those activities to constitute a single business that is separate from the other business activities being conducted, then the profits and losses of those particular business activities (divisions) are combined for purposes of determining the amount to be included in income pursuant to Rev. Rul. 78-201.

The determination of whether a particular group of business activities (divisions) constitutes a single business that is separate from the other business activities depends upon the facts and circumstances of each particular situation. In general, business operations, even if nominally separate, do not constitute separate businesses for purposes of Rev. Rul. 78-201 if there is a substantial identity of products, customers, operational facilities, operational processes, accounting and record-keeping functions, managements, employees, distribution channels, sales and purchasing forces, and headquarters staffs. Although many of these same factors are relevant in determining what constitutes a separate business for purposes of section 355 of the Code, no inference should be drawn that the test under section 367 is the same as the test under that section.

Profits and losses of the several different business operations or functions of an integrated business which constitute a single business will be combined for purposes of Rev. Rul. 78-201. In the instant situation, the facts indicate that divisions #4 and #5 constitute a single business, the losses of which should be combined for purposes of Rev. Rul. 78-201. Further, the profits or losses of identical or integrated operations which are located in different parts of a country, but which nonetheless constitute a single business, will be combined for purposes of Rev. Rul. 78-201. In the instant situation, the facts indicate that divisions #2 and #3 constitute a single business, the profits and losses of which should be combined for purposes of Rev. Rul. 78-201. If, on the other than, a particular business is separate from the other business activities being conducted, the profits or losses of that business will not be combined with the profits and losses of the other businesses for purposes of Rev. Rul. 78-201. Thus, the profits of division #1, which factually is a separate business operation, are not combined with the profits and losses of the other businesses for purposes of Rev. Rul. 78-201.

Further, when a foreign business is incorporated in a transaction to which Rev. Rul. 78-201 applies, in order for the nonrecognition provisions of section 351 of the Code to apply, the domestic transferor must recognize as gain on the transfer an amount of ordinary foreign source income equal to the sum of the losses incurred by that business, even though not all of the assets of that business are transferred. See Rev. Rul. 80-247, 1980-2 C.B. 127. Thus, the losses incurred by both division #4 and division #5 (which together constitute a single business that was effectively transferred when division #4 was transferred) must be included in income by P, pursuant to Rev. Rul. 78-201, even though the assets of division #5 were not transferred.

HOLDING

In the instant situation, P must include in income, pursuant to Rev. Rul. 78-201, an amount equal to (1) the $600x in losses attributable to the business of divisions #4 and #5, plus (2) the $150x in net losses attributable to the business of divisions #2 and #3 (the excess of $300x in losses, less the $150x in income), or a total of $750x.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 78-201 is amplified.