The IRS recently released guidance (AM 2022-004) addressing exceptional situations under the active trade or business (“ATB”) requirement in Treas. Reg. Sec. 1.367(a)-3(c)(3)(i)(A).
Generally, when stock is exchanged between a U.S. person and a foreign corporation, gain is recognized on the transfer under Section 367. However, Treas. Reg. Sec. 1.367(a)-3(c) provides an exception to the general rule under Section 367 for certain transfers by a U.S. person of stock or securities of a domestic corporation to a foreign corporation if certain reporting requirements and other conditions are satisfied. One of these conditions is the ATB test which, among other things, requires that the foreign corporation be engaged in an ATB.
Under the ATB requirement set forth in Treas. Reg. Sec. 1.367(a)-3(c)(3)(i)(A), the transferee foreign corporation must be engaged in an ATB outside the U.S. for the entire 36-month period immediately before the transfer. The determination of where there is a trade or business is based on all facts and circumstances as described in Treas. Reg. Sec. 1.367(a)-2(d)(2). In general, a trade or business is a specific unified group of activities that constitute (or could constitute) an independent economic enterprise carried on for profit and such group of activities must ordinarily include the collection of income and the payment of expenses.
In the generic legal advice memorandum (GLAM), the IRS analyzed the ATB requirement under two scenarios. In scenario 1, the transferee foreign corporation is a “pre-revenue corporation” that received offers to purchase or license its products, and its products will likely obtain the requisite approvals. The foreign corporation has decided not to license or sell because it believes it will generate more consumer interest with further development. According to the GLAM, the foreign corporation’s lack of income during the development phase does not constitute an exceptional situation, and it has not demonstrated that its activities “ordinarily” include the collection of income. Thus, the IRS concluded that the foreign corporation’s lack of income does not constitute an exceptional situation and the ATB requirement was not satisfied.
In scenario 2, the transferee foreign corporation generated income for two of the three years immediately preceding the transfer. The foreign corporation’s failure to earn income during part of the period was due to a regulatory agency’s discovery of a product defect which was not reasonably anticipated by the foreign corporation. According to the GLAM, the unexpected discovery of a product defect and the resulting loss of income constitutes an exceptional situation and thus the ATB requirement was satisfied.
Taxpayers considering transactions involving an outbound transfer of stock or securities of a domestic corporation to a foreign transferee corporation without income during the entire 36-month period immediately before the transfer should consider whether their situation may be an exception situation similar to scenario 2 in the GLAM.
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