November 2012 Bar Bulletin
Taxation of Outbound Property Transfers
By Jennifer Coates
New Regulations under Section 7874
A number of particularly draconian U.S. tax provisions apply to transfers of property out of the United States into a foreign corporation.1 Although the U.S. tax code ("the Code")2 generally encourages U.S. business reorganizations, allowing many to occur on a tax-free basis, these more favorable rules generally do not apply to outbound transfers, where different policy considerations apply.3
Section 7874 has been one of the more difficult sets of rules to apply due to a lack of guidance regarding a key element, namely, the existence or non-existence of substantial business activity in the foreign jurisdiction post-acquisition. After years of uncertainty, the Internal Revenue Service has finally promulgated regulations that provide a bright-line test for determining whether the requisite activity exists.
If section 7874 applies, the acquisition is subject to U.S. taxation over a 10-year period with very limited availability of credits or deductions to offset gain. If the shareholder continuity is 80 percent, rather than 60 percent or more, section 7874 requires that the foreign corporation be treated as a U.S. corporation for all purposes of the Code, including estate and gift tax. This is an extremely harsh result, even by U.S. international tax standards.
Section 7874 applies to transfers of property to a foreign corporation where:
- substantially all of the properties held4 by a U.S. entity5 are transferred;
- former owners of the U.S. business own at least 60%6 of the foreign business after the transfer; and
- the resulting business group has "no substantial business activities" in the foreign country.
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