Q: What is the resulting tax of combining legal entities? Our U.S.-based business currently has three legal entities in China and is investigating merging the three to one. Is there a tax impact of going to one entity?
The U.S. tax consequences of the restructuring and reorganization of U.S.-owned foreign subsidiaries are subject to special rules set forth in IRS regulations issued under Sec. 367. In Sec. 367, Congress has given the IRS regulatory authority to limit or deny normal non- recognition treatment in the case of reorganizations and similar transactions involving foreign corporations.
The merger or combination of three foreign entities into a single entity may be effected in a number of ways. The existing subsidiaries could transfer their assets and liabilities to a newly formed foreign subsidiary, or two of the existing subsidiaries could similarly transfer their assets and liabilities to the third subsidiary. Another alternative would involve the transfer of the stock of the three subsidiaries to a newly-formed foreign holding company, followed by the liquidation of each of the transferred subsidiaries into the holding company.
Each of the above described transactions literally falls within the definition of a tax-free reorganization under Sec. 368. If the only consideration for the transfers is the stock of the acquiring foreign corporation, the exchanges would normally be tax-free under Secs. 354 and 361. If non-stock consideration, such as money or other property, is exchanged, the U.S. parent corporation may recognize income under Sec. 356. However, these non-recognition provisions are themselves subject to the special rules contained in the Sec. 367 regulations.
In the case of reorganizations of foreign corporations, as described above, the principal concern of the Sec. 367 regulations is to prevent the normal non-recognition provisions from eliminating or reducing the potential for taxing the earnings of foreign corporations to U.S. shareholders under Sec. 1248. Under Sec. 1248, a U.S. shareholder selling stock of a foreign corporation is required to report gain to the extent of the foreign corporation’s earnings and profits attributable to the U.S. shareholder’s stock as a dividend, if, at some time in the last five years, the foreign corporation was a controlled foreign corporation (CFC), and the U.S. shareholder owned at least 10 percent of its voting stock. For example, if the foreign acquiring corporation in the reorganization is not a CFC after the exchange, or the U.S. shareholder does not own 10 percent of the acquiring corporation’s voting stock after the exchange, the potential for applying Sec. 1248 may be lost.
In the case of the merger or combination of the three wholly-owned Chinese subsidiaries, the potential loss of Sec. 1248 treatment is not present. The resulting single entity will be a CFC and the U.S. parent will continue to own 100 percent of the stock of that corporation. Under the Sec. 367 regulations, for Sec. 1248 purposes, the earnings and profits of the acquired subsidiaries will carryover to the acquiring corporation. Moreover, certain other rules in the Sec. 367 regulations will not apply as the existing subsidiaries are members of an “affiliated group;” i.e. joined to the U.S. parent corporation in a brother-sister relationship with more than 50 percent ownership.
Although the normal non-recognition provisions that apply to domestic reorganizations should apply to the combination of the Chinese subsidiaries, the U.S. parent will be subject to the reporting requirements set forth in the Sec. 367 regulations. Failure to comply with these reporting requirements may subject the U.S. parent to gain on the transaction.
Although the parent may be able to combine the Chinese subsidiaries on a tax-free basis for U.S. tax purposes, the taxation of the transaction in China is less clear. The Chinese tax system has not yet fully developed a tax-free rollover regime similar to the U.S. rules. Therefore, in addition to possibly needing government approval for the transaction, the transfer of assets by the Chinese subsidiaries may be subject to taxation if the value of the assets has increased over their cost.
Frank J. O’Connell, International Tax Partner
Crowe Chizek & Co. LLP
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