Treas. Reg. § 1.367(b)-2: Core Definitions for Application

The U.S. tax code contains provisions to address international corporate transactions that might otherwise avoid taxation. Section 367(b) of the Internal Revenue Code governs the tax consequences of certain corporate reorganizations involving foreign corporations that would ordinarily be tax-free. These rules are designed to prevent the untaxed repatriation of foreign earnings into the United States.

At the heart of these regulations is Treasury Regulation § 1.367(b)-2, which provides the foundational definitions necessary to apply the broader rules. Understanding these terms is necessary for navigating the complexities of international reorganizations, as they establish the framework for when and how these tax provisions are triggered.

Core Definitions for Application

The application of Section 367(b) relies on a set of specific definitions. A central figure is the “Section 1248 shareholder,” which is a U.S. person who owns, or is considered to own, 10 percent or more of the total combined voting power of a foreign corporation. This ownership test must be met at any time during the five-year period ending on the date of the exchange when the foreign corporation was a controlled foreign corporation (CFC). A CFC is a foreign corporation where such U.S. shareholders collectively own more than 50 percent of its vote or value.

Directly linked to the shareholder definition is the “Section 1248 amount.” This term represents the portion of a foreign corporation’s earnings and profits (E&P) that would be taxed as a dividend if the shareholder sold their stock. The calculation is limited to the positive E&P accumulated by the foreign corporation during the period the stock was held by the Section 1248 shareholder while the corporation was a CFC. This quantifies the earnings that have not yet been subject to U.S. tax at the shareholder level.

A broader concept is the “all earnings and profits amount.” Unlike the Section 1248 amount, this measure is not limited to the shareholder’s specific holding period or their pro-rata share of earnings accumulated only while the entity was a CFC. Instead, it includes all of the foreign corporation’s E&P for all taxable years. This provides a more comprehensive measure of the total untaxed value within the foreign entity.

A “foreign corporation” is any corporation not created or organized in the United States or under the law of the United States or any State. This definition, along with the others, works to identify the specific parties and transactions subject to Section 367(b).

Scope of the Regulation

The rules under Section 367(b) target specific situations where earnings accumulated offshore could be brought into the U.S. tax system without immediate taxation. The primary trigger is an “exchange” of stock in a foreign corporation by a U.S. person as part of a transaction that would otherwise qualify for nonrecognition of gain. These transactions include corporate reorganizations and certain transfers to controlled corporations.

These regulations most commonly apply to inbound and foreign-to-foreign reorganizations. An inbound transaction could involve a U.S. person exchanging stock of a foreign corporation for stock of a domestic corporation. Without Section 367(b), the untaxed foreign earnings could be absorbed by the U.S. corporation without triggering a taxable event for the shareholder.

Foreign-to-foreign reorganizations are also within the regulation’s scope, such as when a U.S. shareholder exchanges stock of one foreign corporation for stock of another. While the earnings remain offshore, the nature of the investment may change. The regulations are triggered to ensure the potential U.S. tax liability associated with the accumulated earnings is preserved.

For the regulation to apply, the transaction must be one of the specified nonrecognition exchanges, such as those defined under Internal Revenue Code Sections 332, 351, 354, 356, 361, or 368. The person exchanging the stock must be a U.S. person who is a Section 1248 shareholder of the foreign corporation immediately before the exchange. If these conditions are met, the shareholder may be required to recognize income.

Calculating the Required Income Inclusion

When a transaction falls within the scope of Section 367(b), the shareholder may be required to include an amount in income as a deemed dividend. The core rule requires an exchanging Section 1248 shareholder to include in income the Section 1248 amount attributable to the stock they are exchanging. This amount is treated as a dividend paid by the foreign corporation to the shareholder immediately before the transaction, ensuring the accumulated foreign earnings are subject to U.S. tax.

To illustrate, assume a U.S. shareholder owns 100% of a foreign corporation and has been a Section 1248 shareholder for five years, during which the corporation generated $500,000 of E&P. If the shareholder exchanges this stock for stock in a domestic corporation in a qualifying reorganization, their Section 1248 amount is $500,000. The shareholder must include this full amount in their gross income as a dividend for the taxable year of the exchange.

The character of this income inclusion is a dividend. For corporate shareholders, this is significant because it may allow them to claim a deemed-paid foreign tax credit under Section 960 for foreign income taxes paid by the foreign corporation on those earnings. This credit helps to mitigate double taxation on the same income.

Post-Inclusion Tax Attribute Adjustments

Recognizing a deemed dividend is not the final step; a series of adjustments to tax attributes must be made to prevent the same earnings from being taxed multiple times. These adjustments account for the fact that the shareholder has already paid U.S. tax on a portion of the foreign corporation’s earnings.

A primary adjustment is made to the basis of the stock involved. The exchanging shareholder increases their basis in the foreign corporation’s stock by the amount of the deemed dividend included in income. This basis increase occurs immediately before the exchange. As a result, the shareholder’s basis in the new stock received in the exchange reflects this increase, which will reduce the gain or increase the loss on a future sale.

Simultaneously, the foreign corporation’s E&P that gave rise to the deemed dividend must be adjusted. These earnings are reclassified as “previously taxed earnings and profits” (PTEP). This reclassification ensures that when the foreign corporation makes an actual cash distribution in the future, the portion attributable to PTEP will not be taxed again to the shareholder. This mechanism prevents the double taxation of the same pool of earnings.