PLR 1027036: Related-party structure did not prevent like-kind exchange nonrecognition

Plain-English summary

The IRS ruled that section 1031(f) would not prevent nonrecognition treatment for a controlled foreign corporation's proposed like-kind exchange using a qualified intermediary. Related companies would acquire the relinquished property after the exchange, but the IRS concluded that the arrangement did not amount to a prohibited related-party exchange or a transaction structured to avoid section 1031(f). If all other section 1031 requirements were met, the deferred gain or loss would not be treated as foreign base company income for the year of the exchange. The deferred amount also would not affect the controlled foreign corporation's earnings and profits for that year.

Ruling snapshot

• Question: Does section 1031(f) prevent nonrecognition and affect foreign base company income or earnings and profits in the proposed exchange?
• Outcome: approved
• Key authorities: IRC §§ 1031, 952, 954, and 964; Treas. Reg. §§ 1.952-2 and 1.964-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201027036 Third Party Communication: None
Release Date: 7/9/2010 Date of Communication: Not Applicable
Index Number: 952.00-00, 964.01-00,
1031.00-00 Person To Contact:
--------------------, ID No. ------------
----------------------------------- Telephone Number:
----------------------------- ---------------------
-------------------------- Refer Reply To:
------------------------------------------------------ CC:IT&A:5
In Re: PLR-143973-09
----------------------------------- Date:
----------------------- March 30, 2010

LEGEND:

Taxpayer = ------------------------------------

Company TP = -----------

Company A = --------------------------------------------------------------

Company B = -------------------------------------------------------------------

Company B1 = ---------------------------------------------------------------------------------

Company B2 = -------------------------------------------------------------------

Company B3 = ---------------------------------------------------------------------------------

Company C = -------------------------------------------------------------------

Company D = ---------------------------------------------

Partnership = -----------------------------------------------

Manufacturer = -----------------------------

Intermediary = -----------------------------------------------------------

Institution = ----------------------

Product = ---------
PLR-143973-09 2

Component A = --------------

Component B = -----------------

Relinquished Property = ---------------------------------------------------------------------------------

Replacement Property = ---------------------------------------------------------------------------------

Country X = ---------

Location A = -----------------------

Location B = -----------------------

Activity = ------------------------

A% = ----------

Dear -----------------:

This letter responds to your ruling request submitted on behalf of Taxpayer by letter
dated September 30, 2009, as to (1) whether § 1031(f) precludes nonrecognition
treatment under § 1031 in the transaction described below, and (2) if not, whether any
gain or loss realized but not recognized under § 1031 by Company B will affect the
foreign base company income and the earnings and profits of Company B.

STATEMENT OF FACTS

We rely on the facts, representations, and conditions set forth in Taxpayer’s
submissions dated September 30, 2009, January 27, 2010, and February 17, 2010.

Taxpayer, the common parent corporation of a group of corporations, files a
consolidated U.S. Federal income tax return. Taxpayer conducts a global commercial
Product leasing business under the trade name Company TP. Taxpayer indirectly
wholly owns Company A, which is a domestic corporation and a member of the
consolidated group. Company A indirectly wholly owns Company C and Company D,
which are domestic corporations and members of the consolidated group. Company A
also wholly owns, directly and indirectly, Company B, which is organized in Country X
and classified as a corporation for U.S. Federal tax purposes. Company B is a
controlled foreign corporation within the meaning of § 957(a). Company B, in turn,
PLR-143973-09 3

wholly owns multiple companies in Country X that are disregarded as entities separate
from Company B: Company B1, Company B2, and Company B3. Taxpayer owns
indirectly A% of Partnership, which is a domestic limited partnership. Company A,
Company B, Company C, and Company D are related parties within the meaning of
§ 1031(f)(3).

Company TP operates its Product leasing business through two operational centers:
one in Location A for Product used in Activity, and the other in Location B for all other
Product. At the end of a Product lease, Company TP customarily either disposes of or
re-leases the Product. Depending on market conditions, it may be more profitable to
dismantle the Product and sell the parts. Company TP’s Component A parts business
operates through wholly owned direct and indirect subsidiaries of Company A, including
Company C. Company C acquires Component A by purchase or consignment,
disassembles Component A, and sells the reconditioned parts from its warehouse in
Location B. Company TP’s Component B parts business operates through Partnership,
which acquires Component B through purchase or consignment, disassembles
Component B and services the parts, and sells the revamped Component B parts from
the Partnership warehouse in Location B.

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Company B proposes to dispose of and replace Relinquished Property through an
exchange of like-kind property that is intended to qualify for nonrecognition treatment
under § 1031(a). Company B2 leases Relinquished Property to customers for use in
Activity. Company B2 will enter into a contract (Sale Agreement) with Company C and
Company D for the sale of Relinquished Property. Company C will acquire the
Component A and all parts other than the Component B on Relinquished Property and
Company D will acquire the Component B on Relinquished Property.

Taxpayer represents that Replacement Property is like kind to Relinquished Property
and will be used in Activity. Company A and Company B1, as joint and several
purchasers, have entered into a purchase agreement (Purchase Agreement) with
Manufacturer to purchase Replacement Property. Manufacturer is a domestic
corporation not related to Taxpayer or any of Taxpayer’s affiliates described above.

Prior to closing on the Sale Agreement, Company B2 will enter into an exchange
agreement (Exchange Agreement) with Intermediary, which is a domestic corporation
PLR-143973-09 4

unrelated to Taxpayer or any of Taxpayer’s affiliates described above. Intermediary is a
qualified intermediary as defined by § 1.1031(k)-1(g)(4), and not a “disqualified person”
with respect to Taxpayer within the meaning of § 1.1031(k)-1(k). The Exchange
Agreement will require Intermediary to acquire Relinquished Property from Company
B2, transfer Relinquished Property, acquire a like-kind replacement property, and
transfer the replacement property to Company B2. The Exchange Agreement will
expressly limit Company B2’s right to receive, pledge, borrow, or otherwise obtain the
benefits of the cash or cash equivalent held by the Intermediary as provided in
§ 1.1031(k)-1(g)(6).

Company B2, Institution, and Intermediary will enter into a trust agreement (Trust
Agreement), in which Company B2 will be the beneficiary and Institution will be the
trustee. Institution is not a disqualified person as defined in § 1.1031(k)-1(k). The Trust
Agreement will expressly limit Company B2’s right to receive, pledge, borrow, or
otherwise obtain the benefits of the cash or cash equivalent held by Institution as
provided in § 1.1031(k)-1(g)(6).

Pursuant to the Exchange Agreement, Company B2 will assign in writing its rights in the
Sale Agreement to Intermediary. Company B2 will give to Company C and Company D
written notice of the assignment of its rights in Relinquished Property on or before the
date of the transfer of Relinquished Property. On the closing date of the Sale
Agreement, Company C and Company D will pay their respective portions of the
purchase price to Intermediary in cash, those amounts will be deposited in the trust, and
Intermediary will direct in writing Company B2 to transfer title to Relinquished Property
to Company C and Company D.

Prior to delivery of Replacement Property, Company A and Company B1 will assign in
writing their rights and obligations under the Purchase Agreement to Company B3
(Assignment Agreement). Company B2 will assign, for value, its rights and obligations
in the Exchange Agreement to Company B3. Pursuant to the Exchange Agreement,
Company B3 will identify in writing Replacement Property as replacement property by
midnight of the 45th day after the closing date for the sale of Relinquished Property.

Pursuant to the Exchange Agreement, Company B3 will assign in writing its rights, but
not its obligations, under the Assignment Agreement to Intermediary. Company B3 will
give to Manufacturer, Company A, and Company B1 written notice of the assignment of
its rights in Replacement Property on or before the date of the transfer of Replacement
Property.

Company B3 or Company B will pay to the Intermediary funds equal to the excess of
the purchase price of Replacement Property over the proceeds from the sale of
Relinquished Property held in the trust that are available for the purchase of
Replacement Property.
PLR-143973-09 5

Pursuant to the Exchange Agreement, Intermediary will direct in writing Manufacturer to
transfer title to Replacement Property directly to Company B3. The transfer will occur
by the earlier of midnight of the 180th day after the closing date for the sale of
Relinquished Property or the due date of the Company B Federal tax return for the tax
year in which Relinquished Property was transferred.

After the above transactions, Company B3 will own Replacement Property, and
Company C and Company D will own Relinquished Property. Within two years of
acquiring the Component A, Company C plans to dismantle the Component A and sell
the dismantled parts of the Component A to a third party or parties not related to
Company C or Company B. Depending on the market conditions for Component B at
the time of the acquisition of the Component B, Company D will either lease the
Component B to a customer or consign the Component B to Partnership, which will,
within two years of Company D acquiring the Component B, dismantle the Component
B and sell the dismantled parts of the Component B on behalf of Company D. Taxpayer
anticipates that most of the parts will be sold to a third party or parties not related to
Company D or Company B.

LAW AND ANALYSIS

Exchanges between Related Parties under § 1031(f)

Section 1031(a)(1) generally provides that no gain or loss shall be recognized on the
exchange of property held for productive use in a trade or business or for investment if
such property is exchanged solely for property of like kind which is to be held either for
productive use in a trade or business or for investment.

Section 1031(f)(1) sets forth special rules for exchanges between related persons.
Section 1031(f)(1) provides that if (A) a taxpayer exchanges property with a related
person, (B) there is nonrecognition of gain or loss to the taxpayer in accordance with
§ 1031 with respect to the exchange, and (C) within two years after the date of the last
transfer that was part of the exchange, either the taxpayer or the related person
disposes of the property received in the exchange, then there is no nonrecognition of
gain or loss in the exchange. In other words, the gain or loss that was deferred under
§ 1031 must be recognized as of the date of the disposition of the property received in
the exchange (the second disposition).

The Ways and Means Committee Report discussing § 1031(f), H.R. Rep. No. 247, 101st
Cong. 1st Sess. 1340 (1989), describes the policy concern that led to its enactment:

   Because a like-kind exchange results in the substitution of the basis of the
   exchanged property for the property received, related parties have engaged in

PLR-143973-09 6

   like-kind exchanges of high basis for low basis property in anticipation of the sale
   of the low basis property in order to reduce or avoid the recognition of gain on the
   subsequent sale. . . . The committee believes that if a related party exchange is
   followed shortly thereafter by a disposition of the property, the related parties
   have, in effect, ‘cashed out’ of the investment, and the original exchange should
   not be accorded nonrecognition treatment.

Section 1031(f)(4) provides that § 1031 shall not apply to any exchange that is part of a
transaction, or series of transactions, structured to avoid the purposes of § 1031(f).
Thus, if a transaction is set up to avoid the restrictions of § 1031(f), § 1031(f)(4)
operates to prevent nonrecognition of the gain or loss in the exchange. See Rev. Rul.
2002-83, 2002-2 C.B. 927 (nonrecognition treatment precluded under § 1031(f)(4)
where related parties used qualified intermediary to circumvent the purposes of
§ 1031(f)(1)).

In the present case, § 1031(f)(1) is not applicable because Company B is exchanging
property with Intermediary that is not a related person. In addition, § 1031(f)(4) does
not apply to preclude nonrecognition because Company B, Company C, and Company
D did not exchange properties either directly or through Intermediary. Company C and
Company D did not own, prior to the exchange, any property that Company B will
acquire in the exchange. Company B did not transfer Relinquished Property to
Company C and Company D as part of a transaction or series of transactions structured
to avoid the purposes of § 1031(f)(1). The related parties in this case did not exchange
high basis property for low basis property in anticipation of the sale of the low basis
property. Accordingly, Company C and Company D’s proposed disposal of
Relinquished Property within two years of the acquisition would not result in a “cashing
out” of an investment or shifting of basis between Company B, Company C, and
Company D.

Foreign Base Company Income and Earnings and Profits

Under § 1.952-2(a) and (b), the gross income and taxable income, respectively, of a
foreign corporation (other than a foreign corporation that would be taxed as a life
insurance company if it were domestic) for any taxable year shall be determined by
treating such foreign corporation as a domestic corporation taxable under § 11 and by
applying the principles of §§ 61 and 63 and the regulations thereunder, subject to
certain limitations described in § 1.952-2(c) that do not apply in this situation. Because
the income of a controlled foreign corporation is generally computed as if the
corporation were domestic, the results of a valid § 1031 like-kind exchange are
respected for purposes of computing the controlled foreign corporation’s income.
Accordingly, in a qualifying § 1031 exchange, a controlled foreign corporation has
income only to the extent of gain recognition under § 1031, if any.
PLR-143973-09 7

Further, any gain or loss realized but not recognized by a corporation pursuant to a valid
§ 1031 exchange will not affect the earnings and profits of the corporation for the year in
which such gain or loss is realized but not recognized. See §§ 312(f)(1) and 1.312-
7(b)(1). In the case of a controlled foreign corporation, section 964(a) states that,
except as provided in § 312(k)(4) (relating to the effect of depreciation on the earnings
and profits of certain foreign corporations), for subpart F purposes the earnings and
profits of any foreign corporation, and the deficit in earnings and profits of any foreign
corporation, for any taxable year, are determined by rules substantially similar to those
applicable to domestic corporations, under regulations prescribed by the Secretary.
Under § 1.964-1(a), the earnings and profits (or deficit in earnings and profits) of a
foreign corporation for its taxable year are computed substantially as if such corporation
were a domestic corporation, by preparing a profit and loss statement with respect to
such year from the books of account regularly maintained by the corporation and
making any necessary adjustments as described in § 1.964-1(b) and (c).

RULINGS

Based on the given facts and representations:

(1) Section 1031(f) will not preclude nonrecognition treatment in the transaction
described above.

(2) To the extent that all other requirements of § 1031 are satisfied so that any gain or
loss resulting from the above-described transaction is realized but not recognized,
Company B will not recognize any income or loss from the transaction and, as a result,
no amount of realized but unrecognized gain from the transaction will be treated as
foreign base company income, as determined under § 954, for the year in which the
gain or loss is realized but not recognized.

(3) Assuming no gain or loss will be recognized as a result of § 1031, any gain or loss
realized but not recognized by Company B pursuant to § 1031 on the transfer of
Relinquished Property will not generate earnings and profits (or a deficit in earnings and
profits) of Company B under § 964 for the year in which such gain or loss is realized but
not recognized. See §§ 312(f)(1), 1.312-7(b)(1), and 1.964-1.

DISCLAIMERS

Except as provided above, no opinion is expressed as to the Federal tax treatment of
the above transaction under any other provisions of the Internal Revenue Code and the
Income Tax Regulations that may be applicable, including § 482, or under any other
general principles of Federal income taxation. Neither is any opinion expressed as to
the tax treatment of any conditions existing at the time of, nor effects resulting from, the
transaction that are not specifically covered by the above ruling.
PLR-143973-09 8

This letter is not a ruling that the above transaction satisfies all of the requirements for
nonrecognition treatment under § 1031 and the regulations thereunder. While this office
has not verified any of the material submitted in support of the request for a ruling, it is
subject to verification on examination. No opinion is expressed as to whether the
accommodators used in this transaction are disqualified persons as defined in
§ 1.1031(k)-1(k), as that would constitute essentially a factual determination.

This ruling is directed only to Taxpayer. Section 6110 (k)(3) provides that it may not be
cited as precedent. Pursuant to the Power of Attorney submitted by Taxpayer, a copy
of this letter will be sent to Taxpayer’s authorized representatives.

                                                     Sincerely,



                                                     ______________________________
                                                     Amy Pfalzgraf
                                                     Senior Counsel, Branch 5
                                                     Office of Associate Chief Counsel
                                                     (Income Tax and Accounting)

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