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Check-the-Box Elections and Worthless Securities Deductions (Revenue Ruling 2003-125); New Reporting for U.S.-Owned Foreign Disregarded Entities (Announcement 2004-4)

In December 2003, the IRS published two pronouncements relating to disregarded entities.

• In Revenue Ruling 2003-125,[1] the IRS has confirmed that the deemed liquidation that occurs when a check-the-box election is made to treat a corporation as a disregarded entity is an identifiable event that "fixes" a worthless security deduction under IRC Section 165(g)(3).

  • In the Ruling, the IRS points out that all of the assets of the corporation (including intangibles that may not be on the corporation's balance sheet) must be taken into account in determining worthlessness.

• In Announcement 2004-4,[2] the IRS and Treasury requested comments on new, proposed Form 8858, "Information Return of U.S. Persons With Respect to Foreign Disregarded Entities" (copy available from the IRS website).

  • While new, proposed Form 8858 looks very similar to Form 5471, it requests information relating to foreign exchange gains and losses under IRC Section 987, losses claimed under IRC Sections 165 and 166, the classification of the foreign disregarded entity (or "FDE") as a "separate unit" under Treas. Reg. Section 1.1503-2(c)(3) and (4), and the classification of the FDE as a manufacturing, selling, or purchasing branch under IRC Section 954(d)(2) (all potentially implicated by a FDE).

Revenue Ruling 2003-125

Revenue Ruling 2003-125 sets forth two similar factual situations:

• In Situation 1, P, a domestic corporation, has a wholly-owned foreign subsidiary ("FS") that has been treated as a corporation for U.S. federal tax purposes. FS derives its gross receipts from manufacturing. FS is indebted to P, as well as to trade creditors, and the indebtedness is valid debt for tax purposes. On December 31, 2002, P's shares in FS are not worthless. On July 1, 2003, P elects to treat FS as a disregarded entity effective as of that date. At the close of business on June 30, 2003, the fair market value of FS's assets, including intangible assets such as goodwill and going concern value, exceed the sum of its liabilities. However, if the value of FS's intangible assets are not taken into account, the sum of FS's liabilities would exceed the value of its assets.

• In Situation 2, the facts are the same except that at the close of business on June 30, 2003, the fair market value of FS's assets (including intangible assets) does not exceed the sum of its liabilities.

In its analysis of Situation 1 and Situation 2, the IRS states that IRC Section 332 only applies where the recipient corporation receives at least partial payment for the stock it owns in the liquidating corporation. If IRC Section 332 is not applicable (because payment was not received), IRC Section 165 becomes operative. A shareholder receives no payment for its stock in a liquidation if, at the time of the liquidation, the fair market value of the corporation's assets is less than the corporation's liabilities. For this purpose, all of the corporation's assets, including intangible assets (such as goodwill and going concern value) and other assets that may not appear on the corporation's balance sheet, must be taken into account.[3]

Under this analysis, in Situation 1 the IRS found that P had received payment for its FS stock and that therefore IRC Section 332 applied to the deemed liquidation and a deduction was not available under IRC Section 165(g)(3). In Situation 2, the IRS found that P had not received payment on its FS stock. Accordingly, IRC Section 332 did not apply to the deemed liquidation and a deduction under IRC Section 165(g)(3) was available. With respect to Situation 2, the IRS also noted that FS's creditors, including P, might be entitled to worthless debt deductions under IRC Section 166.

Announcement 2004-4

As noted above, the IRS and Treasury requested comments on new, proposed Form 8858, "Information Return of U.S. Persons With Respect to Foreign Disregarded Entities."

Proposed Form 8858 is three pages long and consists of an introductory section, five schedules, and a separate Schedule M.

• The introductory section requests identifying information regarding the person filing the form, the FDE, and the tax owner of the FDE (if different from the filer);[4]

• The five schedules include:

  • Schedule C (an abbreviated income statement);

  • Schedule C-1 (information relating to remittances and the recognition of foreign exchange gains and losses under IRC Section 987);

  • Schedule F (an abbreviated balance sheet);

  • Schedule G (six yes/no questions); and

  • Schedule H (information regarding current earning and profits or taxable income).

• Schedule M requests information regarding related party transactions between the FDE and the filer and other related entities.

Form 8858 will be required to be filed for annual accounting periods of tax owners of FDEs beginning on or after January 1, 2004 and will be due when the filer's U.S. federal income tax or information return is due, including extensions.

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If you have any questions regarding Revenue Ruling 2003-125 and/or Announcement 2004-4, please contact Lewis J. Greenwald or another member of our Tax Department at (617) 338-2800.

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1 2003-52 I.R.B., 12/09/2003.

2 2004-4 I.R.B., 12/29/2003.

3 The IRS points out that for purposes of determining the value of property, the IRS and the courts "regularly apply" the willing buyer/willing seller standard of Treas. Reg. Section 20.2031-1(b). The IRS also points out that the fair market value of a corporation's intangible assets is determined by reference to all of the facts and circumstances, which may include, but are not limited to:

The corporation's prospect for future profit as evidenced by:

• The corporation's economic outlook;

• The demand for the corporation's product;

• The efficiency of the corporation's operations; and

• The size of the corporation's customer base;

Whether a substantial capital infusion will be necessary in order to continue operations;

Whether any significant operational changes are anticipated; and

Whether an impairment loss is or will be reported for financial statement purposes or whether the operations will be reported as discontinued operations for financial statement purposes.

4 For this purpose, the Announcement provides the following example:

A, a U.S. individual, is a 60 percent partner of CFP, a controlled foreign partnership. FDE 1 is a foreign disregarded entity owned by CFP, and FDE 2 is a foreign disregarded entity owned by FDE 1. In this example, CFP 1 is the direct owner of FDE 1, and FDE 1 is the direct owner of FDE 2. CFP is the tax owner of both FDE 1 and FDE 2. A would be required to file the Forms 8858 relating to FDE 1 and FDE 2.