On May 23, 2006, IRS Notice 2006-46 announced that the IRS will issue final regulations under Code sections 897(d) and 897(e); those regs revise rules for inbound and foreign-to-foreign asset reorganizations involving the transfer of US real property interests (USRPIs) pursuant to the Foreign Investment in Real Property Tax Act (FIRPTA). The revisions are necessary because recently amended regs issued under section 368(a)(1)(A) allow statutory mergers or consolidations under foreign law to qualify as tax-free type A reorganizations; current regs and IRS guidance related to sections 897(d) and (e) do not contemplate that result.

Under section 897(a), the disposition of a USRPI by a non-resident alien individual or a forco is taxable as effectively connected income under sections 871(b)(1) and 882(a)(1), as if the taxpayer were engaged in a US trade or business. A USRPI is generally defined as any interest (other than an interest solely as a creditor) in US real property or an interest in a US corporation unless the taxpayer establishes that the corporation was not a US real property holding corporation (USRPHC) at any time during the shorter of the taxpayer's holding period and the five years preceding the date of disposition. A USRPHC is defined as any corporation if the FMV of its USRPIs is at least equal to 50 percent of the sum of the FMV of (1) its USRPIs, (2) its foreign real property interests, and (3) any of its other assets used or held for use in the trade or business.

If a forco distributes (including in a liquidation or redemption) a USRPI in an otherwise non-recognition transaction, gain is recognized pursuant to section 897(d)(1), except as provided in the regs. An exception applies if (1) at the time of the property's receipt, the distributee is taxable on its subsequent disposition and its basis in the distributee's hands is not greater than its pre-distribution adjusted basis plus any gain recognized by the distributing corporation, or (2) non-recognition treatment is provided for in regulations under section 897(e)(2). Temporary regs provide further guidance for section 897(d) distributions in the context of certain subsidiary-to-parent liquidations (section 332), spinoff transactions (section 355), and other non-recognition transactions (section 361); IRS Notice 89-85 revises the application of certain exceptions.

Generally, any non-recognition provision applies only on an exchange of a USRPI for an interest whose sale is otherwise taxable under Code chapter 1 (sections 1 to 1400T) (subject to section 897(d) and any regs issued under section 897(e)(2)). Temporary regs impose certain requirements for non-recognition transfers of USRPIs (section 1.897-6T(a)(1)). The IRS and Treasury decided that these temporary regs--and those issued for non-recognition transactions under sections 897(d) (and related Notice 89-85)--must be changed in light of the January 2006 final regs on statutory mergers and consolidations described in section 368(a)(1)(A). The IRS revisions address the new rules for statutory mergers and consolidations and include other changes to the section 897 regs.

The final regs intend to revise Notice 89-85 and Treasury reg section 1.897-5T(c)(4) relating to inbound asset type C, D, and F reorganizations so that they encompass section 368(a)(1)(A) statutory mergers and consolidations as well. The regs also revise Treasury regulation section 1.897-6T(b)(1) to take into account foreign-to-foreign statutory mergers and consolidations and to create two additional exceptions that provide a forco with non-recognition treatment on a USRPI's transfer in certain foreign-to-foreign asset reorganizations.

Taxpayers may rely upon the guidance in Notice 2006-46 before the final regs are issued. The final regs generally apply to distributions, transfers, or exchanges occurring after January 22, 2006 in the context of a statutory merger or consolidation; other changes in the regs apply to transactions occurring after May 22, 2006. However, taxpayers may generally apply the regs during any non-statute-barred tax year if they do so consistently for all transactions.

The new guidance allows greater flexibility in structuring mergers and consolidations with Canadian corporations and Canadian investors owning USRPIs. Not only may a merger under foreign law qualify for US tax-free treatment under section 368(a)(1)(A), but if USRPIs are involved, a merger may be structured to avoid FIRPTA.