On September 14, 2015, the Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “IRS”) issued proposed regulations under section 367 of the Internal Revenue Code of 1986, as amended (the “Code”), which would subject to tax otherwise tax-free outbound transfers of foreign goodwill or going concern value (the “Proposed Regulations”).[1] The Proposed Regulations eliminate the foreign goodwill exception to section 367(d) and limit the scope of property that is eligible for the active trade or business exception to section 367(a). As a result, U.S. persons engaging in outbound transfers (“U.S. transferors”) of foreign goodwill or going concern value will be forced to either recognize gain immediately upon the transfer under section 367(a) or recognize deemed royalties over the transferred property’s entire useful life under the so-called “super royalty” provisions of section 367(d).

Background

Section 367(a) – General Outbound Transfers

Section 367(a)(1) provides that transfers of appreciated property by U.S. transferors to foreign corporations (“outbound transfers”) are not eligible for the benefits of the nonrecognition provisions that would otherwise apply to transfers to U.S. corporations. However, section 367(a)(3)(A) provides that the general recognition rule in section 367(a)(1) will not apply to any property transferred to a foreign corporation for use by such foreign corporation in the active conduct of a trade or business outside of the United States (the “ATB exception”). Five categories of property are ineligible for the ATB exception, including intangible property within the meaning of section 936(h)(3)(B) (“section 936(h)(3)(B) intangible property”).

Section 367(d) – Special Rules for Outbound Transfers of Intangible Property

Section 367(d) provides specific rules for outbound transfers of intangible property. Section 367(d)(1) provides that if a U.S. transferor transfers section 936(h)(3)(B) intangible property to a foreign corporation in certain tax-free exchanges, the U.S. transferor is treated as having sold the property in exchange for payments that are contingent upon the productivity, use, or disposition of the property. Specifically, the U.S. transferor is treated as receiving amounts that reasonably reflect the amounts that would have been received annually in the form of such payments over the useful life of such property (limited to 20 years), or upon the subsequent disposition of the intangible property after the transfer. These deemed royalty payments must be commensurate with the income attributable to the intangible. The regulations provide that section 367(d) applies to transfers of intangible property but not to transfers of foreign goodwill or going concern value (the “foreign goodwill exception”).

Section 936(h)(3)(B) – Intangible Property

Foreign goodwill or going concern value is defined under the section 367 regulations to mean the residual value of a business operation conducted outside of the United States after all other tangible and intangible assets have been identified and valued. Section 936(h)(3)(B) intangible property includes various forms of intellectual property including, but not limited to, patent, copyright, and trademark rights; however, goodwill or going concern value is not explicitly included within this definition. This ambiguity regarding the scope of section 936(h)(3)(B) intangible property has allowed taxpayers to claim favorable treatment for foreign goodwill or going concern value using two alternative approaches. Under the first approach, taxpayers take the position that foreign goodwill or going concern value are notsection 936(h)(3)(B) intangible property and therefore are not subject to section 367(d). Such taxpayers also claim eligibility for the ATB exception to section 367(a). Under the second approach, taxpayers acknowledge that foreign goodwill or going concern value are section 936(h)(3)(B) intangible property and instead rely on the foreign goodwill exception. Such taxpayers also claim either that section 367(a) does not apply to transfers of section 936(h)(3)(B) intangible property or rely on the ATB exception to section 367(a).

The Proposed Regulations

The Proposed Regulations eliminate the foreign goodwill exception and limit the scope of property that is eligible for the ATB exception generally to certain tangible property and financial assets. Under the Proposed Regulations, an outbound transfer of foreign goodwill or going concern value by a U.S. transferor will be subject to either current gain recognition under section 367(a)(1), or the deemed royalty treatment under section 367(d).

The issue of whether section 936(h)(3)(B) intangible property includes foreign goodwill or going concern value is not resolved by the Proposed Regulations. Instead, the Proposed Regulations modify the definition of “intangible property” applicable to both sections 367(a) and 367(d) to mean either section 936(h)(3)(B) intangible property or property to which a U.S. transferor applies section 367(d) (in lieu of applying section 367(a)). This modified definition facilitates both the elimination of the foreign goodwill exception as well as the addition of a new rule that a U.S. transferor may apply section 367(d) in lieu of 367(a) to certain transfers of property that otherwise would be subject to section 367(a) under the U.S. transferor's interpretation of section 936(h)(3)(B).

Additionally, the existing rule that limits the useful life of intangible property transferred to 20 years is eliminated by the Proposed Regulations. This change is proposed in response to the concern that when the useful life of the intangible property transferred exceeds 20 years, the existing limitation might result in less than all of the income attributable to the property being taken into account by the U.S. transferor.

The Proposed Regulations also narrow the scope of the ATB exception (which under current law applies to most property) by providing an exclusive list of eligible property, including tangible property and financial assets (subject to four carveouts). Neither intangible property nor “foreign goodwill or going concern value” are covered by this more restrictive definition of eligible property. In order to satisfy the ATB exception under the Proposed Regulations, eligible property must also be considered transferred for use in the active conduct of a trade or business outside of the United States and certain reporting requirements must be satisfied.

The IRS and Treasury concurrently released temporary regulations under section 482 which clarify the application of the arm’s length standard and the best method rule to various Code provisions, including outbound transfers of intangible property under section 367.[2]

The Proposed Regulations would apply to transfers occurring on or after September 14, 2015 and to transfers occurring before September 14, 2015 resulting from entity classification elections filed on or after September 14, 2015.