On September 14, 2015, the Internal Revenue Service (the “IRS”) released proposed Treasury Regulations (the “Proposed Regulations”) that would clarify, or perhaps significantly change, the treatment of outbound transfers of goodwill and going concern intangibles under existing law. This alert provides a general overview of the key portions of the Proposed Regulations that may be relevant to your business.
Generally, section 367(a) of the Internal Revenue Code of 1986, as amended (the “Code”), turns off certain non-recognition provisions of the Code (i.e., “non-recognition treatment”) for transactions that involve transfers of property to a foreign corporation, such as the treatment of capital contributions to corporations under section 351. Section 367(a)(3)(A) carves out from this general rule, and therefore preserves otherwise non-recognition treatment, the transfer of property to a foreign corporation for use in an active trade or business conducted outside of the United States (the “ATB exception”).
Special rules apply, however, to intangibles listed in section 936(h)(3)(B) (“section 936 intangibles”). First, section 936(h)(3)(B) intangibles are specifically ineligible for the ATB exception. Second, a section 936 intangible otherwise subject to the override of non-recognition treatment under section 367(a) will instead be subject to the so called “super royalty” provisions of section 367(d) if the section 936 intangible is transferred in an exchange described in section 351 (capital contributions) or 361 (reorganizations). Under this super royalty provision, the transferor is treated as having sold the section 936 intangible in exchange for annual payments that would have been received over the useful life of the property.
Section 936(h)(3)(B) lists the following categories of intangible property:
- patent, invention, formula, process, design, pattern, or know-how;
- copyright, literary, musical, or artistic composition;
- trademark, trade name, or brand name;
- franchise, license, or contract;
- method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or
- any similar item
that has substantial value independent of the services of any individual. This definition of section 936 intangibles does not explicitly include intangibles such as goodwill or going concern value.
In addition to this definition, existing temporary Treasury Regulations under section 367(d) provide that section 367(d) does not apply to the transfer of foreign goodwill or going concern value, which is defined as the residual value of a business conducted outside of the United States after all other assets have been identified and valued.
As a result of the foregoing rules under existing law, the IRS recognized that taxpayers have taken the position that transfers of goodwill and going concern value are not subject to the rules of section 367(d). Under this interpretation, goodwill and going concern value would be subject to the general rules of section 367(a). If correct, the taxpayers could then take the position that such goodwill and going concern value is part of an active trade or business conducted outside of the United States and thus not subject to section 367(a) under the ATB exception.
Similarly, the IRS recognized that taxpayers may assert that a significant portion of an outbound transfer of intangibles to a foreign corporation is attributable to foreign goodwill and going concern value, which is therefore expressly excluded from the application of section 367(d) by the temporary Treasury Regulations.
The IRS has concluded that the taxpayer positions and interpretations described above “raise significant policy concerns and are inconsistent with the expectation, expressed in legislative history, that the transfer of foreign goodwill or going concern value developed by a foreign branch to a foreign corporation was unlikely to result in abuse of the U.S. tax system” and therefore will amend the Treasury Regulations under section 367 to address such positions and interpretations.
II. Proposed Regulations under Section 367
Under the Proposed Regulations, the IRS does not purport to resolve the question of whether goodwill and going concern value are included in the definition of section 936(h)(3)(B) intangibles. Rather, the Proposed Regulations generally allow a taxpayer to apply either section 367(a) or section 367(d) to any property, including goodwill and going concern value. However, the Proposed Regulations generally eliminate the exception for foreign goodwill and going concern value in the existing temporary Treasury Regulations under section 367(d).
The Proposed Regulations also modify the ATB exception to provide an exclusive list of property eligible for the exception. Under the new list, the only categories of property that are eligible for the ATB exception are tangible property, working interests in oil and gas property and certain financial assets that, in each case, are transferred for use by the foreign corporation in an active trade or business. Therefore, intangibles such as goodwill and going concern value will not be eligible for the ATB exception.
III. Effective Date
The Proposed Regulations provide that, when finalized, they will be effective as of September 14, 2015. Thus, the final Treasury Regulations will have retroactive effect and could affect any outbound transfer of intangibles in a transaction consummated after September 13, 2015. Clients are encouraged to consider these rules in connection with any such transactions.
IV. Coordinating Rules under Section 482
The IRS has simultaneously released other proposed Treasury Regulations dealing the coordination of the transfer pricing rules in the context of section 367. These proposed Treasury Regulations clarify that, when valuing property transferred in a transaction that is both a controlled transaction under the section 482 rules and a transaction subject to other provisions of the Code (such as section 367(d)), taxpayers must use the valuation method that provides the most reliable measure of an arm’s length result. This “best method” principle requires, when appropriate, taxpayers to analyze transactions in the aggregate where the aggregate approach reaches a more reliable measure of an arm’s length result. Therefore, taxpayers must take into account certain synergies and interrelated value on an aggregate basis with respect to such integrated transactions if such approach is the best method.
Furthermore, these rules require taxpayers to apply the transfer pricing analysis independently of the form or character of the controlled transaction. Therefore, in determining arm’s length compensation, the taxpayer must consider the entire arrangement in light of the actual conduct of the parties regardless of the form of the arrangement. If the formal arrangement fails to reflect the full value of the services being provided, then the IRS may impute additional agreements consistent with the economic substance of the arrangement between the parties. When finalized, these Treasury Regulations under section 482 will have retroactive effective to September 14, 2015.