On September 16, 2015, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) published proposed regulations under section 367 and proposed and temporary regulations under section 482 that together would significantly change the U.S. federal tax treatment of outbound transfers of intangible property and could impact any U.S. multinational considering incorporating a foreign branch operation or otherwise transferring foreign operations outbound. The proposed regulations:
- Eliminate the long-standing exception from gain recognition on outbound transfers of foreign goodwill and going concern value.
- Limit the scope of the active trade or business exception from gain recognition on outbound transfers.
The temporary regulations:
- Provide clarification on the coordination of the transfer pricing rules under section 482 with other sections of the Code (including section 367), providing that in determining arm’s-length compensation, the entire agreement between parties will be examined as a whole, without regard to the form or character of the transaction.
Generally, section 367(a)(1) turns off certain non-recognition provisions for transactions involving transfers of property to foreign corporations (e.g., contributions of property to a corporation that otherwise qualify for non-recognition under section 351) thus making such transfers taxable absent an exception. Section 367(a)(3)(A) provides an exception to this general rule, effectively preserving non-recognition treatment, for transfers of property to a foreign corporation for use by such corporation in an active trade or business conducted outside the U.S. (the Active Trade or Business Exception). The Active Trade or Business Exception does not apply to transfers of intangible property as defined in section 936(h)(3)(B) (Section 936(h)(3)(B) Intangibles). Neither goodwill nor going concern value is listed in the definition of intangible property under section 936(h)(3)(B).
Under section 367(d), a U.S. transferor of a section 936(h)(3)(B) Intangible in an otherwise qualifying non-recognition transaction is treated as having sold the property for payments contingent on the productivity, use or disposition of the property, which are recognized over the useful life of the property. The regulations under section 367(d) provide that the useful life of intangible property is limited to 20 years for these purposes.
The regulations under section 367(d) provide that section 367(d) does not apply to transfers of foreign goodwill or going concern value (the Foreign Goodwill Exception). For these purposes, foreign goodwill or going concern value is defined as the residual value of a business operation conducted outside the U.S. after all other tangible and intangible assets have been identified and valued. The legislative history of section 367(d) supports this long-standing exception, providing that “ordinarily, no gain will be recognized on the transfer of goodwill or going concern value for use in an active trade or business.”
The preamble to the proposed regulations indicates that Treasury and the IRS are concerned that “certain taxpayers attempt to avoid recognizing gain or income attributable to high-value intangible property by asserting that an inappropriately large share (in many cases, the majority) of the value of the property transferred is foreign goodwill or going concern value that is eligible for favorable treatment under section 367.” The preamble further notes that Treasury and the IRS “have determined that allowing intangible property to be transferred outbound in a tax-free manner is inconsistent with the policies of section 367 and sound tax administration.”
Elimination of the Foreign Goodwill Exception
The proposed regulations (REG-139483-13) eliminate the Foreign Goodwill Exception by modifying the definition of intangible property for purposes of sections 367(a) and (d) to include foreign goodwill and going concern value. While section 367(d) guidance has long been anticipated, in light of the strong support for the Foreign Goodwill Exception in the legislative history, the complete elimination of this exception is controversial, and the statutory and policy basis for this change is not clear.
The proposed regulations do not address the issue of whether goodwill and going concern value are Section 936(h)(3)(B) Intangibles. However, the proposed regulations permit taxpayers that take the position that goodwill and going concern value are Section 936(h)(3)(B) Intangibles to elect to apply section 367(d) with respect to outbound transfers of such property, which would otherwise be subject to section 367(a).
The proposed regulations also eliminate the 20-year limitation on the useful life of intangible property for purposes of section 367(d). Under the proposed regulations, the useful life of intangible property is the entire period during which the exploitation of the property is reasonably anticipated to occur, which, if the property is anticipated to contribute to its own further development or to the development of other intangibles, includes the anticipated period of exploiting such further development. Thus, for purposes of section 367(d), an intangible could potentially be treated as having a perpetual life, and a transferee could correspondingly have perpetual income inclusions in respect of such property.
Limiting the Scope of the Active Trade or Business Exception
Under the existing regulations, all property is eligible for the Active Trade or Business Exception unless specifically excluded. In contrast, the proposed regulations provide an exclusive list of property that is eligible for the Active Trade or Business Exception. For these purposes “eligible property” includes tangible property, working interests in oil and gas property, and certain financial assets, unless such property is described in a category of ineligible property. The definition of “eligible property” does not include intangible property. Thus, a taxpayer that takes the position that a transfer of foreign goodwill and going concern value is subject to section 367(a) would not be able to rely on the Active Trade or Business Exception to avoid gain on such transfer.
Under the proposed regulations, in order for an outbound transfer of property to satisfy the Active Trade or Business Exception under the proposed regulations, (i) the transferred property must be eligible property, (ii) the property must be transferred for use by the foreign corporation in the active conduct of a trade or business outside the U.S., and (iii) certain reporting requirements under section 6038B must be satisfied.
The proposed regulations also combine the guidance on the Active Trade or Business Exception, which is currently spread across several sections of the regulations, into a single section in an effort to make the rules more “accessible.”
Coordination with Section 482
The preamble to the temporary regulations (TD 9738) notes that Treasury and the IRS are concerned about situations in which controlled groups evaluate economically integrated transactions involving economically integrated contributions, synergies and interrelated value on a separate basis in a manner that results in a misapplication of the best method rule and fails to reflect an arm’s-length result.
The temporary regulations provide that when valuing property transferred in a controlled transaction under section 482 that is also subject to another section of the Code (e.g., section 367(d)), a taxpayer must apply a best method analysis in determining arm’s-length compensation. In making such a determination, it is necessary to consider the entire agreement between the parties as a whole, without regard to the form or character of the transaction, in accordance with the economic substance of the arrangement to ensure that the overall value provided (including any synergies) is properly taken into account. If the parties’ formal arrangements do not reflect the full value of the property transferred and services provided, the IRS may impute additional agreements that reflect the economic substance of the arrangements between the parties.
The proposed regulations under section 367, once published as final, will apply to transfers occurring on or after September 14, 2015, and to transfers occurring before September 14, 2015, resulting from check-the-box elections that are filed on or after September 14, 2015. The temporary regulations under section 482 apply to taxable years ending on or after September 14, 2015.