On July 13, 2012, the Internal Revenue Service (the “IRS”) issued Notice 2012-39 (the “Notice”), which provides guidance on the tax treatment of certain outbound transfers of intellectual property under Section 367(d).1 As part of the Notice, the IRS announced its intention to issue regulations reflecting the guidance outlined in the Notice. Such regulations will apply to outbound transfers of intellectual property occurring on or after July 13, 2012.
Section 361 provides that a corporation which is a party to a reorganization will not recognize gain or loss on the exchange of property for stock or securities in another corporation that is also a party to the reorganization.2 If a corporation receives property other than stock (“Boot”) from another corporation that is a party to the reorganization, the receiving corporation recognizes gain in an amount that does not exceed the fair market value of the Boot (collectively, a “Section 361 Exchange”).3
Under Section 367, however, if a U.S. corporation transfers property to a foreign corporation in a Section 361 Exchange, the foreign corporation is not treated as a corporation for purposes of the Section 361 non-recognition rules. Moreover, the U.S. transferor will also recognize gain or loss on the outbound transfer unless an exception applies.4
One such exception is Section 367(d), which applies to a transfer of intangible property from a U.S. corporation to a foreign person. This section treats the U.S. corporation as having sold intangible property in exchange for payments that are contingent upon such property’s productivity, use or disposition.5 The U.S. transferor corporation is also treated as receiving amounts which reasonably reflect the amount that either would have been received over the useful life of the property or, in the case of a later disposition, at the time of the disposition.6 The amounts that are taken into account under Section 367(d) must be commensurate with the income attributable to the intangible and are treated as ordinary income in the same manner as if the inclusion were a royalty.7
Temporary regulations currently provide additional guidance on the tax treatment of outbound transfers of intellectual property under Section 367(d). Such regulations provide that if a U.S. corporation transfers intangible property subject to Section 367(d) to a foreign corporation, the U.S. corporation is treated as selling the intangible property in exchange for annual payments contingent on the productivity or use.8 Therefore, the U.S. corporation will, over the useful life of the property, annually include in income an amount that reflects an approximate arm’s-length charge as determined under general Section 482 principals for the use of such intangible property.9 If the U.S. corporation subsequently disposes of the stock of the foreign corporation to an unrelated person during the useful life of the property, the U.S. corporation is treated as having simultaneously sold the intangible property to the unrelated person acquiring the stock of the transferee foreign corporation for the fair market value of the intangible property.10 The U.S. corporation recognizes gain (but not loss) in an amount equal to the difference between the fair market value of the transferred intangible property on the date of the subsequent disposition and the U.S. corporation’s adjusted basis in the intangible property on the date of the initial transfer.11 If the U.S. corporation instead disposes of stock of the foreign corporation to a related U.S. person during the useful life of the property, the related U.S. person must annually include in income a proportionate share of the contingent annual payments that would otherwise be deemed to have been received by the U.S. transferor.12 Any amounts which must be taken into income but not actually received can be used to establish an account receivable from the transferee foreign corporation equal to the amount deemed paid.13
The IRS is aware that taxpayers are engaging in transactions intended to repatriate earnings from foreign corporations without the appropriate recognition of income. For instance, U.S. parent, a domestic corporation (“USP”), owns 100% of the stock of U.S. transferee, a domestic corporation (“UST”). USP’s basis in its UST stock equals its value of $100x. UST’s sole asset is a patent with a tax basis of zero. UST has no liabilities. USP also owns 100% of the stock of a foreign corporation (“TFC”). UST transfers the patent to TFC in exchange for $100x of cash and, in connection with the transfer, UST distributes the $100x of cash to USP and liquidates. The taxpayer takes the position that neither USP or UST recognizes gain or dividend income on the receipt of the $100x of cash. USP then applies the Section 367(d) regulations to include amounts in gross income in subsequent years. USP also applies the Section 367(d) regulations to establish a receivable from TFC in the amount of the aggregate income USP included. USP takes the position that TFC’s repayment of the receivable does not give rise to income. Accordingly, the transactions have resulted in a repatriation in excess of the $100x because there was $100x received at the time of the reorganization and then additional amounts are repatriated through repayment of the receivable in the amount of USP’s income inclusions over time. However, there is only recognition of the income in the amount of the USP’s income inclusions over time.
The IRS realizes that other transactions may be structured to have a similar effect, including, for example, transactions that involve TFC’s assumption of liabilities of UST. Similar results may also be achieved in cases where a controlled foreign corporation uses deferred earnings to fund an acquisition of all or part of the stock of a domestic corporation from an unrelated party for cash, followed by an outbound asset reorganization of the domestic corporation to avoid an income inclusion under Section 956. Therefore, as the IRS believes that these transactions, as well as other similar transactions, raise significant policy concerns, the IRS issued the Notice in order to change the manner in which income is recognized in Section 361 transactions to which Section 367(d) applies.
Impact of the Notice
The Notice and the forthcoming regulations are designed to ensure that, with respect to all outbound Section 367(d) transfers, the total income to be taken into account under Section 367(d) is either included in income by the U.S. transferor in the year of the reorganization or over time by one or more “qualified successors.” A qualified successor is a domestic corporation that is the shareholder of the U.S. transferor that receives stock of the transferee foreign corporation in the transfer. The Notice (and forthcoming regulations) will govern over the prior regulations.
First, in an outbound Section 367(d) transfer, the U.S. transferor will take into account as a prepayment a percentage of the money and the fair market value of other property received by the “qualified successor” in exchange for, or with respect to, the stock of the U.S. transferor, reduced by the portion of any U.S. transferor distributions received by the qualified successor. This amount is included in income regardless of the productivity of the transferred Section 367(d) property in the year of the transfer or in subsequent years. The U.S. transferor will also take into account income in an amount equal to the product of the sum of the ownership interest percentages of all non-qualified successors, if any, multiplied by the amount of gain realized on all of the Section 367(d) property transferred in the Section 361 Exchange.
A qualified successor will take into account the income attributable to a proportionate share of the contingent annual payments that the U.S. transferor would have been treated as receiving under Section 367(d) had the U.S. transferor remained in existence and retained the qualified stock received in the reorganization and had the U.S. transferor not recognized any income. The income attributable to the contingent annual payments is excluded from gross income to the extent such income that is attributable to the qualified successor is included by the U.S. transferor pursuant to the Notice. This amount is known as the “credit amount.” The qualified successor is permitted to establish an account receivable for any contingent annual payments included in gross income by the qualified successor under the Notice.
Any income taken into account under the Notice is treated as ordinary income and, for purposes of applying Section 904(d), in the same manner as if such amount were a royalty.