In Notice 2012-39 the Service provided guidance on some transfers of intangible property by a U.S. corporation to a foreign corporation in an exchange that falls within Section 361(a) or Section 368(b) The Service’s motive in issuing the Notice was to thwart transactions intended to repatriate earnings from foreign corporation without recognition of income. A regulations projection on the same issue is pending. The effective date of the proposed regulations is announced as to transfers occurring after July 12, 2012.

Background: Section 367(a) and Section 367(d) and Outbound Transfers to Controlled Foreign Corporations

Subject to certain exceptions, section 367(a) generally applies to the transfer of property by a United States person to a foreign corporation in an exchange described in section 332, 351, 354, 356, or 361. Section 367(d)(1) provides that, except as provided in regulations, if a U.S. person transfers any intangible property (as described in section 936(h)(3)(B)) to a foreign corporation in an exchange described in section 351 or 361, section 367(d) (and not section 367(a)) applies to such transfer. Income or gain attributable to the transfer of property by a U.S. person to a foreign corporation in an exchange described in section 351 or 361 is taken into account either in accordance with section 367(d)(2)(A)(ii)(I) or (II), or possibly in accordance with section 367(a).

Section 367(d)(2)(A) provides where a U.S. person transfers intangible property is treated as having sold the property in exchange for payments that are contingent upon the productivity, use, or disposition of such property, the transferor is treated as receiving amounts that reasonably reflect the amounts that would have been received: (1) annually in the form of such payments over the useful life of such property (section 367(d)(2)(A)(ii)(I)), or (2) in the case of a disposition of the intangible property following such transfer (whether direct or indirect), at the time of the disposition (section 367(d)(2)(A)(ii)(II)). For this purpose, an indirect disposition of the intangible property following the transfer includes a disposition of the transferor's interest in the transferee corporation. S. Rep. No. 169, 98th Cong., 2d Sess., at 367 (1984). The amounts taken into account under section 367(d)(2)(A)(ii) must be commensurate with the income attributable to the intangible. Section 367(d)(2)(A) (flush language).

Section 367(d)(2)(B) provides for federal income tax purposes, earnings and profits of a foreign corporation to which the intangible property was transferred are reduced by the amount required to be included in the income of the transferor of the intangible property. Section 367(d)(2)(C) provides that any amount included in gross income pursuant to section 367(d) is treated as ordinary income. For purposes of applying section 904(d), any amount included in income under section 367(d) is treated in the same manner as if such amount were a royalty. Section 367(d)(2)(C).

Treasury Regulation Section 1.367(d)-1T(c)(1) provides that if a U.S. person transfers intangible property that is subject to section 367(d) to a foreign corporation (transferee foreign corporation) in an exchange described in section 351 or 361, then such person is treated as having transferred that property in exchange for annual payments contingent on the productivity or use of the property. The regulation further provides that such person shall, over the useful life of the property, annually include in gross income an amount that represents an appropriate arm's-length charge for the use of the property. Treasury Regulation Section. 1.367(d)-1T(c)(1). See Section 482.

Treasury Regulation Section 1.367(d)-1T(d)(1) provides that a U.S. person who transfers intangible property subject to section 367(d) to a transferee foreign corporation in an exchange described in section 351 or 361 and, within the useful life of the intangible property, that U.S. transferor subsequently disposes of the stock of the transferee foreign corporation to a person that is not a related person (per Treasury Regulation Section 1.367(d)-1T(h)). the U.S. transferor is treated as having simultaneously sold the intangible property to the unrelated person acquiring the stock of the transferee foreign corporation. Treasury Regulation Section 1.367(d)-1T(d)(1). The U.S. transferor is required to recognize 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. transferor's former adjusted basis in that property.

Treasury Regulation Section 1.367(d)-1T(e)(1) provides that where a U.S. person transfers intangible property  per section 367(d) to a transferee foreign corporation in an exchange described in section 351 or 361 and, within the useful life of the transferred intangible property, the U.S. transferor subsequently transfers the stock of the transferee foreign corporation to U.S. persons that are related to the transferor (per Treasury Regulation 1.367(d)-1T(h)). These rules generally provide, in part, that the related U.S. persons, over the useful life of the property, annually include in gross income a proportionate share of the contingent annual payments that would otherwise be deemed to be received by the U.S. transferor under Treasury Regulations Sections 1.367(d)-1T(c) and 1.367(d)-1T(e)(1).

Treasury Regulation Section 1.367(d)-1T(g)(1)(i) provides that if a U.S. person is required to recognize income under certain provisions of the regulations under section 367(d), including Treasury Regulation Section 1.367(d)-1T(c), and the amount deemed to be received is not actually paid by the transferee foreign corporation, then the U.S. person may establish an account receivable from the transferee foreign corporation equal to the amount deemed paid that was not actually paid. Such account receivable may be established and paid without further U.S. income tax consequences to the U.S. transferor or the transferee foreign corporation. Treasury Regulation Section 1.367(d)-1T(g)(1)(i).

Notice 2012-39: Identifying What the Service Considers Abusive In this Area

One example that is targeted by the Notice involves a U.S. parent corporation and a wholly owned domestic as well as a foreign subsidiary. The only asset of the domestic subsidiary is a patent with a tax basis of zero that is transferred to the foreign subsidiary for cash. Then the U.S subsidiary turns around distributes the cash to its U.S. parent corporation and liquidations under Section 332. The Service notes that some taxpayers have taken the position that neither the parent nor the domestic subsidiary recognizes gain or dividend income on the receipt of the cash. The parent then applies the section 367(d) regulations to include amounts in gross income in subsequent years and to establish a receivable from the foreign subsidiary in the amount of the parent's aggregate income inclusion. The parent claims that the foreign subsidiary's repayment of the receivable does not give rise to income so that the parent effects a repatriation in excess of the amount of cash transferred while only recognizing income in the amount of the inclusions over time. The pending regulations are intended to ensure that for all outbound section 367(d) transfers, the total income taken into account is either included in income by the U.S. subsidiary (transferor) in the year of the reorganization or, when appropriate, over time by one or more qualified successors. Any income taken into account must be commensurate with the income attributable to the section 367(d) property transferred in the outbound transfer.

Specifically, the Notice states that the regulations will provide that in an outbound section 367(d) transfer, the U.S. transferor will take into account income under section 367(d)(2)(A)(ii)(I) regarding each qualified successor, if any, by treating as a prepayment of such income the product of the section 367(d) percentage multiplied by the sum of: (1) the money and fair market value of other property received by the qualified successor in exchange for, or in connection with, stock of the U.S. transferor, reduced by the portion of any U.S. transferor distributions received by the qualified successor; and (2) the product of the qualified successor's ownership interest percentage multiplied by the amount of non-qualifying liabilities that are either assumed by the transferee foreign corporation in the reorganization or satisfied by the U.S. transferor with money or other property provided by the transferee foreign corporation. As a prepayment of the income, the amount is included in income by the U.S. transferor in the year of the outbound section 367(d) transfer, regardless of the productivity of the transferred section 367(d) property in the year of the transfer or in subsequent years.

Income under section 367(d)(2)(A)(ii)(II) will be taken into account by the U.S. transferor in an amount equal to the product of: (1) the sum of the ownership interest percentages of all non-qualified successors, if any, multiplied by (2) the amount of gain realized on all the section 367(d) property transferred in the section 361 exchange.

Each qualified successor will generally 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 had the U.S. transferor remained in existence and retained the qualified stock received in the reorganization (assuming for this purpose that the transfer continues to qualify as an exchange described in section 361), and had the U.S. transferor not recognized any income under the provisions of Notice 2012-39.

Stay tuned for the Proposed Regulations on this Subject.