Taxation of Outbound Transfers of Foreign Goodwill or Going Concern Value Under Secs. 367(a) and (d)

Editor: Michael Dell, CPA

On Sept. 14, 2015, the Treasury Department and the IRS released proposed regulations under Sec. 367 (REG-139483-13) modifying the application of Secs. 367(a) and (d) to certain outbound transfers of property. The proposed regulations would eliminate the exception in the current Sec. 367(d) temporary regulations for the transfer of foreign goodwill and going concern value. The proposed regulations would also permit taxpayers to elect whether the transfer of foreign goodwill and going concern value will result in immediate taxation under Sec. 367(a) or a deemed royalty over the useful life of the intangible under Sec. 367(d).

Additionally, the proposed regulations would eliminate the 20-year limitation for the useful life of intangible property under the Sec. 367(d) temporary regulations, providing that the useful life of intangible property for purposes of Sec. 367(d) will be the entire period during which the exploitation of the intangible property is reasonably anticipated to occur, as determined at the time of transfer. The proposed regulations would also narrow the scope of the active trade or business (ATB) exception of Sec. 367(a)(3).

In conjunction with the proposed regulations, Treasury and the IRS issued temporary regulations under Sec. 482 (T.D. 9738), which refine the application of the arm’s-length standard. The text of the Sec. 482 regulations also serves as the text of the proposed regulations.

With a limited exception, the proposed regulations would apply to transfers occurring on or after Sep. 14, 2015, and to transfers occurring before that date resulting from entity classification elections filed on or after Sept. 14, 2015.

Application of Sec. 367(a) or (d) to Foreign Goodwill and Going Concern Value

The proposed regulations are primarily intended to address the interaction of Secs. 367(a) and (d) with respect to foreign goodwill and going concern value. Sec. 367(a) generally requires a U.S. transferor to recognize gain (but not loss) when the U.S. transferor transfers property to a foreign corporation in an exchange described in Sec. 332, 351, 354, 356, or 361 (an outbound transfer), unless a specific exception applies. One exception to Sec. 367(a)’s mandatory gain recognition rule applies when the foreign transferee corporation uses the property transferred by the U.S. transferor in an active trade or business conducted outside the United States (Sec. 367(a)(3)(A)). The ATB exception, however, does not apply to certain types of property, including any intangible property described under Sec. 936(h)(3)(B) (see Sec. 367(a)(3)(B) and Temp. Regs. Sec. 1.367(a)-5T).

Sec. 367(d) generally treats a U.S. transferor that transfers intangible property described in Sec. 936(h)(3)(B) in an exchange described in Sec. 351 or 361 as having sold the intangible property for an amount contingent upon the productivity, use, or disposition of the property and requires the U.S. transferor generally to include a deemed annual royalty in income over the useful life of the intangible. Moreover, Sec. 367(d) provides that, if Sec. 367(d) applies to an outbound transfer of property described under Sec. 936(h)(3)(B), Sec. 367(a) does not apply to the same outbound transfer. Accordingly, if a U.S. transferor transfers intangible property described under Sec. 936(h)(3)(B) in a Sec. 351 or 361 exchange, the U.S. transferor is subject to the deemed royalty rule of Sec. 367(d) rather than the gain recognition rule of Sec. 367(a), even though that property otherwise would not be eligible for the ATB exception.

The interaction of Secs. 367(a) and (d) with respect to foreign goodwill and going concern value is complicated due to three additional considerations. First, the description of intangible property in Sec. 936(h)(3)(B) does not expressly include goodwill or going concern value, although the IRS has taken the position that the “similar item” language of that provision is broad enough to encompass such property. As a result, different views have emerged regarding whether goodwill or going concern value is described in Sec. 936(h)(3)(B). Second, although the ATB exception specifically excludes intangible property described under Sec. 936(h)(3)(B), the relevant legislative history indicates that Congress envisioned that no gain or income would be recognized on the outbound transfer of foreign goodwill and going concern value used in an active trade or business. Third, consistent with the legislative history, the temporary regulations under Sec. 367(d) expressly exclude foreign goodwill and going concern value from the deemed royalty rule (Temp. Regs. Sec. 1.367(d)-1T(b)).

The preamble to the proposed regulations notes that taxpayers have interpreted current law to conclude that the outbound transfer of foreign goodwill and going concern value does not result in taxation under either Sec. 367(a) or (d) under one of two interpretations. Moreover, Treasury and the IRS are concerned that, having concluded that foreign goodwill and going concern value are not taxed under Sec. 367(d), some taxpayers have taken an expansive view of foreign goodwill and going concern value, incorporating into that amount the value associated with a business operated primarily by U.S. employees or created by customer-facing activities within the United States.

Under the first interpretation invoked for the position that foreign goodwill and going concern value are not taxed under either Sec. 367(a) or (d), taxpayers assert that foreign goodwill and going concern value are not intangible property described under Sec. 936(h)(3)(B) and thus are subject to Sec. 367(a) rather than Sec. 367(d). Further, they claim, because foreign goodwill and going concern value are not Sec. 936(h)(3)(B) property, they are eligible to satisfy the ATB exception of Sec. 367(a)(3) (i.e., not specifically excluded from the ATB exception), with the result that the U.S. transferor recognizes no immediate gain on the transfer of foreign goodwill and going concern value in an exchange described in Sec. 351 or Sec. 361. In the case of an outbound reorganization (i.e., a transfer subject to Sec. 361), to be eligible for the ATB exception, however, the taxpayer would still have to satisfy the requirements of Sec. 367(a)(5) and Regs. Sec. 1.367(a)-7, which include adjustments to the basis of the foreign transferee stock in the hands of the U.S. transferor’s shareholder to reflect the inside asset gain of the U.S. transferor.

Under the second interpretation, taxpayers assert that foreign goodwill and going concern value are intangible property described under Sec. 936(h)(3)(B), and thus, under Secs. 367(d)(1)(A) and (B), their transfer is subject solely to the provisions of Sec. 367(d) and not Sec. 367(a). Furthermore, they say, because Temp. Regs. Sec. 1.367(d)-1T(b) specifically provides that Sec. 367(d) does not apply to foreign goodwill and going concern value, its outbound transfer does not result in a deemed royalty under that subsection. Because Sec. 367(a) cannot apply to the outbound transfer of foreign goodwill and going concern value by reason of Sec. 367(d)(1)(A), and Sec. 367(d) cannot apply by reason of Temp. Regs. Sec. 1.367(d)-1T(b), the outbound transfer of foreign goodwill and going concern value is taxable under neither Sec. 367(a) nor Sec. 367(d).

Treasury and the IRS are concerned that such interpretations of current law “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” (preamble to REG-139483-13). To address these concerns, the proposed regulations would modify the existing final and temporary regulations to ensure that the outbound transfer of foreign goodwill and going concern value is subject to either Sec. 367(a) or (d). The preamble to the proposed regulations states that Treasury and the IRS considered, but ultimately rejected, preserving favorable treatment for foreign goodwill and going concern value through regulations that would use certain parameters to limit the portion of value attributed to that property.

In this regard, the relevant changes to the regulatory scheme introduced by the proposed regulations are as follows:

• The proposed regulations would narrow the application of the ATB exception to only specific categories of assets that constitute eligible property (as defined below) (Prop. Regs. Sec. 1.367(a)-2(a)(2)). Because foreign goodwill and going concern value do not fall under any definition of eligible property, they cannot qualify for the ATB exception.
• The proposed regulations would eliminate the foreign goodwill and going concern value exception of Temp. Regs. Sec. 1.367(d)-1T(b), so the deemed royalty rule may apply to foreign goodwill and going concern value (see Prop. Regs. Sec. 1.367(d)-1(b)).
• The proposed regulations provide that a U.S. transferor may apply Sec. 367(d) and its regulations, rather than Sec. 367(a), to an outbound transfer of property that would otherwise be subject to Sec. 367(a), provided the property is not “eligible property,” without regard to the exception thereto (Prop. Regs. Sec. 1.367(a)-1(b)(5)). Under the proposed regulations, eligible property includes only (a) tangible property, (b) working interests in oil and gas property, and (c) certain financial assets (cash and cash equivalents, certain securities, commodities, and notional principal contracts) (Prop. Regs. Sec. 1.367(a)-2(b)).

The proposed regulations would amend the definition of intangible property under Temp. Regs. Sec. 1.367(a)-1T(d)(5) to include intangible property described in Sec. 936(h)(3)(B)or “property to which a U.S. person applies Sec. 367(d)”(Prop. Regs. Sec. 1.367(a)-1(d)(5)). The definition of intangible property in the proposed regulations, however, excludes property described in Sec. 1221(a)(3) (generally, certain copyrights) and working oil and gas interests (id). The proposed regulations would also eliminate the definition of foreign goodwill and going concern value contained in current Temp. Regs. Sec. 1.367(a)-1T(d)(5)(iii), since a definition of foreign goodwill and going concern value is no longer necessary under the approach of the proposed regulations. The proposed regulations would also conform the definition of Sec. 367(d) property under Regs. Sec. 1.367(a)-7 to the definition of intangible property in Prop. Regs. Sec. 1.367(a)-1(d)(5). The preamble of the proposed regulations also notes that a similar change will be made to the definition of Sec. 367(d) property when regulations are issued to implement Notice 2012-39.

Broadly speaking, the proposed regulations use the previously mentioned rules to divide all property into one of three categories for corporate taxpayers and then apply the immediate gain recognition provision of Sec. 367(a) or the deemed royalty construct of Sec. 367(d) to each asset based on this classification. In addition to creating these categories, the proposed regulations provide special treatment to assets described under Sec. 1221(a)(3) (generally relating to certain assets, including copyrights, created through the “personal efforts” of the taxpayer). Consistent with the existing regulations, the proposed regulations appear to subject these assets to per se taxation under Sec. 367(a) (see Temp. Regs. Secs. 1.367(a)-5T(a) and (b)(2)). The categories of property are as follows:

Eligible property: This property generally is subject to the Sec. 367(a) gain recognition rule but may qualify for the ATB exception, provided that certain requirements are satisfied and that the property is not per se excluded from qualifying under that exception(see Prop. Regs. Sec. 1.367(a)-2(c)).

Property clearly described in Sec. 936(h)(3)(B), other than assets described in Sec. 1221(a)(3): This property is subject to the deemed royalty rule of Sec. 367(d) and is not subject to Sec. 367(a).

Property that is not eligible property and is not clearly described under Sec. 936(h)(3)(B): This property, which may include foreign goodwill and going concern value, depending on the taxpayer’s interpretation, is subject to either the gain recognition rule under Sec. 367(a) or the deemed royalty rule under Sec. 367(d), based on whether the U.S. transferor chooses to apply Sec. 367(d) to its outbound transfer of that property. It should be noted that, while this category may include goodwill and going concern value, it may also include other assets that are neither eligible property nor property clearly described under Sec. 936(h)(3)(B).

Therefore, Treasury and the IRS have addressed their concern that the outbound transfer of foreign goodwill and going concern value might escape taxation under Sec. 367 by subjecting the property to either the gain recognition rule of Sec. 367(a) or the deemed royalty rule of Sec. 367(d). Specifically, if a U.S. transferor takes the first position described above (i.e., that foreign goodwill and going concern value are not intangible property described under Sec. 936(h)(3)(B)), the outbound transfer of foreign goodwill and going concern value does not qualify for the ATB exception under the proposed regulations, and thus the U.S. transferor would generally be required to recognize gain under Sec. 367(a).

Under the proposed regulations, however, a U.S. transferor taking that position may instead “elect” to apply Sec. 367(d) to the transfer, but, because there is no longer an exception to the deemed royalty rule for the transfer of foreign goodwill and going concern value in the proposed regulations, this would result in a deemed royalty over the useful life of the foreign goodwill and going concern value under Sec. 367(d). On the other hand, if a U.S. transferor takes the second position (i.e., that foreign goodwill and going concern value are intangible property described under Sec. 936(h)(3)(B)), the U.S. transferor must apply Sec. 367(d), for which, again, the proposed regulations provide no exception.

Useful Life of Property Subject to Sec. 367(d)

Sec. 367(d)(2)(A)(ii)(I) deems an applicable U.S. transferor as receiving royalty payments over the useful life of the transferred intangible property. The temporary regulations under Sec. 367(d) provide that, for this purpose, the “useful life” of intangible property “is the entire period during which the property has value,” except that in no case will the intangible property’s useful life be deemed to exceed 20 years (Temp. Regs. Sec. 1.367(d)-1T(c)(3)). The proposed regulations would eliminate this 20-year limitation, providing that the useful life of intangible property “is the entire period during which the exploitation of the intangible property is reasonably anticipated to occur, as of the time of transfer” (Prop. Regs. Sec. 1.367(d)-1(c)(3)). For this purpose, exploitation of intangible property includes its use in research and development (id.).

Other Modifications to the ATB Exception Rules

The proposed regulations would make additional changes to the ATB regulations under Sec. 367. The majority of these modifications merely consolidate the existing ATB rules into a single regulation, Prop. Regs. Sec. 1.367(a)-2. The proposed regulations, however, also contain several additional substantive changes to the existing regulations. First, while retaining all the rules describing property that is per se ineligible for the ATB exception (generally, inventory, installment obligations and accounts receivable, foreign currency and property denominated in foreign currency, and certain leased property), the proposed regulations would eliminate the rule under the current regulations that expressly prevents intangible property described in Sec. 936(h)(3)(B) from qualifying for the ATB exception (see Prop. Regs. Sec. 1.367(a)-2(c)). This express rule is no longer necessary because such intangible property is not eligible property in the first instance under the proposed regulations, and as noted above, only eligible property can qualify for the ATB exception.

Second, the proposed regulations would eliminate the provision under current Temp. Regs. Sec. 1.367(a)-5T(d)(2) allowing certain property denom-inated in foreign currency to qualify under the ATB exception. Accordingly, the proposed regulations would require a U.S. transferor to recognize gain on the outbound transfer of such property.

Sec. 6038B Reporting

The proposed regulations would also make conforming changes to the information-reporting provisions under the Sec. 6038B regulations. Importantly, these disclosure rules would require a U.S. transferor to disclose whether it is applying Sec. 367(a) or (d) to intangible property not clearly described under Sec. 936(h)(3)(B) (Prop. Regs. Sec. 1.6038B-1).

Interaction With Sec. 482

As discussed previously, Treasury and the IRS indicated their concern in the preamble to the proposed regulations that the current rules create an incentive to allocate an inappropriately large share of value in outbound property transfers to foreign goodwill and going concern value. In particular, according to the preamble, some taxpayers have valued property on an item-by-item basis when an aggregate basis would achieve a more reliable result under Sec. 482, or have failed to perform a factual and functional analysis of the business using the intangible property, resulting, in each case, in the overvaluation of foreign goodwill and going concern value. In light of these concerns, the proposed regulations reaffirm that the value of property transferred to a foreign corporation in a “controlled transaction” (e.g., a transaction under Sec. 367) is determined by applying Sec. 482 and its regulations (Prop. Regs. Sec. 1.367(a)-1(b)(3)). In addition, Treasury and the IRS also issued the Sec. 482 regulations to clarify the application of Sec. 482 principles when multiple Code sections (e.g., Secs. 482 and 367) apply.

Effective Dates

The proposed regulations under Sec. 367, once finalized, will generally apply to transfers occurring on or after Sept. 14, 2015, and to transfers occurring before that date resulting from entity classification elections filed on or after Sept. 14, 2015. The removal of the exception currently provided in Temp. Regs. Sec. 1.367(a)-5T(d)(2) (related to certain property denominated in foreign currency qualifying under the ATB exception), however, will apply to transfers occurring on or after the date the proposed regulations are adopted as final and to transfers occurring before that date resulting from entity classification elections filed on or after that date.

Implications

Since the issuance of Notice 2012-39, officials from Treasury and the IRS have repeatedly indicated that the regulations under Secs. 367(a) and (d) would be modified to ensure “nothing escapes” (see, e.g., Sheppard, “Intangibles Prepayment Theory Will Apply to Pre-Notice Transactions,” 2012 TNT 202-1 (Oct. 18, 2012)). It will be surprising to some practitioners that the government did not simply provide definitive guidance on whether foreign goodwill and going concern value are subject solely to Sec. 367(a) or solely to Sec. 367(d). Instead, the proposed regulations avoid this controversy altogether by permitting the U.S. transferor to elect between Secs. 367(a) and (d), while ensuring that one of those provisions would apply to the transfer of foreign goodwill and going concern value regardless of the transferor’s election.

Though the transfer of foreign goodwill and going concern value is discussed at length in the preamble, it is noteworthy that the provisions of the proposed regulations in no instance actually refer to foreign goodwill and going concern value. As discussed, the proposed regulations permit a U.S. transferor to choose whether Sec. 367(a) or Sec. 367(d) applies to a transfer of property (other than Sec. 1221(a)(3) property) that is neither “eligible property” within the narrow definition of Prop. Regs. Sec. 1.367(a)-2(b) nor, under the taxpayer’s interpretation, intangible property within the meaning of Sec. 936(h)(3)(B). Thus, presumably, such electivity extends to the tax treatment of U.S. goodwill and going concern value, as well as any other asset that is not eligible property and not specifically enumerated in Sec. 936(h)(3)(B), including, for instance, workforce in place. To ensure the desired treatment is obtained for those assets, a U.S. transferor should disclose whether it is applying Sec. 367(a) or Sec. 367(d) to the outbound transfer.

Although the proposed regulations, once they become final, will be effective as of Sept. 14, 2015, they are currently only in proposed form. Moreover, the current final and temporary regulations have not been withdrawn and remain in effect. Thus, until the proposed regulations are finalized, taxpayers may be uncertain which set of rules will ultimately apply to their transactions. Given the possible retroactive effect of the proposed regulations on transactions entered into on or after Sept. 14, 2015, but prior to the proposed regulations’ becoming final, taxpayers should evaluate, and potentially take steps to mitigate, the effect of the proposed regulations on any such transactions.

A version of this item appeared in an EY Global Tax Alert.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.