New Developments in Outbound Transfers of Intangible Property

In recent years, the legislative, judicial, and executive branches have all attempted to clarify the meaning of “intangible property” under Sec. 367, which has guided U.S. multinational businesses seeking to defer realized gains on transfers of high-value intangible assets to foreign-based corporations. Several judicial decisions, including Veritas Software Corp.,¹ have raised questions about whether the definition of intangible property under Sec. 367(d) covers foreign goodwill, going concern value, or the value of workforce in place. President Barack Obama’s administration has consistently challenged what it perceives as an abuse-prone definition of intangible property, through both the IRS and the language of the president’s proposed fiscal-year budgets. As such, the president’s budget requests since 2009 have proposed legislative changes that seek to clarify the definition of intangible property.

To address perceived tax avoidance practices, Treasury and the IRS issued proposed regulations (REG-139483-13) under Sec. 367 on Sept. 14, 2015, that modify and clarify the application of Sec. 367(a) and Sec. 367(d) to outbound transfers of certain intangible property. The proposed changes in the outbound transfer rules will have far-reaching consequences for transfers of foreign goodwill, going concern value, and workforce in place, and are likely to affect commercial decisions of a broad array of multinational businesses. This article updates CPAs about the changes in tax treatment of outbound transfers of goodwill or going concern value so that they may help their clients in planning these transfers of intangible assets. This article explores (1) the definition of intangible property; (2) the controversy over the definition of intangibles; and (3) the proposed changes in REG-139483-13 and key recent developments that could impact the proposed regulations as they become final.

Editor’s note: The proposed regulations discussed in this article were finalized on Dec. 16, 2016, without major changes. For more on the final regulations, see “Final Rules on Sec. 367 Transfers of Intangibles Apply Retroactively.” However, these regulations were identified as burdensome by the Treasury Department in July 2017 and are being reviewed for possible modification or withdrawal. See “Treasury Identifies 8 Regulations as Burdensome.”

The Definition of Intangible Property

It is not clear whether the general definition of intangible property under Sec. 936(h)(3)(B) and the tax treatment of international transfers of those assets under Sec. 367 includes goodwill, going concern value, or workforce in place. Of course, corporate taxpayers have pushed for tax deferral on the value of outbound transfers of these intangibles for many years. Conversely, the IRS has asserted that goodwill, going concern value, or workforce in place is not intangible property within the meaning of Sec. 936(h)(3)(B) and, consequently, foreign transfers of such intangibles are ineligible for tax deferral. They do not fall within the statutory exception and are taxable under Sec. 367, the IRS contends. The Obama administration has consistently sought to broaden the definition of intangible property through the president’s proposed fiscal-year budgets. The latest instance can be seen in the administration’s international tax proposals in the fiscal year 2017 budget,² which directly addresses the current controversy over the definition of intangible property under Sec. 936(h)(3)(B).

Sec. 367(a) taxes realized gains on outbound transfers of business property to a foreign corporation if the transfer is related to certain corporate nonrecognition exchanges, including those covered by Sec. 332, 351, 354, 356, or 361, unless an exception applies.³ One of the exceptions is when a foreign corporation uses transferred property in the active conduct of a trade or business outside the United States (ATB exception).⁴ However, the ATB exception does not apply to certain assets, such as copyrights, inventory, accounts receivable, and “intangible property” within the meaning of Sec. 936(h)(3)(B). The transfer of these properties outside the United States triggers immediate gain (but not loss) recognition on realized gains (see the exhibit  below).⁵ The following scenario illustrates the application of the Sec. 367(a)(1) exception.

Example 1: ABC Corp., a U.S. corporation, incorporates its Singaporean operations in its affiliate XYZ Corp. to engage in business activities in Singapore. ABC Corp. transfers to its XYZ affiliate equipment with a tax basis of $4,000 and a fair market value (FMV) of $9,000 (resulting in a realized gain of $5,000), inventory with a tax basis of $1,000 and an FMV of $3,000 (resulting in a realized gain of $2,000), and accounts receivable with a tax basis of $2,500 and an FMV of $3,000 (resulting in a realized gain of $500).

While the total realized gain of $7,500 ($5,000 + $2,000 + $500) is deferred under Sec. 351, the gain would still be potentially taxable under Sec. 367 because these assets were transferred outside the United States. Because the assets are used in the active conduct of business in Singapore, the gain on the equipment would be deferred by operation of the ATB exception. Notwithstanding the Sec. 367(a)(1) exception for property used in the active conduct of a trade or business, however, ABC Corp. must recognize the realized gains attributable to inventory and accounts receivable because these assets are explicitly excluded from the ATB exception.

Unlike the situation for tangible personal property, foreign transfers of intangibles come within the purview of Sec. 936(h)(3)(B), and realized gains are tax deferred to the extent such transactions are contributions of capital under Sec. 351 or part of a corporate reorganization in connection with Sec. 361. The rationale is that the aforementioned contributions of intangibles in exchange for stock are covered by the special rules for transferring intangibles in Sec. 367(d) rather than Sec. 367(a). Foreign transfers of intangibles under Sec. 367(d) are treated as sales of such intangibles in exchange for payments that are contingent on the productivity, use, or disposition of the property.⁶ Taxpayers are then considered as receiving royalty amounts annually that would have been reasonably received, and they are taxed on the deemed annual royalty receipts during the assumed useful life of the intangible asset.⁷ These deemed royalty receipts should be “commensurate with the income attributable to the intangible,”⁸ which means that the income paid to a U.S. corporation for intangible properties should be based on the income earned by the foreign subsidiary using the intangible property. If Sec. 367(d) applies to an outbound transfer of intangible property, Sec. 367(a) cannot apply to the same transaction. However, current Treasury regulations indicate that Sec. 367(d) applies to transfers of intangible property but not to foreign goodwill, going concern value, or workforce in place. Example 2 illustrates the application of Sec. 367(d) under the current regulations.

Example 2: ABC Corp., a U.S. corporation, developed a patented product and transfers the patent to its Singaporean subsidiary, XYZ Corp., in a Sec. 351 transaction when the product is commercially feasible. XYZ uses the patent to produce the product in Singapore. Under these circumstances, ABC is treated under Sec. 367(d) as having sold the patent to XYZ, and the transaction would be considered a contingent sale. Under Sec. 367(d), ABC would be required to recognize ordinary income annually over the useful life of the patent on deemed royalty payments from XYZ. See the exhibit below for an illustration of the application of Secs. 367(a) and 367(d).

Controversy Over the Definition of Intangibles

In practice, it is often difficult to define whether foreign goodwill, going concern value, or workforce in place should be treated as intangible property within the meaning of Sec. 936(h)(3)(B). This issue often arises because these items are not explicitly enumerated as intangible property under Sec. 936(h)(3)(B), but corporate tax planners argue the “any similar item” language of Sec. 936(h)(3)(B)(vi) is broad enough to treat such property as intangible property. This can be clearly seen in Veritas Software Corp.,⁹ in which the Tax Court considered whether the valuation of certain intangibles, including goodwill, going concern value, or workforce in place, should be taken into account in calculating a buy-in payment. Judge Maurice B. Foley in Veritas noted that goodwill, going concern value, and workforce in place are not items of intangible property within the definition of Sec. 936(h)(3)(B) and thus concluded that transfers of these properties should not be taken into account in calculating the buy-in payment.

In Veritas, Veritas Software Corp. (Veritas U.S.) entered into a cost-sharing arrangement with its foreign subsidiary Veritas Ireland to develop and manufacture data storage management software products. In accordance with the cost-sharing arrangement, Veritas U.S. transferred preexisting intangible property to Veritas Ireland and requested a $166 million buy-in payment from Veritas Ireland as consideration for the transfer, based on the Sec. 482 comparable uncontrolled transaction method.

Veritas U.S. reported a $166 million lump-sum buy-in satisfaction of the transaction with Veritas Ireland in its federal income tax returns for 2000 and subsequently reduced the amount to $118 million on Dec. 17, 2002, in response to Veritas Ireland’s updated sales figures and forecasts. However, the IRS issued Veritas U.S. a notice of deficiency based on an expert’s conclusion that, based on the income of Veritas Ireland, a $2.5 billion buy-in payment was required, which was a staggering 21 times higher than the intangible asset transfer price of $118 million. The Service subsequently reduced the $2.5 billion to $1.675 billion (14 times higher), based on an alternative report.

In determining the proper allocation for the requisite payment, the IRS took into consideration a transfer of “certain other intangible rights,” including access to Veritas’s U.S.-based research and development (R&D) team; access to Veritas’s U.S.-based marketing team; and Veritas’s U.S.-based distribution channels, customer lists, trademarks, trade names, brand names, and sales agreements.¹⁰ In particular, during the trial and on brief, the IRS considered “access to R&D team” and “access to marketing team” as constituting workforce in place.¹¹ However, Veritas U.S. argued in a challenge that the IRS’s determinations were “arbitrary, capricious, or unreasonable” under Sec. 482 because the Service’s allocation took into consideration items that did not have significant value.¹²

The issue before the Tax Court was whether the IRS’s $1.675 billion allocation of the buy-in payment from Veritas Ireland was arbitrary, capricious, or unreasonable. The court noted that the distribution channels, customer lists, and customer base had insignificant value.¹³ The Tax Court further noted that there was insufficient evidence regarding whether access to the R&D team and access to the marketing team had value.¹⁴ In a lengthy footnote, the court pointed out that, even if such evidence were provided, the Service’s allocation would still be incorrect because “access to research and development team” and “access to marketing team” are not enumerated in Sec. 936(h)(3)(B) (defining “intangible property”) or Regs. Sec. 1.482-4(b) (defining “an intangible”).¹⁵ Although Judge Foley noted that the Obama administration proposed in 2009 to expand the Sec. 482 definition of intangibles to include goodwill, going concern value, and workforce in place, the applicable Treasury regulations remained in proposed form during the years at issue.¹⁶ Therefore, the Tax Court concluded, certain intangible rights, including workforce in place, should not be taken into account in calculating the requisite buy-in payment. Example 3 highlights the issues litigated in the Veritas case.

Example 3: ABC Corp., a U.S. corporation, assigned an R&D team to work with its Singaporean subsidiary XYZ Corp. Based on the Veritas decision, ABC’s assignment of the R&D team would be considered workforce in place. As such, ABC would not be required to recognize gain on this transfer because workforce in place is not enumerated as intangible property under Sec. 936(h)(3)(B) or under the Sec. 482 Treasury regulations. Thus, Sec. 367(d) does not apply, and no taxable royalty payment need be recognized on this transfer.

As noted by Judge Foley in Veritas, the executive branch has tried to clarify the definition of intangible properties since 2009. The Obama administration has proposed to change the law in its annual fiscal-year budgets, including the fiscal year 2017 budget proposal, explicitly expanding the Sec. 482 definition of intangibles to include goodwill, going concern value, and workforce in place. The administration noted that “the scope of the intangible property subject to sections 482 and 367(d) is not entirely clear or consistent.”¹⁷ The administration also expressed concern that “[t]his lack of clarity and consistency may result in the inappropriate avoidance of U.S. tax and misuse of the rules applicable to transfers of intangible property to foreign persons.¹⁸

While the IRS did not appeal the Tax Court decision in Veritas to the Ninth Circuit, it subsequently released an action on decision (AOD) announcing that it would not acquiesce to the court’s holding or its reasoning in its national enforcement policies.¹⁹ The IRS stated that the Tax Court improperly rejected the possibility that, depending on the facts and circumstances, the R&D and marketing team parts of the intangibles and services would have substantial value. For instance, the Service asserted, an experienced R&D team’s contribution to the value of the intangibles and services package could well exceed the total compensation expenses incurred by a company to employ individual members. The IRS argued that, either as individuals or as teams, the value transferred does not come merely from the R&D and marketing teams but from their “interrelationship in combination with other important elements in an intangibles and services package such as in this case.”²⁰ In this regard, since workforce-in-place intangibles may have significant value, depending on the facts and circumstances of the particular corporate setting, the IRS concluded that the Tax Court’s factual findings and legal holdings are erroneous. However, irrespective of the Service’s AOD, Veritas remains the binding authority in the Ninth Circuit and Tax Court cases appealable within that circuit.

The issues in Veritas reflect the complex interactions of Secs. 367(a) and (d) regarding foreign goodwill, going concern value, and workforce in place. Although the IRS has expressed that the “any similar item” language of Sec. 936(h)(3)(B)(vi) is broad enough to include such property, the statutory language simply says “intangible property” and does not specifically include goodwill, going concern value, or workforce in place.²¹ The relevant legislative history indicates that Congress intended that no gain or income would be recognized on the outbound transfer of goodwill and going concern value when those assets were incorporated into an active trade or business. Legislators had not seen instances of abuse in the tax system at the time,²² and the IRS noted that the Senate Finance Committee and the House Committee on Ways and Means each stated that it “does not anticipate that the transfer of goodwill or going concern value developed by a foreign branch to a newly organized foreign corporation will result in abuse of the U.S. tax system.”²³ So, neither the statutory language of Sec. 936(h)(3)(B)(vi) nor its legislative history defines goodwill or going concern value. Consequently, the temporary regulations (Temp. Regs. Sec. 1.367(d)-1T(b)) issued under Sec. 367(d) made no mention of foreign goodwill or going concern value in the deemed royalty rule, arguably enabling taxpayers to recognize no gain on such transfers.²⁴

Corporate tax planners have interpreted current tax law to mean that the outbound transfer of foreign goodwill and going concern value receives tax-free treatment under either Sec. 367(a) or (d), applying two quite different interpretations of current law. Using the first interpretation, taxpayers have argued that foreign goodwill and going concern are exempt under Sec. 367(a) because foreign goodwill and going concern are not intangible property enumerated under Sec. 936(h)(3)(B). Therefore, they could argue that these are subject to Sec. 367(a) rather than Sec. 367(d). Taxpayers then would assert that since foreign goodwill and going concern value are not included in Sec. 936(h)(3)(B), they are subject to the ATB exception of Sec. 367(a)(3).²⁵ By doing so, taxpayers are able to defer gain on the transfer of foreign goodwill and going concern value.

Using the second interpretation of the current tax law, taxpayers have argued that foreign goodwill and going concern are subject to Sec. 367(d) and not Sec. 367(a) because foreign goodwill and going concern are considered intangible property within the broad meaning of Sec. 936(h)(3)(B). Because Temp. Regs. Sec. 1.367(d)-1T(b) expressly states that Sec. 367(d) does not apply to foreign goodwill and going concern value, taxpayers argue that their outbound transfer does not result in a deemed royalty.²⁶ So, currently, taxpayers can take either of two facially valid positions to avoid recognizing gain under Sec. 367(a) or Sec. 367(d) on the outbound transfer of foreign goodwill and going concern value.

Proposed Changes to the Regulations

While Congress did not express serious concerns regarding the tax treatment of outbound transfers of foreign goodwill or going concern value, Treasury and the IRS have consistently maintained that the ambiguities of the current tax law would result in abuse of the tax system. In the case of outbound transfers, they noted that certain taxpayers transferred high-value intangible property without recognizing gain or income.²⁷ Treasury and the IRS also noted that taxpayers attempted to defer gain by broadly interpreting the language of foreign goodwill and going concern value.²⁸ Specifically, while foreign goodwill or going concern value is defined clearly as “a business operation conducted outside of the United States,”²⁹ certain taxpayers have argued that a substantial portion of the value of their transfer consisted of foreign goodwill or going concern value, even when a large amount of the transferred property was closely associated with business conducted in the United States.

On Sept. 14, 2015, to clarify the ambiguities and to reduce tax avoidance practices, Treasury and the IRS issued proposed regulations under Sec. 367 limiting the scope of intangible property that is subject to tax-free treatment under either Sec. 367(a) or (d).³⁰ Once finalized, these proposed regulations under Sec. 367 will tax transfers of foreign goodwill or going concern value occurring on or after Sept. 14, 2015. [Update: The proposed regulations were finalized (T.D. 9803) in December 2016, after this article went to press. However, the final regulations were subsequently identified as burdensome by the Treasury Department and are being reviewed for possible modification or withdrawal. See “Treasury Identifies 8 Regulations as Burdensome.”]

The two most significant aspects of the proposed regulations are (1) a significant limitation of the scope of eligible property that is subject to the ATB exception under Sec. 367(a); and (2) the elimination of the Temp. Regs. Sec. 1.367(d)-1T(b) exception from Sec. 367(d) for transfers of foreign goodwill and going concern value.³¹

With respect to the first proposed change in the Treasury regulations, taxpayers may still take the position that foreign goodwill and going concern value are not intangible property enumerated under Sec. 936(h)(3)(B) and are thereby subject to Sec. 367(a). Yet, under the proposed regulations, these transfers cannot qualify for the ATB exception because foreign goodwill and going concern value are not explicitly included under the definition listing “eligible property.” Under the current regulations, all properties are eligible for the ATB exception unless explicitly excluded. Under the proposed regulations, the ATB exception rule would apply only to certain listed eligible property. This includes tangible property (such as equipment), a working interest in oil and gas properties, and certain financial assets such as securities, but clearly excludes foreign goodwill and going concern value, which are not listed.³² Therefore, an outbound transfer of foreign goodwill or going concern value not treated by the taxpayer as a Sec. 936(h)(3)(B) intangible would be subject to gain recognition and taxation under Sec. 367(a). Alternatively, taxpayers may elect to apply Sec. 367(d) rather than Sec. 367(a) to the the transfer, resulting in the recognition of deemed royalty income under Sec. 367(d), as discussed below.³³

Under the second proposed change, if a taxpayer claims that foreign goodwill and going concern value are Sec. 936(h)(3)(B) intangibles and the Sec. 367(d) deemed royalty rule applies, the transfer is no longer eligible for nonrecognition treatment because the foreign goodwill and going concern value exception from the deemed royalty rule in current Temp. Regs. Sec. 1.367(d)-1T(b) is eliminated.³⁴ Additionally, the deemed useful life of property for the purposes under Sec. 367(d) would be the entire period of the exploitation of the intangible property, instead of the maximum 20-year useful life set by current law.³⁵

The likely and intended consequence of the proposed changes to the applicable Treasury regulations is that taxpayers will have to recognize gain on the outbound transfer of foreign goodwill and going concern value under either Sec. 367(a) or (d). Although the proposed regulations focus on foreign goodwill and going concern value and do not address workforce in place, the regulations and future developments in the definition of intangibles are likely to affect workforce in place in the same manner as foreign goodwill and going concern value. Example 4 illustrates the likely consequence of the proposed regulations.

Example 4: ABC Corp., a U.S. corporation, incorporates a foreign affiliate in Singapore. This foreign affiliate has operated in Singapore for 20 years and did not have any previous connection to the United States. Under the proposed regulations, outbound transfers of foreign goodwill and going concern value from ABC to its Singaporean affiliate on its incorporation will result in (1) a taxable gain under Sec. 367(a), or (2) annual gross income commensurate with the assumed royalty stream under Sec. 367(d). Although the proposed regulations do not address whether foreign goodwill and going concern value are Sec. 936 intangible property, the IRS will allow taxpayers to apply Sec. 367(d) to such property when eligible instead of recognizing the entire gain immediately.

Recent Developments That Could Impact the Proposed Regulations

Because of the substantial amount of money involved in outbound transfers of intangible property, major financial institutions such as Bank of America Corp., Citigroup Inc., and JPMorgan Chase & Co. submitted a proposal for an industry exception to the proposed regulations during the 90-day notice-and-comment period.³⁶ The companies asserted that foreign transfers of goodwill and going concern value by bank holding companies, insurers, and credit card operations should not be taxable because nontax business reasons are often the driver for the operation of ­affiliates in host markets. The Silicon Valley Tax Directors Group also submitted comments on the proposed regulations on Dec. 14, 2015, urging that the proposed regulations be dropped because they go against congressional intent, as described in the legislative ­history of Secs. 367(a) and (d).³⁷

Conclusion

The IRS’s efforts to curb tax avoidance practices by U.S. multinationals and to clarify present ambiguities in the foreign transfers of intangible property, through the proposed regulations limiting the scope of intangible property subject to tax-deferred treatment under Sec. 367(d), are likely to be finalized in the current form. Because of the substantial consequences the new and significantly altered regulations would have for their clients, CPAs should stay up to date on these important developments in the outbound transfer rules.  

Footnotes

¹Veritas Software Corp., 133 T.C. 297 (2009).

²Treasury Department, General Explanations of the Administration’s Fiscal Year 2017 Revenue Proposals, p. 14 (February 2016).

³Sec. 367(a)(1).

⁴Sec. 367(a)(3).

⁵Sec. 367(a)(3)(B)(iv).

⁶Sec. 367(d)(2)(A).

⁷Sec. 367(d)(2)(A)(ii)(I).

⁸Sec. 367(d)(2)(A).

⁹Veritas Software Corp., 133 T.C. 297 (2009).

¹⁰Id. at 322.

¹¹Id., fn. 24.

¹²Id. at 322.

¹³Id.

¹⁴Id. at 323.

¹⁵Id., fn. 31.

¹⁶Treasury Department, General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals,p. 32 (May 2009).

¹⁷Id.

¹⁸Id.

¹⁹Action on Decision 2010-005.

²⁰Id. at 4.

²¹Sec. 936(h)(3)(B).

²²Preamble, REG-139483-13.

²³Id. (quoting S. Rep’t No. 169, 98th Cong., 2d Sess., at 362, and H.R. Rep’t. No. 432, 98th Cong., 2d Sess., at 1317).

²⁴Id.

²⁵Id.

²⁶Id.

²⁷Id.

²⁸Id.

²⁹Temp. Regs. Sec. 1.367(a)-1T(d)(5)(iii).

³⁰REG-139483-13.

³¹Id.

³²Prop. Regs. Sec. 1.367(a)-2(b). See also preamble, REG-139483-13: “The category for intangible property is not retained because it is not relevant: Intangible property transferred to a foreign corporation pursuant to section 351 or 361 is not eligible property under proposed § 1.367(a)-2(b) without regard to the application of proposed § 1.367(a)-2(c).”

³³The proposed regulations add this “election” to apply Sec. 367(d) to a transfer to which Sec. 367(a) would otherwise apply by amending the definition of intangible property for purposes of Secs. 367(a) and (d) in Temp. Regs. Sec. 1.367(a)-1T(d)(5) to include property to which a U.S. transferor applies Sec. 367(d) (in lieu of applying Sec. 367(a)).

³⁴REG-139483-13.

³⁵Id.

³⁶Gregory, “Financial Services Companies Seek Exceptions to 367(d) Rules,” Daily Tax Report, Bloomberg BNA (Dec. 29, 2015).

³⁷Id.