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Proposed regs would significantly alter tax treatment of certain outbound transfers

Preamble to Prop Reg 09/14/2015; Prop Reg § 1.367(a)-1, Prop Reg § 1.367(a)-2, Prop Reg § 1.367(a)-3, Prop Reg § 1.367(a)-4, Prop Reg § 1.367(a)-5 , Prop Reg § 1.367(a)-6 , Prop Reg § 1.367(a)-7, Prop Reg § 1.367(a)-8, Prop Reg § 1.367(d)-1, Prop Reg § 1.367(e)-2, Prop Reg § 1.482-1, Prop Reg § 1.6038B-1

IRS has issued proposed regs relating to certain transfers of property by U.S. persons to foreign corporations in nonrecognition transactions under Code Sec. 367. Significantly, the proposed regs would eliminate the foreign goodwill exception under Reg. § 1.367(d)-1T and limit the scope of property that is eligible for the active trade or business exception, thus subjecting more transfers to current gain recognition under Code Sec. 367(a)(1) or the deemed distribution rule for intangibles under Code Sec. 367(d).

IRS contemporaneously issued temporary regs under Code Sec. 482 to clarify the coordination of the transfer pricing rules with other Code provisions, including Code Sec. 367 (see ¶ 25). The text of these temporary regs serves, in part, as the text of the proposed regs.

Background—outbound transfers in general. Under Code Sec. 367(a)(1), if a U.S. person transfers property to a foreign corporation in connection with an exchange described in Code Sec. 332, Code Sec. 351, Code Sec. 354, Code Sec. 356, or Code Sec. 361, then the foreign corporation generally isn’t considered a corporation for purposes of determining gain on the transfer. As a result of the Code Sec. 367(a)(1) rule, transfers of property to a foreign corporation that would otherwise be tax-free are treated as taxable exchanges.

However, there are a number of exceptions to the Code Sec. 367(a)(1) rule. One exception is under Code Sec. 367(a)(2), for certain transfers of stock or securities, and another is under Code Sec. 367(a)(3), for transfers of certain property used in a trade or business. Specifically, Code Sec. 367(a)(3)(A) states that, except as otherwise provided in regs, the Code Sec. 367(a)(1) rule won’t apply to any property transferred to a foreign corporation for use by such foreign corporation in the active conduct of a trade or business outside of the U.S. (the “active trade or business,” or “ATB,” exception). However, certain property isn’t eligible for the ATB exception, including (i) property described in Code Sec. 1221(a)(1) or Code Sec. 1221(a)(3) (relating to inventory and copyrights, etc.); (ii) installment obligations, accounts receivable, or similar property; (iii) foreign currency or other property denominated in foreign currency; (iv) intangible property within the meaning of Code Sec. 936(h)(3)(B) (see below); and (v) property with respect to which the U.S. transferor is a lessor at the time of the transfer, unless the foreign corporation was the lessee.

In addition, under Code Sec. 367(a)(3)(C)’s “branch loss recapture rule,” except as otherwise provided in regs, the ATB exception won’t apply to gain realized on an outbound transfer of the assets of a foreign branch to the extent that previously deducted losses of the branch exceed the taxable income earned by the branch after the losses were incurred (but realized gain in the property transferred that exceeds the branch losses and must be recaptured, may qualify). The Code Sec. 367(a)(1) rule also won’t apply to an outbound transfer of any property that IRS, in order to carry out the purposes of Code Sec. 367(a), designates by reg. (Code Sec. 367(a)(6))

Existing regs under Code Sec. 367(a) provide rules regarding the ATB exception, including on:

…determining whether property is transferred for use by a transferee foreign corporation in the active conduct of a trade or business outside the U.S.; (Reg. § 1.367(a)-2 and Reg. § 1.367(a)-2T)
…determining whether certain property satisfies the ATB exception (Reg. § 1.367(a)-4 and Reg. § 1.367(a)-4T), and providing rules for when depreciation recapture is required upon an outbound transfer of U.S. depreciated property; (Reg. § 1.367(a)-4T)
…the five categories of property ineligible for the exception, and exceptions to these categories; (Reg. § 1.367(a)-5 and Reg. § 1.367(a)-5T), including Reg. § 1.367(a)-5T(d)’s rule that allows certain property denominated in the foreign currency of the country in which the foreign corporation is organized to qualify under the ATB exception if that property was acquired in the ordinary course of the business of the U.S. transferor that will be carried on by the foreign corporation; and
…applying the branch loss recapture rule. (Reg. § 1.367(a)-6T)

Background—outbound transfers of intangible property. Code Sec. 367(d), sometimes referred to as the “disposition rule,” provides special rules for outbound transfer of intangibles. Except as provided in regs, under Code Sec. 367(d)(1), if a U.S. transferor transfers any intangible property (within the meaning of Code Sec. 936(h)(3)(B)—generally, patents, copyrights, trademarks, methods, and other similar items with substantial value independent of the services of any individual) to a foreign corporation in an exchange described in Code Sec. 351 or Code Sec. 361, the U.S. transferor is treated as having sold the property in exchange for payments that are contingent upon the productivity, use, or disposition of the property, and as receiving amounts that reasonably reflect what would have been received annually in the form of such payments over the shorter of the property’s useful life (Code Sec. 367(d)(2)(A)(ii)(I)) or 20 years (Reg. § 1.367(d)-1T(c)(3)), or in the case of a disposition of the intangible property following such transfer, at the time of the disposition. (Code Sec. 367(d)(2)(A)(ii)(II)) These amounts must be commensurate with the income attributable to the intangible.

However, under the “foreign goodwill exception,” the transfer of foreign goodwill or going concern value is excepted from the disposition rule. “Foreign goodwill or going concern value,” in turn, is defined as the residual value of a business operation conducted outside of the U.S. after all other tangible and intangible assets have been identified and valued (and which includes the right to use a corporate name in a foreign country). (Reg. § 1.367(a)-1T(d)(5)(iii)) This rule effectively originated from legislative history underlying Code Sec. 367—in general, an expectation 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.

Issue. IRS has become aware that certain taxpayers, in the context of outbound transfers, attempt to avoid recognizing gain or income attributable to high-value intangible property by asserting that an inappropriately large share of the value of the property transferred is foreign goodwill or going concern value eligible for favorable treatment under Code Sec. 367. To do so, taxpayers are valuing the property transferred in a manner contrary to Code Sec. 482’s transfer pricing rules.

In addition, some taxpayers are interpreting the meaning of foreign goodwill and going concern value too broadly for Code Sec. 367 purposes.

IRS has concluded that the above practices raise significant policy concerns and are inconsistent with the expectations described above (i.e., that abuse was unlikely to occur in this situation). Accordingly, IRS proposes to amend the regs under Code Sec. 367, as described below.

New proposed regs. Significantly, the proposed regs would eliminate the foreign goodwill exception and limit the scope of property that is eligible for the ATB exception to certain tangible property and financial assets. Thus, under the proposed regs, upon an outbound transfer of foreign goodwill or going concern value, a U.S. transferor would be subject to either current gain recognition under Code Sec. 367(a)(1) or the tax treatment provided under Code Sec. 367(d).

Specifically, Prop Reg § 1.367(d)-(1)(b) would state that Code Sec. 367(d) and Prop Reg § 1.367(d)-1 apply to an outbound transfer of intangible property, without providing any exception. The definition of intangible property that applies for purposes of Code Sec. 367(a) and Code Sec. 367(d) would also be modified. (Prop Reg § 1.367(a)-1(d)(5))

In addition, the proposed regs would eliminate the existing rule (in Reg. § 1.367(d)-1T(c)(3)) that limits the useful life of intangible property to 20 years and would instead provide that the useful life is the entire period during which the exploitation of the intangible property is reasonably anticipated to occur at the time of transfer. (Prop Reg § 1.367(d)-1(c)(3)) The preamble notes that, where the useful life exceeds 20 years, limiting it may result in less than all of the income attributable to the property being taken into account by the U.S. transferor.

Noting that the rules for determining property’s eligibility for and satisfaction of the ATB exception are somewhat spread out, the proposed regs would combine these rules (other than the depreciation recapture rule) into a single reg—Prop Reg § 1.367(a)(2). This consolidation, however, is not intended to reflect any substantive changes other than those described below.

Under the current regs, all property is potentially eligible for the ATB exception unless specifically excluded. IRS stated that this provides taxpayers with an incentive to claim that certain intangible property is not described in Code Sec. 936(h)(3)(B), and is therefore not subject to Code Sec. 367(d), but is instead subject to Code Sec. 367(a) but excepted from its application by virtue of the ATB exception. This, in turn, results in taxpayers attempting to undervalue the intangible property subject to Code Sec. 367(d). To deal with this issue, the proposed regs would provide that (i) only certain types of property are eligible for the exception, and (ii) the property must be considered transferred for use in the active conduct of a trade or business outside of the U.S.

Under Prop Reg § 1.367(a)-2(b), eligible property would include tangible property, working interests in oil and gas property, and certain financial assets, unless the property is also described in one of four categories of ineligible property. These ineligible property categories would include (i) inventory or similar property; (ii) installment obligations, accounts receivable, or similar property; (iii) foreign currency or certain other property denominated in foreign currency; and (iv) certain leased tangible property. (Prop Reg § 1.367(a)-2(c)) In other word, the proposed regs would not retain the category for intangible property and they would eliminate the existing exception for property denominated in the foreign currency in the country in which the foreign corporation is organized.

The proposed regs would also allow a taxpayer to apply Code Sec. 367(d) to a transfer of property (with certain exceptions) that otherwise would be subject to Code Sec. 367(a). Under this rule, a U.S. transferor that takes the position that goodwill and going concern value are not Code Sec. 936(h)(3)(B) intangible property may nonetheless apply Code Sec. 367(d) to goodwill and going concern value. (Prop Reg § 1.367(a)-1(b)(5)) To implement this rule, as well as the removal of the foreign goodwill exception (as noted above), the proposed regs would modify the definition of “intangible property” to mean either (i) property described in Code Sec. 936(h)(3)(B), or (ii) property to which a U.S. transferor applies Code Sec. 367(d) in lieu of Code Sec. 367(a).

The proposed regs would replace the rules in Reg. § 1.367(a)-1T(b)(3) with a new rule providing that, in cases where an outbound transfer of property subject to Code Sec. 367(a) constitutes a controlled transaction, the value of the property transferred is determined in accordance with Code Sec. 482 and its regs. In general, this change would clarify the coordination of the arm’s length standard and the best method rule with Code Sec. 367 in determining the proper tax treatment of controlled transactions. For contemporaneously issued temporary regs, see ¶ 25.

In addition, the proposed regs reflect various other minor changes and conforming amendments, including to existing reporting requirements under Code Sec. 6038B.

Effective/applicability dates. The proposed regs are proposed to generally apply to transfers occurring on or after Sept. 14, 2015, as well as to transfers occurring before that date resulting from entity classification elections under Reg. § 301.7701-3 that are filed on or after Sept. 14, 2015. However, the removal of the exception in Reg. § 1.367(a)-5T(d)(2) (for certain property denominated in the foreign currency of the country in which the foreign corporation is organized) is proposed to apply to transfers occurring on or after the date that the regs are published as final, as well as to transfers occurring before that date resulting from entity classification elections that are filed on or after that date.

References: For transfers to foreign corporations, see FTC 2d/FIN ¶  F-6000; United States Tax Reporter ¶  3674; TG ¶  4925.