Proposed Regulations Significantly Narrow the Scope of Assets That Can Be Transferred Offshore Tax Free
On September 14, 2015 the IRS issued proposed regulations that eliminate the foreign goodwill exception under Code Section 367(d). The proposed regulations are to apply to transfers occurring after September 14, 2015. Under the proposed regulations, all outbound transfers of foreign goodwill or going concern value will be subject to either current gain recognition under 367(a) or the treatment provided under 367(d). Under 367(d), a U.S. person is treated as selling property for payments that are commensurate with the transferee’s income from the property.
In addition the proposed regulations would no longer limit the useful life under 367(d) to 20 years.
Under current law, a transfer of assets to a domestic company is tax-free under Section 351.
Under Section 367(a)(1), if a U.S. person (U.S. transferor) transfers property to a related foreign corporation in connection with any tax-free exchange described in sections 332, 351, 354, 356, or 361, the transferee foreign corporation generally is not considered to be a corporation for purposes of determining whether gain is recognized on such transfer. In other words, under section 367(a)(1), the U.S. transferor recognizes gain (but not loss) on the outbound transfer of the property, unless certain exceptions apply. One exception is under section 367(a)(3)(A) for transfers of certain property to a foreign corporation that will be used in the active conduct of a trade or business by such foreign corporation outside of the United States. However, certain categories of property are not eligible for the exception, including (i) property relating to inventory, copyrights, musical, artistic, or similar property;(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 section 936(h)(3)(B) (as discussed below); and (v) property with respect to which the U.S. transferor is a lessor at the time of the transfer, unless the transferee corporation was the lessee.
Section 367(d) imposes U.S. tax on certain outbound transfers of intangible property by treating the U.S. transferor as if it sold the intangible property in exchange for annual payments contingent upon the productivity, use or disposition of the property, with the amount of this deemed royalty commensurate with the income attributable to the intangible. Section 367(d) defines intangible property by reference to the list of property in section 936(h)(3)(B). The current regulations (promulgated in 1986) exclude the transfer of foreign goodwill or going concern value from the application of section 367(d), based on the legislative history of section 367(d). For these purposes, foreign goodwill and going concern value equal the residual value of a foreign business operation after all other tangible and intangible assets have been valued. As a consequence of the regulatory exclusion, a U.S. person that transfers assets to a foreign corporate transferee may achieve non-recognition treatment for built-in gains attributable to foreign goodwill and going concern value.
Reasons for Change
Controversy often arises concerning the value of intangible property transferred between related persons and the scope of the intangible property subject to sections 482 and 367(d). According to the IRS, the lack of clarity may result in the inappropriate avoidance of U.S. tax and misuse of the rules applicable to transfers of intangible property to foreign entities.
The Proposed Regulations Change the Result Above
The proposed regulations 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. Such a change would subject a U.S. transferor of foreign goodwill or going concern value to either current gain recognition under section 367(a)(1) or the tax treatment of intangibles under section 367(d) discussed above.
In addition, the proposed regulations would eliminate the rule that limits the useful life of intangible property to 20 years. Instead, the proposed regulations would provide 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 the transfer.
The 367 proposed Regulations would generally apply to transfers occurring on or after September 14, 2015 and to transfers occurring before September 14, 2015 resulting from entity classification elections under the check-the-box regulations filed on or after September 14, 2015.*
- The proposed regulations are effective September 14, 2015 or prior if an election to classify a foreign entity as a corporation is made after September 16, 2015 but is effective prior to that date.
- The proposed regulations reverse current regulations under 367(d) and can be construed as contrary to congressional intent.
- It will be interesting to see if the taxpayers challenge the regulations on the basis they are contrary to congressional intent or the recent holding of the Tax Court in Altera, which requires the IRS to adhere to the Administrative Procedures Act when drafting regulations.
*The proposed regulations published on September 14, 2015 had an effective date of September 16, 2015. However, the official version of the proposed regulations published in the Federal Register is September 14, 2015