The Section 367(d) Paradox: Peering into the Abyss from a Safe Distance

Transcription

1 The University of Chicago Law School 67 th Annual Federal Tax Conference November 7, 2014 The Section 367(d) Paradox: Peering into the Abyss from a Safe Distance Presentation By: Eric B. Sensenbrenner Skadden, Arps, Slate, Meagher & Flom LLP Moderator: Lowell Yoder McDermott, Will & Emery Commenting Rocco Femia Marjorie Rollinson on the topic: Miller & Chevalier Internal Revenue Service 0

2 Agenda/Contents Section 367(a) and section 367(d) general principles. Role of section 367(d) and relationship to subpart-f Intangible property subject to section 367(d) Valuing Intangible Property Notice and role of section 367(d) as antirepatriation provision Conclusions 1

3 Section 367(a) General Principles Part of subchapter-c, section 367(a) essentially steps in to override basic deferral principle implicit in section 351 and reorganization provisions where there is a loss of taxing jurisdiction (e.g., subchapter- C provisions of gain deferral, basis preservation, etc. based on premise of a closed system ). Mechanism of operation is to treat transferee foreign corporation as not a corporation. Section 367(a)(1) provides: if in connection with any exchange described in section 332, 351, 354, 356, or 361, a United States person transfers property to a foreign corporation, such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered to be a corporation. 2

4 Section 367(a) General Principles Section 367(a) regime (including 367(d)) and the regulations thereunder, produce three different types of income recognition: Gain recognition Recapture of previously deducted expenses/losses Income inclusion (shifting)- Deemed commensurate with income royalty 3

5 Section 367(d)- Background Rev. Proc : Guidelines for IRS ruling that transfer of property to foreign corporation did not have as one of its principal purposes avoidance of federal income tax. Transfers of property for use in active conduct of foreign trade or business ordinarily received favorable treatment. Transfers of US patents, trademarks, and similar intangibles to be used in connection with (1) conduct of US trade or business, or (2) manufacture of goods for sale/consumption in the United States, and transfers of foreign patents, trademarks and similar intangibles to be used in connection with the sale of US manufactured goods would not receive favorable treatment. Implication that transfers of intangible property (whether US or foreign) for use in a foreign trade or business or manufacturing for sale or consumption outside the United States generally would result in favorable treatment. 4

6 Section 367(d)- Background In 1982, Congress enacted the predecessor to 367(d)- limited to transfers of possessions-related intangibles. Motivated by concern about taxpayer response to other changes to 936 rules. In 1984, Congress expanded section 367(d) to apply to transfers of any intangibles (retained cross-reference to section 936(h)(3)(B) for intangibles definition). In 1986, Congress again amended section 367(d) to add commensurate with income standard (simultaneous change to section 482). 5

7 Section 367(d) (d) SPECIAL RULES RELATING TO TRANSFERS OF INTANGIBLES.- (1) IN GENERAL.- Except as provided in regulations prescribed by the Secretary, if a United States person transfers any intangible property (within the meaning of section 936(h)(3)(B)) to a foreign corporation in an exchange described in section 351 or 361- (A)Subsection (a) shall not apply to the transfer of such property, and (B) the provisions of this subsection shall apply to such transfer. (2) TRANSFER OF INTANGIBLES TREATED AS TRANSFER PURSUANT TO SALE OF CONTINGENT PAYMENTS.- (A) IN GENERAL.- If paragraph (1) applies to any transfer, the United States person transferring such property shall be treated as- (i) Having sold such property in exchange for payments which are contingent upon the productivity, use, or disposition of such property, and (ii) Receiving amounts which reasonably reflect the amounts which would have been received- (I) Annually in the form of such payments over the useful life of such property, or (II) In the case of a disposition following such transfer (whether direct or indirect), at the time of the disposition. The amounts taken into account under clause (ii) shall be commensurate with the income attributable to the intangible. (B) EFFECT ON EARNINGS AND PROFITS.- For purposes of this chapter, the earnings and profits of a foreign corporation to which the intangible property was transferred shall be reduced by the amount required to be included in the income of the transferor of the intangible property under subparagraph (A)(ii). (C) AMOUNTS RECEIVED TREATED AS ORDINARY INCOME.- For purposes of this chapter, any amount included in gross income by reason of this subsection shall be treated as ordinary income. For purposes of applying section 904(d), any such amount shall be treated in the same manner as if such amount were a royalty. (3) REGULATIONS RELATING TO TRANSFERS OF INTANGIBLES TO PARTNERSHIPS.- The Secretary may provide by regulations that the rules of paragraph (2) also apply to the transfer of intangible property by a United States person to a partnership in circumstances consistent with the purposes of this subsection. 6

8 Outline of Section 367(d) Temporary Regulations Treas. Reg (d)-1T (a) Purpose and Scope (b) Intangible property subject to section 367(d) (c) Deemed payments upon transfer of intangible property to foreign corporation (1) In general (2) Required adjustments (3) Useful life (4) Blocked income (d) Subsequent transfer of stock of transferee foreign corporation to unrelated person (1) Treatment as sale of intangible property (2) Required adjustments (e) Subsequent transfer of stock of transferee foreign corporation to related person (1) Transfer to related U.S. person treated as disposition of intangible property (2) Required adjustments (3) Transfer to related foreign person not treated as disposition of intangible property (4) Proportionate share (f) Subsequent disposition of transferred intangible property by transferee foreign corporation (1) In general (2) Required adjustments (3) Subsequent transfer of intangible property to related person (g) Special rules (1) Establishment of accounts receivable (2) Election to treat transfer as sale (3) Intangible property transferred from branch with previously deducted losses (4) Coordination with section 482 (5) Determination of fair market value (6) Anti-abuse rule (h) Related person (i) Effective date 7

9 Impetus for 367(d) Lack of consistent track record in applying existing tools to address transfers of intangibles in tax-free transactions. Application of section 482 to override tax-free transfers, based on clear reflection of income principles, was limited. National Securities/Central Cuba line of cases Eli Lilly Challenges to the principal purpose determination under Rev Proc Dittler Brothers Hershey Foods 8

10 Role of 367(d) In General In light of the nature of intangible assets, role of section 367(d) not dissimilar to 367(a)- essentially attempting to bridge what is a jurisdictional issue. 367(a)- Where basic deferral principle cannot be maintained due to loss of taxing jurisdiction, gain recognition. But also, Recapture of previously deducted losses Hot assets - inventory, leased property, etc. 367(d)- matching of development expenses with associated income produced- Clear reflection principle 367(d)- deemed royalty approach- CWI principle 9

11 Nature of Intangibles- In General In contrast to tangible assets, intangibles: Lack a particular geographic locus/produces mobile income Cost of intangible development relatively high compared to costs associated with exploitation, e.g., manufacturing costs Costs of development often are expensed Have a tendency to generate non-routine returns 10

12 Role of 367(d) as Anti-Deferral Regime Under the CWI principle, 367(d) would also appear to function as an anti-deferral regime, somewhat of a super-subpart-f rule for transferred intangibles. Compare the following scenarios involving use of transferred intangibles: Scenario 1 Scenario 2 USP USP Contributed IP Contributed IP CFC Sale of Product 3d Party CFC License of IP 3d Party Manufacturer 11

13 Role of 367(d) as Anti-Deferral Regime- Relationship to subpart-f In scenario 1, IP used in manufacturing and CFC earnings are not subpart-f, CWI royalty under 367(d) included in US income- effectively anti-deferral mechanism with respect to IP return associated with CFC s business. In scenario 2, 1.367(d)-1T(c)(2) treats CFC s 367(d) royalty expense as allocated against subpart-f income- effectively netting-out subpart-f income. In effect, 367(d) allocation rule here effectively supplants subpart-f inclusion, and imposes US income inclusion where underlying income from exploitation of the intangible would not otherwise constitute subpart-f. If similar policies (e.g., highly mobile passive income) motivate both subpart-f and 367(d), can 367(d) be seen not as merely backstopping subpart-f, but effectively expanding the anti-deferral regime applicable to IP- suggests other motivating factors- recapture of expenses? 12

14 Role of 367(d) as Anti-Deferral Regime- Relationship to subpart-f If similar policies (e.g., highly mobile passive income) motivate both subpart-f and 367(d), why does 367(d) effectively expand the antideferral regime beyond the circumstances in which income generated would be picked-up under the subpart-f rules? Focus of 367(d) on US-developed intangibles, in contrast to the focus of subpart-f on activities and manner of generating income from the intangibles. Possible rationales: Focus on US-developed intangibles where development expenses were previously deducted- recapture approach? Premise that income associated with US-developed intangibles must necessarily remain subject to US tax? In contrast, if the CFC had developed the intangible, income would be eligible for deferral in both scenario 1 and scenario 2- Suggests recapture approach. 13

15 Intangible Property Subject to 367(d) 1.367(a)-1T(d)(5) defines intangible property as knowledge, rights, documents, and any other intangible property within the meaning of section 936(h)(3)(B). 936(h)(3)(B)- Intangible Property means any: (i) patent, invention, formula, process, design, pattern, or knowhow; (ii) Copyright, literary, musical, or artistic composition; (iii) Trademark, trade name, or brand name; (iv) Franchise, license or contract; (v) Method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or (vi) Any similar item, Which has substantial value independent of the services of any individual (d)-1T(b) provides that section 367(d) and the rules of section 1.367(d)- 1T shall not apply to the transfer of foreign goodwill or going concern value. Consistent with legislative history underlying enactment of section 367(d). Regulations also state that foreign goodwill and going concern value is expressly subject to the rules of 1.367(a)-6T (branch loss recapture). 14

16 Foreign Goodwill/Going Concern Value 1.367(a)-1T(d)(5)(iii) defines foreign goodwill or going concern value as the residual value of a business operation conducted outside of the United States after all other tangible and intangible assets have been identified and valued. (includes right to use corporate name in a foreign country). Relationship of goodwill/gcv to identifiable intangibles Not developed through incurrence of deductible expenses, but through activities performed outside the US. Typically, cannot be exploited apart from the conduct of underlying business. Is foreign goodwill/gcv included in the 936(h)(3)(B) definition? How is foreign goodwill/gcv treated, if it is carved out of 367(d)? Not subject to 367? Subject to 367(a)? Foreign business exception available? Consequences of subjecting foreign goodwill/gcv to 367(a). Scope of foreign goodwill/gcv in relation to other intangible assets Workforce in place Network intangibles 15

17 Selection/Valuation of Intangible Property Role of commensurate with income standard Administration Proposals regarding valuation of intangibles Valuation on aggregate basis where achieves a more reliable result Consideration of realistic alternatives to transaction undertaken Challenges in the valuation of intangibles: Veritas Software Corporation & Subs. v. Commissioner, 133 T.C. 297 (2009). TAM

18 A Question of Basis USP USP contributes recently-acquired IP, having full basis to CFC for use in CFC s manufacturing business outside the United States. Contributed IP USP licenses recently-acquired IP, having full basis to CFC for use in CFC s manufacturing business outside the United States. CFC USP sells recently-acquired IP, having full basis to CFC for use in CFC s manufacturing business outside the United States. 17

19 A Question of Basis Statute refers to person transferring intangible property being treated as having sold such property in exchange for payments which are contingent upon the productivity, use or disposition of such property [emphasis added]. Treasury Regulations, 1.367(d)-1T(c), refers to transferor including, annually in gross income an amount that represents an appropriate arms-length charge for the use of the property [and such amounts] shall be treated as ordinary income. Treasury Regulations, 1.367(d)-1T(d), implementing the statutory disposition rule, provides that the amount of gain recognized on a subsequent transfer is measured by 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 (determined as of the original transfer) [emphasis added]. Is there any policy justification for not allowing basis recovery under 367(d)? Recapture theory is premised on development expenses being deducted in the US. Retention of the intangible property and actual license would permit basis amortization over time. 18

20 Section 367(d) as Anti-Repatriation Weapon USP $ / Note UST Stock FMV 100x A/B 100x 367(d) Receivable UST Intangibles 70x Tangibles 30x CFC UST USP transfers all of the stock of UST to CFC in exchange for cash/note; UST converts to LLC or liquidates. UST recognizes gain on tangible assets, if any; intangible assets subject to annual deemed royalty under 367(d) USP does not recognize gain on receipt of cash/note under 356 (due to high outside basis) USP establishes receivable for 367(d) royalty under 1.367(d)-1T(g) 19

21 Section 367(d) as Anti-Repatriation Weapon-2 367(d) Receivable? $ USP CFC $ (1) UST SHs UST Foreign Sub (2) reorg UST Foreign Assets US Newco US assets CFC acquires stock of UST for cash in public transaction. UST undergoes D or F reorganization (before quarter-end) without boot; US tangible assets are contributed to US Newco. 367(a)(5) and 1.367(a)-7(b) cause gain recognition to the extent of the tangible assets. 367(d) applies to intangible property of UST? 20

22 Notice On July 13, 2012, IRS and Treasury published Notice to address transactions that raise significant policy concerns. Notice represents the latest in a series of government responses to address concerns about taxpayers ability to repatriate low-taxed foreign earnings with little U.S. tax (Notice ; 367(a)(5) regulations). Under the Notice, regulations will: ensure that, with respect to all outbound section 367(d) transfers, the total income to be taken into account under section 367(d) is either included in income by the U.S. transferor in the year of the reorganization or, where appropriate, over time by one or more qualified successors. The Notice addresses 3 main categories of transactions. The regulations that Notice describe would apply to transactions occurring on or after July 13,

23 Notice Category 1 Outbound D with Boot USP Liq. $70x stock $30x cash FMV 100x A/B 100x UST $70x stock $30x cash TFC E&P Assets Patent b 0x v 60x Non-IP Asset? 40x 22

24 Notice Category 2 Outbound D or F with Debt Assumption + USP FMV 70x A/B 70x E&P - UST $70x stock TFC E&P Assets + Liab. Patent b 0x v 60x Non-IP Asset? 40x + 30x Liability owed to USP 23

25 Notice Category 3 CFC Purchase; Outbound D or F USP Liq. 100x stock UST FMV 100x A/B 100x CFC 100x stock Assets TFC Patent b 0x v 60x Non-IP Asset? 40x 24

26 Notice : Prepaid Royalty Section 4.02 provides that a US transferor will take into account income under section 367(d)(2)(A)(ii)(I) (the deemed royalty rule) with respect to each qualified successor, by treating as a prepayment of such royalty an amount equal to: the product of the section 367(d) percentage multiplied by the sum of: (i) the money and FMV of other property received by the qualified successor in exchange for stock of the US transferor (reduced by the portion of any US transferor distributions); and, (ii) 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 or satisfied with money or other property provided by the transferee foreign corporation. Amount included as a prepayment of section 367(d) royalty in year of transfer. Applicable to transactions in categories 1 and 2. 25

27 Notice : Disposition Rule Section 4.03 provides that a US transferor also will take into account income under section 367(d)(2)(A)(ii)(II) (the disposition rule) an amount equal to the product of: i. the sum of the ownership percentages of all non-qualified successors, if any, multiplied by, ii. The amount of gain realized on all of the section 367(d) property transferred. Amount included as income in year of transfer. Applicable to transactions in category 3. 26

28 Notice : Category 1 D w/boot USP Liq. $70x stock $30x cash FMV 100x A/B 100x UST $70x stock $30x cash TFC E&P Assets Patent b 0x v 60x Non-IP Asset 15x 40x Under 4.02, UST includes in income, as prepaid royalty, 60% (367(d) percentage) multiplied by 30x cash (boot), or $18x. UST, a qualified successor, will continue to take into account a proportionate share of annual section 367(d) royalties, with credit for amounts included by UST under $28x of stock is treated as received for 367(a) asset, permitting basis adjustment under section 367(a)(5) and 1.367(a)-7 to avoid recognizing gain on Non-IP Asset? 27

29 Notice : Category 2 D or F with Debt Assumption + USP FMV 70x A/B 70x E&P - UST $70x stock TFC E&P Assets + Liab. Patent b 0x v 60x Non-IP Asset 15x 40x + 30x Liability owed to USP Similar result as Category 1: Under 4.02, UST includes in income, as prepaid royalty, 60% (367(d) percentage) multiplied by 100% (qualified successor s interest) multiplied by 30x liability assumed, or $18x. Non-qualified liability assumption treated same as boot. 28

30 Notice : Category 3 Outbound D of F USP Liq. 100x stock UST FMV 100x A/B 100x CFC 100x stock Assets TFC Patent b 0x v 60x Non-IP Asset 15x 40x Under 4.03 of the Notice, because CFC is not a qualified successor, UST must take into income an amount equal to the product of 100% (percentage of ownership by non-qualified successors) and the amount of gain on the transferred 367(d) property, $60x. Result does not appear to turn on whether CFC used $/property or its own stock to acquire UST. Here, there does appear to be basis offset. Under 367(a)(5) and 1.367(a)-7(b), UST recognizes $25 gain on Non-IP Asset. 29

31 Theory of Boot as Prepaid Royalty The approach taken by the Notice of treating boot and non-qualified liability assumption as a pre-payment of the 367(d) royalty appears inconsistent with the tax treatment of boot under sub-c principles. Section 361(b)(1)(A) provides that gain is not recognized to the transferor corporation, provided the boot is distributed pursuant to the plan of reorganization, which has effectively been required in every asset reorganization since The Notice would appear to extend beyond the traditional realm of section 367(a) in addressing what is essentially a loss of taxing jurisdiction- i.e., overriding sub-c treatment where such provisions are unable to continue to operate. There is nothing, apparent, in these transactions that would prevent 367(d) from operating in the normal fashion. Appears to borrow the concept of boot-as-prepayment from the 351 context. See CCA , addressing the simultaneous application of 351(b) and 367(d) in the context of a section 351 exchange with boot. 30

32 Application of 367(d) in 351 Exchange with Boot Contributed IP USP CFC Stock Cash/note USP transfers IP to CFC in exchange for CFC shares and cash/note. CCA addressed overlap of 351(b)/367(d) in this context. Noted potential for double taxation due to simultaneous application of 351(b) and 367(d)- Looked to LH, structure of 367(a) generally, principles of statutory construction, and concluded that 367(d) takes priority over 351(b). Treated boot as a 367(d) payment In 351, transferor of 367(d) property is also the person treated as recognizing income/gain under sub-c principles. 31

33 Application of 367(d) in 361 Exchange with Boot USP Liq. $70x stock $30x cash FMV 100x A/B 100x UST $70x stock $30x cash TFC E&P Assets Patent b 0x v 60x Non-IP Asset 15x 40x Doesn t appear to present same issue with respect to simultaneous application of sub-c gain recognition (i.e., 361(b) does not tax UST) and 367(d) as in the 351 context (where transferor of intangible is party subject to tax under sub-c principles). 32

34 Application of 367(d) in 361 Exchange with Boot and 356 Gain USP Liq. $70x stock $30x cash FMV 100x A/B 70x UST $70x stock $30x cash TFC E&P Assets Patent b 0x v 60x Non-IP Asset 15x 40x But, where USP recognizes gain under there is the prospect of double-tax as was considered in the CCA. In such a case, would 367(d) similarly trump 356(a)? 33

35 Theory of 361 Distribution as Disposition Two subsequent transfer rules in the 1.367(d)-1T regulations implicated by the Notice, transfers of TFC stock to related US persons, and transfers of TFC stock to related foreign persons (d)-1T(e)(1)- If a U.S. person transfers intangible property that is subject to section 367(d) and the rules of this section to a foreign corporation in an exchange described in section 351 or 361 and, within the useful life of the transferred intangible property, that U.S. transferor subsequently transfers the stock of the transferee foreign corporation to U.S. persons that are related to the transferor... [e]ach such related U.S. person shall be treated as having received... A right to receive a proportionate share of the contingent annual payments that would otherwise be deemed to be received by the U.S. transferor (d)-1T(e)(3)-... and within the useful life of the transferred intangible property that U.S. transferor subsequently transfers any of the stock of the transferee foreign corporation to one or more foreign persons that are related to the transferor.... then the U.S. transferor shall continue to include in its income the deemed payments.... in the same manner as if the subsequent transfer of stock had not occurred. 34

36 Theory of 361 Distribution as Disposition Approach to Category 3 transactions in the Notice appears to be based on two propositions: Section 361 distribution in asset reorganization constitutes a disposition of stock of the transferee governed by the disposition rule.... within the useful life of the transferred intangible property, that U.S. transferor subsequently transfers any of the stock of the transferee foreign corporation... Under the disposition rule of 1.367(d)-1T(e)(3), the U.S. transferor is required to continue including 367(d) royalty, but is unable to do so, due to its liquidation. Regulations do not appear to make any provision for the distribution in a 361 transaction, despite expressly contemplating that the provisions apply to section 361 transfers It has been required that the transferring company liquidate in every section 361 asset reorganization since [Cite to 1994/1996 PLR] 35

37 Theory of 361 Distribution as Disposition USP Liq. stock CFC UST TFC stock Assets TFC Notice implies that under the disposition rule of 1.367(d)-1T(e)(3), because UST no longer exists, the 367(d) deemed-royalty regime cannot be applied. As an alternative, where the related foreign person is a CFC, could a regime similar to that for dispositions to related U.S. persons apply, i.e., CFC would include deemed royalty income as subpart-f? Instead, could the 367(d) receivable jump to USP? If not, as the Notice implies, is it clear that the amount of 367(d) income is determined by the gain in the intangible asset? 36

38 Conclusions 37