Obama Seeks to Tax Outbound Transfers of Workforce in Place

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1 Checkpoint Contents International Tax Library WG&L Journals Journal of International Taxation (WG&L) Journal of International Taxation 2009 Volume 20, Number 09, September 2009 Articles Obama Seeks to Tax Outbound Transfers of Workforce in Place, Journal of International Taxation, Sep 2009 Workforce in Place Obama Seeks to Tax Outbound Transfers of Workforce in Place Hidden within the far-reaching proposed changes to U.S. international tax law is a little-noticed provision that would clarify the definition of intangible property to include workforce in place, goodwill, and going concern for purposes of Sections 367(d) and 482 to prevent the inappropriate shifting of income outside the United States. Author: Lewis J. Greenwald, Douglas S. Stransky, and Eric J. Fuselier [pg. 28] Lewis J. Greenwald and Douglas S. Stransky are tax partners, and Eric J. Fuselier is a tax associate, in the Boston office of Sullivan & Worcester LLP. Mr. Greenwald and Mr. Stransky both practice exclusively in the area of international taxation. Mr. Greenwald is a member of the Board of Advisors of the Journal and a frequent contributor. Mr. Stransky has written previously. Often when U.S.-based multinationals ( MNCs ) enter a new foreign market, they initially establish a branch or a business entity that is treated as disregarded for U.S. federal tax purposes. 1 After the start-up/loss phase, the MNC often converts the branch into a corporation or, for a disregarded entity, makes a second check-the-box election to reclassify the foreign entity as a corporation for U.S. federal tax purposes. In both instances, an outbound transfer of property occurs (or is deemed to occur) from the MNC to the new foreign corporation, thereby implicating Sections 351(a) and 367(a). 2 [pg. 30] Section 367(a)(1) denies corporate status to a foreign corporation in a transaction that otherwise would be tax free under Section 351. As such, gain recognition generally is required on the outbound transfer of property to a foreign corporation. That said, Section 367(a)(3) contains an exception to Section 367(a)(1) for certain property that the transferee foreign corporation will use in the active conduct of a trade or business outside the United States ( active trade or business exception ). The active

2 trade or business exception does not apply, inter alia, to transfers of intangible property; rather, Section 367(d) provides that, with respect to outbound transfers of intangible property (within the meaning of Section 936(h)(3)(B)), Section 367(a) will not apply and the U.S. person transferring the intangible property will be treated as having sold that intangible property in exchange for payments that are contingent on the productivity, use, or disposition of the property over its useful life. 3 Section 936(h)(3)(B) defines intangible property as any (1) patent, invention, formula, process, design, pattern, or know-how; (2) copyright, literary, musical, or artistic composition; (3) trademark, trade name, or brand name; (4) franchise, license, or contract; (5) method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or (6) any similar item that has substantial value independent of the services of any individual. Property excluded from the purview of Section 367(d) includes foreign goodwill and going concern value. 4 What is not so clear, and has not been clear for years, is whether workforce in place is a Section 936(h)(3)(B) intangible that is subject to the provisions of Section 367(d) on an outbound transfer of assets to a foreign corporation. 5 On May 11, 2009, Treasury released the General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals ( Green Book ). 6 With the view of raising significant revenue, the Green Book calls for, inter alia, sweeping changes to the U.S. international tax system, including elimination of disregarded entity status for certain low-tier entities, elimination of the benefits of deferral, and creation of one blended E&P and tax pool. Hidden within these far-reaching changes proposed changes to U.S. international tax law is a little-noticed provision that would clarify the definition of intangible property to include workforce in place, goodwill, and going concern for purposes of Sections 367(d) and 482 to prevent the inappropriate shifting of income outside the United States. 7 The President's proposal to tax the outbound transfer of workforce in place is consistent with the IRS position on this issue. For the reasons discussed below, however, the President and the Service have it wrong workforce in place should not be considered a Section 936(h)(3)(B) intangible, and the outbound transfer of a workforce in place should not be taxable under Section 367(d). Taxpayers' Position Plain Language of the Statute As noted above, Section 367(d) applies only with respect to outbound transfers of intangible property within the meaning of Section 936(h)(3)(B). In the first instance, therefore, it must be determined whether workforce in place squarely fits within the meaning of intangible property under that provision. Also, as noted, Section 936(h)(3)(B) does not list workforce in place as an item of intangible property for purposes of that section. Section 936(h)(3)(B) provides only that intangible property includes any similar item to the other items listed in Sections 936(h)(3)(B)(i)-(v), as long as that similar item has substantial value independent of the services of any individual (emphasis added). Although similar item is not defined, the Supreme Court has stated that it is a fundamental canon of statutory construction that the words of a statute must be read in their context and with a view to their place in the overall statutory scheme. Section 936(h)(3)(B), all of the items of intangible property described by that [pg. 31]

3 section, as indicated by the flush language, must have substantial value independent of the services of any individual. Consequently, workforce in place cannot, by definition, be a Section 936(h)(3)(B) intangible because its value is wholly and completely dependant on the services of the individuals/employees that make up the workforce in place. IRS Position the Directive, the CIP, Section 197 On February 7, 2007, the IRS issued a directive and audit guidelines with respect to issues that arose in connection with the termination of the possessions tax credit under Section 936 ( Directive ). 9 In relevant part, the Directive provides: Taxpayers may improperly classify workforce in place as foreign goodwill and going concern value or take the position that workforce in place may be transferred tax free. Workforce in place is an intangible asset for purposes of section 936(h)(3)(B) and must be analyzed: 1) under section 367(d), if transferred offshore under section 351 or section 361; or 2) under section 482 in the case of all other controlled transactions. 10 Further, on September 27, 2007, the IRS issued a coordinated issue paper (CIP) 11 wherein it argued that: Regarding value independent of an individual's services, it may be that a given individual's employment contract or know how may lack substantial value independent of the services of such individual, as the gross value is effectively offset by the liability to pay the individual's compensation [even then, the IRS notes that there may be independent value to a long-term contract with an individual who possesses special know how]. The U.S. group's assembled research team, however, may be expected to have a substantial value independent of the services of any individual member of the team attributable to the team's collective contracts and know how, as no one or several individuals may be able to bargain compensation sufficient to eliminate a premium. Thus, the value of a research team workforce in place is either derived from the contract or know how items expressly listed in section 936(h)(3)(B)..., or represents a similar item to such items. The logic in the CIP is faulty at best the gross value that an employee provides to the company for his services must always be greater than the compensation he receives. Example. MNC has a branch office in Germany where it pays a single consultant $50 per hour for his services but charges $500 per hour to customers for the consultant's advice. The consultant worked 2,000 hours during the tax year, and was paid $100,000 in compensation for his services. In turn, the MNC was able to charge its customers $1 million for those same services. If the Service's logic holds, there would be a premium with respect to the consultant equal to $900,000. Multiply this individual premium by the size of the workforce in place and it becomes real money. In short, whether the argument is that the value of the workforce in place is based on employee [pg. 63] contracts, the employee's know-how, or some similar item, the value of the workforce in place is always dependent on the individuals/employees that make up that workforce in place and the services that they provide. Some commenters have argued that, in the context of a Section 351(a)/367(a) exchange, workforce in place constitutes going concern value, which, along with foreign goodwill, is not subject to section 367(d). 12 These commenters question whether there could possibly be any going concern value with respect to a trade or business without the workforce in place. 13 In response to that argument, the IRS has maintained that workforce in place must be analyzed separately from going concern value and, as discussed below, has incorrectly based this assertion on Section 197 and related case law. Section 936(h)(3)(B) to Section 197 and citing Ithaca Industries, Inc., 73 AFTR 2d , 17 F3d 684, 94-1 USTC Ithaca Industries, Inc.. Under Section 197(a), any "Section 197 intangible" may be amortized over a 15-year period. Section 197(d) provides that, for this purpose, a "Section 197 intangible" means, inter alia, goodwill, going concern, and workforce in place. Also, the court in Ithaca Industries held that it is no longer appropriate to classify an intangible asset based on its resemblance to the classic conception of goodwill or going concern and thus viewed workforce in place as an intangible asset that is separate from going concern. 15

4 Contrary to its earlier position that workforce in place was part of a business' going concern value, 16 the IRS has taken the position in the CIP that the workforce in place must be viewed separately from going concern, Section 197 and Ithaca Industries. But the Service's reliance on Section 197 (to separate workforce in place from going concern) is misplaced. Indeed, Section 197(d) defines a section 197 intangible only for purposes of that section there is no cross reference to Sections 367(a), 367(d), or 936(h)(3)(B). 18 Further, asserting that workforce in place is separate and apart from goodwill and going concern (and, therefore, magically a Section 936(h)(3)(B) intangible) avoids the real issue that workforce in place does not have substantial value independent of the services of individuals. Conclusion A plain reading of Section 936(h)(3)(B) makes it clear that workforce in place should not be classified as a Section 936(h)(3)(B) intangible because its value is solely dependent on the services of the individuals that comprise it. Whether the gross value of an employee's services is greater than the cost/compensation for that employee, or whether workforce in place is a part of going concern, does not change that result. Thus, contrary to the President's proposal and the IRS published position, the outbound transfer of workforce in place should not be taxable under Section 367(d) (provided that the workforce in place is used by the transferee foreign corporation in an active trade or business outside of the United States). 1 The U.S. federal tax classification as a disregarded entity is pursuant to either the default rules under Reg (b)(2), or an affirmative check-the-box election (with IRS Form 8832) under Reg (c). Pursuant to Reg (a), a disregarded entity's activities are treated in the same manner under the Code as those of a sole proprietorship, branch, or division of its owner (here, the MNC). 2 See Reg (g)(1)(iv). 3 Sections 367(a)(3)(B)(iv) and 367(d)(1), (2)(A). Other properties generally not eligible to be transferred tax free to a foreign corporation by virtue of Section 367(a)(3)(B) include (1) inventory and certain property created by the efforts of the taxpayer; (2) installment obligations, accounts receivable, and similar property; (3) foreign currency or other property denominated in foreign currency; and (4) certain property leased by the transferor. 4 Temp. Reg (d)-1T(b). Foreign goodwill or going concern value is 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. Temp. Reg (a)-1T(d)(5)(iii). 5 See, e.g., Fuller, Bassett, and Skinner, "International Tax Controversies: IRS Creates a New Category of Intangible Property Significant Implications for Code Sec. 367," Int'l Tax J. (May 1, 2007); Zollo and Holland, "The Transfer of Workforce in Place to a Foreign Corporation," KPMG Tax Advisory (August 31, 2007). 6 See also Hess, "Change Is Good, Dollars Are Better: Prospects for International Tax Reform," 20 JOIT 24 (August 2009); "International Tax Reform Proposals Treasury's Green Book," 20 JOIT 6 (August 2009). 7 Green Book, page 32. Beyond the scope of this discussion is whether foreign goodwill and going concern should also be taxable on an outbound transfer under Section 367(d). 8 Davis v. Michigan Dept. of Treasury, 63 AFTR 2d , 489 US 803, 103 L Ed 2d 891, 10 EBC 2097, 89-2 USTC 9456, at See Industry Director's Directive on Section 936 Exit Strategies (Exit Strategies #1), 2007 WTD (February 2, 2007). The audit guidance indicates that the issues in the Directive are Tier 1 compliance issues. In general, Section 936 allowed a tax credit against U.S. taxes imposed on income earned by a U.S. corporation (usually referred to as a possession corporation ) from the active conduct of a trade or business in Puerto Rico. 10

5 Id. 11 LMSB See "Baker & McKenzie Transfer Pricing Annual Update," 19 JOIT 24 (June 2008). 12 See Fuller, Bassett, and Skinner, supra note Id. 14 See note 11, supra. 15 In concluding that workforce in place was an intangible asset separate and distinct from going concern, the court in Ithaca Industries relied on Newark Morning Ledger Co., 71 AFTR 2d , 507 US 546, 123 L Ed 2d 288, 93-1 USTC 50228, which held that a taxpayer able to prove that a particular asset can be valued and that it has a limited useful life may depreciate its value over its useful life regardless of how much the asset appears to reflect the expectancy of continued patronage (i.e., goodwill). 16 See IRS ISP Coordinated Issue Paper, "Amortization of Assembled Workforce," 91 TNT (April 23, 1991). 17 See note 11, supra. 18 Accord, Fuller, Bassett, and Skinner, supra note Thomson Reuters/RIA. All rights reserved.