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IRS Eliminates Foreign Goodwill Exception for Tax-Free Transfers of US Intangibles.

(Parker Tax Publishing October 6, 2015)

The IRS has issued proposed regulations that eliminate the foreign goodwill exception for the outbound transfers of intangibles, and limit the scope of property that is eligible for the active trade or business exception. The proposed regs are effective for transfers occurring on or after September 16, 2015. REG-139483-13.

The proposed rules also apply to transfers occurring before September 16, 2015 resulting from entity classification elections made under Reg. Sec. 301.7701-3 that are filed on or after that date.

Background

Code Sec. 367(a)(1) provides that if, in connection with any exchange described in Code Secs. 332, 351, 354, 356, or 361, a U.S. person (U.S. transferor) transfers property to a foreign corporation (outbound transfer), the transferee foreign corporation will not, for purposes of determining the extent to which gain is recognized on such transfer, be considered to be a corporation. As a result, under Code Sec. 367(a)(1), the U.S. transferor recognizes any gain (but not loss) on the outbound transfer of the property.

An exception in Code Sec. 367(a)(3)(A) provides that the general rule of Code Sec. 367(a)(1) will not 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 United States ("active trade or business exception"). Reg. Secs. 1.367(a)-5 and 1.367(a)-5T address five categories of property ineligible for the exception, which includes intangible property, as defined in Code Sec. 936(h)(3)(B).

Code Sec. 367(d)(1) provides that, in general, if a U.S. transferor transfers any intangible property to a foreign corporation in an exchange described in Code Secs. 351 or 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. Reg. Sec. 1.367(d)-1T(b) generally provides that this rule does not apply to the transfer of foreign goodwill or going concern value, (foreign goodwill exception).

Congress enacted Code Sec. 367(d) to address problems with respect to outbound transfers of intangible property. Congress had identified issues arising when transferor U.S. companies attempted to reduce their U.S. taxable income by deducting substantial research and experimentation expenses associated with the development of the transferred intangible and, by transferring the intangible to a foreign corporation at the point of profitability, to ensure deferral of U.S. tax on the profits generated by the intangible.

The Senate Finance Committee and the House Committee on Ways and Means each noted in a senate report following the enactment of Code Sec. 367 that they did not anticipate that the transfer of goodwill or going concern value developed by a foreign branch to a newly organized foreign corporation would result in abuse of the U.S. tax system. However, neither Code Sec. 367 nor its legislative history defines goodwill or going concern value of a foreign branch, nor discusses how goodwill or going concern value is attributed to a foreign branch.

Taxpayers Interpret Code Section 367 to Claim Favorable Treatment for Foreign Goodwill

The IRS notes that, in general, taxpayers interpret Code Sec. 367 and the related regulations in one of two alternative ways when claiming favorable treatment for foreign goodwill and going concern value.

Under one interpretation, taxpayers take the position that goodwill and going concern value are not Code Sec. 936(h)(3)(B) intangible property and therefore are not subject to Code Sec. 367(d). Under this interpretation, taxpayers assert that the foreign goodwill exception has no application. Furthermore, these taxpayers assert that gain realized with respect to the outbound transfer of goodwill or going concern value is not recognized under the general rule of Code Sec. 367(a)(1) because the goodwill or going concern value is eligible for, and satisfies, the active trade or business exception.

Under a second interpretation, taxpayers take the position that, although goodwill and going concern value are intangible property, the foreign goodwill exception applies. These taxpayers also assert that Code Sec. 367(a)(1) does not apply to foreign goodwill or going concern value, either because of Code Sec. 367(d)(1)(A) (providing that, except as provided in regulations, Code Sec. 367(d) and not Code Sec. 367(a) applies to intangible property) or because of the active trade or business exception.

Proposed Regs Remove Foreign Goodwill Exception and Limit Scope of the Active Trade or Business Exception

The IRS has stated that, in the context of outbound transfers, certain taxpayers attempt to avoid recognizing gain or income attributable to high-value intangible property by asserting that an inappropriately large share (in many cases, the majority) of the value of the property transferred is foreign goodwill or going concern value that is eligible for favorable treatment under Code Sec. 367. The IRS notes that some taxpayers broadly interpret the meaning of foreign goodwill and going concern value for purposes of Code Sec. 367. Specifically, although the existing regulations define foreign goodwill or going concern value by reference to a business operation conducted outside of the U.S., some taxpayers have asserted that they have transferred significant foreign goodwill or going concern value when a large share of that value was associated with a business operated primarily by employees in the United States, where the business simply earned income remotely from foreign customers.

The IRS has determined that allowing intangible property to be transferred outbound in a tax-free manner is inconsistent with the tax policies underlying Code Sec. 367 and sound tax administration and therefore the proposed regulations eliminate the foreign goodwill exception under Reg. Sec. 1.367(d)-1T and limit the scope of property that is eligible for the active trade or business exception generally to certain tangible property and financial assets. Accordingly, under the proposed regulations, upon an outbound transfer of foreign goodwill or going concern value, a U.S. transferor will be subject to either current gain recognition under Code Sec. 367(a)(1) or the tax treatment provided under Code Sec. 367(d).

Separately Issued Temporary Regs Make Coordinating Amendments

Temporary regulations (T.D. 9738 (9/17/15)) clarify the coordination of the application of the arm's length standard and the best method rule in Code Sec. 482 (dealing with transfer pricing arrangements) in conjunction with certain controlled transactions, including controlled transactions that are subject in whole or part to both Code Secs. 367 and 482. The text of the temporary regs also serves as the text of a portion of the proposed regulations, and are effective for tax years on or after September 14, 2015. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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