The Internal Revenue Service recently proposed regulations that could have a big impact on U.S.-based multinational corporations that are considering incorporating a foreign branch operation or transferring intellectual property abroad.
The proposed regulations, under section 367 of the Tax Code, reflect a concern by the IRS that “certain taxpayers 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 that is eligible for favorable treatment under Section 367.”
The IRS noted in the proposed rules that such methods are “inconsistent with the policies of section 367 and sound tax administration.” The regulations allow foreign goodwill and going concern value to be exempt from taxation. But the IRS is concerned that companies are claiming that high-value intellectual property such as patents are exempt as well.
“It’s been in the regs for a very long time,” said Carol Tello, a partner in the Washington, D.C., office of the law firm Sutherland Asbill & Brennan LLP, which represents multinational companies on U.S. tax issues. “When you transfer property offshore, it’s often done in a corporate setting or reorganization. Generally if you meet certain requirements, it’s tax-free. But there’s an overlay of those provisions when you engage in those corporate reorganization transactions with a foreign entity transferee. In other words, I’m either going to transfer property to a foreign corporation which I’ve incorporated somewhere or have a reorganization where two companies combine like a U.S. company and a foreign company. While it might ordinarily be tax-free under these special provisions of 367, unless you agree to additional provisions or you meet certain requirements, the gain that’s inherent in the assets that you transfer offshore is going to be subject to U.S. tax.”
She pointed out that not all assets get tax-free treatment under the existing rules. One of the major provisions applies to an actively traded business outside the U.S. “Generally if you’ve got some assets that together are used in a trade or business and you’re shifting your business outside of the U.S., usually you’d be incorporating a branch, and that’s what’s most relevant here,” said Tello. “Let’s say you’ve already got a branch business going in the U.K., and now you want to incorporate that business. What that means in the tax world is the assets that constitute the branch are going to be transferred into the U.K. corporation that you’ve set up. As long as those assets are going to be used in a U.K. trade or business, then generally it will be tax-free, with some exceptions for certain types of entities.”
There are special rules for transfers of intangibles, she noted. “Under those rules, you’d be treated as though you got a royalty back from the foreign corporation to compensate you for that intangible asset,” said Tello. “The regulations have for a long time—probably for 30 years or more—said that foreign goodwill and going concern value would not be subject to these rules and you wouldn’t be subject to tax. When you’re incorporating your U.K. branch, one assumes you build up some goodwill and going concern value, and then that wouldn’t be subject to gain. In these new regulations the IRS and Treasury said that’s no longer going to be treated as tax-free and they’re taking away that exception. They say you can’t qualify under the active trader business and it’s not an intangible under 367(d). So you’re just out of luck. You’re going to have to be taxable.”
Some tax experts were dismayed to see the proposed changes. “What has gotten people upset is it’s going to be taxable, and the temporary regs were effective as of September 16, without any notice and comment,” said Tello. Tax experts also pointed to the legislative history behind the longstanding rules.
In a legal alert, her firm noted, “While section 367(d) guidance has long been anticipated, in light of the strong support for the Foreign Goodwill Exception in the legislative history, the complete elimination of this exception is controversial, and the statutory and policy basis for this change is not clear.”
But Treasury officials believe the old rules have been stretched a little too much. “In speaking at various conferences, the Treasury has addressed that point about the legislative history and has said that in their view the legislators assumed people would be using and not abusing that rule in using the going concern value and goodwill in the active trade or business, and the IRS and Treasury believe these rules have been abused,” said Tello. “Particularly with respect to high-value intangibles, some of the value has either been undervalued or it’s been treated as goodwill and going concern value, which of course escapes taxation altogether. That’s their rationale for this change in the rules. It will mostly impact 367 transactions generally, but most specifically incorporation of branches, which is foreign goodwill. The change in the rule has all been foreign goodwill and going concern value.”
The proposed regulations would also change the limitation on the “useful life” of intangible property from 20 years to a potential perpetual life. But Tello is not sure that’s as controversial as the elimination of the foreign goodwill and going concern value.
The changes in the new rules to the active trade or business exception have also provoked some concern. “Only tangible property is permitted to receive the benefit of that exception to taxation,” said Tello.
The energy industry will still be able to benefit from the exception, however, for those businesses that have a working interest in oil and gas properties. Tello believes that’s appropriate.
“A working interest in an oil or gas property is going to be still subject to the active trade or business rule exception to taxation,” she noted. “I think that makes a lot of sense because a working interest is where you bear the burden of the cost as well as enjoy the income, so I think it has to do with a rational analysis of what a working interest is.”
The impact could be significant for multinational businesses, and their accountants and tax executives, who have become accustomed to the existing rules over the years.
“I think it’s going to be more costly to incorporate a branch that you have outside the U.S., and it may change people’s behavior, not to have a branch,” said Tello.
One result could be that foreign goodwill and going concern value will be developed within the corporate entity, and multinationals will be less likely to do a transfer that might result in a recognized gain.
Tello doubts the elimination of the 20-year limitation will have a major impact on corporate tax planning, but she noted the active trade or business change will eliminate some of the ability for companies to transfer some of the value of high-value intangibles offshore.
“If you look at the preamble to these regs and what the IRS has said there about the positions that taxpayer were taking, clearly the government disagrees with those positions and wants to just shut them down and the opportunity for that,” she said. “That will result in more tax and I guess people will have to be thinking about new strategies for intangibles offshore.”
She pointed out that the ability to transfer intangibles offshore without incurring a tax has eroded over the years after the issuance of cost-sharing regulations under section 482 of the Tax Code.
“There’s been a lot of litigation on that, still ongoing, about what has to be taken into account, so I think it’s a general trend that you see, that the government is thinking about transfers of high-value intangibles offshore,” said Tello.
The proposed regulations may fit into the Organization for Economic Cooperation and Development’s plan to curb tax base erosion and profit shifting, or BEPS, by multinationals.
“There has to got to be substance,” said Tello. “You can’t just transfer property to a low-tax or no-tax jurisdiction. Where there’s no functionality, there’s no risk. The government has clearly stated the position that the creation of so-called ‘stateless income’ by U.S. companies has been one of the drivers of the BEPS project. This isn’t aimed at a particular jurisdiction, as some of the rules are, but nonetheless I suppose you could see a connection there. The IRS feels some taxpayer positions have eroded the U.S. tax base.”