2015-Issue 34—On September 14, 2015, the Department of the Treasury and the Internal Revenue Service released proposed regulations under Section 367 that would dramatically change the treatment of goodwill and going concern value transferred by a U.S. person to a foreign corporation in what would otherwise be a tax-free transaction in a purely domestic context. If finalized as proposed, the regulations would be effective (retroactively) for transfers occurring on or after September 14.
Under existing Section 367 regulations, the transfer of goodwill and going concern value to a foreign corporation can qualify for non-recognition of gain or loss if it is transferred for use in the active conduct of a trade or business outside the United States. Under the proposed regulations, the outbound transfer of goodwill and going concern value would no longer qualify for non-recognition of gain.
The proposed change reflects the Obama Administration’s views on the proper policies for Section 367, but is diametrically opposed to the policy views of Congress expressed in the legislative history to Section 367. Because of this conflict with legislative intent, there is reason to believe that if they are finalized as proposed, the regulations may be determined to be invalid if challenged in court (i.e., aChevron analysis).
The proposed regulations present difficult choices for taxpayers now considering the incorporation of foreign operations that are now conducted in pass-through (i.e., branch or partnership) format; and they may change the calculus for taxpayers contemplating the choice of entity for start-up operations outside the U.S.
U.S. tax law contains certain non-recognition rules that generally permit the transfer of property to a corporation on a tax-free (actually tax-deferred) basis in connection with the formation or reorganization of a corporation. Code Section 367 provides a set of rules that override non-recognition treatment, to some extent, where the transferor is a U.S. person and the transferee is a foreign corporation (so-called “outbound transfers”).
Ever since its enactment in 1976, Section 367 has been interpreted to permit the tax-free transfer of goodwill and going concern value to a foreign corporation for use in the active conduct of a trade or business outside the United States. The Obama Administration has made no secret of the fact that it disagrees with the policy views of Congress regarding the favorable treatment of goodwill and going concern value, as expressed in the legislative history to Section 367. The Administration’s budget proposals to Congress have consistently called for the elimination of that favorable treatment of goodwill and going concern value, citing the present treatment as a source of abuse of the U.S. tax system. Apparently unwilling to wait any longer for Congress to act, the Administration has taken it upon itself to make this change.
Under the proposed regulations, taxpayers would have two options for the treatment of outbound transfers of goodwill and going concern value:
- They could opt for immediate recognition of gain under Section 367(a);
- Or, they could treat goodwill and going concern value as being subject to the rules for intangible property covered in Section 367(d). Under Section 367(d), a U.S taxpayer who contributes intangible property to a foreign corporation is treated as though it sold the intangible to the foreign corporation for a stream of contingent payments over the useful life of the intangible, with the hypothetical contingent amounts being “commensurate with the income attributable to the intangible.”
In addition to making outbound transfers of goodwill and going concern value ineligible for non-recognition treatment, the proposed regulations would also eliminate a rule in the existing regulations that limits the useful life of intangible property to 20 years for purposes of Section 367(d). As a result of that change, the hypothetical contingent payments created by Section 367(d) would continue on for the entire period during which the exploitation of the intangible property was reasonably anticipated to occur, as of the time of the outbound transfer (which could be far longer than 20 years).
These proposed regulations come on the heels of Notice 2015-54, issued on August 6, indicating that Treasury and the IRS will be issuing regulations, based on similar policy concerns, that will reduce the possibilities for non-recognition treatment of transfers of property to partnerships that have foreign partners. For more on that, see Tax Advisor Weekly Issue 32, “And Then There Were Two... One Less Way to Efficiently Migrate IP Offshore — the Impact of Notice 2015-54 on IP Partnerships” (September 29, 2015).
Alvarez & Marsal Taxand Says:
Taxpayers considering a transfer of business operations to a foreign corporation (either an actual transfer or a deemed transfer resulting from an entity classification election) will need to make a decision as to the likelihood that the proposed regulations will be finalized in their present form and, if so, whether they are likely to withstand a challenge in court. For public companies, this will be a difficult issue to address for FIN 48 purposes and any required disclosures in the Schedule UTPs.
Assuming that the proposed regulations take (and remain in) effect, they may make it undesirable to transfer operations to a foreign corporation. Alternatively, if the taxpayer decides to proceed with an outbound transfer, it will need to decide whether to elect immediate gain recognition under Section 367(a) or deferred/periodic gain recognition under Section 367(d) for goodwill and going concern value. For many taxpayers, the latter choice is likely to be more desirable. But for some, who may have expiring tax credits, the option of immediate gain recognition may represent a tax planning opportunity.
To make informed choices as to whether to transfer operations to a foreign corporation and whether to elect immediate or deferred/periodic gain recognition for goodwill and going concern value, the prudent thing would be to model out the projected after-tax consequences of those decisions.
For new foreign operations, the proposed regulations will tend to make it more desirable to operate through a foreign corporation from inception, rather than through a branch of a U.S. corporation with the possibility of incorporating a foreign subsidiary later.
Alvarez & Marsal Taxand is planning a webinar on the proposed regulations and their tax planning implications at or near the end of the comment period (December 15, 2015). Stay tuned for more information, as well as a more in-depth analysis of the validity of the proposed regulations.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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