“You can’t change the past.”
We don’t know who owns the copyright to that saying. But most of us have probably infringed on that intangible property (IP) right numerous times, and a quick Google search will expose dozens of famous people for that same transgression. If nothing else, this belief (whether copyrighted or not) seems to be universally accepted.
By such conventional wisdom, Congress appears to have engaged in an effort to change legislative history by means of subsequent legislation in the Tax Cuts and Jobs Act (TCJA). Specifically, the TCJA included a provision (Act Section 14221) that appears to be an attempt to retroactively change the interpretation of code Sections 367 (dealing with transfers of property by U.S. persons to foreign corporations), and 482 (dealing with related party transfer pricing) in regard to the required valuation methodology for the transfer of IP rights in the context of “outbound” restructuring transactions, as well as in intercompany transfer pricing arrangements.
The Change in Question
The change relates to an issue with respect to which the Internal Revenue Service has suffered some high-profile litigation losses. The issue is whether transfers of IP should be valued on an item by item basis, on an aggregate basis or if an alternative principle should be applied. The Service’s position is that Sections 367 and 482, prior to the TCJA, authorized the Service to require aggregate basis valuation and the application of the realistic alternative principle, if the Service determined that those approaches achieved a more reliable result. But the Service has had little success in convincing courts to accept that position. In light of the Service’s lack of success, Congress codified the Service’s position in TCJA section 14221(b).
Potential Retroactive Impact
There is little question that Congress had the authority to codify the Service’s position prospectively. But there would seem to be a legitimate question as to the authority of Congress to change the past. The possibility that Congress may have already attempted this is seen by its choice of wording for the heading to Section 14221(b) (“Clarification of Allowable Valuation Methods”) and for the effective date language in Section 14221(c). The heading to Section 14221(b) reads: “Clarification of Allowable Valuation Methods.” That, alone, would seem to send a clear message that this Congress believes that the Service’s position has been right all along.
In regard to the effective date language in Act Section 14221(c), it is relevant to note that the valuation rules added by the TCJA to code Sections 367 and 482 were added by Section 14221 changing the definition of “intangible property” to include goodwill and going concern value. Sections 14221(a) and (b) effectively changed the definition of IP as well as the valuation rules. The effective date provision in 14221(c)(1) says that “the amendments made by this section shall apply to transfers in taxable years beginning after December 31, 2017.” Section 14221(c)(2) then goes on to say the following:
“Nothing in the amendment made by subsection (a) shall be construed to create any inference with respect to the application of Section 936(h)(3) of the Internal Revenue Code of 1986, or the authority of the Secretary of the Treasury to provide regulations for such application, with respect to taxable years beginning before January 1, 2018.”
It is important to note that Section 14221(c)(2) does NOT say that the amendment made by subsection (b) should not be construed to create an inference as to prior law. The Service could point to that distinction as creating a presumption, under one of the longstanding canons of statutory construction, that Congress intended for its “clarification” to the valuation rules to apply retroactively.
It is critical to understand the relative weight that should be accorded to any canon of statutory construction. Canons of statutory construction are tools used by judges (and by those attempting to predict what judges will decide) to interpret the language in statutes and regulations where there is some ambiguity as to their meaning. Canons of construction create presumptions, based on logical analysis of the language chosen by the drafters as well as other relevant circumstances, as to what the drafters intended. But like most presumptions, those created by canons of statutory construction may be rebutted.
It is one thing for Congress to indicate that an amendment to the code is not intended to create any inference as to prior law. It is perfectly within Congress’ authority to refrain from expressing an opinion as to prior law. It is quite another thing for Congress to indicate that an amendment to the code is intended to create an inference as to prior law. In that case, Congress would express its opinion as to prior law. It is recognizable that this is not the first time a Congress has sought to “clarify” prior law. It seems that Congress’ ability/authority (if any) to do so may depend to some extent on how old the prior law is.
The determination of whether the Service’s position on IP valuation should prevail in fact patterns pre-dating the TCJA would seem to involve an exercise in determining legislative intent for Sections 367 and 482, as those sections existed prior to the TCJA. It is relevant to note that the Congress that made Section 367 what it was just prior to the TCJA was the 98th Congress (by way of the Deficit Reduction Act of 1984); and the Congress that made Section 482 what it was just prior to the TCJA was the 99th Congress (by way of the Tax Reform Act of 1986). The question is whether the 115th Congress, more than 30 years later, in 2017, had any more authority to say over the previous Congresses.
This question of whether a subsequent Congress has the authority to determine the legislative intent of a prior Congress is interesting. An in-depth analysis of that Constitutional question is beyond the scope of this article. But there would appear to be reason to question the existence of any such authority. Putting that point aside, the purpose here is to address the more practical question of how taxpayers should be prepared to deal likely attempts by the Service to apply the TCJA’s changes to Sections 367 and 482 retroactively to transfers in taxable years beginning before January 1, 2018.
The codification of the IRS’ longstanding position relative to the valuation of transferred “intangible property” – explicitly including goodwill, going concern, workforce-in-place, etc. – will no doubt alter the debate over the fair market value (FMV) of intangible property in an outbound transfer. To best frame out the potential issue at hand one must first outline the practical effect of the TCJA on the determination of the FMV of intangible property and the appropriate approach for valuing transferred intangible property under the TCJA. That discussion will shed light on why this could be a concern for taxpayers who transferred intangible property prior to the passage of the TCJA.
To properly frame out the issue, it is important to know what not to do from a valuation standpoint, given that some of the historical approaches to valuing intangible assets may in fact form the crux of potential issues associated with pre-2018 intangible asset transfers. As a general rule, do not utilize a relief-from-royalty approach to value the transferred IP on an item by item basis, as this approach does not capture value beyond the rights associated with licensing the specific item of IP in question (thus excluding other items of transferred IP, including goodwill, going concern, workforce-in-place, etc.). Furthermore, if transferring an intangible asset that was recently acquired from a third party, do not utilize the value of the asset that was derived for financial reporting purposes if it was estimated utilizing the relief-from-royalty approach. While acceptable for financial reporting purposes, this value typically is not acceptable for tax purposes as part of an outbound transfer of the asset as mentioned above.
What to do from a valuation standpoint under the TCJA rules? When transferring IP, the default valuation approach (i.e. in the absence of a comparable uncontrolled transaction for the same or similar IP) should be a multi-period excess earnings method (MPEEM), taking into account the combined earnings from all items of IP included in the transfer. As you can imagine, the result of the application of the MPEEM, and corresponding inclusion of aggregated intangible assets, will often result in a higher FMV for transferred IP. One would not expect this to be a contentious issue for intangible assets transferred after the passing of the TCJA given the clarity in the new law. However, as suggested above, what if the IRS utilizes the TCJA to support its position of FMV on pre-2018 IP transfers? Under the premise that the FMV of transferred IP will be higher pursuant to the TCJA, the issue at hand for taxpayers is if the IRS utilizes the TCJA to ascribe value to pre-2018 intangible asset transfers. In this case, taxpayers could be susceptible to the possibility that their previously transferred intangible assets were undervalued. While one cannot predict the actions of the IRS or the supportability of that position, given this uncertainty and the risk of an unfavorable IRS audit, companies may want to consider whether a tax reserve is warranted. This would entail estimating the FMV of the previously transferred IP consistent with the “clarified” standards mentioned above. Most likely this position would result in a higher FMV.
Possible Economic Rebuttal to the Aggregate Approach Requirement for Pre-TCJA Transfers
An interesting economic question arises for those taxpayers who are willing to concede that the valuation rules in the TCJA may be applied retroactively but are not willing to concede that the revised definition of IP (to include goodwill and going concern value) should be applied retroactively. The question relates to how, in applying the MPEEM approach described above, we can exclude any earnings produced by goodwill and going concern value that are related to the transferred IP.
An example of a situation where at least a portion of goodwill and going concern value may be excluded is a transfer of technology IP with a finite life. If the position is that only the current generation of IP is being transferred (and not future generations), the valuation should exclude cash flows and hence value attributable not only to future technology generations but also goodwill that is associated with the perpetual value of the company. If the rights to the current generation of technology are being acquired and the acquirer of the IP must continually invest in research and development to produce a commercially viable product, arguably they would only pay for the current technology generation. This of course assumes the transferred IP is associated with a developed business.
In cases where a company has acquired a business that is in an emerging phase, and then transfers that business’ IP to a related entity, the IRS will take the position that most if not all of the recent purchase price reflects the FMV of the transferred IP (given the lack of significant goodwill in an early stage company). Essentially the IP is in fact the entire value of the business. In this case the burden falls to the taxpayer to identify and value assets other than the transferred IP, e.g. working capital, fixed assets or other intangible assets that may not have been included in the transfer i.e. local distribution network, etc.; and deduct the FMV of these assets from the purchase price.
In many cases, there may not be a reliable method for excluding any earnings produced by goodwill and going concern value that are related to the transferred IP in applying the MPEEM approach described above (to determine the value of the transferred IP on an aggregate basis). In that case, if goodwill and going concern value is thought to be substantial, the aggregate approach may simply not be a reliable method for valuing the transferred IP, as compared to an item by item approach using some other acceptable approach (e.g. the Comparable Uncontrolled Transaction method).
Companies who feel comfortable with the position that the 115th Congress does not have the authority to legislate history (i.e. to “clarify” what was intended by the 98th and 99th Congresses), may not need to consider increasing their tax reserves for pre-TCJA IP transfers to account for the TCJA valuation changes in Sections 367 and 482 (assuming that their audit firms agree, and assuming that there are no other reasons for increasing reserves). Those who cannot get to that comfort level need to seriously consider creating new reserves based on this recent “clarification” of prior law rules for the valuation of IP. See, e.g., Veritas v. Commissioner, 133 T.C. 297 (2009); and Amazon.com Inc. et al. v. Commissioner, 148 T.C. No. 8 (2017). Id. See, e.g., Sullivan v. Finkelstein, 496 U.S. 617, (1990) at 631 (Scalia, J., concurring in part, stating “[t]he legislative history of a statute is the history of its consideration and enactment. ‘Subsequent legislative history’—which presumably means the post-enactment history of a statute’s consideration and enactment—is a contradiction in terms.”