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By James J. Tobin, Esq.
One of the (few) advantages of getting older is having an institutional memory. This came in handy when I read that the Treasury/IRS 2010-2011 Priority Guidance Plan includes revisiting the §367(d) temporary regulations that date back to 1986. (As an aside, are they really temporary when they've been around for 25 years? When I got my 25-year pin from EY, I wasn't thinking my international tax career was temporary. But maybe I could still quit this temporary tax gig and go play for the Yankees.) It's great the government is taking another look at this area; after all, the world is a very different place for global companies than it was in 1984 when Congress enacted the modern incarnation of §367(d) and in 1986 when Treasury originally delivered the temporary regulations. The fierce competition U.S.-based multinationals face in global markets, coupled with the complexity of cross-border transactions today, makes review of these rules a high priority.
I'm not the only one excited about the potential to see these temporary regulations brought up to date. The New York State Bar Association (NYSBA) Tax Section issued an outstanding report on §367(d) in October 2010 that addresses many open issues and makes a number of cogent recommendations. So §367(d) is now prominently on the tax radar screen. And, coincidentally, I've had some recent experience grappling with these issues in practice, which makes me especially glad that's the case and eager for some good news to come.
As Treasury sits down to revise the temporary regulations, I hope the drafters remember Congress's intent when it enacted §367(d) as part of the Deficit Reduction Act of 1984. At that time, the government had real concerns that U.S. companies could transfer valuable intangible property to foreign affiliates without a tax toll charge on the value leaving the U.S. tax system. Recall the result in the seminal case of Eli Lilly, where the U.S. government was unsuccessful under the pre-§367(d) tax law then applicable in its challenge to the transfer of patents and manufacturing know-how to Eli Lilly Puerto Rico in a nontaxable §351 transaction with the income from the transferred assets accruing to Eli Lilly Puerto Rico. And developments in theis regard continued, of course, with the addition of the commensurate with income standard to §§482 and 367(d) in the 1986 Act.
Let's start with the basics: the purpose of §367(d) is to require a U.S. person that transfers intangible property to a foreign corporation in an exchange described in §351 or §361 to recognize income equal to the income it would have recognized through a license of the intangible. Section 367(d) accomplishes this by requiring the inclusion of deemed royalties over the useful life of the transferred property (but, as the temporary regulations tell us, not in excess of 20 years).
So there should be no potential U.S. tax benefit from an outbound §351 transfer of intangible property as opposed to a license of the intangible property to the foreign corporation. Thus, there would be no tax reason for a U.S. company not to license or cost share (subject obviously to the very burdensome cost-sharing regulations) the intangible property instead of transferring the property to the foreign corporation in exchange for shares. So policy objective achieved! In fact, as illustrated in the example discussed below, due to many of the vagaries of the §367(d) temporary regulations, it seems to me to almost always be desirable to avoid §367(d) and instead license or actually sell the intangible property to the foreign corporation, particularly in order to get equal treatment of the transaction in the United States and the foreign country. The problem arises, however, when, for commercial reasons, a "tax-free" transfer of intangible property cannot be avoided (for example, in a third-party joint venture scenario) and then one must deal head-on with §367(d) and the temporary regulations.
There are many things not to like about the current temporary regulations. In my view, the problems are rooted in the creation of a one-sided fictional transaction – i.e., for U.S. tax purposes only, and not for legal, accounting, or foreign tax purposes. This is the same type of unilateral recharacterization that I whined about in a commentary recently with respect to part IV of the OECD Business Restructuring Report. Fortunately, the final version of that report at least made very clear that such a one-sided recharacterization would occur only in "exceptional cases." Seems to me §367(d)'s broad application to outbound transfers of intangible property (exacerbated by interpretations reflected in the temporary regulations), particularly in today's global economy, goes way beyond "exceptional."
To illustrate some areas of concern created by the §367(d) construct, let's examine a simple hypothetical fact pattern. Let's assume a U.S. corporation (USP) intends to contribute a disregarded foreign entity (F1) to a foreign joint venture (FJV) solely in exchange for FJV shares. Let's further assume that F1 owns §367(d) intangible property with a fair market value of $150x and an adjusted tax basis of $100x.
The first instinct of USP, having surely been warned of the potentially dire consequences of §367(d), might be to simply recognize the full $50x gain in the §367(d) intangible property up front as a cost of entering into the joint venture deal. The current temporary regulations, however, provide only a limited election to have the "privilege" of current gain recognition rather than ongoing deemed royalty treatment. In this example, to qualify for the election, either USP's ownership of FJV must be between 40% and 60% and the intangible property must represent less than 50% of F1's assets, or the intangible property must be an "operating intangible." I would submit that because of the protection afforded the government by the commensurate with income rules of §482, Treasury could and should be much more liberal in allowing a gain recognition election, particularly in the case of a foreign joint venture.
Assuming the gain recognition election is not available, the current temporary regulations would require USP to recognize annually deemed royalty payments from FJV based on the productivity or use of the transferred intangible property. So it's necessary to construct a "pretend license" between USP and FJV to ascertain the amount of the annual deemed royalty, which is clearly inconsistent with the commercial agreement of the parties and with how the foreign tax authorities see the transaction. Nonetheless, that's what §367(d) and the current temporary regulations require.
It seems to me that it's tougher to determine the arm's-length royalty for a pretend license than for a real license (and there's lots of hand-wringing these days about how tough it can be to determine the arm's-length royalty for a real license). At least a real license defines the rights and obligations of the parties and provides the terms and basis of calculating the royalties (e.g., based on sales, units of production, gross margin, declining or flat royalty schedule, etc.). In the case of a pretend license, how should USP's lack of ongoing obligation to develop, fund, or direct the exploitation of the intangible property that has been transferred to the FJV through full legal and economic ownership influence the deemed royalty amounts? The NYSBA report suggests, and I agree, that USP should be permitted to establish reasonable terms for the deemed royalty payments, akin to drafting a pretend license agreement to support its calculations of the required pretend royalties. One fiction begets another and the tax folk get more interesting work – what's not to like?
So let's assume USP's pretend license agreement with FJV produces an annual pretend royalty of $20x. The next issue to be addressed is whether and how USP should recover its $100x adjusted tax basis in the intangible property. If USP had actually licensed the property to FJV, it presumably would be claiming amortization deductions over the property's useful life or over 15 years under §197. Alternatively, if USP had sold the intangible property to FJV for contingent payments based on the future use of the property, the contingent sale would likely be accounted for as an open transaction and USP would be able to recover the $100x adjusted tax basis as it received the contingent payments. (Interestingly, the §367(d) statutory language indicates contingent sale treatment for the transaction while the temporary regulations require income inclusion as if from a license.) The temporary regulations, however, seem to provide USP no basis recovery, at least not until an eventual disposition of the intangible property. I can think of no technical or policy reason for such a result. In my view, the more appropriate approach would be to follow the contingent sale approach contemplated by the statute, allowing USP to recover its adjusted tax basis against the deemed contingent payments and providing appropriate earnings and profits ("e&p") deductions to FJV.
The next area of focus for USP would be the deemed receivable that can be created for the pretend royalty or contingent payment. Since FJV will not actually pay USP a royalty, the current temporary regulations permit USP to establish annually a pretend receivable from FJV. If USP receives payments from FJV within three years, presumably dividends, it can treat the payments as received instead in satisfaction of the pretend receivable. Some interesting consequences also may arise here when one thinks about the foreign tax credit aspects of the §367(d) fiction. As noted above, the pretend royalty payments will create e&p deductions to FJV but will not be deductible for local tax purposes, thus increasing the §902 effective tax rate of FJV above the local statutory tax rate. However, because the increased §902 effective tax rate will apply to all dividends paid by FJV (including those paid to the other venture participants), USP will get a potential foreign tax credit benefit for only part of the §902 rate effect. Depending on the magnitude of the §902 rate effect, USP may be better off not treating a portion of its dividend as payment in satisfaction of the pretend receivable. For example, to the extent USP treats a portion of a dividend as payment in satisfaction of a pretend receivable, a greater percentage of e&p is paid out to the other JV parties, further diluting USP's foreign tax credit. Of course, as USP is analyzing all of its options and the collateral consequences with respect to the pretend receivable, it can't forget that the current temporary regulations contain an arbitrary three-year rule after which the pretend receivable is automatically capitalized into the equity of FJV. I'd recommend that new regulations eliminate the trap of the three-year rule, and instead permit USP to determine the timing and extent of any capitalization of the pretend receivable.
There are lots of other complexities and problems in the §367(d) area that are beyond the scope of this short rant. I would recommend to readers the NYSBA Report. While I appreciate the need for appropriate anti-avoidance rules in appropriate areas of the tax law, I do think the current §367(d) approach really is overkill. It is needlessly complex in some areas and is flawed in other areas, such as the unsymmetrical treatment of the transaction and the hidden traps for the unwary. As I noted above, given the other protections in the tax law, including the commensurate with income standard and tightened cost-sharing regulations, I would urge that Congress and the Treasury join forces for the positive here by considering narrowing the scope of §367(d) to U.S.-developed intangibles and liberalizing the current gain recognition rules. Unfortunately, legislative proposals included in the Administration's FY 2010 and 2011 budgets would go the other direction and would expand §367(d)'s scope.
Sadly there doesn't seem to be hope that §367(d) as we know it might go away, but let's hope Treasury dedicates immediate resources to modernizing and improving the well-aged temporary regulations that contain the operative rules under that section. After all, a new century has dawned since those temporary regulations were issued, bringing with it an environment for U.S. companies that is characterized by both more global activity and more competitive pressure.
This commentary also will appear in the March 2011 issue of BNA's Tax Management International Journal. For more information, in the Tax Management Portfolios, see Davis, 920 T.M., Other Transfers Under Section 367, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.
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