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By Herman B. Bouma, Esq. Buchanan Ingersoll & Rooney PC, Washington, DC
This commentary discusses the advantages to a foreign parent corporation of setting up a U.S. research and development (R&D) facility as a branch rather than a U.S. corporation. In particular, it focuses on the U.S. income tax advantages to a U.S. R&D facility of being a branch when making available to foreign affiliates 1 and foreign sister branches intangible property it has developed.
Consider the following facts: FCo is a limited liability business entity formed under the law of a foreign country and treated as a foreign corporation for U.S. income tax purposes. It is engaged in a trade or business, directly and indirectly through wholly owned subsidiaries, in a number of countries. (As used here, a “subsidiary” is a separate limited liability business entity, but not necessarily a corporation for U.S. income tax purposes.) FCo is planning to establish an R&D facility in the United States. It will be established as a U.S. limited liability company and, under the entity classification rules of Regs. §§301.7701-2 and -3, will be treated either as a U.S. corporation or as a U.S. branch.
The discussion below considers the U.S. income tax ramifications if the U.S. R&D facility makes available to foreign affiliates and (if it is a branch) to foreign sister branches rights to intangible property it has developed, first assuming the U.S. R&D facility is a U.S. corporation (“USCo”) and then assuming it is a U.S. branch (“USBr”).
TRANSFERS OF RIGHTS TO INTANGIBLE PROPERTY BY A U.S. CORPORATION (USCo)
Transfer Without Compensation (and Not as a Contribution to Capital) to a Foreign Subsidiary of FCo
If USCo transfers rights to intangible property to a foreign subsidiary of FCo and does so without receiving compensation therefor (and the transfer is not a contribution to capital), then there are several possibilities with respect to its characterization for U.S. income tax purposes.
If USCo transfers substantially all the rights with respect to a particular country,2 then the transfer could be characterized in one of two ways. First, it could be considered a sale and the arm's-length price determined accordingly. There are two possibilities with respect to effecting this characterization as a sale. First, the foreign subsidiary could be treated as having paid USCo the arm's-length amount and then USCo treated as having made a distribution in that amount to FCo (constituting a dividend if USCo has sufficient earnings & profits 3) and then FCo treated as having made a capital contribution to the foreign subsidiary (perhaps indirectly through other subsidiaries).4 Alternatively, USCo could be permitted, under Rev. Proc. 99-32,5 to set up a receivable from the foreign subsidiary (relating to the time of transfer) and then receive payment pursuant to the receivable.6 Second, instead of being treated as a sale, the transfer of substantially all the rights to the foreign subsidiary could be viewed as a distribution by USCo to FCo (constituting a dividend if USCo has sufficient earnings & profits) and then a capital contribution by FCo to the foreign subsidiary. Pursuant to §311(b), USCo would realize gain on the distribution equal to the difference between the fair market value of the rights at the time of distribution and USCo's basis in the rights. (USCo's basis in the rights would probably be close to zero given that USCo could expense, under §174, basis reductions incurred in conducting the R&D, e.g., depreciation reductions related to basis in equipment and full reductions related to bases in services and supplies.)
If USCo transfers less than substantially all the rights, then the transfer would probably be treated as a license, and arm's-length royalty amounts would be determined along with appropriate conforming adjustments. (Given that only “license rights” are transferred, it is unlikely that the transfer would be treated as a distribution of those rights by USCo to FCo and then a capital contribution of those rights by FCo to the foreign subsidiary.)
Transfer as a Contribution to Capital
If USCo transfers the rights to intangible property to a foreign subsidiary of FCo and the transfer is considered a contribution to capital,7 then USCo would be receiving stock in the foreign subsidiary (or, if it already owned stock in the subsidiary, and did not receive additional stock, then, pursuant to §367(c)(2), it would be deemed to receive stock in the foreign subsidiary). The transfer might or might not qualify as a transaction subject to §351.8 If it does not, USCo would immediately be subject to taxation on the gain realized.9
If the transaction does qualify as a §351 transaction, ordinarily it would be tax-free. However, because USCo is a U.S. corporation and the foreign subsidiary of FCo is a foreign corporation (or part of a foreign corporation), the transfer would be subject to §367(d) (which applies to transfers of rights in intangible property as defined in §936(h)(3)(B)). Under §367(d)(2)(A), USCo would be treated as “having sold such property in exchange for payments which are contingent upon the productivity, use, or disposition of such property, and … receiving amounts which reasonably reflect the amounts which would have been received … annually in the form of such payments over the useful life of such property …” and the amounts taken into account must be “commensurate with the income attributable to the intangible.” Section 367(d)(2)(C) provides that any such amount included in gross income is treated as ordinary income and, for purposes of applying §904(d) (the foreign tax credit limitations), any such amount is treated as if it were a royalty.
Thus, if USCo transfers the rights to intangible property to a foreign subsidiary as a contribution to capital, USCo either will be immediately taxed on the appreciation in the rights or will be deemed to receive from the foreign subsidiary royalty payments in compensation for the rights.
TRANSFERS OF RIGHTS TO INTANGIBLE PROPERTY BY A U.S. BRANCH (USBr)
Transfer Without Compensation (and Not as a Contribution to Capital)
If USBr transfers rights to intangible property to a foreign corporation different from that to which it belongs and does so without receiving compensation therefor (and the transfer is not a contribution to capital), the analysis would be the same as that set forth above for USCo. However, if a distribution is considered to have occurred, that would be considered a distribution from USBr, which could trigger the branch profits tax under §884.10 If an income tax treaty applies, that tax might be significantly reduced by the “Dividends” article of the treaty.11 However, if rights to intangible property are considered distributed, the branch profits tax might be minimal, given that §311(b) would not apply and USBr might have a very low basis in the rights as a result of the operation of §174.
If USBr transfers rights to intangible property to a foreign sister branch (i.e., a foreign branch of the foreign corporation of which it is a part) and does so without receiving compensation therefor,12 then, if no income tax treaty applies, it is likely that the only repercussion would be the possible triggering of the branch profits tax. Moreover, if only “license rights” are transferred to the other branch, this might not constitute a distribution for purposes of the branch profits tax. (It should be noted that sales income realized by the foreign branch from foreign sales of products produced by such branch using intangible property developed by USBr would not be subject to tax by the United States as effectively connected income.13)
If an income tax treaty applies, then, because USBr would be treated as a “distinct and independent enterprise,” the analysis might be the same as if the transfer were to a foreign corporation different from that to which USBr belongs. Thus, USBr might be treated as having sold or licensed the rights to the intangible property to the foreign branch to which the rights were transferred. However, a taxpayer could always elect to apply the Code provisions and not the treaty provisions.14
For U.S. income tax purposes, it would be possible, assuming all foreign subsidiaries of FCo are “eligible entities” within the meaning of Regs. §301.7701-3(a), to treat them all as part of FCo. Thus, FCo would be treated for U.S. income tax purposes as a foreign corporation with many branches, including USBr. Therefore, rights to intangible property, including both substantially all rights and license rights, could possibly be transferred to sister branches without adverse tax consequences.
In his budget proposals released on May 11, 2009, President Obama proposed modifying the entity classification rules by providing that “a foreign eligible entity may be treated as a disregarded entity only if the single owner of the foreign eligible entity is created or organized in, or under the law of, the foreign country in, or under the law of, which the foreign eligible entity is created or organized.” 15 Although the proposal is aimed at tax planning used by U.S. persons to avoid taxation under the controlled foreign corporation (CFC) rules, literally this language would also prevent FCo from “checking the box” with respect to all of its subsidiaries (assuming they are formed in jurisdictions other than that in which FCo is formed).
Transfer as a Contribution to Capital
If USBr transfers the rights to intangible property to a foreign corporation (different from that to which it belongs) as a contribution to capital, and the transfer is structured so as to qualify for treatment under §351, then the transfer would be tax-free. Section 367(d) would not apply because USBr is a branch of a foreign corporation and, therefore, not a U.S. person.16 Dividends received from the foreign corporation would not be effectively connected income.17 If an income tax treaty applies, the §351 transfer would likely still be tax-free,18 but the dividends received might be considered attributable to the permanent establishment. As mentioned earlier, USBr could elect to apply the Code provisions and not the treaty provisions.
Transfer without compensation (and not as a contribution to capital): If USCo transfers intangible rights without compensation (and not as a contribution to capital) to a foreign affiliate, either the transfer would be subject to §482 (and USCo would realize sales income or royalties) or USCo would be treated as having made a distribution of rights to intangible property (which would be subject to §311(b) and treated as a dividend to the extent of its earnings and profits). A similar result would obtain for USBr, except a distribution from USBr of rights to intangible property would not be subject to §311(b) and might be subject to minimal branch profits tax because of low basis. If USBr makes a transfer of intangible rights to a foreign sister branch, there might very well be no U.S. income tax consequences, particularly if USBr simply makes license rights available.
Transfer as a contribution to capital: If USCo transfers intangible rights as a contribution to capital to a foreign affiliate, it either would be subject to immediate gain recognition or would be subject to the deemed-royalty rules of §367(d). However, if USBr makes such a transfer to a foreign affiliate, it would be tax-free for U.S. income tax purposes, assuming it qualifies as a §351 transaction.
This commentary also will appear in the October 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Connors, 909 T.M., The Branch-Related Taxes of Section 884, and Davis, 919 T.M., U.S.-to-Foreign Transfers Under Section 367(a)and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.
1 As used here, the term “affiliate” refers to a related person that is a corporation for U.S. income tax purposes.
2 In the case of an invention, patent rights with respect to different countries may be considered different assets and each may be sold or licensed. Generally, if substantially all the rights in intangible property (with respect to a particular country) are transferred, that is referred to as a sale; if less than substantially all the rights are transferred, that is referred to as a license. See, e.g., Regs. §1.1235-2(b). References herein to “substantially all” or “less than substantially all” of the rights to certain intangible property are in reference to a particular country.
4 The regulations provide that a conforming adjustment may consist of a deemed dividend or deemed capital contribution. Regs. §1.482-1(g)(3)(i).
5 1999-2 C.B. 296. Rev. Proc. 99-32 superseded Rev. Proc. 65-17, 1965-1 C.B. 833, which provided somewhat similar rules. Rev. Proc. 99-32 can be applied only when both parties to the controlled transaction are corporations. Rev. Proc. 99-32, Explanation of Provisions, E. The revenue procedure states that controlled transactions involving other types of related parties are “the subject of further study by the Service.”
6 The regulations provide that a conforming adjustment may, pursuant to an applicable revenue procedure, consist of a deemed loan. Regs. §1.482-1(g)(3)(i). See also Regs. §1.482-1(g)(3)(ii), Ex.
7 It is assumed that the rights would have to be substantially all the rights in the intangible property in order to constitute a contribution to capital, i.e., license rights involving USCo as the licensor could not be transferred to a foreign affiliate as a contribution to capital.
8 Section 351(a) provides, “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.”
10 Under §884, the distribution of the rights to intangible property could be considered a “dividend equivalent amount” and subject to tax under §881(a) at a 30% rate.
11 See Article 10(8) of the U.S. Model.
12 The transfer could not be considered a capital contribution since it is being made to a sister branch.
14 See U.S. Technical Explanation of the U.S. Model, Article 1 (General Scope), Paragraph 2.
15 Department of the Treasury, General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals, May 2009, p. 28.
16 Section 367(a) and (d) only apply to transfers by a U.S. person to a foreign corporation. §367(a)(1) and (d)(1).
18 Treatment of the permanent establishment as a “distinct and separate enterprise” should not render it a U.S. transferor for purposes of the §351 transfer, and thus the transfer should not be subject to §367.
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