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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
Others have analyzed the §367 and anti-repatriation aspects of Notice 2012-39 (the "Notice").1This commentary will focus on a largely-overlooked aspect of the Notice: its conclusion that the cash transferred in a transaction governed by §367 should be subject to §367(d) and treated as a prepaid royalty. It will explain why §367(d) had no immediate application to the facts set forth in the Notice, and how the IRS could have challenged the taxpayer's position in a much simpler manner that is consistent with the statutory scheme.
The Notice addressed the following simple transaction, which it assumed to be a reorganization to which §361 applied: USP, a domestic corporation, owns 100% of the stock of UST, also a domestic corporation. USP has a basis of $100 in the stock of UST, and the stock is worth $100. UST owns intangible property having a basis of zero and a fair market value of $100. USP also owns 100% of the stock of FS, a foreign corporation. FS transfers $100 of cash to UST in exchange for all of UST's assets, whereupon UST liquidates, distributing the cash to USP.
In this simple example, the Notice concludes that the $100 of cash transferred by FS to UST, and then distributed to USP, should be treated as a prepaid royalty. For the reasons set forth below, this conclusion is incorrect under the statute. But before explaining why the conclusion is incorrect, one must first understand the reasoning applied in the Notice.
The Notice states that it had come to the attention of the IRS that certain taxpayers were taking the position that the $100 of cash in the above example was not taxable to USP by reason of §356, and in addition were setting up a receivable from FS to USP (UST's successor under the §367(d) regulations), permitting future tax-free transfers of cash from FS to USP equal to future income exclusions required under §367(d). The Notice appeared to regard this position as equivalent to double counting of $100 of untaxed repatriated cash.2 But the IRS's solution to this double counting was tainted by its apparent acceptance of the taxpayer's assumption that §367(d) applied to the $100 of cash. The assumption seems to be that §367(d) applies in this example because there has been an outbound transfer of intangible property in a transaction otherwise governed by §361.
Section 367(d), by its terms, applies only to transactions described in either §351 or §361. Where §367(d) applies, the U.S. transferor is treated as having sold the intangible property for a series of payments contingent upon the property's productivity, use, or disposition. Two operative rules govern the amount deemed to be received pursuant to the deemed sale. Under rule I,3the U.S. transferor is treated as receiving the annual payments it would have received if it had actually sold the property for a stream of contingent payments. Under rule II,4if there is a subsequent direct or indirect disposition of the intangible property, the U.S. transferor is treated as receiving the amount it would have received in an arm's-length sale.
The first tax rule of direct relevance to the analysis herein is that §351 does not apply where no stock of the transferee is received or can be deemed to have been received. The law under §351 is ancient and well settled: If the sole consideration for the transfer of property to a controlled corporation consists of stock, the receipt of such stock is not taxable. If part of the consideration is cash or other boot, the transferor's gain, if any, will be recognized to the extent of that boot received. No part of the boot or stock would be treated as a royalty.5But if all of the consideration for the property transferred is paid in cash - that is, if cash in an amount equal to the full fair market value of the property is received - the transaction is not described in §351 at all; it is simply a taxable sale.6It follows from this that if a U.S. person transfers property, including intangible property, to a foreign controlled corporation in exchange for cash equal to the value of such property, §351 cannot apply, and therefore §367(d) cannot apply.7
The law applicable to §368 reorganizations, of which §361 is a part, has developed differently. As applied to the facts in the Notice, current regulations would treat the transaction as a "D" reorganization in which UST transfers its assets to FS in exchange for the $100 of cash plus a nominal share of stock and thereafter distributes that nominal share plus the cash to USP in complete liquidation.8 UST's transfer is thus described in §361 even though UST receives cash in an amount equal to the value of the property transferred. Because the transfer is described in §361, one might conclude that §367(d) can apply (which, of course, the Notice did). However, §367(d) should not apply to this case, for the same reason it cannot apply to the §351 case just described: there has been no uncompensated transfer of intangible property.
Moreover, §367(d) does not construct a deemed license; it constructs a deemed contingent payment sale. Because the fictional transaction created by §367(d) is a sale, no amount received by the U.S. transferor can possibly be a royalty or a prepaid royalty. This is in fact why §367(d)(2)(C) takes pains to provide that any deemed annual payments are to be treated as ordinary income and as royalties for purposes of §904(d). It follows that where the transferor is paid fair market value for intangible property, there has been a §1001 sale, implicating only the normal transfer pricing provisions of §482 and not §367(d).
The regulations under §367(d) do not address how that subsection operates in a case where all or part of the consideration in a §351 or §361 transaction consists of boot. The regulations appear to be limited to the paradigm case to which §367(d) was addressed in which a U.S. person transfers intangible property to a foreign subsidiary in a §351 or §361 exchange for no consideration other than stock or deemed stock. Regulations should be issued turning off §367(d) where full value is paid in cash or other boot for intangible property.9
The correct analysis of the simple example in the Notice, which would avoid any double counting of the $100 cash, is simply to conclude that §367(d) has no application where cash or other boot in an amount equal to the value of the transferred intangible property is transferred. Under this approach, only §367(a) would apply to UST's transfer of its assets in exchange for cash and a nominal share of FS stock.10That transfer would be fully taxable to UST, either because the property is not eligible for the exception in §367(a)(3) or, if it is, because the §367(a)(5) regulations would require UST to recognize its inside asset-level gain. Note that, consistent with the conclusion that §367(d) cannot apply where full value has been paid in cash for the intangible property, UST's inside gain cannot be preserved by an adjustment to USP's stock in FS deemed received in the liquidation, because USP receives only a nominal share having no basis.11
USP would recognize no gain on the distribution of cash, by reason of §356. Regulations might provide that USP is subject to §367(d) (as UST's successor) on a going-forward basis, such that any value attributable to the intangible property over and above the amount paid for it would be taken into account in future years.
Finally, FS should have a full value basis in the intangible property under §362(b). However, if the Notice's prepaid royalty approach were correct, this normative result would be called into question, because §362 provides the appropriate basis increase only where UST recognizes gain on the transfer. Because a prepaid royalty is not gain, the Notice could lead to the incorrect conclusion that FS takes the intangible property with a zero basis. This is just one last indication that the Notice is inconsistent with the statutory scheme.
This commentary also will appear in the November 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Davis, 919 T.M., U.S.-to-Foreign Transfers Under Section 367, Davis, 920 T.M., Other Transfers Subject to Section 367, and in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation.
Copyright©2013 by The Bureau of National Affairs, Inc.
1 2012-31 I.R.B. 95 (7/13/12). See, e.g., Forst and Skinner, "Notices 2012-39 and 2012-15: The IRS Use of Section 367 as an Anti-Repatriation Provision," 118 J. Tax'n (Jan 2013); Sutton, Jr. and Prabhakar, "The Consolidated Return Aspects of Notice 2012-39," 40 J. Corp. Tax'n (Jul/Aug 2013).
2 The Notice is unclear as to why this would be objectionable given the fact that USP would be required to include future §367(d) deemed payments as income. Of course, if the taxpayer took the position that the receivables balance was 100 on day one, without taking 100 of deemed income into account, the IRS would be justified in objecting.
5 The IRS argued, at least in one case, that if less than all substantial rights in intangible property were transferred, the transfer would not qualify as a §351 exchange, and presumably would be treated as a license. See E.I. DuPont de Nemours & Co. v. U.S., 471 F.2d 1211 (Ct. Cl., 1973). But in such a case, there would be nothing for §367(d) to apply to, so we must imagine that no such issue was presented in the Notice.
6 See, e.g.,C.E. Curry, 43 T.C. 667.
7 Section 367(c)(2) does not affect this analysis; it merely clarifies that a contribution to capital in which no stock is received will be treated as an exchange. The law is well-settled that there can be no contribution to capital where the consideration for the transfer is cash equal to the value of the property transferred.
8 Regs. §1.368-2(l).
9 That would leave the question how to treat boot in an amount less than fair market value of the transferred intangible property. The IRS wrestled with this very issue in CCA 20061009 (Nov. 23, 2005) (the "2006 CCA"), involving a §351 transaction. The discussion of this issue was exceptionally incoherent. Rather than attempting to determine how the payment of boot affects the amount taken into account under §367(d), the 2006 CCA decided that the question was whether the boot rule of §351(b) "trumped" §367(d), or vice versa. The 2006 CCA's analysis proceeded from the erroneous assumption that where §367(d) applies, it must apply to 100% of the value of the transferred intangible property, without diminution by reason of any boot received. This assumption is directly contrary to the IRS' own §367(d) regulations, which credit against the §367(d)(2)(A)(ii)(I) amount any disposition gain picked up under §367(d)(2)(A)(ii)(II). Regs. §1.367(d)-1T(e)(1)(iii). In any case, this issue is not relevant to the transaction described in the Notice.
10 The IRS' position is that property transferred in a §361 exchange must be governed either by §367(a) or §367(d). To the extent certain provisions in the regulations state or imply that §367(a) cannot apply to intangible property, these statements should be revised to say that §367(a) can apply where §367(d) does not.
11 Assuming that USP and UST filed a consolidated return, USP's basis in the nominal share would equal its $100 basis in the stock of UST, increased under the investment adjustment rules by the gain recognized by UST on the transfer ($100), decreased by the cash received ($100) and further decreased by $100 as a result of the deconsolidation of UST.
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