Proposed Regulations Eliminate Foreign Goodwill Exception for Outbound Business Transfers
Proposed regulations published on September 15, 2015 would significantly change a key rule concerning how the incorporation of a foreign branch of a U.S. corporation is taxed. Under regulations issued in 1986 a branch of a U.S. corporation that conducts an active trade or business outside the United States may be incorporated in a foreign corporation and the foreign goodwill associated with that active trade or business may be transferred to the foreign corporation free of U.S. tax. These new proposed regulations seek to expand U.S. taxing jurisdiction by making the transfer of such foreign goodwill and going concern value taxable. In the preamble to the proposed regulations, the Treasury and the IRS state that allowing foreign goodwill to be transferred tax-free would be “inconsistent with the policies of section 367 and sound tax administration.”
The corporate non-recognition rules
The Internal Revenue Code provides detailed rules concerning the taxation of various asset transfers involving a domestic corporation (e.g., the transfer of assets to a domestic corporation by its controlling shareholders, the transfer by a domestic corporation to its shareholders when the corporation is liquidated, and the transfer by a domestic corporation that is a party to various types of corporate reorganizations). Section 367 addresses how these rules apply when property is transferred to a foreign corporation in a transaction that would otherwise be tax-free under one of the aforementioned non-recognition rules.
The general rule found in section 367 is that the foreign corporation is not treated as a corporation and the transfer is taxable. There are several exceptions to this general rule, however. For example, gain generally is not recognized if property is transferred to a foreign corporation for use by such corporation in the active conduct of a trade or business outside the United States (the “active trade or business exception”). This exception is itself subject to various exceptions. Thus, gain must be recognized on the transfer of certain property (e.g., inventory, and accounts receivable) even if the property is used in the conduct of an active trade or business. Notably, intangible property as defined in section 936(h)(3(B) is carved out of the active trade or business exception and dealt with separately by section 367(d).
Section 367(d) and foreign goodwill
A transfer of intangible assets to a foreign corporation receives special treatment under section 367. Section 367(d) provides that a transfer of certain enumerated intangible property to a foreign corporation is treated as a sale of that property by the transferor to the foreign corporation contingent upon the productivity, use or disposition of the property.
The list of intangible property subject to section 367(d) references the list in section 936(h)(3)(B), which is narrowly drawn and does not explicitly include goodwill or going concern value. Moreover, the legislative history of section 367 provides that outbound transfers of foreign goodwill and going concern value are not taxable under section 367(d). When a foreign active trade or business is incorporated, the transfer of associated foreign goodwill and going concern value also should not be subject to tax under the active trade or business exception found in section 367(a)(3).
The IRS has argued, however, that the transfer of goodwill and going concern value is an enumerated intangible asset and such transfers are taxable under section 367(d). Unsure that this position has a firm foundation in current law, the Obama administration’s budget has, for a number of years, proposed legislation that would clarify this area of law. The Congress has failed to enact such legislation, however. The IRS also has been dissatisfied with the regulations under section 367(d). For at least five years, the IRS business plan listed a regulations project under section 367(d).
Rationale for eliminating the foreign goodwill exception
Abuses identified by the IRS
The scope of the active trade or business exception in section 367 has been the subject of controversy for a number of years. The most recent source of controversy centers on the transfer of assets by “section 936 companies” to controlled foreign corporations. In the past, section 936 companies received tax benefits for performing certain activities in Puerto Rico. However, as those tax benefits were phased out over a number of years, section 936 companies transferred their businesses to controlled foreign corporations in other jurisdictions.
In connection with the outbound transfer of assets by section 936 companies, the IRS argued that such companies made taxable transfers of valuable intangible assets. The IRS has instructed his agents to carefully scrutinize any taxpayers claim that it has transferred foreign goodwill and going concern value. To the best of the author’s knowledge, this issue was never litigated in the courts.
The preamble to the temporary and proposed regulations states that taxpayers have abused the foreign goodwill exception through their choice of transfer pricing methods. The preamble offers that some taxpayers have valued business assets on an item-by-item basis leaving a large residual value to be allocated a foreign goodwill. The IRS argues that valuing the business assets using an aggregate method would be more accurate. Also, according to the IRS, some taxpayers have tried to include in foreign goodwill and going concern “value [that] was associated with a business operated primarily in the United States where the business simply earn income remotely from foreign customers.”
Link to the legislative history
The preamble to the temporary and proposed regulations refers to the legislative history of section 367(d). The preamble notes that the Congress did not believe that providing an exception for foreign goodwill and going concern value would be abusive: “[Congress] does not anticipate that the transfer of goodwill or going concern value developed by a foreign branch to a newly organized foreign corporation will result in an abuse of the U.S. tax system. [Citations omitted.]”
The preamble next discusses whether the Treasury and the IRS could write regulations that would keep the foreign goodwill exception while preserving the U.S. tax base. After discussing how to address the issue might be addressed, the preamble concludes:
The Treasury Department and the IRS ultimately determined, however, that such an approach would be impractical to administer. . . . Given the amounts at stake, as long as foreign goodwill and going concern value or afforded favorable treatment, taxpayers will continue to have strong incentives to take aggressive transfer pricing positions to inappropriately exploit the favorable treatment of foreign goodwill and going concern value, however defined, and thereby erode the U.S. tax base.”
The proposed regulations
The proposed regulations modify the active trade or business exception in several respects for the purpose of eliminating the exception for foreign goodwill and going concern value. First, only certain classes of assets are eligible for the active trade or business exception under the proposed regulations. This class of assets is referred to as “eligible property.” “Eligible property” is defined as tangible property, working interests in oil and gas property, and certain financial assets (e.g., cash and securities). Property that is clearly described in section 936(h)(3)(B) remains subject to tax under the rules in section 367(d).
Significantly, the proposed regulations define the term “intangible property” to mean either property described in section 936(h)(3)(B) or property to which a US person applies section 367(d) under Reg. § 1.367(a)-1(b)(5). This latter class of property is property that is otherwise taxable under section 367(a), provided it is not eligible property. Thus, property that is neither eligible property nor property clearly described in section 936(h)(3)(B) would be taxable under section 367(a) unless the taxpayer elects to apply the rules of section 367(d). The regulations under section 367(d) also are modified to eliminate the 20-year useful life assumption for intangible property. Thus, there is no limit on the period of time for which payments are due under section 367(d).
The proposed regulations would be effective from September 14, 2015. However, the Treasury and IRS did not withdraw the final regulations. Thus, at this time, the final regulations remain in effect, but they could be overridden retroactively once the proposed regulations are issued in final form. To what extent the foreign goodwill and going concern exception will be preserved when the proposed regulations are finalized is unclear. The preamble to the proposed regulations states “comments are requested on whether, with respect to the proposed elimination of the foreign goodwill exception and narrowing of the scope of the ATB exception, a limited exception should be provided for certain narrow cases where there is a limited potential for abuse. One such case, for example, might be a financial services business that operates in true branch form and for which there is a regulatory pressure or compulsion to incorporate the assets of the branch in a foreign corporation.”
Until the proposed regulations are finalized, the taxability of a transfer of foreign goodwill and going concern value is uncertain. However, some bold taxpayers may be tempted to rely on the existing final regulations and take the position that the proposed regulations either will be finalized with a prospective effective date or will be held invalid by the courts for the reasons discussed below.
Some taxpayers believed that the statute itself provides for an exception for foreign goodwill and going concern value when a foreign active trade or business is incorporated. The current regulations are consistent with this view, and they have been in effect for nearly 30 years. While the Treasury and the IRS dislike this provision, they have failed to convince the Congress to change the law.
Faced with these realities, the government has creatively taken another approach by implicitly adopting the view that foreign goodwill is not an intangible asset described in section 936(h)(3)(B). Thus, the government now seeks to rely on section 367(a)(3)(A), which allows the Secretary to exclude property from the active trade or business exception by regulation. Thus, the government now argues that it is not up to the task of policing the foreign goodwill exception that Congress intended. In this regard, the preamble offers no evidence of the government’s failures or successes. It also offers no quantification of the potential revenue loss created by taxpayers’ “abuses.”
The author believes the courts are unlikely to defer to an agency’s assertion that it should not follow Congressional intent absent substantial supporting evidence. Should the courts adopt the low threshold that is implicitly advocated by the Treasury and the IRS in the preamble, agencies could effectively override a Congressional mandate by asserting that, in their discretion, a particular provision could not be effectively enforced by the agency.
 See, e.g., section 351, section 332, section 338. Section 367(a)(1). Section 367(a)(3). Section 367(a)(3)(B). Section 367(a)(3)(B)(iv). As foreign goodwill and going concern value is not an asset described in section 936(h)(3)(B), it is an asset that falls within the scope of the active trade or business exception. For example, see General Explanations of the Administration's Fiscal 2016 Revenue Proposals, 24, available at http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2016.pdf/:
The proposal would clarify the definition of intangible property for purposes of sections 367(d) and 482 to include workforce in place, goodwill and going concern value. The proposal also would clarify that where multiple intangible properties are transferred, the Commissioner may value the intangible properties on an aggregate basis where that achieves a more reliable result. See IRS Audit Guidelines for Former Section 936 Possessions Corporations, IRS LMSB Industry Director Directive on Section 936 Exit Strategies, LMSB-04-0107-002, 2/2/2007: “In a significant exception to the general rule, transfers of foreign goodwill and going concern value in outbound section 351 and 361 exchanges are not subject to tax under section 367(d). The existence of this exception often leads U.S. transferors to contend that a significant portion of the intangibles transferred in a section 351 or 361 exchange, particularly marketing intangibles and workforce in place, should be treated as foreign goodwill and going concern value. Such claims should be carefully scrutinized, and the nature of all transferred intangibles should be examined to determine whether it would be more appropriate to treat the claimed foreign goodwill and going concern value as intangibles subject to section 367(d). Likewise, in the case of section 936 conversions, it may be appropriate to consider whether claimed foreign goodwill and going concern value is really foreign. It may be that these intangibles are goodwill and going concern value, but are not foreign and thus are subject to tax.” Reg. § 1.367(a)-2(b). Proposed regulations have no legal effect until finalized.
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