Strategies to Avoid The Section 367 Tax On Outbound Transfers
Section 367 has two basic purposes
First, Section 367 ensures that (with certain exceptions) a tax liability or “toll charge” is imposed when property with untaxed appreciation is transferred abroad. This is accomplished by treating foreign transferred corporations as not qualifying as a “corporation” for purposes of the tax-free exchange provisions of the Internal Revenue Code.
Second, Section 367 ensures that the earnings of a controlled foreign corporation (“CFC”) do not avoid U.S. tax as a result of shifting assets to an entity that is not a CFC as a result of some corporate reorganization or other transaction. In this latter respect, Section 367 is the mechanism that ensures the enforcement of the rules of Section 1248, which require dividend treatment when a U.S. shareholder sells or exchanges stock in a controlled foreign corporation or the corporation is liquidated. The principal purpose of Section 1248 is to prevent a U.S. shareholder of a controlled foreign corporation from realizing gain on its undistributed earnings at the cost only of the tax on long-term capital gains by selling its stock or liquidating the corporation.
Corporate Formations: Transfers of Appreciated Property to Foreign Corporation
The U.S. tax consequences of an outbound transfer of property (including an outbound transfer of stock) are governed by section 367 of the U.S. Internal Revenue Code. section 6038B requires that U.S. persons satisfy various information reporting requirements when they transfer property outbound to a foreign corporation. Because the penalties for failure properly report outbound property transfers are substantial, a U.S. person that has completed (or is contemplating) a transfer to a foreign corporation will want to make sure to review all reporting requirements under both the substantive rules of section 367 and the information reporting rules of section 6038B.
In a wholly-domestic context, if a domestic corporation transfers appreciated property to a newly-organized subsidiary in exchange for all the shares of that subsidiary, the gain on that exchange is not recognized immediately, but instead postponed by having the subsidiary take a carryover basis in the property received. See IRC Section 351(a) and 362. However, if the subsidiary is a foreign corporation, then the ultimate disposition of the appreciated property may occur outside the U.S. taxing jurisdiction.
As a consequence, transfers of appreciated property to a foreign corporation may represent the U.S. Treasury’s last opportunity for taxing the appreciation.
Internal Revenue Code Section 367 requires U.S. persons transferring appreciated property to a foreign corporation to recognize a gain on the transfer. Internal Revenue Code Section 367(a) is said to impose a toll charge on the outbound transfer of appreciated property to a foreign corporation. If the property contributed to a foreign corporation is intellectual property, the outbound transfer is governed by the rules of Internal Revenue Code Section 367(d). Intellectual property includes any patent, invention, formula, process, design, pattern, know-how, copyright, literary, musical, or artistic composition, trademark, trade name, brand name, franchise, license, contract, method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, technical data, or other similar item. See IRC Section 367(d)(1) and 936(h)(3)(B).
The kinds of property most often raising the question of possible qualifications under Sections 351 and 367 are inventory, equipment depreciated below fair market value, manufacturing intangibles (for example- patents and know-how) and marketing intangibles (for example, trademarks and trade names). These intangibles often have a zero or very low basis because research and experimental costs and advertising costs have been deducted currently. Assets such as these are frequently transferred to a foreign corporation when a foreign business is established or expanded. Sometimes the existence of a transfer of appreciated property is not immediately obvious. For example, if a going sales business previously conducted by a division of a U.S. corporation is taken over by a foreign subsidiary corporation, a transfer of valuable goodwill may be involved.
Under Section 367(d)(2), the contribution is treated like a sale in exchange for payments that are contingent upon the productivity, use, or disposition of the intangible property. In other words, the U.S. person is treated as if it sold the property in exchange for a stream of payments. The stream of income inclusion must reasonably reflect the amounts that would have been received annually over the useful life of the property in an arm’s length sale for ongoing payments. The deemed payments are taxed as ordinary income of the U.S. transferor. The U.S. person must prepare a valuation of the intangible property in accordance with rules set forth in the Treasury Regulations.
Contributions to the capital of a corporation by its shareholders normally are treated as nontaxable to both the corporation and the contributing shareholder. However, when property is contributed to the capital of a foreign corporation by one or more transferors who in the aggregate own at least 80 percent of the total combined voting power of the foreign corporation’s stock, the contribution is treated for purposes of Section 367 as a constructive transfer in exchange for the corporation’s stock equal in value to the fair market value of the contributed property. See IRC Section 367(c)(2). Thus, a U.S. transferor may be taxable on any gain (i.e., fair value of the contributed property in excess of the adjusted basis of the property) realized on the constructive exchange because Section 367(a) prevents the transfer from qualifying for nonrecognition-of-gain treatment under Section 351. Moreover, to the extent provided in the regulations, Section 367(f) requires that a U.S. person’s transfer of appreciated property to a foreign corporation as paid-in surplus or a contribution to capital be treated as a fair market sale and that the gain on such sale be recognized. Unlike Section 367(c)(2), this provision applies without regard to whether the transferor or group of such transferors owns 80 percent or more of the voting stock of the transferee corporation.
Section 368(a)(1) Reorganizations for Outbound Transactions
The Internal Revenue Code provides for nonrecognition of gain or loss realized in connection with a considerable number of corporate organizational changes. These include acquisition and other reorganizations defined in Section 368(a)(1) and divisive reorganizations under Section 355. They are permitted on a tax-free basis on the rationale that they involve merely changes in the organizational forms for the conduct of business and that there should be no tax penalty imposed on formal organizational adjustments that are dictated by business considerations. Reorganizations, as defined in Section 368(a)(1), include statutory mergers and consolidations, acquisitions by one corporation of the stock or assets of another corporation, recapitalizations, changes in form or place of organization.
Section 367(a) of the Internal Revenue Code provides a general rule of taxability with respect to transfers of property in exchange for other property in transactions discussed in Sections 332, 351, 354, 356, or 361 by stating that a foreign corporation will not be considered a corporation that could qualify for nonrecognition of gain. An exchange will be tax-free only to the extent specifically provided in the Internal Revenue Code and its regulations.
How can this charge be legally avoided?
1. Keep the Intellectual Property Onshore and Leverage the FDII Tax Regime
The first option to avoid the Section 367 “toll charge” is to take advantage of the foreign-derived intangible income (“FDII”) tax regime. A number of domestic corporations transfer intellectual property to foreign corporations as part of a modified structure. The problem with this strategy is the intellectual property transferred to the foreign subsidiary is subject to the Section 367 “toll charge.” Instead of forming a foreign corporation that would fully operate a business abroad, the U.S. domestic corporations may consider retaining their intellectual property and license the intellectual property to its foreign subsidiary in return for an actual royalty payment. Such a strategy may avoid the Section 367 “toll charge.” Instead of being subject to the “toll charge,” the U.S. domestic corporation could be subject to the FDII tax regime.
FDII is a type of income that when earned by a U.S. domestic C corporation is entitled to a deduction equal to 37.5 percent of the FDII. Because the current U.S. federal corporate income tax rate is 21 percent FDII income is subject to an effective rate of 13.125 percent (i.e., 21% * (1-37.5%) = 13.125%). The determination of the FDII deduction is a mechanical calculation that rewards a corporation that has minimal investment in tangible assets such as machinery and buildings. Specifically, FDII was designed to provide a tax benefit to income that is deemed to be generated from the exploitation of intangibles. The mechanical computation assumes that investments in tangible assets should generate a return on investment no greater than 10 percent. Thus, a corporation’s income that is eligible for the FDII deduction (“DEI”) is reduced by an amount that equals 10 percent of the corporation’s average tax basis in its tangible assets, an amount that is known as qualified business asset investment or “QBAI.”
The FDII calculation begins with computing a U.S. corporation’s DEI. DEI is a U.S. corporation’s gross income adjusted for certain items and reduced by deductions allocable to the gross income. DEI is determined by adjusting a domestic gross income to exclude subpart F income, financial services income, dividends received from controlled foreign corporations, domestic oil and gas income, foreign branch income, or global intangible low-taxed income.
To qualify for FDII benefits, a domestic corporation must sell property to a foreign person for foreign use. Foreign persons are non-U.S. persons, foreign governments, and international organizations. In addition to being a sale to a foreign person, the sale of general property must also be for foreign use. Intellectual property qualifies for FDII benefits. In other words, if a domestic corporation were to sell intellectual property to a foreign corporation for foreign use, the generated revenue from the sale of the intellectual property would likely qualify for FDII benefits. FDII benefits could also include a license by a U.S. corporation of intangible property to a foreign subsidiary for use outside the United States.
Consequently, rather than transferring intellectual property directly to a foreign subsidiary and being subject to the “toll charge,” a domestic corporation could license its intellectual property to a foreign subsidiary and receive a stream of royalty payment in return for its assets. The royalty payment could be taxed at beneficial FDII rates. The domestic corporation could also sell its intellectual property to its foreign subsidiary and receive a comparable payment in return for its assets. Such a transaction may still qualify for the FDII deduction..However, such a transaction may result in a somewhat different analysis.
2. Transfer the I.P. to a Foreign Partnership
The second alternative available to potentially avoid the Section 367 “toll charge” is to use a foreign partnership as the joint venture vehicle. Under the general principles of Internal Revenue Code Section 1001(a), a partner who contributes property to a newly formed partnership in exchange for a partnership interest would appear to realize gain or loss in an amount equal to the difference between the fair market value of the partnership interest and the adjusted basis of the transferred property. But Section 721(a) comes to the rescue in a manner closely paralleling Section 351, its corporate tax counterpart, by providing that no gain or loss shall be recognized to a partnership or to any of its partners on a “contribution of property to the partnership in exchange for an interest in the partnership.” The rationale for nonrecognition is familiar. The transfer of property to a partnership is considered to be a mere change in the form of the partner’s investment and is viewed as a business transaction that should not be impeded by the imposition of a tax.
The general rule of Section 721, equally applicable whether the contribution is to a newly formed or preexisting partnership, is accompanied by the usual corollary provisions governing basis and holding period. The principal requirement for nonrecognition under Section 721 is that “property” must be contributed in exchange for an interest in the partnership. Since there is no statutory definition of property, the courts have been guided by analogous interpretations under Section 351, which provides for nonrecognition treatment on the transfer of property to a controlled corporation in exchange for stock or securities. The term “property” is defined as money, goodwill, intangible assets, patents, and unpatented technical know-how. But “property” does not include services rendered to the partnership, and a partner who receives a partnership interest in exchange for services.
There are several other exceptions to the general rule nonrecognition rules of Section 721, including Section 721(c), which grants the Department of Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) the ability to promulgate regulations that override Section 721 nonrecognition rules when the contribution of appreciated property to a partnership will result in a foreign person foregoing the recognition gains of assets contributed to a partnership.
Internal Revenue Code Section 367(d)(3) states that the Treasury and the Treasury and the IRS may draft regulations that apply to deemed royalty treatment of Section 367(d)(2) to a transfer of intangible property by a U.S. person to a partnership. Section 721(d) cross-references Section 367(d)(3) for regulatory authority to treat transfers of intangible property as sales. Consequently, under Section 721(c), the Treasury and the IRS has the authority to issue regulations to terminate the Section 721(a) non recognition rules and under Section 721(d) it has authority to issue regulations to apply the deemed royalty treatment of Section 367(d)(2) to an outbound transfer of intangible property to a partnership. However, as of this date, the Treasury and the IRS has only issued temporary regulations under Section 721(c) but has not issued regulations under Section 721(d).
The temporary regulations promulgated under Section 721(c) discuss the contribution of appreciated property by a U.S. person to a partnership. The appreciated property, referred to as “Code Section 721(c) property,” is broadly defined as property other than “excluded property.” Excluded property is cash, securities, tangible property with de minimis built-in gain, and an interest in a partnership in which effectively all of its assets consist of the foregoing excluded property. As a result, Section 721(c) property includes intangible property.
Although the IRS has issued guidance under its authority to treat outbound transfers of property, including intangible property, to a partnership as taxable, the guidance covers only limited situations in which a partnership with a foreign partner is related to the U.S. transferor. As of this date, the Treasury and the IRS has not used its authority to issue guidance or regulations that override the Section 721(a) nonrecognition rule and impose a deemed royalty in the case of intangible property transferred to a partnership for use outside the U.S. This may allow a domestic corporation to form a foreign partnership (a check-the-box election should be made to treat the joint venture as a partnership for U.S. tax purposes) with a foreign corporation and in certain circumstances transfer intellectual property to the foreign partnership without realizing the Section 367 “toll charge.”
More importantly, in order to take a position that the nonrecognition rules of Section 721(a) apply in regards to a contribution of intellectual property to a foreign partnership, certain additional steps must be taken. The foreign partnership must elect to apply a method for U.S. tax purposes of allocating the built-in gain with respect to the contributed intellectual property. This is known as the “gain deferral method.” The gain deferral method ensures that partnerships will not be able to shift the tax on the built-in gain contributed property to the related foreign person and thereby escape U.S. taxation. In order to avoid an unexpected “toll charge” associated with the transfer of intellectual property to a foreign partnership, the steps discussed in the regulations must be carefully followed.
3. Foreign Tax Considerations
Because the transfer of intellectual property is inherently limited to cross-limited to cross-border transactions, the U.S. corporation transferring intellectual property must not only consider U.S. tax law but also be mindful of the income tax impacts in the country where the intellectual property will be transferred. For example, a foreign country may seek to impose some or all of the following taxes: income tax, withholding tax, value-added tax, stamp duty, costumes duty and other transfer taxes, exercise tax and digital services tax. If the local country imposes tax on income of the U.S. corporation far in excess of the U.S. rates, the reduction of U.S. taxes through tax planning becomes irrelevant. Get proper advice!