By James Gannon, Gretchen Sierra, Jeff O’Donnell and Mark Graham

On 13 July 2012, the Internal Revenue Service (IRS) released Notice 2012-39, announcing upcoming regulatory amendments that will address the application of §367(d) to outbound transfers of certain intangible property (IP) in certain outbound asset reorganizations described in §361(a) or (b) (“asset reorganizations”). More specifically, the Notice describes amendments to Treas. Reg. §1.367(d)-1T(c), (d), (e) and (g), that require recognition of income in the year of the reorganization. The amendments will apply to §367(d) transfers occurring on or after 13 July 2012 (i.e. retroactively to the Notice’s release date).

Background

If a U.S. person transfers IP to a foreign corporation in an exchange described in §351 or §361 (a “U.S. Transferor”), §367(d) treats the transfer as a sale of the IP in exchange for payments that are contingent upon the productivity, use or disposition of such property.¹ Temporary regulations under §367(d) provide that such U.S. Transferor shall, over the useful life of the property, annually include in gross income an amount that represents an appropriate arm’s length charge for the use of the property as determined under §482 principles.² If a U.S. Transferor subsequently disposes of the stock of the transferee foreign corporation to a person that is not a related person, the U.S. Transferor is treated as having simultaneously sold the intangible property to the unrelated person acquiring the stock of the transferee foreign corporation. The U.S. Transferor must recognize gain (but not loss) in an amount equal to the difference between the fair market value of the transferred IP on the date of the subsequent disposition and the U.S. Transferor’s adjusted basis in the IP on the date of the initial §367(d) transfer.³

New terminology in the Notice

Several new definitions are introduced for purposes of the Notice. The Notice refers to a “Qualified Successor,” which is defined as a domestic corporation (other than a regulated investment company (RIC), real estate investment trust (REIT) or S corporation) that is a shareholder of the U.S. Transferor in a §367(d) transaction if that domestic corporation owns stock of the foreign transferee corporation immediately after the reorganization. All other persons that are not Qualified Successors are “Non-Qualified Successors.” The Notice defines “Section 367(d) Property” as any property described in §936(h)(3)(B), and “Section 367(a) Property” as any other property that is not Section 367(d) Property. This addresses an argument that some taxpayers made that neither §367(a) nor §367(d) cover “foreign goodwill” or “foreign going concern value.” In informal conversations, the IRS has indicated that no change to the scope of intangibles covered by §367(d) was intended by this definition.

The Notice also defines “Section 367(d) Percentage” as the ratio of Section 367(d) Property transferred by the U.S. Transferor in the §361 exchange to all the property it transferred in the exchange. Lastly, “Non-Qualified Liabilities” are defined to include all liabilities that are not (1) incurred in the ordinary course of the U.S. Transferor’s active trade or business (within the meaning of §367(a)(3)), (2) created in connection with the reorganization, and (3) owed to an unrelated person. Each of these three conditions must be met to exclude the liability from Non-Qualifying Liabilities. The amount of Non-Qualifying Liabilities is increased by the sum of (1) distributions from the U.S. Transferor not funded by the transferee foreign corporation, and (2) any other distributions with respect to stock made by the U.S. Transferor (or a predecessor company) within the two-year period immediately preceding the reorganization.

Transactions covered by the Notice

Prepayment of ordinary income commensurate with income

The Notice will treat any boot that is received by a Qualified Successor in a reorganization transaction to which §367(d) applies as a prepayment of the ordinary income required to be included under §367(d)(2)(A)(ii)(I). This amount is not limited to the gain recognized under §356 with respect to the boot, but is reduced by U.S. Transferor property that is distributed to the Qualified Successor and not received by the transferee foreign corporation in the reorganization. The prepayment is available as a “credit” against the income the Qualified Successor would be required to include under §367(d)(2)(A)(ii)(I) in subsequent tax years until the credit is exhausted.

Example: USP, a domestic corporation, owns 100% of the stock of UST, also a domestic corporation. USP’s basis in its UST stock equals its fair market value (FMV) of USD 100.⁴ UST’s sole asset is IP with zero tax basis, and it has no liabilities. USP also owns 100% of the stock of TFC, a foreign corporation. UST transfers the patent to TFC in exchange for USD 100, and, in connection with the transfer, UST distributes the USD 100 of cash to USP and liquidates. In this fact pattern, no gain or loss should be recognized with regard to the cash received by USP in the §354 exchange pursuant to §356(a). Under §367(d)(2)(A)(ii)(I), the U.S. Transferor would recognize ordinary income on an annual basis, which will allow the taxpayer to repatriate additional cash equal to these amounts includable as ordinary income. However, the Notice would treat the USD 100 of boot as a prepayment of the ordinary income, which the USP must include in its income in the tax year of receipt. In subsequent tax years, the prepayment would be available as a “credit” against the amount USP would otherwise be required to include in income under §367(d)(2)(A)(ii)(I).

The boot treated as prepayment is computed by multiplying the Section 367(d) Percentage in the exchange by the boot received in the exchange (excluding any boot that was not provided by the transferee foreign corporation).

The Notice provides for similar treatment for Non-Qualified Liabilities assumed in a §361 exchange that is subject to §367(d).

Gain recognized on transfer of §367(d) intangibles

The Notice also affects transactions involving Non-Qualified Successors that avoid taxation under the temporary regulations of §367(d). This provision requires a U.S. Transferor to recognize a portion of the gain it realizes in a §361 exchange of any Section 367(d) Property in proportion to the ownership percentage of all Non-Qualified Successors.

Example: A U.S. partnership is owned by two foreign corporations. The U.S. partnership wholly owns a foreign corporation (CFC). U.S. partnership purchases a U.S. target (UST), the sole asset of which is Section 367(d) Property. Pursuant to a §361 exchange, UST transfers its assets to CFC in exchange for CFC shares. Following the transfer, UST distributes its CFC shares to U.S. partnership and liquidates. UST’s disposition of its CFC shares would, under the temporary regulations, require U.S. partnership to include in its income the amount that would have been included in the income of UST under §367(d)(2)(A)(ii)(I).⁵ This income earned by U.S. partnership would flow through to its foreign owners under partnership taxation principles and escape U.S. taxation as a payment from one foreign corporation to another. However, under the Notice, all of the gain UST realizes on the §361 exchange must be recognized by it because it is wholly-owned by Non-Qualified Successors. Under the Notice, stock of a U.S. Transferor that is owned by a partnership is treated as owned by its partners. Both partners in the partnership are foreign corporations and Non-Qualified Shareholders. This income is included by U.S. Transferor in its final federal tax return.

Footnotes

¹ §367(d)(2)(A).
²Treas. Reg. §1.367(d)-1T(c)(1).
³Treas. Reg. §1.367(d)-1T(d)(1).
⁴As basis is equal to FMV, this fact patterns suggests a situation where UST was recently purchased by USP.
⁵Treas. Reg. §1.367(d)-1T(e)(1).