The Treasury Department and IRS today released for publication in the Federal Register temporary regulations (T.D. 9738) to clarify the arm’s length standard and the best method rule under Code section 482 and, by cross-reference, proposed regulations (REG-139483-13) relating to the transfer of property—including foreign goodwill and going-concern value—to foreign corporations in nonrecognition transactions under section 367.
The following discussion focuses primarily on the proposed regulations under section 367, and provides some first impressions based on an initial review of these regulations.
The proposed regulations [PDF 280 KB] affect “United States persons” that transfer certain property, including foreign good will and going-concern value, to foreign corporations in nonrecognition transactions described in section 367.
Although the regulations are issued in proposed form, they generally are proposed to apply to transfers occurring on or after September 14, 2015 (and to transfers occurring before that date resulting from entity classification elections filed on or after that date).
Under the proposed regulations, as a new general rule, transfers of property by a U.S. person to a foreign corporation would be subject to tax whether or not used in an active trade or business. The “active trade or business” exception would apply only to specified “eligible property” that is transferred for use in an active trade or business and with respect to which certain reporting requirements are met. Accordingly, eligible property would include
Eligible property would not include, however, certain “hot” assets—in particular, inventory or similar property, receivables to the extent the principal amount has not been included in income, foreign currency and foreign currency-denominated instruments, and certain leased property. Depreciation recapture would be required.
At the taxpayer’s election, transfers of intangible property (with certain exceptions but including goodwill and going-concern value, whether or not foreign) would be taxed under the section 367(d) deemed royalty regime rather than, as currently, under section 367(a), even if the taxpayer takes the position that the property is not section 936(h)(3)(B) property. The section 367(d) regime would implicate the “commensurate with income” rules.
The current law deemed 20-year maximum useful life of property for purposes of inclusions under section 367(d) would be eliminated, and instead the useful life would be the entire period during which the exploitation of the intangible property is anticipated to occur, as of the time of the transfer.
Reporting requirements under section 6038B, which must be complied with in order to satisfy the active trade or business exception, would be revised to reflect the changes.
As a justification for the revised approach to foreign goodwill and going-concern value, the preamble to the proposed regulations alludes to Treasury and IRS concerns that some taxpayers may be undervaluing section 936(h)(3)(B) intangibles and concomitantly overvaluing the amount treated as nontaxable foreign goodwill. The preamble references issues such as item-by-item valuation—addressed in the concurrently released temporary regulations under section 482. The preamble explains that the Treasury and IRS considered whether the favorable treatment of foreign goodwill and going-concern value could be preserved while protecting the U.S. tax base through regulations restricting it to, for example, value created outside the United States, but concluded that such approaches would be too difficult to administer.
The IRS and taxpayers have long struggled with the question whether goodwill and going-concern value may be treated as a section 936(h)(3)(B) asset. The current longstanding regulations have provided that foreign goodwill is exempt under section 367(a), and have been unclear as to whether domestic goodwill was taxable under section 367(a) or 367(d). The preamble to today’s release states that the proposed regulations do not take a position with respect to whether goodwill and going-concern value are described in section 936(h)(3)(B). The proposed regulations, however, would change the treatment of foreign goodwill and clarify the treatment of domestic goodwill to make both taxable under section 367(a) unless the taxpayer elects for section 367(d) treatment and discloses the elected treatment in accordance with reporting required under section 6038B. In light of legislative history indicating favored treatment for foreign goodwill, and the longstanding nature of the existing eligibility of foreign goodwill for the active trade or business exception, taxpayers may question the approach proposed.
The proposed immediate effective date is unusual. The extent to which it may be retained likely will depend on the degree to which, as the result of public comment, final regulations deviate from the proposals.
As noted above, the temporary regulations [PDF 216 KB] are intended to clarify the coordination rules that apply to controlled transactions—including controlled transactions that are subject in whole or part to both sections 367 and 482.
The preamble explains that transfers of property subject to section 367 that occur between controlled taxpayers require a consistent and coordinated application of sections 367 and 482 to the controlled transfer of property and any related transactions between controlled taxpayers. The controlled transactions may include transfers of property subject to section 367(a) or (e), transfers of intangible property subject to section 367(d) or (e), and the provision of services that contribute significantly to maintaining, exploiting, or further developing the transferred properties. All of the transactions (and any related elements) must be analyzed and valued on a consistent basis under section 482 in order to achieve the intended purposes of sections 367 and 482.
The temporary regulations are being issued to address Treasury and IRS concerns that certain results reported by taxpayers reflect an asserted form or character of the parties’ arrangement that involves an incomplete assessment of relevant functions, resources, and risks and an “inappropriately narrow analysis of the scope of the transfer pricing rules.”
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