Proposed regulations dramatically change tax consequences of outbound asset transfers by eliminating goodwill and going concern exceptions under section 367
On September 14, the IRS issued proposed regulations under §367, eliminating the goodwill exception from gain recognition in outbound transfers of intangibles. Additionally, the proposed regulations limit the scope of property that is eligible for the active trade or business exception. Effective on the date of publication, the impact of these proposed regulations changes the way businesses must plan for foreign entity restructurings and check-the-box elections. The proposed regulations are effective for transfers taking place on or after September 14, 2015, and for transfers occurring before September 14, 2015, for which a check-the-box election is filed on or after September 14, 2015.
Note that these are only proposed regulations and do not carry the force of law until finalized. The IRS is currently requesting comments on the proposed regulations until December 15, 2015. Once finalized the regulations will be effective retroactively, so any taxpayers with outbound asset transfers subject to §351 should consider the impact of these proposed regulations.
Previously, taxpayers were able to use the active trade or business exception under the regulations to achieve a tax-free transfer of assets to a foreign corporation. In general, a qualifying transfer of property to a corporation solely in exchange for stock of that corporation is a non-taxable event under §351. In the case of a foreign corporate transferee, the regulations under §367 dictate that an otherwise qualifying §351 transfer is not eligible for non-recognition, unless the assets transferred are considered to be assets of an active trade or business.
A separate rule under §367(d) specifically disallows the tax-free transfer on transfers of intangibles to foreign corporations. Under §367(d), income recognition would occur on the transfer of an intangible asset to a foreign corporation by treating it as a deemed sale in exchange for contingent payments for use over the expected life of the intangible, not to exceed 20 years. However, regulations under this code section provide that goodwill and going concern of a business were not included in the definition of intangibles under §367(d).
The result of this prescribed exclusion and broad definition of active trade or business assets previously allowed taxpayers to treat goodwill as a foreign active trade or business asset, thereby qualifying for non-recognition treatment.
New proposed regulations
The Treasury was of the opinion that taxpayers were attempting to avoid recognizing gain on transferred assets by attributing an inappropriately large share of value to foreign goodwill or going-concern value as opposed to high value intangibles subject to §367(d). Therefore, the new regulations effectively remove goodwill and going concern from the definition of trade or business assets by more narrowly defining trade or business assets, thereby causing transfers of goodwill and going concern to be taxable. To take it a step further, the change in the regulations limits the scope of trade or business assets such that only transfers of fixed assets and certain financial assets will qualify for tax-free treatment under §367(a)(3).
Additionally, where intangible assets are concerned, the 20-year cap on useful life for intangible payments has been removed, making it more difficult to anticipate the expected revenue stream created by the transfer of intangibles.
In a scenario where a transfer of goodwill or going concern takes place, taxpayers are left choosing between an immediately taxable event under 367(a)(1), or the payment for use of an intangible over its life under 367(d). Not only is the transfer no longer tax free, but additional consideration must be given to the breakdown of goodwill and other intangible assets, which under these rules may have to be valued based on a perpetual useful life.
Planning for impact
Check-the-box election planning
A change in the classification election from a partnership or disregarded entity to a corporation under the “check-the-box rules” is generally treated as a contribution of the business assets to a new corporation under §351 and often qualified to receive non-recognition treatment under the prior regulations. Under the new regulations, only the fixed assets of the company could be transferred tax free under §351 and the value of the company above those assets would trigger any built-in gain on the transfer, making it more difficult and costly for taxpayers wishing to change the classification of an entity for tax purposes. Any taxpayers who may have checked the box on a foreign subsidiary to flow through start-up losses with the intention of electing corporate classification at some point in the future may now be facing additional tax costs related to that future classification election.
Acquisition or restructuring planning
When contemplating an acquisition or restructure of a company with foreign subsidiaries, consideration should be given to the current entity types of any target foreign entities, as conversion from a pass-through entity to a corporation may now bring with it a tax cost. These considerations will need to be part of the overall structure planning as well as a part of negotiations when considering the tax burden associated with the acquisition structure and deal.
Where a company has been operating a branch in a foreign country and wishes to convert to a legal entity in corporate form, there will now be a cost associated with the contribution of the operations to a corporation. An analysis to determine the fair market value allocated among the tangible and intangible assets will need to be performed.