Tax alert: IRS issues final §367 regulations impacting check-the-box and foreign entity restructuring
On December 16, 2016, the IRS released the final regulations under, §367 that address tax consequences of outbound asset transfers. The impact of these final regulations changes the way businesses may plan for foreign entity restructurings and check-the-box elections. The final regulations are effective for transfers occurring before September 14, 2015, and for transfers taking place on or after September 14, 2015, for which a check-the-box election is filed on or after September 14, 2015.
History and comment on proposed regulations
In the preamble to the final regulations, IRS and Treasury addressed many of the comments submitted by practitioners in response to the proposed regulations issued in fall of 2015. Among these were 5 main areas of comment: (1) Assertion that 1984 regulative history pointed to an intended exception to taxable transfer of foreign goodwill and going concern, (2) Request that incorporation resulting from foreign legal or regulatory compulsion be excepted, (3) Industry-specific or professional service businesses goodwill and going concern be excepted, (4) Foreign goodwill and going concern value not associated with highly valuable §936 intangibles be excepted, and (5) Tax of goodwill and going concern value be capped formulaically based on expenses or information reported to foreign tax authorities.
Treasury and the IRS first outlined the changing tax law and business landscape that renders the perceived intention of regulators in 1984 to except goodwill and going concern from taxable transfers inapplicable. At the time regulation allowed for exception, tax law did not yet allow for amortizable goodwill, and so it was then common practice for businesses to try to allocate intangibles to classes that were amortizable, with the unidentifiable remainder going to goodwill and going concern. Therefore, the likelihood of abuse seemed minimal. Once goodwill became an amortizable asset under §197, it lessened the perceived benefit of going through the process to specifically identify amortizable intangibles. Further, businesses began to see high-value intangibles become a larger part of their overall asset base. One study quoted in the preamble indicated a rise in intangible assets as a percentage of the S&P market value from only 32 percent in 1985 to 84 percent in 2015. The combination of these two factors and results of these changes was a greater likelihood of businesses to minimize value allocated to intangibles under §936 and §367(d) and to lump them in under a vague goodwill and going concern umbrella with more favorable tax outcomes. The IRS and Treasury noted that while at the time abuse seemed minimal, regulators provided the ability to propose regulations to curb abuses in cases where they arose.
Of the several comments on various exceptions, carve-outs and caps to the taxability of outbound transfers of goodwill and going concern, Treasury and the IRS had a clear common response – none of the comments provided a “sufficiently administrable approach that would reliably ensure that §367 applies with respect to the full value of all §936 intangibles”. If Treasury and the IRS could not find a way to allow for goodwill exceptions while still dependably stopping abuses, then there would be no exceptions at all.
Changes under final regulations
In comparison to the proposed regulations, there are few changes in the final regulations. The final regulations continue to severely restrict the definition of a trade or business asset under §367(a) and have eliminated the temporary Reg §1.367(d)-1T(b) that excepted foreign goodwill and going concern value from treatment under §367(d). Clarity was requested in identifying whether foreign goodwill and going concern is meant to be treated as property under §367(a) and thus immediately taxable, or as an intangible under §936(h)(3)(B) and §367(d) and taxable under the income inclusion method. Other than pointing out that treating property described under §936(h)(3)(B) as subject to §367(a) rather than §367(d) would be inconsistent, Treasury and the IRS provided little new guidance and stated that such guidance was beyond the scope of the final regulations issued.
One notable change from the proposed regulations is the modification of the 20 year limit on useful life for income recognition under §367(d). While the proposed regulations did away with the limitation completely, the final regulations keep the 20 year limit, modifying that it is electable in the year of transfer with the 20 year period to begin in the first year that income is taken into account under§367(d). This allows for delays between the year of transfer and the first year that exploitation of the intangible results in income. Additionally, taxpayers electing the 20-year limit are required to include amounts that reasonably reflect the amount over the life of the intangible that would be required to be included in the absence of a limitation. Taxpayers are required to consider income not only from the current intangible but the possible income derivative from subsequent iterations of the intangible. The argument made by Treasury and the IRS being that, if sold in an arms-length transaction, a reasonable seller would build the future value of subsequent software versions built from the current version in the purchase price. If a taxpayer chooses to elect the 20-year useful life, no adjustments will be made for taxable years beginning after the end of the 20-year life. However, the IRS can still use income produced in years after the inclusion as a basis for determining if income inclusions within the 20 year period still under the statute are commensurate with the income attributable to the transferred property. Lastly, the regulations also modify the definition of useful life to include the entire period that the intangible property is reasonably anticipated to affect taxable income. This allows for consideration of both the impact of increases in revenue and decreases in cost associated with the intangible.
Other issues addressed include the clarification on the definition of foreign currency or other property denominated in the currency of the transferee’s country excepted from the general rule in§367(a)(3)(B)(iii) that turns off the trade or business property exception under §367(a). In the final regulations, §1.367(a)(a)-2(c)(3) reflects changes to describe property as nonfunctional currency and other property that gives rise to §988 transaction treatment, to be more in line with language and concepts codified in the foreign currency rules of Subpart J.
Several issues were not addressed by the finalized regulations, as they were deemed outside the scope of the regulations by the IRS and Treasury. These included valuation of intangibles and the form that deemed payments should take, whether a receivable was created upon an audit-related adjustment, tax basis consequences under §367(d) and the anti-churning rules under §197, disposition rules under §367(d) and coordination with general rules, the definition of property for purposes of §367, subsequent transfer rules under the trade or business exception, and issues raised in connection with Notice 2012-39 on boot received and treated as a royalty payment under §367(d). The IRS recognized 3 the uncertainty around the application of subsequent transfer rules involving hybrid partnerships but expressed an expectation that those rules would be amended by a separate and detailed consideration of transactions involving partnerships.
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.
- Branch operations
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 to the tangible and intangible assets will need to be performed.
The below fact pattern illustrates the potential tax cost of transferring assets to a foreign corporation under the previous and final regulations.
US tax cost*
US tax cost*
Fixed assets (NBV)
Fixed assets (NBV)