Executive summary

Final Treasury regulations under Section 337(d) (TD 9803) (the Final Regulations), published on December 16, 2016, eliminate the exception under Treas. Reg. Section 1.367(d)-1T(b) for outbound transfers of foreign goodwill and going concern value (FGGCV) and limit application of the active foreign trade or business (ATB) exception under Section 367(a)(3) to certain specified property (not including FGGV). For FGGCV, the Final Regulations require the US transferor to either recognize gain currently under Section 367(a) or elect into the deemed royalty regime of Section 367(d), thus subjecting to US taxation transfers that have not generally been subject to income or gain recognition under Section 367. The Final Regulations apply on a retroactive basis 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 September 14, 2015.

Detailed discussion

With certain modifications discussed below, the Final Regulations generally adopt the proposed regulations (REG-139483-13) published on September 16, 2015 (the Proposed Regulations). Specifically, the Final Regulations,

1. Narrow Section 367(a)(3)'s ATB exception to exclude FGGCV and eliminate the exception under Temp. Reg. Section 1.367(d)-1T(b) for FGGCV

2. Allow US transferors to apply Section 367(d)'s deemed royalty regime to certain property that would otherwise be subject to gain recognition under Section 367(a) (including FGGCV)

3. Require generally deemed royalties under Section 367(d) to be included during the entire useful life of the transferred property (including any property for which the US transferor elects to apply Section 367(d)), but permit the US transferor to elect to instead include such amounts during the 20-year period beginning in the first tax year in which an inclusion is required

4. Require immediate gain recognition on the transfer of certain property denominated in foreign currency that previously qualified for the ATB exception

5. Change the valuation rules in Temp. Reg. Section 1.367(a)-1T to better coordinate the Treasury regulations under Sections 367 and 482

Changes related to FGGCV. The preamble states that Treasury received 19 comment letters concerning the Proposed Regulations, primarily focused on the proposed changes to the treatment of outbound transfers of FGGCV. Two comments supported the proposed changes, but the remainder requested the Proposed Regulations be withdrawn entirely or that, at a minimum, Treasury provide exceptions to the proposed rules in certain cases. Several comments challenged Treasury's ability to exercise its authority to promulgate regulations providing for immediate or deferred income recognition for outbound transfers of FGGCV, either in all or certain fact patterns.

The preamble indicates that Treasury "carefully considered all the comments received," but ultimately concluded that: (1) its proposed changes were consistent with the policies underlying Section 367; and (2) finalizing the proposed changes was an appropriate exercise of its authority to promulgate regulations in this area. In reaching this conclusion, the preamble notes, Treasury determined that the market context in which Section 367(d) was enacted has changed significantly following the enactment of Section 197 and promulgation of the entity classification regulations under Section 7701. In other words, according to the preamble, the stakes of outbound asset transfers are much higher today, which justifies, in Treasury's view, finalizing the proposed changes without providing relief for non-abusive fact patterns.

For similar reasons, Treasury rejected requests to: (i) provide exceptions for certain industries or the incorporation of a long-standing branch; (ii) value FGGCV using a formulaic approach; and (iii) provide an exception for certain transfers to joint venture companies, particularly when the US transfer is going into business with an unrelated foreign person.

Changes concerning the useful life of intangible property. The Final Regulations define the "useful life" of transferred intangible property during which deemed royalties must be included under Reg. Section 1.367(d)-1T(c)(1) as "the entire period during which exploitation of the intangible property is reasonably anticipated to affect the determination of taxable income, as of the time of transfer." For this purpose, the Final Regulations provide that exploitation of the transferred property "includes any direct or indirect use or transfer of the intangible property, including … use in the further development of the intangible property itself … and … in the development [and exploitation] of other intangible property … "

If the useful life of the transferred property is indefinite or is reasonably anticipated to exceed 20 years, the Final Regulations permit taxpayers to elect, in the year of transfer, to instead take all the required inclusions into account during the 20-year period that begins with the first year in which the US transferor takes a Section 367(d) inclusion into account. Taxpayers making this election must increase their projected income inclusions to recognize the entire present value of the transferred property during the 20-year period. If this election is made, generally no adjustments to income with respect to the transferred property will be made outside the 20-year period; the Commissioner may, however, take into account information regarding tax years after that 20-year period (including income attributable to the transferred property during the later years). This election must be made on a timely filed return of the year of the transfer. The Final Regulations include an example illustrating how the general rule and the 20-year exception apply, including when other property derived from the transferred property is exploited. See Treas. Reg. Section 1.367(d)-1(c)(3)(iii), Example.

Implications

The Final Regulations adopt broad-reaching changes to the treatment of outbound transfers of certain property, particularly FGGCV, which will result in immediate gain recognition or, at the transferor's election, annual inclusions over the useful life of the transferred property. These rules will apply equally in connection with an outbound transfer described in Section 351 or 361.

It is unfortunate Treasury could not identify any non-abusive fact patters and promulgate an exception for FGGCV generated and transferred in such contexts. The complexity and difficulty of formulating an exception should not be a reason for requiring recognition in all cases.

The 20-year useful life safe harbor could provide some certainty by limiting the period that inclusions are required, but taxpayers must still recognize the entire present value of the transferred property through larger income inclusions during the shorter period and determining the proper amount to include may create challenges. Further, the election to use the 20-year safe harbor must be made on a timely filed return, and the Final Regulations provide no remediation for untimely or otherwise defective elections. In addition, taxpayers must now account for the use of the transferred property in the development and exploitation of other intangible property (i.e. derivative works), which could lengthen the useful life of the transferred property and the required income inclusions under Section 367(d). Finally, taxpayers that completed outbound transfers of property (including FGGCV) on or after September 14, 2015, must determine the effect of the Final Regulations on previously reported transactions.

While the 20-year useful life safe harbor will provide some certainty, taxpayers must still recognize the entire present value of the transferred property through larger income inclusions in the shorter period. Further, the election to use the 20-year safe harbor must be made on a timely filed return, and the Final Regulations provide no remediation for untimely or otherwise defective elections. In addition, taxpayers must now also account for the use of the transferred property in the development and exploitation of other intangible property (i.e. derivative works), which could lengthen the useful life of the transferred property and the required income inclusions under Section 367(d). Finally, taxpayers that completed outbound transfers of property (including FGGCV) on or after September 14, 2015, must determine the effect of the Final Regulations on previously reported transactions.

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