On September 14, 2015, the IRS released proposed regulations (the “Proposed Regulations”) that would significantly alter the treatment of outbound transfers of foreign goodwill and going concern value by a U.S. person to a foreign corporation. Under the Proposed Regulations, an outbound transfer of these types of assets will no longer be exempt from gain recognition under Section 367. As discussed below, this change will eliminate an important planning opportunity currently available in many outbound transfers. Once finalized, the Proposed Regulations would apply retroactively to transfers occurring on or after September 14, 2015.

Section 367, in General

Generally, Section 367(a) triggers gain recognition in outbound transfers of appreciated property by U.S. persons to foreign corporations in what would otherwise be a non-taxable transaction (e.g., under Sections 351 or 361). An important exception to this rule exists for transfers of property to a foreign corporation for use in an active trade or business outside of the United States (the “ATOB exception”).

Outbound transfers of intangible property (within the meaning of Section 936(h)(3)(B)) are subject to a different set of rules. Section 367(a), along with the ATOB exception, does not apply to the transfer of intangible assets. Instead, such transfers are subject to Section 367(d). Section 936(h)(3)(B) defines intangible property as including patents, designs, copyrights, trademarks, franchises, contracts, systems, programs, and customer lists, “and any similar item which has substantial value independent of the services of any individual”. Notably, current regulations provide that Section 367(d) does not apply to foreign goodwill and going concern value, which is defined as the residual value of a business conducted outside of the United States after all other assets have been identified and valued.

Under Section 367(d), gain is not immediately recognized, but instead the U.S. person recognizes income annually over the useful life of the intangible property. These deemed annual amounts must be “commensurate with the income attributable to the intangible.” The current regulations define the useful life of an intangible as the period during which the property has value, but not to exceed 20 years.

As a result of the foregoing rules, taxpayers have taken the position that outbound transfers of foreign goodwill and going concern value are not subject to the rules of Section 367(d). Instead taxpayers have argued that such goodwill and going concern value are subject to Section 367(a) but exempt from tax under that provision pursuant to the ATOB exception. (The taxpayers would contend that because foreign goodwill and going concern value are exempt from tax under Section 367(d), they also should be exempt from the rule that carves out intangibles from the ATOB exception under Section 367(a).)

Not surprisingly, taxpayers have taken aggressive positions in certain outbound transfers by attempting to allocate the substantial majority of the value of the transferred assets to foreign goodwill and going concern value. For example, in TAM 200907024, the IRS National Office concluded that the synergistic value of a network of foreign contractual arrangements transferred in the context of a global delivery business was attributable to the contracts themselves and therefore subject to Section 367(d). The taxpayer, on the other hand, took the position that this synergistic value was foreign goodwill or going concern value and therefore exempt from Section 367(d). The taxpayer’s position would have allocated 97 percent of the value of the transferred assets to goodwill or going concern value.

These interpretations, according to the IRS, “raise significant policy concerns and are inconsistent with the expectation, expressed in legislative history, that the transfer of foreign goodwill or going concern value developed by a foreign branch to a foreign corporation was unlikely to result in abuse of the U.S. tax system.” The Proposed Regulations were issued to address these concerns.

Proposed Section 367 Regulations

Under the Proposed Regulations, the IRS does not address the issue of whether goodwill and going concern value are included in the definition of a Section 936(h)(3)(B) intangible. Instead, the Proposed Regulations amend the ATOB exception with respect to transfers of foreign goodwill and going concern value, so that such transfers either would be (i) subject to immediate tax under Section 367(a); or (ii) at the election of the taxpayer, subject to tax over its useful life under Section 367(d). In addition, the Proposed Regulations would no longer limit the useful life under Section 367(d) to 20 years.

The Proposed Regulations modify the ATOB exception by providing an exclusive list of property eligible for the exception. Under the new list, the only categories of property that are eligible for the ATOB exception are tangible property, working interests in oil and gas property and certain financial assets that, in each case, are transferred for use by the foreign corporation in an active trade or business. Therefore, intangibles such as goodwill and going concern value will not be eligible for the ATOB exception.

What the Regulations Fail to Address

It should be noted that because the Proposed Regulations are focused on the proper tax treatment of foreign goodwill and going concern value, and do not change the definition of a Section 936(h)(3)(B) intangible, it is not clear whether U.S. goodwill is subject to immediate tax under Section 367(a) or subject to the rules of Section 367(d). Some commentators have argued that U.S. goodwill and going concern value are not Section 936 intangibles. They claim that the list under Section 936(h)(3)(B) does not include such items while lists of intangibles in other provisions expressly mention those items, and the principles of statutory construction and the legislative history support this conclusion. The IRS, on the other hand, has taken the position that U.S. goodwill and going concern value are Section 936 intangibles under existing law because they are similar to the items listed under Section 936(h)(3)(B), and it would have otherwise been unnecessary to exclude foreign goodwill or going concern value from the scope of Section 367(d).

The Proposed Regulations also fail to address the treatment of workplace-in-force and whether such an asset should be treated as a component of goodwill and going concern value. Historically, the IRS has taken the position that workforce-in-place should be considered as a “similar item” within the meaning of Section 936(h)(3)(B) and therefore subject to Section 367(d) where it has substantial value independent of the services of any individual member of that work-force (e.g., a large research and development team).¹

¹See LMSB-04-0107-002 (Feb. 2, 2007); LMSB-04-0108-001 (Feb. 13, 2008); but see Veritas, 133 TC 29 (2009) (the Tax Court rejected the IRS argument to treat work-force-in-place as a Section 936 intangible).