Background

Section 367(d) applies when a US taxpayer transfers intangible property to a foreign corporation pursuant to sections 351 or 361. As a result of the transfer, the US taxpayer is treated as having sold the intangible property in exchange for annual, contingent payments or, in the case of certain dispositions of the intangible after the initial transfer, a payment reflecting the value at the time of that disposition. The deemed annual payments reflect the productivity or use of the intangible by the foreign corporation and last through the intangible’s useful life. They must be commensurate with the income attributable to the intangible property. The US taxpayer must include these payments in income regardless of whether the payments are actually made. Each year’s annual payment or inclusion is taxed as ordinary income to the US taxpayer. Under Treas. Reg. §1.367(d)-1T(g)(1), the US taxpayer may establish an account receivable for payments not actually received. Any future payments from the foreign corporation may be deducted from the balance of that account and received by the US taxpayer without further US income tax consequences. The US taxpayer is deemed to make a contribution to the capital of the foreign corporation of any portion that remains unpaid by the end of the third year following the year to which the receivable relates, and the receivable is deemed settled. 

Section 367(d) essentially deems the US taxpayer to be receiving taxable contingent payments in a section 351 or 361 transfer that otherwise generally would not have triggered gain recognition. Congress designed section 367(d) with the concern that US companies might deduct research and development expenses for an intangible and then transfer the intangible abroad to defer paying taxes on any profits generated. Section 367(d) addresses these concerns by creating annual inclusions that are subject to tax.

The AM indicates that the IRS was concerned about situations in which US companies wish to accelerate their annual inclusions under section 367(d) through advance payments. A US company may cause a controlled foreign corporation to make a payment that not only covers prior year obligations under section 367(d) but also covers future years of the intangible’s useful life. While section 367(d) and its regulations do not refer to advanced payments, the IRS has approved advanced payments in certain scenarios. In Notice 2012-39, the IRS stated that boot received in an outbound section 361 transfer of intangible property should be treated as an advance payment of annual inclusions under section 367(d). Advice Memo 2006-10019 reached the same result for section 351 transactions with boot. 

The AM’s position

The AM maintains that section 367(d) does not allow advance payments outside of the receipt of boot in the initial transaction. Instead, the IRS stated that it will apply general tax principles to any payment exceeding prior annual inclusions, meaning distribution treatment would apply absent any facts to the contrary. The AM provides the following example to illustrate this conclusion. 

A US corporation (“USP”) owns all the stock of a foreign corporation (FC). USP transfers section 367(d)(4) intangible property to FC solely in exchange for stock pursuant to a section 351 transaction. USP must account for annual inclusions related to the intangible property under section 367(d). In Year 1, i.e., the year of the transfer, USP records an annual inclusion amount of USD 10 in its accounts receivable. In Years 2 and 3, USP records USD 12 per year. Before the close of Year 3, USP wishes to accelerate the remaining annual inclusions, and so USP instructs FC to pay USD 60 to USP. USP intends USD 34 to cover accounts receivable from Years 1-3 (USD 10 plus USD 12 plus USD 12) and the remaining USD 26 to be applied to future years.

The AM states that section 367(d) and its regulations do not allow USP to treat the payment exceeding prior annual inclusions as an advance payment of 367(d) annual inclusions. The IRS would therefore treat the USD 26 in excess of the prior annual inclusions using general tax principles. Without facts to the contrary, the IRS would treat the $26 payment as a distribution of property by FC to its shareholder, USP, with respect to its stock.

The AM’s reasoning

The AM disallows advance payments based on section 367(d)’s text, administrative concerns, and taxpayers’ freedom to structure the transfer differently. Neither section 367(d) nor its regulations discuss advance payments. Section 367(d) and its regulations only establish annual inclusion procedures, which the AM interprets as requiring taxpayers to pay on a year-by-year basis rather than in advance. Section 367(d) requires annual payments to track the productivity and use of the intangible transferred. The AM argues that advance payments “would undercut the fundamental connection” between the payment and the intangible’s actual value that section 367(d) requires. The AM concludes its statutory argument by stating that investigating whether prepayments matched actual returns “would raise significant administrative concerns.”

The AM also suggests that US taxpayers’ flexibility in structuring their transactions should lead to a strict interpretation of section 367(d). Taxpayers could choose to transfer intangibles through actual sales or licenses, to which section 367(d) would not apply. In those situations, advance payments may be permissible. By choosing to transfer intangibles outbound through section 351 or 361, taxpayers subject themselves to the rules under section 367(d). The AM rejects the argument that principles applicable to these other types of transfers should also apply under section 367(d). For instance, the AM notes that while a section 367(d) transaction may resemble a contingent sale in some respects, Congress did not apply the installment method of tax accounting under section 453 to section 367(d). Moreover, while section 367(d) transactions may resemble a license agreement in certain respects, the transferee corporation owns the intangible and need not actually pay the transferor corporation under section 367(d). For these reasons, the AM states that advance payments in the sale or licensing context are irrelevant in determining whether section 367(d) allows advance payments. In the IRS’s view, the specific circumstances of section 367(d) disallow advance payments.

Without going into detail, the AM states that its conclusion is not inconsistent with Notice 2012-39. The IRS argues that an initial section 367(d) transaction with boot is “distinguishable factually, legally, and in terms of applicable policy, from the advance payment at issue in this Memorandum.” The AM’s overview of Notice 2012-39 states that treating boot as an advance payment was intended to prevent what could be perceived as an inappropriate repatriation of cash in excess of income recognized under section 356(a)(1). 

Conclusion

In light of the IRS’s new stance, US companies should consider any past or planned advance payments of section 367(d) annual inclusions. Although the AM has no precedential value, it provides valuable insight into how the IRS may approach prepayments in this context.