Background on Section 367(d)
Section 367(d) provides rules for outbound, non-recognition transfers of certain IP (i.e., copyrights, trademarks, franchises, licenses, contracts, methods, systems, goodwill, going concern, workforce in place, or other items the value or potential value of which is not attributable to tangible property or the services of any individual) by a US person (the “US Transferor”) to a foreign corporation (the “Transferee Foreign Corporation”).
If section 367(d) applies to an outbound transfer of IP, the US Transferor is treated as having sold the outbounded IP in exchange for payments from the Transferee Foreign Corporation contingent upon the productivity, use, or disposition of the IP. Accordingly, the US Transferor is treated as receiving amounts that reasonably reflect the amounts that would have been received annually in the form of royalty payments over the useful life of the IP (the "Annual Inclusion Amount"). As a result, the US transferor increases its US taxable income by the Annual Inclusion Amount. Correspondingly, the Transferee Foreign Corporation reduces its earnings and profits by the Annual Inclusion Amount, and treats that amount as a deductilble expense for purposes of determining its subpart F income, tested income, and tested losses (the "Deemed CFC Expense").
Questions Arising Under the Current Regulations Upon Repatriation of IP Subject to Section 367(d)
The current regulations are unclear about what happens to the Annual Inclusion Amount and the Deemed CFC Expense when the outbounded IP is repatriated into the US.
Under the normal transfer rules, if the Transferee Foreign Corporation subsequently transfers the outbounded IP to a related person (the “New Related Transferee”), the US Transferor should not recognize gain, and the New Related Transferee is treated as stepping into the shoes of the Transferee Foreign Corporation. The US Transferor should continue to recognize the Annual Inclusion Amount, and the New Related Transferee is allowed to take into account the Deemed CFC Expense. However, it is not clear how the current regulations apply when the New Related Transferee is a US person. The IRS has taken the position that the US Transferor should continue to recognize an Annual Inclusion Amount, even if the Transferee Foreign Corporation subsequently transfers the IP to a related US person. In addition, the IRS has indicated that that the New Related Transferee would not be allowed to deduct the Deemed CFC Expense against its US taxable income, absent further actions by the taxpayer.
Nevertheless, the IRS has recognized the inappropriate nature of section 367(d) requiring the US Transferor to continue recognizing an Annual Inclusion Amount where the New Related Transferee is a US person that is not allowed to take a corresponding deduction. To remedy this unfair result, the IRS has stated that taxpayers may request a private letter ruling ("PLR"), where the IRS would provide that the US Transferor does not need to include the Annual Inclusion Amount in its income under Treas. Reg. §1.1502-13(c)(6)(ii)(D). Under this regulation, the IRS can issue a PLR ruling that a taxpayer can exclude income arising from a transaction between consolidated group members from the taxpayer's taxable income. Taxpayers have requested at least two of these rulings. See PLR 202107011 and PLR 201936004. The preamble to the Proposed Regulations reaffirms that IRS's position that, until the Proposed Regulations are effective (i.e., a final version is published), a taxpayer will only be able to turn-off the Annual Income Inclusion if and when the taxpayer receives a PLR to that effect.
Despite the IRS's position, some taxpayers have taken the position that the matching rule under Treas. Reg. §1.1502-13(c) permits taxpayers to exclude the Annual Inclusion Amount from the US Transferor's income without requesting a PLR. In addition, if the IP is repatriated back to the US Transferor, some taxpayers have taken the position that the deemed license ceases to exist resulting in the termination of the Annual Inclusion Amount because a US Transferor cannot license property to itself.
Repatriation of Section 367(d) IP under the Proposed Regulations
The Proposed Regulations modify the current regulations for repatriated section 367(d) IP in two primary ways. First, the Proposed Regulations would allow taxpayers to repatriate section 367(d) IP without requesting a private letter ruling to turn-off the Annual Income Inclusion. Second, the Proposed Regulations prevent taxpayers from engaging in certain basis step-up transactions to repatriate previously outbounded section 367(d) IP back into the US.
The Proposed Regulations terminate the application of section 367(d) (i.e., the Annual Income Inclusion and Deemed CFC Expense) when the Transferee Foreign Corporation repatriates the outbounded IP within its useful life, provided the following applies:
1. The IP Is transferred to a “Qualified Domestic Person”
2. The US Transferor satisfies certain reporting requirements
3. The US Transferor recognizes the amount of gain determined under Treas. Reg. §1.367(d)-1T(f)(4)(ii), which generally taxes gain if there has been a basis step-up while the IP was offshore, or if the section 367(d) IP was transferred to the US in a taxable transaction.
Qualified Domestic Person
For purposes of the rules under the Proposed Regulations, a Qualified Domestic Person is defined to include:
1. The US Transferor that initially transferred the outbounded IP
2. A US person that is treated as the US Transferor pursuant to Treas. Reg. § 1.367(d)-1T(e)(1)
3. US individuals that are related (within the meaning of Treas. Reg. § 1.367(d)-1T(h)(2)(ii)) to the US Transferor or a successor to the US Transferor
4. Certain US corporations (excluding certain tax exempt organizations, RICs, REITs, DISCs, and S corporations) that are related to the US Transferor or a successor to the US Transferor
In general, a corporation or individual is related if the corporation or individual is related to the US Transferor (or its successor) under section 267 after taking into account certain modifications. Notably, the Proposed Regulations would not treat a domestic partnership as a Qualified Domestic Person, regardless of the identity of the partners of the domestic partnership.
The relevant reporting requirements are provided in Prop. Treas. Reg. § 1.6038B-1(d)(2)(iv). Among other things, the rules generally require the US Transferor to provide: (i) a statement providing that the Proposed Regulations apply to the transfer; (ii) a general description of the transfer; (iii) a description of the IP; (iv) a copy of the original Form 926; and (v) certain other identifying information. Prop. Treas. Reg. § 1.367(d)-1(f)(5) also offers a retroactive relief provision to Qualified Domestic Persons who promptly report after becoming aware of their failure to report after the fact.
When Gain Must Be Recognized By the US Transferor upon Repatriation of Section 367(d) IP
The Proposed Regulations also contain rules that prevent taxpayers from repatriating outbounded section 367(d) IP to the US if the basis of the IP has been stepped up. Specifically, the Proposed Regulations require the US Transferor to recognize gain if the repatriated IP:
1. Is transferred in a non-recognition transaction (such that the IP qualifies as “Transferred Basis Property,” as defined under section 7701(a)(43)), and the Transferee Foreign Corporation's basis in the IP at the time of the repatriation is greater than the US Transferor's basis in the IP at the time of the original offshoring transaction
2. Is transferred to a US person in a taxable transaction, and the fair market value of the IP at the time of the repatriation is greater than the US Transferor's basis in the IP at the time of the original offshoring transaction.
(The "Gain Recognition Rule"). Confusingly, neither the current nor Proposed Regulations are clear on how the Transferee Foreign Corporation is supposed to determine its carryover basis in the IP after the initial outbounding transaction.
In addition, where the US Transferor recognizes gain upon the repatriation, the Proposed Regulations provide that the Transferee Foreign Corporation must reduce the portion of its earnings and profits and gross income arising by reason of the subsequent disposition by the amount of gain recognized, but not below zero.
The term “Transferred Basis Property” refers to property the basis of which is “determined in whole or in part by reference to the basis in the hands of the donor, grantor, or other transferor” (e.g., property transferred in a nonrecognition transaction in which the transferee has a carryover basis under sections 334 or 362).
Thus, if the repatriated IP is Transferred Basis Property, the US Transferor should recognize gain that is equal to the difference between the Transferee Foreign Corporation's current basis in the IP minus the US Transferor's basis in the IP at the time of the original transfer. If gain is recognized on IP that is Transferred Basis Property, then the Qualified Domestic Person should take a basis in the repatriated IP that is equal to the sum of: (1) the lesser of the US Transferor’s former adjusted basis in the IP or the Transferee Foreign Corporation’s adjusted basis in the IP (as determined immediately before the subsequent disposition); plus (2) the greater of the amount of gain (if any) recognized by the US Transferor or the amount of gain (if any) recognized by the Transferee Foreign Corporation in connection with the IP by reason of the repatriation.
If there is a repatriation of non-Transferred Basis Property, the US Transferor should recognize gain equal to the excess, if any, of the fair market value of the IP on the date of the repatriation over the US Transferor's former adjusted basis in the IP. The Qualified Domestic Person should then take a basis in the repatriated IP that is equal to the fair market value of the IP. For example, if the Transferee Foreign Corporation repatriates the IP to the US Transferor in a distribution described in section 311, the IP does not qualify as Transferred Basis Property, and normal gain recognition rules should apply. Thus, the US Transferor should recognize gain equal to the current fair market value of the IP minus the US Transferor's basis in the IP before the IP outbounding transaction. In addition, the Transferee Foreign Corporation has to recognize section 311(b) gain equal to the fair market value of the IP minus the Transferee Foreign Corporation's basis in the IP. However, the Transferee Foreign Corporation should be able to take a deduction that is equal to the amount of gain recognized by the US Transferor. Thus, the Gain Recognition Rule is aimed at preventing the Qualified Domestic Person from receiving a tax-free step-up in basis in the repatriated IP, while also avoiding the potential adverse impacts of a continued section 367(d) Annual Income Inclusion.
The Gain Recognition Rule creates a harsh result if a taxpayer has inadvertently triggered a basis step-up of its section 367(d) IP and now seeks to repatriate that IP (e.g., in inbound liquidations subject to section 334, CFC-to-CFC transfers with boot inclusions, etc.). As a result, it would be helpful if the final regulations include an election that allows taxpayers to step-down the basis of repatriated IP in lieu of recognizing any gain.
The Proposed Regulations only apply to subsequent dispositions of IP occurring after the date final regulations are published in the Federal Register. Moreover, the Preamble to the Proposed Regulations does not contain language permitting taxpayers to rely on the Proposed Regulations in the meantime.
The Proposed Regulations provide answers to some of the complex issues not addressed in current section 367(d) regulations. The Proposed Regulations should facilitate the repatriation of IP to the US, but could cause taxpayers to recognize gain if there has been an inadvertent basis step-up of the previously outbounded IP. Lastly, we note that taxpayers would have benefitted from the ability to rely upon the Proposed Regulations before their publication in the Federal Register.
Multinationals that wish to repatriate previously offshored IP subject to section 367(d) should consider reaching out to their tax adviser to determine whether the Proposed Regulations would apply to their facts.