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Complex rules burden outbound transfers of tangibles and intangibles.

For more than 60 years, Congress has been concerned with the tax-free transfer of appreciated property to foreign corporations, enacting a number of provisions over that time to ensure that such transfers are denied gain nonrecognition treatment. While the general purpose of Sec. 367 and the regulations thereunder i$ merely to ensure that the U.S. maintains taxing jurisdiction over such transfers, this article suggests that these rules surpass their intended purpose in many situations.

The general intent of Sec. 367 is to preserve U.S. taxing jurisdiction over appreciated property transferred to foreign corporations in certain tax-deferred exchanges. Prior to the enactment of the predecessor to Sec. 367 in 1932, Congress perceived a "serious loophole"(1) with respect to built-in gain property transferred outside of the U.S. in nontaxable exchanges. Sec. 367(a)(1) provides that if property is transferred by a U.S. person to a foreign corporation in an exchange described in Sec. 332,(2) 351, 354, 356 or 361, the corporation will not be treated as a corporation for gain recognition purposes (but losses remain deferred under the relevant nonrecognition provision). The effect is to negate nonrecognition treatment through the denial of corporate status to the foreign transferee, a critical element in qualifying for such treatment under these provisions. Exceptions are provided for certain (1) transferred property to be used by the foreign transferee in the active conduct of a trade or business outside of the U.S. and (2) transfers of stock or securities if the U.S. transferor(s) satisfies enumerated ownership tests and other requirements.

The Tax Reform Act of 1984 (TRA '84), Section 131(b), enacted Sec. 367(d) to address separately certain outbound transfers of intangibles under Secs. 351 and 361. Essentially, this provision treats the U.S. transferor(s) as having sold the intangible for a series of annually determined U.S.-source payments. Section 1231(e)(2) of the TRA '86 added the "commensurate with income" (CWI) standard to Sec. 367(d), which requires the U.S. transferor's annual deemed payments to reflect an amount contingent on the productivity, use or disposition of the intangible in the hands of the foreign transferee. This article summarizes the legislative history and current statutory and regulatory authorities dealing with outbound transfers under Sec. 367.(3)

Outbound Transfers of Stock or Securities

Prior to the enactment of the predecessor to Sec. 367, certain perceived abuses existed relating to outbound transfers of stock or securities:

Example 1(4): A, an American citizen, owns 100,000 shares of stock in corporation X with a basis of $1,000,000 and a fair market value (FMV) of $10,000,000. Instead of selling the stock outright, A organizes corporation C under the laws of Canada, then transfers the 100,000 X shares for C's entire capital stock in a nontaxable exchange. C sells the X stock for 310,000,000. The latter transaction is exempt from tax under Canadian law and is not taxable in the U.S. C organizes U.S. corporation Y and transfers the $10,000,000 received on the sale of the X stock for the entire capital stock of Y. C then distributes the Y stock to A in connection with a reorganization. By this series of transactions, A has had the X stock converted into cash and now has it in complete control.

Since 1932, many provisions (in addition to Sec. 367) have been added to the Code to battle such abuses. For instance, in the above example, C's disposition of the X stock would currently result in a subpart F inclusion to A under Sec. 954(c)(1)(B)(i). Also, under Sec. 956(c)(1)(B), the mere holding of X stock under the facts of the example would potentially produce a deemed dividend to A. With the enactment of these and other related provisions,(5) it might reasonably be argued that, in many cases, Sec. 367 has surpassed its intended purpose of preserving U.S. taxing jurisdiction over outbound transfers of built-in gain property.

Legislative Overview

As originally enacted, Sec. 112(K) (the predecessor to Sec. 367) provided that a U.S. transferor had to obtain a favorable ruling prior to an outbound transfer to a foreign corporation under Sec. 332, 351, 354, 355, 356 or 361, concluding that the principal purpose of the transfer was not tax avoidance, for the foreign transferee to be treated as a corporation. Rev. Proc. 68-23(6) contained the first set of comprehensive guidelines indicating when such favorable rulings would be issued, although the U.S. transferor continued to be denied a judicial remedy to the extent an adverse IRS determination was issued.(7) In addressing this issue, the Tax Reform Act of 1976 (TRA '76), Section 1042(d)(1), added former Sec. 7477, which allowed taxpayers to petition the Tax Court for declaratory judgments after all administrative remedies had been exhausted. The TRA '76 also allowed U.S. transferors to delay a ruling request until 183 days after the initial transfer. Section 131(e)(1) of the TRA '84 repealed the mandatory ruling procedure under Secs. 367 and 7477 altogether.

In May 1986, temporary regulations(8) (1986 regulations) were issued dealing in part with outbound transfers of stock or securities. Due to concerns that these regulations were overly complex and failed to provide coherent guidance, the IRS issued Notice 87-85(9) (generally effective for transfers occurring after Dec. 16, 1987), which, for the most part, repealed the 1986 regulations, except for those dealing with "gain recognition agreements" (GRAB) (discussed below). Notice 87-85 stated that new regulations would be issued providing for exceptions to gain recognition under Sec. 367 for outbound transfers of stock or securities of both foreign and domestic corporations based on the U.S. transferor's ownership in the foreign transferee immediately after the exchange. In August 1991, the IRS published two sets of proposed regulations (1991 regulations): one set dealt with outbound transfers under Sec. 367(a)(10) by incorporating the changes previously announced in Notice 87-85; the other addressed inbound so-called "foreign-to-foreign" transfers under Sec. 367(b).(11) Notice 94-46(12) (effective for transfers occurring after Apr. 17, 1994) effectively overrode Notice 87-85 with respect to outbound transfers of domestic stock or securities. Notice 94-46 also provided that final regulations would be issued to deny nonrecognition treatment for certain outbound transfers of domestic stock. Temporary regulations(13) under Notice 94-46 were issued in December 1995 (1995 temporary regulations). These regulations were finalized in December 1996 (1996 final regulations); the latter contains slight modifications to the 1995 temporary regulations.(14)

Under Notice 87-85 and the Sec. 367(a) 1991 regulations. nonrecognition treatment to U.S. transferors with respect to outbound transfers of foreign (and domestic) stock was based principally on the U.S. transferor's ownership in the foreign transferee (applied on a transferor-by-transferor basis). If such ownership (measured by vote and value) in the foreign transferee was less than 5% after taking into account the Sec. 958 attribution rules, gain recognition was not required.(15) If ownership in the foreign transferee was at least 5%. gain recognition could generally be avoided only if the U.S. transferor(s) entered into a five-year (if the foreign transferee was not U.S.-controlled) or 10-year (if the foreign transferee was U.S.-controlled) GRA with the IRS.(16) However, gain recognition was required under Notice 87-85 if (1) on transfers of domestic stock a particular U.S. transferor owned more than 50% of the foreign transferee immediately after the transfer, or (2) a U.S. transferor transferred stock in a controlled foreign corporation (CFC)(17) to a foreign transferee that was either (a) not a CFC immediately after the exchange or (b) a CFC immediately after the exchange, but the U.S. transferor was no longer a "U.S. shareholder."(18)

The first exception to nonrecognition, also contained in Prop. Regs. Sec.1.367(a)-3(b)(3), was intended to prevent U.S. corporate transferors from creating two consolidated groups for foreign tax credit (FTC) limitation purposes.(19) As to the second exception, it is not clear why the IRS mandated recognition of the U.S. transferor's entire gain on the transfer, because the untaxed earnings and profits (E&P) in the transferred CFC would have been recognized or otherwise considered under the Sec. 367(b) temporary regulations in existence prior to the issuance of Notice 87-85.(20) The IRS apparently reconsidered its position on this matter; the Sec. 367(a) 1991 regulations do not contain this "no exception" to the gain recognition requirement.

However, the 1991 regulations allow U.S. transferors to elect to be governed by those regulations' gain recognition rules. The election triggers application of the Sec. 367(b) 1977 temporary regulations.(21) (In the absence of such an election, Prop. Regs. Sec. 1.367(a)-3(f) provides that U.S. transferors are subject to Notice 87-85.) Once made, the election overrides Notice 87-85 and entitles the U.S. transferor to the general exceptions to gain recognition for transfers of CFC stock; however, these exceptions only apply to the U.S. transferor's Sec. 367(a) gain on the transferred shares; the current Sec. 367(b) regulations still generally mandate protection of U.S. taxing jurisdiction over the CFC's untaxed E&P.(22) Two different treatments generally apply under these regulations, depending on whether the U.S. transferor of the CFC stock is a "U.S. shareholder" in the foreign transferee immediately after the exchange. If the U.S. transferor is a U.S. shareholder in the foreign transferee, the taint associated with the transferred CFC's untaxed E&P is attributed to the shares received in the foreign transferee.(23) If the U.S. transferor is not a U.S. shareholder in the foreign transferee immediately after the exchange, the U.S. transferor must include in income a deemed dividend equal to the untaxed E&P in the transferred CFC under principles similar to those under Sec. 1248.(24) This gain would be a deemed dividend under Sec. 1248 and potentially allow the U.S. transferor an indirect FTC for the foreign taxes paid by the transferred CFC attributable to the deemed dividend.

For outbound transfers of domestic stock occurring after Apr. 17, 1994, Notice 94-46, the 1995 temporary and the 1996 final regulations modify Notice 87-85 and the Sec. 367(a) 1991 regulations when the U.S. transferors (in the aggregate) own more than 50% of the foreign transferee immediately after the transfer; once this threshold is met, gain recognition applies to all U.S. transferors (even those owning less than 5%). In contrast, gain recognition under Notice 87-85 and the Sec. 367(a) 1991 regulations only applied to a transfer of domestic stock if a particular U.S. transferor (as opposed to all U.S. transferors in the aggregate) owned more than 50% (applying constructive ownership principles) of the foreign transferee immediately after the transfer. The shift in treatment initiated by Notice 94-46 was a result of Treasury's concern over "corporate inversion" transactions, in which a CFC formerly held by a domestic corporation (DC) became the DC's parent. This "flip" in ownership was typically accomplished by the DC's shareholders transferring their DC shares to a foreign corporation (FC) for newly issued FC shares. This transaction often resulted in "decontrolling" the FC under the subpart F provisions25 and effectively expatriated the FC's E&P in a tax-deferred manner,26 a concern of Treasury's discussed in Notice 94-46:

The Internal Revenue Service and the Treasury Department are concerned that widely-held U S. companies with foreign subsidiaries recently have undertaken certain restructurings for tax-motivated purposes. These restructurings typically involve a transfer of the stock of the domestic parent corporation to an existing foreign subsidiary or a newly-formed foreign corporation in exchange for shares of the foreign corporation in a transaction intended to qualify for nonrecognition treatment under the Code. Following the transaction, the former shareholders of the domestic corporation own stock of a foreign corporation that typically is not a controlled foreign corporation ...within the meaning of section 957....

Notice 87-85 (and, by election, the Sec. 367(a) 1991 regulations) continues to apply to outbound transfers of foreign stock, while the new (somewhat harsher) treatment discussed above under Notice 94-46 and the 1995 temporary regulations applies to transfers of domestic stock after Apr. 17, 1994.(27) Under final Regs. Sec. 1.367(a)-3(c)(11), the 1996 final regulations apply to transfers occurring after Jan. 29, 1997, although taxpayers may elect to apply them to transfers occurring after Apr. 17,1994, assuming the statute of limitations for the affected tax year(s) is open.

GRAs

The preamble to the 1991 regulations states that the GRA provisions set forth therein do not differ significantly from the terms and conditions set forth in the 1986 regulations(28) and Notice 87-85. These terms and conditions are generally adopted in their entirety by both the 1995 temporary and the 1996 final regulations, except for certain ownership threshold requirements triggering the GRA procedures(29) (discussed above). Although the 1991 regulations are proposed, the IRS has been applying the GRA provisions of those regulations in practice.(30) Nonetheless, Prop. Regs. Sec. 1.367(a)-8 cannot be elected; thus, the following discussion is based on the 1995 temporary regulations.

As explained in Temp. Regs. Sec. 1.367(a)-3T(g), under a GRA, a U.S. transferor agrees to file an amended return and recognize the gain deferred on the original transfer if (1) the foreign transferee disposes of part or all the transferred stock or securities or (2) the transferred corporation disposes of substantially all of its assets outside of the normal course of business. The GRA must be filed with Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, Foreign Estate or Trust, or Foreign Partnership, and attached to the transferor's income tax return for the year of transfer under the Sec. 6038B information reporting requirements.

Additionally, Temp. Regs. Sec. 1.367(a)-3T(g)(5)(i) requires an annual certification providing information on any dispositions occurring during the year. Temp. Regs. Sec. 1.367(a)3T(g)(5)(u) requires that the U.S. transferor agree to waive the statute of limitations for eight years (for five-year GRAB) or for 13 years (for 10-year GRAB). The amended return is due by the ninetieth day after the GRA is triggered, according to Temp. Regs. Sec. 1.367(a)-3T(g)(3)(i), and must reflect an imputed interest charge on the deferred gain over the deferral period. Once triggered, the gain to be recognized under the GRA is the excess of the property's FMV over its basis at the time of the original transfer.

Certain transfers following the original transfer do not trigger the GRA. For example, under Temp. Regs. Sec. 1.367(a)-3T(g)(7), a liquidation of the transferred corporation into an 80% or-greater shareholder does not trigger the GRA, but the taint associated with the transferred assets attaches at the parent level; thus, a disposition of substantially all of these assets (outside of the normal course of business) within the GRA period riggers gain on the original transfer. A subsequent disposition by the foreign transferee will not trigger the GRA if (1) the transferee's gain is not subjected to U.S. taxation, (2) the transferee receives share, partnership or trust interests in the acquiring entity and (3) certain procedural rules are met.

Outbound Transfers of Assets

Legislative Overview

As was discussed, transfers of appreciated assets to foreign corporations under the predecessor to Sec. 367 generally resulted in gain recognition to the U.S. transferors unless a favorable ruling was obtained prior to the transfer. Rev. Proc. 68-23 attempted, in part, to provide guidance on obtaining a favorable ruling for certain outbound transfers of assets to be used by the foreign transferee in an active trade or business outside the U.S. The active trade or business exception, currently embodied in Sec. 367(a)(3)(A), is discussed below.

Active Trade or Business Exception

Sec. 367(a)(3)(A) exempts certain transfers of tangible assets that will be used by the foreign transferee in the "active conduct of a trade or business"(31) outside the U.S.(32) This exception often provides relief when a foreign branch's assets are transferred to a foreign corporation, as long as (according to Temp. Regs. Sec. 1.367(a)-4T(d)) "it is reasonable to believe" that the transferee will not dispose of any material portion of the transferred property "in the foreseeable future" in a transaction outside the ordinary course of business. However, Temp. Regs. Sec. 1.367(a)-4T(b) provides that a U.S. transferor will recognize depreciation recapture on the transferred assets as ordinary income to the extent the recapture provisions would have applied in a normal disposition. Nonrecognition treatment is also denied on the following "tainted" assets, under Temp. Regs. Sec. 1.367(a)-5T(b) and (c): (1) inventory property held for sale in the normal course of business: (2) installment obligations and accounts receivable; (3) foreign currency or other property denominated in foreign currency; (4) intangibles (excluding, according to Temp. Regs. Sec. 1.367(a)-5T(e), goodwill and going concern value developed by the foreign business prior to incorporation); and (5) under Sec. 367(a)(3)(B)(v), certain leased property if the U.S. transferor is the lessor and the foreign transferee is not the lessee. Congress apparently chose to deny nonrecognition treatment on these assets because they are relatively liquid in nature and would thus potentially offer the transferee an opportunity to quickly convert them into cash.(33)

Nonrecognition treatment is also denied by Sec. 367(a)(3) (C) on the incorporation of a foreign branch to the extent it has any remaining net losses incurred prior to incorporation. The purpose of the "branch loss recapture rule" is to prevent U.S. taxpayers from enjoying a flowthrough of losses during the start-up period and a deferral of income in subsequent profitable periods due to incorporation (although a time value of money benefit is nonetheless obtained on the loss deferral period). Under Temp. Regs. Sec. 1.367(a)-6T(c)(3), the recapture is the lesser of the previously deducted branch losses or the gain realized on the transfer.(34)

Example 2: Net branch losses prior to the incorporation of company F are $200. Tainted branch assets (i.e., inventory, accounts receivable, etc.) have a potential gain of $60, other untainted assets have a potential gain of $180. Thus, the transferor, T, would recognize $240 ($60 on tainted assets + $180, the lesser of realized gain or prior branch losses). If the gain on the untainted assets was $60, T would recognize $120 ($60 on tainted assets + $60, the lesser of realized gain or prior branch losses). If the gain on the untainted assets was $300, T would recognize $260 ($60 on tainted assets + $200, the lesser of realized gain or prior branch losses).

Recaptured gain is deemed to be foreign source under Sec. 367(a)(3)(C) and has the same character as the previously deducted branch losses. If incorporation of a branch also results in gain recognition under Sec. 904(f)(3) (dealing with certain asset disposition events for FTC purposes), branch losses are reduced by an allocable portion of the Sec. 904(f) (3) gain recognized, according to Temp. Regs. Sec. 1.367(a)-6T(e)(3) and (5).

As was noted, nonrecognition treatment is generally denied on transfers of tainted assets from U.S. transferors in a Sec. 351 exchange. Congress enacted Sec. 367(c)(2) in 1971 to capture capital contributions not literally falling under Sec. 351 due to the nonissuance of stock by the foreign transferee. Under Sec. 367(c)(2), a U.S. transferor's contribution is treated as having been made for stock equal in value to the contributed property if the U.S. transferor owns at least 80% of the transferee immediately after the transfer. Additionally, under Sec. 367(a)(4), transfers of partnership interests are direct asset transfers to the extent of the U.S. transferor's pro rata share of the partnership's assets.

Outbound Transfers of Intangibles

Sec. 367(d) was enacted in 19S4 to address perceived abuses associated with transfers of intangibles by U.S. persons to foreign corporations in Sec. 351 incorporation transfers and Sec. 361 reorganization transfers. Congress was concerned with outbound transfers of intangibles because such property was often transferred out of the U.S. at a point of profitability, even though the U.S. transferors had substantially reduced their U.S. taxes by research and experimentation deductions previously incurred during the development of such property.(35) Prior to Sec. 367(d), such transfers were often exempt from taxation under Sec. 367(a)(3) if the intangible was used outside of the U.S. in the active conduct of a trade or business; thus, U.S. transferors often avoided gain recognition on the outbound transfer and were also generally successful in deferring U.S. taxation on the operating profits from use of the intangible until such profits were actually returned to the U.S. in a repatriation transfer.(36) Congress also noted that by incorporating the foreign transferee in a low-tax jurisdiction, the U.S. transferors avoided any significant foreign tax on the operating profits generated from the use of the intangible.(37)

To the extent an outbound transfer of intangibles falls under Sec. 367(d), the U.S. transferor is treated under Sec. 367(d)(2) as having sold the intangible in exchange for a series of annually determined payments contingent on the productivity, use or disposition of such property in the foreign transferee's hands. According to Sec. 367(d)(2)(A)(ii)(I), the deemed payments continue over the useful life of the property, defined by Temp. Regs Sec. 1.367(d)-1T(c)(3) as consisting of the period over which the property has value (not to exceed 20 years). The U.S. transferor is also imputed a lump-sum deemed payment when the stock of the foreign transferee is disposed of or the foreign transferee disposes of the intangible before its useful life expires.(38) According to Sec. 367(d)(2)(C) and Temp. Regs. Sec. 1.367(d)-1T(c)(1), these deemed payments (whether imputed while held by the foreign transferee or at a later disposition) are U.S.-source ordinary income, regardless of whether a sale or exchange of the intangibles would have given rise to capital gain. According to Sec. 367(d)(2)(B) and Temp. Regs. Sec. 1.367(d)-1T(c)(2), the deemed annual payments are treated as a reduction of the foreign transferee's E&P and can be allocated as a deduction to the transferee's subpart F income.

Due to the harshness of Sec. 367(d), it is generally recommended that the intangible be licensed (rather than contributed) to the foreign transferee; such an arrangement generally allows the transferee a deduction in its home country for the royalty payment and allows the U.S. licensee to characterize such payments as foreign-source income.(39) However, a licensing agreement is not always practical from a business point of view. In the case of a joint venture (JV) arrangement, for instance, the JV partner(s) not contributing intangible property would typically object to the contributing partner pulling out JV profits (i.e., in addition to its allocable share) in the form of royalties. In such a case, it has been suggested that the U.S. transferor license the intangible to a wholly owned foreign subsidiary that would contribute its interest in the intangible to the foreign JV; such an arrangement arguably avoids Sec. 367(d), because the contributing entity is not a U.S. person.(40)

Current Statutory and Regulatory Guidance

Treasury issued temporary regulations under Sec. 367(d) in May 1986(41); Temp. Regs. Sec. 1.367(d)-1T(i) applies them retroactively to transfers of intangibles occurring after 1984. TRA '86, Section 1231(e)(1) and (2), amended Sec. 367(d) concurrently with Sec. 482 by adding the CWI standard to both sections as they relate to transfers of intangibles. Although the Sec. 367(d) regulations have not been updated to take this amendment into account, Temp. Regs. Sec. 1.367(d)-1T(c)(1) cross-references the Sec. 482 regulations, which have been significantly revised to deal with this matter.(42) This cross-reference, coupled with the fact that the CWI standard was added to Secs. 367(d) and 482 at the same time, indicates that the standard should be applied similarly for both provisions; thus, the Sec. 482 regulations should be relevant when dealing with Sec. 367(d).

Intangibles Subject to Sec. 367(d)

According to Secs. 367(d) and 936(h)(3)(B), the deemed royalty provisions apply to outbound transfers of a patent, invention, formula, process, design, pattern, know-how; copyright, literary, musical or artistic composition; trademark, trade name, brand name; franchise, license, contract; method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, technical data; or any similar item that has substantial value independent of the services of any individual.(43) Foreign goodwill and going concern value used in a business outside of the U.S. (along with certain foreign marketing intangibles) are excluded by Temp. Regs. Sec. 1.367(d)-1T(b). Sec. 367(d)(1) applies only to outbound transfers under Secs. 351 and 361; thus, intangibles not meeting the definition of "property" under these provisions would not be covered under Sec. 367(d), and may be subject to gain recognition under other provisions. Therefore, it is likely that transfers of items not qualifying as property will likely be governed by Sec. 482, as it relates to sales and/or licenses of intangibles.

Deemed Annual Royalty Payments

The deemed royalty under Sec. 367(d) must be adjusted periodically to capture the current income being earned by the intangible. For this purpose, Regs. Sec. 1.482-4(f)(2)(i) provides that Regs. Sec. 1.482-4 should apply when property is transferred under an arrangement covering more than one year. The CWI standard reflects congressional intent to adjust the deemed annual payments to reflect actual changes in the income being generated by the foreign transferee.44 Temp. Regs. Sec. 1.6038B-1T(d)(1)(v) requires a U.S. transferor of intangibles to provide and explain the calculation of the deemed payment on Form 926.

Under Temp. Regs. Sec. 1.367(d)-1T(c)(1), the deemed payment is treated as received by the U.S. transferor on the last day of its tax year, despite the foreign transferee's year-end; thus, the U.S. transferor's computation of its estimated tax payments should not be affected by the deemed payments under the annualized income installment method. (This is no longer the case with deemed income inclusions under subpart F.(45)) Under Temp. Regs. Sec. 1.367(d)-1T(c)(4), the deemed payments are treated as received, even if the payment could not have been legally made by the foreign corporation, although no allocation would generally be made under Sec. 482 for income otherwise blocked under the laws of the foreign jurisdiction.

As previously noted, the deemed annual payments are treated as U.S.-source ordinary income; thus, in the absence of an "excess limitation" under Sec. 904(d), the U.S. transferor will not be able to offset the U.S. tax associated with the deemed income against its FTC. This is an important point when viewed in connection with the disallowance of a deduction in the foreign jurisdiction for the "deemed payment." The net result is double taxation, because both the U.S. and the foreign country will be taxing the income attributable to the use of the transferred intangible. An interest-free account receivable is deemed established in the year of income imputation to allow an actual payment by the foreign transferee without any further U.S. consequences, as long as such payment is made by the last day of the third tax year following the year the income was originally imputed to the U.S. transferor. (Temp. Regs. Sec. 1.367(d)-1T(g)(1) disallows a Sec. 166 bad debt deduction to the extent an actual payment is not made.) It is unclear how (any) foreign withholding tax attaching to an actual payment by the foreign transferee would be basketed for FTC purposes. It is also unclear how the E&P reduction in the foreign transferee is matched with the deemed payments when the transferee is not wholly owned by the transferor (i.e., the transferor would pay U.S. tax on all of the deemed royalty income, while presumably receiving a benefit only for its pro rata portion of the E&P reduction in the foreign transferee).

Dispositions of Stock and/or Intangibles

If the foreign transferee stock is disposed of during the term of the deemed royalties to an unrelated person, the deemed royalties are no longer required to be recognized; the U.S. transferor instead recognizes U.S.-source income (but not loss) under Temp. Regs. Sec. 1.367(d)-1T(d)(1) equal to the difference between the value of the intangible on the date of disposition less the transferor's basis in it as of the date of the original transfer. (Apparently, the transferor's basis in the intangible is not adjusted upward by the deemed income imputed prior to the disposition.) Under Temp. Regs. Sec. 1.367(d)-1T(e)(3), the U.S. transferor's treatment under Sec. 367(d) continues unaltered if the foreign transferee shares are transferred to a related foreign person; dispositions to a related U S. person result in the deemed royalties being shifted to that person, under Temp. Regs. Sec. 1.367(d)-1T(e)(1).

If the foreign transferee disposes of the intangible during the term of the deemed royalties to an unrelated person, the U.S. transferor recognizes gain of the excess of the intangible's FMV at the time of the subsequent transfer over the U.S. transferor's basis in it at the time of the original transfer; the foreign transferee is treated as if it made a distribution to the U.S. transferor of the amount of the U.S. transferor's gain recognized on the subsequent transfer. (Under Temp. Regs. Sec. 1.367(d)1T(f)(1) and (2), this deemed distribution will reduce the foreign transferee's E&P and increase the U.S. transferor's share basis in the foreign transferee.) According to Temp. Regs. Sec. 1.367(d)-1T(f)(3), dispositions of the intangible to related persons have no tax effect on the U.S. transferor.

Conclusion

This article has attempted to concisely summarize the legislative history and current statutory and regulatory authorities dealing with outbound transfers under Sec. 367. Although an attempt has been made to discuss some of the more practical aspects surrounding outbound transfers of built-in gain property to foreign corporations, there are many snares and traps for the unwary. Thus, extreme caution is advised when dealing with the Sec. 367 outbound transfer provisions.

(1) See S. Rep. No. 72-665, 72d Cong., 1st Sess. 26 (1932), 1939-1 CB (Part 2) 496, 515.

(2) Sec. 367(e)(2), enacted by Section 631(d)(1) of the Tax Reform Act of 1986 (TRA '86), currency governs outbound liquidating transfers. A discussion of transfers under Sec. 367(e) is beyond the scope of this article.

(3) For more in-depth coverage, see generally, Kuntz and Peroni, US. International Taxation (Warren Gorham and Lamont, 1992), [paragraph][paragraph] B2.04, A3.06; Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders (Warren Gorham and Lamont, 6th ed., 1994), [paragraph] [paragraph] 15.80-15.84; Bittker and Lokken, Federal Taxation of Income, Estates and Gifts (Warren Gorham and Lamont, 2d ed., 1991), [paragraph] 68.6; Dolan, U.S. Taxation of International Mergers, Acquisitions, and Joint Ventures (Warren Gorham and Lamont, 1995), [paragraph] 9.04; Davis, "Outbound Transfers of Tangible Property Under Section 367(a), Parts I and II," 23 Tax Management International Journal 55 (Feb. 11, 1994) and 103 (Mar. 11, 1994); "Outbound Transfers of Stock or Securities Under 367(a) After Notice 94-46, Parts I, II and III," 23 Tax Management International Journal 263 (June 10, 1994), 319 (July 8, 1994) and 371 (Aug. 12, 1994); "Outbound Transfers of Intangible Property Under Section 367(d) After The New Section 482 Regulations," 23 Tax Management International Journal 471 (Oct. 14, 1994).

(4) Adapted from H. Rep. No. 72-708, 72d Cong., 1st Sess. 20 (1932), 1939-1 (Part 2) CB 457, 471.

(5) The passive foreign investment company (PPIC) rules (Secs. 1291-1297) would also require income recognition to A or assess an interest charge on the deferral.

(6) Rev. Proc. 68-23, 1968-1 CB 821.

(7) See Dittler Bros., Inc., 72 TC 896, 907 (1979).

(8) Temp. Regs Sec 1.367(a)-3T, TD 8087 5/15/86), amending TDs 7530 (12/27/77) and 7863 (12/23/82), and amended by TD 8638 (12/26/95).

(9) Notice 87-85, 1987-2 CB 395.

(10) Prop. Regs. Sec. 1.367(a)-3, INTL-054-91, INTL-178-86 (8/26/91).

(11) Prop. Regs. Sec. 1.367(b), INTL-054-91, INTL-178-86 (8/26/91). A discussion of the Sec. 367(b) proposed regulations is beyond the scope of this article.

(12) Notice 94-46, 1994-1 CB 356.

(13) Temp. Regs. Sec. 1.367(a)-3T, TD 8638 (12/26/95).

(14) TD 8702 (12/27/96). The primary modifications deal with transfers of "other property" in the context of the 50% ownership requirement and the active trade or business requirement; see final Regs. Sec. 1.367(a)-3(c).

(15) Notice 87-85, note 9, p. 396; Prop. Regs. Sec. 1.367(a)-3(b)(1)(i).

(16) Notice 87-85, note 9, p. 396; Prop. Regs. Sec. 1.367(a)-3(b)(1)(ii).

(17) See note 25 for the definition of "CFC."

(18) See note 25 for the definition of "U.S. shareholder."

(19) See Sec. 904(i), which was enacted to address the same concern.

(20) Regs. Secs. 7.367(b)-(4)(b), -(7)(b) and -9; see the discussion in the next text paragraph.

(21) Prop. Regs. Sec. 1.367(a)-3(f)(2), cross-referencing Regs. Secs. 7.367(b)-4 and -7 of the 1977 regulations.

(22) The general principle under Sec. 367(b), as it relates to the discussion herein, is to preserve U.S. taxing jurisdiction over untaxed E&P of CFCs transferred to a foreign transferee that is either (1) a non-CFC after the transfer or (2) a CFC after the transfer with "U.S. shareholders" that do not include the U.S. transferor.

(23) Regs. Secs. 7.367(b)-(7)(b) and -9.

(24) Regs. Sec. 7.367(b)-7(c) and Sec. 1248.

(25) Very generally, a foreign corporation is a CFC under subpart F, if, applying constructive ownership principles, its U.S. shareholders (u.s. persons owning at least 10% of the vote) own more than 50% of the corporations vote or value.

(26) See, e.g., Rohinton K. Bhada, 892 F2d 39 (6th Cir. 1989) (65 AFTR2d 90-421 90-1 USTC [paragraph] 50,001), aff'g 89 TC 959 (1987); Edward J. Caamano, 879 F2d 156 (5th Cir. 1989) (64 AFTR2d 89-5335, 89-2 USTC [paragraph] 9464), aff'g 89 TC 599 (1987).

(27) Temp. Regs. Sec. 1.367 (a)-3T(d), cross-referencing Notice 87-85 with respect to outbound transfers of stock or securities of foreign corporations.

(28) See Temp. Regs. Sec. 1.367(a)-3T(g).

(29) Compare the 1986 and 1995 versions of Temp. Regs. Sec. 1.367(a)-3T(g); Temp. Regs. Sec. 1.367(a)-3T(g)(iii) was deleted from the 1995 temporary regulations. Regs. Sec. 1.367(a)-3 of the 1996 final regulations contains slight modifications to the five- and 10-year GRA provisions.

(30) See IRS Letter Rulings 9022057 (3/7/90) and 9022058 (3/7/90).

(31) For this purpose, "trade or business" is defined at Temp. Regs. Sec. 1.367(a)-2T(b)(2) to include a specific unified group of activities that constitute an independent economic enterprise carried on for profit.

(32) Temp. Regs. Sec. 1.367(a)-2T(b)(4) states that substantially all assets and primary management and operational activities must be conducted outside the U.S. to qualify under this provision.

(33) See Staff of the Joint Committee on Taxation, 98th Cong., 2d Sess. (1984), General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, p. 427 (hereinafter, the "Blue Book").

(34) The gain computation includes foreign goodwill and going concern value.

(35) See Blue Book, note 33, p. 427.

(36) Operating income from the intangibles derived in the active conduct of a trade or business would generally not be tainted income under subpart F (Secs. 951-964) or the PFIC rules (Sees. 1291-1297).

(37) See Blue Book, note 33, p. 427.

(38) Sec. 367(d)(2)(A)(ii)(II); Temp. Regs. Sec. 1.367(d)-1T(e) and (f); see the discussion below under "Dispositions of Stock and/or Intangibles."

(39) Sec. 862(a)(4) sources royalties as foreign-source income when the intangible is used outside the U.S.

(40) See Davis and Lainoff, "U.S. Taxation of Foreign Joint Ventures," 46 Tax Law, Review 165, 193-194 (Winter 1991).

(41) TD 8087 (5/15/86).

(42) Due to subsequent changes in the Sec. 482 regulations, the revised cross-reference should be to Regs. Sec. 1.482-4.

(43) Temp. Regs. Secs. 1.367(d)-1T(b) and -ST(b)(2) exclude any copyright, etc., described in Sec. 1221(3).

(44) See Staff of the loins Committee on Taxation, 99th Cong., 2d Sess. (1986), General Explanation of the Tax Reform Act of 1986, p. 1015.

(45) See Sec. 6654(d)(2)(D), enacted by Uruguay Round Agreements Act Section 711(b), which effectively revoked IRS Letter Ruling (TAM) 9233001 (4/28/92).

RELATED ARTICLE: EXECUTIVE SUMMARY

* Sec. 367's goal is to preserve U.S. taxing jurisdiction over appreciated property transferred to foreign corporations in certain tax-deferred exchanges, by denying the transferee corporate status for gain recognition purposes (resulting in denial of gain nonrecognition).

* Exceptions to gain nonrecognition are provided for certain transferred property to be used by the foreign transferee in the active conduct of a trade or business outside the U.S. and for certain transfers of stock or securities if the U.S. transferor meets ownership and other requirements.

* Sec. 367(d) treats the U.S. transferor of intangibles as having sold the property for a series of annually determined U.S.-source payments that must reflect the CWI standard.
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Author:McLeighton, Steven W.
Publication:The Tax Adviser
Date:Feb 1, 1997
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