By Anthony Diosdi
Whenever a U.S. person decides to establish a business abroad that will be conducted by a foreign corporation, it will be necessary to capitalize the foreign corporation with a transfer of cash and other property in exchange for its stock. When appreciated property, such as equipment or intangible property rights (e.g., foreign patents, knowhow and trademarks), is transferred to a foreign corporation, gain will often be realized by the U.S. person. This gain will be recognized and subject to U.S. tax unless one of the tax-free-exchange provisions of the Internal Revenue Code applies. The imposition of U.S. tax on a transfer of appreciated property to a foreign corporation is a substantial deterrent in many cases. Accordingly, tax planning is necessary to ensure that the transaction is structured in a way to minimize or eliminate the initial U.S. tax burden associated with transfer.
If a U.S. corporation is liquidated and its assets are distributed to foreign shareholders, U.S. tax will be imposed on the gain realized by the distributing corporation except to the extent that a tax-free-exchange provision provides otherwise.
If the stock or assets of a U.S. corporation are acquired by a foreign corporation in exchange for stock of the foreign corporation in exchange for stock of the foreign corporation, or if, conversely, a foreign corporation is acquired for stock of a U.S. corporation, gain realized by U.S. shareholders and the U.S. corporation will be subject to tax, except to the extent that the gain is sheltered by a tax-free-exchange provision.
Under the Internal Revenue Code, gain or loss realized in exchanges of property in connection with a variety of transactions involving only U.S. corporations will go unrecognized if the requirements of the applicable tax-free-exchange provisions are met. Such transactions include transfers of property to a controlled corporation, liquidation of a controlled subsidiary into its corporate parent and certain corporate reorganizations.
The basic roadblock for anyone involved in cross-border transfer or merger transactions planning is Internal Revenue Code Section 367. Section 367 requires U.S. persons transferring appreciated property to a foreign corporation to recognize a gain on the transfer. Section 367 stands sentinel to ensure that (with certain exceptions), a U.S. tax liability (sometimes called a “toll charge”) is imposed when property with unappreciation is transferred beyond U.S. taxing jurisdiction. The character and source of the gain produced by the outbound toll charge is determined as if the transferor had sold the property to the transferee in a taxable transaction. For example, if the outbound transfer involves inventory that the transferor purchased for resale, any resulting taxable gain would be soured under the title passage rule applicable to inventory sales in general. In addition, the U.S. transferor must recapture and recognize as ordinary income any depreciation deductions claimed on depreciable property that was used in the United States. Finally, the U.S. transfer’s basis in any shares received in an outbound transfer equals the U.S. transferor’s basis in the property transferred, increased by the amount of gain recognized on the transfer.
Active Foreign Business Use Exception
The outbound toll charge does not apply to property transferred to a foreign corporation if the following requirements are satisfied:
1) The foreign corporation actively conducts a trade or business;
2) The trade or business is conducted outside the United States; and
3) The foreign corporation uses the property in that trade or business.
In these situations, the policy of allowing companies to make routine corporate adjustments unaffected by taxes is considered more important than taxing all appreciated property being transferred out of the taxing jurisdiction of the United States. With that said, the depreciation recapture rule discussed above still applies, however, and therefore the U.S. transferor still must recapture and recognize as ordinary income any depreciation deductions claimed on depreciable property that was used in the United States.
Whether a particular transfer satisfies the requirements of the active foreign business use exception is a question of fact. In general, the active conduct of a trade or business requirement is satisfied only if the officers and employees of the transferred or the officers and employees of related entities, if supervised and paid by the transferred, carry out substantial managerial and operational activities. To satisfy the requirements that the business be conducted outside the United States, the primary managerial and operational activities of the trade or business must be conducted abroad and, immediately after the transfer, substantially all of the transferred assets must be located outside the United States.
Certain assets are ineligible for the active foreign business use exception. These tainted assets include:
1) Inventories, raw materials, supplies, and finished goods;
2) Installment obligations and accounts receivable;
3) Foreign currency or other property denominated in foreign currency;
4) Intangible property; and
5) Generally, property that the transferor is leasing at the time of the transfer.
Below, please see Illustration 1 which provides an example of active foreign business use exception.
During the current year, General Mistake (a domestic corporation) organizes MEXCali, a manufacturing subsidiary incorporated in Mexico. General Mistake then transfers inventory and some machinery and equipment to MEXCali in exchange for all of MEXCali’s shares. At the time of the transfer, the basis and fair market value of the transferred assets are as follows:
|Basis||Fair Market Value|
|Inventory||$5 Million||$7 Million|
|Machinery and Equipment||$10 Million||$15 Million|
The machinery and equipment were purchased two years ago for $14 million and General Mistake took $4 million of depreciation deductions on the machinery prior to the transfer. The machinery was used solely in General Mistake’s U.S. factory.
Assuming MEXCali’s foreign manufacturing operation satisfies the active foreign business requirements, the outbound transfer does not trigger U.S. taxation on the appreciation of the machinery and equipment. However, because General Mistake previously used the machinery and equipment in its U.S. factory, General Mistake must recognize $4 million of depreciation recapture income. The inventory is a tainted asset and therefore, General Mistake must recognize $2 million of gross income ($7 million market value – $5 million basis) on its transfer.
The active foreign business use exception will not apply if, at the time the property is transferred, it is reasonably believed that the transferee foreign corporation will soon dispose of the transferred property other than in the ordinary course of business. If the transferred foreign corporation transfers the property to another person as part of the same transaction, the active foreign business use exception will not apply to the initial transfer. Furthermore, any subsequent transfers to a third party in the next six months are presumed to be part of the initial transfer. A facts and circumstances test applies to subsequent transfers that occur more than six months after the original transfer.
Below, please see Illustration 2 which provides an example of active foreign business use exception.
Greedy Oil Co, a domestic corporation, organizes Great White, a manufacturing subsidiary incorporated in Canada. Greedy Oil Co transfers machinery purchased last month to Great White in exchange for all of Great White’s shares. At the time of the transfer the machinery had a basis of $30 million and a fair market value of $32 million. The machinery was purchased this year for $30 million and has jumped in value due to its suitability for use in the suddenly lucrative oil and gas industry. The machinery has been used solely in Greedy Oil Co’s U.S. refinery.
Assuming Great White’s foreign manufacturing operations satisfy the active foreign business use exception, the outbound transfer does not trigger the U.S. taxation of $2 million of appreciation in the value of the machinery ($32 million fair market value minus the $30 million basis). However, if Great White transfers the machinery to a third party in three months, the subsequent transfer is presumed to be part of the initial transfer and Greedy Oil Co would recognize the $2 million gain. If such a subsequent transfer occurred within seven months, which is more than six months after the initial transfer, a facts and circumstances test would apply to determine whether the subsequent transfer was part of the initial transfer.
Branch Loss Recapture Rules
A major exception to the active foreign business use exception is the branch loss recapture rule. Under this provision, a U.S. person must recognize gain on the incorporation of a foreign branch to the extent the U.S. person has previously deducted branch losses against its taxable income. These branch loss recapture rules must be separately applied to each foreign branch that a taxpayer transfers to a foreign corporation. Thus, the previously deducted losses of one branch may not be offset by the income of another branch for the purposes of determining the amount of gain that must be recognized under these rules.
Because various provisions requiring recognition of gain overlap, gain that is taxable under the branch loss recapture rule of Internal Revenue Code Section 367(a)(3)(C) could also be taxable under Internal Revenue Code Section 367(a)(3)(A) and (B) (gain on assets not used in active business abroad and gain on tainted assets) or be subject to Internal Revenue Code Section 904(f)(3) recapture under the overall foreign loss rules subject to the general limit or “cap” that the total gain to be recognized under Section 367(a) cannot exceed the gain that would have been recognized if the assets had been sold individually without offsetting individual losses against individual gains.
The basic rule of Internal Revenue Code Section 367(a)(3)(C) calls for recognition of gain realized on the incorporation of the branch to the extent that the previously deducted losses of the branch exceeded:
1) Any taxable income of the branch recognized prior to incorporation;
2) The amount of any foreign-source income that the taxpayer had to recharacterize as U.S.-source in the current or a prior taxable year by reason of the overall loss recapture provisions of the foreign tax credit limitation;
3) Any gain recognized on the transfer of the branch’s appreciated property to the newly organized foreign corporation;
After taking into account these reductions, the remaining branch loss recapture income is further limited to the amount of gain that would have been recognized on a taxable sale of the transferred property if each item was sold separately.
Deemed Royalty for Intangible Property
For a number of tax and business reasons, U.S. companies transfer intellectual property to foreign corporations. Congress has enacted special rules to tax the transfer of intellectual property offshore. With that said, the market value of patents, trademarks, and other intangibles often is highly uncertain, due to the inherent uniqueness of these assets. This uncertainty significantly weakens the deterrent effect of a one-time toll charge imposed at the time of the transfer, since new technologies and products can turn out to be far more successful than originally anticipated. As a consequence, a specific deemed royalty regime for intangibles treats an outbound transfer of an intangible as a sale in return for a series of royalty payments that are received annually over the useful life of the intangible and that are contingent on the productivity, use, or disposition of the intangible. This income is characterized as royalty income that is foreign source income.
Below, please see Illustration 3 which provides an example of the deemed royalty rules.
Pear (a domestic corporation) incorporates Jamsung, a manufacturing subsidiary incorporated in a foreign country by transferring a patent to Jamsung in exchange for all of Jamsung’s shares. Pear had a zero basis in the patent because it had deducted the related research and development expenditures as these expenditures were incurred.
Ignoring Internal Revenue Code Section 367(d), Pear’s outbound transfer to Jamsung is not subject to U.S. tax because it is part of a tax-free incorporation transaction. However, Section 367(d) recharacterizes the transaction as a sale in return for the foreign-source royalty payments received annually over the life of the patent.
The deemed royalty regime applies to a U.S. person’s contribution of intangible property to a foreign corporation in exchange for shares of the foreign corporation, where immediately after the exchange the U.S. person controls the foreign corporation. The deemed royalty regime also applies to a U.S. person’s transfer of intangible property to a foreign corporation as part of a corporate reorganization. For purposes of the deemed royalty regime, intangible property includes any patent, invention, formula, process, design, pattern, know-how, copyright, literary, musical, or artistic composition, trademark, trade name, brand name, franchise, license, contract, estimate, customer list, technical data, or other similar item. See IRC Section 367(d)(1). However, a copyright, literary, musical, or artistic composition transferred by a taxpayer whose personal efforts created the property is exempted from the deemed royalty requirement and can be transferred to a foreign corporation tax-free. See Treas. Reg. Section 1.367(a)-1(d)(5) and IRC Section 1221(a)(3).
Below, please see Illustration 4 which provides an example of an exception deemed royalty rules.
Bark Dog is an artist with many hits. His music catalog is worth millions of dollars. Bark Dog writes and composes all of his music. Bark Dog wants to transfer the rights to all his music to Phony, to Phony Music, a Japanese foreign corporation in a tax-free transaction. Since Bark Dog wrote and composed all his music, Bark Dog can transfer the rights to his music to Phony Music in a tax free transaction.
Cherry Ice is a successful rapper. Cherry Ice told all of his adoring fans that he grew up in a rough neighborhood in Miami, Florida and this was the inspiration for his music. In fact, Cherry Ice grew up in Beverly Hills, California and he purchased all of his music from Garvey Weinstein a former music mogul who is now in jail for tax evasion. Since Garvey Weinstein needed money for his legal defense, Cherry Ice bought the rights to dozens of songs at bargain prices. Because of Cherry Ice’s success, the value of these songs have skyrocketed. Unfortunately for Cherry Ice, a former girl has told Cherry Ice she will expose him as a fraud to his fans. Cherry Ice decides to transfer the rights to his music to Phony Music in a tax-free exchange before the value of his music plummets. Since Cherry Ice did not create his music, this transaction will not be exempted from the deemed royalty requirements.
The deemed royalty must be an arm’s-length amount, computed in accordance with the provisions of Internal Revenue Code Section 482 and its regulations. The deemed royalty amount also must be “commensurate with the income attributable to the intangible.” See IRC Section 367(d)(2)(A). In other words, the royalty amounts must reflect the actual profit experience realized subsequent to the outbound transfer. To meet this requirement, the royalty amount must be adjusted annually to reflect any unanticipated changes in the income actually generated by the intangible. See Treas. Reg. Section 1.482-4(f)(2)(i). For example, if a new patent leads to a product that turns out to be far more successful than was expected at the time the patent was transferred, the amount of the deemed royalty must reflect the unanticipated profit.
Under certain circumstances, a U.S. transferor may prefer having the transfer of intellectual property or an intangible to a foreign corporation taxed entirely at the time of the transfer as a taxable sale for its fair market value at a fixed price, rather than taxed as royalties over the life of the intangible. The regulations permits an election to treat the transfer of an intangible as a sale at its fair market value if certain requirements are met. If this election is made, the individual or corporation includes as ordinary gross income in the year of transfer the difference between the fair market value of the intangible on the date of the transfer and its adjusted basis.
The regulations permit this deemed sale election in three situations. First, the individual or entity may so elect if the intangible is an operating intangible. An operating intangible is an intangible of a type not normally licensed or transferred in transactions between unrelated parties for consideration contingent on use of the intangible. Examples include surveys, long-term contracts or supply contracts, customer lists, and studies.
Second, an individual or corporate entity may elect deemed sale treatment if the transfer is legally required by the government in the country of incorporation of the transferred corporation or is compelled by a genuine threat of immediate expropriation by such government.
Third, the individual or corporate entity may elect deemed sale treatment if:
1) The individual or corporation transferred the intangible to the foreign corporation within three months of the organization of that corporation as part of the original plan of capitalization of the corporation;
2) Immediately after the transfer of the intangible, the individual or business owns at least 40 percent and not more than 60 percent of the total voting power and total value of the transferred foreign corporation’s stock;
3) Immediately after the transfer of the intangible, foreign persons unrelated to the U.S. transferor own at least 40 percent of the total voting power and total value of the transferee corporation stock;
4) Intangibles constitute at least 50 percent of the fair market market value of property transferred by the U.S. person to the foreign corporation; and
5) The transferred intangible will be used in the active conduct of a trade or business outside the United States and will not be used for manufacturer or sale of products in or for use or consumption in the United States.
As an alternative to these rules, a U.S. transferor may prefer to enter into a license agreement with the transferred foreign corporation providing for actual royalties to the U.S. transferor for use of the intangible. Actual royalties will be subject to Internal Revenue Code Section 482, which generally authorizes the Internal Revenue Service (“IRS”) to reallocate income, deductions, credits, and allowances between related parties to reflect what the arrangement would have been if those parties had been dealing as independent parties at arm’s length. Although the U.S. tax treatment of royalties may be the same, the foreign tax consequences may differ. By licensing an intangible, the foreign transferee can ordinarily deduct the actual royalty payment for foreign tax purposes, whereas the deemed royalty amount is generally not deductible.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.