By Anthony Diosdi
Whenever a U.S. person decides to establish a business outside offshore that will be conducted through a foreign corporation, it will likely be necessary to capitalize the foreign corporation with a transfer of cash and other property in exchange for corporate stock. When appreciated assets, such as equipment or intangible property rights (i.e., patents, trademarks, copyrights, and other intangible property), is transferred to a foreign corporation, the U.S. transferor may be subject to taxable gain. This taxable gain will be realized by the transferor 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 to the transfer of property. Accordingly, the taxplanner should seek to ensure that the transaction is structured in a way to minimize or eliminate the initial U.S. tax burden.
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 a U.S. corporation is liquidated and its assets are distributed to a foreign corporation, U.S. tax will be imposed on the gains recognized by the distributing corporation. That is, unless a tax-free exchange provision contained in the Internal Revenue Code applies. If the stocks or assets of a U.S. corporation are acquired by a foreign corporation in exchange for stock of the foreign corporation, taxable gain may also be realized by the U.S. corporation unless the gain is sheltered by a tax-free exchange provision contained in the Internal Revenue Code. Even an acquisition of one foreign corporation by another foreign corporation involving U.S. shareholders who exchange their stock in the acquired corporation for stock in the acquiring corporation may be subject to U.S. tax unless the transaction qualifies as a tax-free exchange. Similarly, if a foreign corporation engages in a recapitalization or a reincorporation, U.S. shareholders who exchange their original stock or securities of the foreign corporation for new stock or securities will be taxed on any gain realized, except to the extent that a nonrecognition provision applies.
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. When the transaction involves one or more corporations organized in a foreign country, however, nonrecognition of gain is limited and frequently a transfer of appreciated assets or stock of a U.S. corporation to a foreign corporation is subject to a significant U.S. tax burden. Section 367 was enacted to protect the right of the United States from tax-free transfers by U.S. taxpayers of appreciated property to foreign corporations that could then sell the property free of U.S. tax.
Section 367 has two basic purposes. First, Section 367 ensures that (with certain exceptions) a tax liability or “toll charge” is imposed when property with untaxed appreciation is transferred abroad. This is accomplished by treating foreign transferred corporations as not qualifying as a “corporation” for purposes of the tax-free exchange provisions of the Internal Revenue Code. Second, Section 367 ensures that the earnings of a controlled foreign corporation (“CFC”) do not avoid U.S. tax as a result of shifting assets to an entity that is not a CFC as a result of some corporate reorganization or other transaction. In this latter respect, Section 367 is the mechanism that ensures the enforcement of the rules of Section 1248, which require dividend treatment when a U.S. shareholder sells or exchanges stock in a controlled foreign corporation or the corporation is liquidated. The principal purpose of Section 1248 is to prevent a U.S. shareholder of a controlled foreign corporation from realizing gain on its undistributed earnings at the cost only of the tax on long-term capital gains by selling its stock or liquidating the corporation.
Corporate Formations: Transfers of Appreciated Property to Foreign Corporation
When property is transferred to a corporation in exchange for stock, recognition of gain or loss is governed by Section 351 and, if gain on a transfer to a foreign corporate transferee is involved, by Section 367 as well. Under Section 351, no gain or loss is recognized 1) if property is transferred to a U.S. corporation by one or more persons solely in exchange for stock in the corporation and 2) if immediately after the exchange such person or persons are in control of the corporation. Section 351 thus may come into play whenever property with a value greater or less than its tax basis is transferred to a newly formed corporation by the initial subscribers to its stock. It may also operate to prevent recognition of gain or loss when such property is transferred to an existing corporation. However, where a transfer of property to a foreign corporation in exchange for its stock is involved, the nonrecognition of gain under Section 351 will apply only to the extent provided in Section 367.
The kinds of property most often raising the question of possible qualifications under Sections 351 and 367 are inventory, equipment depreciated below fair market value, manufacturing intangibles (for example- patents and know-how) and marketing intangibles (for example, trademarks and trade names). These intangibles often have a zero or very low basis because research and experimental costs and advertising costs have been deducted currently. Assets such as these are frequently transferred to a foreign corporation when a foreign business is established or expanded. Sometimes the existence of a transfer of appreciated property is not immediately obvious. For example, if a going sales business previously conducted by a division of a U.S. corporation is taken over by a foreign subsidiary corporation, a transfer of valuable goodwill may be involved.
Contributions to the capital of a corporation by its shareholders normally are treated as nontaxable to both the corporation and the contributing shareholder. However, when property is contributed to the capital of a foreign corporation by one or more transferors who in the aggregate own at least 80 percent of the total combined voting power of the foreign corporation’s stock, the contribution is treated for purposes of Section 367 as a constructive transfer in exchange for the corporation’s stock equal in value to the fair market value of the contributed property. See IRC Section 367(c)(2). Thus, a U.S. transferor may be taxable on any gain (i.e., fair value of the contributed property in excess of the adjusted basis of the property) realized on the constructive exchange because Section 367(a) prevents the transfer from qualifying for nonrecognition-of-gain treatment under Section 351. Moreover, to the extent provided in the regulations, Section 367(f) requires that a U.S. person’s transfer of appreciated property to a foreign corporation as paid-in surplus or a contribution to capital be treated as a fair market sale and that the gain on such sale be recognized. Unlike Section 367(c)(2), this provision applies without regard to whether the transferor or group of such transferors owns 80 percent or more of the voting stock of the transferee corporation.
Section 368(a)(1) Reorganizations for Outbound Transactions
The Internal Revenue Code provides for nonrecognition of gain or loss realized in connection with a considerable number of corporate organizational changes. These include acquisition and other reorganizations defined in Section 368(a)(1) and divisive reorganizations under Section 355. They are permitted on a tax-free basis on the rationale that they involve merely changes in the organizational forms for the conduct of business and that there should be no tax penalty imposed on formal organizational adjustments that are dictated by business considerations. Reorganizations, as defined in Section 368(a)(1), include statutory mergers and consolidations, acquisitions by one corporation of the stock or assets of another corporation, recapitalizations, changes in form or place of organization.
Section 367(a) of the Internal Revenue Code provides a general rule of taxability with respect to transfers of property in exchange for other property in transactions discussed in Sections 332, 351, 354, 356, or 361 by stating that a foreign corporation will not be considered a corporation that could qualify for nonrecognition of gain. An exchange will be tax-free only to the extent specifically provided in the Internal Revenue Code and its regulations.
Transactions subject to Section 367(a) is the acquisition of the stock or assets of a U.S. corporation in exchange for stock of a foreign corporation discussed in Section 368(a). Triangular Type A mergers, whether in the form of a forward triangular merger described in Section 368(a)(2)(D) or a reverse triangular merger described in Section 368(a)(2)(E), in which the shareholders of the acquired U.S. corporation exchange their stock in the U.S. corporation for stock in a foreign corporation, are treated as an indirect transfer of stock by the U.S. shareholders to the foreign corporation. The same analysis applies to a triangular Type B reorganization in which a U.S. person transfers stock in the acquired U.S. corporation to a U.S. subsidiary of the foreign corporation in exchange for stock of the foreign corporation. A U.S. shareholder is also deemed to make a transfer of stock of a U.S. corporation if substantially all of its assets are acquired by a U.S. subsidiary of a foreign corporation in exchange for stock of the foreign corporation in a Type C reorganization and the U.S. acquired corporation is then liquidated.
For example, let’s assume that a French corporation acquires a U.S. corporation through the merger of the French corporation’s wholly owned U.S. subsidiary into the U.S. acquired corporation in a reverse triangular merger. The shareholders of the U.S. acquired corporation exchange the stock they formerly held in that corporation for voting stock issued by the French corporation. The U.S. acquired corporation is the surviving U.S. entity. Under Section 367(a)(1), the U.S. shareholders of the U.S. acquired corporation are treated as having transferred their shares in the U.S. corporation to the French corporation in exchange for its shares. This is an outbound transaction and, unless an exception to Section 367(a) applies, the nonrecognition provisions of the Internal Revenue Code will not be available to shield the U.S. shareholders from tax on the gain realized on the disposition of their U.S. corporate stock.
Branch Loss Recapture Rules
Section 367 also applies to transfers foreign branches and imposes branch loss recapture when a U.S. person transfers certain assets to a foreign branch. Under the branch loss recapture rules, a U.S. person that transfers part or all of the assets of a foreign branch to a foreign corporation in a Section 367(a)(1) exchange must recognize as recapture gain of the previously deducted cumulative losses of the branch. A foreign branch is defined for this purpose as an integral business operation carried on by a U.S. person outside the United States. Temp. Reg. Section 1.367(a)-6T(g)(1).
The amount of gain to be recognized is the sum of the previously deducted ordinary losses and the sum of the previously deducted capital losses. These branch loss recapture rules must be separately applied to each foreign branch that a taxpayer transfers to a foreign corporation. 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.
Gain Recognition Agreements
The general rule of taxability applies to transfers of stock or securities by a U.S. person to a foreign corporation unless an exception is available. One potential exception to the Section 367(a) tax rules is a “gain recognition agreement” entered into between the transferor and the Internal Revenue Service (“IRS”). A gain recognition agreement is an agreement pursuant to which a U.S. transferor agrees to recognize gain if the transferee foreign corporation disposes of the transferred stock or securities during the term of the agreement and pay interest on any additional tax owing if a so-called “triggered event” occurs during a five-year gain-recognition period. If the transferee foreign corporation disposes of the transferred property during the five-year period in which the gain-recognition agreement is in effect, the U.S. transferor must recognize any previously unreported gain please pay an interest charge to compensate for the benefit of deferral of the U.S. tax on the unrecognized gain. If gain is triggered under the gain-recognition agreement, the U.S. transferor may file an amended return for the original year of the transfer, reporting the recognized gain and interest charge. Alternatively, the U.S. transferor may elect to report the gain, plus the interest charge, on the return for the year in which the triggering event occurs. See Treas. Reg. Section 1.367(a)-8.
Internal Revenue Code Section 367(d)
Congress recognized that transfers of manufacturing and marketing intangibles to a foreign corporation presented special problems. At one time, a U.S. taxpayer would develop intangibles and deduct the costs of such development against U.S. income. The U.S. taxpayer would then transfer the intangible to a foreign corporation for use in an active trade or business abroad tax-free. Even if a toll charge were imposed on the U.S. taxpayer at the time of transfer, it would not necessarily remedy the tax-avoidance potential inherent in these transfers. The value of the intangible at the time of transfer was often uncertain and speculative, resulting in an amount of gain recognition at the time of transfer that would not reflect the ultimate value of the intangible. To deal with these problems, special rules for intangibles were adopted by tax legislation set forth in Section 367(d) and 482. With the enactment of the Global Intangible Low-Tax Income (“GILTI”) provision many question the need for Section 367(d). Nevertheless Section 367(d) is still good law. Thus, we will discuss Section 367(d) and potential ways to mitigate Section 367(d) along with the GILTI tax regime.
Under Section 367(d), marketing and manufacturing intangibles, as broadly defined in Section 936(h)(3)(B), are treated as a special class of tainted assets. Intangible property is defined in Section 936(h)(3)(B) as any 1) patent, invention, formula, process, design, pattern or knowhow; 2) copyright, literary, musical or artistic composition; 3) trademark, trade name or brand name; 4) franchise, license or contract; 5) method, program, system, procedure, campaign , survey, study, forecast, estate, customer list or technical data, or 6) any similar item, which property has substantial value independent of the services of any individual.
In every case involving the transfer of such assets in a transaction falling within Section 351 or 361, the transferor will be treated as having sold the property in exchange for payments that are contingent on the productivity, use or exchange for payments that are contingent on the productivity, use or disposition of such property. These imputed or constructive royalty payments must reflect the amounts that would have been received annually in the form of such payments over the useful life of such property. See IRC Section 367(d)(2)(A)(ii)(I). These imputed or constructive royalty payments must reasonably reflect the amounts that would have been received annually in the form of such payments over the useful life of such property. Internal Revenue Code Section 367(d) provides that in the case of intangible property in a Section 351 or 361 exchange, the royalty income with respect to such transfer is to be commensurate with the income attributable to the intangible. This means that the constructive royalty is calculated in an amount that represents an arm’s length charge for the use of the property under the regulations of Section 482. Under certain circumstances, a U.S. transferor may transfer intangibles to a foreign corporation taxed entirely at the time of transfer as a taxable sale if certain circumstances are satisfied.
Keep the Intellectual Property Onshore and Benefit From the FDII Tax Regime
The first option to avoid Section 367(b) (and GILTI) is to take advantage of the foreign-derived intangible income (“FDII”) tax regime. A number of domestic corporations transfer intellectual property to foreign corporations as part of a modified structure. The problem with this strategy is the intellectual property transferred to the foreign subsidiary is subject to the Section 367 “toll charge.” Instead of forming a foreign corporation that would fully operate a business abroad, the U.S. domestic corporations may consider retaining their intellectual property and license the intellectual property to its foreign subsidiary in return for an actual royalty payment. Such a strategy may avoid the Section 367 “toll charge.” Instead of being subject to the “toll charge,” the U.S. domestic corporation could be subject to the FDII tax regime.
FDII is a type of income that when earned by a U.S. domestic C corporation is entitled to a deduction equal to 37.5 percent of the FDII. Because the current U.S. federal corporate income tax rate is 21 percent FDII income is subject to an effective rate of 13.125 percent (i.e., 21% * (1-37.5%) = 13.125%). The determination of the FDII deduction is a mechanical calculation that rewards a corporation that has minimal investment in tangible assets such as machinery and buildings. Specifically, FDII was designed to provide a tax benefit to income that is deemed to be generated from the exploitation of intangibles. The mechanical computation assumes that investments in tangible assets should generate a return on investment no greater than 10 percent. Thus, a corporation’s income that is eligible for the FDII deduction (“DEI”) is reduced by an amount that equals 10 percent of the corporation’s average tax basis in its tangible assets, an amount that is known as qualified business asset investment or “QBAI.”
The FDII calculation begins with computing a U.S. corporation’s DEI. DEI is a U.S. corporation’s gross income adjusted for certain items and reduced by deductions allocable to the gross income. DEI is determined by adjusting a domestic gross income to exclude subpart F income, financial services income, dividends received from controlled foreign corporations, domestic oil and gas income, foreign branch income, or GILTI.
To qualify for FDII benefits, a domestic corporation must sell property to a foreign person for foreign use. Foreign persons are non-U.S. persons, foreign governments, and international organizations. In addition to being a sale to a foreign person, the sale of general property must also be for foreign use. Intellectual property qualifies for FDII benefits. In other words, if a domestic corporation were to sell intellectual property to a foreign corporation for foreign use, the generated revenue from the sale of the intellectual property would likely qualify for FDII benefits. FDII benefits could also include a license by a U.S. corporation of intangible property to a foreign subsidiary for use outside the United States.
Consequently, rather than transferring intellectual property directly to a foreign subsidiary and being subject to the “toll charge,” a domestic corporation could license its intellectual property to a foreign subsidiary and receive a stream of royalty payment in return for its assets. The royalty payment could be taxed at beneficial FDII rates. The domestic corporation could also sell its intellectual property to its foreign subsidiary and receive a comparable payment in return for its assets. Such a transaction may still qualify for the FDII deduction. However, such a transaction may result in a somewhat different analysis.
Transfer Intellectual Property to a Foreign Partnership
The second alternative available to potentially avoid the Section 367(b) “toll charge” is to use a foreign partnership as the joint venture vehicle. Under the general principles of Internal Revenue Code Section 1001(a), a partner who contributes property to a newly formed partnership in exchange for a partnership interest would appear to realize gain or loss in an amount equal to the difference between the fair market value of the partnership interest and the adjusted basis of the transferred property. But Section 721(a) comes to the rescue in a manner closely paralleling Section 351, its corporate tax counterpart, by providing that no gain or loss shall be recognized to a partnership or to any of its partners on a “contribution of property to the partnership in exchange for an interest in the partnership.” The rationale for nonrecognition is familiar. The transfer of property to a partnership is considered to be a mere change in the form of the partner’s investment and is viewed as a business transaction that should not be impeded by the imposition of a tax.
The general rule of Section 721, equally applicable whether the contribution is to a newly formed or preexisting partnership, is accompanied by the usual corollary provisions governing basis and holding period. The principal requirement for nonrecognition under Section 721 is that “property” must be contributed in exchange for an interest in the partnership. Since there is no statutory definition of property, the courts have been guided by analogous interpretations under Section 351, which provides for nonrecognition treatment on the transfer of property to a controlled corporation in exchange for stock or securities. The term “property” is defined as money, goodwill, intangible assets, patents, and unpatented technical know-how. But “property” does not include services rendered to the partnership, and a partner who receives a partnership interest in exchange for services.
There are several other exceptions to the general rule nonrecognition rules of Section 721, including Section 721(c), which grants the Department of Treasury (“Treasury”) and the IRS the ability to promulgate regulations that override Section 721 nonrecognition rules when the contribution of appreciated property to a partnership will result in a foreign person foregoing the recognition gains of assets contributed to a partnership.
Internal Revenue Code Section 367(d)(3) states that the Treasury and the Treasury and the IRS may draft regulations that apply to deemed royalty treatment of Section 367(d)(2) to a transfer of intangible property by a U.S. person to a partnership. Section 721(d) cross-references Section 367(d)(3) for regulatory authority to treat transfers of intangible property as sales. Consequently, under Section 721(c), the Treasury and the IRS has the authority to issue regulations to terminate the Section 721(a) non recognition rules and under Section 721(d) it has authority to issue regulations to apply the deemed royalty treatment of Section 367(d)(2) to an outbound transfer of intangible property to a partnership. However, as of this date, the Treasury and the IRS has only issued temporary regulations under Section 721(c) but has not issued regulations under Section 721(d).
The temporary regulations promulgated under Section 721(c) discuss the contribution of appreciated property by a U.S. person to a partnership. The appreciated property, referred to as “Code Section 721(c) property,” is broadly defined as property other than “excluded property.” Excluded property is cash, securities, tangible property with de minimis built-in gain, and an interest in a partnership in which effectively all of its assets consist of the foregoing excluded property. As a result, Section 721(c) property includes intangible property.
Although the IRS has issued guidance under its authority to treat outbound transfers of property, including intangible property, to a partnership as taxable, the guidance covers only limited situations in which a partnership with a foreign partner is related to the U.S. transferor. As of this date, the Treasury and the IRS has not used its authority to issue guidance or regulations that override the Section 721(a) nonrecognition rule and impose a deemed royalty in the case of intangible property transferred to a partnership for use outside the U.S. This may allow a domestic corporation to form a foreign partnership (a check-the-box election should be made to treat the joint venture as a partnership for U.S. tax purposes) with a foreign corporation and in certain circumstances transfer intellectual property to the foreign partnership without realizing the Section 367 “toll charge.”
More importantly, in order to take a position that the nonrecognition rules of Section 721(a) apply in regards to a contribution of intellectual property to a foreign partnership, certain additional steps must be taken. The foreign partnership must elect to apply a method for U.S. tax purposes of allocating the built-in gain with respect to the contributed intellectual property. This is known as the “gain deferral method.” The gain deferral method ensures that partnerships will not be able to shift the tax on the built-in gain contributed property to the related foreign person and thereby escape U.S. taxation. In order to avoid an unexpected “toll charge” associated with the transfer of intellectual property to a foreign partnership, the steps discussed in the regulations must be carefully followed.
Section 6038B Reporting Requirements
So that the IRS will be informed of outbound transfers covered by Section 367, Section 6038B requires the U.S. persons involved to notify the IRS of the existence of these transactions. In order to assist the Internal Revenue Service police outbound transfers of U.S. property, a U.S. person who transfers property to a foreign corporation must attach Form 926, Return by Transferor of Property to a Foreign Corporation, to their U.S. federal tax return for the year of the transfer. The fair market value, adjusted tax basis, and gain recognition with respect to the transferred property must be disclosed on a Form 926. In addition, the taxpayer must provide a notice that a gain recognition agreement is filed with the IRS.
The penalty for a failure of a U.S. person to properly report a transfer to a foreign corporation equals to 10% of the fair market value of the property transferred. The penalty cannot exceed $100,000 unless the failure is due to an intentional disregard of the reporting rules.
There are a variety of cross-border transactions that may trigger a reporting obligation under Section 367, including:
1. Transfers of certain domestic target corporations to a foreign corporation.
2. Transfers of certain domestic and foreign securities.
3. Certain “indirect stock transfers.”
4. Distributions under a plan of reorganization to foreign corporations.
5. Transfers of property over a certain threshold to a foreign corporation.
6. Liquidations of domestic or foreign corporations into a foreign parent.
Remedies for untimely or incomplete filings
A taxpayer can potentially remedy an untimely filing of a Form 926 or an untimely gain recognition agreement filing if the failure to comply was due to “reasonable cause and not willful neglect.” If the taxpayer can demonstrate that the failure to timely file a Form 926 or timely file a gain recognition agreement to file was not willful. In order to avoid penalties under Section 6038B regarding reporting requirements, the taxpayer must go a step further and demonstrate affirmatively that the failure was due to reasonable cause.
Conclusion
In response to changing business conditions, U.S. corporations routinely organize new subsidiaries and divide, merge, and liquidate existing subsidiaries. With proper planning, these corporate adjustments may be tax-free transactions, based on the principle that the transactions involve a change in the form of the corporation’s investment. However, if the subsidiary is a foreign corporation, then the ultimate disposition of any appreciated property may occur outside the U.S. taxing jurisdiction and could be subject to a so-called toll-charge. In these cases an international tax attorney should be consulted to determine how this toll-charge could be eliminated or mitigated. In addition, to help the IRS to better police the outbound transfers of “property,” a U.S. person who transfers “property” to a foreign corporation must attach Form 926, Return by Transferor of Property to a Foreign Corporation, to their regular tax return for the year of the transfer and comply with other requirements. This reporting requirement applies to outbound transfers of both tangible and intangible property. Failure to comply with these rules may result in significant penalties. A qualified international tax attorney can advise you how to avoid these penalties.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
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.