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 same applies to U.S. corporations. 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.
Properly planned, under the Internal Revenue Code, most taxable gains realized in exchanges of appreciated property in connection with a variety of transactions involving U.S. corporations will qualify for tax-free exchange treatment. As a result of Internal Revenue Code Section 367, these tax-free exchange rules do not apply to cross border transactions. Section 367 was enacted to prevent tax-free transfers by U.S. transferors of appreciated property to foreign corporations that could then sell the property tax free. Section 367 has two basic rules. 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 provides 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.
All outbound transfers by U.S. persons of appreciated property to foreign corporations and to certain other foreign persons will give rise to recognized gain provided in Internal Revenue Code Section 367(a) and (b). This article will discuss the complexities of Sections 367 and potential planning options.
Section 367(a) of the Internal Revenue Code
Internal Revenue Code Section 367(a) requires a U.S. person transferring appreciated property to a foreign corporation to recognize a gain on the transfer. The transaction subject to Section 367(a) that is most commonly encountered is probably a transfer of property to a foreign corporation in exchange for its stock under Internal Revenue Code Section 351. A liquidation of an 80-percent owned U.S. subsidiary into its foreign parent corporation is also encompassed by the terms of Section 367(a) but specifically dealt with in Section 367(e)(2).
Other transactions that less obviously involve outbound transfers of property are also subject to Section 367(a). Acquisition of the stock or assets of a U.S. corporation in exchange for stock of a foreign corporation in a reorganization described in Section 368(a) is normally within the scope of Section 367(a). Triangular Type A mergers, whether in the form of a forward triangular merger described in Section 368(a)(2)(E), in which the shareholder 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. shareholder 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.
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.
Of the aforementioned three prong tests such, the element most subject to abuse is the “trade or business” requirement. A foreign corporation conducts a “trade or business” outside the U.S. only if its officers and employees “carry out substantial managerial and operational activities.” This requirement may be met even though independent contractors carry out “incidental activities” of the trade or business on behalf of the foreign corporation. However, only the activities of the foreign corporation’s officers and employees are taken into account in determining whether the corporation’s officers and employees perform substantial managerial and operational activities. To meet the requirement that the trade or business be actively conducted outside the United States, “the primary managerial and operational activities of the trade or business must be conducted outside the United States and immediately after the transfer the transferred assets must be located outside the United States.”
To meet the requirement that the trade or business be actively conducted outside the United States, “the primary managerial and operational activities of the trade or business must be conducted outside the U.S. and immediately after the transfer the transferred assets must be located outside the United States.” The regulations further explain this as a requirement that substantially all the transferred assets be located outside the United States, not that every item of transferred property be used outside of the United States.”
Property is treated as used or held for use in a foreign corporation’s trade or business if it is:
1) Held for the principal purpose of promoting the present conduct of the trade or business;
2) Acquired and held in the ordinary trade or business; or
3) Held in a direct relationship to the trade or business.
The regulations treat property as held in a direct relationship to a trade or business if it is held to meet the present needs of the trade or business and not its future needs.
Internal Revenue Code Section 367(a) also imposes a tax or toll charge on the income realized on transfers of certain tainted assets even though they will be used in the active conduct of a foreign trade or business. Categories of tainted assets under Section 367(a) include 1) property described in Section 1221(a)(1) or 1221(a)(3) – relating to inventory and certain narrowly defined intellectual property (i.e., a copyright held by the creator of work); 2) installment obligations, accounts receivable or similar property to the extent that the taxpayer has not previously included the principal amount in income; 3) property with respect to which the transferor is a lesser at the time of the transfer, unless the transferred was the lessee; 4) foreign currency and other property denominated in foreign currency; and 5) depreciable property to the extent that gain reflects depreciation deductions that have been taken against U.S.-source income. Recapture gain is required as ordinary income on the transfer of depreciable property used in the United States to the extent that depreciation deductions previously claimed by the taxpayer with respect to the transferred property would be recaptured if the property were sold.
The regulations provide an exception to Section 367(a). The drafters at the Department of Treasury and the Internal Revenue Service recognized that when an outbound transfer of shares occurs and the owners of the U.S. corporation whose shares are transferred are minority shareholders, the Section 367(a) outbound toll charge should not apply because there is little chance for abuse. As a result, a “limited-interest” exception provision under Treasury Regulation Section 1.367(a)-3(c) was added to the regulations. A limited-interest exception provides for the nonrecognition of gain on the transfer of U.S. shares to a transferee foreign corporation provided five tests are met:
1) The U.S. transferor receive 50 percent or less of the shares of the transferred foreign corporation in the exchange;
2) There is not a control group of U.S. persons with respect to the transferee foreign corporation immediately after the transfer. Under this control group test, officers, directors, and 5 percent or greater shareholders of the domestic corporation may not, in the aggregate, own more than 50 percent of the voting power or value of the transferred foreign corporation immediately after the transfer;
3) The transaction satisfies the active trade or business test, which is comprised of two parts, both of which must be satisfied: i) The transferred foreign corporation has engaged in an active trade or business outside the United States for 36 months; and ii) At the time of the exchange, neither the transferor nor the transferred foreign corporation intend to discontinue or dispose of the trade or business.
4) A U.S. transferor who owns 5 percent or more of the transferred foreign corporation immediately after the exchange must enter into a five-year gain recognition agreement. See Treas. Reg. Section 1.367(a)-8. Under the gain recognition agreement, the U.S. transferor must recognize any gain deferred on the initial transfer if the transferred foreign corporation disposes of the transferred shares within five years and
5) The value of the transferred foreign corporation is, at the time of the exchange, equal to or greater than the value of the domestic corporation.
For purposes of determining the ownership of stock, securities or other property in applying these requirements, the constructive ownership rules of Internal Revenue Code Section 318, as modified by Internal Revenue Code Section 958 apply.
If the active foreign business use exception cannot be utilized, the limited-interest rule offers the tax planner a way to minimize or eliminate the U.S. burden associated with shifting appreciated assets offshore. However, the analysis does not end here. Section 367(b) must also be considered. We will next discuss the impact of Section 367(b) on cross border transactions.
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.
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.
Actual Royalties Under License Agreement as Alternative to Constructive Royalty Treatment Under Section 367(d)
As an alternative to constructive royalties under Section 367(d) of the Internal Revenue Code, a U.S. transferor may prefer to enter into a license agreement with the transferred foreign corporation providing for actual royalties to the transferor for the use of the intangible. The U.S. tax treatment of actual and constructive royalties may qualify for favorable rates under the foreign derived intangible income (“FDII”) tax regime of merely 13.125%. On the foreign side, the actual royalty may be deductible for foreign tax purposes.
Foreign Reporting Requirements
Transfers of U.S. property to a foreign corporation requires the filing of a Form 926 with the Internal Revenue Service. 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 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.
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: 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.