United States | Proposed regulations would turn off IRC Section 367(d) following certain repatriations of IP

• The proposed regulations include a taxpayer-favorable rule that would remove a significant disincentive to repatriating previously "outbounded IP."
  
  
• Taxpayers evaluating whether to repatriate IP subject to IRC Section 367(d) are encouraged to consider whether the proposed regulations would present a repatriation opportunity that simplifies their operating model and aligns IP ownership with the functions and employees associated with the IP.
  
  

In proposed regulations (REG-124064-19; Proposed Regulations) released 2 May 2023, the United States (US) Department of Treasury (Treasury) and the Internal Revenue Service (IRS) would apply new rules to "repatriations" of intangible property (IP) subject to IRC Section 367(d). In certain circumstances, the Proposed Regulations would permit the annual inclusions that IRC Section 367(d) and its regulations require to cease. The Proposed Regulations would be effective only for IP repatriations occurring on or after the date on which the final regulations are published. Comments on the Proposed Regulations must be received by 3 July 2023.

Detailed discussion

Background

Original outbound transfer

IRC Section 367(d) applies when a US person transfers IP to a transferee foreign corporation (TFC) in an exchange under IRC Section 351 or 361 (original outbound transfer). In the simplest case, the US transferor continues to own the TFC's stock over the IP's remaining useful life (outbounded IP), and the TFC continues to own the outbounded IP. In that case, IRC Section 367(d) and its regulations (IRC Section 367(d)) require the US transferor to include in income annually an amount (annual inclusion) that is commensurate with the income that the TFC earns using the outbounded IP. For each annual inclusion, the TFC reduces its earnings and profits (E&P) by an equal amount and may treat the annual inclusion as an "expense . . . properly allocated and apportioned to gross income subject to subpart F" (required TFC adjustments). This can include GILTI tested income.

Subsequent transfers of TFC stock or outbounded IP

Over the outbounded IP's useful life, the US transferor will often transfer shares of the TFC's stock, or the TFC will transfer the outbounded IP. The consequences of these events under IRC Section 367(d) depend on the form of the transfer and the identity of the transferee.

For example, the TFC might transfer the outbounded IP to a person that is not related to the TFC (with "related" defined for purposes of IRC Section 367(d) as encompassing an ownership connection as low as 10%). In that event, the US transferor must include in income an amount (disposition gain amount) that approximates the gain, if any, that the US transferor would have recognized on the IP transfer if the US transferor had not undertaken the original outbound transfer. The disposition gain amount equals the excess, if any, of the fair market value (FMV) of the outbounded IP at the time of its transfer over the US transferor's basis in the IP at the time of the original outbound transfer (original basis). The TFC's E&P is reduced by the disposition gain amount.

If, in contrast, the transferee of shares of TFC stock or the outbounded IP is a related person, annual inclusions and required TFC adjustments generally continue, but with one or more "successor" US transferors or TFCs.

• On the one hand, if the US transferor (original US transferor) transfers shares of the TFC stock to a related US person, the transferee (successor US transferor) thereby becomes obligated annually to report in income a portion of the annual inclusion (in lieu of the original US transferor) that is proportionate to amount of the TFC stock that it acquired. (Hereinafter, "US transferor" as of a particular date refers to the person or persons then required to take annual inclusions into income, whether the original US transferor or successor US transferors.)
  
  
• On the other hand, IRC Section 367(d) treats a person that is related to the TFC and acquires the outbounded IP from the TFC as if it were the original TFC (successor TFC) "for purposes of any required [TFC] adjustments" — even, apparently, if it is neither a foreign person nor a corporation. (Similarly, hereinafter, "TFC" as of a particular date refers to the person then treated as the original TFC for purposes of the required TFC adjustments.)

Suppose that X, a US person, had transferred IP to a TFC in an exchange under IRC Section 351 or 361. Suppose further that, several years later but within the IP's useful life, the TFC "repatriated" the IP by transferring it to a related US corporation, Y. Y then used the IP, earning $100 from it each year. The TFC's transfer of the IP to Y, a related person, would not relieve X of continued annual inclusions (for example, $100 each year). Yet, for each annual inclusion, Y might only be permitted a deduction properly allocated and apportioned to gross income that is subject to subpart F — which, as a US corporation, it would not have. Each year, the aggregate result for X and Y would be $200 of gross income subject to US federal income taxation, notwithstanding that their aggregate economic gross income would total only $100. In the Preamble to the Proposed Regulations, Treasury and the IRS acknowledged that this would be "excessive taxation." Moreover, according to Treasury and the IRS, even if both X and Y were US corporations and members of the same consolidated group, the "matching rule" in Treas. Reg. Section 1.1502-13(c) would not automatically redetermine X's gross income to exclude the annual inclusions of $100. Instead, the consolidated group would need to obtain discretionary relief via a private letter ruling from the IRS. Regardless of whether a private letter ruling is actually needed in the consolidated group context, it would be prudent to seek a ruling where possible.

Reporting requirement

The original US transferor of outbounded IP must report certain information about the original outbound transfer and any subsequent transfer of TFC stock or the outbounded IP. The information is reported on a statement attached to Form 926, "Return by a U.S. Transferor of Property to a Foreign Corporation," which is attached to the original US transferor's income tax return for the tax year that includes the date of the applicable transfer. A failure to report the information, however, does not affect how IRC Section 367(d) operates.

Proposed Regulations

Termination Rule

The Proposed Regulations would modify the subsequent transfer rules to terminate continuing annual inclusions if two conditions are met:

• The TFC repatriated the outbounded IP to a "qualified domestic person"
  
  
• The original US transferor complied with certain reporting requirements
   

The form of the IP repatriation, including the recognition of gain or loss, would not affect the applicability of this rule (Termination Rule).

For particular outbounded IP, the following persons would be a qualified domestic person (QDP):

• The original US transferor
  
  
• A successor US transferor that is either an individual or a corporation subject to US federal income tax
  
  
• A US person that is either an individual or a corporation subject to US federal income tax and that is related to a person described in (a) or (b)
   

An important caveat for transactions "related" to an otherwise qualifying IP repatriation: If outbounded IP were initially repatriated to a US person, but that US person later transferred the IP to another person in a related transaction, the US person could not be a QDP unless the IP's ultimate acquirer (taking into account all related transactions) were also a QDP.

The Termination Rule would not apply to an otherwise qualifying IP repatriation — and annual inclusions would continue to be required — unless the original US transferor reported certain information about the repatriation. This information would include the original US transferor's original basis in the outbounded IP, a copy of the Form 926 that the original US transferor filed for the original outbound transfer, and the QDP's name, address, and taxpayer identification number. Relief for a failure to report the information would be available, however, if the original US transferor promptly provided the information upon becoming aware of the failure.

Ancillary consequences of an IP repatriation

The Proposed Regulations would also address certain ancillary consequences of an IP repatriation (whether or not the Termination Rule applies). They include:

• The amount of gain required to be recognized by a US transferor
  
  
• The basis that the QDP takes in the repatriated IP
  
  
• Adjustments to the E&P of the TFC

This Alert describes in detail the first two of these three ancillary consequences.

Gain required to be recognized

Upon an IP repatriation, the US transferor might be required to recognize gain on the IP (whether or not the Termination Rule applies). The amount of gain required to be recognized, if any, would depend on whether the repatriated IP were "transferred basis property" to the QDP by reason of the repatriation. Transferred basis property is, in general, property whose basis is determined (in whole or in part) by reference to the transferor's basis. Repatriated IP would generally be transferred basis property if it had been repatriated in a nonrecognition transaction (even one including boot); if repatriated in a fully taxable transaction, in contrast, the IP would not be transferred basis property.

If the repatriated IP were transferred basis property, the amount of gain (if any) to be recognized would equal the gain (if any) that the TFC would have recognized in the IP repatriation if its adjusted basis in the IP had been the original US transferor's original basis in the outbounded IP. Accordingly, if outbounded IP were repatriated by way of a complete liquidation under IRC Section 332, the US transferor would not be required to recognize any gain because the TFC would not recognize any gain (whatever its basis in the IP) under IRC Section 337. In contrast, consider a repatriation accomplished through a nonrecognition transaction with boot, such as an exchange described in IRC Section 351(b). In theory, the TFC might not have actually recognized any gain in the IP repatriation — due to its actual basis in the outbounded IP — but would have if it had the US transferor's original basis in the IP. In that case, the US transferor would be required to recognize gain.

If the repatriated IP were not transferred basis property — because, for example, the TFC distributed the outbounded IP to the QDP with respect to its stock, recognizing gain under IRC Section 311(b) — the amount of gain (if any) required to be recognized would equal the excess, if any, of the FMV of the IP at the time of its repatriation over the original US transferor's original basis in the outbounded IP.

QDP's basis in repatriated IP

The QDP's basis in the repatriated IP similarly would depend on whether the repatriated IP were transferred basis property. If it were, the QDP's basis in the IP would generally equal:

• The lesser of (a) the original US transferor's original basis in the outbounded IP or (b) the TFC's adjusted basis in the IP immediately before the repatriation increased by
  
  
• The greater of (a) the gain (if any) recognized by the original US transferor in the IP repatriation or (b) the gain (if any) recognized by the TFC in the repatriation
   

If the repatriated IP were not transferred basis property, the QDP's basis in the IP would equal the FMV of the IP as of the date of the repatriation.

Other changes

Finally, the Proposed Regulations would amend or add provisions that apply regardless of whether the outbounded IP is repatriated. Perhaps most significantly, the Proposed Regulations would "clarify" that each annual inclusion results in an allowable deduction to a TFC, which is properly allocated and apportioned to the "appropriate" classes of its gross income in accordance with certain provisions, "as applicable" — rather than solely to gross income that is subject to subpart F in all circumstances. Even if the Termination Rule did not apply to a TFC's transfer of outbounded IP to a related US person, the related US person apparently could deduct an amount equal to each annual inclusion. As a result, "excessive taxation" might be minimized or eliminated.

Disregarded transfers of IP under Treas. Reg. Section 1.904-4(f)

The Proposed Regulations include an ancillary provision under Treas. Reg. Section 1.904-4(f). That subsection defines "foreign branch income" for purposes of the foreign tax credit rules. Other rules, however, incorporate Treas. Reg. Section 1.904-4(f) by cross-reference. Treas. Reg. Section 1.904-4(f)(2)(iv)(D) generally provides that the principles of IRC Sections 367(d) and 482 apply to adjust foreign branch income when IP (which need not be outbounded IP) is transferred in a disregarded transaction to or from a foreign branch. The Proposed Regulations effectively would preclude the principles of IRC Section 367(d) from encompassing the Termination Rule. Specifically, each transfer of IP to or from a foreign branch would need to be considered independently of any preceding or subsequent transfer.

Implications

The coming implementation of the Pillar Two GloBE Rules, as approved by the OECD Inclusive Framework on Base Erosion and Profit Shifting (BEPS), is causing many companies to re-evaluate their operating models for owning and using IP. With the US corporate tax rate at a globally competitive 21% and the potential for lower effective tax rates under IRC Section 250, many US companies have an incentive to simplify their operating models by repatriating IP. Uncertainty around the consequences of repatriating outbounded IP subject to IRC Section 367(d) complicates any re-evaluation of operating models in light of global developments.

The Termination Rule would be a taxpayer-favorable rule removing a significant disincentive to repatriating previously outbounded IP. Taxpayers that have previously considered repatriating IP that is subject to annual inclusions under IRC Section 367(d) have encountered ambiguity and possible "excessive taxation" caused by the current regulations. While the Proposed Regulations are not "reliance regulations," and therefore may only be applied if finalized, taxpayers with outbounded IP should start re-evaluating IP operating models in light of BEPS and the Proposed Regulations. Taxpayers considering whether to repatriate IP subject to IRC Section 367(d) are encouraged to consider whether the Termination Rule would present a repatriation opportunity that simplifies the operating model and aligns IP ownership with the functions and employees associated with the IP.

For additional information with respect to this Alert, please contact the following:

International Tax & Transaction Services

• Craig Hillier
  
  
• Colleen O’Neill
  
  
• Allen Stenger
  
  
• Martin Milner
  
  
• Adam Becker
   

Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor

For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.