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IRS releases guidance on outbound transfers of intangible property
October 2022
In brief
The IRS released an internal Advice Memorandum (AM 2022-003 or the ‘AM’) on September 23, concluding that a transferee foreign corporation (‘FC’) may prepay annual Section 367(d) income inclusions (‘annual Section 367(d) inclusions’, colloquially referred to as ‘Section 367(d) deemed royalties’) when it transfers “money or other property” (‘boot’) in connection with a Section 351 transfer of intangible property subject to Section 367(d), but not in other situations. Therefore, the AM takes the position that FC may not prepay annual Section 367(d) inclusions after the initial transfer has occurred.
Observation: The memorandum represents the first time the IRS has addressed prepayments (advance payments) of annual Section 367(d) inclusions made after the initial outbound transfer. The conclusion of the AM is consistent with prior nonbinding guidance regarding such advance payments made in the initial Section 351 transfer involving boot.
Action Item: While Advice Memoranda are not binding on taxpayers and cannot be used or cited as precedent, companies should evaluate the IRS reasoning in the AM in connection with advance payments and Section 367(d).
The AM addresses whether Section 367(d) permits advance payments of annual Section 367(d) inclusions. In reaching its conclusion, the IRS analyzes the following example.
Example in AM
In AM 2022-003, USP is a domestic corporation that transfers intangible property with a useful life of 10 years to FC, a transferee foreign corporation, solely for FC stock in a Section 351(a) exchange in Year 1. USP takes into account annual Section 367(d) inclusions for Years 1 to 3 in an amount commensurate with the income attributable to the intangibles. Section 367(d) regulations permit, but do not require, FC to make actual payments for the inclusions; FC did not pay cash during Years 1 and 2. For those years, USP established accounts receivable for the unpaid inclusions pursuant to Temp. Reg. Sec. 1.367(d)-1T(g)(1) (‘Section 367(d) receivables’).
In Year 3, the taxpayer intends to accelerate its annual Section 367(d) inclusions for all future years. To that end, FC pays USP an amount that includes (1) a repayment of the Section 367(d) receivables attributable to Years 1 and 2, (2) a payment for the current annual Section 367(d) inclusion for Year 3, and (3) an advance payment of annual Section 367(d) inclusions for Year 4 and other future years.
Observation: The AM provides new insight on the IRS’s position regarding the portion of the Year 3 payment attributable to Year 4 and future years.
Background
When a US person transfers intangible property to an FC in a Section 351 or 361 exchange, the transferor is treated under Section 367(d) as having sold that property in exchange for annual payments that are contingent on the productivity, use, or disposition thereof, i.e., annual Section 367(d) inclusions. The US transferor takes into account annual Section 367(d) inclusions over the useful life of the intangible, commensurate with the income attributable thereto.[i]
The statute does not indicate whether FC is permitted or required to make actual payments or advance payments for the annual Section 367(d) inclusions. The Section 367(d) regulations permit, but do not require, FC to pay for the annual Section 367(d) inclusions for the current tax year and previous tax years for which a Section 367(d) receivable remains outstanding. The regulations do not address advance payments.
The amount of the annual Section 367(d) inclusion corresponds to the annual exploitation in the hands of the foreign transferee throughout the useful life of the transferred intangible property. Outside the context of boot received in an initial exchange, the AM states that any prepayments intended to be made against the annual inclusion amount “would undercut the fundamental connection” between the form of payment and the associated annual income inclusions and, therefore, are to be analyzed under general tax principles (e.g., potentially treated as a distribution of property with respect to the transferee corporation’s stock and subject to the rules that apply to such distributions). The AM states that, without facts to the contrary, the portion of the Year 3 payment intended to be an advance payment of Section 367(d) inclusions for Year 4 and forward is treated as a distribution by FC with respect to its stock to USP.
The remaining portion of the Year 3 payment, relating to income that USP already included in Years 1 through 3, does not lead to further US federal income tax consequences.
Aside from the situation described below, the AM states that “the only basis for permitting an advance payment of annual section 367(d) inclusions must therefore arise exclusively from section 367(d) and the section 367(d) regulations. However, neither section 367(d) nor the section 367(d) regulations give effect to advance payments… Thus, there is no basis for accelerating the annual section 367(d) inclusions.” The IRS also cites “significant administrative concerns” among the policy considerations for not allowing a FC to prepay annual inclusion amounts.[ii]
[i] In the case of certain direct or indirect dispositions of the intangible property following an initial exchange, the transferor includes in income the amount that reasonably reflects the amount that would have been received at the time of that subsequent disposition. See Section 367(d)(2)(A)(ii)(II) and Temp. Reg. Sec. 1.367(d)-1T(d) through (f).
[ii] To further support its conclusion, the AM distinguishes a Section 367(d) transfer from advance payments involving a licensing agreement and a contingent sale governed by Section 453.
Notice 2012-39
AM 2022-003 concludes that an advance payment of annual Section 367(d) inclusions is not permitted when the payment occurs after the initial outbound transfer of the intangibles. As described below, AM 2022-003 states that its conclusion is not inconsistent with Notice 2012-39, which reaches a different conclusion on advance payments of annual Section 367(d) inclusion amounts in an initial exchange involving boot in an outbound asset reorganization.
While the 2012 Notice addresses advance payments in an outbound asset reorganization rather than a Section 351 exchange, the AM states that the approach taken in the Notice is appropriate at the time of the initial Section 351 exchange.
Observation: Although Section 367(d) and the regulations thereunder do not provide a rule for advance payments, the AM is the IRS’s fourth piece of guidance permitting such advance payments in an outbound Section 351 exchange in which boot is received. See PLR 200845044, CCA 200610019, and 1990 IRS NSAR 8126.
In AM 2022-003, the IRS discusses Notice 2012-39, which concludes that an allocable portion of boot received in an outbound asset reorganization subject to both Section 367(d) and Section 361(b) is taken into account as a prepayment against annual Section 367(d) inclusions. The AM also acknowledges CCA 200610019, which arrives at a similar conclusion where boot is received in an initial transfer subject to both Section 367(d) and Section 351(b). AM 2022-003 states that an initial Section 367(d) transfer is factually and legally distinct from advance payments of annual inclusion amounts, with differing underlying policy concerns.
Observations:
AM 2022-003 provides useful guidance as to IRS thinking in the context of Section 367(d) prepayments. In addition to setting forth the IRS’s arguments for disapproving prepayments outside of initial transfers with boot, the AM appears to confirm the conclusions in prior guidance allowing for such prepayments if made in connection with an initial Section 351 transfer that includes boot.
The AM does not address several other questions that often arise in the context of Section 367(d) prepayments and such transfers generally due to the lack of updated regulations and binding administrative guidance. Examples of such issues that remain include the consequence of outbounding intangible property with substantial basis, basis consequences to the transferee corporation, the timing of deductions for the transferee corporation in the limited circumstances where prepayments are allowed, and the scope of Section 367(d) in light of the revised definition of intangible property.
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